Penetration pricing and price skimming are two contrasting pricing strategies. Both strategies come with different objectives.
Let us discuss what are penetration and skim pricing strategies and their key differences.
What is Penetration Pricing?
Penetration pricing is a pricing strategy where the seller sets low prices initially. It aims to attract more customers and quickly penetrate a market.
When the seller company sets too low prices, it is also called predatory pricing. This pricing strategy sets very low product prices to capture market share.
The market penetration pricing is set by new market entrants. Usually, these companies are the market challengers rather than market leaders.
How Does Penetration Pricing Work?
The market penetration strategy works for new entrants with existing products. It is used when a company’s product does not have any differentiation or a competitive edge over rivals.
The company analysis its marginal cost of production. Then, it considers the market prices of the competitors.
For penetration pricing to succeed, the seller’s prices should be visibly lower than its competitors. Market challengers often achieve this objective by setting very low profit margins.
Once a low price is set, the product is launched in the market with to drive big sales up front. The low profit margin is compensated by high volume sales initially.
A company using penetration pricing would also want to lower its cost of production. Otherwise, it will be unsustainable for the company to operate with a very low profit margin.
Objectives of Penetration Pricing
Market penetration pricing is used by companies without a competitive edge over rivals. It comes with a few objectives to gain profits.
The foremost and important objective of penetration pricing is to derive economies of scale. It means the company aims to generate high volume sales with low product pricing.
The next objective is to capture the market share as much and as quickly as possible. Since the company’s only advantage here is to offer lower pricing than its competitors, it is a risky strategy.
Finally, the company aims to establish brand loyalty. Once it captures the market share, it can establish its customer base. It can later increase prices if it sees loyal customer followership.
Pros and Cons of Penetration Pricing
Penetration pricing offers some advantages and disadvantages to its users.
Advantages of the penetration pricing strategy include:
- It offers a high adoption rate of customers as customers usually accept low prices.
- It helps the seller generate high economies of scale.
- It creates and increases brand loyalty.
- It helps a company regain or capture the market share.
- High volume sales also mean high inventory turnover.
- Market entrants can also this pricing strategy to block other entrants and reduce market competition as a result.
A few disadvantages of the market penetration strategy include:
- It only works when the seller has developed low-cost operations.
- It is not sustainable in the long run.
- The seller may lose the market share again when prices are increased.
- It may result in compromised product quality and customers may not accept the product at all.
Suppose a company ABC wants to enter into a new market X. It produces LED energy bulbs that are priced at $10 on average by its competitors.
ABC company has developed a low-cost operational efficiency. It estimates a low price of $6 per unit to attract more customers.
ABC company’s new price is set at the break-even point. The company expects to capture the market share in the beginning.
Later, the company can gradually increase its prices up to $9 per unit. While it increases its profit margin, the final price per unit still remains below the competitor’s price.
What is Price Skimming?
A price skimming or skim pricing is a strategy where sellers set a high price initially. This pricing strategy targets high profit margins initially.
Skim pricing is used by established market players. It is often used by market leaders that rely on innovative products.
Price skimming is suitable for companies that have product differentiation over competitors. This strategy sets high product prices to maximize early profits.
Skim pricing then lowers the prices gradually to retain customers. However, most of the profits earned through this strategy are in the initial phases.
How Does Price Skimming Pricing Work?
The price skimming strategy is useful when a company introduces new products or services. The product or service must also contain a competitive edge over its rivals.
It is used by companies already holding the market share. This strategy is often deployed by companies enjoying brand loyalty from their customers.
The seller sets a high product/service price initially. The objective is to maximize profits through higher profit margins.
A skim pricing strategy derives low sales volume initially. However, as the profit margins are higher, the gross profits for the company are higher in the beginning.
When the market competitors launch rival products with lower prices, the market leader can reduce its prices to match the competition.
The price skimming strategy cannot be applied for the long term though. New entrants or market challengers would often lower their prices to regain the market share.
Objectives of Price Skimming
The price skimming strategy aims to generate high profits in the beginning when a new product is launched. It does not aim to capture the market share through economies of scale.
It is also widely used when a breakthrough or prestigious product is launched. A price skimming strategy would set a high price for such products keeping their luxurious status in front of customers.
The price skimming strategy also aims to offer flexible pricing to the market leaders. Once they harness profits through early adopters, they can lower prices in the later stages of the product cycle.
Pros and Cons of Price Skimming
The price skimming strategy offers a few discrete advantages and disadvantages to its users.
Advantages of the price skimming strategy include:
- It generates high profits in the early stages of the product lifecycle.
- It establishes a prestigious brand image for the market leaders.
- It is suitable for companies that maintain a perceived high quality of products.
- It helps the seller recover costs of production, research and development, and other costs quickly.
- It is a flexible pricing strategy that can adjust when competitors react.
Some disadvantages of the skimming strategy include:
- It is a risky pricing strategy as customers may not accept new products at higher prices.
- It does not generate high sales volume so it reduces inventory turnover.
- The high prices with skimming prices are not sustainable in the long run.
- The company may lose consumer brand loyalty when the prices of the same product are lowered in the later stages.
Suppose a company ABC produces smartwatches. It sets the new smartwatch price at $ 1,000 when its competitors are offering at $ 700 on average.
ABC company would have to offer the highest quality and build a brand image that suits its pricing decision. If the customers accept its pricing, it will generate high profits early on.
Then, the ABC Company can reduce its prices (suppose to $750) when its competitors launch similar products to generate profits through economies of scale.
Penetration Pricing Vs Price Skimming- Key Differences
As we have seen, penetration pricing and skim pricing take two contrasting approaches.
Let us summarize some key differences between both pricing strategies.
Penetration pricing is setting low prices of products/services to rapidly capture the market share. Prices can be increased in the future gradually.
Price skimming is setting high prices of products/services to capture high profits in the beginning. Prices can be reduced in the future.
Penetration pricing objectives are:
- Market share capture
- High sales volume
- Create brand loyalty
- Create economies of scale
- Compete with competitors
Objectives of price skimming are:
- Generate high profits
- Increase perceived product quality perception
- Gain early competitive advantage
- Cost recovery with early profits
When to Use
The penetration pricing strategy is suitable in situations when:
- The aim is to reduce competition by creating entry barriers
- You want to compete with rivals
- You need to launch a new product
- When you aim to capture market share
- When there is price elasticity in your existing market
The price skimming is suitable when:
- You launch a new product with differentiation
- There is a low price elasticity or price inelasticity in the market
- You want to attract early adopters
- When there is unknown demand for your product
- Enhance the brand’s perceived quality perception
Penetration pricing generates low profit margins early on. Profit margins increase as the seller gradually increases prices. However, due to the high volume of sales, high total profits can be generated.
Price skimming generates high profit margins early on. However, profit margins reduce as the seller reduces prices in the later stages of the product lifecycle.
Penetration pricing generates high sales volume as low prices attract more customers.
Skim pricing generates low sales volumes as it targets only early adopters.
Product Demand – Elasticity
Penetration pricing is suitable for markets with high price elasticity that increases sales with lower prices. Whereas, skim pricing is suitable for markets with price inelasticity where sales do not increase with a change in prices.