When it comes to running a business, one of the most important decisions involves how much to charge customers.
Without the right pricing, a business can struggle or even fail.
But determining the appropriate price isn’t easy. That’s where a pricing strategy comes into play.
Overview: What is a pricing strategy?
In its simplest terms, a pricing strategy is a tactic used by a business to drive sales of its products or services.
Development of a pricing strategy takes into account several factors, such as costs, the value conveyed to customers, competitive pressures, and the brand image you want to convey.
Your pricing approach should be determined through customer research, and supported by a go-to-market strategy. This includes input from the marketing team, since they execute the marketing strategy that conveys the pricing rationale to customers.
In fact, it’s ideal to collect feedback from anyone involved with producing and selling your offerings, such as a sales team.
Types of pricing strategies you can utilize
Many pricing approaches exist. Let’s review some common strategies used by businesses.
1. Cost plus pricing
This is a traditional pricing method, and very common.
A business adds up the costs related to the creation and delivery of its offerings, such as labor and overhead, then determines the markup to arrive at a final price.
Many types of businesses use this approach, from retailers to restaurants to manufacturing companies, because it’s so straightforward.
Pro tip: This approach is ideal for businesses needing a pricing strategy that’s simple to implement, or if you have a cost advantage (i.e., achieve lower costs vs. competitors) and want to use price as a differentiator.
2. Value-based pricing
The antithesis to cost plus, value-based pricing applies a price depending on your customers’ perceived value of your offerings.
The higher the value perceived in your product or service, the more you can charge.
Companies like Starbucks use value-based pricing. That’s why Starbucks can charge a lot for a cup of coffee relative to the costs involved. Its perceived value of higher-quality coffee allows Starbucks to succeed.
Pro tip: To understand what drives value for customers, focus on a specific customer segment rather than trying to appeal to all customers. For instance, Starbucks went after customers who cared more about coffee quality than a cheap price.
3. Skimming pricing
Price skimming is the concept of charging a high initial price when launching a new product or service, then reducing that price over time. (You’re skimming maximum profit at the start.)
Apple uses this strategy when introducing a new product. Every new iPhone launches at its highest price point, then the price drops when the next model arrives.
Pro tip: Price skimming works best if you’ve got a built-in audience (like the fans that flock to the latest technology from Apple), your offering is unique or there’s little competition, or you’re building a high-end brand marketed toward customers who are not price sensitive.
4. Premium pricing
Akin to price skimming, premium pricing is the idea that a company’s product or service is worth a high price tag.
Unlike price skimming, the price remains high because it’s part of the company’s brand, and conveys the high-quality nature of the offering.
Businesses like Rolex and Cartier employ this type of pricing strategy; for these brands, the high price is actually an attractive characteristic for customers.
Pro tip: This approach has to be supported with a marketing strategy that conveys the premium quality of the offering to justify the higher price to customers.
5. Economy pricing
The opposite of premium pricing, economy pricing is about delivering the lowest price to consumers. This strategy is used by companies like Wal-Mart, which created a brand associated with being a low-price leader.
Pro tip: Don’t assume providing the lowest price is the best way to obtain customers. Many consumers equate a low price with low quality, and won’t buy for that reason.
6. Freemium pricing
A portmanteau of free and premium, the freemium pricing model is where the base product or service is given to customers for free. Usually, the free version lacks a number of advanced features. If customers want these additional capabilities, they must pay.
Another freemium approach is to offer a product for free for a limited time as a trial period. Once the trial ends, customers must pay to continue using the product.
The freemium model works well for software accessed via the internet. Hence, it is used by many online software products such as Evernote and Alphabet’s Google Drive.
Pro tip: A business should be prepared to absorb the cost of the free component. For instance, Dropbox has over 600 million consumers using its product but less than 3% actually pay; the remainder use the free version.
7. Penetration pricing
Penetration pricing is a popular approach to enter the market since the goal is to gain market share. The price is set low, usually below competitors, in order to attract customers. Once the desired market share is achieved, the price moves up.
Pro tip: If the switching cost is equally low for your customers (i.e., customers can easily go back to the competition), your efforts could be in vain. Therefore, think through how you’ll retain customers as part of this pricing strategy.
8. Promotional pricing
This strategy involves discounting a product or service, usually over a period of time, like a weekend sale or via a coupon. The goal is to generate a sales boost by attracting customers to your offering for a lower price than what’s normally available.
Pro tip: Promotional pricing requires a marketing strategy to get the word out, such as direct marketing techniques.
9. Subscription pricing
This strategy requires the customer to pay a recurring fee (usually monthly or annually) to get access to a product or service. This is a popular pricing strategy today because businesses can obtain a predictable, recurring revenue source through subscriptions.
Netflix employs a subscription strategy in an industry that traditionally priced on a per–movie rental basis.
Pro tip: Consider offering different subscription tiers where a customer can pay a higher fee for more features. For instance, Netflix charges nearly double its base rate to customers who want to stream content to four devices simultaneously.
10. Wholesale pricing
Wholesale pricing is a strategy used to sell your offerings to other businesses at a rate lower than selling directly to consumers so that these other businesses can do the selling for you.
Pro tip: Keep in mind that your B2B customers need to make a healthy profit by reselling your offerings. At the same time, their retail pricing must be in line with consumer expectations or competitor pricing. So your wholesale price has to balance your company’s need for a profit with those of your B2B customers.
How to determine the right pricing strategy for your business
Now that we’ve looked at some pricing strategies, let’s examine how to choose one (or more depending on your customer segments) for your business.
Pricing starts with your customers
First, be aware of how your offerings deliver value from the customer’s perspective. If the customer perceives low value, then an economy pricing or freemium strategy may be the way to entice people.
Also, identify the type of customer you want to attract, and keep in mind that not all customers are the same. If you’re targeting other businesses as customers, their desire to buy will depend more on the value delivered than price. Your company’s B2B sales efforts should inform the pricing strategy in this case.
Align pricing strategies with company goals
A pricing strategy’s goals should align with the company’s objectives. This doesn’t mean the right price leads to selling the most units. It could be about growing market share, defining the company’s brand (for example, as a low-price leader), or keeping competitors at bay.
Experiment, evaluate, and repeat until it’s right
It’s difficult to get a pricing strategy right the first time.
You should go in with a plan to test an approach, then evaluate the results through measurable key performance indicators (KPIs) to allow you to continue experimenting and fine-tuning until the pricing resonates well with both your company goals and your customer’s willingness to pay.
Final advice for the pricing strategy beginner
Because developing the right pricing strategy takes time to evolve, it’s worthwhile to use CRM software to help segment your customer base and track results in order to fine-tune the strategy. Try out different pricing approaches with a small percentage of your various customer segments to see which deliver the best results.
That’s how you’ll know you’ve found a winning strategy.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Robert Izquierdo owns shares of Dropbox, Inc. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), HubSpot, Netflix, Salesforce.com, and Starbucks. The Motley Fool has a disclosure policy.