The pricing strategies are very important for a business. When you buy a product a small one like a pen or a luxury one like a car; you pay something for it, that’s the price tag for that product. Service agencies like digital marketers also charge your business for something. As buyers, you often come across sale price tags, discounts, offers, and promoted prices. How do companies decide, what is the right price to charge? Will you pay $ 10 for a $ 5 ball-point pen?
Pricing is a critical decision in any product or service’s successful launch. The concept of pricing and costing can often be mixed together. Understanding pricing strategies require differentiating between costing and pricing. A cost is the sum of expenses that an entity incurs to make a product or charge for a particular service. A price is what a customer will pay for that product or service. Companies decide pricing strategies on three broad categories’ basis:
- The Cost based approach
- The Demand-based approach, and
- The Marketing based approach.
We commonly divide these broad categories into different pricing strategies.
The Cost Based Approach to Pricing Strategies
In this cost based approach, we divide into 3 sub-categories as follow:
The Cost Plus Pricing Strategy
In this strategy, each entity first determines the full cost of the product or service, and then they add the markup on that cost to derive the desired price. We most widely use this approach as it takes into account for the full cost of the product unit and then adds the profit margin. The cost plus pricing includes both fixed and variable costs and hence is the most comprehensive approach deriving the right pricing decision.
Advantages of the Cost-Plus Pricing Strategy:
- It is the most conventional method of pricing, easy to calculate, and decision making is faster under this strategy.
- This pricing makes sure that full costs are covered, and an appropriate profit margin is added.
- It can be useful for seasonal products where prices are often increased.
- The benchmark rate of profit margin can vary from industry to industry; this approach allows adjusting those margins independently.
However, as in the case of every theory, there are certain limitations:
- When it adds a margin to all costs, companies sometimes loose incentive to reduce costs
- It makes product pricing less competitive as the profit margins are pre- decided.
- This approach ignores the replacement costs associated with products.
The Marginal Cost Pricing
We know the marginal costing of a product is all about the “Contribution Margin”. In simplified terms, the marginal cost is the sales less the fixed overhead costs. The marginal cost pricing is adding a margin to the fixed overhead costs of a product or the service. This pricing strategy aims to increase the contribution margin and minimize the fixed overhead costs.
There are certain advantages and disadvantages associated with this approach:
- This method emphasis on contribution margin i.e. marginal production costs, which makes companies more competitive
- It avoids the overheads apportioning to different segments of a company
- When production level changes, the marginal cost changes which in turn allows for robust marginal cost pricing adjustments
- It favors short term decision making
- As it follows marginal costing, it ignores the fixed costs.
- In the long term, the Marginal Cost Pricing decision may not be enough to cover all the project costs
- This method ignores the market competitive pricing issues
The Target Return on Investment Pricing
In this method, a Rate of return on investment is preset and then added to the full cost of the product or the service. Generally it is more difficult to determine the ROI to adapt and makes the product less competitive in the market. This method only suits the Market leaders who enjoy the premium share of the market.
The Demand-Based Approach to Pricing Strategies
As the name suggests this pricing method adapts to the product demands in pricing decisions. In other words, this approach is directly linked to the price elasticity of the products. In addition, this method follows a simple trend, when the product demands go high the price is higher, when the demands are less the price is set lower. However, it is important to establish a link between the elasticity of the demand and the price of the product. We calculate the price elasticity of demand as follow:
Price elasticity of demand = % change in demand ÷ % Change in the price.
The Marketing Based Approach to Pricing Strategies
There are several types of marketing based pricing methods; these are all closely linked to market competition, segmentation, and buyer behavior.
Market Penetration Pricing
This is a pricing strategy to increase the market share with lower prices. This method is useful especially when each entity launch a new product to make it more competitive and increase the market share quickly.
Market Skimming Pricing
This approach is opposite to that of market penetration; in this method, each entity charges high prices to maximize the initial profits. It is suitable only for market leaders or products with a series of high demand products.
In this method, each entity need to price a total of by-products together, where a low priced complementary product is sold together with the main product. For example, a Smartphone sells with a phone case. The main product is slightly lower in price to encourage buyers to buy a complementary product, which increases the total profitability.
This is a marketing pricing method where each entity set the price in odd numbers to make a psychological impact on the customers. Retail markets often use this method to increase sales.
Different pricing strategies have their benefits and limitations. Cost- based pricing strategies are more suitable in situations where the cost margins are tougher to beat. The demand based and marketing pricing strategies are set according to the product demand, market segmentation, and customer buying behaviors. For strategic success in long term a mix of suitable pricing strategies complementing each other will yield the maximum profitability to any business.