pricing

Basic unit economics of a business

Basic unit economics of a business

Every startup or business ultimately aims to turn a profit by providing a product or service with a higher value than the costs to deliver it. Whether you are planning to start a new venture or currently running one, it's important to understand the unit economics of your business.

Unit economics is defined as the direct revenues and costs associated with a particular business model expressed on a per unit basis. 

Understanding the unit economics of your business provide a way to measure its profitability. So let's start by identify the unit for your business. If you are selling a product like a glass of lemonade 🍋, that would be the unit. For those providing a service, the unit would be the customer or client.

Pricing models for different types of product

Read it Later recently relaunch as Pocket​ and moved from a paid up-front pricing model (iOS apps) to freemium. Nate Weiner (developer of Read It Later/Pocket) posted an insightful article on why they decided to make the jump.

He categorized products into 3 simple categories.​

  1. ​Those that value fade over time like a meal. When you are hungry, it is worth more to you. After you consume it, not so much.
  2. Some products' value stay constant over time. The example he gave was newspapers subscription that shows up at your front door daily​
  3. Products with value that grows over time. These are things that you don't see much value at the beginning but as you keep using it, they become more and more valuable to you. (e.g. services like Evernote & Dropbox)​

​He realized that Read It Later was charging up-front like a meal but its actual value increases over time. By using the freemium model, they can also madeit easier for new users to give Pocket a try without committing anything up-front.

Lesson learned here is to determine the type of value your product delivers over time then choose the matching pricing model.​

Pricing in reverse

uite often, entrepreneurs build their product first before coming up with a price. Here's an interesting article on why we should do the reverse. Determine the price first then try to justify it. This is makes a lot of sense for those of you who sells your product online.

wrong: build something and then figure out how much you can charge. right: choose your desired price, then figure out how to justify it. -- Amy Hoy (@amyhoy) 
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Ramp vs Treadmill

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Are you charging higher and higher for your products or services as time goes by? Or are you charging the same rate or worse, less and less? Dave Navarro argues that if you are not charging more, you are using the wrong business model.

Your business can be one of two things: A ramp, or a treadmill.

A ramp leads to a bigger and bigger business.  A treadmill leads to more of the same, and a plateau of sales.  (Or, if you have a fancy treadmill, a gentle incline that doesn’t get you that much farther.)

A ramp gets you to the next level.  A treadmill doesn’t.

Credits: Dave Navarro

However, don't be mistaken and think that all you need to do is increase the price of your products. You need to increase the value provided by your products and services. To command a premium, you need to improve your skills, innovate and be different.

Read the post by Dave on why you should build your own ramp and how to go about it.

Don't be content with running on the same spot. Build a ramp by improving and innovating the value you can deliver to your customers. Only a ramp can bring you and your business forward.

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Pricing ahead

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This is an excerpt from the book Free by Chris Anderson. He's the one who coined the term Long Tail and wrote a book about it.

In the early 1960s, Fairchild Semiconductor was selling a specialized early transistor, called the 1211, to the military. Each transistor cost $100 to make. Fairchild wanted to sell the transistor to RCA for use in their new UHF television tuner. At the time RCA was using traditional vacuum tubes, which cost only $1.05

What they did was the unthinkable. They lowered their price to $1.05 from the start, banking on the fact that once production volume increases, the cost of each transistor will fall dramatically. Two years later they were able to sell the transistors at 50 cents a piece and still make a profit.

We were going to make the chips in a factory we hadn't built, using a process we hadn't yet developed, but the bottom line was: We were out there the next week quoting $1.05, we were selling into the future - Jerry Sanders

As stated by Moore's law, the number of transistors that can be placed inexpensively on an integrated circuit doubles approximately every two years. This also applies to hard disk capacity and network bandwidth which both gets cheaper and cheaper in a faster rate than transistors.

Knowing this, it is not hard to see why Google paid 1.6 billion dollars for Youtube a few years ago. Even though, at that time the service was burning milions a month for bandwidth and lacks a proper business model. Google banked on the fact that eventually the cost of storage and bandwidth will get cheaper and cheaper.

The ability to price your product way ahead of the price decline curve can be extremely disruptive. This is the very nature of the web and software. After all, they are just bits of information and eventually the only factor that determines the price of your product is not its cost but the value it creates.

Price and cost

In the simplest form, we can describe both price and cost with this equation.

Price = Cost + Profit

However, this equation isn't exactly accurate. It shows that the price is somehow correlated to the cost, which isn't true in some cases. Regardless whether you watching Avatar with a 200+ million budget or The Blair Witch Project filmed with just 22,000, you are going to be paying the same ticket price at the cinema. Here, the price is uncorrelated to the cost.

Price is actually a function of supply and demand. But, cost will in one way or another determine the lower bound for the price. If you want to know more about the relationship between price and cost, check out this post from Chris Dixon.

Importance of price

Ever wondered what if there's no price tag on things we buy. How will it affect our buying decisions? Will we end up just getting the best or will the removal of price also removes the need to have different choices and we all end up buying the same thing? Some things are free, which means by definition they don't have a price. If you were to choose between a bunch of freebies what would you do? If price is no longer the differentiating factor or guide, will we be able to make better decision?

Price is important because our notion of value is based upon it. Without a price, we will have to judge products solely based on their specifications. Something we are supposed to do but apparently not many can due to the lack of domain knowledge.

So if the target of your product is the mainstream (e.g. clueless), should you use price as the guide to educate users on the value of your product in relation to your competitors? And if you are aiming for the early adopters, will being free makes it easier for them to see the true value of your product?

How much will you pay?

If you run a business or do some gigs on the side, this is probably a question that you wish you could ask your client and get a honest response. Your customer will perceive the quality, value, demand, speed and other attributes of your product or service from the amount you charge them. Airlines charges a business traveler that needs to travel on the same day higher than a leisure traveler who booked his ticket 6 months ahead in time. Book publishers provide hardcovers and paperbacks to target different readers. Offering different pricing to different customers allows you to profit from those who are willing to pay more.

Restaurants will often list some high margin items on their menu to take advantage of anchoring. Not only will this convey the quality of the meal but also help make other items on menu look cheaper in comparison.

Freemium is another way to price your product. Web services like Flickr provide a free plan for the majority of users and a premium plan for those who need more features and disk space for their photos. You make money as long as the cost of each user is small enough that your paying customers is able to absorb it.

New companies and freelancers tend to charge less than the competition in order to strike the deal. This is not a long term strategy because if your only advantage over the competition is price, eventually someone will undercut you. You should strive to be the Apple of your industry, not the next Walmart.

If you are interested in knowing more about cost, price, margin and options you have in managing them, you should check out this free ebook, Fixed to Flexible from Todd Sattersen.

What are we paying for?

Did you ever stop to wonder why things we buy are priced that way? The hardcover version of a book cost more than the paperback version even though the content is the same. In fact most books are around the same price range regardless who the author is or what's inside. Are we paying for the content or the medium? This is also true for things like CDs, DVDs and even the digital revolution did little to change that. iTunes sells all music at the same price and Rphasody offers a subscription model.

Companies like Apple and Nike know that we are willing to spend on better designs and cooler branding. Occasionally, we'll splurge on innovative products like Dyson vacuum cleaners.

Quite often, the price we pay have little to with the quality or content of the product. Maybe we don't really want to pay for the content or it's just too hard to determine the price . But if you are given a chance to change the price of one thing, what will that be and why?