Pricing strategy: Understand the layers of pricing to achieve premiums and improve profits
For many businesses pricing strategy is sporadic and focused on setting the prices then moving onto other tools of the marketing mix — product, place and promotion. But pricing can have a direct impact on your bottom line so having a strategy around how prices are set and using techniques to avoid or minimise discounting can quickly improve profitability.
Layers of pricing strategy
Academic research on pricing is not as broad as other areas of business. There are a range of terms and jargon in use making it hard to understand the themes of the topic. A good way to look at it is a layers of pricing model: pricing approach, pricing model and pricing strategy.
Pricing Approach
At the first level, pricing approach refers to the information base that dominates your pricing decision. It is generally accepted that pricing approaches across industries, countries and companies fall into one of three buckets:
· cost-based pricing
· competition-based pricing
· value-based pricing (sometimes called customer value-based pricing)
Cost-based pricing refers to taking pricing decisions primarily using accounting data, with the aim of achieving a certain mark-up on costs or particular return on investment. Typically you would use your variable per unit costs (materials, packaging, labour to assemble, etc.) plus an allocation of your fixed costs (rent, electricity, management salaries, etc.) then add the mark-up. If you’ve measured your costs correctly you know you are guaranteed a profit where you hit your sales volume targets.
A competition-based approach analyses competitive price levels or anticipated price actions of competitors to determine appropriate price levels. Here you are benchmarking off what the market is doing. You may go above or below depending on your environment, but you are at the mercy of the pricing level of others (and whether you can keep your costs sufficiently below the price to earn a margin).
Value-based pricing uses data on the perceived value of the product for the customer as the main factor for determining price. You communicate the value of your product to your customers and set the price based on their willingness to pay, or the benefits they get over the next best alternative. Bear in mind an alternative may be another product or simply not purchasing.
Your choice of pricing approach needs to be made consciously and then you can go about collecting the data you need to set the price. Value-based pricing is the most complex because of the subjective nature of each customer’s perceived value (and this level of value can change or evolve from week to week). More detail on value-based pricing is available in this article.
Pricing Model
Once you have your approach and are working towards calculating your price levels, give thought to the pricing model. The pricing model shapes how revenue is agreed and collected from buyers for individual products. A good example of the pricing model is the SBIFT model developed by Iveroth et. al which also includes the pricing approach as one of the five dimensions.
Many companies have achieved success by differentiating themselves from the market normby allowing innovative ways for customers to access and pay for the product. Here are some examples. Unbundle and sell each component separately (like Ryanair or Southwest). Allow customers to bid or choose their own price (Radiohead did this when they launched the ‘In Rainbows’ album). Creating different ways of charging customers based on the volume consumed (your mobile phone plan perhaps already does this if you go over a cap of minutes or data). Limit the term of access (can your customer buy your product and take it away to use it forever, or are they limited to the months/years they pay for as with Medium and Netflix).
The pricing model will depend on the nature of your business and can even vary across different product lines or customer segments. Talk to your customers and try offering different models of consumption to see what they prefer — it could drive much better uptake and help establish new means of recurring revenue.
Pricing Strategy
To wrap it all together, pricing strategy encompasses the approach and model — describing the collective systems, infrastructure and culture, which an organisation adopts for pricing its portfolio of products. Your pricing strategy should take a holistic view of customer orientation, purchase behaviour and market orientation without overlooking cost and profit priorities.
Think about the market segments that you are targeting and what you are trying to achieve with each. Is your product at an early stage in its life cycle or perhaps your business is entering a new market and needs to price for market penetration? These factors will influence your decisions for the approach and pricing model.
Many successful firms employ a dedicated pricing department, responsible for collecting pricing data, setting the price and evaluating pricing success. This includes looking at how much discounting goes on and the driver behind discounts — perhaps sales people trying to hit targets before the end of a month/quarter, or reductions due to pressure from customers struggling with the Covid19 impact. If it is not feasible to have a dedicated pricing function, try setting up a committee with representatives from management, finance, sales and product teams.
The key is continuously monitor the pricing performance and look for new opportunities to use price as a source of competitive advantage. Gaining buy-in across the business and communicating that price is an important area of focus will help employees get on board with new ideas and help to avoid discounts that hurt the bottom line.
Summary
The layers of pricing framework gives an overview for the different levels of focus for pricing in your business. Bringing structure and rigour to the way you price will help to identify areas for improvement specific to individual product lines and customer segments, which in turn can drive higher margins and returns that are more consistent.
The information in this article is based on Masters level research, particularly focused on value-based pricing in software companies. For further reading see the following articles:
Adelstrand, C., & Brostedt, E. (2016). Creating competitive advantage by rethinking B2B software pricing. Publication №935655 Master’s Thesis, KTH Royal Institute of Technology
Hinterhuber, A. (2008). Value delivery and value-based pricing in industrial markets. In A. Woodside, F. Golfetto, & M. Gibbert (Eds.), Creating and managing superior customer value (Vol. 14, pp. 381–448). Bingley: Emerald Group Publishing Limited.
Hinterhuber, A., & Liozu, S. M. (2014). Is innovation in pricing your next source of competitive advantage? Business Horizons, 57(3), 413–423.
Iveroth, E., Westelius, A., Petri, C. J., Olve, N. G., Cöster, M., & Nilsson, F. (2013). How to differentiate by price: Proposal for a five-dimensional model. European Management Journal, 31(2), 109–123.
Liozu, S. M. (2017). State of value-based-pricing survey: Perceptions, challenges, and impact. Journal of Revenue and Pricing Management, 16(1), 18–29.
