What’s it: Pricing strategy is companies’ policy in setting the selling price of their products. Some firms may set prices with more consideration to the market (market-based pricing), while others consider cost-based pricing more.
Pricing is a critical factor in securing profits. Price is the only component of the marketing mix that determines revenue for the company. Meanwhile, the other three components (product, distribution, and promotion) generate costs. The right price ultimately results in optimal demand.
Pricing strategy framework
The selection of the right pricing strategy is essential to achieve company goals. Price affects demand, profit, and product position in the market.
Also, pricing has implications for costs. For example, suppose a company sells at a high price. It usually costs a lot of promotion. Companies must convince consumers that products do have superior quality and features.
Factors to consider in pricing strategies
Seven factors are the primary consideration in pricing. They are:
- Types of products
- Target market
- Price elasticity of demand
- Product life cycle
A company makes a profit if it charges a sale price higher than the average cost of production—the more significant the difference between the selling price and the cost, the higher its profit.
Some companies consider costs more than other factors. They then use a cost-plus pricing approach to set prices.
This approach is the easiest. The company only needs to add a profit margin (markup) to the unit cost.
Some customers may be cost-conscious. They want a product that is cheaper because it fits their budget.
While others are more quality-conscious and less considerate of price in making purchasing decisions. They see quality products as more prestigious and following their self-image.
Price affects demand. For most products, lowering the selling price increases demand.
But, there are some exceptional cases. Lower prices actually make the product unattractive to some consumers. They think low price means low quality.
Types of products
Pricing for differentiated products requires a different approach to mass products. The mass product is relatively homogeneous. Therefore, firms often offer it at an average level to competitors’ prices.
In contrast, for differentiated products, the firm adopts premium pricing—a higher price signals better quality than other products on the mass market.
In general, markets fall into two categories: new markets and existing markets. Both require different pricing strategies.
Say, the company is targeting a new market. They may charge a low price (penetration price). The goal is to attract as many and as quickly as possible new customers. That way, the company has a customer base to sustain a stronger market position.
Low prices are also essential to support lower cost structures. With high sales volumes, the company quickly achieved economies of scale and lower average costs.
Price affects relative competitiveness against competitors. Consequently, the price of a competitor’s product is an essential consideration in pricing. Companies monitor what prices competitors are charging for their products.
Companies may charge prices below, equal to, or above the average competitor’s price. Each of these has implications for the success of the product in the market. Which of the three is most appropriate depends on the company’s goals.
If the firm’s goal is to improve market position, the firm charges a lower price than the average competitor’s price. Lower prices attract more consumers, allowing the company to immediately increase sales and market share.
In highly competitive markets, firms may charge a price equal to the average price of competitors. To attract more demand, companies can focus on non-price aspects, such as quality and support services.
Furthermore, the firm may also charge a higher price than competitors. Instead of targeting price-conscious customers, the company sells its products to quality-conscious segments. They strive to offer superior quality products as a justification for high prices.
The price elasticity of demand shows you how responsive the consumer is to changes in price. Product is elastic in demand if a small change in price leads to a higher increase in demand. For example, if the price drops by 5%, it increases the demand by more than 5%.
Conversely, if demand is inelastic, consumers are relatively less sensitive to price changes. For example, if the price is down by 5%, demand increases by less than 5%.
Such consumer responsiveness is an essential input in making pricing policies. For example, if demand is elastic, the company may charge a lower price than its average price. Because they are more responsive, consumers would switch to company products. As a result, sales and market share increased higher than competitors.
Product life cycle
A product undergoes 5 typical phases during its lifetime:
- Development stage
- Introduction stage
- Growth stage
- Mature stage
- Decline stage
Each stage requires a different pricing approach.
At the introduction stage, for example, consumers are unaware of the company’s products. The company’s first job is to educate consumers. Its next task is to build a customer base and achieve a stronger market position.
In such a situation, a company might choose penetration pricing by offering a low price. That way, the company can increase sales and immediately achieve economies of scale.
But some companies may choose price skimming. They sell at a high price and slowly bring it down. The goal of this strategy is to achieve high revenue to cover development costs.
Price skimming is suitable for highly differentiated products or recent inventions such as the personal computer at its release. Consumers have never found a similar product before. The company targets a few customers who are willing to take the risk of buying.
Types of pricing strategies
Within a broad classification, experts classify pricing approaches into two main groups:
- Market-based pricing. Under this approach, the company considers more market factors (customers and competitors) in setting prices.
- Cost-based pricing. Under this approach, production costs become a significant consideration in setting prices.
The two approaches have various variations. The following are among them:
Under the basing-point pricing approach, companies add shipping costs to customers based on their location from a specific reference point. The farther their location, the higher the shipping costs, and the more expensive the product price.
A pricing strategy whereby the firm sells a by-product at a separate price.
For example, suppose a company produces canned fish. Apart from producing the main product (canned fish), the company also produces unused fish pieces. The company then sells the two products (canned fish and cut fish) separately.
The company sets the product selling price at the break-even point. This strategy generates zero profit because revenue will equal costs.
The main goal of the company is usually to boost sales and increase market share. The company may still benefit from other products, thus subsidizing the zero profit product.
Companies charge different prices for core products and product accessories. Typically, core product prices are lower than product accessories.
Customers may be attracted to the core product because of its low price. Then, the company tries to direct customers to buy product accessories. Some product features may not perform well in the core product unless they purchase accessories for the product.
This strategy is similar to the freemium concept. The company offers the core product for free but has basic features. To get more advanced features, consumers have to pay for it. You can find this approach in most software sales.
It is the practice of pricing based on the prices that competitors charge for similar products. In other words, the company uses the price of a competitor’s product as a benchmark to determine the selling price. The selling price may be slightly below, equal to, or above competitors’ prices.
If the company sets the price below, it results in a lower profit per unit. But, it will result in higher sales, allowing the company to achieve economies of scale.
If the price is above the benchmark, the company must think about the justification. I mean, companies have to think about additional features so that customers are willing to buy the product and not turn to competitors.
This approach yields a high profit per unit. However, the sales volume will be relatively low.
On the other hand, by setting prices below the benchmark, the company produces more units sold. But, that led to a lower profit per unit.
Firms set prices at the average level of competitors’ prices when the market comprises many firms, and the products are homogeneous. To make a profit, the company will reduce production costs. An extreme example is a perfectly competitive market, where firms take the market price as their selling price.
Companies offer different prices to different customer groups for the same product. The main consideration factor is the customer reservation price, which is the maximum price they are willing to pay.
In an extreme case, the company sets the price according to the respective reservation price. Let’s say the market consists of three customers, each with reservation prices of Rp4, Rp5, and Rp6. Then, the company sets three different prices according to the reservation level. That way, the company’s profits will be maximum. In economics, we call this perfect price discrimination (or first-degree price discrimination).
But, to be successful, companies must, of course, be able to measure the reservation price of each customer precisely. The company must also ensure that a customer who buys the Rp4 price will not sell it to other customers willing to pay a higher price.
Freight-absorption pricing is a specific form of geographic pricing practice. In this case, the seller chooses to absorb part or all of the shipping costs instead of charging them to the customer. Often times, the goal is to secure sales or long-term contracts with customers.
Loss leader pricing
Loss leader pricing is a pricing practice that is softer than predatory pricing. Under this approach, the firm charges price at a loss but is still above average variable costs. In other words, the selling price only covers variable costs and some fixed costs.
The main goal of loss leader pricing is to increase short-term sales.
The retail industry usually adopts this strategy. To compensate for the loss leader products, retailers will direct customers to buy higher-margin products. That way, the overall profit is still high because of the high margin product compensates for the loss in the loss leader product.
Markup pricing or cost-based pricing is a pricing approach in which a company adds a profit margin to the unit cost. For example, suppose that the company reports a unit cost of $ 100. To determine the selling price, the company adds a markup of 10%. So, the selling price for the product is $ 110 = $ 100 (1 + 10%).
Peak-load pricing is the use of charging different prices to customers according to demand conditions. Companies charge higher prices during peak periods and regular prices in other periods. For example, airlines charge higher prices during the holiday period than the regular season.
Companies charge low prices to spur sales. This approach is usually to sell a new product. Or, it’s for an existing product to a new market. The main objective is to build a customer base and achieve a stronger market position by boosting sales.
When adopting predatory pricing, the company’s goal is to force competitors out of the market and build entry barriers. Firms charge at a loss (below average variable cost) to divert customers away from competing products.
This strategy allows the company to gain monopoly power. After a competitor exits the market, the firm increases the selling price to compensate for the losses while adopting this strategy.
The predatory pricing strategy is illegal in some jurisdictions. As the company tried to eliminate competition in the market, regulators charged them with anti-competitive practices.
Prestige pricing or premium pricing is a pricing strategy in which the company charges high prices to give an impression of superior quality. Typically, companies target quality-conscious customers.
Take the iPhone as an example. Apple sells them at a higher price than their mass-market competitors. The company strives to provide an image of superior quality, which you will not find from other products on the mass market.
Companies set high prices at the start and slowly lower them. The price skimming strategy is usually for the latest inventions or new highly differentiated products.
Due to the high price, only a few customers were willing to buy. Apart from the reason for the high price, most consumers are not aware of or have not dared to take risks inherent in new products.
Product line pricing
Under the product line pricing approach, companies classify goods into cost categories. Its purpose is to create a perception of quality and features in the minds of consumers. The company charges a base price for the base model product. Meanwhile, they offer higher prices for products that have better quality or features.
The company offers a selling price that is lower than the regular price. The goal is to increase sales in the short term.
There are a variety of options for carrying out this strategy. The company might discount prices, offer a bundle, offer coupons, or launch loyalty cards.
Under target pricing, the company sets the selling price first, then adjusts the product features. The marketing department sets the ideal price for the product taking into account the competitive and demand conditions.
The ideal price includes two components: production costs and profit margins. The research and development team then designs products with appropriate features within predetermined cost limits.
In contrast to basing-point-pricing, customers pay the same shipping costs under a uniform-delivered pricing strategy, regardless of their distance from the delivery point.
This approach is to set prices according to the perceived value of the product by customers. The company calculates value by comparing the added value of the company’s products with those of competitors in the target segment.
The company charges the same price for customers in certain zones and charges different prices for customers in other zones. If the zoning is based on the delivery center’s location, then we call it basing-point pricing.
Apart from distance from delivery location, other factors to consider for zoning are:
- Population or consumer density
- Transportation infrastructure
- Number of competitors in each zone