Pricing a SaaS product is a tricky business. How do you set the price high enough to be profitable while still appealing to customers? I get it, as I've struggled with this, too.
That's why I want to introduce you to price skimming - it's helped many successful SaaS companies launch new products.
Here's the basics...Price skimming is when you first set a high price for an innovative new offering, then lower it over time. It lets you maximize revenue from early adopters who value being first, before opening up to more price-sensitive customers.
Done right, skimming fuels growth. Apple does this with iPhones. Salesforce did it by launching the first cloud CRM.
Of course, you risk backlash if customers feel ripped off. And it only works for truly unique solutions - not me-too products.
But implemented correctly, price skimming gives SaaS businesses like ours a strategic advantage. It accelerates cost recovery so we can keep improving our products. And it segments users so we can tailor pricing plans.
Intrigued and want to geek out on the details? Read on my friend! I'll walk you through real SaaS examples, pros and cons, and help you decide if skimming could work for your business.
What is Price Skimming?
In one of our posts earlier, we mentioned that the pricing structure is at the heart of any SaaS product: it is the pillar that ensures repeatable sales processes and recurring profits.
Pricing a product is one of the trickiest things, however. How do you price your product in such a way it appeals to a wide enough spectrum of audience? You price it too high, and people won’t see the value, and there won’t be any takers. You price it a bit too low, and it might come across as cheap and poor quality.
Price skimming is one of the pricing techniques that you should consider when you are scratching your head and wondering what’s the right way to price your product. But what exactly is price skimming? Let us try to understand.
In its simplest term, price skimming is a pricing strategy where a marketer first sets a fairly high starting price for a good or service, then reduces the price over time to draw in more consumers who are price sensitive. A first mover in the market, facing little to no competition, typically uses the price strategy.
As per Wikipedia,
“Price skimming is sometimes referred to as riding down the demand curve. The objective of a price skimming strategy is to capture the consumer surplus early in the product life cycle in order to exploit a monopolistic position or the low price sensitivity of innovators.”
The theory behind this pricing is that at the launch stage, when your product is freshest, you try to "skim" off the top customer segment to which you appeal the most, thus boosting your initial income. It is a complex and challenging strategy and one that is not for just any business. But if implemented right, price skimming can lead to an enormous competitive edge in the market and a huge boost in both sales and brand awareness of your product and business.
Taking into account the diffusion of innovation theory which explains the rate at which a product spreads across a social system, innovators are the ones that want to be the first to receive a new product or service. They are price-insensitive and risk-takers. Skim pricing strategy is aimed at these innovators, it is aimed to get the maximum benefit from such innovators and early adopters. When demand from these two segments increases and touches their full capacity the product 's price is brought down to target price-sensitive customers including early majority and late majority users.
Examples of price skimming
Let’s see what it looks like in real life when we examine the strategy with some examples. We will consider some popular product categories.
No price skimming example list can be complete without mentioning Apple. Apple is a classic example of employing this pricing strategy in just about all its products. Remember the time when the iPod was launched for the very first time or maybe that time when the iPhone was launched. They were both products of novelty with expensive pricing. But the older generation of the product saw a massive price cut making way for the newer generation. Circling back to the same Diffusion of Innovation theory the price cut made it approachable to so many more people who now saw an immense value that some time ago was an exorbitant piece of electronics.
On its smartphone lineup, Apple's pricing strategy follows the price skimming strategy religiously. Every year, Apple launches new iPhone models and new iPhone prices are pretty high, usually much higher than the rest of the market. Meanwhile, the lineup of its previous year gets a price cut as they are no longer considered to be tech's cutting-edge pieces.
We can also consider the example of Sony’s Playstation. The PS3 was priced at $599 when launched a few years ago but now costs $200 or even less in online retail stores. PS3 effectively had no competition and was bound to be successful because its previous console, PlayStation 2, was a big success. Even though the PS2 was priced conservatively, the company realized there were plenty of potential customers for the PS3, setting a higher initial launch price. The PS3 's price was then lowered every year and eventually sold at less than $200.
4K TVs were first launched by Sony in the US in 2012 at an eye-watering price tag of $20,000. A year later the price was about $7,000. Today's prices fall below $1,000.
Part of the price drop might've been attributed to advanced technologies and lower production costs. Initial sales did not have the same economies of scale, either. There 's definitely price skimming there, though. Only very few people are prepared to shell out $10,000 + for a TV. Only the early adopters may be the first to get a special category of TV – if they are willing to pay a premium.
The longer consumers are able to wait, the more likelihood of the discounted prices.
Price skimming in SaaS
Price skimming is predominantly seen in consumer electronics industry and not many SaaS companies have been able to pull price skimming off that successfully as Salesforce did years ago when it launched a truly cloud-based CRM system in a day and age when it was completely unheard of. Salesforce made the most of it by setting the prices really high. That went on for a substantial period of time until it decided to expand its customer base by lowering the prices and extend the CRM to smaller businesses too.
If you have a SaaS product and giving serious thoughts about price skimming, I’d advise you to tread your path cautiously. If not done properly it can backfire mightily and the path to recovery could be long and tedious.
If it’s a B2B SaaS product, my answer is going to be plain and simple. Just don’t do it. It’s not feasible. It’s not beneficial for neither the customer nor you. For a B2C SaaS, it might work, considering it is an immensely novel product. Something that’s so unique and useful that simplifies people’s lives by orders of magnitude. And people are more than willing to pay a premium price to use it. Do thorough customer research still.
Always ask yourself, is the product or idea fresh or revolutionary enough to justify market skimming? Can you accurately measure the real value your SaaS product adds to customer business processes?
Advantages of price skimming
Superior profit margins
A product priced at its upper limit is going to help the company generate higher profits. It helps them make the most of the specific market segment that is created from selling at high prices, and then reach the rest by lowering the price as time goes by.
Price skimming helps businesses change their product prices by market situation, brand perception, customer response, product features, and competition. Price skimming helps businesses better control their product pricing.
Quicker real-time monitoring
Early adopters and enthusiasts are the two main target audiences during the original product launch – as they are the ones who buy the product at the higher launch price and are usually well-informed and eager to give feedback to the company. These early adopters and enthusiasts help businesses gain insight into their products' performance and position.
Helps create buzz
High prices attract news and media attention, helping to get easier product exposure and advertising. The higher price also helps consumers build a better brand identity if properly implemented.
This is an important advantage of proper price skimming implementation. By setting the initial price high, businesses tend to segment the market into various categories – early adopters, brand loyalists, and regular consumers. This also helps to maintain inventory and test the waters when entering new markets or introducing new products.
Quicker cost recovery
A relatively high initial price right from the launch helps quickly and easily recover the money invested in product research and development. This also helps quickly recover advertising and marketing costs.
Downsides of price skimming
Can affect the brand negatively
Customers who purchase early can feel 'ripped off' when the same product is offered at a reduced price. This can create a negative image. Some early Sony Playstation 3 adopters feel they've been cheated. Companies engaged in price skimming could be considered greedy or manipulative, highlighting the fact that all companies or all products should not use price skimming.
Competition takes advantage
Selling steeply means the company will only sell small quantities early. This could make it prone to losing to a cheaper rival. Android phones, for example, increasingly took market share from Apple.
The product must have an inelastic demand
Skim pricing strategy is appropriate when the product follows an inelastic demand curve – a demand curve where the product quantity is not significantly affected by the price change. If a product does not follow the inelastic demand curve, it eventually leads to sales fluctuations, which may cause increased demand when prices are lowered and vice versa. This makes keeping their production and inventory incredibly hard for businesses.
Short term advantages
While the skim pricing technique helps increase the company's profit margins, it's only for a limited period. It doesn't last long since the market gains a few competitors, and it will be harder to hold on to its products' high price tags. It also leads to a loss of sales and user base if the business can not justify the long-term higher price.
Thorough implementation mandatory
Price skimming can only be implemented after thorough market conditions research and analysis, customer feelings, and brand perception. There are many factors that come into play if done wrong – most of which adversely impact the brand.
Price skimming and penetration pricing
Pricing penetration is the opposite. When a company enters a competitive market by setting very low prices and then with enough market share, it gradually raises the price. In India, Reliance Jio, a new entrant in the Telecom sector, did just that. In just a couple of years, it managed to turn out to be the largest telecom company in the Indian subcontinent. Another example is Android which has been slowly and gradually eating up market share from Apple in the premium range smartphone segment.
Penetration price is a bottom-up strategy. Price low to reduce adoption pressure, expand rapidly, then switch up-market after broad adoption. In the SaaS domain, Netsuite, New Relic, Slack follow this model. Penetration emphasizes market share.
Should you or should you not?
Well, like most of the good things, it depends.
If you have credentials and a product capable of disrupting an industry, then just go for it, it can be an instant path to massive success. Be careful when setting high introductory prices and lowering them quickly as a PR backlash will definitely arise from the sudden price drops. Analyzing and knowing what your consumer values in your product can help you discover the true essence of the demand curve and along with it, the feasibility of executing a price-skimming strategy. So long as there are only a few rivals in the market and you articulate price cuts effectively, skimming will produce the revenue you need to recover costs rapidly, keep upgrading the product, and ensure your company's survival.
What is price skimming?
Price skimming is a pricing strategy where a high price is set for a product initially, followed by gradual price reductions over time. It aims to maximize profits in the early stages of a product's life cycle by capturing value from customers willing to pay more before lowering prices to attract more price-sensitive segments. The high initial price communicates the product's uniqueness and value.
When is price skimming an appropriate strategy?
Price skimming works best when the product is new, innovative, and in high demand, there are few or no competitors in the market, customers are willing to pay a premium for exclusivity, production costs decrease over time, and the company has a strong brand reputation and influence.
What are some examples of price skimming?
Notable examples of price skimming include Apple dropping prices of older iPhone models when new versions launch, Sony pricing the PS3 at $599 initially then lowering to $199 over time, 4K TVs debuting at over $20,000 before current sub-$1000 prices, and new drug treatments launching at high prices then dropping over patent lifecycles.
What are the advantages of price skimming?
Key advantages of price skimming include maximizing profits early when demand is highest, generating buzz and media interest due to the high initial price, segmenting the market into customer groups based on willingness to pay, recouping R&D and launch costs quickly, and ability to dynamically adjust pricing based on changing conditions.
What are the risks associated with price skimming?
Potential downsides to be aware of are that early adopters may feel cheated when prices drop rapidly, it can create perception of greed if not communicated properly, it must have highly inelastic demand unaffected by price changes, it is a short-term strategy vulnerable to competition entering market, and it requires thorough understanding of market and customer demand.
How does price skimming differ from penetration pricing?
Penetration pricing is the opposite approach - setting a low initial price to gain market share rapidly. Price skimming focuses on maximizing profit margins early on while penetration pricing emphasizes building market share through affordability.
When does penetration pricing work better than price skimming?
Penetration pricing has advantages when entering a competitive market against established players, if the product benefits from widespread adoption and network effects, production costs are inherently low or economies of scale kick in with volume, and brand reputation has not been established yet in the market.
What mistakes should be avoided with price skimming?
Common mistakes to avoid are applying it to commodity products with many cheaper substitutes, failing to clearly communicate the exclusivity and value of the product, lowering the price too quickly without regard for optics, assuming that high prices alone infer quality or status, and not anticipating competitive responses to defend market share.
How can a company determine optimal initial skimming price?
Ways to set the right introductory price include surveying customer willingness-to-pay and estimated demand at various price points, analyzing prices of comparable substitute products, factoring in messaging around product differentiation and positioning, estimating the revenue needed to break even on development costs, and leaving room to drop 30-40% subsequently while maintaining margins.
How should companies promote and communicate price decreases?
Smart ways to message future price drops include highlighting how it improves affordability for more customers, emphasizing how production efficiencies and scale reduce costs, offering early adopters discounts, perks or grandfathered pricing, bundling added features or capabilities at lower prices, and framing it as making the same great product more accessible.