“A customer’s price ceiling isn’t set by the value you deliver. It’s set by their perception of the value you deliver.” – Dan Adams, AIM Institute Founder & President
In long-standing research published in Harvard Business Review based on the economics of 2,463 companies, pricing experts Michael V. Marn and Robert L. Rosiello demonstrated that a 1% improvement in price resulted in an 11.1% increase in operating profit.
Although their research dates from 1992, more recent research has corroborated their results.
The reason is simple. Unlike other levers like acquisition or retention, pricing has a direct impact on profitability.
Charge more, earn more. Profits.
Yet, ProfitWell found that, on average, businesses spend less than ten hours per year working on their pricing strategy.
The reason for this is simple. Price setting and optimization doesn’t have a natural home in organizations.
Sometimes pricing and pricing research are the responsibility of marketing, sometimes it’s finance, and sometimes it’s sales. Everyone has an opinion on this topic, which makes making real progress difficult.
As general benchmarks, if more than 10% of your users leave for pricing reasons (churn/cancellation), or if less than 15% of your revenue comes from expansion, then your pricing probably needs some work.
Getting pricing right first means making sure that you price for value, not cost. Don’t base your pricing on what competitors are doing. And definitely don’t base it on guesswork.
Why Pricing Research is Challenging
There are two key challenges associated with analyzing and iterating pricing:
- You need stable product value: For this reason, it’s usually best to hold off on optimizing pricing until you have reached product-market fit and have a good understanding of your unit economics.
- Evaluation cycles can be long (especially for subscription-based businesses): You need to factor in seasonality and full subscription cycles if you want to understand the impact of any changes that you make.
Pricing is not an absolute. The market that you’re in, your packaging, and your pitch all impact perceived value and willingness to pay.
To optimize your price point(s), it’s a good idea first to try to understand price sensitivity—how much the market is willing to pay for your product.
How to Evaluate Price Sensitivity
Price sensitivity tends to be a range rather than a single value.
The best way to evaluate price sensitivity is by using the Price Sensitivity Meter (PSM), which was introduced by Dutch economist Peter van Westendorp in 1976.
You can run this survey with both prospects and customers. It can be useful to capture more information from respondents (e.g. roles, personas, subscription plans, etc), as this will help to refine your segmentation later on.
The four questions of the survey are:
- At what price would you consider the product to be so expensive that you would not consider buying it? This first question points to a price point that’s too expensive for the customer.
- At what price would you consider the product to be priced so low that you would feel the quality couldn’t be very good? The second question points to a price point that is too cheap for the customer.
- At what price would you consider the product starting to get expensive, so that it is not out of the question, but you would have to give some thought to buying it? The third question gives you a price point at the high end of acceptable prices.
- At what price would you consider the product to be a bargain—a great buy for the money? The fourth question gives you the low end of the range of acceptable prices.
You can either use open-ended questions and let respondents fill in amounts, or you can ask them to select values from a range. It’s important to ask the questions in this sequence.
The first two questions force respondents to anchor themselves to an acceptable price range, while the last two help to narrow down answers around an optimal price range.
Analyzing Data from Your Pricing Research
Once a statistically significant number of people has answered these four questions, you can start plotting the answers on a chart, so that you can determine the optimal price band and find the optimal price point.
Van Westendorp survey results are usually plotted on a chart that combines all four data points. The section at the center of the chart represents the range of acceptable price points:
The intersection of the ‘Too cheap’ and ‘Too expensive’ lines—the point of marginal expensiveness—is often the optimal price point.
As pricing expert Madhavan Ramanujam says: “An acceptable price is the price that people are super comfortable paying. No friction, they just love your pricing because it’s a steal. If you’re pricing for growth, maybe you can price in the acceptable area. Expensive is the price that they would actually pay you, but they don’t like it. Neither do they hate it, but it’s the price usually that’s aligned with value. The prohibitively expensive is the price that they’ll pretty much be laughing you out of the room. Asking that question gives you some sense of where you can actually be someday, but not at the moment.”
You can also use the PSM to evaluate the perceived value of certain features—by comparing the price points given by participants when you include (or remove) certain features from product packaging.
Slice and dice any changes you make. You should introduce any pricing changes through an A/B test so that you can compare the conversion rates (the percentage of buyers), revenue (customer lifetime value and revenue), and churn rates (the percentage of churners) associated with pricing changes that you have made.
Pricing Experiments to Consider
As you experiment and learn from pricing, you should also consider experimenting with:
- payment cycles (one-time, monthly, quarterly, yearly, etc);
- price plans (up to five plans, more plans often mean more money);
- segmentation (per-seat, per feature set, per persona, etc); and
- discounting based on longer commitments.
Pricing is an important lever. Do the research, experiment, and improve profitability.
This post in an excerpt from Solving Product. If you enjoyed the content, you'll love the new book. You can download the first 3 chapters here →.