Former university professor of marketing and communications, Sallie is an independent publisher and marketing communications consultant.
Riddle: What is that has just about everything for sale at a low price, but causes trembling vibrations and the sound of doors slamming closed, for good, wherever it goes? Answer: The opening of a new Wal-Mart store.
Hundreds of neighborhood businesses, around the nation and the world, have felt the impact of the opening of a new Wal-Mart store. Many have found out, after the giant retailer came to town, that having such a big new neighbor meant the end of their business. They simply could not compete because Wal-Mart uses a pricing strategy that knocks them completely out of the boxing arena. Why? Because most small retailers do not have the kind of bargaining power that Wal-Mart has with suppliers. They cannot compete on price with a company that owns more than 10,000 stores worldwide.
This article is not about the Wal-Mart phenomenon, but the phenomenon does underscore how vital the concept of price is in the marketplace. Not just for mom and pop retailers, but also for manufacturers and marketing executives as well. Pricing decisions are make-or-break decisions for businesses, and for this reason, decisions about pricing must be made with great care, taking into consideration an incredibly complex array of environmental and competitive concerns.
In this article, I will be looking not at how a company sets a single price, but rather at how companies adopt pricing structures that will cover different items in a product line. When a company makes or markets more than one product, pricing methods are needed that take into consideration all of the company's market offerings.
New-Product Pricing Strategies
Pricing structure usually changes over time as a company's products move through their life cycles. When a new company is bringing a new product to market, it is presented with the challenge of setting prices for the first time. In this situation, a company can choose between two broad strategies, market-skimming pricing or market-penetration pricing.
Market skimming is a strategy that works for a new product that is also a new type of product: One that has no copycat competitors or substitutes, yet. Companies that create innovative new products can set high initial prices allowing them to “skim” revenues from the market. But market-skimming pricing only works under certain conditions:
- Condition #1: The product’s quality and image must be strong enough to support its high price, and enough buyers must want and be willing to buy the product at the high price.
- Condition #2: Costs involved in producing a smaller volume of the product cannot be so high that they "eat up" the advantage of charging more.
- Condition #3: It cannot be easy for competitors to enter the market and swiftly undercut the high price.
With market-skimming pricing, the goal is to siphon off maximum revenues possible from the market prior to the introduction of substitutes or copycat offerings. Once the market has been skimmed, the company is free to lower the price, drastically, to capture low-end buyers while rendering competitors unable to compete on price.
Achieving an initial high volume of sales, with a new product, is the primary objective of market-penetration pricing. Instead of setting a high price to skim off small but profitable segments of the total market, a company can choose to use market-penetration pricing. Although this strategy calls for a product to be widely promoted, it allows the setting of a low initial price enabling the company to penetrate the market quickly and deeply. Using the market-penetration strategy, the company can attract a large number of buyers quickly while it also captures a large share of the market. There are conditions that must be met, however, for market-penetration pricing to work:
- Condition #1: The market for the product must be highly price sensitive so that a low price produces more market growth.
- Condition #2: The market must be large enough to sustain low profit margins, and production and distribution costs must fall as sales volume increase.
- Condition #3: The low price must help keep out the competition.
- Condition #4: The company must be able to maintain its low-price position—otherwise, the price advantage will be only temporary. Once competitors enter the market, they may also lower prices.
Product Mix Pricing Strategies
When a company produces a line of products and/or services, they have what is called a "product mix." A company's objectives, when setting prices for a product mix, is somewhat different from setting prices for a single product or service. In pricing for a product mix, the company is seeking a set of prices that will allow it the most profit potential from selling a mix of products. There are five basic product-mix pricing strategies; product-line pricing, optional-product pricing, captive-product pricing, by-product pricing, and product-bundle pricing.
Product quality, real or perceived, is used in product-line pricing. When a company offers a line of products, product-line pricing is used to separate market offerings by price gaps between categories. The price gaps are used to alert interested buyers to real or perceived differences in the quality of offerings. Established price points of competitive offerings are often used in the setting of different prices for different products in the line. Retailers use this approach to separate goods into cost categories as well, so that customers can see distinctions in levels of quality of merchandise.
This method allows a company to set a low price for its most basic product or service, while offering desirable/needed add-on accessories or services that are costly. This method allows the company additional ways to profit. Companies/industries using optional-product pricing include airlines and cell phone companies. Using optional-product pricing, the company's challenge is to determine what to include along with the price of its base offer, and what to present as optional.
This method is used by companies that market their own supplies for a main product, when the main product is sold separately. Using this method, the company will usually set prices low for the main product, but will have high mark-ups on the supplies needed for use it. For example, makers of computer printers use this method by offering printers at relatively low prices, with printer ink cartridges being offered at substantial prices. Products such as computer software, staples, and razor blades, also provide good examples of this method.
In the case of services, the captive-pricing method is called two-part pricing. Part one is a fixed fee for a basic service (for example, a leased automobile, or copier machine). Part two of the service is a variable usage rate (usage rate, in the example of leased auto, would be based on mileage; for the leased copier, on the number of copies made). Using this method, it is up to the service firm to decide what the pricing should be for use of the basic service and the variable usage rate.
Sometimes, the manufacturing process results in production of a useful, and therefore marketable, by product. When there is a market for the by-product, by-product pricing is a method that can allow a manufacturer to obtain a competitive advantage by charging a lower price for the main product (since making the product produces something else of value). By-products can be of no, little, or great value. When they are of value, marketers can accept a price that offers little more than the cost of storing and delivering them, or, they can have significant value. Some examples of profit-making by-products include, lanolin (comes from the cleaning of wool); whey (from cheese manufacturing), and asphalt (from the refining of crude oil).
Product Bundle Pricing
This method calls for the "bundling" of several products which are offered for sale as a combined unit. The price of each item inside the bundle is usually reduced from what the price would be for the item, if purchased separately. Purchasing the bundled unit allows buyers to get each item in the bundle at a reduced price. This method allows marketers to include in a bundle some items that, alone or separately, might not be as popular with consumers as other items in the bundle.The price must be low enough, however, for the "package deal" to be attractive to consumers. Cable television, telephone/telecommunications services companies, and fast-food marketers use bundle pricing often and effectively.
There are many different and complex ways that pricing can be approached, however, the bottomline rules of pricing are simple and straightforward. When it comes to pricing, the most important thing to remember is that prices must be set in a way that will cover costs and profits. With this in mind, pricing must be flexible, because prices should always be in line with changing costs, consumer demand, competitive pricing moves, and profit goals. When the time comes that there is a need to lower prices, the company should first find a way to lower costs, because pricing should always be done in a way that will assure sales and profit.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2013 Sallie B Middlebrook PhD