Pricing a product or service correctly is crucial for all businesses, especially for startups and young businesses who are still trying to penetrate the market and find their unique selling proposition.
While setting the price may seem simple on the surface, there are numerous pricing strategies that you should consider. Before we go into each strategy, keep in mind that there is no perfect pricing strategy. The pricing strategy that works best in one industry may be completely inappropriate in another.
Let’s quickly look at different pricing strategies available to your business.
Different Pricing Strategies:
- Cost-Plus Pricing
- Competitive Pricing
- Penetration Pricing
- Bundle Pricing
- Loss-Leader Pricing
- Price Skimming
- Anchor Pricing
- Value-Based Pricing
Don’t worry if you’ve never heard of some of these before. We will go into each pricing strategy, give you examples, and show you how you can apply them to your product/service.
Probably the most straightforward pricing strategy and the default pricing option for many small businesses. As the name suggests, with the Cost-Plus strategy, you simply calculate your cost and add a margin (“plus”).
Cost-Plus Price = Cost + Margin. For example: Unit Price $200 = $160 + $40 (20% Margin)
In the example above, we priced our office chair at $200 because it costs us $160 to acquire the chair from a manufacturer, and we simply added a 20% margin ($40) on top.
The simplicity of this pricing model appeals to many businesses. Also, adjusting the price is relatively easy because if the unit/materials/labor cost goes up, we can adjust the cost and keep the same margin. But, obviously, the price increase is passed on to the customer.
While we used a product (office chair) in this example, a cost-plus pricing strategy is also widespread across service industries. For example, a local electrician may charge $300 for a service call, and the breakdown may look something like this.
$300 = Gas ($20) + Materials ($50) + Labor ($150) + Margin ($80)
In the above example, labor can be considered a “plus” that you add to gas and material costs, but we frequently advise our clients to add a margin after labor costs; hence, why we structured it this way.
Simply put, competitive pricing is following what your competitors are charging with slight variations. For example, slightly higher to signal a better product, or slightly lower to attract price-sensitive shoppers.
If your product or service has been commoditized, or you are selling raw material, the chances are you are following the competitive pricing strategy.
Gas stations are an excellent example of competitive pricing. While they have the freedom to set their price, the price you (consumers) pay would have been determined by what other gas stations are charging. As we mentioned above, the price can be adjusted slightly higher (e.g., Shell) or slightly lower (e.g., Arco), but your competition will largely determine what you charge.
- Average gas price = $4.00
- Shell = $4.20
- Arco = $3.90
Let’s look at the hospitality industry next. Let’s assume there are ten different restaurants within walking distance from each other, all collecting between $60 and $90 per receipt. A new Mexican restaurant will probably have to follow a competitive pricing strategy and ensure its menu pricing fits within this budget.
As you can imagine opening a high-end restaurant in this area and expecting customers to pay over $200 will be a tough sell – when all competitors offer similar pricing, it’s very difficult to deviate from it, irrespective of how good your product/service is.
Another example is real estate agents/realtors. Most realtors charge 4-6 percent commissions because other realtors charge the same rate, and most clients (homeowners) know the going rate.
A competitive pricing strategy is not ideal but often necessary. The major downside of this pricing strategy is that your competitors primarily dictate what you can charge and, consequently, what your profit margins are.
With the penetration pricing strategy, you use a low price to enter the market. The most common examples are phone, internet, and cable companies with their “new customer” introduction pricing – often considerably lower than regular pricing.
On the surface, the penetration pricing strategy appeals to new businesses because you are immediately differentiating yourself from your competitors. However, there is a risk. You may attract price-sensitive customers and boost your sales, but many price-sensitive customers will leave when you increase your pricing.
Startups and young businesses are often unprofitable or run on paper-thin margins, so they need to be extremely careful with penetration pricing. Offering special “Grand Opening” pricing is ok, but maintaining penetration pricing for too long can bankrupt a small business.
Bundling services or products can be a win-win for you (businesses) and your customers. Again, prevalent examples are phone, internet, and cable companies. For example, the consumer will save by bundling their phone and internet services. Also, the travel industry often bundles flights, hotels, and car rentals. And the insurance industry with home and auto insurance.
From the consumer’s perspective, bundle pricing is attractive because of savings, and the convenience of having a single bill (provider) is very appealing. And from the business’s perspective, bundle pricing is great because you sell more products/services. Also, bundling will make your product/service stickier – more complicated for the customer to switch to your competitors.
So are there any downsides to bundle pricing? It depends. As mentioned above, the customer expects significant savings, which often means a lower profit margin. If you can bundle your product or service and not take a substantial profit margin hit, bundle pricing is a win-win (customer and business). However, bundle pricing can significantly strain your business if you already have low-profit margins. Lastly, if you don’t make the bundle appealing enough, it will likely fail.
Countless large companies use bundle pricing because they have numerous products/services and are large enough to absorb lower margins. Can a small business execute a bundle pricing strategy successfully? Of course, but think about the value of your bundle to the customer and its impact on your profit margin.
Loss-leader pricing is when you intentionally price your product/service at a loss. Why would any business want to price their product at a loss? Because their goal is to make money (profit) on other products.
The loss-leader is a favorite pricing strategy of your preferred grocery store. They will intentionally advertise and sell some groceries at a loss to get you in the store. And considering most people will purchase their weekly groceries from a single store, the grocery store will cover the loss and make a profit by the time you checkout.
Office printers are another well-known example of loss-leader pricing. Companies like Epson, HP, and Xerox will often take a loss on the printer itself but make their money back and more on the high-margin cartridges that you will need over the life of the printer.
We often advise our clients (startups and small businesses) to stay away from loss-leader pricing because small businesses often have difficulty upselling higher-margin products/services – to cover the cost of the loss leader.
If your business has a good conversion rate (selling high-margin products/services), then loss leader pricing is worth considering because it will bring new customers to your door.
With the price skimming pricing strategy, you come out of the gates with the highest possible price and gradually decrease it over time. As you can imagine, this is the most challenging pricing strategy to execute well because your product or service has to justify its high cost instantly.
In our experience, price skimming only works if your product/service is innovative or scarce; attempting price skimming in a mature or saturated market with an average product/service will likely fail. Therefore, your product/service has to be particularly desirable to come out of the gates with the highest possible price and for consumers to happily pay the premium.
Naturally, as competitors increase and scarcity decreases, the price of the product/service will come down.
Should you use price skimming? If you truly have a unique and desirable product/service and do a fantastic job creating the hype, coming out of the gates with a high price may be a great pricing strategy for your business.
With value-based pricing, you charge what you perceive your product to be worth. That sounds great! Who wouldn’t want to sell their product or service based on the value it brings?
Value-based price = Cost + Markup + Value
In theory, most businesses can implement value-based pricing, but it is not suitable for many industries. Also, it’s tough to execute well, which is why most companies don’t use it.
Let’s look at some examples to understand this particular pricing strategy better. Let’s assume we are a small five-employee business that needs a new logo. We hire Greg (designer), and he charges us $1,000 for our new logo. Do we feel like the new logo is worth $1,000 to our business? Yes, it looks much better than the original logo and makes our business look more professional.
We are so happy with the new logo that we recommend Greg to our distributor, who has 1,000 employees. After a few weeks, we learned that Greg charged our distributor $5,000 for the logo (five times more). This is value-based pricing at work.
While it might have taken Greg more time to design a $5,000 logo (compared to the $1,000 logo), it did not take five times longer. The time Greg spent designing the logo is irrelevant because Greg is charging for the value of the logo and not man-hours.
- Logo #1: $1,000 = Lobor Cost ($400) + Margin ($100) + Value ($500)
- Logo #2: $5,000 = Lobor Cost ($600) + Margin ($150) + Value ($4,250)
How can Greg justify the higher price? While our $1,000 logo will only be used on the website, brochure, and business cards, the distributor will also use it in print ads, display banners, employee merchandise, industry conferences, product documentation, etc. So, as you can see, the value of the second logo is much greater.
What “value” can you bring to the table that businesses will happily pay for?
- Increase in brand awareness, leads, sales, revenue, and profitability
- Decrease in operating costs
- Notable time-savings
- Significant efficiency improvements
Now that we looked at an example of an appropriate value-based pricing strategy, let’s look at an example of when it’s not. How much value does your internet service provider bring to your life? Many businesses cannot operate without the internet, so internet access is essential.
Can Verizon, T-Mobile, and Spectrum charge a value-based price instead of a flat fee? In theory, yes. However, there would be an uproar if customers found that they are paying a lot more just because their business is more dependent on the internet to run their day-to-day operations. Or imagine a drug company using value-based pricing to price their life-saving drugs. So, as you can see, value-based pricing is inappropriate in some cases and inconceivable in others.
That being said, value-based pricing is superior in many ways if appropriate and implemented well. Also, from our experience, a value-based pricing strategy only works if your product/service is differentiated (unlike the competition). Finally, and more importantly, you genuinely have to provide more value than the price of the product/service the customer paid. In other words, the customer has to walk away thinking they got a deal. If they do not, you need to go back to the drawing board – revisit your unique selling proposition, key product/service benefits, differentiation (competition), etc.
Value-based pricing is common with professional service firms, and luxury products and services. However, more businesses are trying this pricing strategy because profit margins are typically higher.
You may not be familiar with “Anchor Pricing,” but you see it daily. With anchor pricing, you display multiple prices, with one price acting as an anchor. So, for example, when you see the original price (usually crossed out) next to the new (discounted) price, the original price acts as an anchor.
The anchor’s job is to make the new price more attractive. So, for example, if you are shopping for a new TV, seeing the original price of $1,200 next to a new price of $700 makes this specific TV a great deal! Irrespective, if there are numerous TV options in the $700 price range.
Software pricing is another typical example of anchor pricing. For example, Microsoft has multiple pricing options for their Microsoft 365 Office software. Personal, $69.99/yr, Family $99/yr, and One-time purchase $149.
In this specific case, $149 is acting as an anchor. Of course, most people will not select the highest price option (e.g., buy a “one-time purchase” – $149), but that’s by design because the anchor’s main job is to make the other deals more appealing.
Anchor pricing in some capacity is appropriate for most startups and small businesses, but how exactly it should be implemented will depend on your specific industry, business, and growth strategy.
As you can see, choosing the right pricing strategy is a lot more complicated than it initially seems. While a pricing strategy may not be the main reason your business fails or succeeds, it will play a large part. Therefore, understand the different pricing strategies available to you, and take the time to evaluate each option.
Also, remember that your customers will forgive a single pricing misstep, but they won’t if you do it multiple times, so think long and hard every time you adjust your pricing.
Lastly, we know picking the right pricing strategy can be complicated and overwhelming, so if you are a small business or a startup and need help, send us a quick email, and we will do our best to answer your questions and guide you in the right direction.