Pricing strategies
/What are Pricing Strategies?
Pricing strategies are used to better position a business in the marketplace, or to enhance its profitability. The correct pricing strategy can markedly enhance a firm’s ability compete, while the use of an incorrect approach can drive it into bankruptcy. Further, a business can selectively employ a set of different pricing strategies at the same time, depending on its distribution channels, product lines, sales regions, and so forth. Thus, it is essential to understand the different types of pricing strategies, and how they can be applied. The key pricing strategies are listed below, along with a brief description of each one.
Absorption Pricing
Absorption pricing is a method for setting prices, under which the price of a product includes all of the variable costs attributable to it, as well as a proportion of all fixed costs. This is a variation on the full cost plus pricing concept, in that the full cost is charged to a product, but profit is not necessarily factored into the price (though it is likely to be). The term includes the word "absorbed," because all costs are absorbed into the determination of the final price.
Breakeven Pricing
Break even pricing is the practice of setting a price point at which a business will earn zero profits on a sale. The intention is to use low prices as a tool to gain market share and drive competitors from the marketplace. By doing so, a company may be able to increase its production volumes to such an extent that it can reduce costs and then earn a profit at what had previously been the break even price. Alternatively, once it has driven out competitors, the company can raise its prices sufficiently to earn a profit, but not so high that the increased price is tempting for new market entrants. The concept is also useful for establishing the lowest acceptable price, below which the seller will begin to lose money on a sale. This information is useful when responding to a customer that is demanding the lowest possible price.
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Cost Plus Pricing
Cost plus pricing involves adding a markup to the cost of goods and services to arrive at a selling price. Under this approach, you add together the direct material cost, direct labor cost, and overhead costs for a product, and add to it a markup percentage in order to derive the price of the product. Cost plus pricing can also be used within a customer contract, where the customer reimburses the seller for all costs incurred and also pays a negotiated profit in addition to the costs incurred.
Dynamic Pricing
Dynamic pricing is a partially technology-based pricing system under which prices are altered to different customers, depending upon their willingness to pay.
Freemium Pricing
Freemium pricing is the practice of offering a basic set of services for free, and enhanced features and/or content for a fee. This approach will result in a large proportion of customers using the company's offerings for free, and a smaller proportion paying for additional services. This approach has had notable success on the Internet, where basic services can be provided by the seller at close to a zero variable cost. The concept allows a company to scale its customer base rapidly with little or no incremental cost for each additional customer gained (assuming no incremental marketing expenses), and then charge for additional services.
High-Low Pricing
High-low pricing is the practice of setting the price of most products higher than the market rate, while offering a small number of products at below-market prices. By doing so, a retail or web store location hopes to attract customers with its low-price offerings, at which point they will also buy some of the high-price items. The seller hopes that the net effect of this strategy is to increase overall profitability, despite incurring losses on the few low-priced items.
Limit Pricing
Limit pricing is the practice of setting a product or service price at a level just low enough to deter potential market entrants from competing in a market. A business engages in limit pricing when it wants to minimize the number of competitors. The price point chosen may not be the price at which a business earns the largest profit, but it does keep other companies out of the market. Limit pricing must be inferred, since it is not an active monopolistic act; that is, other companies may enter the market as long as they are willing to accept the low price point or have other means of differentiating their products or services.
Loss Leader Pricing
Loss leader pricing is the practice of selling a small number of products either at or below cost. This is done on the assumption that buyers will purchase other products at the same time that are considerably more profitable. The resulting combined sale transaction is assumed (or hoped) to be profitable. The loss leader concept can be used to bring customers into a physical store location or to access a website - in either case, selected merchandise that is much more profitable will be positioned near the loss leader product, so that buyers have every opportunity to make additional purchases.
Marginal Cost Pricing
Marginal cost pricing is the practice of setting the price of a product at or slightly above the variable cost to produce it. This approach typically relates to short-term price setting situations. This situation usually arises when a company has a small amount of remaining unused production capacity available that it wishes to use, or when it is unable to sell at a higher price.
Penetration Pricing
Penetration pricing is the practice of initially setting a low price for one's goods or services, with the intent of increasing market share. The low price is likely to attract price-sensitive customers. The price may be set so low that the seller cannot earn a profit. However, the seller is not irrational. The intent of penetration pricing can follow any of these paths:
Drive competitors out of the marketplace, so the company can eventually increase prices with little fear of price competition from the few remaining competitors; or
Obtain so much market share that the seller can drive down its manufacturing costs due to very large production and/or purchasing volumes; or
Use excess production capacity that the seller has available; its marginal cost to produce using this excess capacity is so low that it can afford to sustain the penetration pricing for quite some time.
Premium Pricing
Premium pricing is the practice of setting a high price to give the impression that a product must have unusually high quality. In some cases, the product quality is not better, but the seller has invested heavily in the marketing needed to give the impression of high quality.
Price Leadership
Price leadership is a situation in which one company, usually the dominant one in its industry, sets prices which are closely followed by its competitors. This firm is usually the one having the lowest production costs, and so is in a position to undercut the prices charged by any competitor who attempts to set its prices lower than the price point of the price leader. Competitors could charge higher prices than the price leader, but this would likely result in reduced market share, unless competitors could sufficiently differentiate their products.
Price Skimming
Price skimming is the practice of selling a product at a high price, usually during the introduction of a new product when the demand for it is relatively inelastic. This approach is used to generate substantial profits during the first months of the release of a product. By doing so, a company can recoup its investment in the product. However, by engaging in price skimming, a company is potentially sacrificing much higher unit sales that it could garner at a lower price point. Eventually, a company that engages in price skimming must drop its prices, as competitors enter the market and undercut its prices. Thus, price skimming tends to be a short-term strategy designed to maximize profits.
Psychological Pricing
Psychological pricing is the practice of setting prices slightly lower than a whole number. This practice is based on the belief that customers do not round up these prices, and so will treat them as lower prices than they really are. Customers tend to process a price from the left-most digit to the right, and so will tend to ignore the last few digits of a price. This effect appears to be accentuated when the fractional portion of a price is printed in smaller font than the rest of a price. An example of psychological pricing is setting the price of an automobile at $19,999, rather than $20,000. This type of pricing is extremely common for consumer goods.
Time and Materials Pricing
Time and materials pricing is used in the service and construction industries to bill customers for a standard labor rate per hour used, plus the actual cost of materials used. The standard labor rate per hour being billed does not necessarily relate to the underlying cost of the labor; instead, it may be based on the market rate for the services of someone having a certain skill set, or the cost of labor plus a designated profit percentage.
Value Based Pricing
Value based pricing is the practice of setting the price of a product or service at its perceived value to the customer. This approach tends to result in very high prices and correspondingly high profits for those companies that can persuade their customers to agree to it. It does not take into account the cost of the product or service, nor existing market prices. Value based pricing is usually applied to very specialized services. For example, an attorney experienced in defense against criminal charges can charge a high price to his or her clients, since the value to them of not being incarcerated is presumably quite high.