The 5 most common pricing strategies
Pricing can keep you up at night.
Price your offer too low, and you leave money on the table. Price it too high, and you can say goodbye to sales that could have made your year.
Finding the ideal price means choosing a pricing strategy that’s appropriate for your company’s circumstances.
“How much the customer is willing to pay for the product has very little to do with the seller’s cost and has very much to do with how much they value the product or service they’re buying,” says Eric Dolansky, Associate Professor of Marketing at Brock University in St. Catharines, Ont.
The 5 most common pricing strategies
Cost-plus pricing. Calculate your costs and add a mark-up.
Competitive pricing. Set a price based on what the competition charges.
Price skimming. Set a high price and lower it as the market evolves.
Penetration pricing. Set a low price to enter a competitive market and raise it later.
Value-based pricing. Base your product or service’s price on what the customer believes it’s worth.
Finding your ideal price
So how do you get to an ideal price, the “sweet spot” that will deliver the most profit given your circumstances?
Effect of price on profit
As you raise your price (moving left to right), your profitability goes up—to a point. It’s at the point where you’ve raised your price by too much that your profitability goes down.
Source: Eric Dolansky
“Pricing is one decision that shouldn’t be driven by accounting,” says Dolansky. He says that arriving at an ideal price means taking into account factors that some entrepreneurs may overlook.
When considering your price, it’s important to realize that it’s not for yourself, but for your target customers.
Finding the right price range
Your customer needs to find that your price falls within their range of what’s acceptable, and your ability to price is constrained by your costs.
In the chart below, the floor of your pricing is your total costs for what you’re selling. The ceiling, or highest price, is the number at which your customer values your offer. Above this price, you lose the sale because the customer feels that your price exceeds the value he or she gets from your offer.
Between the floor and ceiling sits a price your customer will find acceptable.
Price floor and price ceiling
Source: Eric Dolansky
To choose the right price within your customer’s acceptable range, consider the main factors that affect price:
- operating costs
- scarcity or abundance of inventory
- shipping costs
- fluctuations in demand
- your competitive advantage
- perception of your price
Choosing the right pricing strategy
1. Cost-plus pricing
Many businesspeople and consumers think that cost-plus pricing, or mark-up pricing, is the only way to price. This strategy brings together all the contributing costs for the unit to be sold, with a fixed percentage added onto the subtotal.
Dolansky points to the simplicity of cost-plus pricing: “You make one decision: How big do I want this margin to be?”
The advantages and disadvantages of cost-plus pricing
Retailers, manufacturers, restaurants, distributors and other intermediaries often find cost-plus pricing to be a simple, time-saving way to price.
Let’s say you own a hardware store offering a large number of items. It would not be an effective use of your time to analyze the value to the consumer of each nut, bolt and washer.
Ignore that 80% of your inventory and instead look to the value of the 20% that really contributes to the bottom line, which may be items like power tools or air compressors. Analyzing their value and prices becomes a more worthwhile exercise.
The major drawback of cost-plus pricing is that the customer is not taken into consideration. For example, if you’re selling insect-repellent products, one bug-filled summer can trigger huge demands and retail stockouts. As a producer of such products, you can stick to your usual cost-plus pricing and lose out on potential profits or you can price your goods based on how customers value your product.
2. Competitive pricing
“If I’m selling a product that’s similar to others, like peanut butter or shampoo,” says Dolansky, “part of my job is making sure I know what the competitors are doing, price-wise, and making any necessary adjustments.”
That’s competitive pricing strategy in a nutshell.
You can take one of three approaches with competitive pricing strategy:
In co-operative pricing, you match what your competitor is doing. A competitor’s one-dollar increase leads you to hike your price by a dollar. Their two-dollar price cut leads to the same on your part. By doing this, you’re maintaining the status quo.
Co-operative pricing is similar to the way gas stations price their products for example.
The weakness with this approach, Dolansky says, “is that it leaves you vulnerable to not making optimal decisions for yourself because you’re too focused on what others are doing.”
“In an aggressive stance, you’re saying ‘If you raise your price, I’ll keep mine the same,’” says Dolansky. “And if you lower your price, I’m going to lower mine by more. You’re trying to increase the distance between you and your competitor. You’re saying that whatever the other one does, they better not mess with your prices or it will get a whole lot worse for them.”
Clearly, this approach is not for everybody. A business that’s pricing aggressively needs to be flying above the competition, with healthy margins it can cut into.
The most likely trend for this strategy is a progressive lowering of prices. But if sales volume dips, the company risks running into financial trouble.
If you lead your market and are selling a premium product or service, a dismissive pricing approach may be an option.
In such an approach, you price as you wish and do not react to what your competitors are doing. In fact, ignoring them can increase the size of the protective moat around your market leadership.
Is this approach sustainable? It is, if you’re confident that you understand your customer well, that your pricing reflects the value and that the information on which you base these beliefs is sound.
On the flip side, this confidence may be misplaced, which is dismissive pricing’s Achilles’ heel. By ignoring competitors, you may be vulnerable to surprises in the market.
3. Price skimming
Companies use price skimming when they are introducing innovative new products that have no competition. They charge a high price at first, then lower it over time.
Think of televisions. A manufacturer that launches a new type of television can set a high price to tap into a market of tech enthusiasts (early adopters). The high price helps the business recoup some of its development costs.
Then, as the early-adopter market becomes saturated and sales dip, the manufacturer lowers the price to reach a more price-sensitive segment of the market.
Dolansky says the manufacturer is “betting that the product will be desired in the marketplace long enough for the business to execute its skimming strategy.” This bet may or may not pay off.
Risks of price skimming
Over time, the manufacturer risks the entry of copycat products introduced at a lower price. These competitors can rob all sales potential of the tail-end of the skimming strategy.
There is another earlier risk, at the product launch. It’s there that the manufacturer needs to demonstrate the value of the high-priced “hot new thing” to early adopters. That kind of success is not a given.
If your business markets a follow-up product to the television, you may not be able to capitalize on a skimming strategy. That’s because the innovative manufacturer has already tapped the sales potential of the early adopters.
4. Penetration pricing
“Penetration pricing makes sense when you’re setting a low price early on to quickly build a large customer base,” says Dolansky.
For example, in a market with numerous similar products and customers sensitive to price, a significantly lower price can make your product stand out. You can motivate customers to switch brands and build demand for your product. As a result, that increase in sales volume may bring economies of scale and reduce your unit cost.
A company may instead decide to use penetration pricing to establish a technology standard. Some video console makers (e.g., Nintendo, PlayStation, and Xbox) took this approach, offering low prices for their machines, Dolansky says, “because most of the money they made was not from the console, but from the games.”
Penetration pricing makes sense when you’re setting a low price early on to quickly build a large customer base.
Misconceptions of penetration pricing
“Businesspeople think ‘If I sell more, I'll be more successful,’” says Dolansky. “That’s only true if your margins are sufficiently high. It’s important to remember that penetration pricing serves a strategic need, that there is a reason why you benefit from greater volumes in and of themselves, so that selling more units helps attain your goal of making the most profit.”
The risks of penetration pricing
- Your customers may expect constant low prices.
- Price-sensitive customers can be disloyal.
- A price war with your competitors may ensue.
Ask yourself if you can sustain this pricing for the long term without endangering your business.
5. Value-based pricing
In value-based pricing, the perceived value to the customer is primarily based on how well it’s suited to the needs and wants of each customer.
Dolansky says a company applying value-based pricing can gain an advantage over its competitors in a couple of ways:
- The price is a better fit with the customer’s perspective.
- The pricing brings more profit, allowing you to acquire more resources and grow your business.
When a price doesn’t work, the answer isn’t just to lower it, but to determine how it can better match customer value. That may mean altering the product to better suit the market.
In an ideal world, all entrepreneurs would use value-based pricing, Dolansky says. But entrepreneurs who sell a commodity-like service or product, such as warehousing or plain white t-shirts, are more likely to compete on low costs and low prices.
For entrepreneurs offering products that stand out in the market—for example, artisanal goods, high-tech products or unique services—value-based pricing will help better convey the uniqueness they’re offering.
How do you set a value-based price? Dolansky provides the following advice for entrepreneurs who want to determine a value-based price.
- Pick a product that is comparable to yours and find out what the customer pays for it.
- Find ways that your product is different from the comparable product.
- Place a financial value on these differences, add everything that is positive about your product and subtract any negatives.
- Make sure the value to the customer is higher than your costs.
- Justify the price to customers, which might include reaching out to them.
- For an established market, its current price range will help educate you on customers’ price expectations.
Make sure the value to the customer is higher than your costs. Otherwise, you will lose money with every product you sell.
Pros and cons of different pricing strategies
|Cost-plus pricing||Time-saving way to price||Does not incorporate the value to the customer|
Simple: adjusts to competitors’ prices
Aggressive pricing: good for companies with healthy margins
Dismissive pricing: offers market leadership protection
Focuses too much on what others are doing.
Lower prices can bring financial trouble if sales volume dips.
|Price skimming||Its early high prices help recoup development costs.||Copycat products can rob later-stage sales potential.|
|Penetration pricing||Its significantly lower price can motivate customers to switch brands||Price wars and too-low prices can become the norm.|
|Value-based pricing||A boon to artisanal goods, high-tech products and other unique services.||Not beneficial for all products where differentiation is not a key variable.|
Can you combine pricing strategies?
Some of these pricing strategies can co-exist as your product evolves through its lifecycle in the market; some elements must coexist. You need an overall price strategy (e.g., cost-based or value-based), you need to determine generally how high or low the price will be (skimming and penetration pricing), and you need to respond to competitors (competition-based pricing).
For example, you may want to initially price your product using a value-based approach, then switch to a skimming strategy and conclude with penetration pricing.
How does pricing strategy fit into your marketing strategy?
Pricing is one of the most important and visible aspects of your market strategy, which also includes promotion, placement (or distribution) and people (the classic four “Ps” of marketing).
The price you offer, Dolansky says, must be consistent with “how you would like to be seen among your competitors, and consistent with your promotional messages, your packaging and types of stores that your product is in.”
Let’s say your product is a premium olive oil. It needs to have a premium price that reflects the refined packaging, distribution in better grocery stores and upscale promotional messages.
All pricing strategies are double-edged swords. What attracts some customers will turn off others. You cannot be all things to all people. Just remember that you want the customer to buy your product, which is why you must use a strategy that’s appropriate to your target market.