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After developing a product, companies need to figure out how much to charge customers before executing their go-to-market (GTM) strategy.
Product pricing is much more complicated than it looks—price optimization involves various internal and external factors, such as setting a price that maximizes profits, taking into account customer demand, market and competition data, and development costs.
What is Product Pricing?
Product pricing is the process of setting a selling price for a product or service that considers all costs associated with producing and selling it, as well as what customers are willing to pay.
The goal of product pricing should be to match the value of the product or service with its cost and customer demand so that the company can maximize profits while providing competitive prices.
Several factors work together when setting a price for a product or service:
- Overhead Costs: This includes all the expenses related to producing a product or providing a service, such as labor costs, marketing/advertising costs, and shipping costs.
- Competition: What are other businesses charging for similar products or services in the same market? Companies should consider their competitors’ pricing structures when setting prices for their own products and services.
- Price Sensitivity (Demand Elasticity): How sensitive are customers to changes in prices? If demand for a product or service decreases too much with an increase in price, it may not be profitable to charge more.
- Value Proposition: The value of a product or service should reflect its price. Companies should consider the extra features, quality, customer service, and brand value that customers gain when they purchase their products or services.
- Pricing Strategy: Loss leaders, price skimming, penetration pricing, premium pricing—there are many different strategies to consider when setting prices for products and services. Companies should determine the most appropriate strategy based on their goals and market situations.
- Product Complexity: Businesses with complex products (e.g., software with multiple features) may need to consider different pricing models depending on the complexity of their products. For example, subscription-based pricing or pay-as-you-go plans may be suitable for software products.
On the surface, product pricing seems simple—just set a price. But in practice, the difference of even a few dollars can sway customers. This is especially true when companies are competing against each other, as customers will look for the lowest price available.
- Pricing Model – The strategy or structure used to set prices for products.
- Product Pricing Method – A systematic approach to setting prices for products.
- Product Pricing Strategy – A set of tactics and strategies used to optimize prices for products.
Top Product Pricing Methods
The exact method a business uses to find a product price will vary depending on the factors listed above.
Some organizations use a combination of pricing models. But there are some common pricing models that companies use.
Here are a few:
Value-based price is a pricing strategy that bases prices on the value customers receive from products or services rather than their production costs.
Rather than focusing on competitors, companies that use value-based pricing largely base their retail price on the value customers attribute to the product or service (i.e., what they are willing to pay).
In theory, money can be left on the table when setting prices too low—value-based pricing seeks to capture that value. When correctly executed, this approach can drastically improve profitability by allowing for higher prices without sacrificing sales volumes.
The main drawback to the value-based method is that it requires a lot of market research to understand the customer’s value perception, which may be too low to justify the internal costs.
Value-based pricing works best for companies that:
- Sell unique products with a high perceived value.
- Sell lightweight and efficient products that exponentially boost revenue growth for their clients.
- Have a limited number of competitors in the market.
- Have substantial market research data about customer perceptions.
Competitor-based pricing is the opposite of value-based pricing. It’s a pricing method that bases prices on those of competitors in the same market.
Companies should consider their competitors’ pricing strategies when setting prices for their own products and services.
It’s important to note that competitor-based pricing isn’t about having the lowest price, but rather finding a balance between charging what customers are willing to pay and what the company needs in order to make a profit.
To be truly successful with this pricing model, the organization can theoretically charge the same amount as its competitors but sell a more efficient product.
Competitive pricing is well suited to companies that:
- Sell products with similar features across a competitive market.
- Have a limited number of customers and aren’t able to charge higher prices due to competition.
- Recently entered the market and don’t have much customer data.
- Have the resources needed to track competitor pricing strategies.
- Are comfortable charging the same price as competitors, but offering a better product or service.
The cost-plus pricing strategy is a product pricing method that uses the production costs of a product or service as the baseline and adds an additional percentage (the “plus”) to determine the final price.
In other words, companies figure out their costs for producing a product, then add a profit margin on top of that cost. This helps them cover overhead expenses, account for risk, and gain a profit.
Cost-based pricing strategies work best when the product or service has:
- High production costs (e.g., industrial goods).
- Few competitors in the market.
- A large customer base that can absorb price increases.
Market-oriented pricing is a strategy where companies set their prices based on the current market trends and customer preferences.
This method is closely tied to competitor-based pricing, but it focuses more on understanding customers’ needs and behaviors than tracking competitors.
Companies that use this approach try to identify what customers are willing to pay for products or services and set prices accordingly. It’s important to note that this method isn’t solely about setting prices low or high—it’s also about understanding how customers respond to different pricing strategies and using that information to make informed decisions.
Market-oriented pricing works well when businesses:
- Have a large customer base with diverse needs and preferences.
- Have a good understanding of customer needs and behaviors.
- Are able to respond quickly to changes in the market.
- Are comfortable with risks such as pricing experiments and variable pricing.
Dynamic pricing is an approach where companies adjust their prices in real time based on market demand, customer behavior, and other factors. This type of pricing strategy relies heavily on analytics and data to make sure prices are set correctly.
In terms of revenue optimization, dynamic pricing is one of the most effective strategies. It allows companies to adjust their prices in real time and maximize profits while still offering customers a good value.
Airlines, for example, use dynamic pricing to adjust their fares according to customer demand. By doing this, they can make sure that the prices are in line with market conditions and maximize profit potential.
Still, it is important to note that airlines can only get away with demand pricing because they sell a commodity product that customers have few—if any—lower-cost alternatives.
Dynamic pricing is most suitable for companies that:
- Have access to large amounts of customer data.
- Are able to respond quickly to changes in the market.
- Can create models or algorithms to analyze customer data and adjust prices accordingly.
- Are comfortable with risk.
- Have enough leverage to guarantee that customers will accept the pricing changes.
Factors to Consider in Product Pricing
To develop a competitive price that is also profitable, companies need to consider several factors, including costs, demand, and their target customer.
For a business to stay alive, it needs to continuously generate revenue. And that revenue needs to be greater than the cost of making and selling a product or service.
Depending on the product and company structure, there are several costs they may incur:
- Product research and development (R&D)
- Continued maintenance (for software products)
- Production costs (raw materials, labor, utilities)
- Shipping and distribution
- Marketing and advertising
- Sales and customer success
- Rent and utilities
Plenty of businesses operate remotely, using a contract workforce, and outsource production and other tasks to save on costs. Some Software-as-a-Service (SaaS) and ecommerce companies even operate as one or two people.
Either way, it’s important to calculate all costs before setting a price that meets business goals.
Figuring out how much to charge is the easy part. Determining how much customers are willing to pay and whether there is enough demand for the product is a much more complicated equation.
There are a few best practices to keep in mind when evaluating market conditions:
- Understand the value that the product or service provides to customers.
- Analyze customer demographics, needs, and behaviors.
- Research competitors’ pricing strategies.
- Take into account any seasonal changes in demand.
If the product or service is new, it’s also critical to test different pricing models with a select group of customers to understand the market better.
An organization’s ideal customer profile (ICP) is a key factor in product pricing. It is a detailed description of an ideal customer, based on customer data and market research, that helps businesses target the right demographic and provide more tailored prices to maximize profits.
Once the target audience is identified, companies can tailor their prices accordingly. They may offer discounts for larger orders or product bundles, volume-based pricing (i.e., enterprise plans), or recurring revenue models with different tiers (i.e., SaaS companies).
It is also important to note that customers may have different price points depending on their location, age, income level, and other demographic details.
Unless a business is the first of its kind (which is almost never the case), there will always be competitors vying for market share. Once businesses understand the value they offer to customers, they can set prices that are competitive within their industry.
Companies should also keep in mind that the price of a product or service doesn’t have to be fixed. They can experiment with different pricing models and sales discounts as well as increase or decrease prices as needed.
Ideal Profit Margin
The profit margin is the amount of profit a business makes after subtracting all expenses from revenue. A healthy profit margin ensures that the business can stay in operation, pay its employees, and generate returns for its investors.
There are two profit margins businesses need to consider: gross and net profit margin.
- Gross Profit Margin: The amount of revenue left after subtracting production costs from sales revenue.
- Net Profit Margin: The amount of revenue left after subtracting all expenses (including overhead, marketing, and other operating costs).
The ideal level of profitability depends on factors like the industry, company size, and type of product or service being offered. For example, ecommerce businesses typically operate at a profit margin of around 10%.
SaaS companies typically operate using the Rule Of 40, meaning the growth rate and profit should add up to about 40%.
When it comes to product pricing, businesses need to consider how they will distribute the product or service. Distribution channels include retail stores, ecommerce websites, digital retailers, direct-to-consumer (D2C) platforms, and more.
Each channel has different costs associated with it that must be taken into account when setting prices.
For instance, a business selling on Amazon will need to pay the retail giant’s commission fee (usually around 15%).
Software companies have fewer required distribution channels, but they often need sales reps and a robust sales stack to manage the process.
Technology to Manage Product Pricing
There are numerous software tools available to help businesses manage their product pricing. These solutions typically offer features like price tracking, optimization, and analytics so businesses can make smarter pricing decisions.
A pricing engine is a powerful accounting software tool that helps companies identify profitable prices for their products and services.
This system works by taking into account various conditions to determine the best cost for each item, ultimately aiming to help businesses maximize earnings through price optimization.
Businesses use pricing engines to automate pricing so they can focus more on customer engagement, product innovation, and growth.
Pricing software helps businesses track and analyze pricing data to ensure that the prices they set are competitive. It also provides insights into customer behavior, enabling companies to make better decisions about their product pricing strategies.
Enterprise resource planning (ERP) isn’t exactly product pricing software, but it helps businesses manage their operations efficiently. This includes automated processes like inventory tracking, sales order processing, and financial reporting.
All of these features can help inform product pricing decisions and optimize profitability.
Organizations use ERP systems to get the clearest possible view of their variable and fixed costs, and one of the residual benefits is they can also determine the optimal pricing strategies.
CPQ software (configure, price, and quote) helps streamline the sales process from start to finish. It enables businesses to configure their products or services, generate quotes quickly, and identify the best prices for certain customers based on their needs.
In terms of product pricing, CPQ helps businesses identify the right price for their offerings so they can increase sales while still generating a healthy profit. Then, it enables them to generate proposals and quotes quickly so they don’t miss out on potential sales opportunities.
People Also Ask
What is the purpose of product pricing?
Product pricing ensures that businesses are able to generate a healthy profit margin while still providing competitive prices for their customers. When making pricing decisions, stakeholders must take into account various factors, including the industry, cost of production and distribution, market conditions, customer needs, and more.
Why is product pricing important?
Optimal product pricing ensures that companies and their potential customers both get the most fair and equitable value out of the product or service. Businesses need to set prices that are competitive enough to attract customers, while still providing a healthy return on investment (ROI). At the same time, customers want to know they are getting a good deal.
What is an example of product pricing?
An example of product pricing is a software company’s pricing model. Software companies typically offer tiered pricing, meaning their product can be sold at different levels of features and usage. To determine the relative value at each tier, they must carefully measure the additional value it provides against the price customers are willing to pay.