Should a buyer care how a product is priced?
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talio.
Companies take different approaches to designing packaging and pricing. From one perspective, these all seem to be different paths to the same outcome. Working out how to put together functionality and services into packages that buyers can buy and then setting a price for these packages.
Beyond that, pricing generally needs to cover how unit prices change across scale (volume discounting) and how other discounts are awarded for time commitments, buying more than one package, expanding usage and so on.
There are six standard ways to design pricing, all of which can be seen in B2B SaaS.
The six common approaches to setting B2B SaaS pricing
Cost Plus
Competition Based
Willingness to Pay (B2B)
Value Based
Behavioral Based
Outcomes Based
Ibbaka’s current research into AI monetization in 2024 asks what approach companies are taking to pricing the new value being created by artificial intelligence.
You can take the AI monetization in 2024 survey here.
The answers by the first 180 respondents to the question “What method did you use to set prices?” are distributed as follows.
The 4 most common approaches for this group of companies is
Cost Plus 14%
Competition Based 32%
Willingness to Pay (WTP) 19%
Value Based (all types) 27%
Outcomes-based pricing was a distant fifth at 4%. Behavioral-based pricing, sometimes mentioned as the next big thing, is being used by less than 1% of the companies.
What behaviors do each of these pricing methodologies encourage?
Which pricing methodology encourages the behaviors that are most in the buyer’s interest?
Let’s work through each approach and try to answer these questions.
Cost Plus Pricing
This was once the most common form of pricing and is still used by a surprising number of companies. Basically, one adds up the cost of the solution and tops it up with the target margin. The key to success is to only consider variable costs when setting prices. Before you begin R&D development costs are variable costs and should be included. But once you are in the market an obsessive insistence on adding a margin to sunk costs can lead to a lot of poor pricing decisions.
Cost plus pricing does a poor job of aligning buyer and seller. Many of the counterproductive behaviors seen in procurement departments are a result of the assumption that pricing is and should be cost plus.
The buyer tries to unbundle the offer and costs in order to negotiate discounts line by line
The seller has no real incentive to reduce costs as lower costs lead to lower revenues and lower margins
Neither party has any real insights into how value is being created and how to create more value
This rapidly becomes a zero-sum game (a game in which whatever one party gains the other loses)
Competition Based Pricing
Many companies look at what their competitors charge and use that as an anchor for their own prices.
This is common at the beginning of innovation, where young companies lack the experience and expertise to execute on other approaches to pricing. The product is still in development and there is uncertainty as to what it is, how it will deliver value, and what the costs will be.
It is also common towards the end of the product lifecycle, where competition has flattened out differentiation, and most products are commodities. The market sets the price for commodities.
Procurement organizations like competition based pricing almost as much as cost plus pricing, and they often blend them together to cherry pick the lowest cost/differentiation part of the solution.
Competition based pricing encourages commoditization and makes it more difficult to get a good return on innovation investment.
In this case the zero sum game is between competing vendors rather than buyer and seller. But it is still a zero sum game.
Willingness to Pay (WTP) Pricing
In willingness to pay (WTP) approaches the seller tries to guess how much a buyer is willing to pay. This can be done through prospect and customer interviews, or with more sophisticated market survey tools like Van Westendorp (see this study of Van Westendorp applied to Microsoft Copilot and other productivity suites) or Conjoint.
Some consultants confuse WTP with value based pricing, but they are not the same thing. Willingness to pay is influenced by value, especially differentiation value, but it is dependent on many other things as well, such as the ability to pay, brand strength, positioning and how effective the sales force is at communicating value.
If a consultant tries to sell you value based pricing based on willingness to pay, run the other way.
Value Based Pricing
In value based pricing one estimates the economic value a solution will provide to a buyer and then finds a fair way to share value between buyer and seller.
Value based pricing aligns the interests of buyer and seller in a positive sum game (a game where both parties can win and one party’s gain can be the other party’s game as well).
There are three approaches to value-based pricing.
Design pricing that approximates value (the most common approach)
Derive pricing directly from the value model
Implement a process where the price is directly based on the value
We ask about all three in the AI monetization survey. By far the most common approach is based on approximating value (19%). Only 6% are using the more advanced technique where price is derived directly from a value model. Even fewer have an adaptive process where value, value share and price are calculated for each customer (2%).
Behavioral Pricing
Behavioral pricing applies insights from prospect theory and behavioral economics to the design and communication of pricing. It has a bad reputation in some circles, as it can be abused to trick buyers into paying higher prices. This does not have to be the case though.
One aspect of behavioral-based pricing uses basic psychology to help frame (put in context) and anchor (set an expected value for) prices. This can be done with any of the other pricing approaches.
Prospect theory also gives a lot of insights into pricing design. The basic insight here is that many people (not all, and there is a lot of situation dependency) prefer to avoid a loss (cost) rather than to win a gain. This can pose some real challenges for value-based pricing, which is focused on gains and, in its standard approach, lacks a good way to weight losses and gains differently.
The emerging best practice is to apply insights from behavioral pricing to pricing design.
Outcomes Based Pricing
Outcomes based pricing is the best way to align the interests of buyer and seller.
Just over 4% of the respondents to the AI monetization survey have indicated that they are using outcomes based pricing to capture the value they are creating through AI. That is just eight companies.
This will likely change over time as AI itself will help to address the most common objections to outcomes based pricing: it makes pricing difficult to predict, and the outcomes have multiple causes, and it is difficult to attribute cause just to one solution.