A common mistake made by many new market entrants is the use of price as a selling point; with these entrants trying to undercut the competition and then falling into the trap of not being profitable enough to justify the effort, or even making a loss. Sun Tzu, a military strategist whose philosophy is studied by industry leaders, wrote:
"The general who wins a battle makes many calculations in his temple before the battle is fought." | ||
| --Sun Tzu, The Art of War. | ||
Like the generals who win on the battlefield, smart people fully evaluate the field they operate within and identify the position they hold before concluding the type of pricing strategy to use. Understanding the market environment in relation to your own attributes opens opportunities to identify to target your products and services at spaces occupied by little or no competition. Described thoroughly in the book Blue Ocean Strategy, these spaces in the market are opportunities for you to establish yourself without resorting to cutthroat pricing strategy that leaves you vulnerable to exploitation and minimizes your ability to earn a decent living.
Fortunately for software developers, the cost to deliver services are minimal—a basic laptop and electricity is all you need to get started; with many of the software development tools now available for free via the Internet. The downside to this the lowered barrier for new market entrants—meaning that there will always be people who are less smart than you who resort to undercutting everyone in the market. Sun Tzu continued his writing by saying:
"The general who loses a battle makes but few calculations beforehand. Thus do many calculations lead to victory, and few calculations to defeat..." | ||
| --Sun Tzu, The Art of War. | ||
It is no coincidence that most startup businesses cease operating within their first three years; mostly due to a mixture of poor management and not understanding their market. Like those generals who lose on the battlefield, people behind failed businesses have lacked the ability to thorough research their market in order to build informed plans that maximize their chances of success. Often, these are the market entrants that you will compete with who cause problems for everyone in the market; not because they are good at what they do, but due to their unrealistic and unmaintainable pricing strategy.
These market entrants are often people who have little or no business experience, with many neither having the required technical skills, who as a result resort to making sales by undercutting everyone in the market. Some of these people may not have any software development skills and simply run their business by outsourcing all of their projects to the lowest bidder. If you operate in a country with high living costs such as the UK, you can't compete on price against people living in countries where living costs are a fraction of your own. You know the pricing situation is bad when there are literally people offering database development for $1 per hour!
Market entrants who haven't done their homework and price themselves in a way that makes it impossible for them to deliver the goods are both a threat and an opportunity:
- Threat: Their low pricing strategy contributes to buyers in the market expecting software development to be provided at rates comparable to the amounts paid to supermarket checkout staff
- Opportunity: Buyers who have been burnt buy sellers who have not been able to deliver on their promises will be looking to use factors other than price to identify value in what they are buying
With so many market entrants emerging with poor pricing strategy and lack of technical skills, many buyers are subsequently being stung when choosing to hire software development at low cost. Although there will always be a market segment for low cost software development, people already stung when choosing price as the main factor in their previous hiring will be looking for other factors that guarantee better quality. This is an opportunity for you to charge a premium price through establishing yourself with reputation for reliability and being an expert in your field.
Important factors to be taken into consideration when deciding on your pricing strategy include:
- The market rate
Knowledge of the average rates already charged in the different market segments can be used as a measure for what you should be charging. Be careful to select prices from competitors who have comparable operational attributes such as the type of product/service you are selling and geographical location you are selling in. For example, looking at freelance web development rates in London would give you a highly distorted view if you are selling these services in a less expensive city such as Liverpool.
Pricing yourself below the market rate sends a signal to people that suggests you perceive yourself as less capable than other software developers. With people often being so busy, this can lead to you being overlooked and missing opportunities to demonstrate your capabilities. At the same time, lower rates can attract the types of client who have unrealistic expectations and/or are actively looking to exploit you.
- Quality standards
This is a major factor that is directly dictated by your pricing strategy:
"The moment you make a mistake in pricing, you're eating into your reputation or your profits."
--Katherine Paine, founder of Delahaye Group When aiming to offer the lowest prices, you are forced into a position where the cutting corners and rushing the job are the only options available to keep your sales profitable at a margin that's worth your time. Both of these options affect the level of quality you can deliver; while this may be acceptable for some, it will never allow you to build a reputation for delivering the type of quality that the highest paying clients seek. With this in mind, there will always be market segments where clients are willing to accept sacrifices in their purchase—that is there's a reason why people wear old clothes when painting and decorating.
At the other extreme, aiming to offer the highest quality will escalate the need to charge the highest prices. While this will price you out of the reach of the majority of the buyers in the market, the reputation you build will place you in a position where only a small number of your competitors are able to reach. With these market segments having more of an interest in the quality you provide over the price you charge, your sales strategy becomes more on focused on making high value sales more than high volume sales. In these circumstances, you may use a specialization, rare skill, guarantee or certification to boost your appeal in a way that allows you to justify extremely high value-based pricing—this being where you sell your services based on the value to the client and not as a fixed hourly rate.
When deciding on your pricing strategy, quality level(s) requirements of your target market segments should be thoroughly investigated to identify whether you are in a position to profitably provide your services and/or products. Always remember that your time has value and therefore has a cost. There's no point in charging the lowest prices to make a few sales with margins that turn out to be earning you less than minimum wage; if you are doing that, you would literally be better off flipping burgers at one of those fast food restaurants we all know!
- Available resources
The availability of resources is the other major influence of pricing strategy. Resources you can access define the options available to you for delivering your services and developing your products. Budget will also influence your ability to access resources—whether they are labor, expertise or digital assets such as code components.
Most of the time, cutting corners will impact on quality; an example of this being technical debt, where poor quality code results in higher ongoing maintenance costs. The exception to this is where you make use of ready made resources that allow you to avoid investing time in building a project's foundations. In this case, the use of ready made resources not only allows you to reduce production time, but also can lead to higher quality output from code components that have already been tried and tested.
These resources could be tools you have developed yourself, have purchased or even make use of one of the many open source projects. They can allow you to significantly reduce production time and therefore be much more competitive with price. This means that it is possible to identify a compromise that cuts out enough development time to make it possible to be profitable and competitive with price sensitive segments of the market; or to be even more profitable in market segments where price is not an issue.
An important consideration for using resources to influence your pricing model is the definition of limitations. Clients will often ask for customizations that are not available in your resources; your options will already be limited if you are buying your resource from a third party. The main risk in this situation is when you have developed your own resource—where the temptation is to agree to create the feature as part of your standard pricing. It's important to distinguish between off the shelf software features that are already available and custom software development that requires the purchase of time. Get this wrong when selling your resources and you will find yourself in a situation where it becomes impossible to satisfy the client while making a profit. It is for this reason that many providers software solutions based on existing resources will only offer minimal customizations—that is eliminating unknown risk to profitability.
- Your experience and professional value
Never undersell yourself; it limits your career prospects and will attract the type of client looking to exploit you. If you are highly experienced, you can produce work faster and at better quality than someone who has less experience so why accept being paid the same hourly rate? In this type of situation, it's only fair that you charge more for your time because the client gets a better outcome in less time. With this also translating to the possibility of them also saving money on their overall costs, you can't fairly compete on an hour for hour rate against someone offering less experience, knowledge and capability at a lower price.
If you have a skill that is rare, then you can negotiate higher prices. In software development, an example would be software development in non-mainstream languages such as Cobol; which allows you to demand as much as eight times more than a programmer doing the same job with a mainstream language like PHP.
Some situations require a certain set of skills, while others have a preference for you to meet certain criteria for red tape. Either way, having some type of specialism allows you to target market segments that has limited competition, and as such, allows you to negotiate higher rates.
Developing specialist skills is certainly something worth considering as part of your strategy if you don't already have them. An ability to negotiate higher rates and more easily secure new work can be gained simply through target market segments where there is a skills shortage. Examples of this include knowledge and experience of statistical analysis theory and AI algorithms; while there are many PHP and Javascript developers, there are not as many PHP developers who have the specialist knowledge and experience of AI algorithms—especially for projects requiring advanced use of AI such as image recognition and big data analysis. With supply and demand having a direct influence on rates being offered, buyers in the market will be willing to offer higher payments when they can't attract enough people with the skills to do the job.
Although the required learning investment to master these skills and knowledge may be high, it is a worthwhile investment because the higher entry level barrier keeps the market segment closed to the types of market entrants who are likely to attempt to undercut everyone. With those operating in the market segment also having to have invest heavily in their learning, it is much more likely that they will value their skills and therefore not be willing to undersell themselves. The limited number of suppliers in the market segment and its difficulty to become a new market entrant results in more demand than there is supply - hence keep rates higher and negotiation power in your favor.
- The market segments you intend to target
Although you may be providing the same services to everyone, different segments of the market will have different expectations for quality, service, and price. Small businesses tend to demand the most for their money, so dealing with this segment and remaining profitable requires an entirely different strategy to dealing with large corporate type organizations where there is often a culture of wastage in expenditure.
Market segments are not only to be defined by business sizes, but also by other factors such as their characteristics and target audiences. For example, targeting charitable organizations will require a completely different strategy to public sector services. In the same way, small businesses that have already been running for a few years have completely different needs to recent start-ups, even though they are both part of the same small business category.
The going rate that you can be paid is directly affected by the markets you operate in and your position within the market. Three main factors that will affect your ability to successfully and competitively price your services are:
- The capability and willingness of the competition to lower their prices
- The skills required by the buyers—in general, the more skills required, the less competitors who are capable and so hence allows you to increase your prices
- Certification is a factor that is value by some, but not all buyers. People who tend to value certification tend to be people with an academic background or people who have inside industry knowledge and trust of the certification vendors; for example, someone who knows about PHP development and knows about the official PHP framework Zend may be more inclined to take notice of developers who are Zend certified—similarly, someone who knows about online marketing would be more confident in hiring people who were Google AdWords certified. The value of certification is being able to immediately be able to show an endorsement by a trusted organization in your skills meeting a minimum standard. However, it should be noted that it is worth investigating how your target audience perceive the value of certifications—as this would have no value if you are dealing with people who only look at your previous experience and/or who are unaware of the certification vendors and the meaning of their certifications
- Brand loyalty—if you have existing relationships with prospective clients or have been recommended to them by their trusted sources, the buyer will have more confidence that you will deliver a quality solution and not let them down
Diagram 2.1: Market volume versus price-based competitor reach.
Diagram 2.1 shows how there is a bigger market for clients with smaller budgets, but with fewer competitors capable of profitably targeting the lower end of the market. As the budgets for the client segments increase, more competitors are capable of profitably targeting the segments on a price only basis.
Diagram 2.2: Market volume versus skill-based competitor reach.
Diagram 2.2 shows how skill level requirements mirror the rates offered from buyers in the market. It shows how more competitors are capable of bidding for projects requiring less skill, with fewer competitors able to compete as skill requirements increase. The lack of supply to market segments requiring higher skill levels allows you to demand higher rates. Examples of clients you should expect to find in each of the project budget segments include:
- Premium segment: These are organizations with very large turnovers (total money going into the business) and are involved in large scale operations. The massive size of these organizations tends to amplify all factors, including outcome of your services offering greater value through massive exposure. Their overall expenditure is amplified to a point that any high rates they offer you is barely noticeable in the greater scheme of their operation costs. Inefficiencies and corporate culture in these organizations often lead to higher value spending decisions that are motivated more by internal politics than the desire to make a saving
- Standard segment: Typically small to medium enterprises (SME businesses) that are established and employ anywhere from 20 to 250 staff. These businesses have experience and financial exposure to allow them to understand realistic costs, but not to the extreme level as the premium segment businesses. Organizations in this segment tend to be savvier about the prices they pay—looking to pay inline with the average market rates
- Budget segment: These tend to be micro businesses and startups. Often one man bands who don't have experience of business and view finances in the same way as personal money; for example, £100 can go far to cover living costs, but doesn't cover much business expenses such as rent, insurance, and so on. Even where owners of these businesses have an understanding of business level finances, they are often in a situation where they have limited funds and hence unable to pay attractive rates even if they appreciate the value of your work
Diagram 2.3: Market volume versus brand-based competitor reach.
Diagram 2.3 shows how fewer competitors are capable to compete on brand loyalty as this factor becomes more important. This is an important factor if you or your competitors have had a successful working relationship with the prospective client or where recommendations have been given by their trusted sources.
Referred to as the equilibrium price, this is the compromise point that offers the best outcome between pricing yourself within reach of the largest number of buyers who are willing to spend at a rate that earns you the best profit. Identifying this price point is important because it dictates what you can deliver within the budget you have available.
While there may be market segments willing willing to pay a high price, the only segments that matter are those that you can reach. For this reason, it is also highly important to identify who your audience is. Who can you access with your marketing and what are the barriers to those you can't?
There will be more people able to pay at the lower end of the scale, but can you deliver your product or service profitably to them? If not, is there a cut down version that you can offer that still satisfies this audience and that delivers you a profit? You will never deliver a profit if you make a loss on every sale—no matter how many you sell!
For the people willing to pay a premium for your product, what additional value can you include that will persuade them to upgrade to the more expensive version? These people will not pay a premium for the same product that you offer to other people at your standard price, yet increasing your prices for everyone may cost you sales from the majority of your customers. If focusing exclusively on premium customers, will their sales cover those you lose from your mainstream customer segment?
In short, each market segment you target should have a version of your product or service that is tailored to their interests; this may not be exclusively based on price, but could also involve features that relate to other factors such as expertise, business category and size of their organization. Pricing can still be used to categorize market segments, such as:
- Budget segment: Those who need what you offer at the lowest possible price; the price is the main and possibly the only factor that will persuade these people to buy from you. In most scenarios, there will be plenty of people in this audience and so hence your earnings will need to come from volume of sales. The question is do you have the capability to produce, deliver, and market your product or service to this audience in a way that earns you enough to be worthwhile?
- Scalability is an approach that can be used to address budget segments of markets. This is where a one size fits all approach is taken to develop a standard solution that can be used to supply a demand—an example being a website template that can be sold to website designers for customization or directly to clients as part of a standard website creation. This approach bares the full cost of development upfront and can break even after a specified number of sales are made. These upfront development costs, known as non-repeatable engineering costs, are a once only investment; whether you sell one copy or a million, the development costs don't scale up with the sales you make. This means that there are opportunities to be highly profitable if you can sell in large volumes, but also a risk of not recovering the cost of your time investment if you don't make enough sales
- It's important to be very specific when selling pre-made template style systems, as this approach goes wrong when offering buyers the ability to request specific customizations; especially when you are already selling to market segments who expect the lowest prices. Many software developers operating this approach minimize their risk by limiting the level of customization they offer—if providing any at all
- Standard segment: People who know the market value of your product or service and are willing to pay a price that's fair. These people are usually better informed and will buy based on their perception of a fair deal and the need for good quality. These people recognize that prices that are too cheap are usually reflected by a reduction in quality and so therefore need your product or service to be provided at a quality standard that is equal to or better than those of the market leader
- Premium segment: Not many people fall into this tier, but those who do will usually have excess money to spend and will be happy to pay above the market rate. These people will also want some added value—a perception of prestige (brand), tailoring and fast turnaround for delivery are just a few examples of what can be offered to this segment
With the preceding insights in mind, it is important to identify which price segments you are able to successfully target with your price strategy. Often it is not possible to target both the top and bottom tiers with the same brand, as there would be a conflict in how both groups perceive you. The equilibrium price shows which market would be most profitable—if you have the marketing and production capability to profitably sell in volume, then targeting the middle and bottom tiers would fit your strategy; otherwise, making less sales with bigger profit margins justified by an increased quality of your product will be less risk and easier to produce a profit.