How to Build a Pricing Strategy That Works
Pricing Strategy as part of the four P's
Pricing is often the most daunting part of starting a business. While pricing is not just about money, it is also about gauging your product or service in the market and how customers will perceive it. You'll need to assess the factors that make up your pricing strategy as part of the four P's. When we break down this model and assess the remaining three Ps (product, place and promotion), we might be able to make sense of pricing your product in the marketplace.
A price tag is not just about the money – it's about perception and how you want to influence your customers. It would be best to never settle with the first price that comes to mind. Instead, use this planning stage to think about how you want to frame your business in your customer's minds and what value they will associate with your business.
Value pricing perspective
When it comes to pricing your product or service, many take a value perspective. This means looking at what value your product or service provides for customers and then determining a price that meets their needs while covering your costs. This value perspective will help you set the right price for your product based on what customers are willing to pay. This is known as the value orientation of your customer.
Next is the set of processes you use to capture this value. These processes make up your pricing strategy and can be divided into three main categories: production costs, marketing costs, and distribution costs.
To determine your production costs, you'll need to consider all of the expenses associated with making your product or service. This includes materials, labour, overhead, and other direct costs of bringing your product to market. Once you've calculated your production costs, you'll add on your marketing costs. These are all expenses associated with promoting and selling your product or service, such as advertising, sales commissions, and packaging. Finally, you'll add in your distribution costs. This is everything involved in getting your product or service to customers, such as shipping and handling fees. Once you've added up all of these cost elements, you'll have a good idea of what it will cost to produce and sell your product or service.
Now that you know what it will cost to bring your product to market, you can start thinking about how much money you want to make on each sale. To do this, you'll need to consider two things: profit margins and markups. Profit margins show how much money you're making on each sale after accounting for all of your costs (both fixed and variable).
This type of pricing considers all of the costs associated with producing and selling your product or service. You add a proposed markup or on top of your product or service.
Profit margins show how much profit you're making on each sale after accounting for all of your costs (both fixed and variable). Whereas Markups show how much above those cost items you're charging customers for each unit sold. For example, if it costs £100 to produce one widget and charges £200 for that widget, your markup would be 100%.
It's important to remember that there is no right or wrong answer to setting prices. It all depends on what makes sense for your business and your target market. Suppose you're selling a luxury item like a designer handbag. In that case, you'll likely have a higher price point than if you were selling a mass-produced item like a t-shirt. On the other hand, if it only costs £50 to produce one widget but you charged £200 for it anyway because that's what the market would support, your margin would be 75%. It all comes down to determining what value your product or service provides for customers and then setting a price that meets their needs while covering your costs.
Break-even analysis is a tool that can be used to determine the point at which your business will start to turn a profit. You'll need to calculate your fixed costs, variable costs, and sales price to do this. Once you have those numbers, you can plug them into the following formula:
Fixed Costs / (Sales Price - Variable Costs) = Break Even Point
For example, let's say that your fixed costs are £10,000 per month and your variable costs are £3 per widget. That means that it will cost you £25,000 to produce 5,000 widgets (£10,000 in fixed costs + £15,000 in variable costs). If you're selling those widgets for £5 each, then your break-even point will be 5,000 widgets (5 x 5,000 = 25,000).You need to sell 5,000 widgets every month to cover your costs. Anything beyond that is profit. Of course, this is just a straightforward example. Most businesses have much more complex cost structures with dozens or even hundreds of variables. But the basic principle remains the same: break-even analysis can help you understand how many units you need to sell to cover your costs and start turning a profit.
While break-even analysis is a helpful tool for understanding the financial side of your business, it's important to remember that there are other factors at play as well. Just because you've reached the break-even point doesn't mean that your business will automatically become profitable overnight. You'll also need to consider things like customer demand
marginal math or contribution margin. To calculate your contribution margin, you will need to divide your total costs by the number of units you are selling. This will give you your average cost per unit. You can take your average cost per unit and subtract it from the price you are selling each unit for. The resulting figure is your marginal math. For example, let's say that it costs you £10,000 to produce 1,000 widgets, and you are selling them for £15 each. Your average cost per unit is £10 (£10,000 / 1,000). If we subtract that from the sales price (£15 - £10), we get marginal math of £5. This means that for every widget sold, you are making an additional profit of £5. Contribution Margin can be a helpful tool for understanding how much profit you are making on each sale and can be used to make pricing decisions accordingly.
The Value-Pricing Thermometer
With Value-based pricing, you're not just looking at the cost of production when setting prices but also considering things like the customer's needs and wants, what they would be willing to pay (or True Economic Value), and what similar products or services are selling for.
There are a few different ways that you can go about this. One popular method is known as the "value-pricing thermometer." To use this tool, you first need to identify all of the possible values that your product or service could provide for customers. This could be things like convenience, quality, customisation, etc. Once you have a list of values, you need to rate each one on a scale from 1-10 in terms of its importance to customers.
From there, you can start setting prices based on your product or service's value. For example, if you have a product rated highly in terms of convenience and quality but not so much customisation, you would likely charge a higher price than a competitor who has a product that scores lower on those two values but higher on customisation. It all comes down to figuring out what makes sense for your business and your target market, especially if they value customisation or another criteria you are weak on.
The beauty of using the value-pricing thermometer is that it considers more than just the cost of production when setting prices. It also feels the needs and wants of customers and what similar products or services are selling for to come up with a fair and competitive price point if you're looking for a way to set prices that will maximise your profits while still providing perceived value to customers.
Assessing True Economic Value
It's important to assess the true economic value of your product or service before setting a price. To do this, you'll need to closely look at things like customer needs and wants, what similar products are selling for, the value gap for your product and the next best offering.
Assessing Perceived Value
Perceptions and reality don't always align. This is especially true when it comes to pricing. Just because you think your product is worth a certain amount doesn't mean that customers will agree. Often, TEV is significantly above APV. To find a fair and competitive price point, it's essential to assess TEV and APV when setting prices.
Costs of Goods Sold
Cost of goods sold (COGS) is a crucial metric for any business. This figure represents the direct costs associated with producing the goods that your company sells. COGS includes things like raw materials, labour costs, and shipping. It does not include indirect expenses like marketing or overhead.
Suppose you want to calculate your company's COGS. In that case, you'll need to track all of the expenses associated with producing your product. This can be done by monitoring invoices and receipts from suppliers and recording employee timesheets if you have employees who work on a production. Once you have all of this information, you can add up the total cost of raw materials, labour, and shipping. This will give you your COGS figure.
Knowing your COGS is crucial because it allows you to track your profitability over time. If your COGS goes up, it's costing you more to produce each unit of product. On the other hand, if your COGS goes down, you're becoming more efficient and can have each team at a lower cost. Regardless of which direction it's moving in, tracking this metric is essential for understanding the financial health of your business.
Combining TEV, APV and COGS
After assessing the TEV and APV of your product or service, it's essential also to consider the COGS. When setting prices, it's essential to consider all three of these factors to find a fair and competitive price point. By taking a closer look at customer needs and wants, what similar products are selling for, and your company's COGS, you'll be able to set a price that maximises profits while still providing perceived value to customers.
Some businesses choose to price their products or services based on availability. This means that the number of products available will affect the price. Suppose there is a limited supply of a product. Businesses can charge more for it since customers are willing to pay a higher price to get their hands on the item. On the other hand, if there is an overabundance of a product, businesses may need to lower costs to encourage people to buy it.
Businesses may also offer custom prices to specific customers or groups of customers. This could be based on the quantity being purchased, the customer's location, or even the time of year. Custom pricing can be complex and time-consuming to manage. Hence, businesses need to ensure that the potential benefits outweigh the costs. Additionally, companies need to have systems to track custom prices and apply them correctly.
The availability of a product can change over time, so it's essential to keep an eye on this factor and adjust your prices accordingly.
You can change your prices based on the proximity of your closest competitor; for example, if your nearest alternative is a significant distance away, you may be able to charge more. Another similar example is soft drinks at the airport/train station and on the plane/train.
Pricing for Segments
Businesses need to understand their customer base and what motivates them when setting prices. Market segmentation divides a more significant market into smaller groups with shared characteristics. Segmentation allows businesses to tailor their products, services, and prices to meet the specific needs of each group.
There are several different ways that businesses can segment their markets. Still, some common methods include using demographic information like age, gender, income, or location. Other companies may use psychographic information like lifestyle choices or personality traits. Businesses may also consider behavioural factors like past purchasing history or spending habits. You should combine all relevant factors when segmenting your market. If you would like to know more about segmentation, we have another article you can read on segmentation here.
Pricing Based on timing.
There are a few ways businesses can price their products or services based on timing. One way is to offer early bird discounts for customers who purchase items. This could be for events like concerts or conferences or for big-ticket items like vacations or appliances. Businesses may also choose to offer dynamic pricing, meaning prices change based on demand. For instance, prices for airline tickets are often higher when there is high demand and lower when there is less demand. If you work on an invoice basis, you could offer a discount for early payments and penalties for late payments.
Another common pricing strategy based on timing is seasonal pricing. This involves raising or lowering prices depending on the time of year. For example, many businesses raise prices during the summer months when more demand for their products or services. Seasonal pricing can be a helpful way to boost profits during busier times of the year while still providing value to customers.
Finally, some businesses operate on a subscription basis, where customers pay a recurring fee to access their products or services. This could be monthly, quarterly, yearly, etc., depending on the business and what they're offering. Subscription models can benefit both businesses and customers since they provide a steady stream of revenue for businesses and allow customers to budget more quickly for their expenses.
Customer Price Sensitivity
It's essential to understand how sensitive your potential customers are to price changes when setting your prices. Some customers may be very price-sensitive, meaning that they're only willing to purchase items offered at a discount or for a lower price. Other customers may be less sensitive to price changes and more concerned with the product or service quality.
You can use various methods to research customer price sensitivity, including surveys, interviews, sales data, and focus groups. Once you understand how your target market feels about pricing, you can make more informed decisions about how to set your prices.
Price skimming is a common pricing strategy where businesses start with high prices and then gradually lower them. This allows companies to capture some of the less price-sensitive customers early on and then still profit from the sales of those more concerned with price as the prices drop. Another benefit of this strategy is that it can help create buzz around a new product or service as people talk about the high initial prices.
Penetration pricing is another strategy where businesses initially charge low prices to attract customers and gain market share. Once they have captured a significant portion of the market, they will raise their prices to earn more profits. This strategy can be risky since it requires businesses to spend more on marketing and promotions to attract customers at the lower initial price point. Additionally, there is always the possibility that competitors will enter the market and undercut your prices. However, it can contribute to building a stronger brand. If it is successful, then companies may not need to lower their prices.
Price Elasticity of Demand
It's essential to understand the price elasticity of demand when setting prices for products or services. Price elasticity of demand measures how much demand for a good or service changes in response to a change in price. If demand for a good or service increases when prices are raised, then it's said to be inelastic and vice versa.
A few factors can influence the price elasticity of demand, including the availability of substitutes, the necessity of the good or service, and customer income levels. Businesses must carefully consider these factors when setting prices to maximise profits while still attracting customers.
Don't confuse this with price gouging, which is illegal in many jurisdictions, and immoral in all. This occurs when businesses dramatically raise prices for goods or services after a significant event such as a natural disaster, covid and toilet roll being a prime example. The goal is to take advantage of desperate people who may be willing to pay any price for these items. This strategy can backfire, however, as it often leads to public outcry and negative publicity
Understanding the Economic Impact on the Firm
Profit is the difference between the total revenue generated and the total costs incurred in making and selling the product. Pricing strategies are essential for businesses to understand because they can significantly impact profits.
To conclude, Pricing strategies are essential for businesses to understand because they can significantly impact profits. The two main pricing strategies are price skimming and penetration pricing. Price skimming is when companies start with high prices and gradually lower them over time. Penetration pricing is when businesses initially charge low prices to attract customers and gain market share.
It's essential to understand the price elasticity of demand when setting prices for products or services. Price elasticity of demand measures how much demand for a good or service changes in response to a change in price.
When setting prices, businesses must carefully consider these factors to maximise profits while still attracting customers.