How to Choose the Right Pricing Strategy for Your Business
Researching how to price a product might feel like an endless black hole, but as we’ll explain, the compact size and flexibility of your small business put you in a good position to make it work. To begin with, there’s no one strategy that should be used at any one time, and no demand for you to stick to the one you choose.
- Full cost pricing
- Price creaming
- Freemium pricing
- Loss leader pricing
- Pay what you want pricing
- Penetration pricing
- Premium pricing
Getting started with pricing strategies
Getting your pricing strategy right is important for your business’s sustainability. If your prices are too high, you’ll struggle to sell; too low, you won’t be able to cover your costs. Setting your pricing is one of the first things to do when starting a new business. It forms an important chapter in your business plan, and arms you with the knowledge to sway investors. And when it’s time to scale, your pricing strategy will heavily influence how that happens.
The factors that influence and affect the pricing of your products include:
- Their value — be that how much it costs to make them or (in the case of services) the time and expertise they demand
- The fixed and variable business costs you need to cover
- The spending power of your target market
- How your competitors price their products and services
Common pricing strategies for small businesses
Pricing strategies can be overlaid, used at strategic points throughout the year, implemented as a reaction and more. It’s unlikely you’ll ever need to use just one strategy, and likely that the strategies you choose today will get tweaked in the future as you grow and develop.
Full cost pricing
With the full cost pricing strategy, the production costs of a product (material, manufacturing and labour costs) are added to the selling and admin costs (accounting, legal, marketing, facilities, sales and corporate costs), before a markup is added to create a profit margin. This number is then divided by the number of units the business expects to sell.
(Total production costs + selling and administration costs + markup) ÷ Number of units expected to sell
- Simplicity: the formula is simple to understand and use.
- Profit-focused: the formula is designed with profits in mind, so if your predicted costs and sales aren’t too far wrong, a profit isn’t far away.
- Easy to justify: your prices can easily be explained.
- Budgeting basis: the formula is based on predictions, which will probably lead to some inaccuracy.
- Uncompetitive: the formula doesn’t take into account competitor pricing or consumer spending power, which may lead to under- or over-pricing.
- Hard to scale: the more products you add to your offering, the more tricky it is to allocate their individual costs.
Creaming (also known as “skimming”) is where a business initially sets a high price for its product, before gradually reducing it over time. Price creaming works best if you’re bringing a new concept to the market where very few or no other competitors are present: your business brings an original and desirable product to market, as there is high demand, customers are happy to pay a premium price. You then gradually reduce prices as both demand decreases and competitors begin to emerge, known as “riding down the demand curve”.
- Captures a surplus: you can capture the majority of the market at a high price point, giving you the monopoly.
- Recoups startup costs: it quickly captures the market at a high price point, giving you high returns early on in your business’s lifetime.
- Demand for absolute originality: this strategy is limited to businesses who are bringing something entirely new to the market.
- You have to move fast: lower-priced competitors can enter the market and snatch the surplus away from you if your marketing and sales efforts don’t prompt sales quickly enough.
Freemium pricing is used a lot by digital companies, like software providers and game developers. It works by drawing customers in with a basic, free product, then charging a premium price for add-ons, like more storage or additional tools.
- Good for growth: by welcoming in customers for free, you can quickly grow your user base.
- Good for testing: it’s an easy way to get more people to test your product without high marketing costs.
- It’s free: it’s harder to break even when you rely solely on people buying add-ons, or making money through other means such as advertising.
- Except it isn’t really free: “nothing in life is free” goes the saying, and as more companies use the freemium model, customers are getting savvy with what they sign up for.
A loss leader pricing strategy uses a product sold at a low price (often below the cost it took to make it) to encourage profitable sales of other products. The psychology behind this is that if you can draw a customer in to buy “bargain” items, you can then upsell higher-priced items. Businesses with physical stores often place loss leader products far from the entrance, so that customers are exposed to higher-value products en route.
- Increases footfall and loyalty: customers know where to go for a bargain, and they keep coming back.
- Inventory cleansing: items that are hard to shift can be paired with high-value products when you’re clearing out inventory.
- Questionable profitability: because the loss leader itself is at or below cost, you absolutely rely on the appeal of your high-value items.
- Research is needed: you need to be spot-on when choosing your loss leaders, so that they and the high-value items shift.
Pay what you want
As you’d expect, the pay what you want pricing strategy asks the customer to choose their purchase price, sometimes with a minimum price in place. This strategy is best used only occasionally, for example when you’re testing a new product or running a promotion.
- Promotion: it’s a great way to showcase new products and get customers hooked so they pay in future.
- A temporary tool: unlike a lot of the other pricing strategies we’ve mentioned, it can be used in short bursts to instantly drive certain customer behaviours.
- It takes thought: too many pay what you want incentives will desensitise your customers.
- Non-returning customers: many customers will try the product and never come back.
A penetration pricing strategy sets product prices low to gain market share through customer volume. The price is gradually raised over time as you make that gain. Done right, it can discourage new competitors who simply don’t think it’s worth their time to contend with such good value being offered.
- Great for new businesses: this is a solid strategy for new businesses building their niche and carving out a safe place among their competitors.
- Long-term impact: the theory is that by creating demand with a bargain product, you create higher demand and higher price potential for the future.
- Maintaining quality: if the quality of the product remains unchanged, or if you fail to create a positive brand experience, customers may buy from competitors when you raise prices.
- Perceived value: if you decrease the price too much, any future increases might be met with resistance from customers.
A premium pricing strategy keeps the price of a product or service high to encourage sales. It’s a method that uses the psychology of “you get what you pay for” — from the luxurious connotations of certain watch brands, to the perceived ethics of organic food products. New trends, social consciousness and social aspiration are three big drivers of premium pricing.
- Great for many small businesses: many small businesses have built their brand around a social, environmental and welfare-based awareness — perfect for premium pricing.
- Entry barrier: if you get your branding right, competitors may be put off by the marketing investment required to justify their own version of a product.
- Branding cost: a premium pricing strategy is driven by a strong brand and proposition — something that takes time, skill and money to build.
- Market limitation: the high price point of your products will only attract certain customers, this means your overall market penetration may be limited.
How to price a product
To price your products so that they drive cash flow, you need to be clear on these things:
- The cost of producing your product, or
- The value of your services to your clients
- How much your customers have and want to spend
- The overall running costs of your business
- What critical costs need to be covered short-term (e.g. loan repayments)
- How your competitors price their products
Your pricing should take all of these into consideration with the ultimate goal of making your business profitable. What that looks like is different for everyone, and could require any number of pricing strategies. You may even uncover a need to tweak your business model through the process of setting your pricing strategy. This includes things like cost-cutting, restructuring your team or developing your brand.
Pricing strategies aren’t for life. All businesses test and change over time, and your compact size and management structure make it far easier to make changes quickly. Your sales are a good source of proof when deciding if and when those changes need to be made. So it pays to have an integrated payments system that tells you how much your selling, when and to who. To find out which payments and business tools would suit your business best, you can contact our sales team.
This article is intended to offer helpful guidance and does not constitute qualified financial advice. Please consult an accountant or financial advisor if you have any questions related to your business.
How to Choose the Best POS System For Your Business
How to Update Your Business Plan
Tips for Managing Your Costs as a Business Owner