« Zynga Game Network
Facebook: “Clean Up Your Room, Mister!” »

Pricing Software

Published January 15th, 2008 in Tech & VC

Apple announced that iPod Touch users will have to pay $20 for a software update to their devices in order to get Maps, Stocks, Weather, Notes, and Mail applications. That pricing choice set my mind spinning about the various choices companies have when pricing software: price based on competition, price based on cost of goods sold, and price based on value to the end-user.

Competition: Apple doesn’t have any competition for software on the iPod Touch because they are the sole provider of iPod software (sure, a user could pay for jailbreak apps on an iPod Touch, but that’s not real competition in my book because of the hurdles to jailbreaking an iPod Touch are too high). So, Apple can’t establish a price based on the competition’s pricing because there is not competition.

Cost of Goods Sold: The cost required to bring these new applications to the iPod Touch are negligible. The fixed cost was the cost of porting the applications and packaging them in an installable firmware update. These new applications already exist on the iPhone and they work perfectly fine on the iPod Touch as compiled. In fact, if you jailbreak and iPhone and iPod Touch, you can install an SSH client on both devices and send the applications from the iPhone to the iPod Touch, where they will work perfectly fine. So, had little (if any) work to do in porting these new applications to run on the iPod Touch. So, the fixed costs are small. The marginal costs are even smaller. It’s the cost of sending each consumer the update over the internet. That’s a fraction of a penny per user. There are some other costs associated with an upgrade that are baked into the costs of goods sold such as customer support, but again, the incremental costs here are negligible. So, if Apple decided to price the iPod Touch new applications on a multiple of cost of goods sold, then that multiple would be absurdly high.

Value to End-User: Instead, Apple chose to price the software update based on value to the end user. Some marketing guy at Apple likely did a survey of current users to determine the amount of money customers would be willing to pay for the added functionality the new applications provided. Then, they picked a price based on the results of the survey.

Pricing based on value to the end-user may seem smart; and it’s certainly the optimal choice when it comes to the bottom line for a company (assuming value is not less than COGS). But, this practice leaves a bitter taste in the mouth’s of tech-savvy customers. There’s the usual griping from early adopters out on the blogs regarding this $20 upgrade tax. And, I’m sure consumers that received an iPod Touch for Christmas will be dismayed at the thought that their device is already outdated after being in their possession for less than a month.

Web services typically set pricing based on value, and I think this is often a mistake that undermines the intelligence of their customers. For example, nearly every service that offers domain mapping (the ability to user your own personal domain name on a hosted web service) charges for this luxury. This is charge is entirely margin for the web service, as there is low fixed cost and zero marginal cost associated with enabling domain mapping. There’s nothing special about the domain mapping feature that makes it more expensive than any other feature to build, but there’s a high perceived valued to the end-user for domain mapping, so web services price domain mapping based on value.

I think this is a mistake because mapping a domain to a web service is one of the highest levels of engagement I can think of. If you’re willing to put up with DNS configuration screens in order to customize your experience with a web service, that’s great for the web services because they gain a passionate user. Tumblr offers domain mapping for free, and I think they are absolutely right to do so. A large percentage of their customers take advantage of this feature, and it helps Tumblr generate a terrific userbase that evangelize on their behalf.

I think, based on the costs associated with this Apple software upgrade, Apple should be giving it away for free. If nothing else, Apple certainly shouldn’t be penalizing their early adopters.

2 Responses to “Pricing Software”  

Feed for this Entry
  1. 1 Erik Schwartz Jan 17th, 2008 at 5:08 pm

    It pissed me off, but I paid the $20.

  2. 2 Ian Cox Jan 29th, 2008 at 10:16 pm

    Though you make some convincing arguments regarding Apple’s pricing policy on this, my gut reaction is “nothing new under the sun.”

    Regarding competition pricing

    How does Porsche price its spare mufflers? Well, they take their cost structure into consideration, sure. However, they also don’t license any other non-OEMs to build clones of their mufflers (much akin to a closed platform like that of the iPhone or iPod touch). This is the entire justification for intellectual property rights as a means to create returns and incentives for innovation in industries that have high up front R&D cost. A marginal cost pricing structure for Apple or for Abbott laboratories just doesn’t cut it.
    If you can’t extract maximum value from a captive audience then what’s the point? It’s perhaps politically incorrect to say out loud, but I doubt dope dealers are giving crack heads price cuts on their 12th purchase. Whereas my go-to deli for lunch, stamps my card every time I buy a sandwich, knowing that if my 12th sandwich isn’t free I’ll just take my 6.50 somewhere else.

    On Cost of Goods Sold

    In a competitive market manufacturers will price their products at marginal cost. As you’ve described above, in a pure sense the marginal cost for this product is virtually 0. Once the software is written, debugged and put into a format that is accessible to different platforms the marginal cost is virtually nil (the cost of transmitting it over, as you said). Depending on the industry you are in and the accounting treatment you want to use, portions of research and development get factored in to cost of goods sold.
    In real life though there is this beautiful thing called overhead: you’ve got to pay for the secretary’s company car, Steve Job’s spa treatment, and the great catered food at the Apple campus. These costs have to get allocated (or eaten) to some product, division, expense code or money laundering activity.
    Apple’s strategy in selling online music through iTunes has been to basically do it for free (royalties paid to record labels negate most of their profits until certain volume thresholds are met). The strategy being that it would boost and create a critical mass of iPods, iBooks, iPhones, iNaseaum. They “ate” some costs (and some negative profits) of their original iTunes operation in order to build up their market share of hardware. Apple already took its medicine, and it took it up front, investing aggressively in iTunes and running it at virtually no profit. If you add in their ultra-aggressive marketing campaign, expenses need to be allocated somewhere. Having achieved their goal of creating a captive audience and a critical mass of users, it only seems reasonable for them to attempt to recoup value wherever possible.
    But Ian, Apple just had its most profitable quarter ever, they don’t need the extra money? If we can’t agree that people should run their businesses as profit maximizers, then that’s a whole different conversation.

    On-End Value to The Consumer

    Though there are some interesting pieces of consumer research investigating consumption decisions and consumer perceptions of marginal benefits, the purest example is what economists call “voting with your feet.” (I know, not all consumers are rational, yadda yadda).
    What is the fair price? Well, the fair price is the price that someone is willing to pay. The fair price is the lowest price I am willing to charge and you are still willing to pay. This might not work as well if we are talking about a pound of bread that will keep you from starving: but lets face it, I only know of few techies that would die without the latest Apple software update. If you don’t like the $20 dollars the best way to communicate it to Apple is to not buy the software, as opposed to writing an email (or an angry blog post!)
    But Ian, I already spent $3000 dollars on an entire Apple suite of hardware? It’s not fair!!
    Exactly - YOU ALREADY SPENT IT! Spending an additional $20 bucks on top of it does not in any way help you recoup your investment; its a sunk cost.
    I understand consumers being pissed off, about learning that the software on their 20 day old iPhone is ‘obsolete.’ Unfortunately its nothing new under the sun; you don’t hear people complaining to Mercedes about them launching a 2009 300E only a year after the 2008 300E. People don’t even seem to realize that major consumer packaged goods manufacturers like Pepsico and P&G on average launch 300-400 new product launches every year.

Leave a Reply