How do you best determine the price to charge customers?
Do you look at the competition and price the same as they do? Undercut them a little? What happens if you do undercut them, then the customer still demands further discounts?
Pricing can be difficult to get right. We don’t know exactly how much the other party is prepared to pay, but we need customers in order to sustain and grow our businesses. So how do we ensure money is not left on the table, yet we still make the sale?
This guide looks at a few fundamental pricing techniques, ideas and strategies. We'll look at how to avoid getting caught in the “race to the bottom” scenario of endless price cutting.
Many people believe that when the buyer and seller agree on a price, then the market has arrived at the optimal price.
This is not strictly true.
What it means is the buyer and seller agreed on a price at a point in time. The seller might be desperate to land the next deal simply to make payroll for one more month. He almost feels sick when he accepted such a low offer, but he’ll worry about the fact he’s running into the red next month. Things will be better by then. Hopefully.
Meanwhile, the buyer now has an expectation she can always get discounts if she pushes hard enough. She makes a note to go even harder on price next month. After all, she got the distinct impression the seller had even more room to move.
Getting pricing right is about more than two parties agreeing on a price at a point in time. Pricing is also strategic. Pricing is about the long-term sustainability of a company.
But ultimately, pricing is about value.
What Do Your Customers Value?
Business is about providing and creating value.
You provide a valuable service or product the buyer can’t provide themselves. They then use your product or service, from which they derive, or add, value, and on-sell that value to their customers.
In order to set appropriate prices, you need to understand what your customers value.
How does one restaurant charge more than another in the same area? Why is that one restaurant always packed? It’s probably because they understand what people value. It might be the type of food they serve, or how they serve it, or they have a great view of the sea. Perhaps they do all three well. Their competitors do not.
They probably couldn’t charge what they do if they were two blocks back and overlooked a parking lot. The restaurant that is two blocks back with a view of the parking lot better figure out something else customers will value, or they are out of business.
The first step in determining pricing is to find out what your customers value, then adjust your service, where necessary, to provide that value. In this way, pricing can be seen as intrinsically linked to your positioning strategy. Perhaps customers value a free and easy returns policy (convenience) over price. Perhaps they want individual items packaged together (individual commodity tools packaged together in a stylish box becomes a toolbox gift idea). Perhaps they didn’t want to buy a handbag at all, they just wanted to rent one (bagborroworsteal.com).
The aim of value based pricing is to shift the focus from price to questions of value.
Move To Value Based Pricing
Value based pricing means pricing based on the value you deliver to a customer.
You figure out the value of your product to to the customer, then take a slice of that value to arrive at your price. Your production cost might be $10 per unit, but if each unit provides $1000 worth of value to your customer, then $500 might be a fair price to charge.
In order to price based on value, you need to understand exactly what your customer values and your point of differentiation to your competitors. Your value proposition combined with your price point must be differentiated. After all, it would be difficult to price at $500 if your competitors were pricing at $300, and both provide the same value to the customer.
The Problem With Cost-Plus Pricing
Cost-plus pricing is when you figure out your total costs, then add a percentage, which is your profit.
It may cost you $X to produce and sell a service and make a profit, but if buyers don’t value what you offer, then your price will always be too high. Also, if you use cost-plus pricing and your customer derives considerable value from what you offer, then the customer may love you, but you’re leaving a lot of money on the table. You could be making more profit and using that to invest in your business.
But what if you’re selling the same stuff as everyone else?
The internet can be a hostile place for commodity sellers as price comparisons are only a click away. This type of environment works well for big players who can compete on price when selling commodity items, yet still make money off thin margins and fat volume.
Low-volume competitors would be wise to consider a shift of focus to value-added services, such as higher service levels, if they can’t compete on price.
Best Interests Of The Customer
It might be in the best interests of your customer to pay higher prices if this means the value they seek can be reliably delivered on an on-going basis. If an industry is run into the ground due to price cutting, then where will the customers get the services they really do value in future?
Part of the process of getting pricing right is customer education i.e. ensure they can see the value. Demonstrate what is involved in arriving at your price points. For example, who pays $70 for an ipad cover when you can get them for $10?
People do if it’s a DODOcase.
DODOcase demonstrate what goes into producing their cases. They’re selling the experience and craft values as much as they are selling the product itself, so this is also a way to differentiate the product. Their customers value the idea of supporting artisan crafts, which is part of the value they’re paying for, but this wouldn’t be obvious if their customers were comparing one case against another on price alone. DodoCase have shifted the debate away from price and made it about value. Well, values.
So, customers like to see what goes into the product. It helps them determine value. Transparency is a big part of pricing, particularly high-end pricing. To be credible and survive scrutiny, high end pricing has to to be accountable and make sense.
Knowing what price to set is knowing what the customer values, or can be made to see value where previously they saw none. Always ask questions and refine your offer based on the answers. Do you need to change how you present your existing offers in order to demonstrate value? Do you need to change your offerings to meet the market?
Let’s look at three of the most common pricing strategies.
Skim pricing is when you set a higher price than your competitors.
In order to set pricing in this way, your customers need to perceive that your offer provides them with greater benefits than they will find elsewhere. Apple use skim pricing.
Customers perceive that Apple products are superior to the competitors, so it is therefore worth paying a premium. Whether this is objectively true or not is irrelevant - so long as the customers perceive that value, then it exists. This justifies the higher price. It could be argued the customer also gains social value by paying a high price, as they have something exclusive.
In order to skim price, you need to offer something the customer can’t easily get elsewhere. The customer must place a high value upon your service.
Consultants with proven reputations can use skim pricing, although maintaining a reputation over and above everyone else in crowded, maturing markets can be difficult. Where there are high margins, competitors will soon enter the space offering similar value.
The benefit of skim pricing is that you get to pick off the price-insensitive top-of-the-market clients. Who wouldn’t want this situation?
The downside is that other competitors can move into the price gap, slightly beneath the skim level, then bump up the value they offer in order to challenge the skim price competitor. They may create greater efficiencies, which means their profit margins are the same, if not higher. The value proposition to the customer remains strong, yet they undercut the leader on price.
It is only so long before the leader is forced to drop prices, refine their value proposition, or collapse. Skim market pricing can lead to a rapid erosion of market share if the leader does not stay well ahead of the market in terms of providing value. This happened to Apple in the 1980’s, and we might be seeing this again on tablet devices.
Analysts expressed concerns that Apple risked losing ground to Nokia smartphones in China, while failing to keep pace with Google in the tablets market.....Traders were also spooked by a report from research firm IDC forecasting that Apple’s share of the tablet market will slip to 53.8pc this year from 56.3pc in 2011, while Google’s share will increase to 42.7pc from 39.8pc.
It added that Apple’s tablet share will slip below 50pc by 2016, as total global tablet sales more than double to nearly 283m units in four years as consumers increasingly opt for them rather than personal computers
Apple could skim price when they were early to market with a product no one else had i.e. iphones and iPads. However, as competitors catch up, and make similar products at lower prices, then Apple’s current pricing strategy may hit problems. Apple get around this, to some extent, by using versioning.
Neutral pricing is when you set your pricing at a comparable level to your competitors.
You’d use this pricing method if you want customers to consider other aspects, besides price, when they contemplate a purchase i.e. they can get SEO software tools from company X, but compay Y offers the same tools but with extra support. Neither company wants to engage in a price war, so they will keep layering on more value in order to make their offer more compelling.
If these companies started cutting prices in order to compete, then they’ve got a “race to the bottom” problem. If customers don’t want to pay for the services they provide, that’s fine, but the customer is unlikely to get them somewhere else, so long as these services cost a certain amount to provide. In so doing, this market sector retains value for all players, so long as they deliver genuine value to customers.
This is an especially good pricing model to use if you want your customers to focus on the features of the offer. If you offer more features for the same price, you will likely win.
Penetration pricing is when you set a relatively low initial entry price, hoping people will switch from a higher priced vendor.
Companies looking to gain market share tend to use penetration pricing. Penetration pricing has been a popular pricing model for internet companies, reasoning if they build the audience, they’ll figure out how to make money later. So long as customers place some value on the service, then the company should build their customer base quickly.
There are obvious problems with acquiring customers on a low-price basis. The customers you land are price-sensitive and will likely become non-customers the minute someone else lowers their price, or you increase your price.
You’re still vulnerable to competitors who offer something better, who are more efficient, or have more venture capital to blow through. Even if you set a low price, they can still undercut you.
There’s More To Price Than Price
Some buyers accept that buying on price alone may be a poor strategy.
In the example I gave earlier, the buyer is screwing down the vulnerable vendor to the point where he may go out of business. Let’s say she derives significant value from his company that she can’t readily get somewhere else. Perhaps he’s been a supplier to the firm at which she works for a few years and he really knows their systems. Any new supplier will have to spend time coming up to speed, and this could affect the productivity of our buyer.
The buyer likely has a switching cost.
As a seller, he should have made more effort to understand his value to the buyer, and be able to articulate it in such a way that she saw it, too. A buyer who understands long-term value is less likely to focus exclusively on price. It is to their advantage to nurture the relationship for mutual benefit.
Many buyers crave highly functional partnerships with vendors. If a search marketing vendor invests significant effort to add value to the company to which they supply services, then it is less likely they’ll be replaced on price alone. The longer the vendor works with the company, and the more success they bring to that company, the less likely they are to be replaced.
Sometimes, these customers will still try to play you. They will try to get a lower price. They know they need what you’ve got, they’re happy with the relationship, but they still want to see if they can get you to move on price. They may say they are reviewing arrangements. They may put you up against other suppliers in the form of a, RFP. Some of those suppliers will bid low amounts, which the buyer will then put pressure on you to match.
The way to counter this is to know your value relative to the competition. You can always match with a lower price, just so long as the customer accepts that you will be reducing your features to match those on offer from your competitors. The buyer will either go for it it, meaning price really was an issue, or accept your higher price, meaning value was the main issue. More on this shortly.
You must also understand your bottom line and stick to it. Some customers simply aren’t worth having. If you land them, and make little money or even a loss, with hopes you’ll raise prices later - what happens? The minute you raise prices they go back out to tender again. They’ll just find another low-priced bid.
This is what happens to vendors who can’t differentiate on value.
Make Your Offering More Flexible
If we don’t offer what the market values, then pricing strategies won’t help much.
Businesses must innovate in order to capture new markets and meet demand. Create new products and services. Relying on price increases alone to drive growth is unlikely to work unless people can’t get what you offer anywhere else, and what you’re offering remains in high demand.
One solution is to provide multiple products or service levels. If some buyers are genuinely price oriented, that’s fine, but they get the lower service level. Contrary to popular opinion, most buyers are actually value oriented, and will choose higher value services, so long as they perceive genuine value, or can be shown that by using you then profitability will be increased.
The "Choice Of Three" Strategy
One price methodology involves creating three levels. One low priced offer, one mid priced offer, and one high priced offer. Many buyers, when faced with the “choice of three” will pick the middle offer.
Appliance stores often price this way. They’ll stock two or three very high end, expensive refrigerators. They’ll also stock some basic, cheap refrigerators. Most customers will use those two points as price guides, and buy somewhere in the middle. If the store didn’t carry the high end refrigerators for the purposes of comparison, then the mid-range refrigerators become the highest price offering, and people’s price expectations will adjust - downwards - accordingly. The middle is seen as the “sensible” choice.
So, try pricing your top level offering at skim pricing levels. Include all the bells-and-whistles. Most people won’t pay this price, but between this and the lowest price offer, it helps set buyer expectations. The middle bundle is actually your full price offering, possibly neutrally priced vs competitors, but buyers may see it as the sensible middle ground compromise. Funnily enough, you’ll be surprised at how many people still go for the bells-and-whistle option!
Getting Differentiation Right
Differentiation between bundles (product or service levels) also helps you identify price buyers and value buyers. For this to work, you need to create clear and logical demarcation between offerings, otherwise customers may try to pay the low price, but get you to include high price features.
In service businesses, one way of preventing a customer from trying to get the expensive bundle for the low-cost price is to be transparent about your pricing. Yes, they can have the extras, but they involve X more hours. How many of those hours do they wish to purchase? This is transparent. It makes logical sense. There is no arguing with this position, as everyone understands that time is money.
However you do it, ensure that the transition between price points makes sense. The transition can’t appear arbitrary. The more expensive bundle is more expensive because it has more input costs, demonstrably delivers more value, or both.
Companies who get this wrong typically create arbitrary price settings between bundles. There isn’t a lot of distinction in terms of value between the jumps, or the core offering is not included at the low level.
Companies typically put their core offerings in every package, and add “nice-to-have” features at higher price levels. All customers will want the core offering. Price sensitive customers will settle for the core offering and nothing else. Value customers will likely add the nice-to-haves so long as these extras provide the value they seek.
Once a customer is on board at the low-value level, then they may wish to add extras later, once value has been demonstrated. Many software-as-a-service companies use this pricing strategy. The core product, if it is commodity, is often free. This hooks you into using it, but doesn’t cost the company much to deliver. It’s a loss leader sales-tool.
If you want to use it more - say, add more people or use advanced features - then you move up the scale to higher price points. It’s very difficult for competitors to compete with this strategy, because the core offering is free and the switching cost, whilst possibly not high, still exists. In order to compete, competitors must offer better services or more features, and probably lower prices. This is also the reason the first-mover needs to constantly innovate i.e. add and enhance services in order to stay ahead of the game.
One way to make the middle tier offering even more compelling is to load it with features vs the entry-price option.
The low price offering provides the core product and nothing else. The mid-priced offering, however, is packed full of features. The buyer may not even use many of the features, but they reason that there appears to be a lot more value at that level than the entry level, so opt for the higher price. This is most effective when the low-price option and mid-price option are reasonably close. You often see this approach used with “but wait, there’s more!” offers. They keep loading on the features, so the buyer perceives more and more value.
Pricing Strategies For Software & Information Products
The very first copy of a Windows release costs billions. The customer pays around $40 for that first copy.
Most of the costs in software development and information products are upfront, but the advantage of these types of businesses is that the cost of producing each additional copy is marginal. Microsoft can produce many millions of copies for a few cents each. How does a software business, or information product, go about pricing a product?
Typically, these companies set a low price in order to build momentum, thus adopting a penetration approach. Once the user is hooked in, they then add additional higher value services on top. A good example of this type of strategy is used by the likes of WordPress and Silverstripe. The core product is free, but if customers want enterprise hosting, support of custom development, then they pay a fee.
It can be pretty difficult to stick to your guns, especially if you really need the business.
However, pricing is really a question of value. So long as you’re certain you provide the customer with value they can’t get elsewhere, then you’re in a strong negotiating position.
Know what the customer values. If the customer values the same things from another competitor, and you can provide no added value, then you are vulnerable on price. However, if you can identify something you have the buyer values over the others, then that is your trump card.
You demonstrate your value to the customer. If the customer still refuses to see it, and still screws you down on price, then you can play your trump card. Sure, they can have the lower price, but they can’t have the high value aspects of your service. They can have the basic core service. You could still make the sale, but you should remove valuable features.
For example, service level agreements tend to be structured at various levels and price points. If the customer wants immediate attention 24/7, then they pay top dollar. If they don’t care about receiving immediate attention, that’s fine - they pay the lower price. Give the customer options, demarcated by obvious value, and they can decide for themselves. If you know they really need high value service X, and can’t get it from somewhere else, then you’ll force them to buy on value and drop their low price demand.
As customers, we value sellers differently, unless we’re buying pure commodity. Yet your customers might try to convey the idea that sellers are all the same to them, it’s only about price.
It seldom is. Find out what they value most.
If your primary purpose is to gain exposure in a market, it will be useful to acquire customers who can help spread your message. I know of one SEO service provider who started out by providing five large companies free search marketing services for a year simply so the SEO service provider could be associated with those companies, thereby gaining credibility in the market as a “leading supplier”. They then skim priced for 2-nd tier companies, which were their real targets. The twist here is that the seller places a value on the buyer.
Pricing changes can depend on where in the product life-cycle you are, and what your competitors are doing. If you are the market leader, and using skim pricing, but you competitors overtake you, and offer more value, then it might be time to rethink your pricing. A shift to neutral pricing might be in order, as well as a revision of the offer to match competitors.
If new entrants move into the market and offer low prices, then adopting a penetration strategy might be useful in order to get rid of them i.e. make part of your offering low cost or free. This is a strategy that has been used by airlines facing threats from low-cost competitors. They start up their own subsidiaries and use these to starve the competitors out of the market as a rear-guard pricing strategy.
Know Your Relative Value
Ensure you’re differentiated. List all the products, services and activities you offer. Make a note of what your value is to the customer next to each product or service.
Next, identify your competitors. Identify those who are similar, those who are better and those who are worse. Evaluate their offerings. What are their value propositions? If you can, find out their price points. Where would a customer see value in their offering?
List your offerings in terms of value i.e. High value, medium, and low value. Then grade the level of differentiation when compared with your competitors. i.e. high differentiated, similar, or weaker. Anything high value and differentiated can likely be skim priced, anything similar can be neutrally priced, and anything low consider penetration pricing, or dropping.
Review your margins. Is it even worth offering low priced services? Should you be focusing on delivering more features at a higher pricing level? Should you be moving to a highly differentiated offering? Only you know the answer to these questions, but it's a quick strategic pricing assessment well worth doing.
But what, after all is said and done, the customer still wants a lower price?
But what if the customer still wants to pay the lowest price, even after you’ve made certain they value what you provide?
Some customers simply aren’t profitable. What is worse, they take up your time, meaning you’ve got less time to dedicate to your profitable customers.
So cut them loose.
There is a rule called the 20-255 rule. It’s a revision of the 80-20 rule, and it goes like this:
In an article published in the Harvard Business Review, Cooper and Kaplan reported the astonishing case of a heating wire company which analyzed its customer profitability and discovered that the famous 20 - 80 rule, which would suggest that 80% of profits came from 20% of customers, had to be revised: "A 20 - 225 rule was actually operating: 20% of customers were generating 225% of profits. The middle 70% of customers were hovering around the break-even point, and 10% of customers were losing 125% of profits
Make a list of your customers from most profitable to least. Contact the least profitable clients and try to renegotiate terms. Some will agree to this, others won’t.
Cut those who don’t. This instantly increases your profits and serves as a reminder not to sell to people in future who don’t adequately value what you do.
I hope this article has provided some food for thought on pricing strategy. Pricing is a huge topic, so can't be covered in one article, so if you've got some pricing strategies and philosophies you've found useful, please add them to the comments!
References & Further Reading:
- Pricing With Confidence by Reed Holden. This is a great book on pricing and the inspiration for some of the ideas presented in this article
- Price Theory by David D Friedman
- The Art Of Pricing by Rafi Mohammed
- The Strategy and Tactics of Pricing: A Guide to Growing More Profitably by Thomas Nagle
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