Pricing Services and SaaS – Part 1

One of the most important (and often most difficult) decisions a vendor must decide upon is the pricing structure for their service offerings. This is particularly the case for product organisations who are building out new service portfolios. As the software product business evolves towards a more service driven industry through SaaS, vendors need to get this part of their strategy right or face potential disaster.

Before exploring some of the important considerations of service pricing I want to point out that this post only examines the fundamentals of pricing services. It does not look at pricing strategies (such as discounting to grab market share) or the subscription pricing models used in SaaS – I will cover those specifics in part 2 of this post at a later date.

So how do you price a service? There are three standard models available:

Cost Plus Pricing

This is the most basic pricing model available and has been used widely as the basis for product pricing. To use this model you need to really understand your cost structure and for many companies new to services (or experienced service organisations developing new services) this can be an inexact science. Different industries use different ’standard’ percentages for cost plus pricing. Many take their minimum product margin, lets say 40%, and apply that to new services too. Unfortunately, most product organisations seem much less capable of estimating actual service provision costs (particularly at the new service launch stage) than they are for their products. Service revenue profitability therefore tends to be much more variable than product margins and many service initiatives fail to meet expectations within product oriented businesses because they don’t apply the same rigour and process in pricing a service than they do in pricing a product.

It need not be this way and with the correct methodologies and service development processes aligned to equally structured service delivery programmes this method can be effective. But, as a general strategy, cost plus pricing is not the most attractive route to pricing service offerings.

Market Based Pricing

Another common approach is to look at the existing market and see what your competition is charging for similar services. Although such competitive analysis is essential as it indicates what customers are already prepared to pay (or expect to pay) it should not be the primary driver in deciding upon service pricing for your own business. Unless your offering is identical to the competition and you really understand their business model and actual profitability then this can be a dangerous path to follow.

So in summary, you should conduct market research and competitive analyses as part of your pricing strategy but this should be one of a number of inputs rather than an overriding one.

Value Based Pricing

For non-commoditised service businesses, value based pricing is the preferred model. The key is understanding the value that the service brings to your customer and pricing it accordingly, rather than simply adding a percentage to your service delivery costs or following the lead of your competitors.

But understanding the real customer value of your service and expressing that value in a compelling manner to your customers can be challanging. It requires a level of insight into your customer’s business and ‘pain points’ that might not be available today. Capturing this insight and building and then pricing a compelling service around it is the key to sucess in any new service.

Conclusions

The most attractive model to use when pricing new services is value based pricing. But this requires a very good understanding of your total cost structure (so you need to perform the analysis outlined in Cost Based Pricing) and you need to understand the existing market and competitive price points. Finally you need to really understand your customer and their needs. If you can succesfully navigate each of these points you can build value based prices that match your service offerings and your final challenge (and not to be under-estimated) is to express these to the customer in a way that defines the total value you bring as part of the service.

The above holds true for most service businesses but what are the implications for the SaaS market in particular? Based on our experience (and that of industry peers and colleagues) of working with a number of software product vendors who are planning or making a transition to a SaaS model there are often major knowledge gaps in each of the areas described above (cost, market & value). Many ISVs significantly under-estimate or miscalculate their overall costs when they build their cost models. The implications of assuming new areas of responsibility from the customer such as hosting, security, compliance, resilience, reporting,  redundancy and so on are often missed.

In addition to problems on the costing side, many ISVs really struggle to both calculate the overall value they are bringing to the customer with their new SaaS offering and express this value to the customer in a convincing and compelling manner. Instead, market based pricing is often used (almost blindly). If competitor X is charging $50 per seat per month for their application then the new entrant will decide they must charge $40. This can lead a race to the bottom that serves nobody any benefit.

If SaaS vendors are to thrive and their customers to receive the best possible service then both parties must be fully aware of the value being offered. To achieve this, the SaaS vendor must get closer to their customer, understand their needs and continously improve the service they offer based on this knowledge.

Later this year, Servitizer will be launching our suite of applications (as a service of course) that help companies define, design, price and deliver new service offerings. If you would like to register an interest in beta testing these applications within your business than please complete this form.

Steve