Today we delve into the world of SaaS pricing concepts. Let’s imagine the following scenario.
You’ve got a fancy application and you’re hosting it on a cloud. Hosting expenses are minimal and your application has already been developed. You are ready to release the application to the world – but what price should you charge for your SaaS?
Let me guide you into the right direction to pricing SaaS. I’ll begin by covering three important pricing aspects that you should keep in mind at all times. Then, we’ll delve into Saas pricing models.
Universal rules for SaaS Pricing
1. You’re not a hosting provider
(…unless you’re a hosting provider, in which case, skip to 2.)
All too often developers use a cost-plus approach for SaaS pricing and only consider hosting (server) expenses. The common approach is to divide the total server cost by the forecasted number of users to arrive at a hosting per user cost, then apply a desired margin. For example, let’s imagine that your monthly server costs are around $300 for an estimated 5,000 users each month. The server cost per user is $0.06. Given a desired margin of 60% – 80% for tech products, the cost-plus approach arrives at an app price of $0.30.
What’s wrong with this approach?
First, you’re not a hosting provider. Your app is there to provide value, not just to connect users to AWS.
Second, you’ll be broke within a minute. With $0.24 gross margin per product ($1,200 / month), it will be challenging to offer services, implement app updates, invest in advertising and pay yourself or your team. Sure, that’s where investment funding can help, but unless your name starts with Zucker and ends with Berg, investors won’t blindly invest. There are other operating expenses to consider when attempting to do a cost-plus pricing method, which I will cover next.
By the way, there’s lots of math involved and clear requirements to capture total server costs. Nikone Lissen has developed a phenomenal calculator to derive monthly server costs.
2. Let’s talk about operating expenses
A few weeks ago I wrote a post about keeping your operating expenses in mind when setting the price for your product. To do this, you estimate the cost of business expenses like rent, advertising, product development, salaries and other operating items. Next, determine which expenses are fixed and which are variable. In other words, which costs will recur whether you sell 1 app or 1,000 apps? Rent expense, for example, is a fixed cost. Sales commissions, royalties and licenses paid are (mostly) variable.
The Shutdown Rule in economics states that if your variable costs are greater than your revenue, then your firm is not covering production costs and should immediately shut down.
If your revenue does not cover variable costs, your company should shut down.
To operate a business for at least a short while, your revenue has to cover variable costs. To be profitable, however, your revenue has to cover variable AND fixed costs (with some left over).
3. What value are you providing?
This is actually the most critical question you should be asking. When you came up with the idea for the app, what problem were you trying to solve? The goal behind value-based pricing is to quantity the customer’s understood value of your product and charge a price that can be deemed “fair” by the customer.
I bold “understood” when I speak about value, because many times we falsely assume others see the value in a our products, when they genuinely don’t.
Example: Let’s imagine that your app allows customers to test their vision online. You’re saving users a visit to the doctor (to get a referral) and eliminating the copay fee at the optometrist. I pay a copay of $10 at my optometrist and my time is super limited. Would I pay $20 for your product? Absolutely. Do I care that your hosting expenses are $0.06? Nope! Would I trust your app if you only charged $0.30? No way!
Let’s discuss SaaS Pricing concepts
Price and payment plan
First, determine whether you want customers to pay up front, in one swoosh, or whether you offer something new and valuable every month (or day / week / year). The price and payment plan should match your offering.
The vision test app I mentioned above – I’d probably use it once and then never again. For this type of app, it makes sense to charge a single, up-front fee. Headspace, Andy Puddicombe’s app for guided meditation, continuously evolves and new sessions are constantly added. Headspace offers a monthly, annual and lifetime subscription program.
Whether you charge a single up-front fee or offer an annual plan with monthly payments, both options must be profitable for your business and be in line with the customer’s understood value of your product.
Proxy based pricing
Pricing becomes more complicated when your product has a sizing component.
Example: Let’s imagine your product is a web-based application that shows electricity usage of light bulbs in a hospital. Would you charge all hospitals the same price? Probably not. You will need a proxy to determine the value of your product given the customer’s size. You could define a pricing model based on the number of light bulbs, the number of rooms, the real-estate size, electricity bill etc. For transparency, you should define your proxy to customers.
What’s great about proxy based pricing
- It’s easily explained to customers.
- It can be adapted to all sizes of customers
- You maximize your revenue: small customers pay a lower fee, while larger customers pay a higher fee.
- Revenue is limited / insignificant for small sized customers. If you underestimate number of small-scale customers in your target market, your revenue will fall below forecast.
- Your or your sales will need to get to know the customer.
Common proxies in SaaS based pricing models:
- Number of users with access (licenses)
- Annual revenue
- Real estate size
- Customer’s monthly expense (of the item we’re providing value to, i.e. electricity)
In this scenario, you look at the price of your competition and offer something in line with them.
Example: Most web-based fitness programs charge $9.99 for monthly access. So, you decide to charge $9.95.
You may already know why this approach isn’t optimal:
- First, the value of product is not considered.
- Second, the customer’s size (and buying potential) not considered.
Why it’s commonly used:
- The price is quickly accepted by customers – they’re familiar with market prices.
- It requires no investigation of operating expenses or quantification of customer’s understood value of your product.
No-cost to start, then pricey extensions
Marketing and sales are expensive operating expenses. The concept behind this pricing model is that you lure potential customers in with minimal initial touch points (fewer sales reps = lower costs). Customers try and use your product for a while for free and once they’re hooked, you make them an offer they can’t refuse.
You could go about doing this by offering a portion of your product at no cost.
- first month access to NetFlix at no cost;
- prestashop E-commerce platform (open source) with pricey add-ons; or
- first 10 guided meditations on Headspace for free.
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