Pricing Strategy 101: The Ultimate Guide To Pricing Your Stuff
Pricing strategy is a complex subject and something that is often overlooked. It becomes your branding and identity, what type of experience you will provide, and how customers view the company.
What is Pricing Strategy?
Pricing strategy is the model used to determine the best price for your product or service.
Many variables go into determining how you should price your goods and services; from the cost of goods sold (COGS) to competitor’s prices, revenue goals, target audience, brand positioning, and even marketing objectives.
With all of these factors, it’s not uncommon for business owners to overlook pricing. Relenting to look at what their costs are and pricing based on what their competitors are doing. While this can work for some businesses, it may not be the most effective strategy for your business. There may be a pricing strategy that is a better fit and could have a significant impact on your bottom line.
Price Elasticity of Demand:
The price elasticity of demand is an economic formula used to determine how a change in price affects customer demand.
Formula: % Change in Quantity / % Change in Price = Price Elasticity of Demand
Let’s take a look at inelastic, unit elastic, and elastic demand.
When the price elasticity of demand is below one, the product is inelastic.
In economics, people buy the same amount whether the prices goes up or drops. This happens with products that people must have. A perfectly inelastic product would have no change in demand, no matter the change in price.
Example: Gasoline is a prime example of inelastic demand. Even though the price fluctuates week to week and even day to day, demand stays relatively the same. For the most part, people still need to use their vehicle - and their vehicles still need gasoline.
Unit Elastic Demand:
When the price elasticity of demand is one, the product is unit elastic.
Changes in price cause an equal change in demand. In this case, if a product increased in price by 15%, demand would decrease by 15% as well.
When the price elasticity of demand is above one, the product is elastic.
This means the impact on demand is greater than the change in price. If a product increased in price by 15%, demand could decrease by 30%. Goods with inelastic demand are typically something that has plenty of substitutes or a consumer doesn’t need to have.
Example: Cable tv providers have plenty of substitutes. Let’s say the price of service goes up 10%. Since customers can easily switch between providers, subscribers fall by 15%. Giving it a demand elasticity of 1.5 (15% / 10% = 1.5).
For the exact formulas for calculating the ideal price with price elasticity of demand, you can check out an article on it here.
Impact on Pricing Strategy:
IF your product or service has inelastic demand you have more flexibility in pricing, whereas if it has elastic demand be aware that changes in price can have a greater impact on the demand for your stuff.
Cliffnotes Version: This concept helps to determine if your product or service is sensitive to price fluctuations. If you could choose, it would be ideal for your product to be inelastic so demand would remain stable if prices fluctuate.
Now with the quick economics lesson out of the way, let’s dive into the different types of pricing strategies.
Types of Pricing Strategies:
Below is a list of some of the more popular strategies. Some have been left out, as they are rarely used.
Adding a markup to the cost of goods and services to arrive at the asking price. You would add up the direct material cost, direct labor cost, and overheads costs for the product; then add a markup percentage to come to the selling price.
Example: You sell candles online. The total expense for a candle to you is $12.50. You want a 50% profit margin, so your markup for the candle is 100%. Making the retail price for your customers $25.00
Typically retailers use this method as it gives them a specific profit margin. It’s not well suited for SaaS or service-based businesses, as the value provided is worth much more to their customers.
This strategy uses the competitor’s prices as the benchmark for their prices; for the most part ignoring cost and consumer demand. It is typically used when the market is a very competitive environment. Where the slightest difference in price can be the deciding factor for potential customers.
With competition-based pricing, you would price your products closer to your competitors; slightly above, the same, or slightly below.
Example: You sell lattes at your cafe. The competitor down the street (who is similar to you in most aspects) is selling their 16oz latte for $3.25. You decide to price your 16oz latte at $3.25 as well.
Commonly used by software companies, this model offers a free basic version of the product to let people try with hopes that they will eventually turn into paying customers. Companies choose this method to allow potential customers to preview what their product is really like.
Example: You sell a SaaS product. To attract customers and allow them to test out your software, you provide a free trial or even a free version. After a period, you ask them if they’d like to upgrade to the paid version that includes more features and capabilities.
With this strategy, the paid version must provide more value than the free version. If you try to ask someone to pay for something they are already getting for free, they won’t go for it.
Dynamic pricing is typically used for airline tickets, booking hotel rooms, and event tickets. The price changes frequently to reflect demand; taking into consideration time, market conditions, competitor’s prices, demand, and other factors.
Example: You have a hotel. To maximize the amount of money you bring in, the price of your rooms changes as it gets closer to check-in and depends on how many rooms are still available. If there are few rooms available and check-in is approaching, the price will go up. If there are a lot of rooms still available, the price will go down to attract more guests.
Companies typically use complex algorithms to determine their price to maximize the prices under the current circumstances.
Some companies will enter the market by charging a significantly lower price than the competitor, to gain market share. They hope to get customers in the door and either raise prices later or encourage customers to buy other high-profit items.
Example: A ride-sharing app comes into a market and significantly undercuts current providers including taxis. They can do this by keeping their margins thin initially. Once customers are hooked they raise the price, therefore increasing their profits.
This strategy is usually best for new businesses looking for customers. It disrupts the marketplace and results in a temporary loss, with the hope that customers will stick around when the prices eventually go up (which can be challenging to accomplish).
A similar strategy to this is lead-loss pricing. An e-commerce store offers a sale on a well-known product that is significantly lower than other retailers. While customers are there, they try to up-sell customers on other products that have a high-profit margin. Think of companies that sell printers; their margin is low on the printer, but you will need their high margin ink cartridges. They may lose money upfront, but with time they make up for it.
In contrast to penetration pricing, the high-low strategy initially sells a product at a high price and as it loses novelty, it lowers the price. This strategy is typically used with retailers who have seasonal or constantly changing products.
Example: A clothing store charges a high price on new arrivals for the season. As it gets close to the end of the season, the store has a sale on these clothes so they can liquidate inventory and bring in the next season’s clothing.
This method is good for retailers as it can create anticipation for discounts and boost sales even when they are getting rid of old inventory.
Similar to high-low strategy except prices are lowered gradually over time, instead of a large sale.
Companies try to charge the highest possible price initially with a new product. As the product becomes less relevant or popular, they lower the price.
Example: A new phone comes out. It is priced fairly high, a year later the price has dropped significantly as new phones have come out that have better features. Its technology is no longer the best.
This is typically seen with technology products, as they become less relevant over time. Think about TVs, computers, video game consoles, and of course smartphones.
Also known as prestige or luxury pricing, this strategy is used when a company presents the image that their products are of high-value and priced accordingly. It focuses on the perceived value instead of actual value or cost to produce the product.
It can be marketed as luxurious, exclusive, and/or rare. This can be accomplished by limited supply, providing an exceptional experience, or using only the best materials.
There needs to be strong branding to pull this off; brand awareness and perception are essential to this strategy. Some brands who have accomplished this are Ferrari, Louis Vuitton, Supreme, among many others.
Example: You are an artisan wallet maker who hand-makes premium leather wallets out of only the best materials. The kicker, you only make 1,000 per year. This story is presented in your marketing, creating a high perceived value. Because of this, you decide to sell each wallet for $999 and so many people are happy to pay this price, you have a backorder over a year out.
This strategy can be a great option if you want to focus on quality instead of mass-produced products. A business using this strategy goes about everything differently, as it needs to reflect the image of luxury.
This is how many service companies price their services, as it is a simple structure; T hours x $ per hour = total amount. It is trading time for money.
Some clients are hesitant to go with this structure as it can promote time spent instead of outcomes produced. Not to mention they don’t know exactly what the end price will be.
Example: An engineering firm charges its employees out at $150 per hour for client work. They pay their employees $60 per hour. Leaving the company with $90 per hour for overhead and profit.
This is ideal for projects where the scope of work is too complex to calculate the cost. Many companies choose to move away from this model as it can produce a low-profit margin - and it doesn’t provide clients with a set cost.
Another model used by service companies, this approach charges clients a set fee for a project instead of exchange time for money.
The price is determined in one of two ways; based on the value of the project or by calculating the fee based on the estimated time it will take.
Example: A marketing company creates a package of services that is a fixed price for the client. Month to month, the number of hours required changes, but the price remains the same. If the project was priced appropriately, the company makes more than it would have at an hourly rate.
This strategy can be good for both the client and the company. The company can get a higher margin, and the client knows how much they will be paying upfront. The drawback is that if the project takes longer than expected, you still get paid the same.
Similar to premium pricing, this strategy bases the price on the value created instead of the perceived value. Products or services are priced based on what the customer is willing to pay.
Example: A software company has a SaaS product that creates approximately $100,000 worth of value for another company. So they decide to price the software at $800 per month (approximately 10% of the value created). Since it is still worth it for the potential customer, they decide to go for it.
This structure promotes value creation over all else. The more valuable you are to customers, the higher premium you can charge.
How to Choose a Pricing Model for Your Business:
Below are our recommendations for what strategy to use based on the type of business you have. You don’t need to stick with one pricing model, your strategy can be a combination of a few.
Restaurant Pricing Strategy: cost-plus, premium, value-based
Services Pricing Strategy: hourly, project-based, value-based
Digital Product Pricing Strategy: competition-based, freemium, value-based
Product Pricing Strategy: cost-plus, competitive, premium, value-based
Event Pricing Strategy: competition-based, dynamic, value-based
Real World Examples:
Premium Pricing: Apple
Apple’s branding has created the perception that they are the premium choice. You don’t go there for cheap products, and customers have come to love their build quality and operating system. Some alternatives cheaper and produce the same outcome, but an Apple product is viewed as higher quality. Since they have created a high perceived value, they price their products accordingly.
Dynamic Pricing: Lufthansa
If you go to buy a plane ticket through them, the price may change daily for a particular route and dates. They use a complex algorithm to price the ticket based on demand and other factors. As it gets closer to departure, you will most likely see prices shoot up.
Penetration Pricing: Amazon
If you’ve ever seen an Amazon Basics product, you have experienced this pricing model. When Amazon sees that a particular product is doing quite well, they create their version of the product and undercut the current vendors. This can create a price war, leading to the other company closing or in some cases selling to Amazon (cough cough… diapers.com debacle). Amazon wins out because they have the resources to sustain the price war. Once the competition is gone, they raise prices to profitability again.
Freemium Pricing: Zapier
They allow new users to sign up for free. The user can test out the software and see how useful it can be. For those that do more than a certain number of zaps per month or want multi-step zaps, they will need to upgrade to a paid version of the software.
Applying this in your business:
Pricing strategy can get complicated. Start with determining COGS, then figure out what your goals are overall. Knowing your numbers is a great way to maintain profitability. You know where you are at as far as expenses and can price appropriately.