Choosing how to price your product or service requires careful consideration of your business aims. There are a wide variety of pricing strategies, some of which can be combined with one another. For example, if your business aims to grow market share quickly, this will require a different pricing strategy from a business which aims to maximise profits.
The following article illustrates some of the most common approaches to pricing strategy, with examples of how each type is used in business. Choosing the right one for your business will depend on a variety of factors, including your aims, the industry in which you work, and the pricing strategies employed by your competitors.
This strategy is used when the high price of the item in itself enhances the perceived value of the product. This is usually seen in high-end or luxury goods, and requires that the brand identity sufficiently supports the premium price point. In most cases the higher price point is related to the exclusiveness or scarcity of the item.
Premium pricing is usually justified by strong brand identity and associations of prestige and luxury. If the brand image is damaged, or is perceived to have fallen out of fashion, consumers may be unwilling to pay the higher price.
Example: A luxury watchmaker sets the price of a watch at several thousand dollars to enhance the appearance of exclusivity and differentiate the product from cheap or mid-price alternatives.
In contrast to premium pricing, an economy pricing strategy sets the lowest possible price for a given product, while maintaining a profit margin (although this may be minimal). This can be an effective strategy for businesses selling commodities, where the comparison of related product offerings by the customer is chiefly influenced by price.
Whilst selling at the lowest possible price point may be an effective strategy for gaining market share, if the quality is not sufficient, customers may be driven to seek more expensive but reliable alternatives.
Example: An electricity supplier sets a tariff lower than any of its competitors to attract customers who are principally motivated by price, rather than any other aspect of the product/service.
The initial price is set high, and then reduced over time, allowing the company to address each layer of the market separately, also known as “skimming” the market.
This strategy allows businesses to realise higher profits from early sales of the product, helping to recoup production costs, and then lower the price to achieve greater market share as production costs decrease due to lower cost of materials or economies of scale.
Example: Games console manufacturers generally release a new product at a high price to sell to a small market of early adopters, and then gradually reduce the price over a number of years, maximising the revenue from each sector of the market.
Penetration Pricing Model
In contrast to skimming, penetration pricing involves setting a low initial price to build market share, and then increasing the price over time for new customers. This works on the principle that a less profitable price is necessary to build initial sales for the product, but that once a level of demand has been established, higher profits can then be realised from new customers.
However, if the price is increased beyond the perceived value of the product, market share may begin to decrease as customers switch to more competitively priced products on the market.
Example: An internet service provider offers cheaper deals initially to build a customer base, and then as demand for the service grows, increases the subscription price for both new and existing customers.
Often used in software and mobile app sales, the freemium model offers a free stripped down version of the product, with the option to upgrade later to a paid-for version with more features or increased value. The aim is to entice the customer to use the product without any initial outlay, with the view that this will encourage them to purchase the enhanced version once the value of the product is proven.
This model works well for building market share quickly, but with low initial revenues. There is a risk that the free version of the product or service will prove sufficiently useful that few users of the service will upgrade to the paid version, and revenue targets will not be met.
Example: The music streaming service Spotify used a freemium model at its launch, whereby customers could use the service for free, but would hear advertisements between tracks. Users could upgrade to a paid version to remove these adverts.
Loss Leader Price
A specific product or product category is priced below the cost price, effectively at a loss, to attract customers who will also purchase more profitably priced products in the same transaction, ensuring that the overall profit remains high.
This model is often used by large retailers such as supermarkets or clothing stores who wish to attract a large amount of footfall customers. Where customers visit solely to purchase the loss leader product, the business may find itself making an overall loss.
Example: A supermarket offers cases of beer at a knockdown price, with the intention that customers visiting their store to take advantage of the offer will purchase multiple profitable items alongside the loss leader, effectively making up for the loss on the discounted item.
Optional pricing is applicable for core products which can be sold with optional extras. In this model the core product is priced competitively, with the optional extras attracting higher profit margins. To maintain profitability, the optional extras must be sufficiently attractive to be selected by a significant proportion of the customer base.
Example: Many car manufacturers offer a base vehicle with a wide range of attractive optional extras which, if selected, significantly boost the profit realised on the sale.
Pay What You Want Prices
This model is used where the cost of producing and distributing the product or service is minimal, but there is substantial value to the customer, and involves inviting the customer to pay as much or as little as they consider the product worth. There may be a minimum price set, or alternatively the customer may have the option to pay nothing.
This model works best where the customer base has an interest in the continued profitability of the business, for example fans of a band accept the band must be profitable to continue to record and release music, and therefore a significant proportion are willing to pay an amount at or above the cost price. Where all customers opt for the free or minimum price option, this strategy may result in an overall loss.
Example: The band Radiohead released their 2007 album In Rainbows as a pay-what-you-want download, allowing fans to download the whole work for free, or make a payment in the amount of their choice.
Cost Based Pricing
A simple model, cost based pricing involves calculating the total cost of the product or service, and then adding the desired profit margin as a percentage of this. This ensures a consistent level of profit, however the reduced flexibility may make this model difficult to sustain in a crowded market, or vulnerable to disruptive pricing by competitors.
Example: Professional services providers, such as lawyers, will bill their client for the cost of their time with a built in profit margin, guaranteeing a certain percentage of profit on all revenue generated.
Time Based Strategy
In this model, the price of the product or service varies according to supply and demand at the time of purchase. This allows the business to adjust pricing dynamically to maximise profit when demand is high and maximise sales when demand is low.
Example: An airline sells seats on an undersubscribed flight initially at an attractively low cost. As the flight begins to fill up, having covered its costs, the airline can raise the price for passengers booking later, maximising profitability.
Value Based Pricing
This model sets the price according to the perceived value of the product by the customer, which may not be directly related to the production cost of the product. This is a model particularly suited to digital products such as media or software, where the cost per unit is minimal once the initial development costs have been met. Due to the high profit margins, value based pricing can be particulalry sensitive to disruption by competitors, potentially leading to price wars or a race to the bottom, unless the product in question has a unique value proposition.
Example: A software company charges $400 for a “home edition” of its office software, but $2,000 for the business edition, as the business user will value the software more highly, even though the cost of the physical product (a CD-ROM) is the same for each version.
How to Choose
The examples above show the breadth of approaches to pricing strategy in use by modern businesses, and some of the risks associated with particular tactics. This list is not exhaustive however, and particularly as technology develops and changes the landscape in which businesses present their product and services, new and innovative pricing strategies, and combinations of strategies emerge.
In setting your own pricing strategy, a good starting point is to look at how your competitors are operating, and then consider whether to compete with them using a similar approach, or disrupt the market by taking an unexpected approach.
As with all aspects of strategic planning, careful weighing of the benefits and risks is vital, but sometimes it’s necessary to learn by doing, rather than imitating what has gone before.