Truth 42. Pricing: The most dicey element in the marketing mix
Of the four elements of a business’s marketing mix—product, price, promotion, and place (or distribution), price is often the toughest. A business doesn’t want to undercharge for its products and services and leave money on the table, nor does it want to overcharge and drive business away.
The price a company charges for its products and services also sends a clear message to its target market. For example, Oakley positions its sunglasses as innovative, state-of-the art products that are both high quality and visually appealing. This position in the market suggests the premium price that Oakley charges. If Oakley advertised innovative, state-of-the art products but charged a bargain basement price, it would send confusing signals to its customers. Its customers would wonder, “Are Oakley sunglasses high quality, or aren’t they?” In addition, the lower price wouldn’t generate the sales revenue Oakley needs to continuously differentiate its sunglasses from competitors’ products in ways that are meaningful to its customers.
The price a company charges for its products and services sends a clear message to its target market.
Most business owners use one of two methods to set the price for their products: cost-based pricing and value-based pricing.
Cost-based pricing
In cost-based pricing, the list price is determined by adding a markup percentage to a product’s cost. The markup percentage may be standard for the industry or may be arbitrarily determined by the business owner. The advantage of this method is that it is straightforward, and it is relatively easy to justify the price of a product or service. The disadvantage is that it’s not always easy to estimate what the costs of a product will be, particularly for a start-up. Once a price is set, it is difficult to raise it, even if a company’s costs increase. In addition, cost-based pricing is based on what a company thinks it should receive rather than on what the market thinks a product or service is worth. It is becoming increasingly difficult for businesses to dictate prices to their customers, given customers’ ability to comparison-shop on the Internet and find what they believe is the best bargain for a product.[1]
Value-based pricing
In value-based pricing, the list price is determined by estimating what customers are willing to pay for a product and then backing off a bit to provide a cushion. What a customer is willing to pay is determined by the perceived value of the product and by the number of choices available in the marketplace. Sometimes, to make this determination, a business has to conduct focus groups or try different pricing options to test markets. A business influences its customer’s perception of value through branding, promotions, and the other elements of its marketing mix.
Whether you choose cost-based pricing or value-based pricing is an important call. Most experts recommend value-based pricing because it hinges on the perceived value of a product or service rather than a cost plus markup, which is a formula that ignores the customer.[2] Most experts also warn new business owners to resist the temptation to charge a low price for their products in the hopes of capturing market share. This approach can win a sale but generates little profit. In addition, most consumers make what’s called a price-quality attribution when looking at the price of a product. This means that consumers naturally assume that the higher-priced product is also the better-quality product.[3] If a business charges a low price for its products, it sends a signal to its customers that the product is low quality regardless of whether it really is.
Most experts recommend value-based pricing because it hinges on the perceived value of a product or service rather than a cost plus markup, which is a formula that ignores the customer.
Of course, regardless of whether a business chooses cost-based or value-based pricing, its price must make sense given the realities of the marketplace. Some businesses are able to charge a premium price for their product or service. To charge a premium price, one or more of the following characteristics must generally be present:
Demand for the product is strong relative to supply.
Demand for the product is inelastic. (People will buy at almost any price.)
The product is patent protected and has a clearly defined target market.
The product offers additional features that produce tangible benefits (for example, a strong warranty that protects against having to prematurely replace the product).
A new technology is being introduced.
The product serves a compelling need (like a pharmaceutical product that relieves pain).
The product is a luxury item and targets an affluent clientele.