Pricing a new product is one of the hardest things you’ll do.
I’ve been through pricing decisions that have taken months, only to still get it wrong. It’s been argued to me that it’s easier to raise the price than it is to lower it, and I’ve been told I was crazy for doing the reverse. I’ve missed the mark way too high and way too low, and I’ve stuck by my guns, painfully, until I was proven right.
When you’re pricing a new product, there are a lot of moving parts in the equation. It’s not something you can just whiteboard or throw into a spreadsheet or sit in a room and brainstorm.
Before you price your lemonade, you need to know a lot more than the just the cost of the lemons.
Here’s what most folks either miss or do out of order.
Gate 1: COGS
Before you can even think about how much you can sell your product for, whether that product is software, hardware, or sandwiches, you’ll need to know everything there is to know about the direct costs to produce the product itself. This is known as Costs of Goods Sold (COGS).
Please don’t try to determine indirect costs — the costs for distribution, sales, marketing, overhead, and so on — with this first pass at COGS. You’re just setting yourself up to be wrong later on, because:
- There is enough variability in the direct costs to make your head spin.
- As far as pricing is concerned, COGS should not change drastically as you scale. In other words, whether you’re selling one product or a thousand products, you want the COGS per item you use to set pricing to remain relatively unchanged.
Yes, you may see some gains buying in bulk, but again, when you’re pricing the product, you haven’t bought in bulk yet. You need to settle on a standard level of purchasing, inventory, and manufacturing to get the COGS you need to be able to price.
Gate 2: Indirect Costs
Indirect costs are where you can start introducing scale in terms of its impact on margins.
The reason I wait to introduce variability until this point is that it keeps me from making the mistake of believing that the per-unit indirect costs to sell a single unit are the same as the per-unit indirect costs to sell 1,000 units. If I have solid, unflinching numbers for my COGS, I’ll have a clearer picture of how changes in indirect costs impact my pricing equation.
I don’t want this post to become an economics lesson, so let me put it another way. If you can make $1 on one unit, you probably won’t make $1,000 on 1,000 units. It could be a bit more or a bit less, a lot more, or a lot less.
Put your COGS in one box and your indirect costs in another box. Now you’ve got a unit cost slider that will get you through the next few gates.
Gate 3: Model Impact
A common mistake I see in pricing these days is when the company lets the pricing model dictate the actual price of the product before the costs are considered. It’s almost as if pricing models like subscription pricing are chosen to build in cushions of margin to reduce the risk of getting the price wrong.
Almost.
Alternative pricing models like subscription pricing won’t hide a pricing mistake forever — the model will just kick the discovery of the mistake down the road. At some point, either the customer will realize they’re paying too much on an annualized basis, or the company will realize they’re charging too little when lifetime value (LTV) comes up way shorter than they guessed.
It’s the same trap with tiered pricing. Guessing wrong about tiers will eventually result in a constant reshuffling of those tiers, their pricing, and the make-up of features within those tiers. That kind of churn usually churns customers out, and gives them a negative perception as they leave.
The way to avoid this is to go through those first two difficult gates before applying the impact of your pricing model. The model you choose should never be an attempt to make something look more affordable than it is. The decision should be based on the scope of the product, the value proposition, and the intended usage of the product itself.
Gate 4: CAC and LTV
The first three gates don’t have a lot of guesswork involved, but the rest of them definitely do, starting with the Cost to Acquire a Customer (CAC) and the customer’s Lifetime Value (LTV). And as alternative pricing models like tier and subscription become more mainstream, accurate numbers for CAC and LTV become more critical.
The only way to start closing in on CAC and LTV with any accuracy is to spend enough time in a pilot or MVP program to churn through several sales and usage cycles. It might take months or even years to get to statistically significant data or at least to a comfort level. The only back-up plan is research — talking to customers, potential customers, even companies with products similar to yours, and extrapolating what they tell you into somewhat educated guesses.
But yeah, you’re still throwing darts.
So always be conservative about what CAC and LTV numbers will be, especially early. Outside of the impact of external forces, CAC will never be higher than it is when the product is new, and LTV will never be lower. Actually, to get technical, CAC usually goes up a bit once a new product’s initial push and early adopter phase is over.
Just don’t price your product as if you’ll have customers beating down your door and swearing lifelong allegiance to your brand.
Gate 5: Markets and Margins
Some maybe-obvious-but-surprisingly-overlooked math. You need to know your market size. Larger markets can withstand lower margins. Smaller markets demand higher margins.
If you’re selling bottled water, your margin can and probably will be razor thin. If you’re selling designer suits, you better be somewhere above 50 percent at your worst case.
Gate 6: Check Your Competition
This step is also usually done too early, and is also mistakenly used as a substitute for the other gates. Once you know what you can sell for, you can then determine what you should sell for.
This is a pretty simple exercise of seeing where your competition comes down on price and making sure you’re at least competitive. But always consider your unique differentiators, and never be the cheapest option.
When you are doing a competitive comparison, you’re checking the hard data (your competition’s pricing) against some more guesswork: Your value.
Gate 7: Value
This the hardest gate to get through, but once you do, all the numbers will fall into place. This will also be the moment you’ll know whether your pricing is right or wrong.
You can’t guess at value; you can only determine it by what your customers tell you. And even then, you’re only listening when they speak with their actions, not with their words.
But again, once you know value, you have a compass that will let you lower your COGS, lower your indirect costs, modify your pricing model, increase CAC, LTV, and margins, and destroy your competition.
