How to price: Strategies for setting prices effectively
This article gives you guidelines on how to price your products and the typical process used in most companies. At a basic level the main constraints on pricing are the costs associated with your offer, customers’ willingness to pay and your competition (see Fig.1). Product costs set a lower limit below which prices are not viable in the long-term. The upper limit is a combination of affordability for your target customers, how they perceive the value of your product and how it compares to the alternatives, e.g. your competition.
The pricing cycle
When launching a product for the first time, pricing is one of many topics that has to be addressed. However, the majority of pricing changes are for products that are already in-life and Fig.2 shows the typical pricing cycle that takes place in most businesses. In some markets this cycle is spread over many years and in very competitive markets sometimes it can all happen in a single day.
At the start of the pricing cycle an initial audit should pull together all the available data and insights. The pricing objectives should be relatively straightforward and flow from your company strategy. The next challenge is to select one or more pricing strategies and then the appropriate pricing structures and price levels to meet the objectives. In many instances these will already be well understood and what’s required is just a tweak to the current pricing levels. Finally, once the pricing has been approved by the business, it must be implemented and the cycle can begin again.
“One of the things I’ve seen quite often is a perfectly good new pricing scheme fail because not enough attention is paid to how to market it. You need to be able to summarise your pricing in 1 or 2 sentences that can be easily communicated by your channels and understood by busy customers with a short attention span.”
James Harvey-Samuel, Pricing Manager, Cable & Wireless
Choosing a pricing strategy
There are 3 basic pricing strategies. Market skimming is setting your pricing high relative to major competitors and is often used if the pricing objective is to maximise profitability. Market penetration is setting your pricing low relative to major competitors and is often used to maximise market share. Finally competitor matching is setting your pricing at a similar level to the competition and is often used to maximise customer retention.
If you’re the only product in the market or have a highly differentiated proposition but can only supply a small proportion of the market, then a market skimming strategy is often best. This allows you to maximise profitability and use your high pricing to limit demand. However, over time, competitors will enter the market and undercut you. One strategy to defend a high-end proposition is to broaden your portfolio to include offers that also address the lower end of the market. Versioning, discussed in the Pricing Structures article, is a great example of this.
Companies usually adopt a penetration pricing approach because they want to grab market share. However, penetration pricing requires an iron-grip on costs and efficiency as it is often only with economies of scale that the product becomes profitable.
Another challenge with penetration pricing is its sustainability; customers buying on price are the most fickle. If a lower-priced competitor with a better operational model comes along (or one that is more desperate) your customers may rapidly churn to them. Japanese companies, in the 1980s, took a penetration pricing approach in hi-tech electronics until they were undercut by Korean and Chinese businesses. At this point their business model had to change to focus on quality, differentiation and brand development.
This pricing strategy results in propositions that are priced at similar levels to the competition. This strategy can be most appropriate where markets are only growing slowly or not at all. In these mature markets any change to pricing can be easily matched by competitors resulting in minor shifts in market share and profit reduction for all. A competitor matching pricing strategy is said to result in a more stable market for everyone. This pricing strategy may also be best for second tier competitors who can align with a strong market leader; for example, second tier competitors without a significantly differentiated offer will price slightly below the leader.
Each of these 3 pricing strategies has their merits and choosing the appropriate one depends on your pricing objectives, where your product is in its lifecycle and how differentiated your proposition is. Pricing strategy usually evolves during the lifecycle of a product category with a tendency toward the average price as markets mature and move into decline (see Fig.3).
Other pricing strategies and structures
These include up-selling where customers are persuaded to buy a more advanced option, cross-selling where customers are persuaded to buy additional products in the portfolio (e.g. bundling) and segment-based pricing where pricing is varied based on different customer segments (e.g. students, employed, people over 60).
Telecoms operators in mature markets often use price complexity to make it difficult for customers to compare offerings with the competition. Supermarkets often use a promotional pricing strategy with a constant set of special offers and discounts.
Cost plus pricing is where an ‘open-book’ approach reveals a supplier’s costs, and a fixed profit margin is agreed with the customer. Although rare, it is seen in some professional services and government contracts.
“In my experience when it comes to pricing for corporates it’s much more about deal pricing than product pricing. Products are bundled in, contract terms are flexed, prices are discounted – anything to get the customer to sign. The challenge for the sales guys is getting past the internal approval committee for these deals. The challenge for product managers is to ensure that these committees clearly understand their underlying product costs and margins so that the business actually makes some long-term profit.”
James Harvey-Samuel, Pricing Manager, Cable & Wireless
Value based pricing
The ultimate pricing strategy is often considered to be value-based pricing. Here the goal is to maximise sales based on the value customers get from your proposition. The challenge however is understanding what customers value and how much they value it. Let’s take a simple example of customer value. Your proposition enables a customer to save 10 hours per month. They are paid £10 per hour giving an annual saving of £1,200. Call this the ‘Objective Price’ for your proposition. The value that customers perceive is affected not only by the objective price but by several other factors as shown in Fig.4.
Within your product category, customers will view your price relative to competitor offers. They will take into account relative market position as well as the value of features included or excluded from each alternative to get to a price they perceive as fair.
Factors that can allow you to charge more are the opportunity value your solution creates, e.g. a solution that frees up valuable time. The brand image of a product might carry desirability that allows pricing far beyond the intrinsic value of what is being purchased, e.g. designer clothes in the fashion market.
There are also significant downward pressures that will affect customers’ perception of your price. Migration and setup costs have to be added in by the user, which may make them want to pay less. People also have to overcome their uncertainty and inertia before they’ll consider buying, and companies typically use price promotions to encourage customers to make a quick decision, e.g. ‘buy while stocks last’. Many companies also offer free trials of products so customers can experience the value before they make a decision to buy.
“It’s important that we do our due diligence and don’t rush in. Once we go to market with a price we have to stick with it. In some of our key markets customers know each other and will soon find out if we vary our pricing.”
Lawrence Poynter, Product Management Director, Infonic
Implementing the pricing strategy
Having a good understanding of what customers value in your proposition and establishing a price is only half the battle. It can be easily undermined by ineffective implementation.
By this we don’t just mean implementation on IT systems, but ensuring adequate training and tools to support all touch points where pricing is discussed with customers. This not only means your direct and indirect sales channels, but also getting buy-in from senior executives that might get pulled into pricing negotiations. Establishing and holding a pricing strategy requires a consistent understanding and communication of the pricing and proposition delivered by these key staff to customers.
As a product manager, you need to ensure regular feedback from the market to monitor the effectiveness of your propositions and pricing. Pricing strategies need to change during a product’s lifecycle, and key indicators that a review is needed include declining market share, discounts failing to drive growth (or becoming the norm) and competitors introducing new offers or aggressive new pricing.
If you work with a pricing specialist, ensure you have a good working relationship and regular communications so you can share pricing issues and ensure they understand what customers value in your product.
What to do if you find your product sucks Having a strongly differentiated product that customers really value is a great position to be in, but so often it isn’t the case. What if you complete your audit and conclude you don’t have any important positive differentiators?
If you are on a par with the market from a customer value perspective and are the market leader by size, your market position and reputation may justify a small premium on the market average. For non-market leaders a small discount on average market pricing might be more appropriate.
If your evaluation reveals you are seriously disadvantaged in the value you deliver to your customers then a low-cost penetration pricing strategy may be the only viable approach. However, if your business cannot support this strategy, a better alternate to a failed launch or pricing re-vamp might be to delay and re-work your proposition to enhance customer value.
As with many aspects of product management, understanding your competitors, your real customer needs, your position in the market and your company’s strategy are the fundamentals on which your price should be built. You should not underestimate the importance of optimising pricing and accept that the pricing cycle with regular pricing reviews and adjustments are an important part of your role. Good luck!