A Guide to Pricing Methods

What is a pricing strategy?

Pricing strategy is the method you use to decide what to charge for your products or services. You want to strike a balance between maximizing profit and taking into account consumer trends and market demand. What should you consider to achieve this balance?

• The value of the product or service. Each product or service you offer has a certain numerical value to you. Calculating that value and simply adding a percentage to it for profit is simple, but it may not be the best or most accurate pricing strategy on its own.
• The comparative value of your product or service alongside competitors’. You’ll need to take into account how your product or service stacks up against your competitors’ and their prices.
• The value of your product or service to consumers. Consumers drive the market, so you have to consider how much what you offer is worth to them. This perceived value can be either lower or higher than the actual value of the product or service, depending on market trends and supply and demand.
• The longevity of your product or service. If your product is replaceable or your service renewable, you’ll likely choose a different strategy than if your product or service is a one-time purchase.

Why pricing matters

The right pricing strategy maximizes profits, which is, of course, the ultimate goal. However, pricing influences other critical aspects of your business as well.

• Reputation. Customers who compare your prices to your competitors’ are not necessarily looking for the cheapest option. They may see price differences in the same industry as reflective of companies’ reputation and resulting demand for their business.
• Quality and value. The price of your product or service indicates quality. For example, pricing inexpensively to increase sales or undercut a competitor may backfire if consumers conclude that the product or service is “cheap”—poorly manufactured or providing inferior service.
• Brand. Pricing is directly connected to the process of building a brand and brand loyalty. The cost means something to your target audience, so your price needs to appeal to them. A well-priced product or service may convince consumers that it is worth not only their business but also their loyalty. On the other hand, a poorly priced product or service may spark indecision at a critical moment in the buying process.

Common pricing strategies

While there are many pricing strategies you can use, here are some of the more common ones.

Cost-plus pricing

Cost-plus pricing is a pricing strategy in its simplest form. You set your price by calculating the cost of creating your product or providing your service and adding a fixed percentage markup on top of that.

• Example: The food industry often uses a rule of thumb of cost plus a 10% markup. Whatever the food costs to produce, vendors add a profit margin of 10% in pricing.
• Advantages: Cost-plus pricing makes pricing physical products simple. When it’s easy to calculate the cost of production, you can establish standard, well-defined profit percentages for your business.
• Disadvantages: This strategy doesn’t take into consideration competitors’ prices or how much consumers are willing to pay—or how much they value the product—in the current market.

Competitive pricing

Competitive pricing refers to setting prices based on what your competitors are charging for similar products or services. You can set prices slightly lower, equal to, or slightly higher than the competition, depending on where you want to be in the market’s price range.

• Example: Some large retailers—with a broad catalog of products—offer prices that are slightly lower than the competition.
• Advantages: This can be a very effective strategy if your organization operates in a highly competitive market, directly competing with other businesses for sales.
• Disadvantages: It fails to take actual production costs into account or consider how much consumers are willing to pay for the product or service in the current market.

Value-based pricing

In a value-based pricing strategy, prices are set based on how much consumers are willing to pay for a product or service. Pricing depends on perceived market value rather than on actual value or competitors’ prices.

• Example: The art world uses this strategy. The price of art is never based on the cost to produce it, but rather on what art enthusiasts think it’s worth.
• Advantages: This works best for products that are not easily mass-produced and that consumers perceive as having a high value.
• Disadvantages: This strategy can be highly subjective. It requires a lot of research to calculate, and you must continually monitor customer perception.

Price skimming

Price skimming means charging a high price when a product is first released and then gradually lowering it over time. Customers pay a premium to be the first to support a brand, and then additional clients are attracted by offers, sales, and incentives as the price is strategically lowered.

• Example: This pricing strategy is often used for new technology.
• Advantages: Profits can be maximized on initial customers before lowering the price to attract the more cost-sensitive segments of the market in greater numbers.
• Disadvantages: Early adopters might become displeased if they know the price will decrease in the future and may even decline to buy at the initial price.

Penetration pricing

Penetration pricing means offering a lower price than competitors when initially entering the market in order to capture a large market share. As your client base grows and you establish your reputation in the industry, you raise your price gradually until it’s equal to or higher than your competitors’.

• Example: You might use this method when you open a restaurant in a market with more established competitors.
• Advantages: You can quickly grab a large share of the market by offering a favorable price to consumers.
• Disadvantages: Initial prices may earn you little to no profit, and you might even incur a loss. It may also be difficult to raise prices once customers become accustomed to lower prices. You must build customer loyalty first, so that customers are willing to pay increased prices.

Premium pricing

In this strategy, you market your product or service as “premium,” or perceived as high-end and of very high quality, and price it accordingly.

• Examples: Organic food is perceived as better than other choices (and more costly to produce), thus it can command premium prices.
• Advantages: If you have a distinct competitive edge in the market or a unique product or service, premium pricing negates a competitor’s strategy of undercutting your share of the market with lower-priced versions of a product or service. Yours is marketed as premium, effectively in a class of its own.
• Disadvantages: This strategy depends heavily on consumer perception of your product or brand in the market, thus requiring a great deal of effort and investment in marketing and branding.

Economy pricing

This strategy involves pricing your product or service to have relatively small profit margins, hoping for a rapid turnover based on volume. It targets price-conscious consumers who are looking for the lowest price possible.

• Example: Some large chain stores rely on huge turnover and volume with lower prices rather than high profit margins per unit.
• Advantages: Economy pricing works best for generic products that are easily replaceable and target audiences who either can’t afford or don’t want to pay for a premium product.
• Disadvantages: Profits are insufficient if you don’t sell enough volume. Your customer base is limited to those choosing inexpensive products and services; therefore, the value set by consumer perception is also low.

Bundle pricing

Bundle pricing means grouping several products together and pricing the bundle lower than purchasing each item individually. This offers the customer the perception of value.

• Examples: Examples of this strategy include combo meals at restaurants, cable channel bundling, and product bundling in retail stores.
• Advantages: This works best for bundling complementary products, selling slow-moving inventory together with more popular services or products, or getting customers to give a new product a try.
• Disadvantages: If your customers don’t want all the items in the bundle, that may dissuade them from buying the whole thing, opting for the individual product they need.

Other strategies

Other pricing strategies include:

• Dynamic pricing, which depends on surges in demand or constrictions of time
• Hourly pricing, which bills by the time it takes to complete a service
• Project-based pricing, an alternative to hourly pricing
• “Freemium” pricing, a variation on premium pricing

Within strategies, you can get more specific; for example, with psychological pricing. This involves deciding on specific price points that customers perceive a certain way. Products with prices ending in .99, for example, are perceived as less expensive than products with prices ending in .00, even if the difference is only one cent.

Choose the right pricing strategy for your business

With so many strategies to choose from, there’s no one-size-fits-all solution to pricing. What are some factors to consider in determining which strategy is best for your business?

• Your product or service. Are you marketing multiple products or services, or just one unique product or service? Is it new or existing? Is it easily replaceable or expendable?
• Your audience. Is your audience diverse or very specific? What is their perception of your brand, product, or service? Are they brand loyal, or do they shop specifically for deals?
• The market. What industry are you in? Is it a highly competitive market? What is current supply and demand? Is it a rapidly evolving industry or more stable and static? Can you rely on volume, or do you need a higher profit margin per unit?

Thinking through these questions might be enough to enable you to choose the best strategy for your business. But you may want to conduct a pricing analysis or build out a pricing model to compare strategies.

1. Calculate the cost of your product or service. Taking into account any expenses involved, including material costs and unexpected variables, in producing a product or offering a service, you’ll end up with a number to base your pricing on.
2. Understand your audience. Conducting market research—using surveys, questionnaires, focus groups—can give you a sense of what your customers value and what they are willing to pay for.
3. Research your competitors. Research the quality, price, and reputation of products and services offered by competitors, whether they sell the same product or service or offer an equivalent alternative.
4. Look into local regulations and compliance. Before deciding on a pricing strategy, investigate whether there are any laws or standards that regulate pricing in your industry.

Armed with this information, you can quickly determine which strategy is best for you: whichever has the most advantages and the fewest disadvantages for your small business or e-commerce shop.

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