Why can Apple charge twice as much for its tablet computers, although it has many competitors? Why can’t other tablet computer manufacturers sell products for as much as the iPad? Just how much can you add to the price for a brand name?
As an entrepreneur or a web professional, you have to determine a price somewhere between what your market is willing to pay and what is necessary for you to produce and sell your product. This is best done through A/B testing, today’s successor to trial and error.
Pricing models: out with the old, in with the new
There are certain time-honored rules of thumb, but they mostly apply to older industries.
- In retail there is “keystoning,” or doubling the price of a product you buy from a manufacturer and sell in a store.
- In consulting, it’s common to charge your clients an hourly rate three times what you pay your junior consultants.
- For products that go through a distribution channel, it is four times the manufacturing cost.
- In a construction project, it is time and materials plus an agreed-on profit percentage.
These traditional pricing models were used to account for direct and indirect overhead in making a product and getting it to market. The simplest, “cost plus” pricing calculated the cost to produce the product and added a percentage for profit to arrive at the selling price.
Unfortunately, this method leaves out the buyer, who might not be willing to pay the price or might be willing to pay twice as much for a great product in short supply. At the root of it all is supply and demand, which is why airplane seats can cost more one day than the next and why concerts can sell out.
Online commerce has removed much of the difficulty of getting products to market. Buyers know this. They expect things to cost less.
These traditional and imperfect models are slowly going out the window as more and more products and services are sold online. Where, for example, is the overhead at Amazon, where there’s no lease and no employees?
Not your father’s brick-and-mortar product
Products themselves have become bits instead of atoms. Web applications aren’t like airplane seats, nor are they like concerts. There is no scarcity of either designs or designers, so what does a site cost to produce? What is a developer’s time worth? Is the programmer the analog to the cost of goods sold?
Try, for a moment, to imagine the services of a trader at a big bank, a guy who moves billions of dollars in “paper” from counterparty to counterparty. As we all know, he “makes” nothing real. And yet his product makes other people money.
In recent years, pricing has increasingly moved from static to dynamic as well: Today homes are sold at auction, used cars are sold on eBay, and all products appear to be sold at a discount or on sale.
Prices are rarely fixed anymore; often they are negotiable.
How to price products you can’t put a finger on
The final step in pricing complexity is when your product itself is intangible: a social network, big data, an iPhone app to tell you what time the neighborhood movie starts.
For a startup team, especially one with an intangible product, it’s tempting to shortcut how to price products and give it away simply to get customers. After all, that’s what Twitter, Facebook and Google do. But that’s a very dangerous model for the long term.
Very few businesses reach the scale of Twitter, Facebook or Snapchat and can attract advertisers. And advertising is troublesome enough lately that many sites have switched away from it at least partly, resorting to subscriptions, paywalls and eCommerce. (Right now, for example, Facebook is doing well monetizing through advertising, but Twitter is not.)
Free (for a small price)
Another common business model is “freemium,” in which a certain amount of the product (think of storage for New York Times articles) or a limited feature set is offered free, but the full product requires payment. If you choose this model, remember that only about 10 percent of your audience will convert to the paid product and that product will have to have much more than 10 percent more value.
Just keep testing
The best way to figure out how to price your product is to back into the decision, test and repeat. If you are selling a service, you can pick an hourly rate common in your industry and A/B test up or down to see what customers will pay. It does require a great deal of discussion, some of it with an accountant who can make you aware of what your true costs are. Once you determine your costs, when you begin to sell, you should price your product at what the market will bear — not below just to acquire customers. The race to the bottom can be very fast, and you don’t want to win it.