Pricing Strategies: Definition and Key Types

Introduction

One of the most important decisions a company makes when introducing a product is determining its price. Companies rely on different pricing policies to meet their business needs while providing consumers with good value. If you are interested in learning how to set a reasonable and profitable price point for your business goods or services, you may benefit from learning about the factors that influence the choice of a pricing policy.

Pricing is defined as determining the value that a producer receives in exchange for the products and services they offer. Simply put, pricing is used to determine the price of a producer's offerings in a way that is satisfactory to both them and the customer. The primary goal of all companies is to generate profit, and this is where pricing comes in. So, what is the importance of pricing? Its objectives? Its policies? And pricing methods?

What is a pricing policy?

A pricing policy is a company's approach to determining the price at which it offers a good or service to the market. Pricing policies help companies ensure they remain profitable and give them the flexibility to price individual products differently. Your company might value having a well-defined pricing policy so that you can quickly make price adjustments and leverage product strengths in one or more markets.

Managers must start setting prices during the development phase as part of strategic pricing to avoid launching products or services that cannot maintain profitable market prices.

This approach to pricing enables companies to align costs with prices or eliminate products or services that cannot be generated cost-effectively.

Through systematic pricing policies and strategies, companies can generate greater profits and increase or defend their market share. Setting prices is one of the key tasks for marketing and finance managers, as the price of a product or service often plays a significant role in the success of that product or service, not to mention the company's profitability.

In general, a pricing policy refers to how a company determines the prices of its products and services based on costs, value, demand, and competition. On the other hand, a pricing strategy refers to how a company uses pricing to achieve its strategic objectives, such as offering lower prices to increase sales volume or higher prices to reduce a backlog of orders. Despite a certain degree of difference, pricing policy and strategy tend to overlap, and various policies and strategies are not necessarily contradictory.

After establishing their price foundations, managers can begin developing pricing strategies by defining the company's pricing objectives, such as maximizing short-term and long-term profits, stabilizing prices, increasing cash flow, and fending off competition. Managers must also consider current market conditions when developing pricing strategies to ensure that the prices they choose fit market conditions. Additionally, an effective pricing strategy involves considering customers, costs, competition, and different market segments.

A pricing strategy entails more than just responding to market conditions, such as lowering prices because competitors have lowered theirs. Instead, it involves more comprehensive planning and consideration of customers, competitors, and company goals.

Furthermore, pricing strategies tend to differ depending on whether a company is a new market entrant or an established business. New entrants sometimes offer products at a low cost to attract market share, while reactions from established companies vary. Incumbents who fear the new entrant might challenge their existing customer base may match prices or go lower than the newcomer to protect their market share.

Considerations for Pricing Policies

Companies often have different priorities when determining how to price their products. Your new business may need to offer its services while providing good value to consumers, or it may be a highly profitable, established firm selling in a market that is willing to pay higher prices. The most important considerations for pricing policies are:

Competition: Your business is likely aware of who its competitors are and what they charge consumers. Pricing policies take into account the competition with other companies in the market.

Profit Goals: You may choose a pricing policy to achieve a specific profit target for your company.

Sales Volume: Pricing policies directly affect how many people purchase your company's product and how much they buy.

Company Health: Your company's financial circumstances may enable it to prioritize market strategy over immediate profit, or you may need to generate revenue as soon as possible to stay in business.

Flexibility: Companies often react to market shifts by changing prices. Your company might consider whether your initial pricing enables you to respond to the market without losing profitability.

Government Regulation: To protect consumers, the government regulates the pricing of certain goods and services. Depending on your industry, this may be irrelevant or a central concern in your pricing policy.

Price Adjustment Method: Increasingly, companies selling massive volumes of goods may automate pricing using specialized software. Pricing policies take into account how your company intends to change prices.

Point of Sale: If your company sells the same product wholesale, retail, or in other venues, pricing policies may differ for each.

What are the Goals of Pricing Policies?

As with many businesses, you may have goals other than just making money in the short term. Your pricing policies are essential tools for achieving the various goals that businesses generally have, such as:

Profit: The fundamental business goal of generating profit remains a key objective. For some companies, it may be necessary to maximize profits in the near future.

Company Survival: Sometimes the only viable pricing policy is one that enables your company to continue operations.

Limiting Competition: Your business may have structural advantages that enable it to produce a good at a price no competitor can match. Companies typically weigh the competitive consequences of any price point against the potential profit.

Gaining Market Share: Your pricing policy may aim to increase market share. Gaining a significant portion of the market provides strategic and financial advantages.

Accessibility: If your company values making its products available to as many people as possible, your pricing policy may need to adapt.

Consumer Satisfaction: Consumer expectations change depending on the price they pay for something. Your business may consider the expectations you want to meet and price accordingly.

Types of Pricing Policies

Cost-based

Traditional pricing policy can be summarized by the following formula:

Cost + Fixed Profit Percentage = Selling Price

Cost-based pricing involves identifying all fixed and variable costs associated with a product or service. After determining the total costs attributed to the product or service, managers add a desired profit margin for each unit, such as a 5 or 10 percent markup. The goal of the cost-oriented approach is to cover all costs incurred in producing or providing the products or services and to achieve a target level of profit.

This method is simple and straightforward in itself, requiring only that managers review financial and accounting records to determine prices. This pricing approach does not involve examining the market or considering competition and other factors that might impact pricing. Cost-oriented pricing is also popular because it is a long-standing practice that uses internal information easily accessible to managers. Additionally, a company can defend its prices based on costs, proving that its prices cover expenses plus a profit margin.

However, critics argue that a cost-oriented strategy fails to provide the company with an effective pricing policy. One problem with the cost-plus strategy is the difficulty of determining the unit cost before setting the price in many industries, as unit costs may vary depending on volume. Consequently, many business analysts have criticized this method, arguing that it is no longer suitable for modern market conditions. Cost-based pricing generally leads to higher prices in weak markets and lower prices in strong markets, hindering profitability because these prices are the exact opposite of what strategic prices would be if market conditions were taken into account.

While managers must consider costs when developing a pricing policy, costs alone should not determine prices. Many industrial goods managers and service companies sell their products and services at a markup, generating significant profits from their best clients and from short-notice deliveries.

When considering costs, managers should ask what costs they can afford, keeping in mind the prices allowed by the market, while ensuring profit can be made from the sale. Additionally, managers should consider production costs to determine which goods to produce and in what quantities.

However, pricing generally involves determining the prices that customers can afford before deciding the quantity of products to be produced. By considering the prices they can charge and the costs they can afford, managers can determine whether their costs enable them to compete in the low-cost market, where customers are primarily concerned with price, or whether they should compete in a high-price market, where customers are primarily concerned with quality and features.

Value-Based Pricing

Value-based pricing adheres to the belief that the optimal selling price is a reflection of the customer's perceived value of the product or service, rather than just the company's costs to produce or provide it. The value of a product or service is derived from customer needs, preferences, expectations, and financial resources, as well as competitors' offerings.

Thus, this approach calls for managers to query customers and conduct market research to determine how much they value a product or service. Additionally, managers must compare their products or services with those of their competitors to identify their advantages and disadvantages.

However, value-based pricing does not just lead to customer satisfaction or generating sales; customer satisfaction can be achieved through discounting alone, a pricing strategy that can also lead to increased sales. Nevertheless, discounting may not necessarily lead to profitability.

Value-based pricing involves setting prices to maximize profitability by leveraging the unique value attributes of a product or service. This pricing approach also relies heavily on strong advertising, particularly for new products or services, to effectively communicate value to customers and incentivize them to pay a premium for the value provided.

How do you determine price based on value?

The following tips are aimed at entrepreneurs who wish to set prices based on value.

Choose a product similar to yours and find out what the customer is currently paying for it.
Identify all the ways your product differs from the comparable one.
Assign a monetary value to each of these differences, adding the positive attributes of your product and subtracting any negatives to arrive at a potential price.
Ensure that the value to the customer is higher than your costs.
Clearly explain to customers why the price is justified, including by speaking with them directly.

If there is an established market, the current price range will help inform you of customer price expectations.

You must still ensure that the value to the customer is higher than your costs; otherwise, you will lose money on every product you sell.

Eric Dolansky – Assistant Professor of Marketing, Brock University

Demand-Based Pricing

Managers who adopt demand-based pricing policies, like value-based pricing, are not primarily concerned with costs. Instead, they focus on customer behavior, characteristics, and the quality and features of their products or services. Demand-oriented pricing focuses on the level of demand for a product or service, rather than the cost of materials, labor, etc.

According to this pricing policy, managers attempt to determine the quantity of products or services they can sell at different price points. Managers require demand schedules to set prices based on demand. By using demand schedules, managers can identify the most profitable levels of production and sales. To determine these, managers examine production and marketing cost estimates at various sales levels. Prices are determined by considering cost estimates at various sales levels and the expected revenue from sales volumes associated with the projected prices.

The success of this strategy depends on the reliability of demand estimates. Hence, the critical hurdle a manager faces with this approach is accurately measuring demand, which requires extensive knowledge of multiple market factors that may influence the number of products sold.

Two common options for managers to obtain accurate estimates are seeking help from sales representatives or market experts. Managers often ask sales representatives to estimate increases or decreases in demand caused by specific changes in the price of a product or service, as sales reps are generally in tune with market trends and customer requirements.

Alternatively, managers can seek assistance from experts such as market researchers or consultants to provide estimates for sales levels at different unit prices.

Competition-Based Pricing

With a competition-based pricing policy, a company sets its prices by identifying other competing firms in the market. A company begins developing competition-based prices by identifying its current competitors.

Following that, the company evaluates its product or service. After this step, the company sets prices that are higher, lower, or equal to those of competitors, based on the advantages and disadvantages of its product or service, as well as the expected response from competitors to the price set.

This latter consideration—competitor response—is an important part of competition-based pricing, especially in markets with only a few competitors. In such a market, if one competitor lowers its price, others are likely to do the same.

This pricing policy allows companies to set prices quickly with relatively little effort, as it does not require precise market data like demand-based pricing. Competitive pricing also makes distributors more receptive to the company's products because they are priced within the range the distributor already deals with.

Furthermore, this pricing policy enables companies to choose from a variety of different pricing strategies to achieve their strategic goals. In other words, companies can choose to set their prices higher, lower, or equal to their competitors' prices and thus influence customer perceptions of their products.

For example, if Company A sets its prices higher than those of its competitors, the higher price may suggest that Company A's products or services are superior in quality. Harley-Davidson has used this with great success. Although Harley-Davidson uses many of the same parts suppliers as Kawasaki, Yamaha, and Honda, its prices are significantly higher than the competitive prices of these rivals. Harley's high prices—combined with customer loyalty and mystique—help overcome buyer resistance to high prices.

However, production efficiency over the past two decades has made the quality among motorcycle producers more equal, yet pricing above the market signals quality to buyers, regardless of whether they actually receive the quality premium they are paying for.

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