In a recent tutorial, we looked at the main
strategies for your small business. We looked at three main strategies:
- Cost-based pricing
- Customer-based pricing
- Competitor-based pricing
Think of that as the foundation for setting your prices. But no matter which of those strategies you choose, there are many different ways in which you can present those prices to your customers.
You could use price bundling, for example, or price skimming, or a freemium model, or many others. It’s those different pricing structures that we’re going to look at in detail in this tutorial. You’ll learn the ins and outs of seven popular pricing structures, with examples of when each one might be effective.
By the time you’ve finished reading this tutorial and the last one, you’ll be confident that you know how to set prices for your small business in the most effective and profitable way.
1. Price Bundling
My wife hates it when I go to the supermarket. I always come back with bags full of things we don’t need. When she looks questioningly at the twelve avocados I’m unpacking, I say defensively, “They were on special offer! Three for the price of two.”
OK, I admit it. I’m a sucker for price bundling.
I’m not the only one, though. Bundling multiple items together and offering an enticing price for the bundle is a tried and tested way of increasing sales. Customers love to feel that they are getting good value, or something free (“Buy one, get one free!”).
The downside of price bundling, of course, is that you reduce the average selling price of each item, and so you cut into your profit margins. But if you hit the sweet spot, you can still make a good profit. It’s particularly effective if you have a large inventory of products that you need to reduce. Price bundling can clear inventory and bring revenue in quickly.
And, despite my avocado example, this kind of pricing can also be genuinely good for your customers. It can give them a good deal on products they actually want and/or need, and the possibility of getting similar deals in the future can keep them coming back to your business.
2. The Freemium Model
If you’ve spent any time on the internet, you’re likely familiar with this model. In fact, you’re experiencing it right now.
Here at Envato Tuts+, we give away thousands of free tutorials, and we charge people $15 a month for premium video courses. The idea is that the free tutorials give people value and encourage them to use and recommend the site, and then some percentage of those people will sign up for the premium version. Here’s our full pricing structure. The tutorials are “free”, and the courses are “premium”, and the combination of the two words creates a “freemium” model.
The advantage of this model is that you can acquire new customers very quickly. People are more likely to try a product if it’s free, and if they like it, they’re more likely to recommend it to their friends. “Hey, check out this free app!” is something we all like to say.
In the early days of Skype, I remember how amazed people were when I told them you could talk to people on the other side of the world, and it was free! Although millions of people only ever used the free part, it didn’t matter, because they acted as salespeople for Skype. Enough people signed up for the premium features to convince eBay to buy Skype for $3.1 billion in 2005, just two years after it started. Not bad!
Although it can lead to explosive growth, the freemium model doesn’t always work. This Wall Street Journal article gives some telling examples of freemium fails, and it also quotes startup accelerator founder David Cohen as saying that typically only 1% or 2% of customers will upgrade to a premium version.
For the freemium model to work, you need to achieve significant scale, you need to be able to cover the cost of a lot of free users, and you also need to get the right balance between the “free” and “premium” elements. The free part needs to be valuable, but the premium part also needs to offer something clearly different and worthwhile to convince people to upgrade.
If you’re not careful, you can end up with a lot of people using your product and costing you money, but very few of them ever signing up for the premium version.
3. Dynamic Pricing
When you go into your local supermarket, there’s one price for every item, printed clearly on a label on the product or the shelf. Imagine how angry you’d be if you were charged $10 for your pack of frozen pizzas, but the person behind you in the checkout line got the same pack for only $5.
Yet a very similar thing happens all the time in certain industries. It’s particularly common with things like airline and hotel bookings. The prices change all the time based on fluctuating supply and demand, so it’s quite possible that the person sitting next to you paid half your fare.
The dynamic pricing model makes sense for the companies, though. They know that an empty plane flying across the Atlantic has a hefty fixed cost attached to it, so their priority is to fill up as many of those seats as possible.
So if bookings are slow, the prices will go down to encourage more bookings. On the other hand, if lots of people are booking and the flight is filling up, the prices will rise so that the company gets maximum profit out of each new customer. Usually, all of this is done automatically, based on preset computer algorithms.
You could easily apply the same model in your small business. If you’ve hired the local town hall to run a seminar or other event, for example, you might offer cheap tickets early on to get the place filled up. Then, later, you could raise prices as seats are becoming scarce—or run special last-minute discounts if you’ve still got too many empty spaces.
You could even use dynamic pricing for your main products or services. For example, a web design studio could raise prices when it already has a lot of business, and lower them if things get slack.
Just don’t forget that pizza example. You don’t want your customers to be confused or angry when they see other people getting better prices. Clear, honest communication is key, so that people understand the rationale for your pricing.
4. Subscription Pricing
Instead of selling products or services individually, why not create a subscription model, where customers get access to a wide range of them in exchange for a regular monthly or annual fee?
Envato, the company that runs this site, recently introduced a subscription service called Envato Elements. It sells things like graphics, fonts, and web templates—the same kind of products as Envato’s existing marketplace, Envato Market.
The difference is that, whereas Envato Market sells items individually, Envato Elements offers unlimited access to its entire library for a single monthly fee. It’s the subscription model in action.
The main advantage of the subscription model is that it creates recurring, relatively predictable revenue stream. And if it’s done right, the Lifetime Value of a Customer can be higher with the subscription model.
The downside is that it can sometimes be off-putting to new customers because it involves more of a commitment. And there’s always the danger that people join for a short time, download everything you’re offering, and then leave.
To keep customers subscribed for the long haul, you either need to have a punitive cancellation policy, which customers hate (remember that gym membership you’re still paying off?) or you need to keep offering them more and more value and giving them reasons to stay (which is the approach Envato Elements is taking).
5. Price Skimming
Price skimming involves having a high initial price for a new product, and then reducing it over time.
The idea behind it is that different customers are willing or able to pay different prices for the same product. In that way, you could see it as a variation of dynamic pricing. But price skimming is more specific: the price always starts high and goes down later.
Price skimming is often used with new “must-have” gadgets or luxury items, where certain customers are willing to pay a higher price to be among the first people to own them. It’s also common in the book industry, where expensive hardcover books are published first, and a cheaper paperback edition comes out months later.
If you do it right, you get the best of both worlds: higher profit margins from the early adopters, and then a bump in sales when you reduce the prices later on for the more cost-conscious consumers.
This approach works best when you’re launching a product that you know people are anticipating eagerly and will value highly. If you can create a buzz, then people may be willing to pay those higher initial prices.
The downside is that if you price your product too high, you may turn potential customers away. And those customers may never come back, even when you reduce the price later on. Or, as with dynamic pricing, you may get a backlash from customers who see others getting the same product more cheaply. To follow this strategy successfully, you need to have a lot of confidence in the appeal of your product and, again, communicate your pricing very clearly.
6. Loss Leader Pricing
As a small business owner, why would you ever sell a product at the same or even a lower price than you bought it for? Surely that’s a recipe for bankruptcy!
Yes, it would be a disaster if you followed that strategy on a regular basis. But businesses do it all the time on selected products, as a way of getting customers in the door.
The idea is that you offer one product at an amazing price, so cheap that customers can’t resist. They flock to your store, and while they’re there, they notice some of the other things you’re selling (at regular prices), and they buy some of those too.
It’s commonly used in physical shops, but small online businesses can use it too. Customers often comparison shop online, and if they see you selling the product they want cheaply, they may choose your store when otherwise they would have gone elsewhere. And while they’re on your site, they may buy more—especially if you design your sales process to offer them other, related products during checkout, perhaps incorporating price bundling.
The danger of loss leader pricing is that people could end up not making those extra purchases. They come and buy your loss leader, and then leave. In that case, all you’ve made is a simple loss.
7. Decoy Pricing
This is an interesting one—it involves offering customers a buying option that is completely unattractive. Why would you do that? To make another option look better, of course!
I touched on this in my tutorial on the psychology of pricing. I mentioned a famous example of decoy pricing highlighted by behavioral economist Dan Ariely. The Economist magazine at some point offered three subscription options:
- Web only: $59
- Print only: $125
- Print and web: $125
Can you spot the decoy? It’s option 2, of course, where you get only the print magazine but for the same price as both print and web. It’s clearly bad value.
Here’s the interesting part. In an experiment, Ariely found that the existence of that decoy price made people more likely to choose option 3, the expensive print and web option. That’s because it looked like a good deal compared to the decoy, option 2.
But when option 2 was removed, people’s behavior changed. They were faced with just two options, and they mostly chose the cheaper one. So including a completely unattractive buying option actually resulted in more revenue.
If you want to use decoy pricing in your small business, the key is to offer a buying option that’s close in price to the one you actually want people to choose, but is clearly worse value. If you structure it right, your decoy should make the real price look more attractive, resulting in an increase in sales.
In this tutorial, you’ve learned about seven common pricing structures you can use in your small business. You’ve seen how they work, you’ve got an idea of the pros and cons of each one, and you’ve seen some examples of when you might want to use them in your business.
Pricing is a huge area, so in these tutorials I’ve tried to keep it simple by sticking to a few of the most popular strategies and structures. If there’s another aspect of pricing that you’d like us to cover in a future tutorial, please leave a comment below!
A good next step at this point would be to delve into the psychology of pricing. Academics have done a huge amount of research into how consumers respond to different types of prices, and some of the results are distinctly counter-intuitive. The following tutorial will teach you how to profit from some interesting cognitive biases.
And if your newfound insight into pricing means you now need to raise your prices, here’s how to do it without losing customers:
Finally, don’t forget to check out my previous tutorial on pricing strategies if you haven’t seen it yet.