One of the most common requests we receive is to help a client select or revise a pricing strategy. It is a simple question, but to answer it, we need to understand a lot more about the business. A pricing strategy should not be picked randomly or because someone read about it being successful elsewhere. It must align with the type of market and the company’s business strategy and objectives. So, to begin, we need to know:
- Where do you compete and how do you think you win in the market?
- What are your goals e.g., market share, profit growth, some mix, etc.?
- Is it a new product or service where there will be a huge advantage to the companies that sign new customers quickly?
- What is your distinct value proposition?
- What are your competitive advantages?
- Do you have a significant cost advantage versus competitors or customers’ other alternatives?
- Is capacity relatively fixed, or can additional capacity be added easily?
- Is demand steady or does it vary according to times and situations?
- What is the split between your fixed and variable costs?
- How are customers and competitors likely to react to any price moves you make?
Business Strategy and Objectives
A company’s business strategy is fundamentally a selection of where to compete (which customer needs, market segments, and geographies), and how to win. Which customer needs are addressed? Those choices dictate how you deploy resources to serve customers, and the pricing strategy must support it. As a simple example, luxury ocean-front hotels have invested significantly in expensive land, furnishings and staff; and they should not have an Every Day Low Price (EDLP) strategy. Skimming or premium pricing should be a part of their pricing strategy.
Similarly, your goals must be considered when picking a pricing strategy. If the primary objective is to grow market share and there are significant advantages to signing customers early (like a land grab), penetration pricing or freemium pricing should be considered. Conversely, if profit growth is your primary goal, EDLP rarely accomplishes that.
Value Proposition and Competitive Advantages
Marketeers and sales people often talk about their value proposition. Sometimes it is a meaningless expression, but it should refer to how you enable customers to do whatever they are doing better. That could be related to the customers’ revenue generation, or efficiency of their operations. It could also affect your customers’ cost structures. The value proposition and competitive advantages describe where and how you improve those things compared to your customers’ next best alternatives.
For example, Costco and Trader Joe’s both compete in the grocery business. Costco also sells non-food items, but let’s focus on groceries. Both chains compete in part with an extensive lineup of private label food which is less expensive than comparable brands. Costco also offers brand-name products in large quantities. The private label brands, no-frills stores, and large package sizes provide Costco and Trader Joe’s cost advantages versus other national chains and brands. In these cases, EDLP is logical.
Conversely, Whole Foods competes with the freshest organic foods, which is important to many customers; and they tend to be in more affluent areas. Consequently, Whole Foods employs premium pricing; and even though they have recently lowered some prices, they are still more expensive than most national chains.
Supply, Demand, and Cost Structure
The supply of goods or services in any market relates to how much capacity exists, and how easy it is to adjust capacity. When capacity is relatively fixed and not easily added, prices can be used to allocate that capacity. This is especially true when the variable cost of serving additional customers is low. In those cases, dynamic pricing can be very useful.
Amusement parks, hotels, airlines, theaters, and sports venues all have fixed capacity on any given day. The demand for their products is significantly affected by the lives of their customers. Parks have high demand during holiday periods and summertime. Hotels and airlines see business customers who primarily travel Monday through Thursday, and leisure travelers on the weekends. Theaters are busier on the weekends.
A related question is how much of the capacity is currently being utilized? In these high fixed-cost businesses, the incremental cost of adding customers is very low until they reach maximum capacity. Lowering prices on days or periods where the business is not operating close to capacity, can increase customer counts on the typically slow days. Those additional customers also then buy more ancillary products like food, drinks, and souvenirs. So, dynamic pricing with higher prices in high-demand periods and lower prices in low-demand periods can increase profits by improving the profit per customer on busy days and increasing demand (and sales) in slow periods.
Cloud-based software is another high fixed-cost, low variable cost business, but demand is usually not seasonal. In addition, it is relatively easy to add servers and computing power as needed. In those types of situations, dynamic pricing would not be helpful. A more profitable pricing strategy would be some type of capacity or feature-based pricing which charges customers according to the features they use and the number of people who can access the software.
Customer and Competitor Reaction
It is also important to estimate how customers will react to price changes. In most B2B situations, demand for a product or service is derived from the demand for whatever the customers are selling. That means lower market prices are unlikely to increase demand overall. Conversely, in consumer markets, overall demand tends to increase with lower prices and vice versa. That means dynamic pricing may add less value in B2B markets. While airlines and hotels have higher prices during the times when people are traveling for business, it would be very difficult for those business customers to switch their travel days to the weekend in exchange for lower prices, but consumers can do it.
Finally, we should ask how are competitors likely to react to your pricing strategy? When one competitor is simply trying to take market share from competitors, we can expect the other competitors to defend their business by matching the lowered pricing. So, switching to EDLP and undercutting competitor prices is often a losing strategy. If you try to use your pricing strategy to capture more customer segments, increase overall demand or improve profitability with existing demand, competitors are likely to copy it without leading to a price war. Likewise, many businesses are happy to see competitors raise prices because it provides them cover to raise their own prices.
Obviously, this post is just a sampling of possible scenarios. There are many other potential examples that would illustrate how different answers to the questions above would result in selecting a different pricing strategy. If you take the time to study the structures of different types of markets and the pricing strategies that have worked, and you answer these questions for your own business, the best pricing strategy will be clearer. Give us a call if you would like some help.