Today’s operating environment is becoming complex and tougher more so for the SMEs. There are many problems that are encountered by entrepreneurs throughout the course of managing their business. However, pricing strategy remains one of the most challenging concepts bedevilling the SMEs today. Pricing is the only avenue in the marketing mix that is of paramount importance to a business; it is the only source of revenue. In this regard, proper crafting of pricing strategies is important to avoid revenue leakages, maximize returns.
So, how much should you charge for that product or service?
Before embarking settling on a particular price, it is advisable that you conduct pricing strategy analysis. It need not be a complex but a just simple process that uncovers all the scenarios. However, the two most critical questions whose answers can help you set proper pricing for your business are: how much should I charge to attain my targeted profit? And are the customers willing and able to pay the suggested price? Even so, there are price determination is mostly denominated by two perspectives that have been adopted by many businesses across the world.
Economic and Cost-Based Pricing
Economic pricing provides an overall viewpoint where the amount demanded and the amount supplied is in equilibrium while cost-based pricing, on the other hand, is price determination approach that involves totalling all costs associated with offering an item in the market then adding an amount to cover profit and expenses not previously considered.
Most businesses use cost-based pricing as it’s easy to rationalize and quite predictable. However, there are two approaches to cost-based pricing; mark-up pricing and profit margin. Mark-up pricing is based on the cost of the item and profit margin is based on the sales price.
Markup pricing is easy to apply, and it is used by many businesses (mostly retailers and wholesalers). However, it has two major flaws. One is the difficulty in determining an effective markup percentage to apply. If this percentage is too high, the product may be overpriced for its market; then too few units may be sold to return the total cost of producing and marketing the product.
On the other hand, if the markup percentage is too low, the seller is “giving away” profit that it could have earned simply by assigning a higher price. In other words, the markup percentage needs to be set to account for the workings of the market, and that is very difficult to do. To remedy this challenge, breakeven analysis tool can be used to determine the minimum sales volume needed at a certain price level to cover all costs.
The other challenge with markup pricing is that it separates pricing from other business functions. The product is priced after production quantities are decided on, after costs are incurred, and almost without regard for the market or the marketing mix. To be most effective, the various business functions should be integrated. Each should have an impact on all marketing decisions.
When doing the pricing, it is important to significantly consider the environment and look at the life stage of the product, whether it’s new in the market or has been in existence for a while. To do this you need to conduct product life cycle analysis so that you can come up with pricing that is flexible enough to match the varying marketplace characteristics at different life cycle stages.
Price Skimming and Price Penetration Strategy
Two basic strategies that may be used in pricing for new products are skimming pricing and penetration pricing depending on the life stage of a given a product.
Price skimming is the strategy of establishing a high initial price for a product with a view to "skimming the cream off the market" at the upper end of the demand curve. It is accompanied by a heavy expenditure on promotion. A skimming strategy may be recommended when the nature of demand is unknown, when a business has spent large sums of money on R&D for a new product, when the competition is expected to develop and market a similar product in the near future, or when the product is so innovative that the market is expected to mature very slowly.
Under these circumstances, a skimming strategy has several advantages. At the top of the demand curve, price elasticity is low. Besides, in the absence of any close substitute, cross-elasticity is also low.
These factors, along with a heavy emphasis on promotion, tend to help the product make significant inroads into the market. The high price also helps segment the market. Only non-price-conscious (early adopters) customers will buy a new product during its initial stage. Later on, the mass market can be tapped by lowering the price. If there are doubts about the shape of the demand curve for a given product and the initial price is found to be too high, the price may be lowered. However, due to human nature, it is very difficult to start at a lower price and then raise it in future. Raising a low price may annoy potential customers, and anticipated drops in price may retard demand at a particular price.
Penetration pricing, on the other hand, is the strategy of entering the market with a low initial price so that a greater share of the market can be captured. The penetration strategy is used when an elite market does not exist and demand seems to be elastic over the entire demand curve, even during the early stages of product introduction. High price elasticity of demand is probably the most important reason for adopting a penetration strategy. The penetration strategy is also used to discourage competitors from entering the market. When competitors seem to be encroaching on a market, an attempt is made to lure them away by means of penetration pricing, which yields lower margins.
Pricing Strategies for Established Products
The succeeding section largely focused on pricing for new products. So, how should you handle pricing for established products? Changes in the marketing environment may require a review of the prices of products already on the market. A review of pricing strategy may also become necessary because of shifts in demand. An examination of existing prices may lead to one of three strategic alternatives: maintaining the price, reducing the price, or increasing the price.
The strategy of maintaining price is appropriate in circumstances where a price change may be desirable, but the magnitude of change is not easy to determine. If the reaction of customers and competitors to a price change cannot be predicted, maintaining the present price level may be appropriate. Alternatively, a price change may have an impact on product image or sales of other products in a company’s line that it is not practical to assess. Politics may be another reason for maintaining prices.
There are three main reasons for lowering prices. First, as a defensive strategy, prices may be cut in response to competition. A second reason for lowering prices is offensive in nature. Lower costs have a favourable impact on profits. Thus, as a matter of strategy, it behoves a company to shoot for higher market share and to secure as much experience as possible in order to gain a cost and, hence, a profit advantage. The third and final reason for price cutting may be a response to customer need. If low prices are a prerequisite for inducing the market to grow, customer need may then become the pivot of a marketing strategy, all other aspects of the marketing mix is developed accordingly.
In adopting a low-price strategy for an existing product, a variety of considerations must be taken into account. The long-term impact of a price cut against a major competitor is a factor to be reckoned with. In a highly competitive situation, a product may command a higher price than other brands if it is marketed as a “different” product. Finally, the impact of a price cut on a product’s financial performance must be reviewed before the strategy is implemented. If a company is so positioned financially that a price cut will weaken its profitability, it may decide not to lower the price even if the lowering price may be in all other ways the best course to follow.
On the flip side, a price increase for an existing product can be implemented for various reasons. First, in an inflationary economy, prices may need to be adjusted upward in order to maintain profitability. During periods of inflation, all types of costs go up, and to maintain adequate profits, an increase in price becomes necessary. How much the price should be increased is a matter of strategy that varies from case to case. Price may also be increased by downsizing (i.e., decreasing) package content size while maintaining price
Prices may also be increased when a brand has monopolistic control over the market segments it serves. In other words, when a brand has a differential advantage over competing brands in the market, it may take advantage of its unique position, increasing its price to maximize its benefits
Sometimes prices must be increased to adhere to an industry situation. Of the few firms in an industry, one (usually the largest) emerges as a leader. If the leader raises its price, other members of the industry must follow suit, if only to maintain the balance of strength in the industry. If they refuse to do so, they are liable to be challenged by the leader. Usually, no firm likes to fight the industry leader because it has more at stake than the leader.
Therefore, in selecting the pricing strategy and assigning the price for a product can be a complex task to small firms. And it becomes extremely challenging for startups and more so those in the cut-throat competition dominated the field. The revenue model and pricing strategy a firm chooses will impact a wide variety of aspects to the business such as the type of clientele the firm deals with and viability of the business in the long run. This means deciding a pricing model is very important for any firm survival.
Geoffrey Sirumba is Marketing Consultant in Nairobi. He can be reached via email@example.com