Create a Pricing Strategy that works for you!
Don’t ask, find instead.All consumer companies know that consumers lie if asked about prices. It is called socially acceptable behavior. People answer as they think is acceptable or suitable to answer. They tell you what they think you want to hear. Although most of us believe we are willing to pay for quality, that is not often the case. So how should you develop your pricing strategy to make good business?
Pricing strategies in marketing
Too often companies give pricing strategies to be solved by production rather than marketing. Marketing is seen as a promotional department whose sole responsibility is to find buyers for overpriced products. Price is seen as a calculation rather than a strategy. How much margin do we need to support us? How many products do we need to sell to get enough margin to make an EBIT? Pricing is the single most critical aspect of your business. Then what should a competitive pricing strategy be based on? To understand pricing, we should study the most important factor which is the optimum price point.
Price strategy is all about optimum price point
What is an optimum price point?
Price elasticity for a price can be either inelastic, perfectly elastic or unit elastic. Depending on the elasticity the price point affects to the demand (Q Quantity sold).
Price is always affected by several factors. Demand, market saturation, competition, etc. All of which have varying levels of importance. The single most important factor is the price elasticity of demand. There is an economic theory behind how the demand and price are related to each other. The price elasticity of demand is always negative for any product on an effective market. If the price rises the demand will decrease and people buy less. When price gets lower the demand increases and people buy more. It’s that simple.
To find the optimum price point a company needs to find a price point where the gross margin and sales volumes are the highest before the demand will start decreasing. This results in some buyers starting to feel that the product is pricey. Especially in retail and ecommerce the price elasticity of demand is flexible or even fully elastic. Meaning that even a slight increase in price has a negative effect on the sales volumes.
A well placed competitive pricing strategy can secure you the optimum price point. This meaning that your price is giving your company the best profit margin and volume that are achievable with your cost structure and marketing skills. If your company is the cost leader in the industry, it can utilize cost leadership and gain the optimum pricing strategy and the best price point.
To understand the role of optimum price point in different industries we should dig into people’s perceptions of price and how price sensitivity changes. Thomas Nagle and Reed Holden outlined 9 laws or criteria in their book that influence consumer price sensitivity in different ways. Here is the list explained roughly:
- Reference Price Effect – if the buyer has more perceived alternatives the price sensitivity increases.
- Difficult Comparison Effect – buyers are less price sensitive if they have less relative alternatives to compare with.
- Switching Costs Effect – Buyers will be less price sensitive if there are high costs related or high investments lost by switching a supplier
- Price-Quality Effect – If a product is perceived to have a quality brand, the buyers are less price sensitive to buy that product
- Expenditure Effect – If the purchase you are going to make is proportionally high compared to your salary you will be more price-sensitive
- End-Benefit Effect – If you are buying a product that equals only 0,01% of your production costs the less likely you are to price sensitive and vice versa. This also includes the chain of price sensitivity. If your buyers are price sensitive, then so are you with every single thing that goes into your product
- Shared-cost Effect – if you don’t have to pay the whole sum the less price sensitive you are.
- Fairness Effect – People get easily price sensitive once they notice that a price is outside the limits of ”fair” or ”suitable level” of pricing. Important to notice when planning your pricing strategy that it is fair.
- The Framing Effect – price sensitivity increases if the buyer feels the price results a loss instead of forgone gain. If the payment is done only on those items that would create the ”loss” the price sensitivity increases higher compared when sold as a bundle.
Different types of pricing strategies
There naturally are various types of pricing strategies but how do you set up the right pricing strategy for your company? As is often said: Lowering a price is not the problem, raising it is. So what are the best pricing strategies for your company? Here is the list of my favorite:
If the buyer is perceiving value in what we offer, we can price the product higher. So the buyer is less price sensitive. Often used in professional services sales where the seller knows well what is creating value for the customer and how desperate are they to buy. Value-based pricing is especially good in consultancy and complicated information based professional services.
Time or need based
This pricing strategy is especially clever. As buyers have different needs for example electric or server capacity they can be rewarded of buying off peak for their need so that the seller can utilize their full capacity with reasonably high margin. At the same time the buyer can optimize their buying price against their needs. If they need to wash clothes during the day, it is more expensive than during night.
Yield Management Pricing Strategy
Yield management is a strategy where companies are selling products that are perishable. They will not be consumable after a certain period. Airlines, hotels etc. use this type of pricing strategy. The pricing strategy is very complex, but basically the price is affected both external and internal factors that reflect the situation on the market. You might have noticed that buying an airline ticket is cheaper early on and the price will go higher as the plane is fuller and time to leave becomes closer. Idea behind this strategy is to try to get the best possible price out of a single unit sold i.e. airline seat on a flight.
Dynamic pricing strategy
Dynamic pricing strategy is based on knowing your competition, market and customers buying behavior well enough to utilize dynamic pricing that will change immediately in response to the market changes and your internal changes. It is similar to a yield management price strategy, but utilizes more business intelligence, market monitoring, market intelligence and price intelligence to always have the competitive price that yields the best profit.
Premium pricing strategy
Premium pricing strategy is based on the idea that you create a brand that people are more willing to pay for. This if definitely one of the best strategies, but require high level of marketing skills and substance for your value proposition. The magic quadrant in this market is when you can sell with premium pricing and with reasonably high volumes.
Economy pricing strategy
Being a cost leader in the industry opens up a position where you can beat the competitors with pricing and still make a good margin. This pricing strategy has its benefits in many industries, but works only if you truly can utilize the low costs and economies of scale in the future as well. Also the industries with the fiercest price competition have a hard time justifying any future price increases. In the economy pricing strategy almost always some kind of psychological pricing is used. This means that products are price $99.99, because psychologically it makes the product appear cheaper than for example in this case $100.00 would.
All cloud based companies use penetration pricing strategy in one way or another. The price is set very low or even free to attract people to try out the product. The idea is that the gain in getting people try out your product is more valuable than even the losses made by the low price of the product.
Freemium pricing strategy
Freemium pricing strategy is based on the idea that you will offer a freemium version that will educate buyers into your product and benefits it yields. Freemium is especially good in cases where production and distribution costs are close to none. That is why most of cloud companies use this strategy to try to acquire customers. The idea is that out a long tail of customer always some will upgrade to paid version of the product.
What pricing strategy should you choose?
The chosen price strategy should always be focusing on three things:
How we create value?
To be able to price well you need to thoroughly understand how your company is creating value to its customers. Unless you do, there is no clear pricing strategy option. Let’s take an example. You are a consultant. You can choose to only concentrate to strategy consultancy which is often seen as more highly valued service. However, your core competencies and output needs to be valued. A few poor strategies and your customer pipeline is drying out. Your options are to understand why your customers buy from you. Are they buying because you have knowledge that they do not have? If so, go for the premium pricing strategy. If not, think of time or need based. Do work for them in cases they need you to and when they do and try not to create value in areas you not able to.
How are we going to differentiate from our competitors?
Is pricing a strategic decision for us? Is price the ultimate differentiator? For IKEA it is. They start from price. They design the price first, then the product. They differentiate their offering with price. The good looks and usability comes as a bonus.
Are we capable of choosing the pricing strategy in all aspects of our business (i.e. branding / costs)?
If you are a local hotel you shouldn’t be competing with the multinational hotels and their pricing. Make sure you are able to offer value with a price that gives value to you as well. Your marketing is not going to justify premium pricing unless the product is excellent. A boutique approach, with selected guests might do it, but you need to make sure you are up for it all the way. It takes a lot of work to keep customers positively surprised. If so, choose the premium pricing strategy.
Whatever pricing strategy and pricing methods a company chooses those need to go through the organization. A bad pricing policy is coming up with a pricing by multiplying costs is a calculation not a pricing strategy. It is a bad pricing policy, nothing else. Simple as that.