Who does discount pricing work best for?
For retail, discounts can be great for liquidating unneeded products. But for SaaS, the pros of discount pricing are not as obvious as the cons. The idea of scoring a deal makes people feel as though they beat the system; however, your price is the exchange on the value you provide, so you need to tread cautiously when discounting.
Attempting to translate a retail practice to software
As human beings, we've been trained by a century's worth of retail pricing to love discounts. The idea of scoring a deal makes us feel like we’re beating the system, and to a greater extent, makes us feel special. Yet, to understand the discount pricing strategy, we need realize that at its core, a price is your exchange rate on the value you’re creating through your product or service. With that number put down in pixels, you’re saying that whatever you’ve produced is worth $X, because that product or service helps the customer in a manner that fits that equates to their perceived value.
Different types of customers value that product or service at different price points, meaning different segments of customers will have a different exchange rate, or perceived value, of your offering. Take a look at the price elasticity graph below (a screenshot from our software). The profile of the graph shows us that different segments of target customers value the product differently. As such, stakeholders need to decide where on that graph their product resides to spur a sizable profit margin for their business.
Once you’ve decided where on this range you’re going to price, discounting then comes into play in an attempt to move more sensitive customers “up river.” Essentially, discounting works in a similar fashion to a free trial or even a freemium tier. You’re lowering the price point to the level of sensitivity of a new tranche of users. Thus, attempting to convince those users during that initial term that the product is worth the higher price, and when the next term comes up they should pay the regular price.
For instance, imagine that this chart is showing the price sensitivity for a particular SaaS tier for a brand new CRM. Management, taking into account different stakeholders in sales, marketing, finance, and the like decide to put a stake in the ground at point A. Of course, they aren’t capturing all of the market, but that’s fine because they believe for the current state of the business there are plenty of customer at that level. The next quarter comes up and sales aren’t going so well, so the team decides to slash prices 20% for inbound prospects to point B. Immediately, a bunch of users hop on board, helping the sales team meet quota.
A discount pricing strategy has sweeping implications
Everything is rainbows and sunshine now, right? Well, no, not at all actually. By discounting you’ve conditioned the customer to de-value your product. Discounting works in the retail space so well, because brands can limit supply (or at least make it look like supply is limited), and therefore create a sense of urgency in the eyes of the consumer. In the software space, supply is practically unlimited and non-physical, and we’re inundated with so many promotions and discounts every day that we know more are coming down the pipeline, even if you say, “for two days only.”
What’s even worse, is that when that next month or updated product comes, the customer is already using the product at a particular price. Very few companies have the first month user retention strategies in place to boost value to the original price point. Switching costs are so low (especially after only one month of use) that customers churn out, wasting you even more money from marketing, onboarding, and any extraneous costs associated with having that non-ideal customer distract you. You've put in anchor pricing that discounted your selling price and left your business with less profit. As David Skok illustrated, churn is kryptonite to startups, and if you’re growing sales through discounts, problems will only get worse, even if you are retaining a certain percentage of those customers.
Let’s talk turkey though, because everything has been philosophical up until this point. We’ve run hundreds of price sensitivity campaigns for software companies and one of the segments we always test is the effect of discounting on willingness to pay. Enough results have come in for us to assert that the numbers back up our above analysis. Even though it varies by product, industry, etc., customers receiving a discount on their first month or initial purchase value the product at least 12% lower than the product’s list price. Note that free trials and promotion still reduce perceived value of the main product, but not as much as if you offer discounts or a freemium offering.