Optimal pricing models: 3 strategies for optimization

I want to tell you a story about three cupcake stores…

Kara’s Kupcakes sold delicious cupcakes and was known for being the most affordable cupcake store in town. Amidst the perpetual line snaking out of her store, Kara operated her business efficiently—but she recently discovered a problem. Despite selling out of cupcakes daily, she was barely making enough profit to cover her expenses.

Some of her more candid customers would tell her they couldn’t believe that she charged so little. Kara knew she wasn’t charging enough to cover the time and energy it spent to make the cupcakes, but she didn’t feel right about disappointing her customers and charging more to make a profit.

Sensing an opportunity, Kara’s friend Chris later opened a high-end cupcake shop across town, charging far more than Kara. Chris’s customers kept coming back because they knew his cupcakes were worth every dollar—each one had surprising and delightful ingredients. After a few months, Kara started to notice less foot traffic coming into her store—it turned out Chris was poaching some of her customers with the premium experience his shop offered.

But all was not right at Chris’ cupcake shop. Many potential customers entering the shop walked out after one glance at the price tags. Chris was disappointed that he’d often make cupcakes that didn’t get sold at the high price (it also hurt to throw them out), but he felt trapped—his costs were too high to slash his retail pricing.

Then, to both Chris and Kara’s surprise, their mutual friend Paulette started Paulette’s Pastries a few months after Chris opened his high-end cupcake shop. After hearing about their struggles with pricing decisions, Paulette felt she could thread the needle between price and cupcake quality.

From the outset, Paulette carefully forecasted, tracked, and calculated her costs to make the cupcakes and added a fair profit margin to the costs to find a price that people were willing to pay. Her line was never as long as Kara’s, but she regularly sold her cupcakes by the dozens and kept doing so as her reputation spread.

Pricing your products can be very psychological and a little like a Goldilocks experience: charge too much, and you don’t attract enough customers. Charge too little, and you create demand, but you may not cover your expenses.

Finding the perfect retail pricing strategy is a delicate balance, but it’s well worth the time to do some pricing analysis to find the best pricing policies for your company.

Price versus value

There’s a fine line between the price of the product and the value they perceive that product to have. In the cupcake example at the start of this article, we saw that customers thought Kara’s Kupcakes provided a stellar value for the price but that Chris’ Cakes weren’t worth what they cost to buy.

The key to pricing is to make customers feel like they’re getting tremendous value without cutting into your total profit. That perceived value—the worth a customer assigns to your product—doesn’t have to come from you offering the lowest prices; you can create value and still charge a fair price by offering add-ons like:

• Unlimited phone calls if a customer has questions
• Free report or assessment
• Surprise gift bag
• Free aromatherapy with a massage
• Exclusive access to content

But how do you determine that fair price—the amount customers are willing to pay for your products or services? The truth is, it usually takes some trial and error to get it right. We’ll dive into three pricing strategies to make things easier in a moment, but as a general rule, it’s better to start by charging too much and then reducing your pricing levels if you’re turning off customers with a high price point.

If your prices have been low and you’re not covering increasing costs as easily, it may be time to raise them. It’s a tricky task, but one that you can take inspiration from Netflix on—the brand recently increased its monthly subscription by $1 or $2 (depending on the plan), and customers haven’t balked much. Why? Because the value that Netflix offers is in line with the slight increase in price. If you’re going to raise prices, make sure there’s value coming along for the ride for your customers.

Optimal pricing analysis

Before determining what a fair price is for a retail product, you need to understand the market demand. Do a pricing analysis to see what they charge for similar products and how frequently they change the price (e.g., through promotional discounts). While you certainly don’t want to go far out of range with your pricing strategy, you don’t necessarily need to offer the lowest price. You just want to get a sense of where pricing falls in your industry.

Next, you need to dig into all of your actual product costs. Many new businesses only focus on materials and labor and don’t factor in other cost structures like brand, overhead, and salaries. Every expense that goes into running your business needs to be accounted for when determining different pricing. Understanding the marginal cost of your products can also help set prices.

And finally, research average profit margins in your industry. The field you work in will determine profit potential: a financial services business might see profits of 26% on average, while a restaurant might see 10% or less. Knowing the average, starting with a quick market survey or Google search, and diving in by asking former business owners or non-competitive operators can help you get an idea of the profit margin you want to build into prices.

Now we’ll look at three ways you can price a product:

• Dynamic: based on the demand curve and perceived value
• Competitive: based on the comparative value in the marketplace
• Cost-Plus: based on margins and volume

Dynamic pricing: supply and demand

Rather than having a constant price, a dynamic pricing strategy adjusts prices for products in real-time based on supply and demand. Consider how utility companies charge more for electricity used during peak use hours. Ecommerce brands like Amazon also leverage dynamic pricing based on demand for specific products. Though not a retail example, the most infamous and controversial example of dynamic pricing might be Uber’s surge pricing algorithm.

Dynamic pricing operates off of perceived value (the worth a customer assigns to your product) and not inherent value (what a product is worth based on expenses incurred), thereby letting the demand of an item determine the price. On a cold winter’s evening, you probably want to jack the heat up to stay cozy in your house. What you pay to use the heater during peak hours is worth it not to have blue fingers and chattering teeth.

Benefits to dynamic pricing strategies

You have greater flexibility over your pricing strategy when you apply dynamic pricing to your products. If a product is in demand, you can charge more for it and see profit maximization. If you’re struggling to sell it, you can reduce the price while still earning enough revenue to remain profitable.

You can also take business away from the competition if your price adapts to lower demand. Once people have purchased from your brand at a low price, you’re aiming for them to pay more for other products down the road.

Having control over your pricing and maximizing your profit margins is straightforward with dynamic pricing. For example, you can set pricing rules to change prices based on certain conditions rather than manually changing them. This might sound complicated, but it’s a cinch with the right business management software.

Examples of dynamic pricing

There are several different techniques within this pricing strategy:

Price discrimination:  A brand sells the same products at different prices. These may be sold to the same consumers or different ones through one sales channel or many. An example is a retailer that sells athletic apparel on its website at full price and lowers its prices on Amazon to meet that audience’s expectations.

Price skimming: With this technique, pricing starts high to attract early adopters and consumers who aren’t price-conscious, then gradually lowers over time. Useful for software or technology companies seeking to communicate high value for new products. Apple is well-known for charging top dollar for its latest iPhone and then reducing the price over time.

Yield management:  For perishable or time-sensitive products (think hotel rooms or airline seats), pricing is adjusted accordingly to maximize sales. Getting a lower profit margin is better than making no money on a product.

Competitive pricing: stand out in the marketplace

If you know what your competitors are charging for similar products, you can match them in the hopes of gaining market share by offering more value to accompany the price level.

An example of competitive pricing happens every week in your Sunday paper. You’ll see multiple drug store brands’ ads selling essentially the same products for around the same price. One might offer triple loyalty rewards with a purchase or a coupon for the next visit.

Benefits to competitive pricing strategies

When you know what the competition is charging, it is easier for you to find ways to stand out with your pricing model. Whether you opt to beat their prices or offer more value to charge more, you know your market and can deliberately choose how to price your business:

Examples of competitive pricing

There are several pricing strategies you can employ with a competitive pricing scheme:

Penetration pricing: For new products in the marketplace, charging a low introductory price gets customers into the habit of buying. When food brands introduce a new product (cereal is a great example), they offer it at a low rate initially. After that, a brand can slowly increase pricing. Once people have tried the cereal, the price goes up because now they enjoy and trust it, they are more likely to keep buying it at the higher price.

Promotional pricing: Similar to penetration pricing, this strategy offers a product at a reduced rate temporarily. For example, Macy’s typically charges higher prices than its competitors for its clothing but often has limited-time discounts or coupons that make their clothing more affordable. Our imaginary business owner from the opening section, Chris, could use this model to get more customers into his store to taste his cupcakes for the first time.

Captive pricing: Pricing for the main product (like a razor) is low, but the accessories or add-on products are higher-priced (razor blades). Because people need the accessory, a business gets built-in high, recurring profits.

Bundle pricing: Offering more than one product as part of a package deal, the shopper pays less for each item when buying them together. A shampoo might be bundled with a conditioner, the total price costing less than the two individually.

Cost-plus pricing: profit margin + cost

One of the most straightforward pricing strategies is cost-plus pricing . Once you determine the cost of your product and your target profit margin (as well as all those other expenses mentioned at the start of this article), add these numbers up to determine your price point. If a coffee maker costs you $15 to make, including all costs, and you want a 20% profit margin, you would charge customers $18.

Leaping back to our opening example, Kara could use cost-plus pricing to move her prices up slightly. Otherwise, she’d have to figure out a more sophisticated captive or bundle pricing model, lower her costs, or go out of business.

If, however, you plan to sell volume amounts to distribution channels like retail and ecommerce, you would need to reduce your per-unit price to reflect wholesale pricing.

Examples of cost-plus pricing

Here are a few examples of cost-plus pricing strategies:

Variable cost-plus pricing:  Sometimes costs aren’t fixed, and that needs to be accounted for. If it’s cheaper on a per-unit basis for you to manufacture 10,000 products versus 1,000, you can charge less for larger orders. A candle brand that sells on its website would drop the price per candle to supply a conference hall with 100,000 candles, and the candle brand’s cost would go down since larger quantities of supplies would cost less per unit.

Tiered pricing: By offering different packages with different levels of services or products, a brand can charge more for each level. An example is a software subscription with Basic, Advanced, and Enterprise packages, each with more features.

Final thoughts

Developing your pricing model can take time, and it requires keeping a pulse on your audience’s ever-changing preferences. Are they more likely to buy based on price, or do they prioritize value above all and are willing to pay a premium for your products?

Know that discounting your pricing might be an excellent promotional strategy temporarily to attract new business. Still, ultimately it will cut into your ability to invest in the future of your business.

Had Kara been a bit more flexible in charging what her cupcakes were worth (calculating her costs, then adding a profit margin), she might still be in business. And if Chris had worked to find more inexpensive ingredients to bring down his price, more customers might be gobbling up those cereal milk cakes. Paulette’s business, driven by the market, was pragmatic — and enabled her business to endure.

Settling on a pricing solution doesn’t have to be carved in stone. You can raise your prices but do so mindfully. Only raise them if you’re not covering your expenses (or if your costs have recently increased), or infrequently—every few years. Let customers know in advance that your prices will increase, so it’s not a nasty surprise.

Finding that perfect price point for each product ensures that you have a healthy profit margin that will help your business thrive over time.