Developing a Pricing Strategy: Part 1

This is the first of two articles on developing a pricing strategy for Internet products and services.

There is a continuum that is used to develop a pricing strategy. On one end is your cost to develop the product and your profit targets (margins). Customer demand, competition, and other market forces define the other end of the continuum.

This first article focuses on margins, the measure of cost and profitability of a product. It is the basis for determining the financial success of your products and therefore your responsibility as a product manager.

Margin Defined

A margin, the ratio of profit to revenue of a particular product, can be used to measure the financial success of a product. To calculate margin, take the profit associated with a product (sales price less total costs) and represent it as a percentage of the selling price (i.e., revenue).

Doing the math:

• Your product sells for $1,000.
• Your total cost to produce that unit is $700.
• Your margin is $300, or 30 percent.

As a product manager, it is your responsibility to manage margins for your products. All tactics used by the product manager (e.g., new features, marketing, etc.) should be justified in terms of how they impact margins of a given product.

In developing your pricing strategy, the target margin (usually set by your CFO) serves as a floor for pricing your product. If, as a company, you must meet 30 percent margins on all products and it costs you $700 to produce a product, the lowest price you could offer would be $1,000.

Gross Margin

Most Internet companies determine their pricing strategies based on the “gross margin” of the product. A gross margin measures only the variable costs to produce the product.

The variable costs, also referred to as the costs of goods sold (COGS), include any cost directly associated with producing and selling one incremental product unit. In other words, these are the costs that you incur when you sell your 15th copy of “How to Marry a Millionaire or Just Look Like One” that you would not incur if you only sold 14 copies.

Typical variable costs include:

• Technical cost to produce/acquire the unit sold
• Sales commission on the sale
• Marketing cost to acquire and retain the customer shared over the number of units purchased
• Cost of professional services to service customer (e.g., salaries)

Doing the math:

Your product sells for $1,000.

Your variable cost is $400.

Your gross margin is $600, or 60 percent.

For start-ups, determining the gross margin for a product prior to launch can be a lot of guesswork. It is not uncommon to see the true cost of acquiring a customer be 2-5 times what you anticipated when you initially defined your pricing strategy. To avoid this kind of error, be conservative in your estimates and benchmark similar products in your industry.

Net Margin

Calculating the “net margin” for a product can be illuminating. The net margin includes the fixed and variable costs associated with producing a product and therefore is much lower than the gross margin.

Typical fixed costs include:

• Development labor and materials required to build the product
• Human (e.g., product manager) and technical infrastructure (e.g., servers) required to build and maintain the product
• Non-variable sales and marketing costs (e.g., print collateral)
• Overhead from general and administrative

To determine the net margin for a product, take the fixed costs, amortize them over the expected life of the product, then add the variable costs.

For traditional offline companies, fixed costs are often spread over three years. For Internet companies for which products are usually out of date shortly after their release, these costs should be amortized over 9-12 months.

Doing the math:

• Your product sells for $1,000.
• Your fixed cost is $500,000.
• Amortize your fixed costs over 12 months.
• Given that you expect 1,000 customers in those 12 months ($500 fixed cost per customer), your net cost is $900 ($500 fixed costs + $400 variable costs).
• Your net margin for your first year is $100, or 10 percent.

If you can record a positive net margin the first year of a product’s life, you should be in good shape. After the first year, the development costs are no longer part of the equation, increasing your net margin significantly.

However, should you decide to do new development to improve or fix your product, this cost will need to be added into your equation. It is treated just like the original development work and amortized over 9-12 months.

Next Steps

So that’s margins. Next week, we will discuss how to determine the right marketing position and overall pricing value for your products given the expected margin of the product.