You’re ready to release the perfect product to market, but you’re stuck with one last decision: pricing. Should you price low or high? Base it upon production costs? Or benchmark against the prices of your competition?
Whether your focus is business-to-business, business-to-consumer, wholesale, or distribution, pricing is an relevant topic for any business owner. Setting prices is complex, and doing it wrong quickly and literally affects your bottom line.
I’ll tell you soon how to find the most efficient price. But first, let’s review common pricing methods.
Economy Pricing
It can be tempting to price low in order to attract more customers. After all, chains like Aldi’s use this pricing model to attract price-sensitive buyers.
But tread lightly here. Economy pricing can harm your brand, leading customers to view your product or service as “cheap.” Even worse, pricing low can create an environment where your margins are slim — and slight changes, within your company or in the marketplace, can send you into the red.
When is pricing low helpful? Sometimes this model can be used when a product or service is newly introduced. This technique, called penetration pricing, can work to attract market share. But penetration pricing can also be dangerous. Besides affecting your brand’s reputation in the long run, penetration pricing can lead to price wars with your competitors, or to a loss of income from which your company cannot easily recover.
For example, when Ford introduced its Model T, it sold them at near-cost price. Up until this point, automobile buyers had been limited to rich men with plenty of time for leisure pursuits. Penetration pricing methods were extremely effective in introducing the automobile to the common man. (Sticking to this pricing method as the automobile became more popular, however, prevented Ford from competing in the long run as the market — both national and international — became more saturated.)
Premium pricing
Some companies set their prices high right out of the gate. Premium pricing can work for niche companies offering unique goods or services.
At the same time, premium pricing requires delivering a consistent higher perceived value. The product, service, and overall customer experience must all match the premium look-and-feel that buyers will expect.
As a well-executed example, in 2009, Starbucks lowered the prices of plain coffee and low-end lattes to compete against those sold at McDonald’s and Dunkin Donuts. But the company simultaneously raised the prices of its high-end drinks, such as caramel macchiatos. Loyal customers viewed those drinks as high in value, and therefore worth the premium price that they would need to pay to obtain them.
Cost-Plus Pricing
This has been the traditional method used to determine the price of a product or service. A company determines the cost of producing produce a given item, adds a predetermined profit margin, and sets the price based on the outcome. For a service business, the logic is similar – determine the cost of labor and overhead, add a fixed margin, and presto! Instant price.
Cost-plus pricing has several advantages: it is relatively easy to estimate, it can be determined without market research, and you tend to match your competition’s prices (more or less). It is used by some market leaders, such as Walmart, who strive to reduce costs as much as possible so that they can lower their prices.
Consider a company like Everlane, a high-end clothing company with prices that are well above the norm. They tout their brand as using “Radical Transparency,” describing each step of their production line – from how much workers are paid to where they source their materials. This ruthless cost-plus model entices those who are willing to spend more in order to pay for what they see as a more ethical product.
Businesses that rely on traditional cost-plus pricing often do so simply because it’s easier. But who cares what you paid for it? The customer definitely doesn’t.
In the end, cost-plus pricing does not produce optimal pricing for many businesses, notably service businesses.
Unique Pricing Strategies
While most companies use one of the pricing models above, or a variety of them, some companies have found effective ways to use some very unusual pricing strategies. For example…
- Pay What You Want (PWYW). This unusual pricing strategy is most often used by companies that are affiliated in some way with a charity. For example, Karma Kegs is an Australian-based phenomenon in which you can buy a glass of beer for any price you prefer. All proceeds (which have been 10-25% more than a typical keg, on average) go to charity. Similarly, Humble Bundle has some video game bundles that are PWYW — with a portion of the profits going to charity as well, and half to video-game creators.
- Flat Pricing. This pricing strategy is most commonly seen at traditional dollar stores, in which everything in the store costs the same flat price. Although the model is enticing to consumers and often easier to manage, it is only practical if your products all have a similar value.
- Personalized Pricing. Using this model, the business will use complex algorithms to present different prices to different customers. For example, the price may vary based on customer loyalty, a customer’s history of previous purchases, or even the device that a customer has used for the ordering process. An item can even change price if it has been in the customer’s online shopping cart for a specified amount of time, in an attempt to nudge the customer into purchasing the product.
This brings us to a model that may be unfamiliar to you: value-based pricing.
Value-Based Pricing
Value-based pricing is based on what your product or service is worth to a prospective buyer. This approach has several benefits.
First, it forces your company to make smart strategic moves up-front. What should we be selling? How will we produce it? Which inputs will be necessary? Second, it ensures that your customer base will be willing to pay your prices. Because you started by thinking about their willingness to pay, you won’t find out, too late, that you’ve priced yourself out of the market. And third, it enables you to to enjoy higher profit margins.
Some major airlines use value-based pricing. It may cost more to fly with Singapore Airlines than with a budget airline, but many customers will find it worthwhile to spend additional money in return for additional value – seating comfort, premium service, or a larger selection of non-stop flights. The price may be well above what it actually costs to run the airline, but it is in line with what people are willing to pay.
Value-based pricing produces optimum profitability — increasing your margins by charging the maximum price that the market will bear.
Note that value-based pricing is not always ideal. In some situations, such as manufacturing entities who gain contracts through bid scenarios, cost-plus may be the way to go.
Value-based pricing can be difficult to determine accurately. Different customers have different price thresholds. And even for the same customers, their price sensitivity fluctuates. You can never be completely sure exactly how much prospective customers are willing to pay.
At the same time, many service and retail businesses would benefit greatly from value-based pricing. If you are willing to take the time and effort to implement it correctly, shifting to value-based pricing is often the best move you can make to increase your profits.
Value-Based Pricing for Your Company
To do this right, you need to start with the buyer. Whether it’s a purchasing manager or a consumer, you will need to ask what your product or service is worth to them. You will then need to figure out if you can deliver that service to them while still making a sufficient profit.
Here are the steps to reach the value-based price for your good or service.
- Know your customers. If you read my articles, you’re probably sick of this by now. But how can you know how much your customers are willing to pay if you haven’t identified who your customers actually are? Are you selling to a corporate buyer or an individual consumer? Are your customers driven by savings or service? Will they prioritize simplicity or selection? Convenience or cost? Most of the time, your customers will fall into several groups. Create a buyer persona for each group.
- Do the legwork. Market research is key when it comes to competitive pricing. A survey, or even better, a focus group, of current buyers can go a long way towards understanding the value they ascribe to your product. You should be probing with detailed questions, such as “At which price would you assume that this product was of poor quality?,” “At which price would you view this product to be a great bargain?,” and “At which price would you view this product as too expensive to consider?” Market research companies are expensive, but good ones are worth their weight in gold.
- Examine your competition. Keep in mind that your customer will consider other options. Consider whether your offering differs in perceived value from theirs. Is your product lighter, simpler, or more durable? Do you provide support or a warranty? Will you offer any extras that the competition does not?
- Analyze your data. In theory, the first three steps will lead you to the perfect asking price. In practice, however, it can be more complex. If you discover that the value to the customer is lower than your costs, or does not provide a large enough profit margin, you will need to consider how you can increase the value of your product to allow for an increase in price. Can you directly target those buyers who would be more likely to pay a higher price point? Can you change the product “bundle,” packaging, or service options to create a higher perceived value? You’ll need to adapt to best suit the market.
So yes, pricing is complicated, but so is everything that’s worth working on. Remember that mistakes in pricing have an immediate and drastic impact on your bottom line, and that the most obvious model is not always the best one. So set your prices carefully, and make sure that you’re providing your customer with the best value possible.
