Your pricing is one of the single most important strategic decisions you need to make as a business manager, since pricing affects both short-term and long-term results. As a rule of thumb, 1% price improvement leads to 10% increase in operating profit; that is, if your prices are too low, increasing prices will increase per-unit profit significantly while only slightly decreasing quantity sold; and if your price is too high, decreasing prices will lead to a substantial increase in quantity sold that outweighs the lower per-unit profit. Other than directly affecting your firm’s topline, pricing is an incredibly important tool in marketing and branding (it’s one of the 4 P’s, after all). It determines how your customers perceive your product, how you position your product against the competition, and essentially tells your customer how much value they will get from buying your product.
Finally, for firms selling multiple products (which most firms do), prices have an anchoring effect; i.e. if a Gucci wallet costs $X, then it will influence how customers perceive the $Y price-tag on a Gucci bag or sathcel. In other words, your prices make up a context in which other product prices are set. Read more about price anchoring here.
Essentially, when evaluating a pricing strategy we look at four factors:
- Profit Optimization
- Brand Optimization
- Context Optimization
- Ease of Use
With this in mind, let’s look at some of the most popular pricing strategies out there, and see how they do in terms of each factor. NOTE: Click the headlines for an elaborate description and review of the individual pricing strategy.
Cost-plus pricing has become very popular because it’s so simple and easy to use. Basically, you calculate your unit costs, and then decide on a fixed markup: that’s it.
It’s appealing to firms because with this strategy, you’ll be sure to make profit. However, firms often fail to take all costs into account, e.g. R&D costs, and end up not making as much profit as they thought they would.
This strategy is not very strategic, however. There is no direct correlation between your costs and the value customers get, and thus, your cost is a poor indicator of what your customers are willing to pay for your product. Consequently, it is very unlikely that this strategy will optimize profit.
Moreover, basing prices on cost alone will not optimize context or branding. Your costs have nothing to do with where your competitors set prices, nor does it consider if you’re about to launch a new product, and the anchoring effects that your current price has; for example, if Apple used cost-plus pricing for its iPhone, prices would remain constant even as the version became outdated; prices may even increase as Apple loses economies of scale when producing old product versions.
But the strategy is great when it comes to ease of use; it requires little research and consideration, which may be beneficial to firms that sell thousands of different products. For such firms, it is simply not viable to conduct extensive research for each and every product, and it does help making prices at least somewhat consistent relative to each other.
A competitor-based pricing strategy is exactly what the name suggests: setting prices primarily based on what you competitors charge.
Your competitors’ prices are not completely irrelevant for your own price setting: especially when it comes to brand optimization, it is good to keep your competitors' prices in mind, as they form the benchmark which you need for evaluating how your own price influences your brand positioning.
However, we often see firms pegging their prices to the competitors’, perhaps even matching the price directly. This is a suboptimal strategy for various reasons; 1) You don’t know if your competitors have got their pricing right, 2) Setting the same price hurts your differentiation and increases choice difficulty, and 3) It can trigger a price war.
This strategy is good in terms of brand positioning (if you intelligently set prices that are different than your competitors), and it’s also fairly easy to use. But it still doesn’t consider your customers’ willingness to pay, and therefore, it will most likely generate suboptimal profits. Finally, it won’t optimize the context for your other products, unless you sell the same products as your competitors and they have got their lifecycle pricing right.
A value-based pricing strategy is about setting prices that are based on the customer’s willingness to pay. This strategy requires much more work than the ones above, as the basis for this strategy is pricing research of the customer’s willingness to pay. However, if you have a relatively small number of products (or services) making up the majority of your sales (which most firms do), then this extra effort will undoubtedly pay off -- for profit optimization, this is by far the best strategy.
Moreover, using value-based pricing will typically aid your brand positioning as well; after all, willingness to pay is determined partially by your brand’s value to customers.
If pricing research is conducted continuously, this strategy will also optimize prices throughout the product lifecycle, so prices are lowered as the product becomes outdated.
That being said, there may be times when it makes sense to deviate from this strategy; if your product has become outdated, and willingness to pay has become significantly lower than it was at product launch, then it may still be desirable to keep prices higher to optimize the context by setting an efficient price anchor: see point #4.
#4: Price Anchoring
This is more a tool than a strategy: price anchoring is all about context optimization and should be used in conjunction with other pricing strategies, rather than as a stand-alone strategy.
When customers review a product and its price, they look at the incremental benefit they get compared to the next-best available substitute; and often, this substitute is supplied by the firm itself. When you consider buying an iPhone 7, you may consider what additional value you get compared to the iPhone 6, and compare that to the price difference between the two products.
If demand for iPhone 6 is low, it may be worth to consider context optimization rather than profit optimization; by setting the iPhone 6 price higher than the customer’s willingness to pay, you make the incremental value in the iPhone 7 appear more substantial.
#5: Prestige Pricing
A prestige pricing strategy is about using your price to influence your customer’s perception of your product. Your price conveys value, i.e. it tells the customer how good the product is: for instance, if you hold up two white t-shirts, one at $5 and one at $50, most people will expect the $50 to be of higher quality without even touching the fabric. Furthermore, once they try them on, they may even feel that the $50 one is of higher quality, better fit etc., even if the products are completely similar.
Prestige pricing is utilized mainly for branding purposes, but also to reach a niche segment that insists on purchasing the best and most exclusive products, as they gain social status from it.
It differs from value-based pricing in that the price is initially set even higher than the willingness to pay for the product, however, if the product can carry the weight of the prestige brand, eventually this niche segment will pay the price for it.
While it may seem easy to use, this is far from the case. Prestige pricing requires tremendous efforts across your entire business, both with distribution channels, marketing, and customer service. When Gucci invests in a store on Fifth Avenue or in Harrods, it’s primarily for brand-building purposes and to justify their prestige pricing strategy.
This is really just a fancy name for trying to differentiate your product solely on prices. You win customers by offering the lowest prices, and if there’s someone cheaper than you, the customers are gone. Granted, some firms have been successful with this strategy, but in the majority of cases, it is simply unsustainable and suboptimal. Those trying to employ such strategy typically do so with the illusion that they can raise prices once they penetrated the market and obtained a substantial market share; however, by then your brand position is set, and it will take a lot of work to convince your customers that your product is worth a higher price without completely rebranding your product.
It is, indeed, very tempting as you will see tremendous growth in the short-term, but it is bad for the bottom-line, eventually leaving you short of funds for product development. It is not advised, unless you have a vast amount of capital and incur costs substantially lower than the competition.
#7: Product Bundling
Product bundling is a great for a variety of reasons; 1) It’s great customer service to provide a bundle of items that go together (it’s nice to get a remote control and batteries with a TV, for instance), 2) It increases sales and profits as the bundle price “evens out” the differences in willingness to pay between customers for individual products.
Example: Jake and Josh go to McDonald’s. Jake is really hungry, but not very thirsty; Josh is not incredibly hungry, but really thirsty. A Big Mac menu consists of 3 items, a burger, fries and beverage, priced individually at $4.00, $2.00 and $1.50 respectively. A Big Mac menu costs, say, $6.50, i.e. you save $1.00 by purchasing the menu. Now, since Jake is really hungry, he’s willing to pay $5.00 for the burger, and $2.50 for fries. But he’s only willing to pay $0.50 for a drink as he’s not thirsty.
Josh, on the other hand, is really thirsty so he’ll happily pay $3.00 for a beverage, but only $3.00 for the burger and $1.00 for fries.
If the items weren’t bundled, Jake would buy a burger and fries, at a total of $6.00, even though his willingness to pay was higher. And Josh would only purchase the beverage at $1.50. Jake and Josh would generate McDonald’s $7.50 in total revenue if the items weren’t bundled.
However, as both Jake’s and Josh’s willingness to pay for the three menu items exceed $6.50, they will both buy a menu, generating a total revenue of $13.00: that’s $5.50 in additional revenue from product bundling.
Combining Pricing Strategies
There’s a time and place for each pricing strategy (except penetration pricing perhaps), and prevailing pricing champions often combine the strategies for an optimal outcome. At PriceBeam, we mainly advocate the value-based pricing strategy, but that doesn’t mean you should completely disregard your competitors’ prices, nor should you neglect lifecycle pricing. Ultimately, you want to set prices that optimize both profit, branding and context, which requires a combination: the biggest mistake, however, is to focus on only context, branding, profit or ease of use.