Establishing the proper price for your product or service plays an important role in your business success. A high price can prevent many consumers from using your product. On the other hand, a low price can lead to losses or profit reduction. In this article we will review the famous pricing models for a single market. In addition, we will discuss how to price a product for international markets.
Pricing models for a single market
More than 30 strategies can be used to price products and services. Some of these strategies are applicable for startups and some are not. In this article, we will focus only on strategies appropriate for use by startups and small businesses.
Neutral pricing strategy
This is the simplest pricing strategy you can use to set a product price. You simply find products similar to yours in the target market and use the average price of these products. By doing so, you ensure that your product price is acceptable. In addition, the application of this strategy to any product is quite straightforward. Firms usually apply this strategy when they are trying to maintain their status quo.
Pros and cons
Although applying this strategy is quite easy, many startups don’t use it. All startups are trying to grow their sales as quickly as possible. This strategy doesn’t lead to fast growth. In addition, instead of finding the best price for your product, you are relying on others to find it. In most cases, this price will not be the best one for your product.
Unlike the neutral pricing strategy, the penetration pricing strategy relies on offering the lowest price in the market. New market players usually rely on this strategy to gain market share in the early stage. This strategy can be effective if the market is new and no big player dominates it. Although this strategy may be powerful for startups and new entrants, it can lead to a price war. Existing players would like to keep their market share unchanged. Therefore, they may lower their prices in an attempt to keep their shares unchanged.
Pros and cons
This strategy is used by many early-stage startups to get the biggest possible market share. However, if a startup is offering a service below its costs, it must raise a lot of investment to sustain the business. In addition, some consumers may switch to other service providers once the prices increase to “normal” levels. Finally, this strategy isn’t the best one to apply in mature markets.
If your product is scalable, this strategy may work for you. To learn more about scalable products, please read our previous article How to know if your idea is worth billions. In simple terms, every firm has two types of costs: fixed costs and variable costs. Fixed costs are those expenses incurred regardless of your sales volume, like employees’ salaries, office rent, utilities, etc. On the other hand, variable costs are what you spent to provide / produce additional product units, like raw material costs, payment processing fees, etc. Those companies with a high fixed-to-variable-cost ratio are usually risky but scalable. For example, let’s say your monthly fixed costs are $100,000 and your variable cost per product unit is $1,000. With such a cost structure, if you produced 100 product units per month, each unit would cost you $2,000. If you could produce 200 product units with the same fixed costs, the unit cost would drop to $1,500.
This strategy depends on selling the product below its current cost to increase the production size. When the product size increases, the product may become profitable. This strategy is used mainly by technology firms, especially software ones. The software industry has a very high fixed-to-variable-cost ratio. Accordingly, by selling more licenses, it can cover all its fixed expenses and become profitable.
This is one of the most famous strategies for setting a price for a product or service. To properly apply it, you must know all the fixed and variable costs incurred for your product. For example, if you are offering an online service, your fixed costs can be the salaries of your employees, office rent fees, device costs, software licenses, etc. Variable costs in online services can be payment processing fees (2-4%) in addition to bandwidth and processing fees.
Once you have determined all the fixed and variable costs, you must predict the sales volume. Afterwards, you will need to calculate the fixed and variable costs per unit. The price should be equal to the costs per unit in addition to some margin. For example, if you expect to sell 1,000 units of your product every month, and if your monthly fixed costs are $1M and your total variable costs are $100K, your product unit cost should be around $1,100. If you want to get a $200 profit, you should sell your product for $1,300.
Pros and cons
Cost-plus pricing is one of the most popular pricing strategies in history. The reason for its popularity is its ease of use. Calculating costs to determine price is a straightforward task. However, this strategy can be very dangerous for businesses that have a high fixed-to-variable-cost ratio. In this case, if the product demand dropped, the company would incur significant losses. In addition, this method does not maximize the company’s total profit.
Contribution margin-based pricing
This method is considered an improved version of cost-plus pricing. This method aims to maximize the company’s total profit regardless of the profit per product unit. As you might know, an inverse relationship exists between product price and demand. In most cases, a price reduction will usually lead to an increase in demand. This method focuses on finding the best price and production size for maximizing total profits.
For example, if you can sell 1,500 product units at $1,100 and 1,000 product units at $1,300, and if your fixed costs are $1M and your variable cost per unit is $100, your profit when selling your product at $1,300 is $200K. On the other hand, your profit will be $498K if you sell your product at $1,100. Your total profit will increase because the fixed costs per unit will decrease as you increase production. In addition, the demand on your product will increase once your price drops by $100. This can be true to a certain limit until you reach the maximum capacity of your fixed costs. Finding this point will help you set the price that maximizes your profits.
Pros and cons
Although this method aims to maximize profits, it may not apply to most startups in the early stage. This method requires a long time and lots of research before the product is launched. In addition, it is very hard to predict the demand for a product before its launch. To apply this method, marketers must conduct many interviews, focus groups, and surveys to determine the price-demand relationship for a specific product. Afterwards, they will determine the equilibrium point that maximizes the product profit. This equilibrium point may change if a competitor enters the market. Therefore, continuous effort is required to determine the price that will lead to maximum profits.
Value-based pricing is also a very popular strategy among startups and large organizations. Unlike cost-plus pricing and its derivatives, this strategy relies on setting a price based on the product’s perceived value. Most online businesses today employ this strategy when pricing their products or services. To determine the best price, you must know about the alternatives for your product. In addition, your product must have some unique features that those alternatives don’t offer.
This strategy is often used when some alternatives to your product are available but are harder to use, more expensive, or less efficient. Once these alternatives are spotted, the marketer can determine the perfect price for the product. For example, if you built a product that can save, say, $100 for its users over alternatives, you can set the product price higher than its alternatives by, say, $50. You can justify charging higher fees than your rivals because of the product’s perceived value.
Pros and cons
This method is often used in sectors with a high fixed-to-variable-cost ratio, like the software industry. Building a software product is usually expensive. However, once it is ready, you can sell any number of licenses without incurring additional costs. As long as the product has some unique values and has alternatives, this method can be the best pricing method. According to HBR, if your product is truly unique with no alternatives, value-based pricing won’t work well.
This pricing strategy is usually used by hardware firms that are constantly upgrading their products. Firms that rely on this method set a high price for early adopters. Afterwards, the price will fall until a new version of the product is introduced with better features. This method is very popular in the gadget and smartphone industries. For example, the following graph (taken from PriceSpy) shows the price of the iPhone 7 in GBP since its introduction. As you can see, the phone was introduced with a price tag of £599, then gradually dropped to reach £330 this month. If you will regularly release new versions of your product with better features, this pricing strategy may work for you.
Pros and cons
Although this method can lead to high profits, a lot of R&D is required to continually upgrade the product to justify the high initial price. Early adopters will not bother paying the high price unless the new version of the product offers new and unique features. In addition, this method is applicable to limited products like computers, gadgets, home appliances, etc.
This method is quite popular in online services. In this method, business owners set high prices for their services. To encourage users to use their services, they give away promotion codes that lower the price significantly. These promotion code are valid for a limited period of time. Once this period passes, the customer is charged the regular price. For example, iDrive gives every new customer a 90% discount for the first year. After the first year, customers are charged the regular price.
Pros and cons
Although this pricing strategy is usually more successful than freemium models, it can be hard to prevent users from creating new accounts to get the discount. To apply this method, you must have high product switching costs. For example, if someone has utilized all his/her cloud storage space in iDrive and has decided to switch to another service provider, he/she must re-upload all the files to the new provider. Uploading all these files can be time-consuming, which can be considered a barrier to switching service providers.
Although it sounds awkward, people may prefer to buy expensive products over cheaper ones even if they are the same. Many consumers believe that expensive products must be better than cheaper ones. For example, I tried to buy the domain name “carfinancedeals.co” from Register.com. I found this domain name available for $250. When I tried to buy the same domain from Namecheap.com, I found that its price was $8.88. Although the product is the same, Register.com charges its customers almost 30 times more than other domain name registrars!
Pros and cons
Apparently, if you can convince your customers to pay a premium for your product, you can go for it. However, don’t forget the inverse relation between price and demand. Usually, a higher price means lower sales. In addition, before using this method, ensure that your customer segment can afford such a price. For example, Register.com targets large organizations and business users. This customer segment is not as price-sensitive as other users. Accordingly, Register.com can sell domains for a much higher price tag than its rivals.
Time-based pricing is a form of dynamic pricing based on the time of purchase or receipt of the service. For example, buying a flight ticket three or four months before a trip is much cheaper than buying it a few days before the trip. Those who buy flight tickets a few days early have a much higher need. Accordingly, the airlines charge them more than they charge those who purchased the tickets a few months ahead of time.
Besides transportation, this pricing strategy is common in hospitality, shipping, and freelancing. You can consider this strategy to be a special version of value-based pricing in which time is the primary value upon which you rely when setting the price. Please note that this strategy is effective only if the service time matters to your customers.
Unlike time-based pricing, this strategy focuses on reducing the price based on time. The time-sensitive pricing strategy is usually used with products that have short shelf lives, especially food. Those products that will soon expire are usually sold at much lower prices than fresh products. Instead of losing the whole product, you can sell it at a lower price when it is not fresh.
Pricing for international markets
Now you have determined the perfect product price for a specific market, but what about for other markets? You can sell your product at different price levels depending on the target market. For example, the iPhone X is sold for $1,218 in Switzerland and for $999 in the US. Determining the best price for your product in each market is the best way to maximize your profits in those markets. Here, we’ll discuss two approaches toward determining the best price in each market. We assume that you have already determined the price of your product in your primary market.
Purchasing power parity (PPP)
Purchasing power parity (PPP) is an alternative for using the currency exchange rate when pricing your product. Many political factors and speculations affect the exchange rate. Accordingly, it is not a good idea to rely on it when calculating your product price for international markets. On the other hand, PPP is calculated by comparing the price of hundreds of goods in different countries. Therefore, it is much more reliable than the exchange rate.
For example, if the PPP of your primary market is 1 and the PPP of one of the new markets you want to enter is 1.2, you can sell your product in that market with a price that is 20% higher than what you charge in your primary market. The same concept is used when the PPP in the target market is lower than your primary market. Make sure the new price covers all your costs in addition to making some profit. If the new price isn’t profitable, reconsider entering that market.
Big Mac Index
The Big Mac Index is a form of PPP. It was invented by The Economist to determine the price of a Big Mac across the world. The Big Mac Index can save you a lot of time and effort in pricing your product for international markets. Many international firms rely on it when pricing the same product for different markets. For example, according to the Big Mac Index, the implied exchange rate of Switzerland is 1.23. If we used this exchange rate to calculate the iPhone X price, it would be $1,228, which is very close to its actual price in Switzerland ($1,218).
Besides PPP and the Big Mac Index, many other indices may help you price your product, like the Coke index, cost of living index, etc. In addition, many firms rely on other indices depending on their sectors. For example, if you are selling a software service, you can check on the price of other services, like Google Drive, in your target market. If you are selling phone services, you can check the average minute rate in the target market.
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