Pricing Models Explained

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Traditionally, pricing in the bricks-and-mortar world has been set under one of four main pricing models.
These are:

  • Cost-based pricing models.
  • Customer-pricing models.
  • Value-based pricing models.
  • Competition-based pricing models.

 

Cost-Based Pricing

To price using a cost based pricing model you need to understand your product costs.

Using this method, you will need to know your variable costs (those costs that are related to the production of the product such as raw materials, labour and transport, advertising) and your fixed costs (those costs that do not change regardless of production such as management salaries, rent, utility bills).

Using the cost based method to price, your price must be higher than your variable costs because the price you get should also make a contribution towards fixed costs. In addition, if you have invested in development (which is typically expensive) you should be pricing to recover this investment as well.

What usually happens is that businesses take the cost of making the product and add an amount to make a profit. This may be expressed as a percentage markup. It is frequently used in retail businesses since a percentage is easy to apply, and suits some manufacturers as well especially where volumes apply or the market may be price-driven.

Price can also be set up calculating backwards. In this technique, a profit objective is set then costs are deducted leaving an amount which is divided by unit to reach a price point.

In other words, if a consultant wants to earn $100,000 gross per annum and has annual billable hours of 1,000 and costs of $20,000, the consultant’s hourly rate will be charged as follows:

$100,000 = $120,000 – $20,000/1,000 = $100.00 per hour

In cost based pricing, the pricing ignores the brand positioning, and as a consequence may not enable you to potentially maximise your profit position.

Add the amount of profit you want to make to determine your product price. After that, you should calculate the breakeven so you know how many units you’ll have to sell in order to make a profit.

Some of the common techniques in which cost based pricing are expressed are:
 

  • Cost plus markup.
  • Keystone pricing.
  • Calculate backwards.

 
Pricing Strategy

For information about how to model costs head to Basics of Costs. If you want to know how to calculate your breakeven go to the Breakeven Analysis module.
 

Customer – based models

The intent of customer based pricing models is to use price to attract customers.

It includes an array of pricing techniques such as using price to support a brand image, or conversely to use it to increase product sales. Some techniques, like those that typify the software industry, use tiered structures to appeal to different niche markets. Others, like telecommunications, use bundles (or packages) of product to create “brand stickiness”.

TECHNIQUES IN WHICH CUSTOMER-BASED PRICING ARE EXPRESSED INCLUDE:
 
SPECIFIC, SEGMENT OR NICHE-BASED PRICING.
This technique is where different groups of customers get different pricing. This can include membership or trade pricing; tiered pricing models which based upon the ability to pay (this is typical of the software industry where trial versions are free and educational versions are cheaper than commercial versions); based on geography and so on.
 
PRODUCT BUNDLING.
Product bundling (including capped plans) and quantity discounts (such as 5 for the price of 4, buy one and get one free, or larger product containers offering 20% extra for free). Popular model in telecommunications where a handset can be bundled with calling; or home phone, Internet and entertainment services are sold as one bundle.
 
SINGLE VERSUS MULTIPLE PAYMENT OPTIONS.
This technique is very popular on home shopping TV channels because it makes the product seem cheaper to buy. Department stores offering lay-by services is another example.
 
ASSET FINANCE BY THIRD PARTIES.
High value goods are offered for sale through third party financiers (such as asset finance companies). This technique is popular in electronic appliance, computer and motor vehicle purchases and is no risk to the retailer since the financier holds the risk. Examples include interest-free periods, no repayment periods and buy now pay later promotions.
 
USING BRAND POSITIONING TO DETERMINE PRICING.
This is especially true in prestige (premium) pricing environments.
 
LOSS LEADING.
This occurs when a retailer sells a product at or below cost. This technique is used to take market share from a competitor or to get customers to whom you will sell more profitable products.
 
SPECIAL OFFERS.
Special offers are used to encourage short-term inventory movement. These are extremely common and include such techniques as sales, coupons and special offers.
 
AUCTIONS.
Auctions allow the market to decide the price of the goods. This is commonly used in the sale of real estate (in some countries) and other goods over sites such as eBay.
 
CONTRACT PRICES.
Under contract, a buyer commits to a minimum spend and/or minimum volume of products purchased over a defined period of time enjoys a reduced price in return for making this commitment.
 
CUSTOMER-NEGOTIATED RATES.
This pricing technique is common in the B2B environment where customers have unique pricing based on their volume, relationship to the vendor or other criteria.
 
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Once you’ve set a price point, you can find out how much volume you need to sell by doing a Breakeven Analysis.
 

Value-Based Pricing

Value-based pricing is a model whereby a business seeks to quantify the benefit a customer derives from using its product and use this as the basis from which to price the product.

For example, what is it worth to a manufacturer to have its raw materials turn up on time? (Especially when a failure may result in factory closure or production lines being halted.)

When looking at the elements of value, look in non-product related area. So value elements may include, for example, such elements as:
 
MAKING A DIFFICULT JOB EASIER.
If you can make a difficult job easier it is therefore less time-consuming. If the time saved can be quantified, and an hourly or daily rate applied to that time saved, you have the basis for a quantifiable benefit.
 
REMOVAL OF MANUAL LABOUR.
Removing manual labour components may lead to potentially reducing staffing requirements. For every staff member that is not required or is redundant, there is a quantifiable benefit.
 
ON-TIME, RELIABLE DELIVERY.
On-time reliable delivery (especially if products are essential to the ability to produce) means factory production continues uninterrupted. The costs associated with lost production time are immense for large manufacturers and are easily quantifiable.
 
BEING CHEAPER THAN THE ALTERNATIVE.
For example, video conferencing using your computer is cheaper (and quicker) than flying to a meeting). It may also be much less stressful especially if travel intrudes on work-family balance requirements.
 
value-based-pricing
 
HOW TO CALCULATE VALUE-BASED PRICING.

To calculate value-based pricing there are two approaches both of which attempt to quantify the benefit to the customer of the product or service supplied.

The first is fairly easy to calculate.

Using this website as an example, you can quite easily quantify the benefits to users.
 
BENEFIT ONE: THE INFORMATION IS CENTRALLY HELD:
So even if you could find all the information somewhere else, you would need to spend hours or days maybe even weeks searching the Internet and libraries to find it.

What’s your time worth? Do you have your hourly rate figured out? And how big is the opportunity cost?
 
BENEFIT TWO: YOU DON’T HAVE TO DO WHAT I DID TO GET THE KNOWLEDGE:

  • You could complete an equivalent MBA to mine (that’s about $30K upwards (depending on your university) and 2 years of your life)
  • Hire a senior marketing director (that’s about $200K or more per annum)
  • Hire a consultant strategist (that’s at least $200 per hour if you can find one).

 
Some products, though, are not so easy to quantify.

One such model that looks to help businesses to better understand and thus quantify value is the Simalto model.

Essentially a grid is created that includes attributes with different levels of service/product option benefit as its columns.

You can use this model to create your own framework (however if you want something more statistically valid, you can properly research Simalto).
 
SIMALTO MODEL PROCESS:

  • First, respondents look through the attributes and rank them in terms of importance.
  • They draw a red circle around their expected option from a top quality supplier.
  • They draw a green circle around what they perceive they currently get.
  • Unacceptable options are indicated with black crosses through them.
  • Then they repeat the same exercise with the main competing brand (their second choice).

 
Then the respondent is given a limited number of points and is asked to assign those points. They are asked:
 

  • How they would allocate their points budget to show first priority improvements.
  • To show where they would make savings.
  • To highlight those activities that would motivate them to change behaviour (such as increase usage, pay more, or change suppliers).

 
Here is an example (you can plot your own):
 
Simalto Value for Money
 

Competition – Based Models

Competition based pricing occurs when you use your competitor to set the benchmark for your price. This can be charging the same, just above or just below competitor prices.

Some of the common techniques in which competition based pricing is expressed are:
 
RECOMMENDED RETAIL PRICE (RRP)
Some manufacturers set a recommended retail price so that smaller businesses can avoid price wars and continue to earn a healthy profit.
 
PENETRATION PRICING
Penetration pricing which is the setting of a price point deliberately designed to lure your customers away from competitors and build your market share. This technique is often used in the introductory and early stages in a product’s life cycle. By growing the customer base rapidly, a business can generate economies of scale and reduce its costs. This can help to secure the first mover advantage and make it harder for other entrants to follow you into the market. Once a business has achieved penetration, it may move to pricing designed to hold its market share.
 
SKIMMING
Skimming is a technique that is applied to unique products or services where the business sells these at a high price. (The key ingredient to this technique is that the product is genuinely unique otherwise it is just premium pricing and there is the potential to price yourself out of the market). Businesses can charge a premium because they have substantial competitive advantage but this advantage is not sustainable. This technique is extremely common in the release of new electronic appliances. For example, the first Plasma (flat screen) televisions released in Australia were priced at $20,000 each. Today, an equivalent television will cost less than $2,000. The same pricing technique has been applied to many products such as DVDs, VCR machines, Microwave Ovens and so on.
 
Pricing Strategy
 

Pricing On The Internet

Many of the offline pricing techniques are used on the Internet.

Rather than spawn a proliferation of new pricing techniques, the Internet has more strongly focused consumer attention on pricing. This is why.

First of all, the Internet is a cheaper channel than setting up a bricks-and-mortar equivalent. So the consumer already has an expectation that pricing will be reduced to reflect this lower cost. Online destinations such as eBay reinforce this perception, as does the proliferation of price comparison sites.

Secondly, the Internet has a great power of reach, far greater than your local corner store.

Websites can be found by anyone, anywhere that has a computer connected to the Internet and it creates a truly global market with a buying public that is massive in size.

Businesses that serviced a local area can now service global markets cheaply and efficiently.

Then, if exchange rates are favourable between countries, a buyer can take advantage of this and effectively slash the purchase price since it can mean that goods bought from overseas are much cheaper to import than buy the local equivalents.

Thirdly, information is instantaneous – allowing the consumer to quickly and easily learn about products, read user reviews and compare prices.

If exactly the same product costs $20 less at an equivalent store, with all other things being equal, a consumer will buy from the cheaper store.

And the transaction is normally secure and immediate.

There is no queuing in line, waiting for a salesperson to attend to you or waiting for a telephone to be answered.

It is the ultimate self-service environment, free from sales pressure, where the customer can help themselves whenever they please.
 
EXAMPLES OF COMMON PRICING TECHNIQUES ON THE INTERNET:
 
AUCTION
Where the market decides what a product is worth. An example of this is eBay.
 
DONATION
Where the price is whatever the user can afford. An example of this is Wikipedia.
 
PRICE REDUCTION
Where the price is permanently lower than bricks-and-mortar equivalents. An example of this is Amazon.
 
PENETRATION PRICING
Where products are given away to secure market share. An excellent example of this is Google.
 
TIERED OR PRODUCT LINE PRICING
Where different price points are offered to different customer groups. This is very common in the software industry.
 
GEOGRAPHICAL PRICING
Where prices differ between countries. An example of this is airlines which offer travellers from one country a different price to travellers in another country even though the flights are the same.
 
EMERGING TRENDS
Free use/access is a technique that is increasingly popular on the Internet (try before you buy). It means that the buyer gets something for nothing and it establishes a market desire for more of the product and it establishes trust, credentials and authority (where appropriate)(for example, online training courses). In the case of apps, free giveaways are very common, with in-app purchases and advertising the main revenue models being used.
 
READ: More about pricing strategy.
 

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