Setting the right price for a product or service is crucial. Not only will your choice of price affect your profits and sales; it could also determine which customers you acquire, alter the competitive dynamics between businesses in your industry, and redefine people’s perceptions of your brand.
In this guide, we’ll tell you about seven popular types of pricing strategies, and how to choose the right strategy to set prices for your business.
7 types of pricing strategy
Even if you haven’t heard of cost-plus pricing before, you’re probably familiar with the concept.
In cost-plus pricing, the product’s price is the unit cost (how much it costs to produce and deliver one unit of the product), plus a certain amount of markup which gives the business its profit margin.
unit cost + markup = cost-plus price
For example, a luxury fashion designer might work out that it costs £200 to produce one unit of a jacket. The industry-standard markup for fashion is about 2.5X – so if the brand multiplied the unit cost by that multiplier, then the jacket would be priced for retail at £500.
Cost-plus pricing has the advantage of basing your prices in the economic realities of your business. The prices take into account your costs AND a profit margin, and as such you should never lose money on the sales you make.
Another benefit to this type of pricing strategy is that it’s very easy to master: just add up your costs and then times the unit cost by your desired markup multiplier.
With that said, there are two sensitive components you need to get right for cost-plus pricing:
- accurately costing your unit price; and
- choosing a markup multiplier that’s appropriate for your industry.
Finding the unit price for your product or service means adding up the costs of labour, materials, overheads and other costs that go into providing that product to the customer. Be thorough in your costing: follow the product from design to delivery, and note every cost that you can. Remember to factor in a certain amount to cover eventualities such as a small percentage of sales being refunded to dissatisfied customers.
Moving on to markup, it’s important to note that profit margins can vary widely between industries. You should check the industry-standard markups that apply to your business before choosing a multiplier to work out a cost-plus price.
One big downside to cost-plus pricing is that it pays little attention to external factors, such as competitor prices, which could profoundly affect your ability to sell. In a perfect business world, cost-plus pricing would work every time – but for many businesses, competition will drive a need to use different strategies, at least some of the time.
Fair’s fair – you just want to sell your product for what it’s worth.
This is the philosophy behind value-based pricing. You ask: how much do consumers think this product is worth? And you set the price accordingly.
There are various ways to determine how much customers believe a product or service is worth. One option is primary market research, which includes methods such as customer surveys and questionnaires. You could also look into market reports on the relationship between price and purchasing decisions in your industry. Your own sales data could also give you an ongoing indication of whether your prices are right for the customer – although other factors such as product quality and marketing strategy are also at play.
Remember to focus on your customer specifically. Not all audience groups will value a product in the same way, so it’s important to set your prices according to your own target customer’s value judgements.
Put it this way: would a London pub price its pints based on a Yorkshire ale-drinker’s value perception? The i reports that the average pint of beer in London costs £5.19 whereas it costs £3.53 in Leeds. The product stays essentially the same, but it’s valued differently in different places, by different audiences. So, when you assess the value of your products, tailor the assessment to people who fit your target audience.
One of the great things about value-based pricing is that it is inherently customer-centric. Prices which are set according to customer opinion should theoretically be perceived as good-value (although this isn’t always the case). Naturally, many brands which use value-based pricing choose to promote their value/affordability in their marketing messaging.
On the other hand, value-based pricing can cause businesses to be excessively subservient to customer opinion. The customer is not always right about the value of a product or service – at least not in terms of assessing a product’s costs and reasonable profit margin – and this can lead to budgetary problems for some businesses using value-based pricing.
One of the simplest types of pricing strategy, competitive pricing means pricing your products similarly to how your competitors price comparable products or services.
The idea is simple:
- Monitor your competitors’ prices on an ongoing basis
- Keep changing your own prices to stay close to your competitors’ prices
If you have lots of rival products and businesses to monitor, you’ll probably want to do this using an automated price monitoring tool. However, if you only have a few key competitors, and prices are relatively stable in your industry, it might suffice to do a manual price check every now and then. To manually check competitors’ prices in other countries, use a VPN to spoof your location.
Tesco advert promoting the supermarket’s price-matching offer.
Some businesses promote their competitive pricing credentials by offering price-matching to their customers: “If you can find a cheaper price somewhere else, we’ll match it!”
The clever thing about price-matching is that the brand is well aware only a small percentage of customers will likely use the offer. competitive environment.
Within any industry, there are usually ‘price takers’ and ‘price makers’. Price takers are brands which base their own prices on their competitors’ prices. Price makers are brands which significantly raise or lower their prices independently, and whom other brands follow in their competitive pricing.
A natural outcome of using competitive pricing is that you become a ‘price taker’. This doesn’t mean you won’t succeed, but it does mean that your pricing strategy is effectively being decided in someone else’s boardroom. And as we’ll see when we discuss ‘predatory pricing’ and ‘penetration pricing’, there are situations where matching another brand on price is not always a safe bet.
When a brand is going to enter a market or launch a product, it may decide to set its prices low for a limited period, in order to drive rapid acquisition of customers. Once the brand has successfully penetrated the market and established a strong customer base, it may then start to increase its prices with a renewed focus on profitability. This strategy is called penetration pricing.
Imagine you’re launching an e-commerce site that will compete against several established websites selling similar products. At launch, you’re at a disadvantage relative to those established brands. They will already have a customer base, they will have learnt things about how to market to their audience, and their established business relationships will help them with everything from sourcing stock to running their website. These are all barriers to entry into the market.
Penetration pricing would be one way for the new business to compete against its better-established rivals. By pricing its products low, for a short initial period or for as long as it could afford, the new brand would give customers a reason to give it a chance, rather than stay loyal to an existing competitor brand.
Penetration pricing is a powerful option to help new brands break into highly competitive markets. However, it is a tactic to be used with some caution. Customers may react negatively when a brand which has used penetration pricing eventually starts to increase its prices.
Arguably, this is what we’ve seen in 2022 with Netflix, which saw an unprecedented drop in subscribers and a $55bn decrease in its value, soon after it announced plans to increase its subscription pricing.
Sometimes, penetration pricing is packaged in the form of promotions, such as discount codes or introductory prices. This approach can be used to do ‘penetration pricing by stealth’, without all of your competitors finding out, since your listed prices should be unchanged.
Penetration pricing overlaps with a strategy known as predatory pricing. This is an aggressive pricing strategy where a brand sets its prices very low, with the specific aim of putting a competing brand out of business.
The most important thing to know about this predatory pricing is that it is illegal in UK competition law, and in some other jurisdictions too.
The illegality of predatory pricing doesn’t stop some businesses from using the strategy, which is infamously difficult to prove in a legal context.
Let’s say you’re launching a new, disruptive taxi service, and you’re going to operate in lots of different cities where there are well-established local taxi firms. You could make the competitive environment in those locations much more accommodating, if you could charge very low fares for an initial period, before increasing those fares after local competitors have been put out of business. It’s easy enough to think of real-world examples of brands which have operated in this way in recent years.
Predatory pricing is not just illegal in many places; it’s also ethically controversial. Sure, there are some who would argue that business is a game, and it’s acceptable to use whatever tools you can to stack the chips in your favour. Businesses might go bust, but that’s the price of progress. But others would say that business isn’t just a game – it’s people’s livelihoods. And through predatory pricing, startups which are not necessarily competitive on quality are out-competing established companies on price, often with the help of massive backing from venture capitalists (VCs).
As Charles Duhigg wrote in 2020, in a New Yorker article which touched on the competitive approach of the co-working brand WeWork, “[There were] similar stories from [multiple] co-working entrepreneurs: WeWork came to town, opened near an existing co-working office, and undercut the competitor on price. Sometimes WeWork promised tenants a moving bonus if they terminated an existing lease; in other instances, the company obtained client directories from competitors’ Web sites and offered everyone on the lists three months of free rent.”
WeWork has fallen from grace in a very public way in recent years – but not before many independent co-working spaces were put out of business due to increased competition in their neighbourhoods. WeWork’s approach to pricing would not have been possible without massive VC funding.
Predatory pricing can go badly wrong for all parties. With that said, it’s important to be aware that there are still businesses out there using this tactic. You need to be ready to identify predatory pricing in your industry, and take legal action to head it off when necessary.
In loss-leader pricing, a brand sells certain products at a loss, with the intention that customers will buy other items – ones that do make a profit – as a result of the loss-leader sale.
The customer might buy the profit-making item(s) at the same time as they buy the loss-leader, or they might do so in a subsequent purchase.
In brick-and-mortar retail, loss-leaders are sometimes used to attract customers into the store, where they may proceed to buy other products as well as the loss-leader. For example, a supermarket might price a loaf of bread at a loss-making price, in the hopes that the same customers who buy that bread will pick up other items too.
Loss-leader items are also used to acquire customers into profit-making systems. In digital services, a software product might be offered for free to most customers. The business makes a loss on delivering the software to these customers – but the expectation is that a percentage of the customers will subsequently buy premium upgrades or related products. This form of loss-leader pricing is sometimes called freemium pricing.
A similar approach can be used when selling ranges of compatible products. One famous example is printers and the ink cartridges that go with them. The printer, which is really quite a complicated piece of machinery with some expensive components, is sold at a loss. But the manufacturer more than makes up for the loss generated by selling profitable ink cartridges and accessories to the same customer.
Loss-leader pricing can be an effective way to make profit in a market where some of your products have too high of a unit cost to sell well at break-even price or higher..
The potential drawback of loss-leader pricing is the risk of customers buying only the loss-leader product, resulting in a net loss on the customer. You can manage that risk with a retention-focused marketing strategy, or in some cases, by making the loss-leader product exclusively compatible with your own profit-making add-on products.
When a highly devoted customer really wants a product – like the brand-new PlayStation 5, a cutting-edge TV, or a garment from the latest Paul Smith collection – they may be willing to pay a premium price at launch.
Other customers who do want those items, but who can’t afford those higher prices or don’t value the item quite so highly, might prefer to wait and buy at a lower price.
This customer dynamic is taken into account by the pricing strategy known as skimming. The brand sells an item at a particularly high price during an initial period, and then reduces the price in one or more steps, selling to customers with a lower price-tolerance at each step.
The beauty of skimming is that it achieves two separate objectives, one after the other. First, it maximises profit-per-unit while items are sold at the higher initial prices. Second, it maximises sales volume (and customer acquisition) at the subsequent lower prices.
Brands like Supreme have become masters at building hype around new product launches.
Many consumers are conscious that certain types of product are likely to become available at lower prices over time. Therefore, in order for skimming to work, it’s crucial to foment a high level of customer interest, or ‘hype’, in advance of product launch. This can be achieved through marketing tactics such as campaigns highlighting the (temporary) scarcity of the product, or PR events that show off product innovations, such as fashion shows and technology expos.
How to choose a pricing strategy
As we’ve seen, there are lots of pricing strategy options to choose from. However, you may find that many of the options can be ruled out through a process of elimination – which makes choosing a pricing strategy much simpler.
WHAT CAN WE AFFORD? → WHAT ARE OUR COMPETITORS DOING? → WHICH STRATEGY OPTIONS ARE LEFT?
Calculating your baseline prices
As we’ve seen, not every product is sold just to make profit. Other common aims include:
- building brand recognition
- acquiring loyal customers
- clearing out excess inventory such as product components
With this in mind, a good place to start with pricing strategy is defining what range of possible prices your business can afford. In particular, what is the acceptable baseline price for each product? Finding this will enable you to consider pricing strategies such as value-based pricing and penetration pricing, while you create the conditions for future profitability.
The first step in calculating the baseline price for a product is to work out its break-even price. If the product sells at this price, you get back exactly the same amount of money you spent producing or manufacturing it and fulfilling the customer’s order.
You can use this simple formula to calculate their break-even price:
fixed costs + variable costs = break-even price
Fixed costs are costs of delivering the product which stay the same over time, e.g. warehouse leasing, insurance payments. Variable costs are costs of delivering the product that can go up or down, such as the cost of materials. If there are variable costs involved in producing/delivering your product, you’ll need to account for the variability in your costing.
Once you’ve worked out your break-even price, you can calculate your baseline price. This is the lowest price at which your business could potentially tolerate selling the product.
Please be aware that selling below break-even price is not the right choice for every business. There’s no reason why your baseline price can’t be the same, or significantly higher than your break-even price. If this applies to you, skip ahead to the next sub-header.
If you’re happy to go below break-even for strategic reasons – e.g. penetration pricing or value-based pricing – then you’ll need to consider how much capital you have in reserve to cover the costs. This could come in the form of funding from a venture capitalist (VC), who invests money into the business in exchange for shares. Or, it could come from the business’s cash reserves, a bank loan, or your own investment.
Calculate how much money you could potentially afford to lose on each sale, based on your projected sales, and then deduct that amount from your break-even price to arrive at your baseline price.
Another factor which strongly influences the pricing strategies available to a brand is the market: how much are competitors charging for comparable products or services? Many of the pricing strategies you might choose, including cost-plus, value-based and competitive pricing, depend on this knowledge.
So, before you price your own products, do an in-depth price analysis of your nearest competitors.
You may find that competitors’ prices are lower than the totals you worked out as the baseline prices for your products. If that’s the case, you may need to reconsider your offering. How can you justify premium pricing to the customer/client?
Now that you know your baseline price and your industry price benchmarks based on competitor prices, you should have a relatively narrow range of price strategy types to choose from. At this point you’ll need to research the strategies used by comparable brands in previous cases, and choose the strategy that seems most likely to achieve your business objectives. You can then set your prices and enter the market.
Pricing strategy is a fluid tool for business success. Much like other components of marketing such as branding and product, pricing should be continually monitored and evaluated – and you should remain open to changing your strategy when the customer data and the market data indicate that it may be advantageous to do so.
With this in mind, we suggest you continually monitor for change in:
- competitors’ pricing;
- customer sentiment towards your pricing; and
- broader pricing trends in your industry.
Finding the best price for a product is all about analysing the push and pull of needs between your brand and the customer, between you and your competitors, and between your industry and the bigger economic picture. Staying alert to change at these three levels of competition will enhance your ability to make decisions about your ongoing pricing strategy.