Whether you sell a good or a service, it’s no secret that pricing is a crucial component to running a business. Not only does the proper pricing of goods affect the amount of money coming into your business, it also affects your ability to target your ideal market. As a result, it’s vitally important for small businesses to set the right prices on their goods and services from the start.
Many new business owners assume that the only way to beat the competition is to offer low prices. Similarly, many may engage in price skimming where they charge the highest initial price that a customer will pay, satisfy the demand at that price, and then lower the cost to meet demand in the next price category. They continually lower their rates until they attract customers in each price segment.
While these strategies could be useful, they could also have a significant impact on the firm’s profit margins. Fortunately, there is an alternative strategy you can consider when offering a new product.
Premium pricing, also known as “image pricing” or “prestige pricing,” involves pricing a product above standard market value so that customers think a product or service is more valuable than similar offerings. In this article, we’ll cover everything you need to know about this price strategy so you can determine whether it’s useful for your business.
What is premium pricing?
Premium pricing involves artificially setting the price of a product higher so that it has a favorable perception among buyers. In essence, the high price gives the appearance of a luxury good or a higher quality.
This strategy is a form of psychological pricing in that it appeals to a buyer’s psyche. Although the price may dissuade some buyers, premium pricing proponents believe that the higher cost will create a market perception that will ultimately bring in more revenue.
Consider the following example. You sell a good with a break-even point of $7. You seek a 10% profit margin, which means you would have to sell the product for $7.70. However, a competitor is already selling its product for $7.50. If you price your product at $7.70, your competitor will have you beat when it comes to a lower price and will get most of the business as a result.
If you choose to utilize a premium pricing strategy, you can set the price to $14. Because of the higher price tag, you give the appearance of a luxury brand. This price point also provides high profit margins.
When pricing the good at $7.70, you would need to sell a high volume of goods — ten, to be exact — to hit the same profit margin that you would when selling one item at a higher price.
Of course, other factors go into this. For instance, if you’re not pushing as much inventory, you may have higher overhead costs. You also may see the price of a product go up because you’re not receiving as good of deals from wholesalers and suppliers. But, this example demonstrates how premium pricing works at the most basic level.
So is a premium pricing strategy right for you? Below we’ve evaluated some of the pros and cons of the approach.
Pros of premium pricing
While small businesses may be hesitant to hike up prices on their products and services, research suggests that premium pricing can be valid under the right circumstances. Here are some advantages associated with adopting a prestige pricing strategy.
One benefit of premium pricing is that it helps companies fend off their competitors in the marketplace. By putting money and energy into advertising premium-brand goods, companies can make it all but impossible for new businesses to enter the same market without investing equal capital in marketing. Additionally, you establish an entry barrier in that other businesses will be forced to sell their product at a lower price point if they wish to have any form of market share.
If you want to raise brand awareness for your product, premium pricing may be an effective strategy. When companies engage in prestige pricing, customers tend to view their products as more prestigious and, as a result, more desirable. The assumption is that a high price indicates high quality as well. Further, raising rates can increase product buzz. As people talk more about your product, brand awareness and general interest tend to grow.
Finally, premium pricing strategies offer the advantage of raising a firm’s profits. However, businesses should be aware that prestige pricing tends to require a greater investment in marketing. To stay profitable, companies must either set the price per unit high enough to cover the additional marketing expense or expand their audiences to sell sufficient volume.
Cons of premium pricing
In spite of the advantages, not all businesses are equally suited to a premium pricing strategy. The following are drawbacks associated with selling goods at premium prices.
The high cost of marketing is a serious drawback associated with prestige pricing. Unless companies invest sufficient and sustainable funding to promote their goods and services, the premium brand recognition is likely to dissipate. After all, customers are unlikely to pay high prices for products they’ve never heard of. If you can’t afford to market your premium brand goods, you may be better off setting rates at a more competitive price point.
Similarly, you also need to invest heavily in research when employing a premium pricing strategy. In reality, you should do this before you set the cost of any good or service. But it’s more critical than ever when employing a premium pricing strategy. You need to have a strong understanding of the average market price in your industry. There’s no point in pricing yourself out of the market if you realize there’s no need for a luxury product.
Premium pricing strategies can be problematic for companies with a great deal of competition. Not only can competitor businesses draw attention away from your goods and services by offering alternatives, they can also create a perception in the market that the product category itself is less exclusive or exciting.
As a result, customers are less willing to pay premium prices. In some cases, a company may be able to use premium pricing as a short-term strategy that it abandons when competitors arrive on the scene. As we highlighted in our introduction, this is an example of skim pricing.
Limited customer base
While premium pricing means higher profits on every unit sold, many businesses that try this strategy find themselves selling to a limited customer base. After all, you are effectively pricing yourself out of an entire segment of buyers. If you choose to employ prestige pricing, you need to focus your marketing endeavors on top-tier clients who can afford your business.
May not work with all products or services
One of the other downsides of premium pricing is that it may not work with every product or service. This goes hand in hand with the “limited customer base” problem. Take rice, for example. In the grocery store, dozens of manufacturers produce rice. Imagine that the average cost of a box of plain white rice is, say, $2.00. You’re comparing boxes, and you come across a box for $6.50.
Is the consumer — or are enough consumers — really going to pay $6.50 for a box of rice when there are dozens of other options available? Probably not. So a premium pricing strategy may not be a viable option for every company.
Premium pricing strategies in the real world
An example of a current-day company that practices premium pricing is Apple. Apple continually prices its smartphones and gadgets higher than those of competitors. Steve Jobs helped build Apple into a worldwide force by focusing on four pillars of business:
- Focus on offering high-end products
- Offer a limited number of luxury products
- Prioritize profits over market share
- Use a “halo effect” marketing strategy that makes people desperate for new Apple products
The company coordinated this premium pricing strategy with similar marketing efforts and company culture. Current CEO Tim Cook told Bloomberg Businessweek, “We never had an objective to sell a low-cost phone. Our primary objective is to sell a great phone and provide a great experience, and we figured out a way to do it at a lower cost.”
This quote demonstrates the marketing stance that Apple has taken. Cook admits that the company’s phones are not low-cost but that they are “great” and that users receive a “great experience.” This plays to a consumer’s psyche. By paying more, they must be receiving great value.
Cook also admits that their costs are low. They could, hypothetically, charge a lower price for their phones because of their lower cost of production. But they choose not to. While this may price them out of the range of some consumers, it also keeps their profit margins high enough that the company is profitable.
This strategy has worked. Flipsy estimates that kids will spend $300,000 in their lifetime on Apple products, compared to the overall average of $75,000. The company is the US-leader in market share in the smartphone industry.
Another example of premium pricing is seen in the luxury car industry. There are hundreds of different models of cars on the market. A handful of them focus on providing luxury vehicles. These companies successfully express to their customers why their product or service provides value — and why customers should consider investing more for such value. Luxury car companies like BMW and Audi can compete and thrive because of the perceived luxury car experience they provide to owners.
The last example is seen in the fashion industry. Companies may increase the cost of shoes, handbags, and clothing because of the demand associated with brand recognition. The perception of certain fashion houses as providing luxury products allows those brands to use premium pricing.
Best businesses for premium pricing
We’ve mentioned a few industries where premium pricing strategies tend to thrive. In addition to these industries, the approach can also be useful in fields that tend to have substantial barriers to entry, such as those with high startup costs or significant marketing costs.
By investing in premium products, a company can make it hard for new competitors to offer similar products at the same prices without raising their marketing budgets significantly.
Additionally, premium pricing can be useful for businesses that don’t have to worry about saving money by mass-producing goods. Because the company is restricting the number of units sold, the products and services become more exclusive and, therefore, desirable in the eyes of consumers.
One caveat of employing premium pricing strategies is that it’s far easier to mark products down than it is to raise rates after launch. In fact, it’s nearly impossible to adopt a premium pricing strategy at a later date without investing a significant amount of cash into marketing and outreach. As a small business owner considering a premium pricing strategy, the time to employ the strategy is when entering a new market.
Is a premium pricing strategy right for you?
As a small business owner, you are likely curious about what price you should charge for your good or service. The answer is not black and white, and depends considerably on your industry and your competitors. You may not be able to afford the marketing costs associated with such a strategy. Employing a strategy could be deemed too big of a risk.
But if you have the funds to handle the necessary marketing expenses, you may want to consider taking advantage of a premium pricing strategy. If you believe your products merit premium pricing, launch them at a higher price point to start. Invest in marketing and building a brand, and you’ll see your profit margins grow as a result.