Value-based Pricing for New Software Products

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Value-Based Pricing For New Software Products:
Strategy Insights for Developers
Robert Harmon1, David Raffo1, Stuart Faulk2,
Portland State University, School of Business, Portland, OR 97207 2
University of Oregon, Department of Computer Science, Eugene, OR 97403 1

Software pricing has traditionally been focused on the vendor’s internal business objectives of covering costs, achieving specified margins, and meeting the competition. Pricing methods such as flat price, tiered pricing, MIPS-based, usage-based, per user, per seat, and pay as you go, are often tactical in nature and easily matched by competitors, which can undermine profitability by accelerating the commoditization process. Conversely, a value-based approach charges a price based on the customer’s perceived value of the benefits received. Value-based pricing methodologies can be used to estimate the market value of new software concepts at various stages of the development process in addition to pricing new products for launch. This paper describes a value-based approach to pricing that is dependent on the firm’s commitment to invest in the development of its long-term “pricing capital.” This investment in methodologies, infrastructure, and processes to create, measure, analyze, and capture customer value is the key to successful long-term pricing strategy.

I.

INTRODUCTION

No tool in the marketing toolbox can increase sales or destroy demand more quickly than pricing strategy. The pricing decision is one of the most critical decisions that a firm can make in the launch of a product. Managers in the software industry have traditionally developed their pricing strategies by overemphasizing cost-related criteria at the expense of focusing on the value of the product to the customer. Cost-based pricing strategies are focused on short-term value to the vendor. Conversely, value-based pricing is based on the customer’s perception of the value of the product, not on product costs (see Figure 1). Value-based pricing strategies are focused on creating long-term value for the customer.

From a marketing perspective, the goal of pricing strategy is to assign a price that is the monetary equivalent of the value the customer perceives in the product while meeting profit and return on investment goals [37]. This paper posits the view that traditional cost-based approaches to software pricing are short-term, tactical in nature, and place the interests of the seller over the interests of the buyer. Conversely, pricing approaches based on customers’ perceptions of value are strategic and long-term in nature since they are focused on capturing unique value from each market segment through the pricing mechanism. We will argue that software firms need to invest to create “pricing capital” to ensure the long-term benefits of value-based pricing. Firms that invest in a strategic pricing center can make better product decisions throughout the development process by understanding how customers value product alternatives and arrive at prices that they are willing to pay.

1

FIGURE 1. Pricing Conflict in the Product Development Process II.

TRADITIONAL COST-BASED PRICING

Cost-based software pricing is historically the most popular method since it relies on more readily available information from the cost-accounting system. This data is generated as a matter of course to produce operating results, budgets, and financial statements. It is imbued with an aura of authenticity. Financial, marketing, and product managers are schooled to price the software product to yield a desired return on fully allocated costs. No product development/business plan for a new software product would be approved without an attractive ROI as its centerpiece [33]. This financial roadmap to profitability, which ignores the voice of the customer, can become a blueprint for mediocre market results. Cost-based pricing strategies can exploit the market power of the seller to force a higher...
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