Charging too little [can be dangerous], Does Penetration Pricing work?
Our current economic shifts, catalyzed by recent events, have invariably had a major and ‘agnostic’ impact on certain key aspects of management’s decision making. Managers are now forced to reevaluate established policies, such as value positioning and pricing strategies.
Companies, having navigated the painstaking development life cycle to bring new products or services (p/s) to the market, are understandably tempted, and at times in a rush, to build market share rapidly through aggressive low pricing. This is penetration pricing.
The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you have a very good business. And if you have to have a prayer session before raising the price by 10 %, then you’ve got a terrible business. Warren Buffett (2011)
Does it work? On the whole, as counter-intuitive as it may be to some, aggressive floor-based pricing is often degenerative and erodes profit and value. Manager’s fixation on volume usually sacrifices profitability. This sort of approach runs the real risk of igniting a price war with fast & ready competitors. On the whole, it is, therefore, better to keep upward pressure on price.
There are, however, several valid scenarios in which aggressively low pricing policies are justifiable.
One reason to adopt this pricing strategy may include entry into a new or under-developed market where the value benefits of the p/s are high and the consumers are particularly price sensitive. If you are able to quickly entrench your position, ahead of your competitors, then you may be able to disproportionately tap into dormant demand and thus, expand your market share. This is particularly more powerful in markets with more pronounced switching costs. A word of caution though, beware, if your customer’s choice and value systems are driven mainly by the benefits rather than price, then penetration pricing can be dangerous.
A second valid reason to employ penetration pricing techniques may involve situations in which your cost to serve may decrease dramatically and quickly, possibly owing to economies of scale or the learning curve effect. In other words, as volume expands and your costs per unit drop, if costs are falling faster than your prices, then margins ought to rise over a period. But, beware, as your p/s market share increases, your competition often reacts quickly to close the gap. Therefore, in return, leading to a constant downward pressure on price, and consequently diminishing your margins.
Another cautionary note managers need to consider will be if penetration pricing energizes demand, which cannot be met owing to limited capacity, then your p/s will be harmed further. Margins will be lost unnecessarily, because available inventory may have been sold at higher prices. Additionally, delivery delays or failures will undermine perception and customer satisfaction, therefore, negatively affecting future demand.
A third reason why penetration pricing may be appropriate as a pricing tactic would be if your competitors have a higher cost structure or perhaps they are somehow locked into channel agreements that limits their pricing elasticity. A prime example of taking advantage of competitors structural legacy cost base is Dell, in the US PC consumer market. Dell created a lower pricing base by eliminating the intermediary to sell directly to the end-user and thus, rapidly increasing their market share.
Setting an up to date, relevant and smart pricing strategy is a science and an art. Managers would be wise to incorporate pricing strategies much earlier in the p/s development lifecycle and avoid the tempting pitfall of undercharging.