Like many of the decisions you will face as an entrepreneur, the process of setting prices for your products/services should be executed in a strategic way.
A pricing strategy starts with defined objectives.
It is too simplistic to say that a company’s strategy is to make as much money as possible.
There are all kinds of reasons to adopt a pricing strategy besides profit maximization.
The following are some common pricing strategy goals:
- Increasing sales
- Maximizing profit
- Discouraging market entrants
- Gaining market share
- Establishing a market position
- Paying back investors
- Increasing cash flow
Once you have determined your pricing objectives, you can identify your range of potential prices.
Your range of pricing flexibility is the space between your price floor and your price ceiling—the lowest and highest prices you can charge for your product or service.
Your price floor is set by your minimum margin.
It is the bare minimum you must receive for each unit in order to cover costs and make a reasonable profit.
Your price ceiling is impacted by a number of factors, but the most influential are your
- market position,
- the prices of competitive products,
- and the price sensitivity of customers in your target market
A market that is price sensitive is one where buyers have a lot of power— they can choose from many different options.
This condition forces companies within the space to compete with one another on price, which is an area where new ventures are at a disadvantage.
Keep in mind that the market position has a huge impact on your price ceiling.
If you are positioned within your market as a luxury or premium brand, you can charge more for your product based on its perceived value.
Economy or discount brands often have much lower pricing flexibility as they compete more intensely on price.
The convergence of strategy, market perception, and competitive factors make determining an optimal price something of an art.
The most important thing to keep in mind is that your pricing strategy needs to be grounded in solid rationales and constructed with a strategic approach in mind.
Under no circumstances should the price that you charge for your products be a WAG (wild-ass guess)!
Strategically Establishing Your Prices
There are four basic ways to establish pricing:
01. Markup Pricing
Markup pricing (also known as “cost-plus pricing”) is a simple pricing calculation that totals the costs to produce and distribute a product (or to execute a service) and adds a markup to those costs to generate a margin.
This markup should place the selling price somewhere within your selling price flexibility range (the difference between your price floor and price ceiling) and generate enough profit to sustain the business.
02. Break-Even Pricing
Break-even pricing is centered on the business’s break-even point.
The break-even point is the equilibrium point where costs equal revenue.
If the money going out equals the money coming in, that means profit is zero.
Break-even pricing is not a sustainable strategy in the long term, but it can be an effective tool to gain a large amount of market share in a short time (known as penetration pricing) or to edge out and discourage new market entrants.
03. Going-Rate Pricing
Going-rate pricing is a method that sets a product or service’s price based on the prevailing market price for similar offerings.
This method of establishing prices is common with products that have few differences, such as commodities or other homogenous markets.
Because new ventures can rarely compete on price, being able to differentiate your product from others in the same space is a lifeline for many startups.
04. Perceived-Value Pricing
Perceived-value pricing is a method that assigns a price to a product or service based on its perceived value rather than on costs, historical prices, or the prices of competitor offerings.
Perceived-value pricing is a tactic commonly associated with luxury or premium brands that are highly differentiated from one another.
Positioning and the Price/Quality Matrix
A helpful tool for determining a pricing strategy is the price/quality matrix.
It is a basic four-quadrant matrix that compares the price versus quality (or perceived quality) of others in the same space.
Low quality in a price/quality matrix isn’t necessarily describing poorly made products or marked-up junk.
Instead, it is a description of the price versus the perceived quality.
If the price and quality are commensurate with each other and both are lower than other similar products in the market, then the product belongs to the bottom left quadrant.
Likewise, if the price and perceived quality are proportionate and both are higher than others in the market, then they belong in the top right quadrant.
When the price is higher than that of other products of similar quality, then the price and quality are incommensurate; these are the products that belong in the top left quadrant.
Let’s examine each in greater detail, moving clockwise from the top left.
01. Pricing Strategy Skimming – High Price, Low Quality
Price skimming is a strategy of charging a price that is not commensurate with the product’s quality compared to similar offerings.
The goal of this strategy is to collect as much revenue as possible from the small market segment that is willing to pay the inflated price.
This tactic has a predictably short life span, and as the number of people willing to pay the price of the product falls, the seller brings the price down as well.
In this way, the seller can “skim” revenues from a wider range of market segments.
After a price reduction, a new market segment will be willing to purchase the product, and the process resets.
After that segment is exhausted, the price will be reduced again until it matches the quality of the product.
This strategy is an effective way to recoup high development costs and is most effective in markets where new product launches are frequent.
But it is not without downsides.
A skimming price strategy effectively penalizes customers who buy the product when it is first introduced; they can (understandably) become frustrated to find out that the same product they purchased has gone down in price.
Additionally, a misstep in the timing of price changes can mean reduced sales overall.
Markets with frequent product launches have customers with short attention spans.
If the product is at its initial price for too long, people will lose interest and pass it over even when the price does drops.
Price skimming strategies are popular in the luxury car market and in consumer electronics and books.
These markets share high rates of new product introduction and high costs to develop new products, making skimming an attractive approach for them.
02. Pricing Strategy Premium – High Price, High Quality
A premium pricing strategy relies on differentiation and a high perceived quality to command a higher price than that of competitors.
This approach to pricing helps firms squeeze more margin out of each sale.
Because the price is tied to the perceived quality and not the costs of the product or service, the potential for higher margins is much greater.
Because it is nearly impossible for new businesses to compete on price, a premium pricing strategy is usually the most sustainable choice for startups.
03. Pricing Strategy Penetration – Low Price, High Quality
A penetration pricing strategy is a perfect example of the strategic use of pricing to make a quick grab for market share.
This is another example of incommensurate pricing; however, unlike price skimming, which favors the seller, penetration pricing favors the buyer.
The goal is to entice customers by offering a product that is of equal or higher quality than others in the market but is sold at a lower price.
Once the objective is accomplished—a new slice of market share has been claimed—the price can rise to become more commensurate with the quality of the product.
This strategy is not without challenges.
Offering a quality product at a reduced price eats into margins and is unsustainable in the long term.
This means that the penetration process must be monitored closely.
Additionally, too low of a price can have the unintended consequence of reducing the value perception of your brand.
Although you may rapidly acquire market share, once the penetration pricing period is over it can be tough to recover from the “budget brand” perception.
Finally, customers don’t like it when they are asked to pay higher prices.
The ground that was gained by the penetration pricing can be lost when dissatisfied customers look elsewhere.
04. Pricing Strategy Economy – Low Price, Low Quality
Economy pricing is a sustainable, long-term strategy for numerous businesses.
It can also spell disaster for businesses that aren’t prepared to compete exclusively on price.
Economy pricing works best when the business in question can leverage some competitive advantage to dramatically bring down their costs.
Leveraging the economy of scale (the ability of large organizations to spread out costs over more units, effectively bringing costs down), a lean supply chain, or advanced processes and techniques are all examples of cost-slashing competitive edge.
In this way, an economy pricing strategy can be used to dissuade new market entrants.
The downside to economy pricing is that being perceived as a “budget brand” can be a tough stigma to shake for a growth-oriented company.
That is if the company has the resources to keep costs low enough to maintain a sustainable economy pricing strategy.
A very real risk of attempting an economy pricing strategy is finding out that your company doesn’t, in fact, have the resources needed to pull it off.
Also, customers who are looking for the best deals and the lowest prices are loyal to the savings, not to the brand.
They are fickle and will always be chasing a better deal and as a result, will only respond to the price aspects of your brand.
Differentiation is difficult for brands that execute economy pricing strategies.
Because startups are rarely able to compete on price alone, an economy pricing strategy is not usually a winning proposition for new ventures.
To sum it up…
None of the abovementioned price-versus-quality pricing strategies is a silver bullet.
Each has associated challenges, and each has strengths or weaknesses when used with various business models.
Also, keep in mind that your pricing strategy can’t be a perfect fit for every customer.
Pick the one that makes the most sense for
- your product or service,
- your market,
- your industry,
- and your business model
The prices you set at the outset of your venture are not written in stone.
Markets and industries change.
Competition forces changes in pricing, as do the costs of materials, supplies, and labor.
Additionally, products and services mature, new opportunities within a market present themselves, and business strategies shift; your prices must also change as appropriate.