Applying the right pricing strategy can be
the difference between success and failure for your business. Get it right, and
you’ll attract customers and beat the competition. Get it wrong, and you could
end up either deterring customers with high prices or leaving money on the
table by charging too little.
Don’t believe me? Believe legendary investor Warren Buffett, who said:
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.”
However, there’s a problem. If you read the marketing textbooks, you’ll hear about dozens of different pricing strategies, and it can all be quite overwhelming. But the good news is that most of those different strategies can be grouped into three main categories:
In this tutorial, you’ll learn the fundamentals of each approach, the pros and cons, and situations in which you can use each of them. By the end, you’ll be ready to choose the right strategy for your business, giving you a vital competitive edge in a tough marketplace.
1. Cost-Based Pricing
Cost-based pricing is the simplest of the three main pricing strategies, so let’s start there.
If you want to run a successful business, the first thing you need to do is cover your costs. So cost-based pricing makes a lot of sense. You add up all the different costs of manufacturing your product or delivering your service, and add a markup on top to give you the amount of profit you’re aiming for.
The advantages of this approach are that it’s logical, easy to understand, and it ensures that you at least cover your costs with every product you sell. Customers may also like it, because it makes intuitive sense and links the price they’re paying to something tangible.
On the other hand, looking at cost alone can sometimes make you uncompetitive, especially in businesses where your costs early on are quite high. And there’s also the chance that your customers would actually be prepared to pay more than just the cost of production plus a markup, so you can end up leaving money on the table.
How to Calculate and Set Cost-Based Prices
Although it sounds simple enough, calculating costs is not always straightforward. After all, you need to include not only the direct costs of each product, but also the indirect costs involved in running your business, reaching customers, and so on.
So let’s look at an example to make it clearer.
Let’s say I run a T-shirt business. My process involves buying plain T-shirts, adding my designs, and selling them online. I’m going to calculate my overall costs, using some purely hypothetical numbers.
Each plain T-shirt costs me $2 to buy, and the printing adds another $3 per shirt. So the cost of the basic raw materials is $5, and on top of that, I spend on average 10 minutes of my own time, which I value at $30 an hour, so that’s another $5 in labour costs.
But on top of that, I have fixed costs. I spend $45 a month on my design software, and $55 a month on running my website, email newsletter, etc. I spend $500 a month renting an office space, and $100 a month for other overheads. So that’s $700 overall in fixed costs.
On average, I sell 350 T-shirts a month, so the cost of all those overheads is exactly $2 per shirt (700 / 350). That’s the beauty of hypothetical numbers!
So right now, my cost per shirt is $12. So $12 is the minimum I can charge for each T-shirt. If I’ve calculated my costs correctly, everything above that will be clear profit.
(Note that this is a simplified example. In reality, a business would probably have a lot more costs, such as sales and marketing, the time spent on the original designs, etc. Make sure that you list everything and account for it all.)
Now I simply apply a markup to each shirt, so that I can generate a profit. That’s the purpose of being in business, after all—not to cover your costs, but to make a profit so that you can pay yourself a good salary and invest in future growth.
I could, for example, add a 25% markup, or $3 per shirt, which would lead to a price of $15. Well, I’d actually make it $14.99 because of the rules of pricing psychology, but you get the idea. You can experiment with different markups, and keep in mind that they vary widely—here are a few examples.
2. Customer-Based Pricing
As we saw in the last section, cost-based pricing is a simple and easy to understand pricing strategy. But it also has a serious flaw: it doesn’t take any account of demand.
What if customers won’t buy your products or services at the price you’ve set? Or what if there’s so much demand for your products that they’d actually be prepared to pay a lot more than your cost-based price?
Because of these limitations, many businesses prefer to set their prices based not on the cost of production, but on the perceived value to the customer.
But how do you define that value? Let’s look at an example.
In this case, I’m running a web design studio. My business produces e-commerce websites that are so well designed and intuitive for customers to use that our previous clients have reported a doubling in sales after implementing our new site design.
Based on this, I decide to charge $10,000 for our services. This may sound like a high price, but it will provide very clear value to any company with a decent amount of online sales. A company that currently makes $20,000 a year, for example, can expect that figure to double to $40,000, meaning that the new website will pay for itself in six months. For a larger company, it will be an even better deal.
Notice that I haven’t even mentioned my business’s costs in this example. It’s irrelevant whether the actual cost of providing the website to the client is $5,000 or just $500. All that matters is what it’s worth to the client. If they’re happy to pay $10,000 and they get clear value from the purchase, then the price is justified.
3. Competitor-Based Pricing
So far, we’ve looked at setting your prices based on your costs and based on your customers. But, of course, your company doesn’t operate in a vacuum. You have competitors, and those competitors have their own pricing strategies that you need to consider.
So some businesses decide to set their prices based on the competitive landscape.
In the UK, for example, retailer John Lewis has been using the slogan “Never Knowingly Undersold” successfully for almost a century. It reassures buyers that the prices they find in John Lewis will be the best available, and that if they find an item cheaper elsewhere, they can get a refund of the difference. Walmart takes a similar approach in the U.S.
But it’s important to note that, while competitor-based pricing often means undercutting the competition, it’s not always the case.
For example, have you been to an Apple Store lately? If so, you’ll notice that the company follows a premium pricing strategy. Whether it’s an iPhone, a laptop, or simply a pair of headphones, the price is often higher than that of competitors. The price may deter some buyers, but Apple knows that it will attract others, who see Apple’s products as higher quality.
Other companies do the same thing. Think of Mercedes or BMW cars—or, at the even more premium end, Ferraris or Lamborghinis. Think of Gucci ties and Tiffany jewelry. Premium pricing strategies are surprisingly widespread. A beer brand, Stella Artois, had a long-running advertising slogan in the UK that sums up premium pricing perfectly: “Reassuringly Expensive”.
So if you want to implement this strategy, do some competitive research and find out what your competitors are charging for similar products or services. For a comprehensive guide to this process, see the following tutorial:
- Small BusinessHow to Write a Competitive Analysis for Your Small Business (With Template)Celine Roque
When you’ve gathered the competitive data,
it’s simply a matter of deciding which approach you want to take. Entice your
customers with lower prices, or position your products as being “reassuringly
4. Choosing the Right Pricing Strategy for Your Business
So how do you decide which pricing strategy is right for you?
Start by thinking about the industry you’re in and the value you offer to your customers. Although there are no hard and fast rules, here are a few guidelines on which strategies may be best suited to which types of businesses.
Cost-based pricing can be effective for traditional, well-established businesses that have a clear picture of what their costs are and want to ensure that they make a clear profit. Often, the process of calculating a production cost per item can be easier for companies that make physical products.
The main downside of this method is that it doesn’t take account of demand, so you may end up with uncompetitive prices. That’s particularly true of startups, which may have high costs to account for. Or, at the other end of the scale, you may charge too little and miss out on opportunities to make a higher profit margin.
If your company enjoys a clear competitive advantage, customer-based pricing may be better for you. It allows you to charge more, knowing that you provide so much value to customers that they’ll be happy to pay.
The danger of customer-based pricing is that you may alienate customers who compare your prices to what they think the product or service must actually cost to produce, and conclude that they’re too high. You also lay yourself open to being undercut by a new competitor who offers a similar service for a cheaper price.
If, on the other hand, you’re in a highly competitive market, with several different companies offering very similar products, then competitor-based pricing may be suitable for you. It allows you to differentiate yourself from the competition and draw customers away from them based on how you position yourself.
The danger here is that you let yourself get drawn into price wars that erode or even destroy your profit margins. That’s particularly true if you’re up against a large company that can afford to undercut you. I talked about this danger in a recent tutorial:
Mix and Match
It’s worth noting that in this tutorial, I’ve separated the strategies into very distinct sections, but in reality you may end up using a blend of different ones.
For example, you may want to use the cost-based method to make sure that you’re at least covering your basic costs and making a profit. But then you may do some customer research and realize that you can justify charging a much larger markup than you’d planned. You always monitor your competitors’ prices, however, and make sure to undercut them at every opportunity.
What’s right for your business depends on a lot of things, including your industry, your size, and your overall strategy and business plan. Take the time to assess your needs and decide which pricing strategy or combination of pricing strategies is right for you.
I hope you’ve enjoyed this overview of pricing strategies. Pricing can be a complicated area of business, but with the knowledge you’ve gained in this tutorial, you should be clearer about some of the underlying principles and be ready to choose the right pricing strategy for your business.
If you want to learn more, take a look at these other pricing tutorials on Envato Tuts+. The first one looks at the psychology of pricing and reveals some surprising insights from scientific research on consumer behavior. The other one covers some effective strategies for raising prices without losing customers.
- PricingThe Psychology of PricingAndrew Blackman
- BusinessHow to Raise Your Prices Without Losing CustomersAndrew Blackman
Within the three broad approaches we’ve
looked at today, there are several different pricing structures you can choose,
such as bundling, product line pricing, the freemium model, dynamic pricing,
subscription pricing, and more. I’ll cover all of those in a future tutorial.
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