Pricing Models
With dozens of pricing models to work from, business owners must look at the specific conditions of their business. Here are 28 strategies to consider:
1. Absorption pricing
Absorption pricing is designed for the seller to recover all the costs of a product or service. The direct cost of materials and labor, as well as fixed and variable overhead costs are included in the price. Take the variable cost of the item, add a percentage of its fixed cost and then mark up to yield a profit.
In Action: Automotive manufacturers have used absorption pricing to offset high fixed costs from factory leases and labor contracts. By mass-producing to capacity and spreading fixed costs out over all vehicles produced, car companies are able to lower per-unit production costs and raise profit margins.
A car manufacturer produces vehicles that sell for $50,000. If they incur direct costs of $30,000 in materials and labor and $10,000 in overhead, they will net a profit of $10,000 per unit sold.
This can produce short-term profitability, but there is a risk to mass-producing to capacity. In the long term, if demand varies, you may face expensive inventory overstocking issues.
2. Contribution margin-based pricing
Contribution margin-based pricing maximizes profit earned on individual unit sales. Take the product’s price and subtract the variable costs required to produce it (materials and direct labor). The difference is called the contribution margin per unit, which can go toward paying for fixed costs (like rent, utilities and payroll).
In Action: If a laptop computer is sold for $500 and the materials and labor used to produce it cost $100, the contribution margin would be $400. That $400 could be used to cover fixed costs and of that $400, whatever isn’t used for fixed costs is your profit.
Accounting for variable costs can get confusing since the variable cost per unit increases the fewer units you produce. It may cost more to make 1,000 laptops than it does to make 100, but your profit margin for producing 1,000 units will be higher.
The contribution margin-based method maximizes profit per individual unit when considered over a quarter or a year.
The strategy does not take into account how scaling up to produce more units can affect fixed costs by raising rent, equipment, and utility fees. It also does not address how sales of individual items impact sales of other items in the company’s product and service line. For instance, if McDonald’s sells more Big Macs, this might lead to fewer sales of cheeseburgers, which has an overall impact on total profits.
3. Creaming or skimming
Creaming, also known as skimming, sells individual units at a high profit margin so that a smaller number of sales are needed to break even.
In Action: This strategy may be used for premium markets or to test early adopters who are willing to pay a higher price point for new technology. In 2015, Sharp released the world’s first 8K television at a price point of $133,000, aiming at early adopters in the corporate market.
4. Decoy pricing
Decoy pricing makes a high-priced item more attractive among competing products. Typically, three products are displayed for sale, including two similarly high-priced products. One of the higher-priced products is less attractive than the other, so that when the buyer compares prices, they will naturally choose the better value.
In Action: This method can push sales of a particular product, but may lead to overstocking. Movie theaters often use medium boxes of popcorn as decoys to drive sales of large boxes.
5. Freemium
Freemium (a combination of free and premium) pricing generates sales by offering a free item upfront as an incentive to purchase a related premium-priced item. For example, early razor blade manufacturers gave away free razors as an incentive for people to buy blades.
In Action: Today, freemium pricing is frequently used to sell digital products or services. Dropbox users can sign up for a free account with limited space. The experience might motivate some users to upgrade to a paid account with more space.
6. High-low pricing
High-low pricing promotes lower-priced items by offering them with lesser frequency than high-priced ones. A common deployment of high-low pricing is selling new products at a high price when they initially hit the market and then dropping them to a discounted price once their popularity and demand have peaked.
In Action: Shoe companies such as Nike, Adidas, and Reebok make high-low pricing a major strategy for their industry.
7. Keystone Pricing
Keystone pricing is a strategy that sets a retail price by doubling the wholesale price.
In Action: If boneless chicken breast have a wholesale price of $2.09 a pound, keystone markup would place the retail value at $4.18 per pound.
Keystone pricing only works well if you can realistically sell the item at the doubled cost to consumers. If the supplier’s price for the item is high relative to the price you can sell it for, or if you are a discount vendor, keystone pricing may not work well for you.
8. Limit pricing
Limit pricing is a strategy which aims to monopolize a market. It sets the price of a product at a level below profitability or where it is barely profitable. This discourages competition from entering the market.
In Action: McDonald’s and Amazon set their prices based on the competition.Limit pricing can be illegal in some cases. It also has limited long-range effectiveness once competitors have successfully entered the market. It’s hard for small companies to use limit pricing effectively; it works best for large companies with the capability to produce and sell products at prices their competition can’t afford.
9. Loss leader
A loss leader pricing strategy sells or gives away a product or service at a low cost or even takes a loss on that item as a way to promote a higher-priced item.
In Action: Supermarkets often offer free food samples to shoppers as an incentive to sell featured products. Giving away a free consultation session as a way to gain a client is another effective loss leader strategy used in industries like legal industry and elective medical.
A loss leader strategy can work effectively when the loss is not significant enough to hurt your profit margin and when the return on premium upsells is high enough to justify the loss.
Loss leaders lose effectiveness when they are too costly to give away profitably. For example, many restaurant chains are less generous than they used to be with free napkins, plastic silverware and condiments because of these items’ rising prices.
10. Marginal-cost pricing
Marginal-cost pricing marks up based on the costs added by materials and direct labor. This strategy has a low profit margin, so it only works well in circumstances like driving sales of items that would not otherwise be sold.
In Action: Priceline.com has used marginal-cost pricing to sell empty seats and hotel rooms by offering them at prices dictated by consumer bids.
11. Cost-plus pricing
Cost-plus pricing sets prices by using the costs of material, direct labor and overhead as a base, then applying a markup percentage to determine list price.
In Action: If costs for a product are $75, applying a 25 percent markup would yield a price of $97.50.
Cost-plus pricing has the advantages of being simple to calculate, easy to justify to consumers and guaranteeing profitability.
This pricing method has flaws though — it runs the risk of becoming inflexible, since market conditions are often dictated by competitor’s pricing. A government contractor who uses cost-plus pricing has no incentive to seek production efficiency, since he’ll will be compensated profitably no matter what his costs are.
12. Odd pricing
Odd pricing, also known as “just-below” pricing, sets prices by assigning the last digits of a price an odd number just below a round number, such as a multiple of 5 or 10.
In Action: TV commercials that sell products for $19.95 instead of $20.
Some marketers swear by odd pricing, but empirical researchers and studies are split on the issue. In 2003 the Quantitative Marketing and Economics Journal published a study supporting odd pricing, but in 2013 Booz & Company published a summary concluding that consumers actually prefer round numbers.
13. Pay what you want
A pay-what-you-want (PWYW) strategy lets consumers name the price they’re willing to pay for an item.
In Action: In some cases, consumers may not be required to set a price until after consumption — as with tips where diners do not decide how much to tip their server until after the meal.
A common PWYW strategy employed online is when software developers offer apps for free with the option of donating a dollar amount.
PWYW pricing can be attractive to buyers initially, but with repeated transactions, margins tend to decrease over time.
14. Penetration pricing
Penetration pricing sets prices low in order to penetrate a market by attracting consumers, with the intent of raising the price later after a market niche has been established.
In Action: Software app companies often offer a free trial period before raising prices. However, it requires enough capital to remain in business until prices can be raised. Once prices have been raised, ongoing discounts and sales are typically needed to retain customers and stave off competition.
15. Predatory pricing
Predatory pricing, also known as undercutting, uses unprofitable pricing to discourage competition. Where limit pricing seeks to discourage competitors from entering markets, predatory pricing seeks to eliminate existing competition.
In Action: Some large cable companies have used predatory pricing to eliminate smaller competitors.
Like limit pricing, predatory pricing is most effective when wielded by large companies with deep pockets, but runs the risk of short-term effectiveness and illegality.
16. Premium decoy pricing
Premium decoy pricing is a variant of decoy pricing that sets one price arbitrarily high in order to promote a lower-priced offer.
An online magazine might run an offer advertising a digital subscription for $25 and a print subscription for $50, expecting that the print option will make the digital option look more attractive to consumers.
In Action: Apple frequently uses this strategy to promote products — like when it priced the iPod higher than the iPhone despite equivalent functionality.
Premium decoy pricing can be effective but the cost of producing the decoy must be low enough to offset the sales it loses to the competing item.
17. Premium pricing
Premium pricing deliberately maintains an item’s artificially high price to create a perception that expensive must equal brand value.
In Action: Luxury cars and jewelry typically use this strategy.
Premium pricing has the advantages of delivering a high profit margin and making it difficult for competitors to enter a niche. However, it requires high unit costs and high expenditures to maintain brand image, as well as restricting sales volume to premium customers.
18. Price discrimination
Price discrimination sets different pricing policies for different market segments.
In Action: Google Apps offers different pricing packages to consumers than it does for business users. Other variations of this method include movie theaters, which may charge different prices for different age groups or show times.
To use price discrimination effectively, three things must happen:
- First, have a good idea of what different market segments are willing to pay.
- Second, prevent resale of products from one segment to another. This occurs frequently with ticket scalping, for example.
- And third, have enough power over the market to control price changes.
The absence of one or more of these conditions tends to make price discrimination less profitable.
19. Price leadership
Price leadership is a strategy employed by companies that control industries enough to establish a pricing pattern that competitors must follow. Companies sharing control of the market agree not to undercut each other through forms of competition such as price cutting or disproportionate advertising.
In Action: Industry control may be achieved through implicit collusion, as when Apple conspired with book publishers to raise ebook prices in order to hurt Amazon and other book retailers, or through explicit agreements, as with OPEC (Organization of Petroleum Exporting Countries).
Price leadership can be effective in a market dominated by limited competition, but the emergence of disruptive competitors can undo its effectiveness, as illustrated by Uber’s disruption of the taxi industry.
20. Psychological pricing
Psychological pricing sets prices based on the assumption that a given price point, color or name has a psychological impact on consumers. This pricing strategy remains controversial.
Odd pricing
Odd pricing of products and services with digits ending in 9 (17.99 for example) is a form psychological pricing.
Colors
Another variant of psychological pricing uses different colors in advertising based on their perceived psychological impact. WhichTestWon study found that changing a website’s call to action button from light green to yellow increased conversion rates 14.5 percent.
Naming
Changing the name of a product to something deemed to sound more valuable is used to justify a higher price point — such as calling a club membership a Gold membership.
21. Target pricing business
Target pricing sets prices at a level aimed to generate a target return on investment at a specific production volume.
In Action: Automobile manufacturers may produce a certain number of a specific car model to be sold at a specific price point. This would be based on market research indicating that the sales point will be profitable at that production volume.
Target pricing works best for companies that invest significant capital into their products and services — car companies and utility providers for example. Target pricing does not work well for companies with low capital investment. It also relies on accurate market forecasting to anticipate how to match production levels to demand levels.
22. Time-based pricing
Time-based pricing is a method mainly used by online companies that use digital data to dynamically adjust prices to consumer demographic profiles, purchase history and willingness to pay. This technique depends heavily on accurate forecasting
In Action: The airline industry uses time-based pricing effectively through online travel sites. Airlines must have a reasonable idea how many passengers will want certain flight seats on a given holiday to know how high they can raise the price and still find demand for the seats.
For retailers moving physical merchandise, it also depends on the ability to adjust stock levels to reflect demand by using backorder options for out of stock merchandise strategies.
23. Value-based pricing
Value-based pricing sets price levels based on value to the consumer. Effective value-based pricing requires establishing the value of your product or service in the eyes of your customer.
In Action: Even though software costs approximately the same amount to place on a physical disc or to deliver digitally, it may be priced differently for the consumer. Lawyers may charge based on the compensation they win for a client rather than simply on an hourly basis.
24. Yield management strategies
Yield management strategy sets prices by studying consumer behavior to maximize profit on perishable goods.
In Action: Concert promoters may raise ticket prices as an event grows closer. This is based on the observation that fans become more desperate for tickets as seats become more scarce and time to purchase grows shorter.
This type of strategy relies on understanding consumer behavior and well-executed timing of price changes, in addition to effective inventory strategies to avoid stockout situations.
25. Congestion pricing
Congestion pricing adjusts prices based on congestion of availability.
In Action: Traffic becomes more congested during weekends and holidays, limiting availability of cab drivers, so Uber raises rates during these times to take advantage of peak travel demand.
Other industries that use congestion pricing include electric companies, bus services, railroads, airlines and shipping. Effective congestion pricing depends on limited availability coupled with high demand. It also depends on your company’s logistical ability to deliver products and services in a congested environment.
26. Variable pricing strategies
Variable pricing sets prices by factoring in the variables in the cost of production.
In Action: Insurance premiums may be priced differently based on different interest rates yielded by different policies.
Variable pricing aims to set product prices to balance sales volume with income per unit sold. This can help businesses accurately predict the total cost needed to develop a new product. However, because it doesn’t factor in fixed costs, it works best when variable costs have greater impact.
27. Real-time variable pricing
Real-time variable pricing has grown more prevalent as technology has enabled finer control of yield management and congestion pricing strategies.
In Action: An example of real-time variable pricing is an auction, where buyers bid for an item in real time. Auction sites such as eBay illustrate how this method can be adapted to an online environment.
The growing amount of consumer data available enables companies to deploy increasingly sophisticated pricing models based on accurate market analysis and prediction. Real-time variable pricing depends on big data and accurate forecasting.
28. Scaled Pricing
Scaled pricing allows users to select from a range of price points that correspond to their needs.
This model is particularly popular with cloud and SaaS offerings.
In Action: Those who use Slack, the team collaboration and communication tool, are dropped into one of four buckets based on the capabilities the team needs or features they want. From there, teams pay per user.
This trend has impacted brick-and-mortar services as well. Physical-based retailers are using mobile marketing data to personalize pricing for individual consumers.
Best Practices
To harness the various pricing tactics available into an effective strategy requires following a few key best practices and principles.
- Establish a different price point from your competition, even if it’s only slightly different. Yale research says identical pricing tends to discourage sales.
- Use price anchoring. The first piece of pricing information consumers see affects or “anchors” their perception of subsequent items. This means that contrasting a premium product with other products can help enhance its perceived value.
- Focus on perception. Consumers make pricing decisions based on the perception of how gain outweighs pain. An $84 monthly subscription sounds less painful than a $1,000 annual subscription, even though they come out to about the same amount over the course of a year.
Similarly, the context of an offer can affect price perception. People will pay more for a multimedia course than an article even if the content is the same.
- Bundling items, emphasizing free offers or adjusting sales copy can also influence perceived value and pain.
- Associate with experiences. Memory associations play a role in perceived value. Ads for beer brands try to associate their products with good experiences such as social gatherings and watching sports events.
- Keep it simple. Research published in the Journal of Consumer Psychology found that prices with more syllables look and sound higher to consumers. For example, $1,500.00 looks more expensive than $1,500, and $1,500 looks more expensive than $1500.
- Don’t emphasize bargain pricing. While this may work for some brands with superior logistics capabilities like Amazon or Walmart, for most companies, it will create a perception of lower value, along with diminishing return on investment.
No single strategy is appropriate for all situations. Selecting a pricing strategy that fits your business requires knowing your company’s target market, accurate market data analysis, knowing your your production costs and capability and logistics and understanding your capital.
Pick a strategy and test it before scaling up. This will allow you to make adjustments based on feedback. Testing these methods in real-market conditions will give you the best insight into whether a particular strategy is right for you.
Source: http://quickbooks.intuit.com/
Theresa Todman, Managing Partner/CEO of B&M Financial Management Services, LLC . Theresa specializes in bookkeeping, accounting, QuickBooks solutions, small business tax issues and consulting.
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