Pricing 101: A roadmap to (re)defining your pricing strategy
This pricing 101 blog series is targeted at wellness entrepreneurs and small business owners but applicable to all industries. Pricing your products or services is not a stand-alone activity. Prices are an integrated part of your business. You cannot set prices effectively without having a deep understanding of the value of your products and services or without knowing the needs and wishes of your customers. In this blog, I take a more holistic approach, making you think about your value proposition and customers first, and pricing second.
In the previous blogs, I talked about the importance of pricing, the shortfalls of common pricing strategies, and customer behavior. We learned that cost-based pricing is difficult because your costs are most likely changing all the time. It also fails to incorporate your unique added value. So does competitive based pricing. Following or undercutting your competitors could easily lead to a lose-lose situation. Customers are smart, but often unaware of the true value of certain services and should be educated accordingly. This is why ‘pay as you wish’ is rarely sustainable as your only pricing tier. Offering customers products and services for free (through freemium, a free pricing tier, or a free trial) is great for marketing purposes but converting them into paying customers is very tough. If there is no strong incentive or lock-in mechanism, it is likely to encourage free-rider behavior and not lead to much revenue.
If all these strategies individually are not the way to go, what is? This blog is intended to help you define your pricing strategy in 4 steps, with the goal of improving your customer satisfaction and ultimately profits (revenue minus costs). I warn you now that defining your pricing strategy is an iterative process that will require you to revise earlier steps, test different tactics, and experiment over time. There is no one right way to do this, or one size fits all. Each of your journeys will be unique to your business.
Big (Steps, Small) Data
Listening to your intuition is great, but when it comes to pricing the holy grail is to use data. What do we mean by data? Factual, quantifiable information such as measurements or statistics. Don’t measure everything and don’t let the ‘big data’ trend drive you crazy. No need for a math degree either. Just start with the basics:
- How many products or services did I sell at different price points? Bonus: to whom or what type of customers?
- How many new customers and recurring customers do I have per month? For each of my different pricing tiers?
- …
Measuring these kinds of data points will help you answer questions like:
- What happened to my sales (e.g. number of classes, class packs, or subscriptions sold) when I started a certain discount or changed your prices?
- Which of my products and services are the most popular? Which are the most profitable?
- How sensitive are my customers to price changes? What is their willingness to pay for my products or services?
- …
Data tracking and analysis is a topic on its own. But what I challenge you to do is to think of 3 — 5 questions you would like to have answered over time (in line with the second set of questions). Next, think about what that means for what data you must collect from your customers. Be as specific as possible. Finally, think about how you are going to collect and store these data points. Do you use a tool or software that does the tracking for you? Or do you plan on tracking it manually in an Excel sheet or Word document?
4 steps to defining your pricing strategy
With this blog, I hope to help you (re)define your pricing strategy, from specifying your value proposition and your customers to your business and pricing model. This blog is broken down into 4 steps with some exercises to get you started:
- Value proposition: What unique value are you providing?
- Target customers: Who are you creating value for?
- Business model: How are you going to charge your customers and make money?
- Pricing model: How much are you going to charge your customers?
1. Value proposition: What unique value are you providing?
I believe that at the core of your pricing strategy should be the value you’re creating for your customers. Having value-creation at the core of your pricing will help you to make decisions that increase customer value. Your value proposition, as a teacher, studio, or any other type of entrepreneur, describes the reason your customers come to you and not someone else. It conveys the promise of your offering, the benefit for your customers, and why you are the best at providing this value (in comparison to competitors).
Before setting your prices, answer these questions for your business and make your value proposition crystal clear. What are you good at, and better at than others. For example, Tony Chocolonely is a Dutch chocolate brand whose mission is to make 100% slave-free chocolate the norm. They promise honesty and transparency to their customers and distinguish themselves by offering high-quality chocolate wrapped in unique packaging with an honest supply chain. They make customers, suppliers, and other partners feel part of their movement. This mission shows in every aspect of their marketing and branding. Their chocolate bars are divided into uneven pieces to illustrate the inequality in the cocoa supply chain. This clear value proposition helps Tony’s Chocolonely make decisions and prioritize only those activities that really align with their core values. It makes it easier to say no to efforts outside that scope.
Some basic well-known value propositions include “the lowest price” or “the superior product”. The former are volume players that want to sell to as many customers as possible for the lowest price (e.g. Planet Fitness). Examples of the latter are luxury players that sell to smaller customer segments for a high price (e.g. Equinox). Your value proposition can be anywhere in between or beyond.
We recommend finding your niche where you can be the superior service for a specific customer segment.
2. Target Customers: Who are you creating value for?
Steps 1 and 2 go hand in hand. Tony’s Chocolonely knew their value proposition wouldn’t resonate with every customer. But that was ok. At the start, they targeted the young environmentally conscious, and more affluent population, living in big cities. In business language, we call this a beachhead market. A beachhead market is a small customer segment with certain characteristics that make them the ideal target for your product or service. A beachhead market is your starting point. After you are established in this market, you can add adjacent customer segments. In the military, a beachhead strategy literally means focusing on dominating a small border area in enemy territory and using that as a stronghold to expand further.
Keep in mind that it is easier and often better to create a lot of value for a few customers, then little value to a lot of customers. High-value customers will be more loyal and willing to pay a higher price since they attribute high worth to your service or product. Let’s get a better understanding of your (desired) customers:
- Write down a list of customer characteristics that define your (desired) customer base. For example, age, location, budget, profession, injuries, online savviness. Whatever characteristics are important to you.
- Make groups of customers with these characteristics that capture most of your (desired) customers. We call this process customer segmentation. For example, group 1 consists of students with a low budget who are active online and live in the big city, group 2 consists of new moms & dads who just had their first kid and live in the city, group 3 consists of cancer survivors of age 60+. This is a balancing act, you want to be specific, but not that specific that your groups consist of only 1 customer.
- Pick 1 to max 3 customer segments for whom you feel you can create the most value. Look for customer segments where you have a competitive advantage, and you can differentiate yourself. Find your niche! However, be realistic, this group should be big enough or have the potential to be big enough to generate enough income for you. And of course, these customers should be accessible to you. They don’t have to be your customers yet, but you should be convinced that you are able to reach and engage them.
Don’t be everything to everyone but rather be something special to someone.
3. Business model: How are you going to charge your customers and make money?
Now you have a better idea of what you are offering and to whom, let’s think about how you can charge them. In business jargon, this is referred to as your business or pricing strategy, model, or architecture. I like to think of the business model as the how you are charging (the structure), the pricing model as the how much you are charging, and the business or pricing strategy as everything together (who you’re charging, how you’re charging, and how much you’re charging). But you will find that all these definitions are used interchangeably. Yes, the business world has a way of using multiple difficult sounding words to describe not so difficult things. Just think of the word revenue — sales, earnings, income, gain, yield can all be synonyms. Seriously? Do they deliberately try to make us feel dumb? Don’t let the business jargon discourage you, you’ve got this!
Back to business. So in my definition, your business model describes in what way, and how often you charge your customers. We are not talking numbers (i.e. exact prices) just yet, we first focus on the how. Your business model depends on your type of business and customers and can consist of a combination of different models (think subscription and individual purchases). For services businesses, hourly pricing (e.g. consultants), or project-based pricing (e.g. plumber) are typical. The goal of almost any business model is:
- Attracting new customers;
- Retaining existing customers;
- Creating a predictable revenue stream.
It is not uncommon to combine multiple models: one to attract new customers and another to retain existing customers. Or different models for your different customer segments, e.g. an off-peak hours’ subscription model for students for a lower price and full-suite subscription including private sessions for a higher price for wealthier clients. Let’s take a closer look at some common models for fitness and wellness classes.
Monthly/Annual membership pricing
In this model, customers pay a recurring monthly or annual subscription fee. The benefits of this model are that it is easy to understand and track (remember our data comment earlier). Most importantly though, it creates a predictable revenue stream. And not only that, these recurring customers provide a great opportunity to build a community around. You prefer customers to commit to your services for a year rather than only a month. The longer the time commitment, the more predictability for you. Therefore, you want to incentivize your customers to commit long term. One way to do this is by giving a discount for annual memberships over monthly memberships. Long-term commitments activate a positive reinforcing cycle: you have more predictable revenue and thus more resources to serve your customers better. Also, you will get to know them better and be better equipped to tap into their needs. In this way, you will improve the value you’re providing for them, which makes them more likely to stay long-term members. I call it the long-term commitment flywheel (see graphic below).
Not every customer wants the same service and is willing to pay the same price. If you are serving distinct customer segments, you could consider different subscription tiers. For example, an unlimited on-demand versus unlimited on-demand and live stream. But be careful not to give too many options. Remember the choice overload problem: people refrain from choosing when presented with an overload of choices.
A subscription model is great to retain customers but can be a barrier for new customers. So how do you attract new customers? One common tactic is to give the first month free to attract new customers. But as I discussed in my earlier blog, converting customers from paying nothing to something is very difficult. My advice? Try it out and do the math. What is your target conversion percentage ([number of people that are still on a subscription 3 months after the free trial] / [number of people signed up for the free trial])? After your experiment, compare that to your actual numbers. Just to manage your expectation: the average conversion rate for software companies is ~1–10% (only 1 to 10 out of 100 converts from a free to a paid plan) and ~15–25% free streaming users convert to paid subscribers (TechCrunch, Muvi.com).
Instead of a free trial, you could also offer a reduced first month. This might not attract as many new customers as with the free trial but will most likely get you a better conversion rate.
Class packages or multi-use tickets
Class packages or multi-use tickets are packages consisting of multiple (often 1, 5, or 10) vouchers for a service (e.g. yoga class) that must be used within a certain period. These packages are appealing to new customers or customers with irregular schedules. Once they’re introduced to your offerings, it is up to you to provide these customers with outstanding customer service and convince them to purchase a longer-term membership or package. You want to incentive your customers to become subscription members or buy multi-use packages since it generates a predictable revenue stream. Like the yearly versus monthly subscription pricing, prize the average ticket of a 10 pack lower than the average ticket of a 5 pack. In this way, you create an incentive for customers to buy a larger package and commit a little longer. This gives you more opportunities to show the customer what you’re worth. In return, increasing your odds of converting the customer into a recurring customer.
Dynamic pricing
A model that is increasing in popularity is dynamic pricing. Dynamic pricing means you charge different prices at different times, depending on the demand and/or supply. Uber is one of the companies that made this model very popular. The price for the same ride can change a lot during the day depending on the weather or time of day. By making peak-hours more expensive than off-peak hours, for example, you can smooth out demand. The risk of this model is that it can have a very negative impact on customer experience. People don’t like to be charged differently for in their perception the exact same service. We don’t recommend doing dynamic pricing yourself, as it will quickly get very complicated. If you work with ClassPass, Mindbody, or another platform, it might be worth exploring since they have automated software to help you. But be aware of the possible implications for your customer satisfaction. If you decide to implement dynamic pricing, we recommend to educate your customers and explain to them what you’re doing and why.
Select a combination of pricing models that appeal to your existing and new customer segments. But aim for longer-term commitments from your customers. It will allow you to serve them better in return. It’s a win for both.
4. Pricing model: How much are you going to charge your customers?
Only now you know who you are serving, what value you’re bringing to them, and how you want to charge them, it is time to set the price levels. I refer to this as your pricing model. Imagine you are a chef. You have just concluded that you excel in French cuisine and have the mission to bring this cuisine to gen Z at an affordable price. Your beachhead market is gen Z in Amsterdam. You decided on two business models: all you can eat during off-peak hours and normal item pricing otherwise. Now it’s time to calibrate the height of your prices. To do this you should get a sense of (but don’t any of these items be the main driver by itself!):
Competitors’ pricing
Know what your competitors are doing and charging. What are comparable businesses offering and for what price? Be clear about your competitive edge in comparison to them. In business, often a distinction between direct and indirect competitors is made. As the word suggests, direct competitors offer a direct substitute (i.e. the same product or service) for your offering with the same customer goal in mind. Indirect competitors offer a different product or service but do satisfy a similar customer need. For example, as a yoga teacher, another yoga teacher can be your direct competitor, whereas a spin instructor could be considered an indirect competitor.
Competitor research can go on indefinitely. Don’t boil the ocean, just pick a few relevant comparables as a benchmark. Below is an example of a competitor analysis for Tony’s Chocolonely performed by a group of students. You can compare competitors on different metrics that are important for your business, e.g. price, quality, speed of service. This type of analysis can be performed in many different ways. There is no wrong or right way, only your way. Do it such that it gives valuable information to you. Incorporate only those characteristics and business that are of interest to you.
Customers’ budget and willingness to pay
Estimate or analyze how much you will sell at different price points. Hence, go back to your customer segments and think about their price sensitivity. Sometimes it makes sense to sell fewer items for a higher price rather than more items for a smaller price. Price increases will have less impact on price-insensitive customers (in business jargon also known as price inelastic customers) than it will have on price-sensitive (or elastic) customers. Ideally, you serve at least one niche customer segment (for example private clients) that are less sensitive to price and are willing to pay more than average.
Willingness to pay is unfortunately not that easy to figure out. Just asking people how much they want to pay is not the way to go, since customers often don’t understand what something is worth. For example, almost no one would have told you that they would be willing to spend more than $1000 on a phone. Today however, many people do. Figuring out willingness to pay requires customer interviews, surveying, or price experiments. Run some experiments yourself and track the effect, but don’t overdo it. People get confused if prices keep changing, so keep it simple! Price decreases are easy, but price increases are much harder to sell to your existing customers. If you decide to increase prices for your existing customers, educate them on why and, if anything, what they get in return. Keep in mind that customers often don’t know what something is worth or don’t know what they are willing to pay, and hence, should be educated about the price and the value they receive.
If you are thinking of a new offering and want to gauge interest and willingness to pay. You could send a survey to your customers. Rather than asking them what they want to pay, you can ask: for price $X, would you buy it? The trick is to test different prices. For example, ask customer 1: for $10, would you buy it? Ask customer 2, for $15, would you buy it? And ask customer 3, for $20 would you buy it? This type of pricing research is known as Monadic Pricing studies (if you’re interested you can find a comprehensive summary here). It basically means that you test one price per customer. Ideally, you have at least 30 people per price point. No stress, this is totally optional and no must, but just for those of you who are interested to dive even deeper.
Cost base
You want to make sure that you can cover your costs. Calculate your total expected costs per month or year (both fixed and variable costs). Don’t forget to pay yourself enough. It might be acceptable (and normal) to make a loss in the first year(s) since you probably have to do multiple investments. In the longer term though, every sustainable business needs to make a profit. Use your costs as a benchmark to calibrate if your pricing strategy makes sense (can you be profitable under this pricing strategy?), rather than as the basis for your price levels (costs/expected number of units sold).
It’s time to bring all these data points together and set your price levels. In an ideal world, you would quantify the value you are providing by comparing the world with and without your product or service, but this is practically impossible. So instead, you estimate what value you’re providing in comparison to your competitors (are you providing more, similar, or less value than competitors), and in the eyes of your different customer segments (how much do you expect to sell at different price points). For example, it might be more profitable (higher revenue and/or lower cost) to sell 1 product for $100 instead of 5 products for $15.
Pick your price levels and estimate how much revenue you expect to make (in a pessimistic, optimistic, and neutral scenario). Compare this to your cost base (your cost base might vary as well depending on the scenario) and make sure it suffices. If not, go back to step 1, 2, 3, 4, and redefine a strategy (maybe another customer segment?) that will make you enough money.
Remember that you don’t want to change your prices too often, because that will confuse people. But do experiment over time with different price models, and even business models, to see what works well for your customer base. If only because customer preferences change over time.
Final considerations
Now you better understand your value proposition, target customer segments, and your business and pricing models, it is time to try them out, keep track of the effect, and make money. Some final key thoughts not to forget (some I cannot repeat often enough):
- Keep it simple. Remember the choice overload effect? People get overwhelmed when presented with too many choices. Most studios have four to five core packages (such as a drop-in, 5- or 10-pack, and monthly unlimited) and then run some promotions as well (again, don’t overdo these either).
- Experient and track your data. Experiment with different business and pricing models over time, but don’t change your prices too often. Make sure to track the effect of these changes, so you can finetune your pricing over time.
- Be smart about discounting and price levels. People are easily anchored to a low price, and increasing prices is hard. You also want to prevent starting a price war or training customers to expect discounts.
- Educate your customers on the value they are receiving. It should be very apparent to your customer what they are getting for their money. You cannot iterate this often enough. Also if offerings or prices are changing, explain, and take them along for the ride.
- Last, but not least. Believe in yourself and don’t sell yourself short!
In this pricing 101 series, I rely on concepts learned in MIT Sloan’s pricing course by Prof. Tucker. If you’re interested, most of her lecture notes are available online. In previous pricing 101 blogs, we discussed:
I’d love to hear from you. So don’t hesitate to ask questions or comment below.
Originally published at https://www.wellmode.com on December 1, 2020.
