Setting pricing strategies can be complicated, but doing it well is essential to the success of your business. In Wikipedia, you can find 23 different pricing models listed along with 9 laws of price sensitivity and consumer psychology. Many companies consider that seeming complexity, and decide they would prefer to simply figure out their costs and add a margin. They just don’t want to tackle that complexity. However, the companies that do it well simplify their pricing strategies to making some fundamental choices about where they will compete and how they will win. They ignore the rest of the noise until those basic choices have been made, and then make sure their pricing decisions are aligned with those strategic choices.
Prior to developing a pricing strategy, a company must establish the business strategy. The leadership team must answer the same questions – “Where will we compete and how will we win?” More specifically, that means identifying which market segments they want to go after, and determining how to beat their competitors (win more customers), and then allocating resources to those segments and those capabilities. The business strategies must not be simple statements of objectives like, “we will grow organically with existing customers and add new products.” Instead the strategies should identify which specific segments and customer needs the company will target, what features are likely to be of sufficient benefit to attract a winning share of customers, and which capabilities are likely to enable the company to deliver those features to those customers. When those questions are answered, it should be much less complicated to set the pricing strategies consistent with the overall business strategies.
For example, if the business has identified target segments that want “white glove” service where their needs are anticipated and met immediately, and the business is built around providing that service better than anyone else, the pricing strategy should be set to both communicate and capture premium prices reflecting the premium service.
At the other end of the spectrum, if the company believes they have a sustainable cost advantage, they are targeting the most price-sensitive customers, products are more commodity-like and it is very difficult to differentiate prices between customers, an every-day low price strategy might be appropriate.
Another variation is a supplier who believes the key to winning customers is to become more ingrained in the customer’s business and provide more value-adds. The more the customer buys and builds the supplier into their base, the less likely the customer is to switch. In such a case the supplier is likely investing in more products and services to meet more customer needs. In such a case, the supplier’s price architecture needs to offer customers incentives to add volume.
Once these basic strategies are in place, it is appropriate to think about tactics that can enhance margins without deviating from the basic pricing strategy. Things like odd-number pricing, variable targets, and even dynamic pricing are more tactical enhancements to the underlying strategy, not strategies themselves.
The other important point is regardless of the pricing strategy selected, costs should not drive prices. Costs are important in determining whether and how much money you make given the prices you can charge, and they can help explain price changes to customers. But customers care about how your product or service benefits them, and that is a measure of value, not cost.
One counter to costs not driving prices is sometimes a penetration pricing strategy makes sense. With a penetration strategy, companies set prices low in order to generate a critical mass of volume quickly and lower their costs of production. When they do so, they can be profitable at those lower prices. However, this would only make sense where the demand curve is steep (think revolutionary products, not me-too products), fixed costs are high, variable costs are low, customers are likely to stay once acquired, and there is an advantage to being a first-mover.
Notwithstanding those instances of creating new markets or introducing revolutionary products, think about business strategy and pricing strategy as making fundamental choices in where you compete and how you win. Make sure they are aligned, and the rest becomes execution.