Pricing Strategies for New and Established Products

Introduction to Price Setting

Setting the right price is important for any product. There are many different approaches, based on the different variables that can be considered. For a new product in the marketplace, getting the price right is all the more difficult, because there is no prior data to help gauge the strength of the current brand, the price elasticity of demand, or other factors that might come into play when pricing an established product. However, there is always an opportunity to adjust prices if a product is not delivering the optimal financial results for the company. Thus, management must have a sound understanding of pricing strategy in order to determine the most suitable price in the marketplace.

The most important thing to keep in mind is that price is one of the five Ps of marketing. The pricing strategy must therefore be aligned with the other aspects of the marketing strategy in order for it to be effective. If the pricing strategy sends a different signal to the marketplace than the other elements of the marketing mix, the company faces greater risk. This is especially true with a new product, because consumers do not have a lot of history with the product or industry to fall back on; they may have trouble interpreting the different signals sent by the various aspects of the marketing plan.

Core Pricing Considerations

There are several different pricing strategies, derived from a handful of core pricing philosophies. The first guiding principle is that the product must cover the cost of production and sale. One approach based on this principle is cost-plus pricing, where the company sets the price of the good in line with its costs without taking the competitive marketplace into account. Some companies that produce luxury goods take this approach, leveraging the relative price insensitivity of their market. Restaurants commonly use cost-plus pricing as well — everything on the menu might be priced at three times ingredient cost, or whatever the local rule of thumb dictates. This approach simply passes the cost of producing something on to the customer and guarantees that everything sold will cover variable costs, thereby contributing to net profits.

Most pricing strategies are more sophisticated than the cost-plus approach, but they still build cost into the strategy. Usually, variable cost is treated as the lower limit of what price can be charged, even during a sale. The reason is straightforward from a managerial accounting perspective: if a product covers its cost of production, it contributes to the profitability of the company, even if that contribution is minimal. If a product is sold for less than the cost to make it, there must be a very compelling reason. Normally, that reason is that the cost of exiting the business is very high — it costs less to continue operating at a loss than to actually exit. But under ordinary circumstances, regardless of the approach taken, a company will at least seek to cover its costs.

Another fundamental principle of pricing is the demand curve (NetMBA, 2010). The demand curve can be well established for existing products. For newer products, it might be entirely unknown, inferred only from other products within the industry, or estimated primarily through focus groups and other market research. The demand curve reflects the level of demand for a product at any given price point, and it is rooted in the concept of utility — the idea that a product is worth only what someone is willing to pay for it, which in turn reflects the value that person can derive from it. If a customer does not receive sufficient utility from a product relative to other uses of that money, they are unlikely to become a repeat customer. For most products, lower prices generate higher demand. There are exceptions, most notably luxury goods. A luxury good derives part of its value from exclusivity, and a high price is one mechanism for achieving that exclusivity. In some cases, demand for a luxury good actually increases when the price rises, because the product is perceived as higher quality and more exclusive. But for the majority of products, the rule holds: lower price means higher demand. This information is combined with cost-of-production data to calculate profit at each price point, and the point where profit is highest represents the ideal price.

For many products, however, it is the market that sets the price. In most markets, intense competition and well-informed consumers mean that price largely reflects what the market will bear for a given good. A company has no justification for charging more, but charging less would be insufficiently profitable. Companies can, however, work to influence demand for their goods. A well-known example is Apple, which builds brand loyalty and simplifies the purchasing process — both of which increase demand beyond what attribute-and-price comparisons alone would support. A company can persuade consumers that it offers more than competitors, or that its offering represents superior value at its price point. Various approaches exist to influence consumer decision-making, which in turn shifts the demand curve for a good.

What this means for most companies is that they must work hard to influence the market and shift their demand curve; otherwise, the market will essentially dictate both price and sales volume. Furthermore, a company selling to another business must also contend with the bargaining power of its buyers. A manufacturer of a consumer good must choose its sales channels, and those channels directly influence price. Some channels are deep discounters that offer high throughput in exchange for tighter margins. Others allow the company to maintain margins but may require greater effort due to lower throughput. Channel decisions ultimately affect how much pricing power a company has in the marketplace. A company may accept a lower price to win a customer when it foresees long-run benefits, or it may use one product as a loss leader to protect margins on others. Any number of environmental factors can influence the final price of a good.

A company must weigh all of these philosophies and environmental factors, then determine the pricing strategy that best fits its overall marketing strategy. Two common strategies are current profit maximization and current revenue maximization. These are distinct from one another. The point at which profit is maximized is not necessarily the point of maximum revenue; rather, it is the point where marginal cost equals marginal revenue. Beyond this point, a company can still increase revenue but will spend more than it earns from that additional revenue. Maximizing profit today means pricing at the point of optimal profit, which can be determined using the demand curve and cost data. Maximizing revenue is less profitable and places more emphasis on bringing money into the organization. This approach makes sense primarily in two situations: first, for companies with high fixed costs, where maximizing revenue provides the greatest raw contribution to those fixed costs even at a lower margin; and second, when the company's goal is business growth.

Maximizing market share is a closely related objective. A company may accept lower profits today at a lower price point in order to gain market share. There are several reasons this is desirable. In a new business, it helps build a customer base — companies seeking to win smartphone market share away from Apple, for example, offered their products at lower prices, recognizing that winning share is critical in a business where customer loyalty is worth cultivating over time. Market share objectives also make sense when share leads to the sale of peripherals or ancillary products. Google sought to win market share away from Apple and licensed Android to hardware companies for free. This expanded Google's advertising business: it earns nothing directly from Android's market dominance, but makes money from advertising and from the data Android collects from users. Google determined that data and advertising were more valuable than whatever it could earn by charging for Android, so it chose not to charge for it at all.

Pricing Strategies

Luxury goods makers prefer not only to differentiate from mainstream goods on price, but also to maximize current profit margins. This approach typically results in high prices and low volumes, but the company extracts as much value as possible from each customer. It works best when customers are not price sensitive — difficult to achieve with pizzas, but relatively straightforward with luxury items, given their uniqueness and the wealth of their clientele. Apple and Microsoft also exemplify this approach in their own ways: both benefit from consumers with low price sensitivity and, as a result, are among the most profitable companies in the world, combining high margins with significant volumes. Apple, notably, has deliberately sacrificed market share because it calculates that maximizing margins with its loyal customer base is more profitable than winning a market share battle at a reduced price point.

Survival pricing is another strategy, typically seen in declining industries. A current example is OPEC. Faced with declining prices and volumes due to the expansion of hydraulic fracturing in Western nations, OPEC flooded the oil markets, driving down the price of crude. OPEC — particularly Saudi Arabia — has very low per-barrel production costs, enabling it to sell oil at prices that fracking-dependent producers simply cannot match. OPEC is using a survival strategy, leveraging its competitive advantage in production cost to push higher-cost competitors out of an overcrowded market. Once that is accomplished, it can cut production and raise prices. This is effectively a predatory pricing practice, which is illegal in most countries; however, variations on this theme can be observed in struggling industries, where companies price low for market share in hopes of outlasting their competitors.

For a new product, two approaches are particularly relevant. Penetration pricing is used to build market share by undercutting existing players at equivalent quality levels. A company introducing a new energy drink, for instance, might use penetration pricing to undercut Red Bull and attract more price-sensitive customers. Penetration pricing is often a temporary strategy to build share and encourage consumers to try the product, giving a company with no established customer base the opportunity to gain a foothold in the market.

Skim pricing is the approach associated with Apple. It sets prices high to attract customers who are either not price sensitive or who are early adopters unwilling to wait for competition to drive prices down. In some situations, a company may not yet have the capacity to produce high volumes, effectively requiring it to pursue high margins from a limited customer base. Skim pricing is well suited to these circumstances.

Discounting is a means of adjusting the normal price downward in order to stimulate higher demand. The type and magnitude of a discount can be informed by the demand curve. Quantity discounts are often offered because companies typically have a fixed production capacity, and any unused capacity represents a deadweight loss on their investment. Discounts provide an incentive for bulk buying, helping the company sell closer to capacity.

Seasonal discounts are used to move goods with seasonal demand patterns, and they are especially important for perishable goods. Valentine's Day chocolates are a useful example: chocolate does not keep indefinitely, and demand for heart-shaped boxes collapses after February 14th. Remaining unsold stock is therefore sold at a discount to induce consumers to choose that seasonal product over all other chocolate options. Such discounts are generally used to attract business that would otherwise be slow. The bar happy hour is a variant of this logic — lower prices encourage some consumers to drink during off-peak hours.

Conclusion and Practical Application

NetMBA. (2010). Pricing strategy. NetMBA.com. Retrieved February 25, 2016, from http://www.netmba.com/marketing/pricing/