Pricing Methods | Basic Pricing Methods and Pricing Strategy
Determining prices - and overall pricing strategies - is one of the toughest challenges most businesses face. Should you be the low-price provider? Should you charge premium prices for premium products or services? What happens if competition enters - or leaves - your marketplace?
Many business owners default to a common position: They determine what the competition charges and then try to either meet or beat those prices. Over the short term that approach can be successful, but since many customers make purchase decisions based on considerations other than price, low-cost providers sometimes struggle to attract customers who make decisions based on a comparison of price and value.
To develop a pricing strategy, the first step is to gather data:
- Competitor prices and pricing strategies
- Customer perception of products and services
- Customer benefits of products and services
- Cost of producing, procuring, or generating products and services (variable costs)
- Fixed business costs (overhead)
The goal is to understand your business model and operating costs as well as the current pricing strategies and price points in the marketplace.
Basic Pricing Methods
Once you have data in hand, apply one or more pricing methods to the specific business and market:
- Cost-Plus: Production costs are determined and then a target profit margin is applied. For example, if a product costs $10 to manufacture, and the business wants to make a 20% profit, the price is $12 per unit.
- Targeted Return: Investment costs are determined, and a targeted rate of return is applied to deliver the required return on investment. For example, if investment costs are estimated to be $5 per unit, and investors seek a 10% return on investment, the price is $5.50 per unit.
- Value: The value customers receive is calculated and pricing is applied accordingly. For example, if a personal session with a business advisor provides the same value as a two-day seminar, the personal session could be priced at the same level (or higher if individual attention and mentoring provides an even greater value than group-based training).
- Psychology: Psychological or emotional impact is used to determine final pricing. For example, customers may respond more positively to a product with a price of $199.00 than to the same product priced at $200.00.
Price Strategy Objectives
Business strategies can also affect price. Keep in mind each strategy can have multiple effects; some positive, some negative. The company may use pricing strategies seeking to:
- Maximize Current Profits: Higher prices, at least in the short term, can help improve overall profit margins. Of course, over time high prices may result in significantly fewer transactions and lower revenues.
- Maximize Cash Flow: Lower prices can increase transactions and increase overall revenue and boost cash flow - but possibly at the expense of profitability.
- Maximize Profit Margins: Higher prices yield higher profit margins but could affect the quantity of sales.
- Maximize Sales Quantity: Lower prices - or product bundles - can increase the total number of items sold and generate discounts or rebates from suppliers or wholesalers.
Pricing strategies should also be tied to company objectives. The following are common business goals and the effect on pricing:
- Serve Different Market Segments: "One size fits all" prices can turn away customers at both ends of the demographic scale. For example, if a company sells a maintenance service, a standard monthly fee of $95 may be too high for small customers and too low for customers who want additional services and faster response times. Fixed prices may not be appropriate for every customer; if that is the case, building price tiers could make sense.
- Serve Different Market Verticals: A company that sells individual products to retail customers may decide to sell products to government agencies interested in bulk purchases. Different pricing strategies are necessary to take into account volume sales, delivery costs, and other factors unique to servicing government clients.
- Generate New Customers: Flat fee pricing often generates additional customers, especially if a flat fee is perceived as cheaper than a la carte purchases. Subscription and time-based purchase agreements are common ways of generating new customers. Typically, a company will create pricing strategies to generate new customers at a low profit margin, and then seek to provide additional services for additional fees.
- Create Additional Sales Opportunities: Existing customers - especially satisfied existing customers - are fertile ground for additional purchases. Tiered pricing systems for services, and ancillary or complementary products for existing products are great ways to generate additional revenue per existing customer.
- Minimize Credit Sales: Retail sales are based on cash (or credit card) payments on an up-front basis. Service businesses typically bill after some portion of those services have been provided, which requires the company to in effect extend credit. Some businesses develop service plans that include up-front deposits or that require up-front payments. For example, most cable companies charge for services ahead of service delivery; the bill delivered on September 15, for instance, may cover the time period running from Oct. 1 to October 31.
- Minimize Barriers to Purchase: Time-based pricing can make an initial purchase more attractive. Variable pricing is most often used for products purchased from television direct marketers: "Three easy payments of $29.95 each!" Variable pricing can make an initial purchase more attractive as well: a company could offer a service for a reduced rate for the first three months, with subsequent months charged at a higher rate. The goal in that case is to give a customer incentive to try a service because the price is low, at least in the short term.
Keep in mind the best pricing strategies are flexible and allow a company to respond to changes in supply or demand, new competition, changes in technology, etc. Price strategies should constantly be evaluated and tested to ensure the company maximizes return on sales while meeting a variety of other goals and needs.