What’s it: Penetration pricing is a pricing strategy by which a company charges a low price initially and slowly increases it over time. This strategy’s main objective is to penetrate the market, that is, to get as many customers as possible and as quickly as possible.
A lower price than the average competitor is undoubtedly attractive to most consumer consumers. Some of them like this price because it is following their budget allocation. Or, they may be curious about the product. They may find the same satisfaction but at a more affordable price.
After consumers try a product, they might like it. That encourages them to switch to a new product and be willing to rebuy it at a later date
As the market position is more robust, the company will increase its selling price. That way, they can compensate for low-profit margins during implementing penetration pricing.
When the company adopts penetration pricing
Price penetration is typical when firms enter new markets. They don’t yet have a customer base, and therefore, their first job is to attract new customers. One tactic is to sell low.
Low prices attract more consumers to try and buy. If successful, the company gets customers and market share.
Once the product position is established, its price will increase to around the average market price. The company will shift product competitiveness through non-price aspects such as features, quality, and support services. That is to avoid competitive reactions from current competitors and avoid price wars.
Take Dell, for example, in the personal computer market. Initially, the company sold high-quality products at relatively more affordable prices. If customers are satisfied, they expect customers to buy again or recommend products to friends or family members.
Another example of a company that adopts penetration pricing is Costco and Kroger in the wholesale business. They sell organic food at lower prices to encourage more sales volume. Even though the profit margins are low, they can improve it immediately by achieving economies of scale. Apart from that, they can also subsidize low margins with higher margins in other product lines.
Why companies adopt penetration pricing
Low prices are one of the easiest ways to attract customers. Price promotes the product itself.
It differs from a differentiation strategy, where companies must design the uniqueness of a product. Uniqueness is also not necessarily according to consumer tastes, so companies have to spend large amounts of money to influence consumer perceptions.
For new revenue, price penetration is the fastest way to build a customer base. The objectives of a price penetration strategy are to:
- Build consumer awareness about the presence of new products
- Create product preferences
- Diverts customers, away from competitors
- Build a customer base and market share
- Generate significant demand in the short term
- Achieve economies of scale to support a lower cost structure
- Achieve savings through learning curve effects as soon as possible
How effective is penetration pricing
Several factors make the penetration pricing strategy effective.
First, the product is price elastic in demand. It shows you that when the price falls, the demand changes by a higher percentage than the price changes. If the price falls by 5%, then the demand will increase by more than 5%.
In short, consumers are price sensitive. They may not be loyal to existing products. Or, the existing products have not provided maximum satisfaction.
So when a company offers a new product at a low price, many consumers are willing to buy it.
Second, companies have substantial economies of scale. That makes it possible to reduce costs as sales volume increases.
The company increases production volume to meet more demand. That way, the firm can spread fixed costs over to higher output, allowing for a lower cost per unit. It can help improve profit margins while adopting this strategy.
Third, the product is for the mass market. That allows a demand large enough to achieve economies of scale. In this market, firms get more profit by lowering production costs.
Also, consumers in the mass market are usually price-conscious as well. They are willing to switch when they find a product at a lower price.
Fourth, the product will face stiff competition as soon as it is introduced. Penetration pricing is a short term strategy. If the company adopts it long enough, it invites a competitive reaction from competitors and can end in a price war. In this condition, instead of gaining a customer base, the company may have to leave the market because it cannot compete with established companies.
Fifth, the quality and product features are relatively similar between companies (slight differentiation). It is unlikely that consumers are loyal to one brand because the product is relatively standard. They will be more interested when there is a new product at a lower price.
Sixth, the market is growing high. The company’s goal is to get as many new customers as possible and as quickly as possible. The company will most likely be able to achieve it if the market is in a growth stage.
Conversely, if the market has matured, market growth is low. Market growth only comes from repeated purchases because most consumers have bought or used it. Thus, the company can increase sales of new products by merely hijacking current competitors’ customers.
Since their position was under threat, competitors immediately retaliated against the company. That may result in a price war or force the company out of the market before it has a sufficient customer base.
How penetration pricing impacts the company
At the start of implementation, the company generates low profits. Although it can sell a higher volume, because the price is lower, the profit margin is also lower.
Over time, as sales volumes increase, profits should improve. Firms can spread production costs across more output, encouraging lower average costs. Improvements in profits also occur when companies slowly increase prices.
Whether this strategy is successful or not in the long term depends on its subsequent strategy and customer loyalty. If the strategy can create loyal customers, the company should benefit from a higher market share and economies of scale, enabling it to retain profits.
Difference between penetration pricing vs. loss leader pricing
Penetration pricing is similar to the loss leader pricing—both charge lower prices than the average competitor.
However, loss leader pricing is more aggressive. That involves pricing slightly above average cost.
Difference between penetration pricing and price skimming
Price skimming is the opposite of penetration pricing, although it is often adopted by new market products.
OK, I’ll focus on price skimming in this section.
Under price skimming, companies sell at a high price initially. They then lowered the price slowly.
Price skimming allows companies to earn a profit margin at the start of the product launch. Such advantages are essential to cover expensive product development costs.
Why do customers want to buy?
Not all products are suitable for price skimming. And not many consumers are willing to buy it. Apart from the high price, consumers also do not realize the benefits. They don’t want to take the risk of buying it.
Therefore, price skimming is usually suitable for “Wow” products. What makes it so:
- Products are highly differentiated, where you will not find features or quality in products currently on the market.
- The product is the latest invention and has never existed before. An example is a personal computer or smartphone during its introduction phase.
Buyers are usually a small part of the population. In the diffusion of innovation theory, they are typically categorized as innovators or early adopters. They are willing to take risks and pay high prices to buy new products.
What are the advantages of penetration pricing
It’s easier to implement
Many new players in the market are adopting penetration pricing. Setting low prices is easier than a differentiating product. Companies can design quality and features similar to the industry. It reduces the risk of rejection inherent in product differentiation.
Differentiation requires more in-depth research related to consumer tastes or the features that make a product unique. Differentiation usually also requires higher advertising costs to highlight this uniqueness. And when it is sold, the risk of rejection may arise because it does not match consumer preferences.
The low price acts as promotional material for the product itself. Companies may not really emphasize quality or features because they are relatively standard.
Increase the customers base in a short period
Penetration pricing is effective for the mass market, where most consumers are price-conscious. Offering low prices will encourage consumers to become aware of new products and try them out. If they are satisfied, they will think about repurchasing them at a later date.
Creating high inventory turnover
Inventory turnover will increase because lower prices encourage product sales. It reduces the burden associated with warehousing.
And for distributors and retailers, high turnover creates critical enthusiasm and support in building the distribution channel. They will be happy to provide shelves for the new product.
More significant opportunity to establish a market position
Competitors need time to respond to price penetration strategies. They should review whether the low price strategy is long term or short term before reacting. Also, they may not have flexible resources to respond more quickly.
Taking advantage of this weakness, the company can seize as many customers as possible and build a market position. The next important task is to retain customers when the company starts to slowly increase prices.
Improvement of profits through the exploitation of economies of scale
Increased sales allow firms to make better use of production capacity. They can quickly achieve economies of scale and spread production costs across a higher number of outputs. That way, the average cost will go down.
Reduced costs ultimately allow for higher profit margins. Even though the price is low, the company can reduce production costs.
Promote operating efficiency
Low prices create pressure on profitability. To avoid deeper profitability pressure, companies must think of ways to control costs. As a result, penetrating pricing will encourage companies to reduce costs from the start of the product launch, leading to greater efficiency.
What are the disadvantages of penetration pricing
The company is not able to generate high profits at the beginning. Low prices mean less profit margin for the company. Indeed, this pressure may not last long because the company will slowly increase the selling price.
But, the strategy can become a boomerang at a later date
Price-conscious customers will expect the company to keep prices low permanently. Any increase in price will create dissatisfaction and encourage them to switch to alternative products.
Therefore, an increase in sales volume may not lead to an increase in profit if prices are kept low to retain new customers.
In the face of price penetration, competitors may react by lowering their selling price. Such situations make it even more difficult for companies to increase profits.
Damage the company’s image
Consumers may not be interested in new, low-priced products. They associate it with low quality or features. Hence, they are reluctant to buy it.
Such perceptions are likely to lead to failure. Say, after purchasing, some consumers find the product does not meet the company’s advertised specifications. The satisfaction immediately spreads to other consumers.
The company’s image is in jeopardy because consumers may associate failures in one product with its other products.
Trigger a price war
Keeping prices low increases the risk of competitive reactions from competitors. Competitors have better resources and capabilities to retaliate. So, they are in a better position to reduce the selling price.
A price war may arise in the market. It can lead to low prices and profits for an extended period. The company may be forced out of the industry because it is unable to achieve the targeted yields.