Complete Guide to Pricing Strategies

Pricing strategies are the methods by which businesses set the pricing of their products or services. A pricing strategy is determined by a range of factors, including the cost of production, consumer demand, consumer income levels, market conditions, and competitor pricing, among others.

Your pricing strategy will largely determine how much revenue you make, making it one of the key decisions in the management of your business. Ultimately, the best price for your product strikes a balance between maximizing profits and being affordable. There is a pricing model and strategy for every conceivable business case, with a host of variables having an influence on your final price. These include internal business elements too, as marketing goals and brand positioning will contribute to your strategy.

Despite this, pricing strategies don't always follow the logic of profit maximization. Sometimes businesses price their goods low to maintain their market share. Sometimes, a product priced below a competing product will suffer from a perception of being lower quality, or lower value, while more expensive products create the illusion of greater value. A customer without any knowledge of your product might unfairly judge it as inferior to the more expensive one when in reality the two might be very similar. Price can create this illusion.

Cost-Plus Pricing

Also known as markup pricing, cost-plus pricing is a pricing strategy where the total cost of producing a product is added up, and the markup is added for profit. The sum of the markup and the total cost of producing the product will give you your price.

This cost is inclusive of a number of things, including the cost of raw materials, the cost of production, and the overhead costs.

Once the total cost of producing the good is calculated, the markup is added. This is also known as the profit margin. To calculate this, your first step is to determine how much profit you want to make on each item sold. Let's suppose you owned an ice cream store. Your cost of producing an ice cream cone is $2.00 and you want to make $1.00 on each cone, so you price your cone at $3.00. This gives you a markup of 50%.

This method is unsuitable for companies operating in a highly competitive market, as the pricing of your competitors should serve as the main reference point. Using this method in a competitive space runs the risk of overpricing your products.

Demand Pricing

This strategy is where the level of demand for a product determines its monetary value. The logic of this method is fairly simple. The greater the demand for a product, the higher you can set your price. Low demand means people are less willing to fork out a small fortune for your product, resulting in a lower price.

Things that can affect demand are weather, natural disasters, the holiday season, cheaper alternatives, and market trends.

Demand pricing falls under a pricing category called Dynamic Pricing. This is a strategy that responds to changing variables in the marketplace. Prices fluctuate regularly and there is a need to adopt a flexible strategy that responds to change.

Companies now use sophisticated algorithms that track consumer demand and change prices accordingly, aligning prices with what they think customers are willing to pay. If you manage a hotel, utility company, or transport company, you will most likely need to adopt this method.

Penetration Pricing

Suppose you're launching a new product in a competitive market. Your competitors are well-established with a loyal consumer base. How do you win over their customers? Enter penetration pricing.

Penetration pricing is the process by which a new company temporarily prices its products far below the industry average, in the hopes of persuading customers to make a purchase. In theory, your product is promising but no one has ever heard of it, so you make it very easy to buy. You put your product in consumers' hands by making it cheaper than the competition in the hopes that it makes an impression on them beyond affordability, and good word-of-mouth starts to spread. Once it owns a piece of the consumer's mind, you gradually restore its price to a profitable one. With penetration pricing, you're sacrificing in the short-term in order to be profitable in the long term.

This method can be risky if your short-term losses exceed the expected time frame and the product hasn't yet garnered attention or gained any traction in the market. In this event, there are a number of working capital loans available to small businesses to keep your company operational during rough patches.

The 'Freemium' Method works in a similar way to penetration pricing. With 'Freemium' Pricing, companies sell a basic version of their software with a limited set of features and a low price point. Once the customer sees the value of your product, they would typically consider upgrading to a more expensive version; one with extra features. They wouldn't necessarily have done so had they not been exposed to the product in some limited way.

Geographic Pricing

You might sell only one product, but you very likely will sell the same product at different prices, depending on where you sell it.

Different markets have different dynamics, so you have to understand what customers are willing to pay in each market before setting your price. Geographic pricing takes into account the diversity of income levels, market conditions, taxes, tariffs, shipping costs, and socio-economic factors that characterize each market.

Geography might also affect supply and demand. A company selling winter clothing, for example, would price their clothing higher in cold-climate countries and lower in warmer climates, as there is more demand for them in colder countries.

Transportation might also play a role in pricing. If you're selling clothing to a country on the other side of the globe, the cost of shipping your products might increase your prices.

Geographic pricing can apply both to global markets and markets within a country, state, or city.

Price Skimming

There are two scenarios where price skimming should be employed; when a company has a competitive advantage that justifies higher margins, and when a company has a monopoly on a product.

A company with a competitive advantage is one that has a natural advantage over its competitors. Their underlying economics or brand value allows them to either over-charge to maximize profits, or under-charge to maintain market share, shielded by something their competitors can't offer. For example, an ice cream shop that uses their own dairy products from a farm will use less money to produce ice cream, allowing them to price their ice cream below their competition while enjoying the same profits.

Businesses primarily use price skimming when they are the first to market with a new product. Their monopoly or intellectual property over their creation allows them to charge a high price before competitors enter the market, after which it is reduced. This strategy is often targeted at early adopters who will pay over-the-odds for something new before making it affordable for the majority of the market.

The Price Skimming strategy hits two birds with one stone. It both allows your company to make good on most of its production costs and creates an initial impression of superiority, based on an exorbitant price.

Economy Pricing

This is a low-price strategy that targets the bottom end of the market. Commonly used by retailers and wholesalers, Economy Pricing ensures that the cost of production is low so that the product can be affordable. The product sold is ultimately of inferior quality and a low price.

Economy Pricing is a strategy employed by large companies and is not recommended for small businesses. They do not generate the same sales volume as larger retailers so they cannot afford to lower their prices.

Psychological Pricing

This method marginally lowers the price of a product to create the appearance of a lower price. You've likely seen this somewhere today. A product is priced at $9.99 instead of $10.00, toying with the customer's emotions. Psychological Pricing works because the difference in price is not as great as the impression it creates on consumers.

Competitive Pricing

This strategy mirrors the pricing of your competition on similar products. Use this method when operating in a highly competitive market, where a slight difference in price might persuade customers to buy your product over your competitors'.

Do some research on your competitors and set your price marginally lower than theirs. Remember that your production costs might not be the same, so setting a similar price might result in lower profit margins. Only lower your price if you can justify it. Determine what profit margins you're aiming for and use your competition as a reference point for realistic pricing.

Bundle Pricing

Price Bundling is the process of pairing two or more products together and selling them at a combined price that is lower than the sum of their individual parts.

This strategy is typically used when two or more products are not selling. The products are bundled together and presented to the customer as a bargain. 'Save $10.00 by buying this package,' or 'Two for the price of one.' The prospect of a bargain often gets unsold products off the shelf.

Restaurants will sell you a meal that is cheaper than if you bought each food item individually, or only bought two items when you could have bought a meal. This makes a convincing argument to the customer, who may feel as though they're getting more value for their money.

Discount Pricing

Discount Pricing is a strategy where businesses offer temporary price reductions on their products. These discounts are typically offered during the holiday season or commercialized holidays like Valentine's Day and include things like coupons, loyalty rebates, and "buy-one-get-one" promotions.

Discount Pricing is a short-term strategy to offload products that aren't selling or to create a buzz around your business. Customers tend to see discounted items as a narrow window of opportunity in which to save money, incentivizing them to make a purchase or miss out.