How to Guarantee Your Pricing Model Is Accurate Using Economic Theory

How you react to this one question will determine whether you’re going to be successful in business or not. Don’t screw this up. “How much should you charge for your product?”

The biggest mistake you can make is to charge too little, meaning inadequate cash flow to support the business and a nice wait in the unemployment line. To which you’d say “No problem, I’ll just charge more!” Wrong again.

Charge too much, and you’ll say goodbye to many customers, or you won’t ever get to say hello to them in the first place. If that’s the case, you can at least look forward to the continued friendship and frequent hangouts with those you meet in that unemployment line.

Fortunately, with a little economic theory learned by Joel Spolsky in his popular post, Camels and Rubber Duckies, we can help determine an accurate pricing model that will keep you in business. Let’s break down a full blown strategy to develop a pricing model that not only works, but drives ROI.

Understanding Economic Theory

Establishing Your Starting Price:

To get started, let’s build some ground knowledge on pricing and economic theory. We’ll look at local Letterpress shop, 26 Press, to evaluate pricing. Their lowest priced wedding invitation comes at a cost of $600. Let’s just use this as an estimated starting point comparative to other competitors who range from $350 to $1000. One more assumption for the sake of analysis: charging $600 gets you 100 customers.

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So, to relate to your own personal products, find the average number of sales you’ve made for a product at its current price. That will represent the starting point above.

What Happens When You Raise the Price?

Imagine if we raised the price of the wedding invitations to $800? Logic indicates that some customers will find this price hike too high, so they will drop out. And if there were already some who thought the $600 price was too steep, then they certainly won’t convert on a higher one. But our hypothesis is if 100 people bought at $600, then we’ll have less customers at the higher prices. Roughly around 75.

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What Happens When You Lower The Price?

Let’s take the same scenario as before, only we lower the price this time to $400. That means everyone who bought the wedding invitations at the higher prices will have a conversion of 100% and will probably attract many more that think this lower price point is an appropriate value. Naturally, this means more wedding invitations will be sold. We’ll assume that means 140 sales at $400.

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React: Now you should be getting the idea as a basis. Continue to build out assumptions based on price (or from your historical pricing data), and you’ll start to recognize something special — adownward sloping curve. The higher the price, the lower the sales and the lower the price, the higher number of sales.

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Your Takeaway: Choose any price between the numbers tested, and you’ll be able to tell how many people will buy your software at that price.

Now that we have a solid understanding of economic theory, we can further evaluate a more optimal pricing strategy for our products. We’re still not ready to make any decision, but at least we have a better idea of where we stand in terms of price and units sold. However, none of this accounts for a very important factor: profitability.

Factoring Profitability Into the Pricing Model

With a better grasp on how many units we’re likely to sell at a given price, analysing profitability by investing our cost of goods sold (COGS) is our next step. For 26 Press, there are the costs of paper and ink to create the “unit” – separate from any design hours spent. Per invitation, that incremental cost is relatively large, about $150 for the COGS.

Now we can calculate our profit per unit. If each unit costs $150, we simply subtract it from the sales price to determine its profitability. To determine the overall success of your campaign, you would simply multiply that price by the quantity you sold.

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As you can see in the table above, the ideal price appears to be drastically different. Interestingly enough, choosing the price point that allows the most sales actually puts them in the negative, and pricing at slightly above the market means they could potentially miss out on increasing their profits by 261% just by changing price points.

What We’ve Been Waiting For… The Perfect Price

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It’s been a long time coming, but after all that heavy data lifting, we’re a lot closer to recognizing an ideal price for a product. At least, if you haven’t been following along, then our nice letterpress company definitely is.

In the graph above, we’ve illustrated the total profits in relation to price and thrown a trend-line into the mix. Pricing couldn’t be more straightforward — you can almost visualize the price that will generate the most money. All that’s left to do is draw a line from the top on down, and you’ll figure it out.

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Pricing isn’t Black and White:

Before our final conclusion that $835 is the optimal price, let’s take a step back. Our goal is to maximize profits by choosing the perfect price. But often, ecommerce marketers make assumptions about pricing that aren’t necessarily true. It’s crucial to break away from these assumptions that a pricing model should rely on a singular set price.

One of the most common mistakes in pricing is believing that there is some majestic, magical price that extracts maximum revenue from every single customer. What about all of the lost earning potential from those 10 customers that would have paid upwards of $1500 for custom wedding invitations? And don’t forget the customers that were willing to pay $220 for wedding invitations and dropped off at anything more. Even though $220 is a small price for a service, they still contributed a nice $70 to the profit margin at the end of the day. The official term for all the money those high paying customers are saving is called consumer surplus.

Segmentation: Separating Success and Failure

Through a process known as segmentation, ecommerce marketers could make a lot more money and impress their bosses. By filtering customers into different groups based on how much they are willing to pay for a product, you can potentially extract the optimal consumer surplus from each customer.

Fortunately, when working on the web, it’s much easier to filter out users through A/B testing, or various qualifying questions. Granted, too many questions will lower your conversion rate, so tread lightly. If you can determine which half of your market is willing to pay at the higher echelons of your price, and which portion represents the customers that would convert at a lower price, then your profits would skyrocket. See below.

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Remember how we had 75 customers who were willing to pay the (almost optimal) price of $800?

Well, 10 of those individuals were also willing to pay $1500 — the highest price offered. If we can successfully manage to segment those individuals, our earning potential increases by $7,000. Now, if we manage to filter in even the low spenders, who still earn us a unit profit of $70, but wouldn’t otherwise buy, we would sell 220 more. We know this because at a $220 price, we initially would have sold 204 wedding invitations. But since 75 of them bought at higher prices, we’re left with 129 new customers, earning a $9,000 additional income.

That leaves us with $64,780 in profits. Compared to the single price point of $800, we only would have made $48,750. That represents $16,030 in additional profit. Make no mistake though. One of the laws of pricing dictates that you must justify every plan. If your lowest plan doesn’t earn you profits, then you cannot and should not keep it. Make sure even your lowest plan is profitable, and don’t consider anything that doesn’t serve your company. “If they’re not willing to pay you, then they are not your customers”.

Implemented Segmentation and the Web

Thinking along the lines of traditional marketing can teach us a few things about implementing segmentation so that our customers don’t get angry when they learn that others are spending less money on the same product. Many companies take the approach of marketing products under different brand names. A common place we see this is within car manufacturers. For instance, General Motors has created a separate brand for Cadillac, where the people with the bigger wallets prefer to shop. But it also owns Chevrolet, a brand that represents the working class. You see it with Toyota as well. Toyota itself provides quality cars for the average person but also owns a separate brand, Lexus — a brand known to represent a richer consumer.

With this information, we address a second common assumption that causes marketers to fail. That is, believing you cannot change a product price once you’ve committed. With ecommerce and service pricing, consider offering a product with various pricing versions. Try offering products or services in packages of three. This works perfectly with our example of segmentation above.

Tips: Be transparent with deliverables, but choose to add and take away inconsequential deliverables to distinguish each plan. That way those willing to pay more will just absolutely have to buy the most expensive option (Peep Laja offers a great example in this post). And those who can’t justify the average price will still convert at the lower one.

For a real world example of this in the service industry, check out our approach to pricing at WebpageFX. On our SEO pricing page, potential clients are given an option of three choices with their deliverables laid out for them. This gives customers the sense that plans are adapted based upon the prices they are willing to pay, and not forgo potential business. Add to mix an option that allows the customer to dictate their own “pay what you want” price through the enterprise plan, and you manage to capitalize on all of the consumer surplus your potential clients carry. Implementing similar strategies for service industries will yield impressive success.

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Don’t Piss People Off

Segmentation is a touchy subject. Introducing that factor into your pricing plan and getting called out for it can be a sure way to ruin your reputation, as well as say goodbye to your profits. Customers want to feel like they’re getting value, meaning they are paying a good price considering the quality of what they receive. The greatest recommendation to make here is to be careful with A/B testing. Don’t simply throw a new product page with different pricing to test; you’ll find word will get out and aggravate many customers.

The main takeaway: While this is a useful tool in capturing the consumer surplus, it can be void due to the negative image that could be associated with the brand when word gets out. Instead of the traditional A/B testing, try to offer a limited number of coupons, discounts and deals, as well as less multiple versions. Or consider asking a qualifying question earlier on in the conversion process.

Segmentation Models That Don’t Work

There are two models I highly recommend avoiding before our comprehensive pricing theories are continued — the methods of site licenses as well as the “Call for a Quote” Pricing models.

Site Licenses for the Big Buyers

A pricing method to avoid — one that’s especially common in the software industry — is the “unlimited” license fixed price model. Offering your product at a lower price to attract sales from the “poorer” customer is good and along the lines of our conversation thus far, but offering your full license at a fixed price is definitely not. By doing this, your largest customers — think the individuals that offered to pay $1500 — would be receiving the biggest price break, when they are the ones with the most expendable income to spend on the product. Think of it this way: if Google wanted to buy Microsoft Office for its entire company, do you really want to let it go for a limited fixed fee? If we’re concerned about profits, that’s a big loss on earning potential!

Don’t Make Them Call!

You see it everywhere in the service industry. If a consumer wants something, then they better start making calls. But it should be easier than that. You’ve probably already discovered that making things easier for the buyer makes business easier for you.

Leaving only “call for a quote” pricing on the page is a poor option. The majority of the time (I’ve seen bounce rates higher than 80% on these pages) if the only call-to-action is to “call for a quote” as your attempt at segmentation, then you won’t get any calls. Buyers will simply go elsewhere. It’s obvious to buyers that if they are to call in and learn about what they can afford, then the sales individuals are simply going to charge them that amount. It’s the simplest form of segmentation.

The main takeaway: Since consumers are smarter than that, aim to achieve a pricing plan similar to the WebpageFX pricing page mentioned earlier. Allow buyers to “segment” themselves, and choose a plan that’s beneficial to them; for those who aren’t sure of the price it will take to convert, then allow them the option to “call for a quote.”

Applying What You’ve Learned

If there is anything to take away from this long case study on Pricing models, it’s that any change in pricing can make a huge impact. In two different independent studies by McKinsey & A.T. Kearney, both concluded that any 1% increase in pricing can affect a company’s profits more than any other change. Simply put, if you’re going to spend any time trying to grow revenue for your company, favourable pricing changes will yield the greatest returns.

But before you go out into the business world to discover that perfect price, remember these few things.

  1. Never believe there is an exact price that will always earn the greatest revenue from every customer. There are many different prices necessary to draw the maximum profit, because every consumer is different.
  2. Never believe you cannot change a price on a product or service once you’ve committed. Value on products and services in the marketplace changes daily, simply because the world changes. Products may deliver more value than the previous year, and customer trends may change due to economic times.
  3. Always charge earlier than you’re comfortable with. You’re wasting your time looking for feedback from customers if they aren’t paying for it. Feedback from those who have vested interest (their money) in a product will be much more useful and serve you greater for the future.
  4. Always charge more than you’re comfortable with. Don’t wait around thinking you need low prices in order to survive. If your product really does make a difference then you can continue to provide even greater value in the future if your price point allows your company to grow and thrive.
  5. Nothing Is Easy. Simply following my “magic” formulas above won’t tell you the perfect price for your product. And they certainly won’t guarantee success. But using them as a guideline to understand the market better and have better expectations for price changes will be very useful. The only way you can really know the “perfect price” is to go out there and experiment. Be curious and you will succeed! To get you started, try out some of these pricing strategies.

Note: The opinions expressed in this article are the views of the author, and not necessarily the views of Caphyon, its staff, or its partners.