The Hidden Competitive Advantage of Pricing

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The Hidden Competitive Advantage of Pricing

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Companies worry too much that changing their strategic pricing architecture and tactical policies risk leaving significant value on the table. Getting pricing right should be a key part of any startup’s strategy, and should be considered early in the growth trajectory.

Running a growth-stage company is hard. Founders and CEOs face constant demands from their investors and pressure to grow fast or die slow. In the midst of building and managing a sales force, figuring out marketing channels, and scaling up product and operations, pricing is often relegated to the list of to-dos with an indefinite deadline.

So, how do companies establish their pricing strategies?  In our experience, it goes something like this: early in the business the CEO needs to set a price. She has little or no data from which to extrapolate, so she takes an educated guess. The product begins to sell! The price is tweaked a little bit if the product evolves significantly, or if the product offerings are expanded.  For the most part, however, it stays the same.  More fundamental changes are considered briefly, but are dismissed due to concerns for messing up and seeing revenue decline or churn increase.  In short, that initial guess becomes an unmovable anchor point.  Does this sound like the way you set your pricing?

Companies worry too much that changing their strategic pricing architecture and tactical policies risk leaving significant value on the table. Getting pricing right should be a key part of any startup’s strategy, and should be considered early in the growth trajectory.“For those companies with the foresight to undertake pricing transformations early in their growth trajectory, it will be a consistent source of competitive advantage.”

For those companies with the foresight to undertake pricing transformations early in their growth trajectory, it will be a consistent source of competitive advantage.

Growth through pricing

Our research and experience shows that startups that tackle pricing issues strategically and tactically see a 10-15 percentage point increase in their revenue growth rate within 12 months of implementation. Those pricing changes can result in higher average customer value (ACV), decreased churn, and the ability to reach new customer segments with better-tailored offerings. And this result holds across a range of industries and business models.

So, why are the potential gains so great for startups in particular?  Startups are exceptional at creating new sources of value for their customers, but they are far less effective at capturing that value. Pricing optimization allows them to reverse that “value leakage,” and they can do so across each of three key levers:

Increase ‘perceived value:’ Customers pay for the value that they perceive in a product, not for the value that is actually there. The relationship between the two is determined by how well a company communicates to its customers the value it delivers. Startups always know they are adding value, but often don’t understand which parts of their value proposition resonate with different customer segments – often resulting in an undifferentiated offering to the middle of the market. Startups can increase customers’ willingness to pay by tailoring their price and product positioning to the specific segments they serve.

Set price to willingness-to-pay: What customers are willing to pay for the value they receive is highly variable across any customer base. This is especially true for startups, which frequently serve customers across industries and sizes. But when startups pursue diverse customers with the same go-to-market motion, they often have little understanding of what different customer segments need and might be willing to pay. Even if they did possess this understanding, pricing to willingness-to-pay requires a system to effectively differentiate pricing based on that willingness-to-pay. Common challenges include:

  • Linking packages to value: How can you package features in a way that leaves customers with low willingness-to-pay satisfied with a truncated offering, but ensures that those with high willingness-to-pay will always upgrade?
  • Linking pricing architecture to value: How can you charge different prices to different customers for the same product in a way that will be perceived as fair? This is about linking your pricing units to customer value. Companies frequently default to metrics like seats and licenses. These metrics are fine so long as the value of the product truly increases with the number of users. But where it doesn’t, usage-based metrics like GB of storage or hours of usage may work better. Some companies are also experimenting with success-based pricing.  Here, they price with metrics based on customers’ revenue or profit so that the price scales in lockstep with the value delivered.
  • Setting price levels to willingness to pay: How do you know what a customer is willing to pay? And if you do know, how can you use that information to optimize market share, revenue or profit? Figuring out the answers to these questions requires not only customer interviews and surveys but a working knowledge of the sophisticated quantitative methodologies used to get customers to reveal their true preferences.

Get the price you deserve: Even if startups have a good system for determining the list price, that system can be undermined during the course of the sales cycle. Companies often willingly bend on price in order to meet logo or volume targets, or they grow so fast that a rigorous approach to discounting is discarded. In either circumstance, there is value to systematizing and rationalizing discounts. For example, you should determine up front what levels of discounting are justified by the value derived from new customers justifies discounting, and you should align reps’ incentives with price to discourage excessive discounting.

Overcoming barriers to pricing success

Given the demonstrated potential impact of pricing optimization, why don’t more startups proactively take the necessary steps?  Several common internal barriers often prevent companies from pricing effectively.

First, there is usually a significant knowledge gap that must be overcome. In contrast to sales, marketing or product development, startups usually don’t have personnel with expertise or experience in changing pricing models, and therefore don’t have the robust quantitative approaches that give real insight into value perception, customer preferences or willingness to pay. Bringing in pricing expertise, from outside the company if necessary, is critical to establishing a more robust pricing function and making sure that pricing changes increase revenue rather than cause churn or declines in ACV.

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Risk aversion is another understandable barrier to price optimization. Changing the price, particularly for existing customers, is perceived to be a dramatic and risky move that many companies are afraid to make. That fear arises less from any risk inherent to changing price and more from the same lack of understanding described above. Targeted market research using proven approaches can mitigate the perceived risk of price changes.

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Finally, growth-stage companies have limited management bandwidth, and often see pricing changes as a secondary priority. This arises in part because of the common misconception that revenue growth is more easily driven by volume than by price, leading management to focus on customer acquisition over pricing optimization. It is amplified by a perception that pricing is always a long-term profitability play rather than a short-term revenue accelerator. But as we’ve shown in this article, there are significant gains to be made from getting pricing right.

Pricing optimization is not an overnight growth lever for startups. But for those companies with the foresight to undertake pricing transformations early in their growth trajectory, it will be a consistent source of competitive advantage, and an undeniable growth accelerator.

About the Authors

James Wilton Headshot

James Wilton

Pricing Lead

James leads the pricing practice for Fuel By McKinsey, helping our clients maximize revenue growth.

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