Pricing your product right is challenging, yet when your pricing is wrong, you lose money. This often ignored P of marketing is a marketing concern rather than a financial one. Read on to learn more about how to price products to capture your market.
Often, prices are determined by simply adding a markup to the acquisition cost or charging what the competition is charging, but these are ineffective pricing strategies. These strategies might be leaving money on the table (if consumers might be willing to pay more) or reducing sales as prices are determined to be too high by some consumers who might otherwise buy your product.
How much should I charge for my product or service?
Knowing how much to charge is critical for new businesses or businesses introducing a new product where you don’t have metrics to guide your decision. Even existing marketing strategies call for periodic reviews of current pricing structures. Unfortunately, this isn’t an easy question to answer.
For some, pricing is a function of supply and demand, which is true to an extent. This law says that when supply is limited, you can charge a higher price, and, when demand is high, you can charge a higher price. Where the two meet is called equilibrium. The notion is that fluctuations in the economy drive prices towards equilibrium. Companies use this law to help make tradeoffs between price and profit. Based on this law, pricing at a low price may mean more profit if it helps you sell more volume, which a high price pays off even if it means you sell less product.
Of course, the assumption is that consumers view alternatives as good substitutes so they switch to a different brand when your price is considered above equilibrium. That’s horse dodo. Marketing is all about differentiating your brand from competing brands so that consumers choose your brand as long as it provides value. That’s because consumers, rather than looking at price, consumers use value — the excess of benefits over price — to determine which products to purchase. The Harvard Business School article linked above offers 30 suggestions of items that create value in the eye of your customers.
Similarly, consumers sometimes use price to determine what’s good, especially in a situation where they can’t really judge the quality. For instance, selling a Rolex for $100 means you make less profit despite selling more volume. In fact, you might even sell less volume as the watch loses its luxury status and competes with the Timexes of the world.
Thus, all those financial tools you learned to help determine price just don’t work in the real world.
Below are some pricing strategies you might consider to get you started in this process.
1. Meet the competition
This strategy is simple and easy. You collect information regarding what your competitors are charging and make pricing decisions to match what competitors are charging. This marketing strategy is commonly employed for commodity-type products where differentiation is not extensive — for instance in pricing gas. Since consumer loyalty to these products is low, and consumers see products as good substitutes, charging a premium price would decrease sales substantially. The absolute endpoint in this process comes when you have unitary demand. For instance, candy bars sell for $0.75 in vending machines or convenience stores. Selling your product for more than that price means you sell virtually nothing. Selling for less than that price likely doesn’t generate any extra sales, meaning you reduce your profits. Commodity-type products commonly display high elasticity of demand — meaning a small increase in price can lead to a larger decrease in sales (see graphic above).
The elasticity of Demand is derived from the percentage change in quantity (%ΔQd) and percentage change in price (%ΔP).
2. Maximize ROI (Return on Investment)
Alternatively, firms might want to make the most return they can from their products. This marketing strategy works best when consumers have some incentive to buy your products over those of your competitors.
This notion underscores marketing strategy’s emphasis on non-pricing factors in framing competition. In other words, you should compete on quality, value, availability, or other benefits consumers might find in your products as it allows you to differentiate your products from your competitors and gives consumers a reason to not only buy your products but to pay a premium price for them. Think iPhones and you can see how effective this strategy is.
Maximizing ROI often requires knowledge of what consumers are willing to pay for your product. A useful tool to guide you in determining willingness to pay is conjoint analysis. Conjoint analysis is a market research technique using primary consumer data to determine the value consumers assign to various features of a product and the trade-offs they are willing to obtain one feature over another.
Although commonly used as part of the innovation process to determine which features to build into a product, a conjoint analysis might be used to build your price based on the trade-offs consumers will make to obtain its features or compare your product and its features against competitors to determine how your price should be set relative to these competitors.
While conjoint analysis is somewhat complicated and has to be tweaked to use in price settings, it’s probably preferable to asking consumers what they’re willing to pay for something. I was involved in a feasibility project for an aquarium where we asked individuals in our target market a number of questions including how much they would be willing to pay for admission. This was used, along with forecasts of attendance, as part of the feasibility study necessary to obtain funds. Unfortunately, stating a price preference is VERY different from actually reaching into your pocket. After building the aquarium, the city used a price somewhat lower than the average reported by respondents, yet, attendance was far below the forecast.
3. Targeted ROI
Targeted ROI is a marketing strategy using break-even analysis with a built-in desired profit.
Breakeven analysis is a powerful tool that you can use in this context, called sensitivity analysis, and is the backbone of many business decisions. A breakeven analysis uses the contribution margin (selling price – variable cost (like raw materials and production wages) along with fixed costs (like rent and insurance) to determine how many units of the product you need to sell to cover your costs. At breakeven, the company neither makes any money nor loses money.
The formula for breakeven is:
Fixed Costs/(Selling Price – Variable Costs)
when used to reach a targeted ROI this formula is modified as:
(Fixed Costs + desired return)/ (Selling Price – Variable Costs)
Penetration pricing involves charging a low price to attract customers. You might choose this strategy for a new product to encourage trial of the product or it might be done to increase market share. Commonly, penetration pricing strategies are used for a defined amount of time — until some target sales volume is reached. After the sales goal is reached, prices commonly increase.
For instance, most new apps and tools offer a free trial. The hope is that consumers are convinced the tool provides value and want to purchase the tool or upgrade to a paid subscription when the trial is over.
Marketers using social networks understand the concept of penetration pricing as well. Social network marketing firms often offer low-cost or free content, including webinars, ebooks, instructional videos, blogs, newsletters, tips, or advice. Free content is offered as part of a marketing strategy to demonstrate the value of paid tools, attract customers and prospects to the website, and gain a reputation as an expert. Social media experts hope free content will build trust, encourage sharing across users’ social networks that further build the expert’s prospect base, and ultimately allow them to make money from their social network marketing efforts.
While social media marketing experts understand the importance of penetration pricing, novices and the uninformed fail to appreciate its importance and attempt to monetize their websites and other social media too quickly. Social network marketing is DEFINITELY a pay-it-forward situation where pushing affiliate marketing programs or selling advertising before giving visitors and network members an incentive to allow marketing efforts is a HUGE mistake. Marketers who fail to provide value as part of the exchange will find themselves unfollowed, unfriended, and with few visitors to their blogs. They may also be reported as spammers and have all access to the social network blocked.
Price skimming involves charging a high price initially with the intent of reducing prices as consumers willing to pay higher prices are satisfied or more competition enters the market. This strategy can ONLY work with radical innovations, such as HDTV, when originally introduced. Price skimming requires that there are:
- few substitutes for your product
- you have a measurable advantage over existing products
- consumers have different elasticities of demand
- a means for reaching customers with different elasticities exists
Price skimming can also work as a strategy for price discrimination. Price discrimination is a pricing strategy designed to maximize profits by charging different groups of consumers different prices. As an example, airlines attempt to charge business travelers (who generally possess inelastic demand since profits are a function of their travel) more relative to personal travelers (who have more elastic demand and might be willing to drive, travel on different dates, or forgoing travel if they don’t get a reasonable price). In the case of airlines, they use rules such as advance booking and Saturday night stays, to separate business and personal travelers.
Price skimming can also work for revenue management (or yield management). Revenue management is a strategy for charging customers different prices depending on how valuable they are to the firm. Thus, customers who require more services, get charged higher prices. Using an airline example again, customers who check their luggage at the airport pay a higher fee than those checking their luggage online as checking at the airport requires more resources.
In marketing, possibilities exist to use price skimming, although caution must be employed to avoid negative reactions from customers when they find they’re paying a higher price than other customers. Thus, charging one price to consumers when their IP address suggests they’re in the US can easily backfire when a friend outside the US reports paying a different price.
To avoid this, there are two solutions — hide it or allow customers to self-select which group they fall into. Hiding price skimming is commonly done in e-commerce by getting some customer information prior to displaying a price. For instance, consumers may be asked for their zip code prior to receiving a price. This allows retailers to charge differently based on geographic area such that more consumers in more affluent zip codes see higher prices than those in less affluent zip codes.
You can’t just set a price based on your pricing strategy. You need to consider what consumers want to spend on your product as highlighted in the HBR article mentioned above. Economists (and accountants) like to think consumers want to spend the least amount possible on a product. That’s just not true.
Consumers want value and a high price is justified if they feel the product has superior attributes. Take an Apple product, for instance. Consumers pay a premium for the “coolness” factor in iPhones, iPads, and Macs. Sure, there are some interesting features on these products (I’m a huge Apple fan), but, objectively, the products just don’t justify the price by any objective measure. And, the difference in pricing isn’t based on higher costs.
Part of Apple’s premium price comes from the lack of alternatives. There’s just no substitute product that provides the same coolness factor. You just don’t brag to your friends about owning a Dell. Plus, Apple is innovative and often their products are first to market — meaning they have no competition.
Sometimes a very low price implies poor quality — remember the value signal inherent in pricing mentioned earlier.
This is especially true for products consumers can’t judge objectively. For instance, jewelry, professional services, car repairs, restaurants, and many other products are hard to judge. We use price as a surrogate for quality and a low price often draws fewer customers, not more.
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