At Spiderz, we’ve had our fair share of dealing with complex bits and bytes that require careful costing and pricing. As a web services provider, we face the unique challenge of pricing services that inherently differ from one another, and require careful consideration of all direct and indirect costs.
In this article I take a basic approach to pricing and apply it to one of our services. I also talk about some of the pricing strategies that can be used to price your services, and why these matter. So let’s start.
Pricing, as it happens, presents both a challenge and an opportunity for businesses. It’s a vital element that bridges the gap between a company’s bottom line and its customer relationships. It’s a complex yet rewarding exercise in balancing costs, market expectations, and company goals.
If we take the example of our web hosting service, we must cost for compute (instances; a fancy name for virtual machines), storage (disk space), backups (snapshots and long-term archiving), data transfer out, software licenses, and customer service. Each of these components incur costs that must be factored into the pricing equation.
A barebones, rookie way to do this is to use a markup or margin. Markup is the percentage increase over the cost price of a service, while margin is the percentage of the selling price that is profit.
There’s a common mistake of interchanging ‘markup’ and ‘margin’ to mean one and the same thing, but these are two very different terms. For instance, a 100% markup on a service costing AED 100 would price it at AED 200. However, a 50% margin on the same service would require a selling price of AED 200 to yield an AED 100 profit.
Now, let’s consider how these calculations apply to our web hosting service:
Pricing Using Markup: If the total cost of setting up a server instance is AED 100 per month per customer, and we want a 50% return on costs, we’d calculate the selling price as follows.
The formula to calculate the selling price using markup is:
Selling price = Cost + (Cost * Markup)
Given that the cost is AED 100 and the markup is 50%, we can substitute these into the formula:
Selling price = 100 + (100 * 50/100)
Selling price = 100 + 50
Selling price = 150
So, the selling price using a 50% markup would be AED 150.
Pricing Using Margin: If we aim for a profit margin of 50% on the selling price, we calculate the selling price as follows.
The formula to calculate the selling price using margin is:
Selling price = Cost / (1 – Margin)
Given that the cost is AED 100 and the margin is 50%, we can substitute these into the formula:
Selling price = 100 / (1 – 50/100)
Selling price = 100 / 0.5
Selling price = 200
And, the selling price using a 50% margin would be AED 200.
Remember, markup and margin percentages won’t give you the same selling price, even if the percentages are the same. This is because markup is a percentage of the cost, while margin is a percentage of the selling price.
To understand pricing a bit better, let’s look into various strategies we can employ. Keep in mind the use of markup or margin and consider that many factors other than cost and percentages determine price.
If we perceive that our customers highly value our services and are willing to pay a premium, a value-based approach might be the best fit. On the other hand, if we operate in a highly competitive market, a competitor-based strategy could be more appropriate, where our pricing mirrors that of our competitors.
In scenarios where we aim to cater to as many customers as possible, an economy pricing strategy could be employed. Here, we’d set a lower price, targeting a smaller margin but hoping to compensate with high sales volume. Contrarily, if our services are uniquely superior, we might adopt a premium pricing strategy, setting our sights on a higher markup or margin.
Bundling our services is another approach, offering multiple services for a single price. Our markup or margin here would be calculated on the total cost of all services within the bundle.
As market dynamics fluctuate, we might need to adopt dynamic pricing, adjusting our prices in response to factors like market demand, competitor pricing, and other external variables.
Upon the launch of a new service, we might implement a price skimming strategy. Starting with a high price (and, therefore, a high margin), we’d gradually decrease the price over time as the novelty of the product fades and competition intensifies. Alternatively, we might opt for penetration pricing, beginning with a low price (possibly even incurring a minimal margin or a loss) to capture market share. As we solidify our position in the market, prices (and margins) can be gradually increased.
Considering the evolution of cost structure and economic factors over time, we need to adjust our prices accordingly to maintain our targeted markup or margin. This is where the costs over time strategy comes into play.
Finally, customer segmentation is an effective strategy where we would offer varying prices to different customer groups. For instance, we might set a lower price (and thus accept a lower margin) for startups and small businesses, while charging a higher price (and aiming for a higher margin) for larger businesses with more demanding needs.
A successful pricing strategy balances our costs, the perceived value to customers, and competitor prices. The perfect approach will depend on our unique circumstances, strategic goals, and market dynamics.
Above that, we need to regularly review and adjust our pricing to remain competitive, cover our costs, and continue to generate an adequate return on our investment. Navigating pricing isn’t a one-time field trip; it’s an ongoing quest that demands constant attention and fine-tuning.
Taking our web hosting service as an example, we need to carefully tally our core costs such as setting up an instance in AWS or Azure, procuring cPanel and Plesk licenses, investing in Immunify 360 for security, arranging long-term backups in AWS S3 Glacier Deep Archive, and managing data transfer out. Once we have accounted for these, we can select a markup or margin to determine our initial pricing.
The choice between using markup or margin can depend on the business context, pricing strategy, and whether a business prefers to set prices based on cost or selling price. However, do keep in mind that determining the right cost of services helps ensure you do actually make a profit. So, don’t forget to keep an eye on your direct and indirect costs. Not just those of the core service.
In our case, if we were to assume that the AED 100 per month per customer cost was enough to determine our selling price, we’d have ignored all the other direct and indirect costs that go into pricing our web hosting service.
Our direct costs also include expenses such as routine maintenance and customer support. While indirect costs are items like rent, utilities, insurance, marketing and advertising, administrative overhead, and any other operational costs necessary for running our business.
Pricing is a complex process that necessitates an understanding of costs, the right application of markup or margin, and attention to evolving market dynamics. There is no universal pricing strategy that fits all. The most effective strategy often depends on our product offering, unique circumstances, strategic objectives, and the ever-evolving business landscape.
If you ask me, and this is true across the board, from products like those of Apple to Kit Kat, if you solve the pricing conundrum, you can actually, stay profitable.