To set the floor and ceiling prices, you’ll need to think about the main factors that affect pricing:
- Operating costs
- Inventory levels
- Shipping costs
- Fluctuating demand
- Competitive advantage
- Price perception
Choosing the right pricing strategy
1. Cost-plus pricing
This strategy considers all direct and indirect costs associated with the product or service for sale.
To determine the price, calculate the cost price of your product or service and add a set percentage, i.e., the profit margin. This method is called cost-plus pricing.
Many entrepreneurs and customers think cost-plus pricing is the only way to set prices.
The pros and cons of using cost-plus pricing
Retailers, manufacturers, restaurants, distributors and other intermediaries often think of cost-plus pricing as a fast and straightforward way of setting prices.
Suppose you own a hardware store that sells many different items. Consumers will probably perceive most items, such as nuts, bolts and washers, as low value. In this case, assigning a price by marking up the cost is much simpler.
Eric Dolansky emphasizes the simplicity of cost-plus pricing: “You only have one decision to make: How much of a margin do you want.”
However, cost-plus pricing has one major drawback. It doesn’t consider the customer. If you use this pricing strategy, you may lose potential profit. Customers will see value in some items, such as electric tools or air compressors.
So, you may be able to set the prices for these items based on value using strategy #5 below. This method may have a positive impact on your bottom line.
2. Competitive pricing
This strategy involves constantly adjusting prices to adapt to the competition’s. Eric Dolansky says, “If I’m selling a product that’s similar to others, like peanut butter or shampoo, part of my job is making sure I know what the competitors are doing, price-wise, and making any necessary adjustments.”
With this strategy, you can take one of the three approaches below.
Co-operative pricing
If you choose this approach, your price matches your competitor’s. If a competitor increases their price by a dollar, you’ll raise yours by a dollar. You’ll do the same if they drop their price by a dollar. By doing this, you’re maintaining the status quo.
This approach is similar to how service stations set their products’ prices.
The weak point of this approach, according to Eric Dolansky, “is that it leaves you vulnerable and prevents you from making optimal decisions for your business because you’re too focused on what the competition is doing.”
Aggressive pricing
Eric Dolansky says, “By adopting an aggressive stance, you’re saying to competitors, ‘If you raise your price, I’ll keep mine the same. And if you lower your price, I will lower mine even more.’ You’re trying to increase the distance between you and your competitors. You’re signalling to them that it’s in their best interest not to mess with your prices, or the situation will get much worse for them.”
This approach is not for everyone. A business’ aggressive pricing needs to rise above the competition, with healthy profit margins into which it can dip.
The most likely trend for this strategy is to gradually lower prices. Still, the business may face financial problems if the sales volume drops.
Dismissive pricing
If a business is a leader in its market and sells a high-end product or service, it can opt for the dismissive pricing approach.
Using this approach, you’re setting the price you want and don’t react to what the competition is doing. In fact, by ignoring the competition, you may be able to increase the distance between you and your competitors in the market.
This approach only works if you’re sure that:
- You understand your customers
- Your prices reflect the value of your products and services
- The information you’re depending on is reliable
Still, you may be overly confident. That’s the weak point of dismissive pricing. If you ignore the competition, your business may become vulnerable to market surprises.
3. Price skimming
Businesses adopt this strategy when launching innovative products with no competition. They set a high price to start, then gradually lower it.
For example, your business is launching a new kind of TV. You set a high price to take advantage of the market of tech enthusiasts called early adopters. The high price also allows your business to recover some development costs.
The more saturated the early adopter market becomes, the more your sales will drop. Therefore, you lower the price to target a more price-sensitive market segment.
Eric Dolansky says the business “is betting that the product will be desired in the marketplace long enough for the business to execute its skimming strategy.” This bet may or may not pay off.
The risks of price skimming
When launching the product, the business must convince early adopters that this new, expensive technology is worth it. Success is not a sure thing.
Moreover, over time, the business may see copies of its product enter the market at a lower price. This way, the competition can steal the sales potential at the end of the price-skimming strategy.
Likewise, the business can launch a follow-up product, i.e., a product that improves on or complements the initial product. It may not be able to take advantage of a skimming strategy because it already benefited from the potential of sales to early adopters.
4. Penetration pricing
This strategy is used in a market where many similar products and services are offered and customers are price-sensitive.
“Penetration pricing makes sense when you’re setting a lower price early on to quickly attract a significant number of customers,” says Eric Dolansky.
This way, you’re setting a much lower price to help your product stand out. You can encourage customers to switch brands and create a demand for your product. Consequently, increasing sales volume may lead to economies of scale and reduce your cost per unit.
A business may use the market penetration strategy instead to set a technology standard. Some companies that produce video consoles, like Nintendo, PlayStation and Xbox, have offered them at lower prices, says Eric Dolansky, “because most of the money they make is not from the console, but from the games.”
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