What is Pricing?

Pricing is the process of determining what a company will receive in exchange for a product or service. It involves setting a monetary value that customers will pay and encompasses various strategies and factors, including cost of production, market demand, competition, and overall business objectives.

How a business prices its products affects several aspects of its operations:

• Revenue generation
• Profitability
• Market positioning
• Customer value perception
• Competitive advantage
• Adaptability and growth

Consider a simple example: a smartphone manufacturer that decides to lower the price of its latest model to increase market share. Initially, the phone was priced at $999. After analyzing market trends and competitor prices, the company reduces it to $799.

The lower price attracts more customers. As more customers purchase the product, the company captures a larger market share, especially from price-sensitive segments. Higher production volumes reduce the per-unit cost, improving overall profitability.

However, the organization would also have to consider the implications of a lower price on its branding and image. If the smartphone company were like Apple, a brand known for sleek, high-end products at premium prices, a sudden price drop could push its core customers (who value exclusivity and luxury) away.

Synonyms

• Product pricing
• Price setting
• Price determination
• Pricing strategy

Demystifying Pricing Terminology

While “pricing” is a term used to describe a lot of things — the general process of setting product prices, the specific monetary value itself — there are several types of pricing and factors that go into a business’s overall pricing strategy.

Now, let’s take a look at some common pricing terminology to understand the nuances of pricing:

Cost vs. Price

The first (and most important) distinction is between “price” and “cost.”

• Price is the amount a business charges for its product or service.
• Cost is the amount of money it takes to produce that product or service. It’s one of the main types of operating expenses.

While the price is ideally higher than the cost, this is not always the case. For example, a business may lower its prices below its profit margin to compete with a competitor or attract more customers (called “loss leader” pricing). In such cases, the price could be less than the cost, leading to losses in profitability.

Another interesting case is in the SaaS industry. A SaaS startup might invest in rapid growth and expensive R&D, expecting to turn a massive profit a few years down the line.

In the long term, no matter what, a company’s production costs need to be lower than the product’s sale price to run a sustainable business. And they need to leave enough room for indirect costs like marketing and sales.

That brings us to our next point: cost-plus pricing.

Cost-Plus Pricing

This pricing method involves adding a markup to the production cost to determine the final price. The cost-plus pricing formula is commonly used in retail, where a business calculates the cost of goods sold (COGS) and adds a markup percentage to make a profit.

There are two types of cost-plus pricing:

• Full costing, or traditional costing, considers direct costs (like materials and labor) and indirect costs (e.g., marketing expenses).
• Variable costing excludes fixed overheads like rent, leaving only variable costs. This method is m most suitable for companies with fluctuating production volumes or material/labor costs.

The main benefit of cost-plus pricing is that it makes calculating a product’s unit economics easy (and guarantees profitability). However, it doesn’t incentivize becoming more efficient to bring down production costs. And there’s no guarantee customers will want the product at that price.

Markup vs. Margin

Markup is the percentage of the production cost added to determine the final price. For example, if a product costs $10 to produce and the markup is 50%, its sale price would be $15.

Margin, on the other hand, is the percentage of profit a business makes for each sale. In this case, if the product was sold at $15 and its cost was $10, the margin would be 33% ($5/$15).

There are two main ways to calculate profit margins:

• Gross margin is the difference between the product price and its cost of goods sold (COGS), divided by the price. It reflects how much a business earns from each sale before deducting operating expenses.
• Net margin is the profit after all operating expenses, interest, and taxes are removed from the equation to arrive at net income. When expressed as a percentage of net sales, it tells us how much a business truly earns from each dollar of sales.

Understanding both terms is crucial for businesses to know how much they’re making from each sale and set targets for growth.

List Price

This is the original, or “sticker,” price of a product. It’s an MSRP (manufacturer’s suggested retail price), which, in the case of a retailer, is recommended but not necessarily the final selling price.

Customers typically don’t pay this price for high-value purchases (e.g., cars). Instead, they negotiate lower prices or take advantage of discounts and promotions.

List pricing is usually calculated based on costs, competition, and market demand.

Retail Price

This is the final price customers wind up paying for a product. The vendor who sells the product to the end user is the one who determines it.

Retail prices can be lower than the MSRP, as in the case of a discount or sale, or higher than the MSRP if the business is charging a premium for its product. This can also happen if inventory or market conditions limit the supply or increase demand (more on this below).

Wholesale Price

The wholesale price is the reduced cost at which a product is sold to retailers or distributors, who then mark it up to retail prices when selling to customers.

Wholesale prices are typically lower than retail but higher than the cost of production (so the wholesaler providing the product and the retailer buying and reselling it can both turn a profit).

Competitive Pricing

Sometimes, a business’ pricing strategy is based on its competitors. To stay competitive, a company can price its product at the same level as its rivals. They can also use competitor pricing data to inform their own prices.

There are several methods for competitive pricing, including:

• Parity pricing, where a business sets prices equal to its competitors’ (can be at the same level or adjusted based on level of quality).
• Premium pricing, where a business charges more than its competitors to communicate a significant increase in product quality.
• Discounting, where a business offers lower prices or promotions to match or beat rivals’ discounts. This can also be used to attract customers away from competitors.
• Penetration pricing, where a business sets prices lower than its competitors to gain market share and attract customers.

Competitive pricing can be risky if businesses don’t understand their own costs, margins, and product value. But every pricing strategy relies at least in part on competitive intelligence.

Price Elasticity of Demand

To determine the right price point for a product, businesses also need to understand how changes in price will affect demand. This is known as price elasticity of demand.

• If a product has high elasticity, it means that small changes in its price will significantly impact customer demand. In this case, a business can increase sales by lowering prices.
• When a product has low elasticity (i.e., its price doesn’t greatly influence demand), increasing the price may result in higher profits.

Understanding the concept of price elasticity is important for businesses to find the balance between maximizing sales and profitability. If you’re dealing with price-sensitive customers, focus on keeping prices steady while reducing costs to maintain healthy margins.

Pricing Structure

While a pricing strategy is the overall approach to setting prices, a pricing structure is the specific breakdown of how a business charges for its products. For complex products like software and services, the pricing structure can be just as important (if not more) than the strategy.

While pricing strategies consider how a business communicates value through pricing, pricing structures factor in the following components:

• Tiers and packages — Different levels of value for different prices.
• Usage — Charging based on consumption or usage (e.g., metered pricing).
• Users/subscribers — The price for each person accessing the product during the period. This can be tied to the package or set as a base price.
• Contracts — Short-term (e.g., monthly) or long-term (annual) contracts. Longer contracts normally come with a discounted price.
• Ad-hoc charges — One-time or recurring fees that go beyond the base price (e.g., software implementation).

In addition to a standard cost-plus strategy and psychological tactics like anchoring and “charm pricing” (e.g., setting prices at $9.99 instead of $10), subscription businesses and B2B companies have to create a structure that caters to diverse and complex needs.

The Importance of Pricing in Business Strategy

Pricing decisions have serious implications for businesses that extend beyond simply determining the cost of a product. When you list your product or service at $X, you’re essentially telling your customers, “This is how much we’re saying it’s worth.” It’s up to the customer to decide for themselves whether solving their pain points is worth that price.

Let’s take a closer look at the specific areas of your business pricing touches:

Revenue Generation and Profitability

The most obvious impact of pricing is on a business’s bottom line. If you can’t sell your offering at a higher price than it costs to produce it, you’ll never be able to sustain your business long-term.

Pricing also affects the total amount of revenue a business generates. Price optimization is the sweet spot between selling at the highest possible price (to maximize revenue) and identifying the optimal price that maximizes demand.

Brand Perception and Customer Value

Pricing also shapes how customers perceive your brand. In fact, the two go hand-in-hand.

• If you’re selling to a high-end market, pricing your product too low can signal that its quality is low.
• Price-conscious buyers care less about quality; they just want something affordable.

Many times, customers don’t actually know what a product is worth. The anchoring-and-adjustment heuristic is a human tendency to use the first piece of information provided (the anchor) as a point of reference for making subsequent judgments.

Market Positioning and Competitive Advantage

Beyond the numerical value itself, there are plenty of ways to justify the price you’ve set for your product or service. Since customers generally don’t know the dollar value of solving a problem or meeting their needs, you have to remind them why they’re buying in the first place.

This is where branding, sales, and marketing come into the fold.

• Your brand image influences how customers feel when buying and using your product.
• Sales reps communicate value in a way that helps customers understand what they get for their money (often pointing to a return on that investment).
• Marketing collateral makes buyers aware of your product, helps them connect with your brand and understand its value, and moves them along the sales funnel.

Sales Volume and Demand

Price sensitivity has huge implications for consumer decision-making. If customers don’t agree with your price and have alternatives, they will choose not to buy. So, your ability to set prices in a way that accurately reflects your product’s value and willingness to pay is critical for maximizing customer demand. 

By understanding which buyers are likely to pay more or less for your product, you can segment the market effectively and develop products that suit different groups. You can also capitalize on periods of high demand or low supply by increasing prices (or vice versa).

Key Factors to Consider When Setting Prices

Before arriving at the final price for your product, you need to consider several variables. These include:

Production Costs

The first and most obvious factor to consider is your cost of production. Your margins should be large enough to cover all your fixed and variable expenses and still leave a profit.

Production costs also play a role in determining your breakeven point — the amount of sales you’ll need to reach before you can start making a profit.

Target Market and Customer Behavior

Knowing who your target customers are is critical for setting the right price. What customers are willing to pay for a product varies greatly depending on their income levels, geographic location, and dozens of other factors.

You’ll also want to consider their buying behavior. What motivates them to buy? Are they willing to pay more for convenience or value-added features? Do they care about the brand image or quality of the product?

Competitor Pricing Strategies

While competitors shouldn’t drive your decision-making, you do need to consider how they price their products.

There are a few reasons for this:

• If customers are already accustomed to a certain pricing structure, it might be harder for you to convince them otherwise.
• If your competitors are selling a similar product, pricing yours too far above or below that price can affect your perceived value and thus willingness to pay. 
• Competitors can be a reference point; you can price a higher-value or budget-friendly product above or below their standard offering.

Business Objectives

Depending on your business model, growth stage, and future plans, your pricing strategy will be different.

An early-stage software company, for example, would be focused on rapid growth at the expense of profit margins. A mature company with a large market share might prioritize maximizing profits over acquiring new customers.

Product Value Proposition and Differentiation

What problem does your product solve for customers? How does it meet their needs better than other options on the market? Your value proposition is a crucial factor in determining the value that customers place on your product and what they are willing to pay for it.

Beyond that, there are several ways to differentiate your product. Product development, marketing, sales, and customer service can all influence how buyers perceive your offering. This perceived value plays a significant role in determining the price customers are willing to pay.

How to Conduct a Pricing Analysis

Pricing analysis is the process of evaluating all the factors mentioned above to determine the best price for your product or service. To do this, you’ll need pricing data to understand your customers’ price sensitivity, spot pricing trends, and stay on top of your competition.

Here’s a basic framework you can use:

1. Identify your direct and indirect competition.

Your direct competitors are businesses that offer a similar product or service to the same target buyers. For instance, Coca-Cola would consider Pepsi its direct competitor.

Indirect competitors offer a different product but serve the same target market. Coca-Cola would call beverage companies like Red Bull and Starbucks its indirect competitors because they fulfill the same need, albeit with different types of products.

2. Research competitor features and pricing models.

Evaluate the features, benefits, and pricing models your competitors use. Look for patterns in how they structure their pricing plans (e.g., with tiers or add-ons) and what features they include in each plan.

Also pay attention to how often they run promotions and the strategies they use to market their products and advertise their pricing.

3. Analyze your target customers and their buying behavior. 

Your next step is to gather data on your target customers. There are a few ways to do this:

• Conduct surveys and questionnaires.
• Use focus groups.
• Map the customer journey
• Analyze your current customers’ purchase history.
• Solicit customer feedback and reviews.
• Monitor your social media mentions.
• Track your website analytics.

You can also conduct pricing experiments. A/B testing, for instance, involves offering your product to two separate groups at different prices and analyzing the results.

4. Calculate your production costs and operating expenses.

Understanding your production costs and operating expenses is essential for setting a profitable and competitive price for your product.

Your first step here is to list all of your direct costs:

• Raw materials
• Labor
• Manufacturing supplies
• Utilities
• Development costs (for SaaS)

Then, account for all your indirect costs. These include rent, salaries for non-production employees, marketing expenses, and other operating expenses.

Add all these costs up, separate them into fixed and variable categories, and determine your breakeven point:

Breakeven Point = Total Fixed Costs / (Price Per Unit - Variable Cost Per Unit)

5. Assess your product’s price elasticity.

To do this, you have to track your customers’ reactions to pricing changes over time. The best way to do this is to run tests in step three and look at the sales data before and after you change the price.

Before running tests, you can also gather historical sales data at different price points. This data should reflect varied pricing over specific time periods. For example, note the quantities sold at $10, $12, and $15 as you raised prices over the past year.

For each price change, calculate the percentage change in the quantity sold. The formula is: 

(New Quantity - Old Quantity) / Old Quantity × 100

Similarly, calculate the percentage change in price using the formula: 

(New Price - Old Price) / Old Price × 100

From there, you can determine the price elasticity of demand (PED) by dividing the percentage change in quantity sold by the percentage change in price to get the price elasticity of demand.

Price Elasticity of Demand = % Change in Quantity Sold / % Change in Price

A PED greater than 1 indicates high sensitivity (elastic demand), meaning a small price change could significantly impact the quantity sold. A PED less than 1 suggests low sensitivity (inelastic demand), where price changes have a minimal effect on sales volume.

Be mindful that price elasticity can vary across different market segments and time periods. Use segmentation to analyze elasticity among different customer groups to gain deeper insights.

Common Pricing Strategies

Depending on your business model, there are several different pricing strategies you could use:

• Penetration pricing — Setting a low initial price to gain a foothold in the market.
• Price skimming — Setting a high price to capture the demand of early adopters before gradually lowering it.
• Bundle pricing — Offering a package deal with multiple products or services at a discounted price.
• Value-based pricing — Setting prices based on the perceived value of your product to customers.
• Psychological pricing — Using pricing tactics that appeal to customers’ emotions and inherent biases, like odd-even pricing (e.g., $9.99 vs. $10).
• Geographical pricing — Adjusting prices based on location and market demand.
• Dynamic pricing — A form of variable pricing where businesses set prices based on real-time data, commonly used in the airline and hospitality industries.

Pricing and the Customer Journey

Pricing plays a critical role throughout the customer journey, significantly influencing decision-making at every stage. During the initial consideration phase, potential customers evaluate whether a product or service fits within their budget and meets their perceived value criteria.

A well-calibrated pricing strategy can enhance a product’s attractiveness. For instance, competitive pricing drives engagement, while premium pricing signals quality and exclusivity, appealing to different segments.

Transparent pricing in the evaluation stage builds trust, increasing purchase likelihood. Hidden costs and complex pricing turn buyers away, causing abandoned carts and delays.

Companies often use pricing tactics tailored to different stages of the customer journey to maximize engagement and conversions. Freemium models, for example, allow customers to experience the basic features of a product for free, lowering the barrier to entry. As customers find value in the product, they’re more likely to upgrade to paid plans.

The Pricing Tech Stack

Pricing Software

Some businesses use a pricing engine to automate and optimize pricing processes. A pricing engine can help you:

• Set optimal prices based on different data points (cost, competitor pricing, customer behavior)
• Create custom price books for different market segments
• Track sales performance by product and rep
• Forecast future revenue with simulated scenarios
• Generate and distribute accurate quotes and proposals

Enterprise Resource Planning (ERP)

ERP software enables businesses to manage critical business processes in one system, including inventory management, supply chain operations, and financial data. Some ERPs offer pricing functionality as well.

ERP systems can help you track costs associated with producing goods or services and create accurate pricing models by considering all direct and indirect costs.

Customer Relationship Management (CRM)

CRM software stores customer data and interactions, such as orders, emails, calls, meetings, and social media activity. You can use this data to analyze customer behavior patterns and improve pricing strategies.

You can also review your sales data in CRM to understand how different customer segments respond to different price points and changes. This information can help you adjust pricing for specific customer groups and improve targeting.

Configure, Price, and Quote (CPQ)

CPQ (configure, price, quote) software streamlines the quoting process for complex products, services, or bundles. It automates the configuration of accurate quotes based on factors such as discounts, quantity breaks, add-ons and upgrades, terms and

CPQ tools help businesses:

• Automate pricing calculations and personalized quote generation
• Set up dynamic pricing rules to ensure consistency across all sales channels
• Integrate with CRM and ERP systems to centralize data and improve accuracy
• Streamline approvals through automated workflows
• Simplify pricing decisions with real-time data and analytics

With CPQ, you’re also guaranteeing every quote you send out has a price that’s within the boundaries of your pricing strategy, reducing the chances of over- or under-pricing and increasing overall efficiency.

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