What is a pricing strategy?
A pricing strategy is a method for deciding the price you will charge. The right price is the one that your customers will willingly pay, but which also maximizes your profits and business success.
Pricing strategies vs pricing models
Pricing strategies are often mentioned in the same breath as pricing models. So are they the same thing? Not quite.
- A pricing strategy is the way you set the price.
- A pricing model is a kind of price format – it’s part of the way you package and present your goods and services to the customer.
An example of different pricing models is subscription vs one-off payments. Take streaming media – whichever pricing model is used, the product is the same (films, TV shows, or music). But with subscription pricing, you’re selling access to a large library of titles on a time-bound basis, rather than charging a one-off cost to own or rent an individual recording.
As a general rule, a pricing strategy is internal to your business, and a pricing model is external, aimed towards your customer. You won’t find many pricing strategies in marketing communications, but you’ll find plenty of pricing models.
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Why is it important to get the price right?
The right price is a matter of balance. If you price your product too high, your customer won’t buy it. If you price it too low, they’ll buy it, but your margins will suffer.
Pricing correctly involves understanding consumer psychology. What will a high or low price mean to your customer? High prices could actually enhance the perceived value of something, especially if it’s a luxury purchase associated with status and aspiration.
And while low prices are more affordable, your customer may see a cheap price tag and perceive the product as lower quality. Pricing too low could reduce customer trust and even degrade your brand value.
It’s not just about you and your customer either. In today’s saturated markets, there’s a third factor in the mix – your competition. When setting prices, it’s important to benchmark against what strategies your competitors are using and what they’re charging for comparable products.
The prices in your market niche will provide a psychological anchor point for customers in terms of what a fair price is, so you should aim to keep in range of your competitors. You may charge a little less or a little more, taking into account aspects of your products, brands and services that will justify price differences to your customer (such as enhanced product features, sustainable manufacturing, excellent service, no-frills store experience and so on).
Cost, margin and markup
Underlying all pricing strategies is the basic mathematics of making a profit and keeping your revenue at a healthy level. To do this, you need a strong grasp of costs, margins and markups.
Here’s a quick recap:
Cost
This is the amount you spend to get your product or service to market. It includes things like manufacturing and materials, cost of labor to produce tangible goods, payment to your suppliers, and any loss or wastage that happens along the way. For pricing purposes, cost of goods and services doesn’t include general overheads like heating, lighting, rent etc. or auxiliary business functions like marketing and sales, which are categorized as operating costs.
Margin
The margin (aka profit margin) is the part of the price you have left over once the costs have been taken out.
Markup
Markup is what you add on to the cost of producing or providing your products and services to arrive at the price your customer pays. It’s often set using a percentage formula.
5 pricing strategies to know about
1. Penetration pricing
A new business enters the market with goods priced well below what its competitors are charging. Customer interest is drawn by the low price and good value on offer. Once the brand is established and has acquired a strong customer base, it begins to bring its prices in line with what’s typical for the industry.
Adopting this strategy involves risk. It means taking a hit on profits during the initial phase, which not all new businesses will be able to survive. However, it’s a powerful way to capture market share from well-established competitors and can help develop a company culture of focus and efficiency.
2. Premium pricing
If an item costs more, a customer will perceive it as having more value. That’s the logic behind premium pricing. A business using premium pricing intentionally charges more than its competitors, trading on a brand that’s all about quality and prestige.
To make this strategy work, brand value and product quality must be carefully built and maintained. The upside is that markup and margin will be higher than typical for the product category.
3. Price skimming
Taking its name from the world of dairy goods, price skimming is the strategy of charging a high price when a product is new on the market. The “cream” of the customer base are early adopters eager to be the first to access the product and willing to pay a price premium. Over time as the product is less novel and appealing, the price may be reduced to appeal to successive levels of the customer base who have less appetite and higher price sensitivity.
This approach has the obvious advantage of bringing in more revenue early in the product’s lifecycle, and maximizing profit by taking advantage of every level of price tolerance within the customer base. It can also help support perceptions of premium quality and make the product more desirable.
On the downside, it’s well-recognized by customers and many people are likely to wait it out rather than pay more early on. Its success also depends on the nature of the product – aspirational tech companies do well out of this strategy, but other sectors may not.
4. Bundle pricing
As much about product packaging as pricing, bundling is the practice of grouping several items together under a single price tag.
Bundle pricing can be a useful psychological nudge technique to motivate customers, especially if you let them know that the collective value of the items in the bundle is greater than the bundle price.
It can increase appeal in terms of utility and ease, especially where the items are complementary in function or form (think shampoo & conditioner sets, or burger and fries meals). Bundling is also used to help with inventory management – you can bundle together a less-popular item with a top seller in order to help move it off the shelves.
5. Loss-leading
Like penetration pricing, loss-leading uses very low prices to grab customer attention. This might be in the form of a special offer, or single product line which is sold at a heavily reduced margin. The business recoups the loss on other products with healthier margins which customers discover after they have been drawn in by the loss-leading item.
Note that loss-leading has a more extreme cousin, known as predatory pricing. This is where a company aggressively underprices a product in order to defeat its competition. Predatory pricing is illegal in many regions. In the US, predatory pricing is often gauged using the Areeda-Turner test.
7 pricing models to consider
1. Freemium
Your basic product or service is free, or ad-supported. Users can opt to pay more for premium features or a better / ad-free experience. An example of a business using a freemium model is Dropbox, which offers a small amount of storage with a free account, and charges users if and when they want more space for their files.
2. Flat-rate subscriptions
Users pay a set cost on a regular basis, for example $9.99 for unlimited music streaming from a library of media that you own. Spotify currently uses this model for its main product (although it also offers a concession rate for students and a bulk price family plan).
3. Tiered subscriptions
As with flat-rate subscriptions, the user pays a regular fee, but they can choose how much to pay depending on their expected usage levels or desired features. This might be combined with freemium pricing (where the lowest tier is free). This model is sometimes used as a form of price anchoring – where the lowest and highest tiers help to position the medium tier as the best value.
4. Pay as you feel / pay what you want
The customer can pay as much or as little as they want to. This approach is often used for charity sales or fundraising. The band Radiohead used this approach when they released their In Rainbows album in 2007.
5. Bulk pricing
Price goes down as the volume of goods or services goes up. This is common in B2B sales and wholesale transactions.
6. Market pricing
Price fluctuates according to the market, rising and falling in line with supply and demand.
7. Sliding scale pricing
Price varies according to the means of the customer. This might be used in settings like healthcare, where client need is considered from an ethical point of view as well as a financial one. This is similar to pay what you feel pricing, but there is a recommended or standard price published, and prices outside that are negotiated on a case by case basis between business and customer.
How to choose a pricing strategy
Choosing how much to charge and how to structure your pricing is a big decision, and one that deserves some consideration and research.
Be clear on costs
Before you think about price, you need a clear understanding of the cost of your goods or services. Make sure you include every element of product development, manufacture and supply, and the delivery of services (including things like equipment and uniform costs if applicable). Add a percentage to cover losses and waste too.
Benchmark against competitors
Carry out competitor analysis to learn what comparable businesses are charging in your market. As well as looking at current prices, explore historical price patterns to see if they’ve employed techniques like penetration pricing or loss leading in the past.
Think about your timeline
If you’re considering a time-bound pricing strategy such as price-skimming or penetration pricing, you need to know how long you will do it for and what the impact will be on your profits over that timeframe. Is an initial loss sustainable? If price skimming, can you predict when to take down your prices on a schedule in order to get the best results?
Research price sensitivity
Last but not least, it’s crucial to get to know your target audience’s price sensitivity and what they are willing to spend. You can use established research methods like Van Westendorp’s Pricing Index and Gabor-Grainger pricing technique to get precise, detailed data about what your customers will be prepared to spend with you.