Updated: Aug 18, 2020
As an entrepreneur, you shouldn’t wear every hat at once. But you should try them all on. Here’s a resource to help you understand the thought process behind how to price your SaaS product before you can afford a CFO.
You have a software service and you’re ready to put it out in the world. But how do you know how much to charge? This process is a combination of subjective and objective inputs and can give you a working framework to begin testing the market without hiring a consultant or commissioning a consumer behavior study.
Regardless of where you start, you will have to adjust your pricing according to natural feedback from the market and from your internal operations.
If you’re looking to price your Software as a Service (SaaS) product, competitor and like products are not the only resource you have, and in many cases, they do not offer the most effective benchmarks. Especially with enterprise software companies, pricing is deeply buried and opaque. is often because many B2B companies, software specifically, are highly negotiable, regardless of your firm size.
In some cases, each package is truly customized to each client, and thus a price indicator would only be appropriate much later in the sales conversation.
But in most cases, firms are insecure about their pricing strategy and worry about scaring off potential clients or setting the bar too low for future negotiations. Now that more than half of the buying process is done online before speaking to a representative, firms should be just as concerned with being discounted for lack of relevant information.
1. Competition and like products
This one is the most straightforward to calculate, so it’s a great place to start. If you have a number of established competitors, what do they charge and how do they structure it? Is price publicly available, or do you need to begin a sales conversation? Are rates set, tiered, or negotiable? Does your product offer more or fewer functions?
You get the picture, figure out how you compare functionally, tweak average competitor price accordingly, and you’ve got your first input.
If you don’t have any direct competitors (yet), look at similar products. For example, if I am looking to price an enterprise software package that assesses employee engagement, then I would look to other human resources (HR) software packages to get a feel for the total price of a full HR package and the prices of individual a la carte functions.
By looking at a full HR software package, I now have a starting point for how much companies are willing to spend on total HR software. By looking at a la carte services from an HR software company, I can understand the price range of each individual function.
Depending on your industry, third party service providers may aggregate pricing across the State, region or country to help with this process.
2. Opportunity Cost for Your Customer
You won’t be able to answer this riddle unless you can first answer this one: what problem are you solving for your people? Everything that people purchase solves a problem in some sense of the phrase.
Most, but not all, services reduce time spent doing something disinteresting or substitute the cost of a pricey expert.
How much time does it save, and exactly how tedious is the task?
Before TaxAct and TurboTax, every year one either had to meticulously sift through paperwork or work directly with an accountant. It’s no wonder these were one of the first commonly used home software programs.
How much time does it save, and how much skill is necessary for your customers to complete tasks without your solution?
3. Cost of goods
What does it cost you to make your product in terms of raw materials and direct labor?
Obviously, your price needs to be higher than your cost of goods, but how much higher is not quite as obvious. You might consider a cost-plus pricing model, which simply adds a pre-determined markup to your cost of goods. Many companies assume a template that is 30% cost of goods, 30% cost of sales, 40% overhead, and hopefully, profit.
For a basic non-SaaS example, think about a simple product like a cast iron pot. If my cast iron pot is made entirely out of, well, iron, then I need to consider the cost of raw material and the cost of labor to produce it.
We should also consider things like cast molds and machinery to be important. Molds and machinery are fixed costs that can be depreciated over many cast iron pots, they are a direct input into their production, and a per-pot attribution is not very difficult to calculate. (How much did it cost, divided by how many years will it last, divided by how many pots can you make in one year without purchasing another).
For a SaaS company you can use the same principles.
Look at your cost to create the product, including the labor of your tech development team, technology consultants, and other up-front investments. Those costs are an investment, not direct COGS, and should be theoretically depreciated (whether you capitalize or expense the investment is a choice you will weigh with your accountant) over a reasonable life of the product, the standard is 7 years.
Then look at your direct costs. What are the direct labor costs of your technology development team, from maintenance to new feature development? Add the recurring expenses such as server fees.
Think about how many licenses you’ll sell over the next year. Add the annualized cost of your upfront investment to the annualized expense of direct labor and costs. Divide that number by the target number of licenses over the next year.
Now you know what you need to break even on direct inputs, not counting the cost of running the business. If you sell your product for less than this, you’ll never make a profit until you update your pricing strategy. Again, many companies will benchmark COGS at 30% of their sales.
4. Cost of sales, including the length and seasonality of sales cycle.
What does it cost you to attract one dollar of sales? First, list the inputs and time allotment into your sales process. In an enterprise software model, you might be looking at an 18 month sales cycle that consists of relationship building, educational resources, and demo environments.
Large corporations and institutions typically allocate funds during their annual budgeting process, which occurs from a few months to a few weeks before the end of their fiscal year. If you have a long sales cycle, then your administrative overhead burden can be significantly larger than even one years’ allocation.
A long sales cycle does not mean an unhealthy sales cycle. When buyers make a purchasing decision, they are weighing their internal training and implementation costs of adopting a new resource, the cost and headache-relieving value of what they expect from the new resource, gauging company buy-in, and deciding if you and your team are individuals they want to work with.
A longer sales cycle is often complemented by a longer customer relationship, and hence, a higher lifetime customer value. The cost of sales still needs to work into the price of your product or service for the length of the contract term.