In the past year, the software industry had a rude awakening. Gone are the times of unlimited access to funds, when venture capitalists and private investors were aggressively investing in technology companies and reaping the benefits of what could be called the fastest growth any industry has witnessed in the history of commerce.
Now, software companies are getting pinched on both sides after capital costs increased precipitously and demand softened. Feeling the pressure to raise prices and cut costs, it is hardly surprising that one of the early outcomes was multiple layoffs. Companies headquartered in the U.S. laid off If layoffs continue at the same pace, it is on track to meet the 2023 numbers at just over 180,000.
In this period of what Wall Street would call “cost discipline,” software companies are being forced to pivot business strategy. While the immediate response is to cut costs, the long-term sustainable path to revenue growth lies in revisiting pricing strategy and implementing discipline in pricing structure and discounting. Companies will be differentiated by their ability in identifying margin leakages and plugging them. But also, the ability to pivot as market conditions change and build that definitive pricing strategy.
To answer this, we have analyzed the impact on pricing from each of the broader trends in the software sector and identified the five key market trends to act upon. In the article below, we outline data-based recommendations that will help you navigate the current volatility and set up your organization for long-term revenue growth.
Increasing Financial Pressure to Demonstrate Profitability
For many years, software companies enjoyed fast growth driven by customer acquisition and easy access to funds. During the pandemic that growth accelerated as explained by the abrupt uptick in virtual or remote working. As is typical, that growth was accompanied by a hiring boom. Also quite common, fast growth also precipitated pricing practices that were inconsistent and included significant discounting to increase the annual rate of return.
Fast forward to today, and much of the optimism has dissipated. Funding is much harder to obtain and more expensive, and those with funding are seeing increased pressure to demonstrate profitability. As we mentioned above, cutting costs through layoffs and reducing spend across the industry is one way software companies have been addressing this issue. While cost optimization is fundamental to successful business, the other side of it is pricing optimization and value creation, which work in tandem to increase topline revenue and minimize margin leakages. Pricing optimization is by far the most effective lever to pull when faced with issues of profitability.
Opportunity: Build Sustainable Pricing Architecture
Overcome Customer Pushback on Price
During periods of uncertainty in business, value and price emerge as the dominant factors during the buying process for software . That translates into escalating requests for customization and increasing downward pressure on price. Especially in the B2B context, customers often have the balance of power that they either use delay tactics such as the threat of going to RFP to prevent price increases or receive discounts.
We have seen this exact situation in clients across software and technology, where client pushback resulted a broadly unsuccessful price increase.
Client Story: 1/3 of Existing Customers Forced a Price Escalator Roll Back
After four years of no price increases, the new management of our client found themselves addressing immediate profitability concerns. The initial plan was an across-the-board 5% YOY price increase escalator for every new contract or renewal. Missing from that price increase rollout was a plan on how to justify the price increase requirement to existing customers.
The pushback from their customer base was immediate and fierce. They demanded that the price escalator be removed, the scope of work be reduced (a decrease in revenue), or failing that, they would initiate RFP. Even with established, long-standing relationships, many in the decades, about 1/3 of these clients succeeded with rolling back the price escalator.
The client approached Revenue Management Labs after this initial attempt at raising prices. A few things could be improved here:
- Freezing price increases eventually erodes margins.
- Optimize price according to the customer willingness to pay setup on customer segmentation analysis
- Use value-based justifications in pricing communications.
- Empowering the sales team with answers to FAQs, with negotiation guidelines to increase your success rate.
- Optimizing price according to the willingness to pay through segmentation reduces customer blowback.
Opportunity: Align Pricing Strategy with Customer Willingness to Pay
According to the 2024 Global Software Buying Trends Report, half of software buyers cite price expectation misalignment as the top reason for dropping a software provider from purchase consideration. This misalignment can stem from inadequate communication of the value or a larger issue with pricing strategy. This second issue can be helped by carefully balancing price strategy for each customer segment with willingness to pay to maximize revenue and margin.
Price expectation misalignment is the top reason that for dropping a software provider from purchase consideration.
The communication issue can be solved painlessly with increased support for the sales team through training on customer negotiation and playbooks that address common pain points. Realigning your pricing strategy with customer willingness to pay is longer process that requires research and analysis. One key pillar is customer segmentation that is based on purchase behaviors and a value-based pricing strategy.
How to Conduct a Willingness-to-Pay (WTP) Assessment
1. Identifying Your Customer Segments
We approach defining customer segments by examining their behaviors and needs. In the example above of the software company, we formed customer segments based on the software use cases, the complexity of their usage (how many different uses), and how critical it was to the customer’s business operations.
2. Mapping Customer Segments to Willingness to Pay
Understanding your customer behaviors and values is fundamental to a willingness to pay assessment. In an ideal world, we would have the full gamut of customer data plus primary research in the form of internal discussions, and surveys and interviews with customers to map the value differentiators, comparison versus competition and price elasticity.
We use various methods to assess WTP such as:
- Conjoint analysis: Present respondents with different product/service features with prices and asking them to choose their preferred option,
- Surveys/interviews: Conduct surveys/interviews to ask customers need or situation-based questions to gauge their willingness to pay.
- Van Westendorp Price Sensitivity Meter: Ask respondents a series of questions to determine price thresholds (e.g., at what price the product is considered too expensive or too cheap).
It is critical to remember willingness to pay can be influenced by numerous factors such as perceived or financial value, and competitive market conditions. For example, if the software is critical to their business and there are not a lot of competitors in the industry, then you can be more aggressive in price, and vice versa.
Complex Price Structure Reduces Adaptability
A streamlined price structure is crucial for profitability during times of economic volatility, allowing companies to swiftly adapt to changing market conditions, customer preferences, and competitive landscapes. What we often see instead is an elaborate pricing process with no structure , which leads to two business managers producing different prices for the same business case, while using the same pricing model.
For one client, their pricing process per customer took two months and involved over 100 variables with frequent back and forth to set scope and labor requirements. The result was a lot of internal resources being spent to set up price resulting in poor customer experience, leaving the impression that our client was hard to work with.
A price structure is more than setting the core price but also includes discounting, sales, tiered pricing, and internal and external controls or rules on how it implemented. A notable example on how to effectively implement new external pricing controls and plug margin leakages comes from Netflix password sharing issue. Netflix made the tough decision to enact a global crackdown on password sharing and the results far exceeded expectations. In their third quarter results from 2023, they added 8.8 million subscribers and a net profit increase of 20% because of the new controls. Now other companies are following their lead.
Weak internal controls can also cause margin leakages. Due to high complexity in the sales process and low visibility to competitive pricing, companies are frequently over reliant on sales to minimize customer turnover, resulting in common issues such as inconsistent price dispersion across customers, such as a small, low-value account may also receive price concessions like large, strategic customers. In such situations, the main issue is not the lost revenue, but rather the exposure to channel conflict. Then, you run the risk of damaging your relationship with your highest value accounts.
Without a structure underlying the pricing process, one possible knock-on effect is that the prices are not often updated as needed, nor is it clearly understood how services are priced across the company. Financially, costs cannot be allocated at a customer level on ongoing implementation, and you will not be able to validate if the original assumptions you made on the contract are in line with the amount of data or time needed to service it.
Opportunity: Standardizing the Pricing Structure
The first step to streamlining the pricing process is to standardize the pricing structure and the discount guidelines with the goal of simplifying the decision-making process. Usually, we recommend identifying the critical variables that have the highest impact on pricing.
One method is to conduct an internal survey to identify pain points and do one-on-one interviews with stakeholders to identify the root cause. In the company with 100 variables, we created a simplified pricing calculation which required only two inputs to recommend a price for the customer. It simplified the customer acquisition process and reduced the pricing process to two weeks instead of two months. By accelerating and streamlining their selling process, they increased their win-rate by 5.4%.
Streamlining the selling process increased their win-rate by 5.4% for one of our clients.
Transitioning to Innovative Pricing Models
Subscription pricing revolutionized the software industry but even a disruption on pricing can still be based on outdated pricing structures such as cost-plus pricing. Instead of a per license fee structure using costs as the basis for pricing, we are seeing a shift to pricing as a service and based on the value created. In a value-based pricing structure, customers are paying both for what they need and what will have a measurable impact on their business. The key to succeeding at this pricing model is having a firm grasp of your impact on their ROI (return on their investment), so you can sell the value.
Opportunity: Increase Customer Retention with Value-based Pricing
Value-based pricing aligns ROI expectations with the price, clearly demonstrating the value of your software and making it easier for your customers to understand. For one of our clients, value-based pricing helped address slowing customer penetration rate. They were catering their offer to niche customers at a premium price point, making it difficult to get new customer and keep existing ones. We identified customer pain points and then developed customer use cases to demonstrate the value. As a result of optimizing their pricing strategy, their customer retention rate reached +95%.
Ongoing Data Issues Hindering Pricing Strategy
All the above is not possible without having the data to inform pricing strategy. You would imagine software companies to use best in class data management processes but at Revenue Management Labs, we have seen every data issue under the sun from inaccessible or too little data to too many data input requirements resulting in bottlenecks to configure pricing. Having a well-executed and consistent data strategy for collecting and using customer information is fundamental to pricing strategy success. It lays the foundation for implementing price adjustments efficiently and understanding how those changes impact margin and profitability.
For one of our clients, their data practices proved to be a significant obstacle to improving their margins. They did not have full visibility into all the costs associated with their services and could not measure their margin. The company hosted all their data on Amazon Web Servers and that data at a customer level on server usage was not available, leaving them unable to quantify their costs at the customer level. To understand their costs, we helped them set up a cost allocation algorithm that provided a more accurate estimate of costs and improved the effectiveness of their pricing decisions.
Opportunity: Identify Short-Term Wins Using Customer Data
Ideally, you would have captured all transaction-level data to effectively capture the full potential of margin optimization. In the less-than-ideal reality, you can start with the customer data you do have to identify initiatives that can be executed within 3 to 4 months.
Absent that data, the first step would be to set up a minimum viable database that enables you to start data-based pricing decision making. In the long-term, you will need to set up a system and processes for data collection and monitoring that will form the foundation of your pricing decisions. This is often a process that can take years, but with short- and medium-term plans in place, improvements in margin do not need to wait for the optimal situation.
Data will become even more crucial as artificial intelligence penetrate business practices in the year to come.
The overarching theme for software is having a strong pricing foundation and basing that on clean, trustable data. Often getting the pricing pillars in place will already set up companies to be more profitable. Then, they will be in a better position to take the next step and explore more innovative pricing models. A strong pricing foundation will also make companies more resilient in the face of increasing financial pressures and the ongoing risk from economic and geopolitical precarity. A well-designed and standardized pricing structure embeds adaptability into business processes and forms the cornerstone for long-term sustainable success, especially in as dynamic an industry as software.
