Pricing strategy relies on a good understanding of customer price sensitivity. The Information and Communication Technology (ICT) sector, including the software industry, is no different. Yet, some peculiarities in this industry present unique challenges.
1) Software is often a substantial investment both in relative and absolute terms; Switching can be costly. Especially as time passes and more users become versed in the software. Beyond direct cost, maintenance and support, indirect costs such as training and implementation also make switching difficult. As a result, customers typically ascribe high value to reliability of the product and expected availability of the vendor for the long term. Reliability of the software and stability of the company will attract a less price-sensitive customer. Estimating the impact of these two factors will have a bearing on quantifying the price/value relationship.
2) Total Cost of Ownership (TCO); A customer may be more interested in total price when assessing the investment in software. Often a customer expects the vendor to assume some of the risks associated with TCO. This has given rise to pricing structures such as subscription models which avoid high up-front prices, spreading them over a longer period of time.
3) Value perception among segments; No uniform formula exists for assessing the benefit of a particular software. Most vendors try to provide an ROI that estimates and quantifies potential benefits. But real value varies from one customer to another. Segmenting customers into a number of distinct groups based on perceived value guarantees an understanding of price sensitivity.
4) Shifting demand; The largest proportion of software license investments are a one-time deal. A company buys a number of modules, and license seats for users to access the modules. Buyers may add modules or seats. Industry growth, however, is expected from new sales. Markets become saturated. The adoption of new software starts with large companies and eventually trickles down to smaller customers. As a product matures, growth opportunities come from smaller customers who are more price sensitive due to less buying power. The subscription model emerged to address this challenge.
5) Software maturity; Software maturity results from the lack of differentiation among offerings. At this point software vendors with greater brand recognition and larger market shares benefit. This is due to their cost leadership and greater ability to compete on price. Price sensitivity is on the rise. Porter s Five Forces Analysis on the software industry points to increased competition and downward pressure on price.
The next step is to map the vendor specific current price/value relationship and where it should be, considering industry dynamics. Typically, the focus shifts to mining historical information in order to gain a better understanding of price sensitivity related to historical purchasing behavior. What is sought is the price level at which an average customer or segment will walk away.
Next is to ensure that a price is set as close as possible to a walkaway point without endangering the sale. The starting point is an examination of historical sales data. There are two primary dimensions to explore.
1) Success rate This analysis is intended to identify the boundaries between successful and unsuccessful sales attempts. It is meant to understand why a deal fails and when it happens if it is due to price. For this analysis, it is necessary not only to have data that captures sales, but also records quotes that did not result in successful closure.
2) Regression If a company changes prices regularly it is important to understand the effects on demand. Linear regression helps detect these relationships and their impact. When a company lacks the required data, neither analysis can be completed. Occasions in which software firms lack reliable and pertinent raw data are not infrequent. In these situations, creativity and imagination are needed to come up with solutions based on whatever data is available. The estimates of price sensitivity still have to be more customer specific while reflecting industry realities. A two-fold approach can be conceptualized: 1. Estimate the typical software budget in a large, medium and small company from external data; 2. Analyze discounts for each of these segments from historical sales data A viable objective is to gain insight on spending patterns of customers in each segment and compare it to external data. Using an estimate of the probability of sales in each segment will yield a price elasticity calculation. In one example, it was confirmed that revenues from large IT customers would increase, suggesting relatively lower price sensitivity. Smaller IT customers showed the opposite. Higher walkaway rates suggested higher price sensitivity. Using analysis of historical data provides input for calculating average discounts awarded to different segments. Comparing actual results against expected results may cover the price/value characteristics of client customers. External data may indicate that large companies should be less price sensitive. In one case, expected software spending of large companies was in the range of 200-250K. However, actual results showed that an average large company spent 150K. The software company in question was closing deals with large customers by giving needlessly sizeable discounts. The same company was achieving premiums from medium sized customers and above average revenues from the smallfry. Some large companies may be price-buyers. Medium companies can be value buyers. And small companies might be relationship buyers. If this is true, overall revenues can be optimized by selling more seats to large companies rather than increasing price, and creating price models that allow for radiating and saturating in this segment. With smaller customers, profit optimization may be achieved by investing in relationships.
In his classic play, Cyrano de Bergerac, Edmond Rostand tells a story of deception. It is the story of a young soldier, Cyrano de Bergerac, helping his comrade to woo Roxanne, the woman with whom they are both in love. He does this because he believes that he is unworthy of her due to his appearance and it is only at the end of the play that Roxanne finds out who her real suitor was and understands his value.
In the IT world the real needs of customers and underlying value in the marketplace must be recognized. To conclude: Price sensitivity is a powerful tool yet one must be wary not to be misled. Price is not the only variable in customer decisionmaking. It is important to understand customer decisionmaking drivers very well. Scenarios that model probabilities of sale to each segment with varying prices provides multiple perspectives. Estimating price sensitivity maximizes the probability of sale by identifying the price that is just below the customer walkaway price.
Price sensitivity in IT is like price sensitivity in any industry. It requires knowledge, care and attention. But understanding it can reap huge benefits. Customers definitely pay a lot of attention to price but that is not the only variable in decisionmaking. The bottom line is to know your customers very well, and understand where they are coming from. Developing scenarios that model probabilities of sale to each segment with varying prices (with changing price sensitivity) provides multiple perspectives. The desired outcome of estimating price sensitivity is to maximize the probability of each sale by identifying the price that is just below the customer walkaway price.
Alain Meloche, M.Sc., M.B.A. Alain has over twenty years of experience advising executives on strategic issues. He began his consulting career at Larson & Company, a strategic consulting boutique that was an offshoot of McKinsey, later acquired by Mercer Consulting, where he also worked. He has developed strategies for high technology companies in the software, internet, telecommunications, logistics, medical products and financial services industries. A key element in Alain s consulting practice has been the combination of analytical approaches such as decision analysis and game theory to develop and implement a range of strategies. In addition to an M.B.A. from the Harvard Business School, Alain also has an M.Sc. in Nuclear Engineering and an Honors B.S. in theoretical physics.
To obtain more information on pricing strategy, software pricing or the work performed by Alain and his partners, please go to our website at www.stratprice.com
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