Pricing Approaches: What price makes the most “cents”?
When it comes to pricing your product or service, which pricing approach is the best? Let’s take a look at a few different pricing approaches for you to consider.
I once heard a story about a man that created a machine that could clean spilled fuel from asphalt. He determined he could build the machine and market it for approximately $15,000 so he charged $25,000 for each machine. Now that may not sound very impressive, until you learn that a fuel spill at an international airport may cost over $150,000 per incident. After these airports began purchasing his machines as soon as he could build them, he found himself in an awkward position. He realized that what he was creating was extremely valuable and worth well over his original $25,000 price. He would like to raise the price but worries about damaging the relationships he’s created. Consider how implementing one of the following pricing approaches would have created a different outcome for the man.
Pricing Approach #1: Cost-based pricing
There are essentially two models of Cost-Based pricing; ”break-even” and “markup“.
The break-even pricing approach is used to determine when you can expect a profit on your product or service. The point at witch you will start making a profit is known as the “breakeven point”. To determine the breakeven point you will need to use the breakeven formula.
To find the breakeven point, do so by dividing total cost by number of units produced plus variable costs.
Some major pitfalls of the breakeven formula and the breakeven point:
- Lacks the complete picture – using the breakeven formula to calculate your breakeven point is a great place to start. However, understanding your breakeven point is only useful if you can actually generate the appropriate consumer demand. In other words, if you can’t generate enough consumer demand to actually hit your breakeven point, why even utilize the breakeven formula to begin with? In most cases, it’s almost always best to consider how much consumer demand you can actually generate.
- Not 100% accurate over the long haul – the breakeven formula assumes that your “fixed costs” will always remain the same. While this is true in the present, in most cases, your fixed costs will actually go up as you scale your business. That’s the goal, right?
The markup pricing approach is often used by retailers due to its simplicity. The easiest and most common use is to speak in terms of the “markup percentage”. For example, an investor may ask you, “what is your markup percentage on the product“.
To find the markup percentage of a product simply subtract the total cost from the sales price and divide again by the total cost.
Pricing Approach #2: Profit-based pricing
Probably the most popular model of profit-based pricing is what’s known as “target profit pricing“.
To use this pricing approach, take the following steps:
- Determine the amount of profit you would like to make – the profit figure will be calculated into the pricing equation just like an additional cost.
- Find the sum of your total cost and profit.
- Divide that number by the total number of units.
*As I mentioned before, the main concern with cost-based and profit-based pricing is that the competition and consumer demand is ignored.
Pricing Approach #3: Demand-based pricing
There are many models of “demand-based pricing“. Let’s take a quick look at market skimming, penetration pricing, prestige pricing, and bundle pricing.
- Market skimming – market skimming is when the initial price is extremely high and reduced slowly over time. This allows for businesses to recoup from production quicker but only in markets where consumers are willing to pay higher prices (think about flat screen TVs).
- Penetration pricing – penetration pricing is, essentially, the opposite of marketing skimming. Penetration pricing is when a business is try to “penetrate” the market using pricing in order to capture market share. To increase their market share, a company will typically offer discounts and rebates and then gradually remove them once they approach their market share goal.
- Prestige pricing – is used to try to communicate the value of the brand (think about Tiffany).
- Bundle pricing – has become wildly popular due to the home cable and phone companies. Bundling combines complimentary products to add to volume.
*A major benefit of “demand-based pricing” is just that; it takes into consideration consumer demand and your strategy for gaining market share.
Pricing Approach #4: Value-based pricing
The last of the pricing approaches may have been the most relevant for the subject of the opening story. In value-based pricing it is important to understand the use of the product and analyze the benefits. Sports teams use the value-based pricing option by charging more for tickets versus major competitors.
Which pricing approaches have you taken in the past?