Which Pricing Strategy Is Right for Your Business?

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:

• cost-based


• customer-based


• competitor-based

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 Business
  
  
  How 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
expensive”?

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

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.

Customer-Based Pricing

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.

Competitor-Based Pricing

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:

• 
  Small Business
  
  
  How Your Small Business Can Compete With a Larger Competitor
  
  
  Andrew Blackman

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.

Conclusion

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.

• 
  Pricing
  
  
  The Psychology of Pricing
  
  
  Andrew Blackman


• 
  Business
  
  
  How to Raise Your Prices Without Losing Customers
  
  
  Andrew 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.