Why Peter Drucker is wrong about price-based costing

Figuring out how to price your product falls right in the Price Intelligently wheelhouse. And while Drucker is 100% correct that companies always need to start with customer willingness to pay, his solution of price-based costing doesn't ring true for SaaS.

The unique economics of SaaS products mean you can use willingness to pay in a different way to best monetize your customers.

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.

Marginal costs don't have a place in SaaS pricing

As a result of the significant marginal costs for traditional retail companies, many companies use cost-based pricing as a knee-jerk reaction. It most obviously incorporates the traditional costs associated with production. First, a company starts with their marginal costs. Then they add an arbitrary profit on top.

This is the company-first way of creating a pricing strategy. It requires minimal effort from the company to ensure a profit and disregards the customers' perspective.

Drucker calls cost-based pricing a deadly business sin, and we agree. Cost-based pricing is inefficient on two levels:

• Consumers don't care how much it costs you to make the product. Customers will purchase products because it helps them solve a problem or adds value, not because they want to help your company earn a profit. When you don't consider what the customer actually needs or what they're getting from your product, you're creating a disconnect because you're not tapping into the essential buying motivation that will drive your customer to your product.
• The costs of servicing a SaaS customer are likely much lower than the value of the solution that you provide. If you simply add a profit to the top of your costs of doing business, you're likely going to leave money on the table and undervalue your product in the eyes of consumers who may be willing to pay much for a solution.

Though cost-based pricing ensures that you recover costs and make a profit in the short-term, it's a poor long-term business model because it alienates your market and has the potential to erode your product's inherent value. Thankfully, it's not the only way to enable profitability.

Drucker's solution: Practice price-driven costing

“The only thing that works [in pricing],” Drucker writes, “is price-driven costing.” His proposed solution—the inverse of cost-driven pricing—involves two components:

1. Determining your market's willingness to pay
2. Designing your product so that the marginal costs are within the market's willingness to pay

For SaaS companies, half of Drucker's advice applies. Determining your target market's willingness to pay is an important first step in any pricing strategy, for SaaS and non-SaaS companies alike.

It's important for SaaS companies to take the time to research their market because customer willingness to pay is often higher than companies realize. Wistia CEO and founder Chris Savage recounts his first experience with his market's willingness to pay that describes the same surprise that many founders feel:

Your solution needs to match with a pain point and makes your customer's workflow easier/more efficient/more lucrative. Then you need to understand how much customers are willing to pay for a solution to that pain point.

SaaS companies don't rely on willingness to pay to determine marginal costs

Drucker's advice to design your production so that the marginal costs are within the market's willingness to pay is solid advice—for traditional businesses that manufacture their products.

Drucker uses the consumer-electronics industry as an example when explaining price-based costing. He cites price-led costing as the reason the Japanese consumer-electronics industry overtook its American counterpart:

• The Japanese industry started with consumer willingness to pay and then optimized its process technology to minimize the marginal cost of each unit
• The American industry added up the costs of production and then added a margin on top, and then were forced to cut the product's price, undergo expensive redesigns, and ultimately take the losses

This is a good case for price-led costing because producing consumer electronics involves significant marginal costs. The same principle applies to car manufacturing, which has high inherent marginal costs: Toyota gained a huge competitive advantage by redesigning the car manufacturing process to minimize marginal costs.

For companies that need to produce a physical product every time they serve a new customer, Drucker's advice lands: start with the market's willingness to pay and whittle down production costs (which will be non-zero) accordingly.

However, engineering your marginal costs based on your market's willingness to pay does not work for SaaS companies. “Whittling down” the marginal costs to fit within your market's willingness to pay range doesn't make sense for SaaS companies because there's nearly nothing to whittle down.

Willingness to pay is nearly useless—in this context. It's actually a very powerful tool in creating a strong SaaS pricing strategy, but it has to be adapted to the SaaS market and understood differently.

Price Intelligently's solution: Use willingness to pay to expand value

The low marginal cost of SaaS products is one of the major reasons why software is eating the world. The ease of software distribution means that it can be widely adopted on a large scale. By virtue of these low marginal costs and the distribution potential, this also means that a SaaS company can use their market's willingness to pay to expand, rather than to reduce:

• Drucker's price-based costing for manufacturing is reductive. He proposes that once a company understands the market's willingness to pay, they constrict the rest of their business to fit within these economic confines. It's a race to reduce marginal costs as much as possible: the mentality is, “the floor's the limit.”
• Pricing along a value scale for SaaS is expansive. A SaaS company can use its market's willingness to pay as a vehicle deliver varying degrees of value that are suited exactly to that customer's needs. This is a way to increase revenue through increased pricing rather than through decreased costs: the mentality is, “the sky's the limit.”

Create a value scale to expand

Without the need to fit marginal costs within the market's willingness to pay, a SaaS company can look for places to create value.

Imagine your market is willing to pay $100/month for a solution. Since it will cost next to nothing to service each customer, you'll have to deliver $100 of value to that customer in some form that justifies their price. This means you can create to meet customer's needs and fill in that value.

But it's likely that your market's willingness to pay will fall over a range of price points. This gives you an opportunity to engineer value that corresponds to each of these price points so that you can provide each different portion of your market exactly what they're willing to pay for.

The costs of each unit stay low as long as you increase the value you provide along the metric defined by the market's willingness to pay. As the customer's willingness to pay increases, you can offer the customer greater usage of your product. This allows you to capture and monetize a wide market and think expansively about your product and your company.

Harnessing willingness to pay is an opportunity for SaaS growth

You should always be looking to create more value in your product for your market. Building a SaaS company gives you an opportunity to capitalize on huge potential for creation and distribution without the traditional economic constraints of manufacturing that have been present for most of the history of business.

Harnessing the demands of your market is a major factor in a SaaS company's development. The most destructive business sin of all would be disregarding the importance of creating pricing that allows for, and encourages, growth.