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Estd 4.22.2023
Introduction
In the complex world of SaaS pricing strategy, one approach continues to dominate despite its fundamental flaws: cost-plus pricing. This traditional method—where companies calculate their costs and add a predetermined profit margin—remains pervasive across the software industry. While it may appear logical and straightforward on the surface, cost-plus pricing can dramatically limit a company's growth potential, profitability, and competitive positioning. This article explores why this common pricing approach often becomes a trap for SaaS executives and offers strategic alternatives that align with value creation in today's market.
The Allure of Cost-Plus Pricing
The appeal of cost-plus pricing is undeniable. It offers several apparent advantages:
- Simplicity: Calculate your costs, add a margin, and you have your price.
- Predictability: Finance teams appreciate the straightforward relationship between expenses and revenue.
- Internal justification: It provides an easy rationale for pricing decisions that stakeholders can understand.
According to a 2021 study by OpenView Partners, approximately 42% of early-stage SaaS companies still rely primarily on cost-plus approaches when setting their initial pricing. The method feels safe, anchored in tangible numbers rather than seemingly abstract concepts like customer value.
Why Cost-Plus Pricing Fails SaaS Companies
Despite its widespread use, cost-plus pricing fundamentally misaligns with how software economics work:
1. It Ignores Customer Value
Perhaps the most significant flaw is that cost-plus pricing has no relationship to the value customers receive. As McKinsey research indicates, customers don't care about your development costs—they care about the problems your software solves and what that solution is worth to them.
When Adobe moved from selling boxed software to a subscription model, they didn't price based on their reduced distribution costs. Instead, they considered the ongoing value their creative tools delivered to professionals and priced accordingly—resulting in substantial growth in recurring revenue.
2. Software Economics Are Unique
The economics of SaaS are fundamentally different from physical products:
- Marginal costs of serving additional customers are minimal
- R&D costs are front-loaded
- Value delivery often increases over time through updates and improvements
"The economics of software are characterized by high upfront investment and near-zero marginal costs," notes Patrick Campbell, founder of ProfitWell. "When you price based on costs, you're effectively ignoring the most important economic characteristic of your product."
3. It Leaves Money on the Table
When you anchor pricing to your costs rather than customer willingness to pay, you create an artificial ceiling on revenue. Salesforce didn't become a $20+ billion revenue company by marking up its server costs—it prices based on the transformational value CRM delivers to enterprises.
Research from Price Intelligently suggests that SaaS companies using value-based pricing strategies grow, on average, 25% faster than those relying on cost-plus methods.
4. It Creates Perverse Incentives
Cost-plus models can inadvertently incentivize inefficiency. If prices automatically rise with costs, where's the motivation to operate efficiently? Worse still, companies might focus innovation on areas that increase costs (and therefore prices) rather than areas that increase customer value.
Moving Beyond Cost-Plus: Value-Based Alternatives
Forward-thinking SaaS executives are abandoning cost-plus models in favor of more sophisticated approaches:
1. Value-Based Pricing
This approach centers on quantifying the economic value your solution creates for customers. For example, if your SaaS platform saves an enterprise customer $500,000 annually in operational costs, pricing at $100,000 represents clear ROI for them while disconnecting your price from your delivery costs.
Zoom's meteoric rise wasn't built on marking up server costs—their pricing reflected the massive productivity value of reliable, easy-to-use video conferencing, particularly as remote work became essential.
2. Customer Segment Differentiation
Different customer segments derive different value from the same product. Enterprise users might extract millions in value from your solution, while small businesses receive thousands.
Slack's pricing tiers don't reflect dramatically different costs to serve—they reflect different value delivered to different customer segments, with features like advanced security and compliance being particularly valuable to enterprise customers.
3. Competitive Positioning Pricing
Your pricing communicates your market position. Premium pricing signals premium value. According to a Harvard Business Review analysis, "Price is the most powerful signal you can send to the market about where your product stands in relation to competitors."
When Figma entered the design tool market dominated by Adobe, they didn't just undercut on price—they created a pricing structure that highlighted their collaborative-first approach, signaling their fundamental difference from legacy tools.
Implementation Steps for SaaS Executives
To escape the cost-plus trap:
Conduct value research: Interview customers to understand the economic impact of your solution on their business.
Develop value metrics: Identify which metrics best align with the value customers receive (e.g., seats, transactions processed, data stored).
Test willingness to pay: Use techniques like the Van Westendorp Price Sensitivity Meter to identify optimal price points across segments.
Create pricing tiers: Develop packages that align with different customer segments and their respective value perceptions.
Communicate value, not costs: Train sales teams to discuss ROI and business impact rather than justifying prices based on your costs.
Conclusion
Cost-plus pricing, while comfortable and seemingly logical, creates a self-imposed ceiling on growth and profitability. In the SaaS industry, where marginal costs are minimal and customer value can be substantial, basing prices primarily on internal costs rather than external value is leaving significant opportunity untapped.
The most successful SaaS companies understand that pricing is not merely a mathematical exercise of applying margins to costs, but a strategic lever that reflects the true value their solutions create in the market. By shifting to value-based pricing approaches, executives can escape the cost-plus trap and unlock their companies' full revenue potential.
As you evaluate your current pricing strategy, consider this question: Are your prices reflecting what it costs you to deliver your solution, or what your solution is truly worth to customers? The answer may reveal significant untapped growth opportunities.