How you set your prices can have a host of implications for your business. Not every price you set needs to maximize your margins. Many small businesses use price to compete, change market share or create different revenue scenarios. Understanding how pricing affects your business model, not just your bottom line, will help you better choose price levels. Your pricing model must be appropriate for the markets and customers you target, and you are constrained by the tactics used by your direct and indirect competitors.
2. Top product pricing models
Before we could discuss how pricing affects a business, deciding a pricing model is a pre-requisite for products of startups and existing businesses. The alternatives range from giving it away for free (like Twitter), to pricing based on costs, to charging what the market will bear (premium pricing). Set out below are the top product pricing models that are available to choose from, depending upon their suitability to the nature of a business.
3. Revenue models
The implications of the decision you make are huge, defining your brand image, your funding requirements, and your long-term business viability. The revenue model you select is basically the implementation of your business strategy, and the key to attaining your financial objectives. Obviously, it must be grounded by the characteristics of the market and customers you choose to serve, the pricing model of existing competitors, and a strategy you believe is consistent with your future products and direction. Figures have been mentioned in the world reserve currency for a global application.
4. Product or service is free, revenue from ads and critical mass
Most social apps, both web and mobile, including Facebook, and Twitter, follow this model. It’s a very difficult model to follow successfully. Under this pricing model, the service is free, and the revenue comes from click-through advertising. It’s great for customers, but not for startups, unless you have deep pockets. If you have real guts, try the Twitter model of no revenue, counting on the critical mass value from millions of customers. It either takes a lot of luck (say, being a huge hit at SXSW, largest music festival in the World with over 2,200 official performers at over 100 venues) or deep pockets for a startup to achieve critical mass with this model.
5. Free product, bundled with paid services
This pricing model is common for open source software, such as Red Hat linux, where the product is available for free download, but customers pay subscription fees if they want support. Customers are also charge for installation, maintenance, training, customization, and consulting services. This is a good model for getting your foot in the door, but be aware that this is basically a services business with the product as a marketing cost. Note that most investors aren’t interested in service businesses.
6. “Freemium” model
In this variation on the free model, used by LinkedIn and many other Internet offerings, the basic services are free, but premium services are available for an additional fee. This also requires a huge investment to get to critical mass, and real work to differentiate and sell premium services to users locked-in as free.
7. Cost-based model
Many consumer products sold through conventional distribution channels are priced at two to five times the production cost, depending on the industry. Margins are much thinner for commodities, of course. Use it when your new technology gives you a tremendous cost improvement. Skip it where there are many competitors. If you are selling into existing retail channels, this is a common pricing strategy.
8. Value model
If you can quantify a large value or cost savings to the customer, charge a price commensurate with the value delivered. This doesn’t work well with “nice to have” offerings, like social networks, but does work for new drugs that solve critical health problems. The key to value-based pricing is to demonstrate that you deliver considerably more value than available alternatives.
9. Portfolio pricing
This model is relevant only if you have multiple products and services, each with a different cost and utility. Here your objective is to make money with the portfolio, some with high markups and some with low, depending on competition, lock-in, value delivered, and loyal customers. In this model, you have an opportunity to offer a customized solution that maximizes the benefit to the customer at maximum profit to you. This strategy can become very complex very fast.
10. Tiered or volume pricing
In certain product environments, where a given enterprise product may have one user or hundreds of thousands (a blog), a common approach is to price by user group ranges, or volume usage ranges. Keep the number of tiers small for manageability. This approach doesn’t typically apply to consumer products and services. If your product is purchased in different quantities by different types of buyers, you can offer tiered pricing. This model is very common for B2B sales - business that is conducted between companies, rather than between a company and individual consumers. This is in contrast to business to consumer (B2C) and business to government (B2G). Example: Depending on the industry, it might be something like a 10% price break for ordering 100+ units, and a 15% price break for ordering 500+ units. This can also apply, directly or indirectly, to certain consumer products and services: for example, the “buy 9 and get the 10th one free” punch card is volume pricing in disguise.
11. Competitive positioning
In heavily competitive environments, the price has to be competitive, no matter what the cost or volume. This model is often a euphemism for pricing low in certain areas to drive competitors out, and high where competition is low. Competing on price alone is a good way to kill your startup.
This model is also known as market pricing model. In highly competitive and minimally differentiated markets where competitors’ prices are visible to all market participants (like most products sold online), prices are set primarily by supply and demand. This takes into account shipping costs and sales taxes. You can earn a slight premium if you have a strong reputation (like Amazon), or if you can promise faster delivery, or if you offer a more liberal return policy. If you can’t justify pricing at a slight premium to the market, then you need to be the low-cost manufacturer or importer, or else you’ll compete yourself out of business.
12. Razor blade model
In this model, like cheap printers with expensive ink cartridges, the base unit is often sold below cost, with the anticipation of ongoing revenue from expensive supplies. This is another model that requires deep pockets to start, so is normally not an option for startups. This pricing model can also be used with medical devices where a fresh, sterilized component must be used with each application. If you are selling the base unit at below cost, you obviously need a deep balance sheet.
13. Keep your pricing model simple
It is best to keep your pricing model as simple as possible. It is far too easy to scare off customers with a complex pricing scheme. Start by researching what’s conventional in your industry and build from there. Marketing is initially required to get visibility and access to the opportunity, but pricing defines how you will actually make money over the long term.
14. Build or choose a pricing model from customers’ perspective
Remember to build or choose a pricing model from the customer’s perspective. Try to interview as many potential customers as possible. Maybe you’ll discover that many of them are frustrated by the pricing conventions that are “standard in the industry” and they’ll be receptive to a different way of doing business. Price should reflect a value as experienced by customers through the product.
15. How price impacts on profit margins
The price you set affects your profit margin per unit sold, with higher prices giving you a higher profit per item if you don’t lose sales. However, higher prices that lead to lower sales volumes can decrease, or wipe out, your profits, because your overhead costs per unit increase as you sell fewer units.
16. How price affects sales volume
One of the most obvious affects pricing will have on your business is an increase or decrease in sales volume. Economists study price elasticity, or the response of consumer purchasing to a price change. Increasing your prices might lower your sales volume only slightly, helping you make up for decreased volume with higher total profits generated by higher margins. Lowering your prices can increase your profits if your sales jump significantly, decreasing your overhead expense per unit. Test the market’s response to price increases by changing prices in targeted areas before instituting an across-the-board price increase.
17. How price affects your position in the marketplace
The price you set sends a message to some consumers about your business, product or service, creating a perceived value. This affects your brand, image or position in the marketplace. For example, higher prices tell some consumers that you have higher quality, or you wouldn’t be able to charge those prices. Other consumers look for low-priced products and services, believing they’ll get the quality they need at a low price. Offering sales, discounts, rebates and closeouts can send the message you can’t sell your products or services at your regular price, or tell buyers they have a short-term opportunity to get a bargain.
18. How price influences market share
The price you set makes you more or less competitive in the marketplace, affecting your share of the market’s volume. Some businesses lower prices temporarily to gain market share from competitors, who can’t respond to and meet a price decrease. After consumers have had time to try your product and develop a brand preference or loyalty, you can raise your prices again to a level that won’t cause them to leave you. Predatory pricing is the practice of selling a product or service below cost for the specific purpose of taking market share away from a competitor or closing it down, then raising prices on consumers when they have fewer, or no options after that competitor is gone. This may be illegal under anti-trust laws.
19. Loss leaders
A loss leader is a product that has a price set below the operating margin. This results in a loss to the enterprise on that particular item in the hope that it will draw customers into the store and that some of those customers will buy other, higher margin items. Some businesses price products or services at or below cost to get customers into their businesses, which then spend more money elsewhere. Restaurants offer low-margin specials to offer a change-of-pace to regular diners to keep their normal business, or to let regulars bring friends who want upscale dishes at a moderately priced eatery.
20. Premium pricing
Premium pricing (also called prestige pricing) is the strategy of consistently pricing at, or near, the high end of the possible price range to help attract status-conscious consumers. The high pricing of premium product is used to enhance and reinforce a product's luxury image. Examples of companies which partake in premium pricing in the marketplace include Rolex and Bentley. A component of such premiums may reflect the increased cost of production. People will buy a premium priced product because:
a. They believe the high price is an indication of good quality;
b. They believe it to be a sign of self-worth - "They are worth it;" it authenticates the buyer's success and status; it is a signal to others that the owner is a member of an exclusive group;
c. They require flawless performance in this application - The cost of product malfunction is too high to buy anything but the best example : heart pacemaker.
21. Pricing objective
A well-chosen price should do the following things:
a. Achieve the financial goals of the company (i.e. profitability);
b. Fit the realities of the marketplace (Will customers buy at that price?);
c. Price is influenced by the type of distribution channel used, the type of promotions used, and the quality of the product;
d. Price will usually need to be relatively high if manufacturing is expensive, distribution is exclusive, and the product is supported by extensive advertising and promotional campaigns; and
e. A low cost price can be a viable substitute for product quality, effective promotions, or an energetic selling effort by distributors.
22. What is optimal pricing level
From the marketer's point of view, an efficient price is a price that is very close to the maximum that customers are prepared to pay. In economic terms, it is a price that shifts most of the consumer surplus to the producer. A good pricing strategy would be the one which could balance between the price floor (the price below which the organization ends up in losses) and the price ceiling (the price beyond which the organization experiences a no-demand situation).
23 Customers beware of seller’s tricks –durable goods like cars and white goods
a. Preying on your lack of information: There's nothing a dealer loves more than an uninformed consumer who's going to negotiate a purchase based on nothing more than the car or truck's sticker price.
b. Imposing finance charge markups: During negotiations, your salesperson may say he or she can offer you a lower price if you'll finance the purchase through the dealership. That's a sign to be very careful. Your salesperson may be hoping to recoup any discount in price through a finance charge markup.
c. Making the deal all about the monthly payment: Salespeople often ask potential buyers what kind of monthly payment they can afford. Don't tell them, because they'll use that number to sell you a more expensive car or a consumer durable good than you may have wanted and maximize the dealership's profits on your sale. The salesperson will figure out the most you can possibly spend by dragging out the payments for as long as possible and still hit that payment. He or she will then show you cars and trucks in that price range, which is often higher than what you wanted to spend, while reassuring you that this fine vehicle is within your budget. For example, you came in to buy a compact sedan that cost about $20,000 but let slip that you could afford a payment of $450 a month. The salesperson immediately recognizes that a 60- or 72-month loan would allow you to buy a $25,000 midsize sedan and your payment would still be about $450 a month — and that is what he or she will try to sell you.
d. Deceptive payoff promises: Let’s say you’re looking to buy a new car but still have a balance on your current car loan. To close the deal, a salesperson will often promise: “We’ll pay off your loan no matter how much you owe.” In the past, dealers counted on making up the difference with your trade-in, which was usually worth far more than what you owed on it. Nowadays, many owners are upside down on their loans, meaning they owe more than their car is worth. That leads some unscrupulous dealers to pay off your old loan, just as they promised, then secretly add that payoff cost to your new loan. By rolling the previous balance into your new loan, they’re counting on you focusing on the monthly payment and ignoring the total amount that you’re financing. Here’s how it works: You’re told that you’ll need to borrow $20,000 over 48 months at 6% to buy the new car or truck you've picked out, which works out to a monthly payment of $470. The dealer adds the $4,000 payoff on your old loan to the balance, and the papers you’re given to sign actually commit you to paying $24,000 over 60 months at 6%. The finance manager directs your attention to the monthly payment, which turns out to be only $464. You think you've actually gotten a better deal than you were promised and happily sign without looking at the details, which is exactly what the finance manager wants.
e. Saying the deal is only good today: Salespeople often tell buyers an offer is "only good today" to keep you from checking out the deals at another showroom or having second thoughts about the vehicle or durable good you're considering. In either case, you're almost always likely to get the same deal the next day.
f. Using the old bait-and-switch: You see an ad that offers a great price on the model you've been considering. But when you arrive at the showroom, you find that it's only good for a basic, no-frills version. And there's only one of those on the lot. The salesperson quickly steers you toward one of the many better-equipped — and more costly — models.
g. Letting you drive away before finalizing the loan: "Spot delivery" or "yo-yo financing" is when you take delivery of a vehicle before finalizing the financing required to pay for it. The salesperson promises to get you a loan, even if you have bad credit, for what sounds like a reasonable rate. You sign some paperwork to get the financing approved, but when you return to close the deal, you find that you're being charged several percentage points higher than you were promised.
h. Dangling dealer add-ons: Dealers try to boost their profits on hot-selling models by charging thousands of dollars for extra accessories that cost them hundreds of dollars to provide. The add-ons can be anything from mud flaps and pinstripes to leather seats installed in a base model that never comes from the factory with such an upscale interior. Those extras — and the new higher asking price — are listed on a second window sticker right next to the factory sticker. Although dealer add-ons are never worth the cost, they're a good indication that the salesperson will expect you to pay the full inflated price or something very close to it.
24. Pricing similar products
For example, a car manufacturer was struggling with overlap between two of their models. The newer model had been growing in size and features and was encroaching on the market for the older model. Their fundamental question to us was: Should we continue to manufacture both models, or should we develop a plan to discontinue the older model?
The issue ultimately came down to pricing. Setting the right price for products and services is one of the more challenging decisions any business faces.
Two complementary approaches can be presented to answer this question. These approaches can help any business that has overlapping products in its portfolio:
1. Indifference price analysis: Estimate the price we would need to charge for the older model to make identical profits between the older and newer models. This approach would make the manufacturer indifferent to the customer's choice of model.
2. Value-in-use price analysis: Estimate the older model price point at which the customer is indifferent between the two models (i.e., the value they derive from using either model, less their purchase cost, is identical). The logic here is simple: If our "indifference" price for the older model is lower than or similar to the customer's value-in-use price, then our path forward with the older model is straightforward:
a. Continue to manufacture both models and promote both of them as viable solutions.
b. Charge a price for the older model where we are more or less indifferent to the customer's choice of models.
c. Let the customer decide which model best meets their needs.
d. If customers consistently choose one model, we may need to revisit the value-in-use price analysis and reopen the question of whether to discontinue the other model.
Conversely, if our indifference price for the older model is much higher than the customer's value-in-use price, we likely need to discontinue the older model, or at least sharply curtail production to serve only those customers that have the highest value-in-use for the older model.
Estimating customer value-in-use can be challenging. In this case, we were selling to commercial customers, so we needed to really understand their economics in detail.
25. Price sensitivity meter
Price Sensitivity Meter (PSM) is a market technique for determining consumer price preferences. It was introduced in 1976 by Dutch economist Peter van Westendorp. The technique has been used by a wide variety of researchers in the market research industry. The assumption underlying PSM is that respondents are capable of envisioning a pricing landscape and that price is an intrinsic measure of value or utility. PSM approach asks four price-related questions, which are then evaluated by producers:
a. At what price would you consider the product to be so expensive that you would not consider buying it? (Too expensive).
b. At what price would you consider the product to be priced so low that you would feel the quality couldn’t be very good? (Too cheap).
c. At what price would you consider the product starting to get expensive, so that it is not out of the question, but you would have to give some thought to buying it? (Expensive/High Side).
d. At what price would you consider the product to be a bargain—a great buy for the money? (Cheap/Good Value).
26. Concluding comments
Business managers, finance and governance professional may like to develop financial modeling that gives various pricing alternatives to CEOs, Boards of Directors and consumers, thereby contributing to building robust markets, efficiently using economic resources and enriching consumer satisfaction. Proper pricing models help keep stable product prices plus a good product pipeline.
By: CS. Anand Varma