The Simple Guide to Pricing Strategy (for Small Business)

1. What is Pricing Strategy?

A little myth-busting to start…

Pricing Strategy is often misinterpreted as “how much margin should I add?”

If I reduce my margin, I’ll have higher sales. Will the higher sales compensate? If I halved my margin but tripled my sales, then I’ll be up in total…

There are two giant assumptions baked into that idea.

Firstly, that you can adjust your price on its own, without it affecting anything else.

Secondly, that reducing prices will lead to more sales.

Those two assumptions are incorrect and have led many a business to flounder. Yes, in some cases they hold true, but in other cases, they have the opposite effect.

If I offered to sell you the best-made car seat for your first-born child for €29.90, would you buy it? Unlikely. If I priced it at €100, you might consider it though.

Pricing Strategy = the full picture

Pricing Strategy is looking at the full effect of your prices - how it ties in with your product design and with your marketing plan. They are all interconnected, and adjusting one means an adjustment to all.

Setting your product’s prices is a full science in itself. Thankfully, getting the fundamentals right is more than enough for most startups and small businesses. Here are the fundamentals we have used to create many successful small businesses.

2. Cost-Based Pricing vs Value-Based Pricing

When I chat to people about pricing strategy, the first thing that pops to mind, for most people, is margins.

“So, that’s deciding how much margin to put onto of my costs, right?”

Well, it could be.

That’s one option, though for the record I don’t recommend it. In fact, there are lots of pricing methods out there, but let’s start by boiling it down to two fundamental options:

Option 1: Cost-Based Pricing Strategy

This is sometimes called the cost-plus pricing method. In short, you look at your costs, stick on a margin, and you have your selling price. Don’t forget to include something to cover your fixed costs as well as your variable costs.

Option 2: Value-Based Pricing Strategy

This is where you ignore the costs completely, and instead look at what value your product brings to your customer. In other words, you set the price by looking at the rivals & deciding what the market is willing to pay.

Selling houses is a great example of the Value-Based Pricing method. When setting the asking price for a house, people do not look at the cost of the bricks used to build it. They look at what people are willing to pay for such a house, i.e. the market value of the house, and set the price based on that.

Which pricing model is better?

Let’s work an example - John’s Garden Shed Company. He has recently decided to start a business selling garden sheds. Go, John.

Rivals are selling similar sheds for €1,000 each, in other words, the market price for a garden shed is €1,000.

Using the Cost-Based Pricing model

Scenario 1 - John’s costs are €400 per shed

The Cost-Plus pricing method would tell John to sell them for €500 per shed. The margin is €100 per shed. That was stupid, the market is happy to pay €1,000 per shed, he could have made a margin of €600 per shed.

Scenario 2 - John’s costs are €1,200 per shed

The Cost-Plus pricing method would tell John to sell them for €1,300 per shed. He sells none at all. Everyone buys from the competition, who sell sheds for €1,000 each.

Cost-Based pricing has led John to set an ineffective price for his sheds in both cases.

Using the Value-Based Pricing Model

In Value-Based Pricing, the method is much simpler. What is the market will to pay for sheds of my quality? €1,000. OK, the price is €1,000 then.

Scenario 1 - John’s costs are €400 per shed

The Value-Based Pricing method would tell John to sell them for €1000 per shed, so making the maximum possible margin of €600 per shed. Good work, John.

Scenario 2 - John’s costs are €1,200 per shed

The Value-Based Pricing method would still tell John to sell them for €1,000 per shed. He realises he has a bad business model before he’s even started and goes back to the drawing board.

The Value-Based model, being market lead, has saved John from setting up a business that was bound to fail.

What about costs in a Value-Based Pricing Strategy?

Your costs tell you if the project you are planning is a good idea. They should have no effect on the price.

When doing a business plan, you should treat pricing and costs as two separate jobs.

If your costs are nicely below the market price, you have a good business idea. If not, it’s back to the drawing board.

Value-Based Pricing is much better. Ignore your costs completely and price to the market.

3. Skimming Pricing vs Penetration Pricing

So, John’s decided he wants to use a Value-Based Pricing Strategy. Kudos to John.

But should he be bang on what the rivals are doing? Touch more? Maybe undercut a little?

We call this decision Skimming Pricing vs Penetration Pricing

Penetration Pricing: undercutting the rivals

Penetration pricing, or undercutting, is where you purposely charge a below-market rate. It’s common where large organisations are trying to force their way into an established market.

It is common in aviation. If I open a new airline offering transatlantic flights, I might need to undercut the rivals for the first 6 months to get some traction and become an established player in the market. Once established, I can change my prices to a more normal rate.

John could go for penetration pricing. He could sell sheds for €750 each and blow the competition out of the water. He might not make any money at that price, but it’s only short-term. Once he’s an established name in the shed game, with word-of-mouth referrals and testimonials flying in the door, he can increase his rates back up to €1,000 where he can make a reasonable profit.

Skimming Pricing: taking the cream from the top

Skimming pricing is usually associated with a unique or very upmarket product. You purposefully set a high price and just take the very top end of the market.

For example, foldable smartphones. These are purposely priced very highly. Few people will be will to pay the high rates, but there’s a good margin on those who do. The high pricing gives a feeling of exclusivity, which in itself is desirable.

High Price = Desirable

It’s often the case that being overpriced is part of the attraction of luxury brand products. Part of the attraction of a Rolls-Royce is the status symbol, I must be wealthy to afford such an item. If Rolls-Royce halved their prices, they would lose an important part of their brand’s appeal.

John could go for skimming pricing for his sheds. Charge €2,000 per shed, but for an amazing shed. Sunroof, decking, downlights… the works. Those extra bits only increase his costs by €400, but he’ll purposefully push the price up by far more.

He’ll not sell many, but as he’s the only person offering such top-of-the-line sheds he’ll have a monopoly on that top-end market. And the margin per shed is great.

4. The Price-Quality Expectation

Price Implies Quality

There’s no getting around it. People associate the quality of an item with its price tag.

“Top Quality for Bargain Prices” - this is a contradiction in most people’s eyes. A product can be expensive and high quality, or cheap and low-quality. Claiming to be both is perceived as a big marketing lie. Your market will think you are untrustworthy and will not believe anything you say about your product.

Your price will be interpreted as your quality level. If you want people to see your product as up-market, it has to be priced as such.

It’s about perception, not truth

Do note that the actual quality level of your product does not matter here.

Effective marketing is about being credible in the eyes of your target market. It’s about what your market will believe about your product.

If you are not credible in the eyes of your market, no one will ever buy your product to then discover its real quality.

For example, many years ago the carmaker Lada made a series of adverts about their cars winning rallies across the desert, complete with dramatic music & footage. It was completely ineffective. Why? The audience watching didn’t believe a Lada could win a rally across the desert. The fact they had actually won those rallies did not matter. It was not perceived as credible.

So even if your product is top quality at bargain prices, you cannot market it as such because no one will believe you.

Discounts: The exception to the rule

The one exception to the rule is special offers & discount pricing. Here you can imply a quality level above the price paid.

Many customers will feel they are getting the quality level of the original price while paying the discounted rate.

Be careful with the overuse of discounts, though. This only works if your customers really believe someone else was buying the product for its original price. Regular customers may see it as a cynical marketing trick, and there are laws governing such in sectors such as retail.

Increasing the price to increase demand

When After-Eight mints were launched, they did not sell well. So, they hiked up the price and put swanky ads on the TV. Suddenly, no self-respecting dinner party guest of the ‘90s would be seen without a pack.

Same product + higher price = more sales.

The higher price instilled desirability in their target market.

Price = Safety

You can buy a bike rack to go on your car for €120.00, and another for €900, both of which do the same job. They all pass the same EU safety tests, so surely everyone would buy the cheaper one?

Not so, at all. There is a significant sector of the market that will not buy a bike rack at €120 because it’s too cheap, so in their eyes cannot be safe. They don’t know the product, they are not engineers. So they decide purely on the price tag and think nothing could be safe going up the motorway that costs €120.

People looking for higher quality may prefer a higher price, as they feel more assured about the quality level of the product.

5. Varying your margin across the product range

Where should you make your margin? It is not on every product, and margins should not all be equal.

Loss Leaders

Bricks and mortar stores use this a lot. Supermarkets with “1 kg of carrots for 50 cents”, or a clothing shop with a sales rack.

They may make a loss selling such items, but it gets shoppers in the door who’ll purchase other more profitable items whilst they are there.

Upselling

This is either persuading customers to upgrade or selling related products along with their main purchase. It is these extras that contain most of the margin.

Take cinemas, for example, which lean heavily on selling sweets and drinks to increase their profit margin. The films are only there to get people to come into their sweet shop.

Or computer vendors. Myself, I’m yet to buy a computer as advertised. I see the machine with a great price tag. Wow, that really is a good price. Then I see that I can double the RAM for only €100 more. And how about a better hard drive too?

The headline product gets me to buy, but the upsells are where the margin is.

Freemium

This is used a lot in digital products. The simple version is free. That gets users to sign up and start using and enjoying the product. But, if I want the extra features, then that’s the premium version that I have to pay for.

Decoy Pricing

Sometimes, a product on its own can look like bad value.

Decoy pricing is where a decoy item is added purely to make the original item look like better value. The decoy is not intended to be sold. It’s there to purposefully look bad, and so make the item next to it look good.

Let’s take cinema popcorn, for example

Imagine I’ve only one size: “Large Popcorn - €5”. That’s sounds expensive, popcorn kernels cost nothing in the supermarket.

So let’s add a decoy:

Small Popcorn (the decoy) - €4.60

Large Popcorn - €5

The small one really is bad value. But next to it, somehow the 5 euro option doesn’t look so bad. You get twice as much popcorn and it’s only 40 cents more.

Or the wine menu

The restaurant is not expecting to sell any of the €80 bottles of wine on the menu. Their purpose is to make the €40 bottle look better, and encourage people to upgrade above the house bottle level.

Rule of 3s to encourage the upgrade

Decoy pricing is often used in threes when you want people to upgrade.

Let’s say my cinema is also selling drinks:

Small drink - 8oz: €3

Large drink - 18oz: €5

Too many people keep buying the small size, we want more to go large

The psychology here is value - people like to feel they are getting the best value / deal out there. So, if I can make large appear better value, more people will pick that.

The problem is that both of the above are pretty similar in value, there’s no clear-cut winner.

Let’s add the decoy:

Small drink - 8oz: €3

Medium drink (the decoy) - 12oz: €4.50

Large drink - 18oz: €5

Suddenly, the large drink stands out as great value. 50 cents more gets you 50% more drink.

Decoy pricing is a huge, and effective, topic. This is a great article by HumanHow.com about decoy pricing if you’d like to know more

Your margins should not be even across the board. Using pricing strategies to vary your margins, across your product range, can lead to far more sales and profit than a consistent margin.

6. Yes, you can change your prices

At first, the number of choices for how to price your products can seem overwhelming.

But don’t worry, it doesn’t have to be a one-time decision. It’s okay to change your product prices if the first system is not working as expected. In fact, I’d encourage it.

If some part of your business isn’t working out, you’d never continue it just because you’ve started it. The same view should be used for how you price your products. There are countless examples of companies, big and small, changing both their product prices and pricing strategies with positive results.

Yes, you might annoy and lose a few customers. But, you’d only do this when the original pricing model isn’t working, so the improved system should gain you far more customers than you’ll lose.

A great example of changing prices for the better comes from British Airways, many years ago when they were flying the Concord.

It was losing money, but they thought they were charging as much as the market would accept per ticket. So they did a survey of the passengers, asking them what they thought they had paid for the tickets.

As it turned out, most of the passengers were business executives and had secretaries who actually booked the flights. The business executives themselves didn’t know what the tickets had cost. When asked, they guessed higher than the real price. So, British Airways increased the prices to match what the customers thought they were actually paying.

If the first product pricing strategy doesn’t work out, don’t worry. Be bold and experiment with a new pricing system.

7. Final Thoughts

Setting your prices is both a fascinating and complex task. Most of the sections above are a full topic in their own right.

The above principles though should stand you in good stead. Certainly, it’s all we’ve needed across a large range of successful businesses that we are involved in.

If I could leave you with 2 final thoughts:

With Pricing Strategy, there are always other options. If your pricing system appears is black and white, plainly obvious, then I’d suggest there’s more homework to be done. There’s always another pricing strategy you could choose.

And, if at first, it’s not working as expected, be bold and try and new pricing strategy. This has been the key for many a successful business.