We tend to think of pricing as its own distinct practice. You develop a product, produce it, promote it, and sell it. In reality, a pricing strategy needs to be baked into the entire process.
You can’t create a product without understanding where it fits into the market. Is it a high-end product? If that’s the case, does the pricing reflect the value? That’s not something you can decide after the fact. It’s a major consideration in any launch strategy.
In this article, we’ll look at what pricing strategy actually is, some different pricing models, and how you can think about your pricing strategy to facilitate long-term profitability and growth.
What is a Pricing Strategy?
A pricing strategy is a model that determines the best way to align the prices of a company’s products or services with its business goals, product attributes, and consumer demands.
Underneath that one-sentence explanation is great complexity. The right pricing strategy isn’t just a matter of trial and error or taking your Cost of Goods Sold and adding a desirable profit margin. It comes about as a result of deliberate decisions from your company’s leadership and emergent decisions that arise from ever-changing market conditions.
Internally, the factors that should influence the pricing strategy you choose include:
- Revenue targets
- Branding
- Product attributes and features
- Cost of Goods Sold
Externally, there are forces in your market that you have to take into consideration when determining pricing, such as:
- Consumer demand
- Macroeconomic conditions
- Competitor pricing
Ideally, your pricing strategy will take into consideration all of these internal and external factors and find a strategy that maximizes your long-term growth and profit. While you may have to make short-term pricing decisions, such as markdowns or discounts, your pricing strategy should have a longer time horizon in mind.
A pricing strategy is a model that determines the best way to align the prices of a company’s products or services with its business goals, product attributes, and consumer demands.
Common Pricing Strategies
In this section, we’ll look at some common pricing strategies you can use to start thinking through what is best for your brand. Keep in mind that at different times and stages of your business’s growth, different strategies may be appropriate. There’s no “one” best pricing strategy that fits all situations.
Penetration Pricing
Penetration pricing is a strategy that is centered around pricing a product lower than your competitors during an initial launch phase of your product. This strategy is best when a product has high competition or is a new entrant to an established market. The idea is to “penetrate” the market by offering a low price that attracts consumers’ interest.
Cost-Based Pricing
Cost-based pricing is a relatively simple concept. It’s a pricing model that bases the retail price of a product or service on the cost of sourcing, manufacturing, and distribution. You take the costs of producing something and add a percentage of those costs on top of the costs to arrive at a selling price that gives you some profit.
Dynamic Pricing
Dynamic pricing refers to a pricing strategy where sellers can optimize their prices based on real-time inputs with the goal of maximizing revenue. It is sometimes known as “price discrimination.”
Dynamic prices can change alongside market demands or outside conditions, such as time or location. One classic example is Uber’s surge pricing, which charges riders more for rides during peak times. Another is Amazon, which shows different prices to different consumers for the same items based on their likelihood to buy.
Dynamic pricing does introduce some complexity into your pricing strategy, while fixed prices are fairly simple to maintain. The difference is that dynamic pricing makes it possible to bring in greater revenue by charging more for customers who are willing to pay a greater amount.
Value-Based Pricing
Value-based pricing is a pricing strategy that sets prices based on the perceived value of a product or service, rather than the cost of the product or competitive prices.
Pricing isn’t just a number. It’s a reflection of how your product is made and packaged. If you know what your customers truly value, you can charge them based on the value and not on the cost of materials or what your competitors are charging. In this way, your customers have a crucial role in defining your pricing strategy.
Bundle Pricing
Bundle pricing is when you price two or more items together under one price tag. Bundling is versatile. You can use it to package two complimentary items together, such as a deal on kitchen appliances. You can use it to add value for captive products, such as razors and razor blades. Or you can just bundle products as a way to entice shoppers to buy more—the classic McDonald’s Happy Meal is a great example of that.
Getting bundling right can increase the perceived value of all products included. Buying multiple items at once can be psychologically challenging, but when you bundle a few desirable products together, you remove the decision paralysis from the consumer and make them feel like they’re getting a discount.
Psychological Pricing
Psychological pricing is a pricing strategy based on human psychology as it pertains to consumer behavior. It’s based on a theory that certain numbers on a price tag can impact customers’ decision making on a subconscious level.
The classic example here is the power of 99. Uneven price points, such as those that end in .99 appeal to buyers’ familiarity with sale pricing. They associate the number with discounts. In other cases, a price like $5.67 stands out because it plays with shopper expectations. They expect round numbers or .99 prices, not uneven numbers.
Price Elasticity and Pricing Strategy
It’s one thing to know the pricing strategies at your disposal, but it’s also crucial to understand how price and consumer demand depend on one another.
The Price Elasticity of Demand is a concept from economics that measures how the quantity demanded of a product changes as its price changes. According to the most basic form of this model, as prices increase, the quantity demanded decreases and vice versa.
The “elasticity” comes into play when we examine to what degree quantity demanded drops when prices increase, or how it increases when prices rise.
If your prices increase but the quantity demanded stays the same, you can say your product has an inelastic demand. People will buy it regardless of price fluctuations. Likewise, if an increase in price causes a decrease in quantity demanded, the demand for the product is elastic.
Understanding which group your products fall into has a major impact on your pricing strategy. You aren’t going to try for value-based pricing if you know demand is highly elastic. On the other hand, if you know quantity demanded for your product will rise as its price drops, penetration pricing might be a winning strategy.
Choosing a Pricing Strategy for Long-Term Growth
If you’re wondering, “Which pricing strategy makes sense for my product and market,” it all comes back to what we said at the beginning: It depends on your revenue goals, your brand, the maturity of your product and market, and the elasticity of demand for your products. If your goal is long term growth, you might need to make use of several pricing strategies over the product lifecycle.
Let’s look at an example scenario.
Say you are launching a new product that is aiming to compete in a crowded market where your product faces price elasticity. You know you aren’t differentiated enough on the basis of product features or branding, so you need another way to break into this market. Penetration pricing makes sense here.
In this case, using a pricing intelligence tool to understand the competitive pricing landscape is a powerful way to know what penetration pricing would look like. Once you’ve established a foothold in the market, you might change your pricing to reflect a psychological pricing strategy, where you’ve raised your price but used an uneven number to keep the perception of a great deal. As part of a promotion, you include this product in a bundle and sell it under a new price with other items.
In this case, the long-term profitability of the product doesn’t come from picking a strategy and sticking with it. It comes from understanding the product’s features, the competitive pricing, and the lifecycle of the product itself.
The possibilities are endless, but the one constant is that long-term growth is only guaranteed for the brands and retailers that are able to constantly adapt their pricing in fast-moving markets. Price intelligence is vital for understanding the dynamics of your market and pricing your products proactively and with an eye on your strategy, rather than scrambling to react to the competitive field.
Editor’s Note: This post was originally written and published in November 2015 by Arie Shpanya and has since been updated and refreshed for readability and accuracy.
