The Real Genius Of The Software Business

January 11, 2013 6:00 am

The hard truth of any business is this: at the end of the day, success boils down to pricing. A business is only successful if it can find a reasonable number of people who are willing to pay a little more for the product or service than what it costs the business to produce it. It is that simple.

There are multiple ways every single customer views at a price tag. Here are the common ways (Pricing is a very complex topic, so obviously we are generalizing a lot here) :

In a cost-plus model, the customer understands the product quite well, and can calculate in his mind, with reasonable accuracy, the cost of producing it. He is willing to pay a premium, but only by so much. This is a very common purchasing behavior, and is applicable for most everyday things in our lives.

In a value based model, the customer tries to calculate the value that the product or service brings to his life, and pays accordingly. This is applicable to products that are a little too difficult for cost calculations – consumer electronics for example. Not many people buy a smartphone knowing how much it costs to make – they buy it because they think that the product adds some value to their lives overall.

The third model is a simple ‘best alternative’ model – the consumer will pay based on what his alternatives will cost him. There is no reasonable way for him to calculate the cost, and there is no point in trying to come up with a value calculation because there are so many ways a benefit number could be arrived at. Software products are a great example here.

The real genius of the software business is this: if you have a product or service out there in the market, the customer has ABSOLUTELY NO WAY to understand the price – he will basically pay any number, as long as it is less than his current solution / workaround, or it is priced less than the alternatives he can find in the market, for the feature set he needs. Generally speaking, he does not know how many employees you have, he does not know if you are located in SFO or in Shanghai, he does not know if you use google docs or Microsoft live – he basically only knows that he is currently paying 29.99 per month for a competing product, and as long as you offer him all the features he needs at a lower price and similar quality, he has no questions on the price. (This is obviously not true for ‘big’ enterprise software, but that is a different topic altogether, with the word ‘investment’ written in bold font)

This ability to price the product or service, where the customer just cannot go for a cost-plus thinking or come up with a dollar number to the benefits, and has to depend on ‘comparing’ the price to his alternatives – that is the real genius of the software business. That is the reason why Microsoft was able to basically sell software, with just the incremental cost of the CD for each license, at 80 percent plus gross margins, for years together.

If you do not buy this argument, try answering this question: do you really know why you pay what you pay for any of your software?

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