Using the right pricing strategy can make the difference between success and failure for your business. If you do it right, you will win customers and beat the competition. Get it wrong and you could end up either putting off customers with high prices or dropping money by undercharging.
Don’t believe me, believe legendary investor Warren Buffett, who said:
“The most important decision when evaluating a company is pricing power. If you have the opportunity to go up the prices without losing business to a competitor, you are in very good business. And if you need to have an hour of prayer before you increase the price by 10%, then you have a terrible business. “
There is one problem, however. If you read the marketing textbooks, you will learn about dozens of different pricing strategies and they can all be very overwhelming. The good news, however, is that most of these different strategies can be broken down into three main categories:
In this blog article, you will learn the basics of each approach, the pros and cons, and situations in which you can use each of them. In the end, you will be ready to choose the right strategy for your business to gain a critical competitive advantage in a tough market.
1. Cost-based pricing
Cost-based pricing is the simplest of the three main pricing strategies. So let’s start here.
If you want to run a successful business, the first thing you need to do is cover your expenses. Cost-based prices are therefore very useful. You add up all the various costs of making your product or providing your service and adding a markup to get the profit you want.
The benefits of this approach are logical, easy to understand and ensure that with every product you sell, you get at least your cost. Customers also like it because it makes sense and connects the price they pay with a tangible price.
On the flip side, just looking at cost can make you uncompetitive, especially in companies where your costs are high early on. And there’s also the possibility that your customers will actually be willing to pay more than just the cost of production plus a mark-up, so you can end up putting money on the table.
How to calculate cost-based prices
It sounds easy, but it is not always easy to calculate the cost. After all, you need to consider not only the direct cost of each product, but also the indirect costs associated with running your business, reaching customers, and so on.
Check out our article on what freelancers should be calculating.
Back to what I was saying, let’s look at an example to make it clearer.
Let’s say I run a t-shirt business. My process involves buying simple t-shirts, adding my designs, and selling them online. I will calculate my total cost using purely hypothetical numbers.
Each plain t-shirt costs me $2 to buy, and the printing adds another $3 per shirt. So the cost of the raw material is $5. Also, I spend an average of 10 minutes of my time, which I estimate at $30 an hour. That’s another $5 in labor costs.
In addition, I have fixed costs. I spend $45 a month on my design software and $55 a month on running my website, email newsletter, and so on. I spend $500 a month on office rentals and $100 a month on other overheads. So that’s a total of USD 700 in fixed costs.
On average, I sell 350 shirts a month, so the cost of those overheads is exactly $2 per shirt (700/350)… That’s the beauty of hypothetical numbers!
Right now my cost per shirt is $12. So $12 is the minimum I can charge for any t-shirt. If I have calculated my costs correctly, everything about it will bring clear profits.
(Note that this is a simplified example. In reality, a company would likely have a lot more costs, such as sales and marketing, the time it took to get the original designs, etc.). Make sure you list everything and take everything into account. )
Now I just apply it to every shirt so I can make a profit. That is the purpose of being in business, not to cover your expenses, but to make a profit so that you can pay yourself a good salary and invest in future growth.
For example, I could add a 25% markup or $3 per shirt, which would result in a price of $15. Well, I’d actually make it $14.99 because of the rules of price psychology, but you got the idea. You can experiment with different markings and note that they are very different.
2. Customer-based pricing
As we saw in the last section, cost-based pricing is a simple and easy-to-understand pricing strategy. But it also has a serious flaw: it does not take demand into account.
What if customers don’t buy your product or service at the price you set? Or what if the demand for your products is so great they are actually willing to pay a lot more than your cost-based price ??
Because of these constraints, many companies prefer to set their prices based on the customer’s perceived value rather than the cost of production.
But how do you define this value? Let’s look at an example.
In this case, I run a web design studio. My company produces eCommerce websites that are so well designed and intuitive that customers can use them, so our previous customers reported a doubling in sales after implementing our new website design.
Based on this, I decide to charge $10,000 for our services. This may sound like a high price tag, but it will offer very clear value for any business with a decent amount of online sales. For example, a company currently making $20,000 a year can expect that number to double to 40,000. This means that the new website will pay for itself within six months. For a bigger company, it’s even better business.
Notice that in this example I didn’t even mention my company’s cost. It doesn’t matter whether the actual cost of providing the website to the customer is $5,000 or just $500. All that matters is what it’s worth to the customer. If they’re happy to pay $10,000 and they have a clear purchase value, the price is justified.
3. Competitive pricing
So far we have set your prices according to your costs and your customers. Of course, your company doesn’t work in a vacuum. You have competitors, and those competitors have their own pricing strategies that you need to consider.
As a result, some companies choose to adjust their prices to the competitive conditions.
In the UK, for example, retailer John Lewis has successfully used the “Never Knowingly Undersold” slogan for almost a century. It reassures buyers that the prices they find in John Lewis are the best and that if they find a cheaper item elsewhere, they can get a refund for the difference. Walmart is taking a similar approach in the United States.
However, it is important to note that competitive pricing often undercuts the competition, but this is not always the case.
For example, have you recently been to an Apple Store? If so, you will find that the company has a premium pricing strategy. Whether it’s an iPhone, laptop, or just headphones, the price tag is often higher than that of competitors. The price may put some buyers off, but Apple knows it will attract others who consider Apple’s products to be of higher quality.
Other companies do the same. Think of Mercedes or BMW cars – or, at the even higher-end, Ferraris or Lamborghinis. Think Gucci ties and Tiffany jewelry. Premium pricing strategies are surprisingly widespread.
A beer brand, Stella Artois, had a long-standing advertising slogan in Great Britain that perfectly sums up the price level of premium products: “Reassuringly Expensive”.
If you want to implement this strategy, do some competitive research and find out which competitors are charging similar products or services.
Once you’ve gathered the competitive data, all you have to do is decide which approach to take. Attract your customers at lower prices or position your products as “reassuringly expensive”.?
Choosing the right pricing strategy for your business
How do you decide which pricing strategy is right for you?
First, think about the industry you are in and the value you offer your customers. While there aren’t any strict rules, there are some guidelines on which strategies are best for which types of businesses.
Cost-based pricing can be effective for traditional, well-established companies that have a clear picture of their costs and want to make sure they are making a clear profit. Oftentimes, companies that manufacture physical products find it easier to calculate the cost of production per item.
The main disadvantage of this method is that it does not take into account demand, so you can get competitive prices. This is especially true for startups, which can incur high costs. However, at the other end of the scale, you may be undercharging and missing out on opportunities to make a higher profit margin.
If your company has a clear competitive advantage, customer-centric pricing may be better for you. This allows you to charge more knowing you are providing customers with such high value that they’ll happily pay.
The danger with customer-based pricing is that you alienate customers who compare your prices to what they believe a product or service must actually cost and conclude that it is too high. You can also be undercut by a new competitor who offers a similar service at a lower price.
On the other hand, if you find yourself in a highly competitive market with multiple companies offering very similar products, competitive pricing might be right for you. You can stand out from the competition and distract customers from the competition depending on how you position yourself.
The danger here is that you will get drawn into price wars that will undermine or even destroy your profit margins.
Mix and match
It’s worth noting that in this article, I’ve broken the strategies down into very different sections, but in reality, you might find yourself using a mix of different pricing strategies.
For example, you might want to use the cost-based method to ensure that you are at least covering your base costs and making a profit. Then, however, you can do some customer research and find that you can justify charging a far larger markup than you planned. However, you always monitor your competitors’ prices and make sure they are undercut at every opportunity.
What is right for your company will depend on many factors including your industry, size, and overall strategy, and business plan. Take the time to assess your needs and decide which pricing strategy or combination of pricing strategies is right for you.
Hope you enjoyed this pricing strategies overview. Pricing can be a complicated line of business, but with the knowledge you’ve acquired in this tutorial, you should have a better understanding of some of the underlying principles and be ready to choose the right pricing strategy for your business.
If you’d like to learn more about it, take a look at these other Envato Tuts + tutorials. The first looks at price psychology and reveals some surprising findings from scientific research on consumer behavior. The other involves some effective strategies to increase prices without losing customers.
Within the three broad approaches we looked at today, you can choose between different pricing structures, such as: Bundling, product line pricing, freemium model, dynamic pricing, subscription pricing, etc. I’ll cover all of these topics in a future article.
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