Of all the things I was asked to do early in my career as a marketer, one of the most intimidating was determining the price of my company’s products and services. To this day I still remember the first time I was asked to come up with a go-to-market pricing strategy, and will never forget the stress I felt and the questions rattling through my brain. Am I taking all of the relevant factors into consideration? If my price is wrong, could this negatively affect the perception of the product? Is my job at risk if I screw this up?
But after pricing nearly 400 products and services over the last 18 years, I realize now I was completely over-thinking the entire process. Although my first instinct was to start crunching math equations and digging out my Economics textbooks from college, it is clear now that simplicity—and a little bit of common sense—can go a long way when it comes to determining the price of a product or service.
This article is Part 1 in a 2-Part posting on pricing strategies, and will focus on four commonly used pricing methods—as well as their fatal flaws. Part Two, tentatively titled 4 Great Ways to Price Your Products and Services, will be published and available within about two to three weeks of the date of this post.
Pricing Strategy #1: The “I Want to Make X Number of Dollars” Method (a.k.a. Cost-Plus Pricing)
Overview: This is the typical manufacturing-driven pricing model, whereby Executive Management calculates how much something costs to make or deliver, then adds a percentage or dollar figure on top of the calculated cost to come up with a final sale price.
Reason for Use: Cost-Plus Pricing is used in many situations because it is easy to calculate and easy to administer. Many also believe that it is the easiest way to ‘guarantee’ their company at least some level of profit on every sale.
The Mistake: When one of your competitors figures out how to manufacture a product or deliver a service more cost-effectively than you do, you will be forced to sell at a loss until you can figure out how to be more efficient. Cost-Plus Pricing also has a second fatal flaw: it completely ignores both the customer AND the market—as well as a little thing called “The Supply and Demand Curve.”
Pricing Strategy #2: The “Let’s Ask People What They Would Be Willing to Pay” Method (a.k.a. Market-Oriented Pricing)
Overview: This method centers around researching or actually communicating with the target market of the product or service directly, then using the collected data to come up with an ideal price point.
Reason for Use: It is relatively easy and inexpensive to ask someone what they might be willing to pay for something, or what your product or service might be worth to them. Unlike other methods, this one also involves the potential customer in the pricing decision. And for the numerically challenged, this pricing method requires no math.
The Mistake: Asking potential customers what they would be willing to pay might seem like a wonderful idea on the surface, but it completely underestimates the intelligence of the target audience. No matter how far you go to hide the intentions of your survey, most respondents will figure out exactly what you are doing (trying to come up with a price) and will tell you what they WANT to pay—which is obviously much less than what your product or service is actually WORTH.
Pricing Strategy #3: The “Let’s Come in Low and Raise the Price Later” Method (a.k.a. Penetration Pricing)
Overview: Not to be confused with Loss Leader Pricing (selling below cost in an attempt to move other goods or services) or Predatory Pricing (selling below cost with the intention of driving out competitors), Penetration Pricing is the practice of setting a low initial entry price, with the intent of raising the price once market acceptance has taken place.
Reason for Use: From a pure economic standpoint, Penetration Pricing will result in more sales, and therefore an increase in market share. Penetration Pricing is also used by many marketers to tear people away from existing brands, and give new ones a try.
The Mistake: Although companies might have had good success with this pricing method 20 years ago, the mere existence of the Internet—and the increased speed of information flow—now means that customers are only one or two clicks away from someone willing to make the same sale for a few dollars less, or in some cases a few pennies less, than you are. A second problem: if a competitor lowers their price to match yours, what is your next move?
Pricing Strategy #4: The “Which Group Are You In?” Method (a.k.a. Third Degree Discrimination Pricing)
Overview: In a nutshell, this particular pricing method involves dividing your target market into discrete groups—by age, gender, organization size, geographic region, non-profit status, etc.—and publishing a specific price (or discount) for each group. For the academics in the audience, you will note that I specified “Third Degree” when referring to the Price Discrimination; specifically excluding First Degree (an ability-to-bear model) and Second Degree (where price varies according to quantity sold).
Reasons for Use: Third Degree Discrimination Pricing is a great way for companies to spread out their risk and revenue streams, and extract money from a variety of low-end vertical markets that might not otherwise make a purchase. Many companies also use this method to work their way into large government and non-profit agencies, where contracts are larger and more long-term.
The Mistake: Although an effective strategy in service industries (senior discounts on movie tickets, ladies’ night at the local hangout) companies who practice Discrimination Pricing on the Retail or Industrial side open themselves up to having their products resold for a profit by people with the right connections (read: an EBay account). Also, contrary to popular belief, a company’s membership in one of your pricing groups does not necessarily discourage them from demanding additional discounts if they believe their order volume or visibility warrants an extra few pennies off . . . which those of you who have dealt with Walmart already know.
Conclusion
Discussing a few examples of pricing traps is certainly a good first step, but the larger question still remains: “How do I effectively price my company’s products and services?” The fact is, determining an optimal price for the things you company sells has little to do with math, formulas and complex calculations, and is based more on perception, convenience and competitive positioning—a point I intend to prove in the recently-released second half of this article, titled 4 Pricing Strategies That Work for Small Companies.
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