One of the most common problems business leaders face is how to price a product. From entrepreneurs putting a new product on the market to executives at a public company revamping a product line, effective pricing is a key pillar of any successful sales and marketing strategy. Moreover, there are many misconceptions about pricing, with internet resources advocating one strategy over another without regard to differing company circumstances.
Pricing strategy is not one-size-fits-all. Instead, it depends on valuable information collected from suppliers and customers and evolving market dynamics.
This article delves into key market concepts, common pricing strategies, and my recommendations to business professionals who want to master pricing in specific markets.
Optimal pricing strategy
The primary goal of pricing strategy is the same as the primary goal of any other management strategy – to maximize economic value over time. This is achieved by striking a balance between setting prices that attract customers while maximizing profitability from sales.
In an ideal world, companies would be able to set prices through price discrimination, which means charging a different price to each customer. In other words, each customer would pay a price that reflects the value the customer sees in the product. By following this pricing strategy, companies would be able to gain the maximum revenue from each sale while simultaneously ensuring that customers are still willing and able to purchase the product. As a result, companies would be able to consistently maximize profits.
Perfect price discrimination, of course, is typically not possible. One reason is that companies often set a single price for a product regardless of the buyer’s ability to pay.
For example, academic publishers often sell new textbooks at a standard uniform price. Wealthier students or institutions would have been willing to pay more for the books, while at the same time less affluent students may find the textbooks prohibitively expensive, leading to lost sales.
Another reason price discrimination may not be possible is that competitive influences may drive down the price at which a company can sell its product. For instance, airlines typically try to practice price discrimination by charging higher prices for business travelers and lower prices for tourists. However, the presence of low-cost carriers can often force an airline to drop prices across all customer segments.
Pricing driven by industry dynamics
The market in which a company operates will determine to a large measure its pricing strategy.
On one end of the spectrum, the market might be perfectly competitive. Telltale signs of perfect competition are a large number of customers and many competitors who all produce an identical or highly similar product. Since information flows freely in this type of market, individual companies have no power to raise prices without losing their customers. Since each company can sell as much as they want at the market price, individual companies also have no incentive to lower prices. Prices are completely determined by the market. This might be the case in agricultural or commodity markets, such as the markets for wheat, corn, gold, or oil. Individual companies face the risk of fluctuating market prices and will try to manage this risk by entering into futures contracts to lock in an agreed future price.
On the other end of the spectrum, a monopoly is a market that entails a sole producer that can charge whatever price it wants according to customer demand. A monopoly can be obtained by dominating a particular region, obtaining exclusive rights to a technology, brand name, or creative work, or by signing long-term contracts with customers that lock them in for an extended period of time.
In reality, most markets will lie somewhere between perfect competition and monopoly. In most cases a market will fall nearer to perfect competition. However, companies can gain pricing power in various ways. This may involve customizing the product, building a strong brand identity, acquiring key competitors, investing in excess production capacity to scare away potential competitors, signing exclusive deals with major suppliers, or differentiating the product in other ways that appeal to customers.
Common pricing strategies
Below is a list of common pricing strategies, which offer a range of options. The one a business chooses will depend on the type of product and business in question.
- Cost-plus pricing: This strategy involves calculating the cost of production, and then determining the selling price by adding a markup. This pricing strategy is intended to be simple and ensure the business both covers its overheads and generates a certain profit margin. Businesses that use cost-plus pricing might include manufacturing or engineering firms that have significant and sometimes highly variable production costs. Professional service firms like law, accounting, or management consulting firms might also use cost-plus pricing to ensure that labour costs associated with each project are covered. A key criticism of this pricing strategy is that it fails to set prices based on the perceived value to the customer. For example, if the ingredients for my bake-sale cookies cost $2.50 for each cookie, I could charge $3 to ensure a 20% profit margin. However, I haven’t considered how much customers may actually be willing to pay for my cookies.
- Competition-based pricing: Setting prices based on what competitors are charging can seem like an attractive pricing strategy since it uses competitor’s prices as a benchmark to determine the market price and ensure that the company is charging the ‘going rate’ for its products. Food chains such as Burger King and McDonalds price this way most of the time. Competition-based pricing should be used thoughtfully and strategically. If overused, this strategy has the potential to lead to unintended price wars where each company tries to gain market share by slightly undercutting on price. Ultimately, prices may reach such a low level that the profitability of all companies in the industry is obliterated. One way for companies to employ competition-based pricing without engaging in a price war is to offer higher regular prices combined with a ‘price-match guarantee’. This discourages competitors from undercutting on price by signalling a willingness to engage in a costly price war if competitors should dare to do so.
- Penetration pricing: This option involves beginning with low prices to gain market share and slowly increasing prices over time. One example is a streaming service or online newspaper that offers an extended free trial to drive adoption and establish brand presence. Another example would be a new restaurant that offers steep discounts during its opening month to attract patrons who are accustomed to dining elsewhere.
- Loss-leaders: Offering a product at a loss to attract customers and then making profits from related products or services is a common pricing strategy. For example, a grocery store might sell popular cereal at a loss to attract customers, anticipating profits from the sale of complementary products like milk, honey, sugar, and other items. For many years, McDonald’s in Australia offered its famous soft serve cone for the ridiculously low price of 30 cents (inflation has now pushed it up to 80 cents). Parents who take their kids to Maccas for a soft serve ice cream might end up buying a Happy Meal, coffee, and other items as well. As a result, McDonald’s makes a profit overall even though it might lose money from selling soft serve ice creams.
- Bundling: Bundling involves offering multiple products or services as a package deal, typically at a lower price than if each item were purchased individually. This can increase perceived value for money and drive increased sales. For instance, travel agencies typically offer vacation packages that bundle together things like flights, accommodation, car rental, meals, and excursions.
- Two-part pricing: This pricing strategy involves charging a fixed fee along with a variable usage fee. Costco uses this strategy through its annual membership fee, which contributes to Costco’s profitability, combined with consistently low prices on a wide range of products that entice customers to remain loyal.
- Premium pricing: Premium pricing entails charging an initial high price to create a psychological anchor. The product is then subsequently offered at a discount, making the discounted price seem like a bargain. For example, if you start by pricing a new pair of shoes on the market for $200, you might then lower the price to $60. Price conscious customers are likely to jump on the “opportunity” even though your intention may have been to price the shoes at $60 all along.
- Peak-demand pricing: Charging higher prices during periods of high demand can maximize revenue, particularly in industries with variable demand. One example might be a golf driving range that charges $10 per hour on weekdays and increases its price to $25 on weekends. Another example might be the toll rates for the Sydney Harbour Bridge which vary based on whether you cross the bridge at peak time ($4.27), off-peak time ($3.20), or night time ($2.67).
Developing a pricing strategy – getting started
When developing your pricing strategy, spend time upfront answering the following questions:
- Who is my target market? Who are my customers and what do they value? What problems do they face? What jobs do they need done?
- Who are my competitors, and what do they offer?
- What distinct value does my product offer? How will this change over time? How does this value differ between customer types? How does this value differ from that offered by the competition?
- How will I maintain a competitive advantage? How can I corner the market with information, timing, location, a unique value proposition, and pricing strategies?
The bottom line
Pricing is a complex and multifaceted aspect of business strategy. It’s important to remember that there’s no one-size-fits-all solution, and the best pricing strategy for your business depends on your specific market, product, and goals.
By carefully considering the range of available pricing strategies, thinking deeply about your target market, competitors, and product, and staying attuned to changing market dynamics, you can start to develop an effective pricing strategy that has the potential to maximize economic value over time and ensure the success of your business.
Wes Brooks is an incoming Summer Business Analyst at Cicero Group and an undergraduate studying economics, management, and strategy. He is a serial entrepreneur, works in venture capital, and enjoys singing a capella and piano improvisation.
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