Our guide to pricing strategies

The importance of the right pricing strategy

‘The price is right’ was a popular game show in which the host invited contestants to ‘come on down’ if they guessed the right price of an item. But in business, setting the right price for your products and services is no guessing game. Or at least it shouldn’t be.

The right pricing model can bring competitive gains, and disadvantages if you get it wrong — and even make or break you financially.

Many small and medium-sized enterprise (SME) leaders underestimate this importance and how much time they should spend setting the right strategy.

What is pricing strategy?

Pricing strategy determines the price you set for your products and services. In setting strategies, aim to understand and capture the product or service’s value relative to its competition, and to demand.

Pricing strategies can fulfil many goals. They can maximise profits for each unit sold or from your overall sales. They can also help you defend your market position against new entrants, increase market share, or enter a new market.

Types of pricing strategy

Cost-plus pricing strategy

In this pricing method, sellers establish the price by calculating the variable costs per unit — such as direct labour and materials — then adding a mark-up to cover fixed costs per unit and a targeted profit margin.

For example, your total variable costs for manufacturing one unit of a product are £5. You estimate fixed costs per unit are £4. To cover the fixed costs and leave £5 profit, you price the unit at £14.

Cost-plus pricing is useful for companies with excess capacity, as increasing production will not incur additional fixed costs.

However, the method is limited because it does not benchmark competitors' prices or consider the customer’s perception of value.

Competitive pricing strategy

Competitive pricing selects prices to maximise sales and profits from a product or service relative to its competition. Businesses often use it after the product or service has been on the market for some time, and many similar items have become available – which is often the case with supermarkets and other sellers of commoditised goods.

The seller calculates what price can achieve the most profitable market share, based on competitors’ prices. The price could be in line with competitors or lower to gain market share.

Examples include price freezes and price matching, when one retailer promises to match other's prices. This helps them keep their loyal customer base when others are trying to undercut their prices.

Competitive pricing requires thorough market research and understanding of your target market and where you stand relative to the competition.

Lowering prices can increase revenue by bringing in more customers and increasing cross-selling and up-selling. But if prices are low and costs remain high, this can wipe out your profits. It can also risk starting a price war, in which rival companies repeatedly undercut each other’s prices.

So rather than focusing solely on grabbing market share, find the best balance of margin and market share to achieve long-term profitability.

Economy pricing strategy

Economy pricing is a volume-based pricing strategy in which sellers set prices low to maximise sales and revenue. They typically use it for commoditised goods, like own-brand groceries, that don't have the marketing and advertising costs of branded counterparts.

This is the reason people buy supermarket brand cereal rather than Kellogg’s, for example.

Bundle pricing strategy

With bundle pricing, companies sell several products or services together as a combined unit. The bundled items are usually related, but they can also be dissimilar items that appeal to one group of customers.

With bundled products, the goal is typically to sacrifice some margin per unit to increase sales.

Premium pricing strategy

Buyers tend to assume that expensive items have a better reputation and quality, so premium pricing sets the price high to encourage this perception. An example is luxury clothing or watches.

Signs that customers could be willing to pay more include high demand, barriers to market entry, and few competitors. You may also have no choice but to use the strategy, for example, when you cannot reduce costs through economies of scale.

Premium pricing can be an effective way to differentiate your brand as well as increase profits.

The biggest challenge is creating a brand, product, or service that the consumer believes is worth more, which could require further investment and higher costs.

Value-based pricing strategy

Premium pricing overlaps with the concept of value-based pricing, which means setting prices according to customers' perceived value of goods or services.

It works where supply and demand forces are biased toward the seller — for example, an engineer with in-depth, niche knowledge that few others have. Though he may only work for a few hours, he can charge disproportionately high fees as his knowledge is worth that to the client.

It can also work well when a product or service is customisable, as opposed to commoditised — or where it appeals to consumers' emotional needs, such as cosmetic surgery.

Value-based pricing requires a comprehensive understanding of how a customer values a product or service.

Important questions include whether the product or service is essential, or meets a strong need; but is hard to find elsewhere. Does it provide additional or differentiated benefits to the consumer?

If it is available from several competitors and lacks differentiation, value-based pricing is less suitable.

Skimming pricing strategy

To price skim, a firm charges the highest initial price it thinks customers will pay, then lowers it gradually.

As the initial demand is satisfied and competition enters the market, it reduces prices to attract more price-sensitive customers. In this way, it ‘skims off’ successive layers, or customer segments, as prices reduce.

This can also lead to segmentation, in which different customers pay higher prices for slightly more deluxe or exclusive versions of a similar product or service.

Penetration pricing strategy

The opposite of skimming is penetration, which sellers use to attract customers to a new product or service by offering a lower price during initial offering. The lower price entices many customers and attracts them away from competitors, enabling you to build market share and hopefully keep the new customers once prices return to normal levels.

Examples include an online magazine offering a one-month free subscription or a bank offering zero current account charges for three months.

Predatory pricing strategy

Predatory pricing is used by companies that dominate their industry to undercut competitors on a large scale. They reduce their prices to loss-making levels in the short-term to force competitors out of the market.

Once they have eliminated competition, the dominant firm will have an even larger market share. It can then raise prices to recoup its losses, because consumers have less choice.

The difference between predatory pricing and competitive pricing is the recouping phase, featuring higher prices.

Predatory pricing can be to the long-term detriment of consumers, so is often considered anti-competitive and restricted by competition laws and regulation.

Which pricing strategy is right for you?

Finding the right pricing model for your company requires hard work and dedication.

Calculating costs and comparing competitors’ prices can help you understand what margin you are likely to make. But you must then consider the many other factors mentioned above such as market position, product differentiation and customer perceptions of your product.

You might decide you can maximise profits by cutting prices, improving the perception of quality, maximising sales through bundling, or some other strategy.

Some companies make millions charging ‘low, low’ prices, others with luxury brands and price tags. There’s no universal answer. But the key is to make sure prices match your customer’s perceived value, and to look at all the factors that impact their buying decisions for your products.