Over the years, we at Cue Ball have come to appreciate the importance of thoughtful product pricing by our portfolio companies. Entrepreneurs spend so much effort in developing and refining their products, and often pricing is an afterthought where we are content to do “price discovery” after product launch. But a proper pricing plan has numerous benefits, including better capturing product value as well as activating dormant customers, and in so doing, increasing profitability and growth.
In an effort to improve pricing strategy across our portfolio, several of our founders have had the privilege of working with one of the world’s foremost thought leaders on pricing – Rafi Mohammed. Rafi is the founder of Culture of Profit and the author of two excellent books on pricing – “The Art of Pricing” and “The 1% Windfall” – and several academic papers which I list in the recommended reading section at the end of this piece.
I thought it would be useful to write a short piece on some of the tools and strategies that Rafi has developed and that we have learned from him (much deeper detail can be found in Rafi’s publications listed in the bibliography).
Why Pricing is Important
Price increases (and decreases) generally fall to the bottom line. In fact, in his writing, Rafi cites a study of 1,500 public companies showing that a 1% price increase leads to an increased profit of 11%. To illustrate (and I recognize this is an extreme example of a company with high revenue and relatively low net income margins) – take the example of Amazon, below, which shows that a 1% increase in revenue would lead to a 23% increase in net income margin:
In addition to capturing more of the economic value customers perceive in your product, a well-executed pricing plan – including one with thoughtful product versioning – can draw in marginal customers to buy, which will further increase revenue.
Overall Design Points of a Well-Executed Pricing Plan
Rafi’s overarching pricing philosophy emphasizes the heterogeneity of customers and the need to take advantage of these differences:
- Customers are different: customers have different payment preferences and product needs.
- Have a multi-price mindset: Value is subjective, and some customers value a product more than others. Indeed, he says that for every product in the history of the world, there are at least two people who will pay different prices.
- Value should drive pricing: Product pricing should not be based on costs (i.e., cost-plus markup) but instead, be based on value.
The next two sections take a deeper dive into two specific tools that Rafi uses to implement these design points.
Building Product Versioning: Good-Better-Best
In our experience, the most impactful tool in Rafi’s arsenal is an intuitive but brilliant framework he calls Good-Better-Best (“GBB”). At its essence, this involves the construction of a tiered product offering (usually with three options). The “good” option is designed to attract new customers that may be price-sensitive but will still find value in a stripped-down product. Adding a “good” offering also limits the need to offer discounts or sales (and concomitant revenue leakage). The “better” option is the base product, which would be designed to keep current customers happy. Rafi emphasizes the importance of including “fence” attributes in this category, which would prevent existing customers from downgrading to the cheaper “good” option, thereby cannibalizing revenue. Finally, the feature-laden “best” option is designed to capture more revenue from premium customers. Management teams often underestimate the likely interest in the “best” category product – which Rafi has found, across his work in various industries, comprises around 40% of sales.
While conceptually simple, creating a GBB pricing grid is not easy. To create the tiers and features, Rafi uses a tool called the “value-barometer,” which considers 13 attributes that can be added or dropped to create value. These attributes are:
- Time period
- Waiting time
- Number of restrictions
- Skill level
The exhibit below shows one such GBB example from Zoom.us, which had one of the year’s most successful IPOs. You can see that each offering – Pro, Business, and Enterprise – start with the features of the lower version and add to it. Additionally, while there are many sophisticated sub-attributes per offering, forcing them into three choices dramatically simplifies the purchasing decision for the customer. If there were more choices, this could lead to decision paralysis. Here, the decision is easy. If I need any of the “business” features, I can eliminate the “pro” offering and go with either the “business” or “enterprise choice.” If I need more than 50 hosts, I buy “enterprise.”
Setting the Price: “Value-Decoder” Analysis
Once you have settled on the attributes of the product offerings, one of the trickier tasks is to set a specific price to it. In terms of relative pricing, Rafi recommends that the “good” price should generally be no less than 25% less than “better,” and “best” should usually not exceed “better) by 50%.
To help with setting the actual price, Rafi urges managers to start with a substitutable product and then systematically quantify the merits and demerits along the following attributes lines:
Sometimes, especially for technology startups, there may not be an apparent competing product to start with. Here, it would make sense to begin with an offering that is the status quo way of doing things – even if it is quite different. For example, one of our portfolio companies offers a fully automated digital assistant for healthcare documentation. At the time of product launch, there was nothing in the market quite doing this that management was aware of, so the founder started with physical and remote medical scribes and then adjusted his price from this starting point.
Over the years, our portfolio companies have used these tactics to more accurately capture the value of their products and go after a larger customer profit pool. If you are interested in learning more, check out some of Rafi’s publications, listed below.
Bibliography and Further Reading
 Mohammed, Rafi. The Good-Better-Best Approach to Pricing. Harvard Business Review, 2018.
 Mohammed, Rafi. The Art of Pricing. Charles River Business, 2017.