SETTING YOUR PRICE

Let’s say you’re on vacation and want to buy a bottle of water. Now, you could purchase one at the local drugstore for $1, or at the coffee shop for $3, or the theme park for $5. You’re welcome to take the bottle of water that’s sitting in your hotel room, but that will cost you $7, or you could wait until you go to that fancy restaurant for dinner and order a bottle of sparkling water for $12. No matter how much you decide to shell out, you’re basically getting the same product: water, aqua, H20. So why does the cost vary so dramatically? Because each establishment has developed its own pricing strategy based on a detailed set of criteria.

Before you can decide how much you’ll charge for a product or service, you must take into account everything from market to consumer to competition. As with business models, there are many strategies to consider—more than twenty popular ones—but here are five of the most common pricing strategies you’ll encounter:

Cost-plus pricing: By far the most basic, cost-plus pricing combines the

price of producing a product with the percentage of profit the company wishes to make. The result of that equation is the selling price. Let’s say, for instance, that your variable costs (materials, labor, production) come to $8 per unit while your fixed costs are $12 per unit, totaling $20 in cost. To make a steady profit, you want to operate at a 30 percent markup, so you add an additional $6 to the cost, which gives you a total selling price of $26.

Although this model may sound like the simplest way to ensure profitability, its simplicity can also be its downfall. The problem with cost-plus pricing is that it doesn’t take into account important factors like demand and competition. Without having more information about the market, it’s difficult to know if your product or service will be able to actively compete.

Value-based pricing: An effective choice for both product and service

or service provides, not on any actual production costs. Take, for example, the eyewear industry. Whether you charge $50 or $500 for a pair of sunglasses, the production cost varies only slightly. You don’t pay $500 for a pair of sunglasses because the materials cost ten times as much. No, what you’re paying for is the perceived value of those sunglasses (e.g., the belief that you’ll look more fashionable). For this pricing strategy to be effective you must have an in-depth knowledge of your market.

Price skimming: Most business owners think that for profit to be high, the

volume of sales must also be high. But that’s not always the case. Price skimming works the opposite way: relatively lower sales at a higher profit. A good example would be a boutique consulting firm. Instead of trying to secure ten clients at $10,000 an engagement, under this strategy the business owner would seek to gain four clients at a $25,000 price point.

Why would anyone want to adopt a strategy that assumes lower sales? Depending on your business, having fewer customers that spend more money might actually be a better solution. Not only do you create more exclusivity for your brand, the clientele you attract generally tends to become better customers. Of course, the danger with this strategy is that losing a handful of customers at the wrong time can greatly impact your organization. Still, it can be the ideal choice for certain types of businesses, especially service-based companies with premium offerings and deeply loyal consumers.

Penetration pricing: Sign up now and get twelve months of high-speed

Internet service for only $29.99 a month. Sound familiar? That’s a perfect example of penetration pricing. Using this strategy, a business sets low initial rates in order to gain market share and then eventually raises prices. That promise of twelve months of cheap Internet usually comes with the caveat that you sign a two-year contract. And chances are, the second year will be billed at a significantly higher rate than the first. The

key to using this pricing strategy effectively is to be transparent from the start. It’s not smart to hike up your rates without warning your customers in advance. Remember what happened when Netflix did that?

“The price of anything is relative to the price of something else, which means you better know the price of everything you’re competing

against. And that isn’t always obvious. It’s not about how much profit you need to make; it’s about what the market will bear for your product or service, relative to something else.”

Psychological pricing: Let’s go back to the example of twelve months of

high-speed Internet service for only $29.99 a month. Would that deal have been as appealing if offered for $30.00 a month? Experts aren’t so sure. Psychological pricing assumes that certain price points—usually just a few pennies short of the dollar—have a more favorable psychological impact.

For many, the first instinct when thinking about pricing is to charge as little as possible. But that’s not always the best way to go. Undercutting your competition for the sake of short-term gain can be damaging to both your business and industry. The race to the bottom is a quick one, and before you know it you’ll have put yourself out of business. Instead, the smarter choice is to develop a keen understanding of your market and create a pricing strategy that will help your business achieve sustainable growth.