For consumers, price points are a simple yet powerful factor that can impact purchasing decisions. For business owners, however, setting price points can seem like anything but a simple process.
Pricing goods requires a careful balance between keeping profits up and maintaining your market share. If you set the price too low, the cost of manufacturing and marketing can outweigh profits. If you ask for too much, customers may turn to your competitors.
This guide will help you weigh complex pricing factors to help find that balance.
Pricing models
Business owners can use different pricing models to find price points that maximize sales and profits. Depending on the factors at play, different industries may rely on different pricing models. Manufacturing businesses, for instance, typically use cost-based pricing. Retail stores often use market-oriented or dynamic pricing in order to account for competitors and market trends. Read on for a breakdown of each of these pricing models.
Cost-based pricing
This model is one of the most simple ways to price a product. Cost-based pricing involves determining the costs of manufacturing a product, then adding either a percentage of those costs or a fixed amount as a profit margin markup. Manufacturing costs should include the costs of material, labor, marketing, inventory management, and any other overhead that may impact the cost to produce a good.
As an example of this pricing structure, suppose that a business must spend $20 to manufacture a product. The organization has a desired minimum profit margin of 30%. Figuring out the price of the good with this model is pretty straightforward:
$20 [cost of manufacturing] + $20 * 0.3 [the profit margin — 30% of 20] $20 + $6 = $26In this example, the price of the good would be $26. This figure will serve as the good’s pricing floor, though the price may increase depending on demand and the business’ competitiveness on the market.
This simple model allows businesses to easily account for costs of production and earn a consistent rate of profit. Even if a business doesn’t use this model to determine their pricing, this is particularly helpful for determining the maximum allowable manufacturing cost of a good while maintaining acceptable profit margins.
On the other hand, cost-based pricing has some flaws. It does not account for customers’ perceived value of the product, leading businesses to miss out on substantial profits. For this reason, this business model is not suited to many industries, though it can be particularly useful when producing custom goods.
Market-oriented pricing
Market-oriented pricing, also known as competition-based pricing, compares similar products on the market in order to determine pricing points.
There are a few different approaches to pricing within this model. If your niche is dominated by a single competitor, you may choose to simply base your price point on the prices of that competitor. Alternatively, if you have several competitors, you may want to average their costs to determine your price point.
For example, let’s say you’re interested in determining the price of a product. Competitor A is selling a similar product for $35, competitor B is selling it for $30, and competitor C is selling it for $28. Figuring out your price point would involve simply averaging these numbers:
($35 + $30 + $28) [price points from competitors A, B, and C] / 3 $93 / 3 = $31
In this example, the model would lead to a price point of $31. This may vary based on some considerations, such as differences in product features, higher costs, or customer preferences. After weighing these factors, business owners may opt to price above market, copy the market, or price below market. Note that higher prices must be justified with improved performance or brand perception. Lower prices may be used to attract consumers based solely on pricing.
A major advantage of market-based pricing is that it will help prevent you from losing market share to competitors due to your pricing. Customers who regularly comparison-shop may find your price points to be particularly attractive.
There are some negatives to consider as well. Pricing above or copying the market may necessitate additional marketing dollars to justify or differentiate your offerings, respectively. This can ultimately hurt your bottom line. If you opt to attract customers through low pricing, this pricing model may cause you to set goods at too low of a price, which can negatively impact profits.
Dynamic pricing
Dynamic pricing provides more flexibility and control than those listed above, though it requires much more research. True to its name, this pricing model involves prices that can dynamically fluctuate with market trends. Depending on the retailer, prices can change multiple times a week or even each day. This model involves analyzing pricing trends across many products and competitors in order to determine current market demand for (and value of) specific goods.
Because dynamic pricing is based on many factors, it’s impossible to express the calculations required in a simple formula. In fact, certain software is designed to perform complex algorithms and help business owners determine ideal pricing points in this model. Software like Microsoft Dynamics 365 can provide helpful information for determining pricing points. When Dynamics is used in conjunction with eCommerce software, this research can be leveraged to its full potential, offering a truly personalized experience for users and maximum profit for entrepreneurs.
There are many benefits to dynamic pricing. This pricing model requires more work, but it undoubtedly results in greater profits for most industries. Retail giants like Amazon and Walmart have embraced this pricing model, resulting in improved profits.
There are also downsides to consider. As noted above, this model requires extensive research — your prices (and profit margins) will only be as good as your research. Consumers may also feel that price fluctuations are unfair, though this concern can be addressed by marketing price decreases as seasonal or promotional sales.
Dynamic pricing may also necessitate certain policies and precautions; for instance, price fluctuations probably shouldn’t cause goods to increase in price while they are in an online customer’s cart. Managing customer expectations and perceptions is essential to pulling off this pricing model effectively.
Pricing strategies
Regardless of the pricing model you use to determine your price point, you must use a pricing strategy that appeals to your target customers and differentiate your offerings from competitors. There are many factors that can influence your approach to pricing, and weighing each of these is vital to remain competitive and profitable. These include:
Target consumer demographics;
Level of demand;
Manufacturing, marketing, and transportation costs;
Perceived brand and product value.
These are just a few of the factors to consider. The following pricing strategies can help business owners weigh these factors and position their product in the market in a way that can realize its full potential.
Premium pricing
The way consumers perceive a product’s quality is largely related to its price. Some brands opt to use premium pricing, also known as prestige pricing. This involves increasing the price of a product in order to improve its perceived value. For brands that use this pricing strategy, the price of the good is a key component to its value to consumers.
This creates higher profit margins and positions your product as a prestigious item. With sufficient marketing, this perception can position your brand as a major authority in your industry. However, it can backfire if the product is not unique, of high enough quality, or scarce enough to justify the price tag.
The opposite of premium pricing, penetration pricing is centered on the idea that customers often make their purchase decisions based on which option is most affordable. Perceived value is not the focus; rather, the price is typically the most appealing aspect of the good.
This strategy can be effective for, as the name suggests, penetrating the market. This is a great way to expose new customers to your product, earning some market share from your competitors in the process. Word-of-mouth marketing can help you generate buzz for the product. After gaining market share, prices can be increased to generate better profit margins. While penetration pricing results in limited profits at first (and, in some cases, losses), it can pay off in the long run.
This approach is effective for products with few differentiating features and in which demand is tightly linked to price. A major example is how Android has taken over the market: through highly competitive prices, Android has gained market share and loyalty, widely outperforming Apple in sales from 2010 to today. Another example is McDonald’s approach to pricing new items; new items will generally start at low prices to generate interest.
Economy pricing
If you’ve ever bought a T-shirt for fewer than $5 or a pair of jeans for just $10, you’ve encountered some prime examples of economy pricing. This strategy is focused on reducing costs to consumers via reduced production costs. Manufacturing, marketing, and other overhead costs — these are kept as low as possible. Further, the profit margins on items in this pricing approach are incredibly thin. The result? Rock-bottom prices.
For people looking for the lowest possible prices, companies using economy pricing are most likely to win these customers over. This can be an excellent way to generate consumer interest in your products, though it requires careful management to ensure profitability.
A major downside to this approach for some industries is related to ethical concerns. For example, the production methods needed to follow this pricing strategy must be very cheap, often involving low-cost labor sourced from overseas. Many customers will take issue with this and avoid your goods entirely.
This approach works well for industries in which marketing and overhead costs can be minimized. Two examples of companies using economy pricing — much to the chagrin of critics — include retail giants like Amazon and Walmart.
Skimming strategy
Price skimming involves releasing a product at a premium price, then decreasing the price after a period of time to attract thriftier customers. The product may be rereleased with fewer bells and whistles, or it may be made less relevant by the release of a new, more advanced version.
The initial release will generate extra profit from die-hard customers who are willing to pay inflated prices, while the decreased price will generate further sales down the road. This enables businesses to appeal to both groups, contributing to both spikes in profits as well as sustainable profits over time. Further, it can reveal what consumers are willing to pay, which is valuable information for future product releases.
On the downside, achieving a balance in this strategy can be difficult. Lowering the price too soon can decrease the perceived value of the product and anger customers, resulting in a loss of brand loyalty. Waiting too long to reduce the cost can lead consumers to seek out products from competitors.
Great examples of industries in which businesses can use this strategy are technology and book publishing. When Apple releases new phones, older models are sold at a discount cost. When Penguin Random House initially releases a book, they may exclusively release hardcover editions, then later release inexpensive softcover editions.
Also listed at Economics Help, some examples of products for which companies use price skimming include:
Smart phones;
Game consoles;
Latest 4k/8k televisions;
Hardcover books.
Psychology pricing
Psychology pricing uses customers’ emotional triggers to entice them to buy your product.
One of the most prominent examples is charm pricing, also known as the rule of nines. This takes advantage of the fact that consumers tend to read from left to right with decreasing attention. For this reason, $19.99 will be subconsciously perceived as “$19.00” rather than “$20.” An item costing $395 will be perceived as $300 rather than $400.
Another example is comparative pricing, which is a strategy retailers can use to improve sales. This involves placing very inexpensive items in close proximity to premium items. This can highlight the value proposition of the former, resulting in improved sales.
Most readers will recognize such strategies from day-to-day life. This is because these approaches are fairly universal and can be used in most consumer-facing industries.
Bundle pricing
Bundle pricing is a strategy in which businesses offer consumers a set of products or services at a discount. If consumers regularly purchase the same set of goods, it can be a good idea to streamline the purchasing process by simply selling them in a bundle. This can make shopping with you more convenient and enticing. Alternatively, this can be a good choice if you have a surplus of specific products.
Selling off these items can reduce inventory management costs for goods that may expire soon or are gradually becoming obsolete. Bundling items is also a great way to improve the perceived value of your goods, which is a good way to entice thrifty consumers. Businesses involved with technology, utilities, groceries, and even food service can employ this strategy to good effect.
With these pricing models and strategies, you’ll be prepared to find ideal price points for your goods. When used in conjunction with an integrated e-commerce solution, you’ll be armed with the knowledge and foresight needed to make a formidable impact in your niche. While market trends and factors can be unpredictable at times, following these practices will ensure that your business is financially sustainable and profitable for many years to come.
