When it comes to pricing your products and services, there are many ways to go about it, two of the most common pricing methods used are cost-plus pricing and contribution margin-based pricing, but if you check the list below, there are many more options open to you. We will go through a long list of them in this article.
- Cost-plus pricing
- Absorption pricing
- Contribution margin-based pricing
- Premium Pricing
- Competition-based pricing
- Marginal cost pricing
- Predatory pricing
- Odd value pricing or Psychological pricing
- Dynamic pricing
- Skimming (unique product/service and sell at high price),
- Penetration pricing
- Limit Pricing
- Loss Leader
- Economy pricing
- Promotional Pricing
- Captive product pricing
- Optional product pricing
- Psychological Pricing
- Product Line Pricing
- Geographical Pricing
- Price leadership
- Drip pricing
- Target pricing
- Value pricing
Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price. This method although simple has two flaws; it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price.
Price = Cost of Production + Margin of Profit.
Absorption pricing is a method of pricing in which all costs are recovered. The price of the product includes the variable cost of each item plus a proportionate amount of the fixed costs. It is a form of cost-plus pricing.
Contribution margin-based pricing
Contribution margin-based pricing maximizes the amount of profit derived from an individual product, and is based on the margin between the product’s price and its variable costs, otherwise known as the contribution margin per unit. To calculate the figure you have to assume how many units of the product you are likely to sell at that price. There is an assumption to be made regarding the relationship between the product’s price and the number of units that can be sold at that price. The product’s contribution to the firms total profit (i.e., to operating income) is maximized when a price is chosen that maximizes the following: (contribution margin per unit) X (number of units sold).
Premium Pricing is used where there exists a uniqueness regarding the product or service and where a substantial competitive advance exists. Premium pricing is used by such luxury brands as Savoy Hotels, Rolls Royce and Prada.
Competition-based pricing comes about when setting the price based upon prices of the similar competitor products. Competitive pricing is based on three types of competitive product:
- Products which have a lasting distinctiveness from competitor’s product. Here we can assume
- The product has low price elasticity.
- The product has low cross elasticity.
- The demand of the product will rise.
- Products have perishable distinctiveness from competitor’s product, assuming the product features are medium distinctiveness.
- Products have little distinctiveness from competitor’s product. assuming that:
- The product has high price elasticity.
- The product has some cross elasticity.
- No expectation that demand of the product will rise.
Marginal cost pricing
Marginal cost pricing is the practice of setting the price of a product equal to the extra cost of producing an extra unit of output. By this policy, a producer charges, for each product unit sold, only the addition to total cost resulting from materials and direct labour. This is often done by businesses during periods of poor sales. If, for example, an item has a marginal cost of £10 and a normal selling price is £20, the firm selling the item might wish to lower the price to £11 if demand is slow. The business would choose this approach because the incremental profit of £1 from the transaction is better than nothing at all.
Predatory pricing is an aggressive pricing strategy intended to drive competitors out of a market. It is illegal in some places.
Odd value or Psychological pricing
Psychological Pricing is used when the business wants consumers to respond on an emotional, rather than rational basis. For example selling for £9.99 instead of £10, this is evident in most supermarkets and retail outlets.
Dynamic pricing is a flexible pricing mechanism made possible by advances in information technology, and employed mostly by Internet based companies. By responding to market fluctuations or large amounts of data gathered from customers – ranging from where they live to what they buy to how much they have spent on past purchases – dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a dynamic pricing success story. In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.
Dynamic Pricing has a number of variants such as:
- Negotiation (bargaining)
- Yield Management – depends on inventory and time of purchase. i.e. hotel rooms or airline seats.
- Real time Market – based on supply and demand.
Skimming is selling a unique product or service at a high price, and sacrificing high sales in preference to high profits, therefore ‘skimming’ the market. Usually employed to reimburse the cost of investment of the original research into the product – commonly used in electronic markets when a new range, such as DVD players, are firstly dispatched into the market at a high price. This strategy is often used to target “early adopters” of a product or service. These early adopters are relatively less price-sensitive because either their need for the product is more than others or they understand the value of the product better than others. This strategy is employed only for a limited duration to recover most of investment made to build the product. To gain further market share, a seller must use other pricing tactics such as economy or penetration. This method can come with some setbacks as it could leave the product at a high price to competitors.
Penetration pricing is the opposite of skimming, where a product is sold with a low price to gain market share.
Limit Pricing is the price set by a monopolist to discourage economic entry into a market, and is illegal in many countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition. The problem with limit pricing as strategic behavior is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm’s best response. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labour for a long period of time.
Loss Leader Pricing
Loss Leader pricing is illegal under EU and US Competition rules. Larger players in a market may use loss leaders as part of an overall pricing strategy, such as using it to draw customers into their establishment and encourage them to buy other products once there. Loss leadership can be similar to predatory pricing or cross subsidization; both seen as anti-competitive practices.
Target pricing is a pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production. The target pricing method is used most often by public utilities, like electric and gas companies, and companies whose capital investment is high, like car manufacturers. Target pricing is not useful for companies whose capital investment is low because, according to this formula, the selling price will be understated. Also the target pricing method is not keyed to the demand for the product, and if the entire volume is not sold, a company might sustain an overall budgetary loss on the product.
Economy pricing include things like the no frills lines found in supermarkets.
Promotional Pricing is used to promote a product and is very commonly used. There are many examples of promotional pricing including approaches such as BOGOF (Buy One Get One Free).
Captive product pricing
Captive product pricing is seen in cinemas when you are forced to buy refreshments from the foyer, or blades for razors, or ink cartridges for ink jet printers, where the ink is often more expensive then the initial printer cost.
Optional product pricing
Optional product pricing is seen when you buy an airline ticket and are charged extra for seat next to window, extra baggage or speedier check-in.
Product Line Pricing
Product Line Pricing is where there is a range of products or services and the pricing reflects the benefits of parts of the range. For example car washes. Basic wash could be £2, wash and wax £4, and the whole package £6.
Geographical Pricing is evident where there are variations in price in different parts of the world. For example rarity value, or where shipping costs increase price.
Drip pricing is agreeing an initial price, with a customer only to add extra charges when the customer is about to buy. It works because once lured by the initial price and into a sense of ownership, a consumer attaches more value to the goods in question. This “endowment effect” makes them more likely to accept later charges as people hate the idea of losing £5 much more than they like the idea of gaining £5. Extra charges also only become apparent after the customer has invested time and effort, which they don’t want to waste, in the sales process. Anchoring helps here (“it doesn’t cost £200, it only costs £x” – £200 is the anchor). Make the pricing structure complex, create a sense of social approval – “everyone is buying” – then chuck in something free and its job done.
Price leadership is seen with regards to oligopic business behavior in which one company, usually the dominant competitor among several, leads the way in determining prices, that the others soon following.
Value pricing is generally used when external factors such as recession and competition pressure sales. This focuses on prices you believe customers are willing to pay, based on benefits your business offers them. Companies try to increase profits and get the maximum value out of their scarcity and are interested in who is willing to pay more, rather than who can afford to pay more.
Imagine that you dealt with every customer as an individual, and knew exactly how much they valued any possible version of your offering and that the price charged to any customer remained unknown to all the others. Develop a pricing scheme which gets as close as possible to this ideal. There are some attempts to make use of this pricing system:
- First degree price discrimination – seen as unfair and unpopular
- Tactic used by car salesmen and estate agents
- Supermarkets use discount cards which are needed to take advantage of sales prices
- Money on – Amazon used to tailor prices based on customer profile using “cookies” to display different selling prices to different customers.
- Group discrimination – more accepted form of price discrimination
- OAP and student discounts
- Discounts for local customers who purchase regularly
- Self discrimination – getting customers to confess they are sensitive to price, while still taking advantage of those willing to pay a premium price
So there you have it, there are lots of pricing options open to you. Use a method that best suites you and your business circumstances. Cost-plus pricing and contribution margin-based pricing are the most commonly used methods historically although some form of price discrimination is the ideal in most instances, although is very difficult to implement effectively for smaller, less technically endowed businesses.
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