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august 09, 2012 • 11:05 AM

What You Need to Know About Pricing

Lifehacker

In Impact Pricing: Your Blueprint for Driving Profits from Entrepreneur Press, pricing expert Mark Stiving offers practical advice to business owners on how to price products and services. In this edited excerpt, he explains several important pricing concepts.

Price may not be the basis of your corporate strategy, but you must have a pricing strategy to implement your corporate strategy. Remember that pricing strategies are big-picture decisions that provide guidance to the people within your organization who actually set prices. They are your pricing processes and policies.

When you ask a marketer "What are some pricing strategies?" you will likely get the answer that there are three pricing strategies: neutral, penetration and skimming. Do a Google search on "pricing strategy," and you'll find the same answer over and over: neutral, penetration, and skimming. These certainly are pricing strategies, but they are not the only ones. A better way to look at this is that these are pricing strategies to define the general level of prices.

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Neutral Pricing

Neutral pricing, the most common pricing strategy, means that you price so that your customers are relatively indifferent between your product and your competitor's product after all features and benefits, including price, are taken into account. Of course not all customers will be indifferent. Some will like your offering better, others will like your competitor's better. From this perspective, think of neutral pricing as maintaining the status quo. You aren't trying to gain or lose market share. Most pricing in relatively stable markets would be considered neutral. As you walk through a grocery store, the prices you see are neutral. Although you may use a combination of neutral, penetration, and skimming prices, you will most often use neutral.

Penetration Pricing

Penetration pricing means pricing more aggressively than neutral. It can be used to gain market share relative to your competition -- but be careful. This can and does start price wars. No company wants to lose market share, and if you lower your price in an effort to gain market share, your competitors are likely to lower their prices just to keep their share.

A more appropriate and common use of penetration pricing is to speed up the growth of a newly forming market. Low pricing is often justified to quickly grow a new market and to gain the largest share as the market grows. This strategy works best when you are the first entrant, or one of the first entrants, into a market. Penetration pricing in this situation may also deter other companies from competing when they recognize there are not huge profits to be gained.

Forward Pricing

Forward pricing is another term similar to penetration pricing, but with a focus on future costs. If you're building a product and it costs $1 to make, you probably don't want to sell it for less than $1. However, if you know that once you sell a million units, your costs will go down to $0.30, you may be willing to sell at a price lower than your current costs knowing that your costs will be lower in the future. The forward part of the name indicates you're looking forward in time to estimate what your costs will be and using that cost as your basis for pricing.

Skimming

Skimming is the opposite of penetration pricing. Companies skim in an effort to segment the market, to get the customers who are willing to pay more to do so. The two common implementations of skimming are at new product launch and at the end of a product's life.

When companies skim during new product launch, they are selling to customers with a high willingness to pay. Once this market is depleted (or at least slows down), the company lowers the price to sell to the next tier of customers.

A recent, famous example of this was the initial release of the Apple iPhone. Apple released the iPhone on Sept. 5, 2007, for $599. Apple fans rushed out to purchase the iPhone. Two months later Apple lowered the price to $399 to capture even more customers. The earliest adopters paid $200 more for the privilege of being first. In this case, though, Apple got a black eye. The huge price decrease was too much too soon according to the early adopters. Remember, these early adopters were big fans and Apple risked losing significant customer goodwill from these, their best customers. Apple eventually gave each of the early adopters a $100 store credit. 

Skimming as a market entry strategy only works when you have a monopolistic position (the iPhone was unique). The lesson from Apple's case is to bring your price down slowly. The news articles at the time didn't berate Apple for lowering the price, they berated it for lowering the price too soon. 

The other common use of skimming is at a product's end of life. Sometimes firms would like to discontinue a product but have too many customers who have a continuing need for it. In this situation, the company may gradually increase prices over market value to gain more revenue from these customers. The firm is trading off being able to compete for new business for additional revenue on existing business. One big caution is that customers, especially loyal customers like these, don't like to have their prices raised. You must have a good explanation and possibly an alternative offering. 

It should be apparent that these three strategies follow specific corporate objectives. If a corporate objective is to raise ASP (average selling price), then skimming may be appropriate. If a corporate objective is to win market share, then penetration pricing is needed. If the corporate strategy is to generate and capture value, then neutral pricing would be appropriate.

Value-Based Pricing

Value-based pricing, another pricing strategy, is the most important. The idea seems simple. How much is your customer willing to pay? Set the price at or just below that point.

However, the implementation and usage of value-based pricing is much more complex.

Throughout business history, firms traditionally used the cost-plus method of determining prices. They determined how much their product cost to make and then added whatever margin they thought they deserved. Hence, the term cost-plus. Cost-plus pricing has some advantages: It's simple, you don't have to understand your customers, and it's easy for you and your competitors to get in sync. However, cost-plus is not optimal pricing.