SaaS is unique in its low marginal costs
The economics of a product are divided into two parts: the setup cost and the marginal cost.
- The setup cost is the cost to make the first unit of your product.
- The marginal cost is the cost of producing every additional unit after the first.
For a retail company that sells physical products, the setup costs are the costs of assembling the team, equipment, materials, etc. to make the first unit. The marginal costs include the materials and labor that go into making each individual unit, every single time you produce a unit.
Marginal costs are—and always have been—a huge limiting factor for traditional businesses that rely on physical production, and therefore have been taken into account when creating prices. In the fourteenth century, Ibn Khaldun presented some of the earliest ideas in commerce for adding value on top of marginal costs, writing that “labor and skill is added to techniques and crafts and then sold at a higher value.” In the eighteenth century, Adam Smith proposed using the division of labor to lower the cost per unit and gain larger production returns.
Marginal costs posed significant constraints on pricing—right up until the rise of SaaS.
Subscription software does not face the same manufacturing costs that traditional retail businesses face. According to many SaaS leaders and investors, the marginal costs of SaaS products is approaching zero.
Most of the costs associated with creating a SaaS product are encompassed in the product's setup cost, while the cost of one additional server for one additional customer is almost zero.
This means that marginal costs are nearly irrelevant for SaaS companies—so “traditional” ideas about economics of pricing need to be reinvented for the success of software businesses. Though they may have played a part in pricing for businesses in the past, using them to shape a SaaS pricing strategy is useless and steers you away from the things that you should really be focusing on.