Education

Approaches to Product and Service Pricing Models

Distinguishing between price and value is important to strengthening the financial sustainability of your enterprise.

What is a pricing model? Price vs Value

A pricing model is the method an enterprise uses to determine the most appropriate price for their products and services.

The price of a product or service is the amount of money required to purchase an item, this is often misunderstood, and is independent from the ‘value’ of an item; the true worth as perceived by the consumer.

The price which is paid for the item is not always representative of the value being created for the consumer. This is seen when goods are seen as overpriced ‘rip-offs’, or under-priced ‘bargains’.

An enterprise should identify the true worth they are creating for their target market and formulate a pricing strategy to best reflect that with a dollar amount. Setting this price thoughtfully can help your business achieves your desired goals.

To do this, in practice, most pricing models are a combination of profitability maximisation and volume growth

At a high level broadly there are two types of pricing strategies:

  • the maximum you can charge based on the value you add to your customers, within the framework of competitors and alternatives, with the view to maximising unit profitability
  • the lowest you can charge based on your cost structure, with the view to taking market share or share of wallet

Both of these strategies are based on facts and testing - NOT gut-feel.

A pricing model is not a static decision prior to the launch of a new product/service. It is a continuous process, accounting for multiple dynamic factors that need to be monitored and adjusted for regularly if possible.

Enterprises should strive for pricing models that increase the profitability of the business currently, or increase the sustainability into the future.

By understanding the value and benefit being created for your target consumers an enterprise can determine the maximum they are willing to pay for the specific item.

Questions to Ask Yourself

  • What is the value your product/service delivers? What is the benefits to customers?
  • Is your current pricing model the maximum or minimum you can charge?
  • Is your current goal to increase your margins or increase your volume? Does you price reflect this?

Why is it important?

The price of an item should represent the value of the product to consumer.

Businesses exist to create and provide value, the price point is exchange rate that consumers can compensate you for it.

As price is seen as an intangible factor in determining profitably, compared to cost reduction or sales and marketing, it is commonly overlooked.

Enterprises are often unaware of the premium price they deserve for their product or service, as they are unaware of the true value they create and instead follow cost-plus pricing model or historical models with no determined reasoning.

To overcome this, enterprises need to understand and quantify the value you deliver, and whenever possible charge for the “extras” you provide or unbundle them from the product.

Value can be best looked at by looking at the alternatives. The “cost” to your customer of the alternatives to your solution is measured by the monetary cost, the time cost and other costs.

This holistic assessment of the value you provide to your customer is the price you can charge them (and what they are willing to pay).

Increasing the profit of an enterprise increases the sustainability and resilience. It also allows the enterprise to invest for its future.

To increase overall profitability of a business, you must close the gap between what a customer is willing to pay and what you are currently pricing the good/service.

It is difficult to judge overall profitability of an item after changing in price due to effects upon the volumes consumers will want to buy, how sensitive consumers are to a change in price. This is known as elasticity.

If the margin is increased, the volume may fall and bring down the overall profitability.

A pricing strategy is important in optimizing profitability by manipulating both the margin and volume through determination of price.

Questions to Ask Yourself

  • What is the current cost of other alternatives?
  • What is the customer willing to pay?
  • Is there a gap between your current price and what your customer is willing to pay?

How you determine a pricing model? Above and beyond what it takes to deliver

The appropriate price for a product/business is one that maximises profit or sales growth for the business. To achieve this the real value of the item, as perceived by the consumer, must be determined.

Commonly, prices are determined with only reference to the production and delivery costs of an item and then desired mark up on top of that.

A mark-up is calculated by adding a set amount to the cost of a product, which results in the price charged to the customer. 

To find the value or true worth of the product an enterprise should identify their customer persona, who they are targeting their product/service, and why they are willing to pay to meet their needs or fix their ‘pain point’. The price of the product should be the value it creates for the customer – this is the importance of identifying your customer persona, as different target markets will perceive different values on the same item.

The competition for a your good is any current solution or alternative that your target market is using to satisfy their ‘pain point’. This could include rival products/services in the same market or cost of another alternative solution e.g. costs of time involved, stress and inconvenience.

Although, the price you should or do charge your customer may be different to this for a range of reasons.

  • The worth of an item is perceived differently within different target markets, or the overall perceived value is different from the real value created.
  • By pricing your solution below the delivered value may allow you to grow your enterprise faster. You will need a strategy to ensure larger numbers of potential customers know about the value your solution delivers.
  • Some enterprise deliberately under-price their solutions as that is appropriate for their clients. As an enterprise owner, that is your decision. We would encourage you to ensure your enterprise is economically sustainable at that price level. If you do decide to intentionally under-price your solution, we encourage to think about point 2 ,so you can deliver this great value to an ever larger group of customers.
  • Similar to above, many social enterprise aim at providing a service or good at an accessible cost for consumers and not aim to maximise profits. Although the understanding the value the enterprise is creating for consumers can assist in determining an appropriate strategy for them, maintaining the sustainability of the business, so it can continue to deliver into the future.

Questions to Ask Yourself

  • What is the customer willing to pay for my product/service?
  • What kind of customer am I targeting? What is their pain point/how much do they need the product/service?
  • How are your competitors pricing? How will you react to your competitors price? Can you offer something your competitors do not, if so what is the additional value of this? Are there any barriers to offering the real value of the product?
  • Is your product accessible to your target market?

Skimming vs Penetration – Pricing for growth (Margin vs Share) Penetration pricing relies on a low upfront price to attract customers, while skimming is the use of high upfront prices to maximize short-term profits from the most eager and interested customers. It is intended for increasing volume to increase profits. It is intended to attract a larger contingent of customers away from completion by applying a lower price point. It can also prevent competitors from cutting into your market at lower prices.

If your upfront price is low and your product or service is of reasonable quality, the burden falls on the competition to justify higher prices on similar offerings. Although Penetration pricing does not allow you to take advantage of consumers willing to pay premium prices for the item. Skimming (or trading at premium/increased value) is intended to increase margins – increasing profits. Operating with a high upfront price point that creates significant profit margin regardless of your cost basis.

Skimming creates a select market of customers, with broader market appeal coming later if prices are reduced/high value is recognised. It make more sense with a niche market of highly selective customers, fox example designer clothing brands charging a premium. Although The door is left open for subsequent competitors to undercut your prices and defeat your ability to generate revenue and profits from early adopters.

Price skimming hopes to pocket significant profit from initial customers and maintain high enough prices over time to maintain steady long-term profit from value-oriented buyers.

Questions to Ask Yourself

  • What is your current margins? What is your current market share?
  • Will decreasing your price lead to a market grab that increases overall profitability above and beyond margins?
  • Will increasing your price lead to increase in margins and overall profitability above and beyond market share?

Other Strategy Examples

Example 1 – Bundles

Bundles package multiple items together to create or demonstrate value to buyers, selling a group of items together at a lower price point than they would be individually.

Bundles can:

  • create demand for a little-known or new product
  • shift unsold stock and you want to get rid of it
  • promote a product that doesn’t sell well on its own
  • create demand for a little-known or new product

Common examples of this include additional options packages on cars or meal combinations at cafes.

Example 2 – Freemium

In a freemium model users get basic features at no cost and can access richer functionality for a subscription fee.

Freemium is often used as a marketing tool or market grab, aiming for virality to reach as many customers as possible.

To be successful the free product must successfully meet a user’s pain point and incentivise them towards to the paid product level. Freemium similar to penetration is used to grow volume/customer base rapidly.

A freemium product /service/platform can be costly to maintain if it fails to convert customers to paying users. it’s important that a freemium product has both (a) low marginal costs and (b) minimal sales and marketing expenses.

Example 3 - Price Discrimination

A price discrimination strategy is when an enterprise sets a different price for the same product based on the characteristics of the buyer. This is primarily relevant to service/subscription providers with fixed costs of delivery.

This is often used by enterprises to deliver services to vulnerable or underserviced demographics who would others not have access to the item.

Affordable housing or pensioners discounts on public transport is an example of allocating products at a reduced price to meet their target market’s needs.

It can also use as a marketing/brand awareness tool to gain market share in specific demographics, such as newspaper subscriptions offering tertiary student prices significantly discounted.

Example 4 – Optional Product Pricing aka Razor and Blades Model

In Optional Pricing, also known as the ‘Razor and Blades Model, a business can decide to sell their product for a much cheaper price than they ordinarily would and rely on the sales of optional products to make up for the difference.

In some cases, they may even sell the product at less than cost and rely on the "loss leader" attract customers to purchase other items produced by the enterprise.

In order for optional product pricing to be a viable method for your business, you need to have at least two products; one will function as the main product and the other as an accessory or complement to the basic product. This tends to work best when the core product relies on costly accessories.

The Main Product must rely on complimentary product in some way, but also be important to the consumer. E.g. Printers.

The complimentary product is something that someone who purchased the main product is likely to buy.  – e.g. Ink cartridges.

Distinguishing between price and value is important to strengthening the financial sustainability of your enterprise.