The price you set for your product or service can have a bigger impact on the profits your business earns than almost any other factor under your direct control. If your margins are 10% and you hike prices just 1%, all else being equal you may have just increased your profits by 10% – a ten-fold leverage. It can work the other way, too. Cut prices 1% in the same situation and 10% of your profits just evaporated.
In practice, of course, all is rarely equal, and pricing changes also can powerfully influence sales volume, customer perception, market positioning and more. Under certain circumstances, a price cut can spur so much demand that volume swells to the point total net profit increases. A pricing strategy helps you understand and employ these influences to maximize your profits.
The typical pricing strategy approach is to total up the cost to produce the product and perhaps after considering competitors’ prices add a percentage for profit. However, there are many other approaches to setting prices, and a more thoughtful and rigorous approach to selecting the best strategy for your product and market can pay big dividends.
What is a Pricing Strategy?
A pricing strategy is a system or approach to setting prices for business offerings. It is integral to every business and connects to every part of the business. Developing a pricing strategy affects and calls for input from operations, accounting, marketing, sales, finance, and even customer service. A robust pricing strategy accounts for marketing objectives, revenue goals, brand positioning, target audience, product life cycle, and more.
Pricing can be one of the first touchpoints customers have with your brand. For instance, many prospects researching purchases will set a price point or band to fit their budget before considering any other feature of available offerings. If your price is too high or too low to get past this initial screen, you’ll never even appear on their radar.
Types of Pricing Strategies
A pricing strategy can be different for each business. However, the many possible approaches can include:
Competition-Based Pricing
Competition-based pricing involves checking what others in your market charge and setting your prices so that you compete effectively while maintaining profits. Highly competitive industries serving particularly price-sensitive customers often use this method.
Cost-Plus Pricing
Cost-plus pricing involves calculating the total cost to provide a service or produce a product, then adding a markup. While this approach covers costs and assures a profit, it doesn’t address market dynamics or possible customer perceptions.
Freemium Pricing
Freemium pricing is often used in software, online platforms, and mobile applications. Businesses will offer a basic version of a product or service for free while charging a premium for a version with more features or advanced functionality. The idea is to attract a wide base of users, some of which will convert to paying customers.
High-Low Pricing
The high-low strategy sets high initial prices but offers frequent discounts through sales or promotions. High-low pricing helps price-sensitive shoppers perceive that they are getting a deal and creates a sense of urgency to buy during the sale period.
Hourly Pricing
Charging by the hour is common in service businesses including professionals and consultants. It allows a business to charge for the effort and resources required to provide the service.
Price Skimming
Setting a high initial price for a new product or service and then gradually lowering it over time is called price skimming. Businesses do this to maximize revenue from early adopters willing to pay top dollar, while also capturing price-sensitive customers later on.
Penetration Pricing
With penetration pricing, a business sets a low initial price to build market share quickly. It helps create brand awareness and create a large and loyal customer base that can help sustain future growth.
Premium Pricing
Sometimes, customers willing to pay more based on brand. Premium pricing aims to create the perception that a product or service is of higher in quality, more exclusive, or otherwise superior because it costs more. Fashion and luxury goods and services can be a good fit with premium pricing.
Project-Based Pricing
Project-based pricing often appears in fields such as construction or consulting. It calls for estimating the time, cost, and other resources required to complete a specific project for a client. Project-based pricing tailors price to individual projects while considering the client’s unique requirements.
Value-Based Pricing
Value-based pricing starts with determining how customers perceive the value that a product or service offers. Their needs take center stage here. With value-based pricing, a business can capture the value it creates while maintaining a fair exchange with customers.
Bundle Pricing
To use bundle pricing, combine multiple products or services into a package and offer them for less than the sum of their individual prices. Ideally, customers are encouraged to buy more, increasing sales volume as well as customer satisfaction.
Psychological Pricing
Psychological pricing taps human psychology to influence customer perception. Bundle pricing is one example. Another, charm pricing, uses prices ending in “99”. Anchor pricing, setting a higher price initially to make subsequent prices seem more reasonable is another psychology-based method that can encourage customers to perceive value.
Geographic Pricing
Geographic pricing sets different prices for different locations or service areas. It addresses transportation costs, local market conditions, and regional variations in customer purchasing power. Geographic pricing helps businesses get the most profit from a specific market.
How to Create a Pricing Strategy
A well-developed pricing strategy considers and coordinates with overall business and marketing objectives. Here’s a process for creating a holistic pricing strategy:
- Start by surveying customers to find out how much value they put on your product. How do they use it and how is it helping them?
- Evaluate their pricing sensitivity. How much or less will they buy at different price points?
- Check competitors’ current prices as well as how they’ve responded to past pricing trends. If you cut prices, will it spur a destructive price war?
- Consider how much it costs to provide your service or product and how much profit you need. Use this as a pricing floor rather than a ceiling.
Ideally, this approach will reveal more pricing power than you suspected. You may be able to charge more and get a higher profit than if you had simply selected what seemed like an acceptable markup to your costs. If, on the other hand, it suggests you can’t profitably supply the value customers want, you may look at other areas such as cost or design to devise a more effective strategy.
What Is the Best Pricing Strategy for Your Business?
Firms in the same industry that target similar audiences with comparable value propositions are likely to use the same pricing strategies. For example, many restaurants use a technique called menu engineering to get more profits from individual menu items. Similarly, companies that produce events frequently employ tiered pricing, basing ticket prices on whether customers buy early, want VIP treatment, or have other preferences or budget needs.
Technology-intensive companies also have characteristic pricing strategies. E-commerce retailers often use dynamic pricing, changing prices in real time based on market demand, inventory levels, competitive reactions, and other factors.
As a first cut to selecting a pricing strategy, see what your direct competitors are doing, then tailor their approaches to fit your particular strengths and weaknesses.
The Takeaway
Setting an appropriate price has tremendous power to open new markets and increase revenues or, conversely, to reduce opportunity and cause sales and profit to shrivel. Understanding the different pricing strategies and how to tailor an effective approach for your business can help you make informed decisions and take greater control of this critical business function.
A version of this article was originally published on May 28, 2010.
Photo: Getty Images
