Pragmatic Pricing

Last week I had the pleasure of talking about pricing to 150+ product managers.  It was a great audience with keen interest and insightful questions.

One of the sponsors video taped the session, took thorough notes, and then blogged about it.  Thank you Nick Muldoon and Atlassian!

I especially liked his opening paragraph:

“At the August 2012 meetup for SF StartUP ProductTalks we were lucky enough to have Mark Stiving speaking about product pricing. Bloody brilliant talk, I thoroughly enjoyed this months meetup!”

Last week, while speaking to 150+ mostly software focused product managers at the Startup Product Talks Meetup in San Francisco, I was surprised to hear negative comments about the freemium business model.  Then I read in the Wall Street Journal two articles that were less than positive about freemiums:  “When Freemium Fails” and “What Grubhub’s CEO Took From The Strategy“.

Here’s the easy answer:  No business model is right for all businesses.

First, a definition.  Freemium is the business model where a company (usually software) develops a functional and useful product and gives it away for free.  The company also develops versions of the product with more features which it sells for money.  Successful freemium companies typically convert 1-2% of their users to paying customers.  Two common examples are LinkedIn and Skype.  Both offer packages we can use for free, and both offer upgrade packages that give us more functionality at a price. Think about this.  Around one percent of LinkedIn users pay so the other 99% of us can use it free.

Why does freemium work so well for companies like LinkedIn and Skype?  The basic concept is that they offer a free product that millions of people want.  It is much much easier to get a user for free than if you charge even a penny.  This large free user base acts as word of mouth to attract even more free users.  Then, you should find a very small proportion of your users (1-2%) that really want some additional features above and beyond the free product.

This works best when there are what economists call network effects.  These are when the value to one user increases as more users sign on.  Imagine how useless LinkedIn was to the first few users.  However, now that they have millions of users, LinkedIn is extremely valuable to all of us who use it.  However, LinkedIn is even more valuable to select users.  HR people looking find new hires and salespeople looking for new clients readily come to mind.  So LinkedIn created more features targeted specifically at those markets.

Freemiums don’t have to have network effects.  For example, many free games on your iPhone or Android phone offer completely free versions up to a level and then sell the full version for even more levels.  Although this is a freemium, it is much less sticky than businesses with network effects.

Now that we understand more about what it is and why it works, will it work for you?  For freemium to work your business needs to have several characteristics:

• Low cost to serve – If 99% of your customers don’t pay, you had better be able to serve them relatively inexpensively.  That’s why freemiums are most popular with software where there is close to zero marginal costs for another customer.
• Offer value for free – The free version of your product must have value to your customers.  You want them to use your product.  Otherwise you won’t get any network effects or word of mouth.
• Upgrades must be VALUABLE to a portion of your users – They must be willing to pay for these additional features.
• Network effects (ideal but not required) – The bigger your network becomes, the more valuable it is to your users.

Of course freemiums don’t work for every business.  But don’t rule them out quickly.  It may be true that companies and VCs have been overly zealous toward them.  Maybe there is a backlash now.  But if you have the right business and market conditions, the freemium business model can be extremely lucrative.  Just ask LinkedIn.

Mark Stiving, Pricing expert, Speaker, Author

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Photo by Nan Palmero

Thank you to Cindy F. Solomon for hosting the Startup Product Talks Event

There are a lot of articles and several books now that talk about the psychological aspects of pricing.  These are fun to read and may have some impact on your business, but long before you even think about psychology, you should focus on the two most important concepts, value based pricing and how your customers use price to decide. 

The most important concept is charge what your customers are willing to pay.  This is value based pricing.  You’ve read about this many times in previous blogs (and will probably do so again), but that is not the topic of this blog.

Second most important concept, you must understand how your customers use price when making their decisions.  We’ve talked about this in many different ways, but it recently struck me that many of those issues revolve around this one topic, how do your customers use price?  The more I thought about it, the more it became clear that this is an easy and practical way for businesspeople to think about pricing.

What follows are brief descriptions of several blog topics that fit naturally in the concept of understanding how your customers use price when making purchase decisions.

The blogs on Will I? Which one? described two different decisions customers make and how price effects each one.  Price has little impact when customers are deciding “Will I buy in a product category?”  Yet price is all powerful when customers are choose “Which one?”

Under the banner of “Which one?” we reviewed how customers make the choice, how they determine value.  When comparing two products they look at the difference in price and the differentiation of the products to decide if the higher price of the more expensive item is worth it.

We talked about the bigger game of pricing.  Sometimes people decide on bundles of products at the same time.  Sometimes people make one choice (like milk at the grocery store) which influence other purchases.  We also have people making repeat choices over time where we don’t want to abuse our customers’ loyalty.

And yes, our customers are influenced by the psychological aspects of pricing.  We’ve talked about 99 cents and good, better, best.  There are more coming.

Nobody says this is easy, but it is important.  Actually, it’s the second most important concept in pricing.  Understand how price impacts your customers’ decisions.  Once you truly understand how your customers think about prices, you can create and implement pricing strategies that will maximize your profitability.

Mark Stiving, Ph.D. – Pricing expert, Speaker, Author

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Photo by Mista Yuck

If you are a believer in Value Based Pricing, you know we get paid based on how much value we offer our customers.  However, are you generating more value than you capture?  Can you capture more of it?

During my keynotes I love to tell the story of Disneyland.  511 acres of attraction in Anaheim California that people fly in from all over the world to see.  What grew up around Disneyland?  Anaheim.  Tons of hotels and restaurants catering to the tourists.  All of these business are capturing value that Disney created.

So, when Disney built DisneyWorld, they built it on 25,000 acres.  Disney owns 26 hotels and many many more restaurants.  When tourists travel to Orlando Florida, Disney captures more of their total spend.  In other words, Disney capture more of the value they create.

Two incidents reminded me of this while traveling.  Note the pictures.  One is from a restaurant where I had breakfast.  They sold advertising on their tables, a 3 year license which varied from $75 to $200, depending on size.  Think about that.  They created value, potential customers attention, and captured some of that by selling advertising.  It’s not their normal business of selling food, but they captured more of the value the created.

Then I looked at the keys on my rental car.  Notice there is a Macy’s discount card attached to these keys.  Wow.  Avis, a rental car company, found a way to make incremental revenue by selling the attention of travelers to Macy’s.

Two questions for you:  What additional value do you create?  How do you get paid for it?

Bonus question – Can you think of other examples of companies that get paid for something other than their main business?

Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author

At first glance, this seems obvious.  Charge what customers are willing to pay.  Customers are external, so pricing is … external.

So why don’t more companies behave this way?

Cost plus is an example of internally focused pricing.  Most companies still use versions of cost plus pricing.  Determine the cost of building a product, add a markup, and that’s the price.  Nothing external about this.

How about finance requirements to raise prices to achieve higher gross margins?  If implemented across the board, this is obviously an internally focused pricing exercise.  What if, instead, the company implements price hikes only on products that can justify them.  Then I have a very important question … Why didn’t the pricing team do that before?  If customers are willing to pay more, then we should have been charging them more.

For pricing to be done right, it has to be focused externally.  Always start with the question, “How much are my customers willing to pay?”

Mark Stiving, Ph.D. -Pricing Expert

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Photo by j.cliss