Pricing strategy

Overview

A business can choose from a variety of pricing strategies when selling a product or service. To determine the most effective pricing strategy for a company, senior executives need to first identify the company's pricing position, pricing segment, pricing capability and their competitive pricing reaction strategy. Pricing strategies, tactics and roles vary from company to company, and also differ across countries, cultures, industries and over time, with the maturing of industries and markets and changes in wider economic conditions. Pricing strategies determine the price companies set for their products. The price can be set to maximize profitability for each unit sold or for the market overall. It can also be used to defend an existing market from new entrants, to increase market share within a market, or to enter a new market. Pricing strategies can bring both competitive advantages and disadvantages to a firm and often dictate the success or failure of a business; thus, it is crucial to choose the right strategy.

Absorption pricing

This pricing method aims to recover all the costs of producing a product. The price of a product includes the variable cost of each item plus a proportionate amount of the fixed costs:

Unit Variable Costs

+

Overhead

+

Managing Costs

Number of Units Produced

=

Absorption Price

{\displaystyle {\text{Unit Variable Costs}}+{\frac {{\text{Overhead}}+{\text{Managing Costs}}}{\text{Number of Units Produced}}}={\text{Absorption Price}}}

Fixed or variable costs, direct or indirect costs, employee salaries, utility costs, and other types of costs can also be calculated by applying the absorption pricing method.

Contribution profit-based pricing

Contribution profit-based pricing maximizes the profit derived from an individual product, based on the difference between the product's price and variable costs (the product's contribution margin per unit), and on one's assumptions regarding the relationship between the product's price and the number of units that can be sold at that price. The product's contribution to total firm profit (i.e. to operating income) is maximized when a price is chosen that maximizes the following: (contribution profit per unit) × (number of units sold)

Contribution profit-based pricing

In cost-plus pricing, a company first determines its break-even price for the product. This is done by calculating all the costs involved in the production such as raw materials used in transportation etc., marketing and distribution of the product. Then a markup is set for each unit, based on the profit the company needs to make, its sales objectives and the price it believes customers will pay. For example, if a product's price is $10, and the contribution margin (also known as the profit margin) is 30 percent, then the price will be set at $10 * 1.30 = $13.

Cost plus pricing

Cost-plus pricing is a cost-based method for setting the prices of goods and services. Under this approach, the direct material cost, direct labor cost, and overhead costs for a product are added together, and a markup percentage is applied (to create a profit margin) in order to derive the price of the product.

Creaming or skimming

Price skimming occurs when goods are priced higher so that fewer sales are needed to break even. Selling a product at a high price, and sacrificing high sales to gain a high profit is therefore "skimming" the market. Skimming is usually employed to reimburse the cost of investment of the original research into the product: commonly used in electronic markets when a new range, such as smartphones, are first sold at a high price. This strategy is often used to target "early adopters" of a product or service. Early adopters generally have a relatively lower price sensitivity—this can be attributed to: their need for the product outweighing their need to economize; a greater understanding of the product's value; or simply having a higher disposable income. This strategy is employed only for a limited duration to recover most of the investment made to build the product. To gain further market share, a seller must use other pricing tactics such as economy or penetration. This method can have some setbacks as it could leave the product at a high price against the competition.

Decoy pricing

Method of pricing where the seller offers at least three products, and where two of them have a similar or equal price. The two products with similar prices should be the most expensive ones, and one of the two should be less attractive than the other. This strategy will make people compare the options with similar prices; as a result, sales of the more attractive high-priced item will increase.

Differential pricing

Differential pricing occurs when firms set various prices for the same product depending on their consumer's portfolio, geographic areas, demographic segments and the intensity of competition in the region.

Double ticketing

A form of deceptive pricing strategy that sells a product at the higher of two prices communicated to the consumer on, accompanying, or promoting the product.

Freemium

Freemium is a revenue model that works by offering a product or service free of charge (typically digital offerings such as software) while charging a premium for advanced features, functionality, or related products and services. The word "freemium" is a portmanteau combining the two aspects of the business model: "free" and "premium". It has become a highly popular model, with notable successes.

Good–better–best

A seller offers three prices for variations of the same good or service: a "good" no frills version, a "best" premium version, and a "better" version in the middle. Invoking the Goldilocks principle, customers may choose the "better" version because they are willing to pay more than the "good" price, but they are not willing to pay for the "best" version. A notable practitioner of the good–better–best pricing strategy is Apple Inc., which originally sold one model of iPhone in 2007, but by 2020, had adopted the practice of introducing good, better, and best models of iPhone and Apple Watch. Apple's competitors, such as Samsung Electronics, followed suit.

High-low pricing

A practice whereby many items are regularly priced higher than by competitors, but through promotions, advertisements, and or coupons, lower prices are offered on key items, or where products are sold initially at a higher price and then discounted. The lower promotional prices are designed to bring customers to the seller where the customer is offered the promotional product as well as the regular higher-priced products.