The hardest part of startups is making choices. Not decisions but choices. A choice is a decision between alternatives, whereby deciding to do one thing you are also deciding not to do another. Pricing strategy selection is a choice. Or at least it should be.
Compared to the other work you need to do on pricing, however, choosing a pricing strategy is actually pretty easy.
Understanding your value proposition? That is hard and needs a lot of insight and empathy.
Figuring out your value metric and finding a pricing metric that tracks value? That requires creativity and willingness to try new things.
Designing your pricing architecture and pricing optimization? That’s technical work that needs a lot of experience.
But choosing a pricing strategy? That is actually pretty simple. The hard thing is the discipline to stick to your choice.
Strictly speaking, there are only three pricing strategies: penetrate, skim, follow.
- Penetrate: Setting a low price, leaving most of the value in the hands of your customers, shutting off margin from your competitors.
- Skim: Initially setting a relatively high price to reinforce your value and capture the profit you need to invest in more innovation.
- Follow: Setting price based on your largest competitor or a dominant input so that you track changing market conditions.
The Follow strategy needs a bit more explanation. This used to mean finding a dominant competitor and setting prices at a premium or discount to their price (in practice usually the latter).
Recently, more sophisticated Market Following Pricing strategies have started to appear. In some industries there is a dominant input that has a big impact on value propositions. The price of oil is one example. As the price of oil goes down, the value of energy-saving technologies can also decline.
In others it is the interest rate — pricing strategies for solutions for financial services companies are very dependent on interest rates. The price that makes sense in a low interest rate environment can be very different from what works in a high interest rate environment.
For companies that serve heavy industry, one could even price based on utilization ratios. When utilization ratios are low you would price based on how much you decrease input or process costs. But when utilization rates are high, you price based on how much you increase the capacity of existing facilities, thereby helping companies avoid or defer capital investments.
For start-ups there are some simple rules to decide which pricing strategy to follow:
- Adopt a penetration pricing strategy when market share (first mover advantage) is the most important thing about your market. Keep in mind you will need to raise a lot of money to win.
- Adopt a skim strategy when you have a compelling value differentiation and have identified a well-defined and relatively small market entry segment.
- Adopt a market following strategy when there is a dominant incumbent that you are going to be compared to, or if there is some input that determines the value of your offer.
Constraints on Pricing Strategy
- Your price makes a statement about your brand. You cannot claim a premium brand and pursue a penetration pricing strategy. And a discount brand cannot pursue a skimming strategy.
- Market Following strategies are the most difficult to execute. You have to be in close touch with the market, be able to change prices quickly, and be able to communicate the logic of the price change, and why the price change is in the customer’s interest. That’s not easy. Only adopt a Market Following strategy if there is so much volatility in the market that any other strategy would rapidly leave you with pricing that did not make sense.
- You can only have one pricing strategy per segment. Even if you have multiple segments you can probably only afford to have one strategy. Your pricing strategy cascades into your marketing communication strategy and your sales execution. Change it drastically or too often and you will confuse your customers and your team.
Pricing strategy can change as you move across Geoffrey Moore’s technology adoption cycle (see B2B Pricing Black Magic). As you move from Early Adopters to Bowling Alley to Tornado you may want to change your pricing strategy at each phase.
Image courtesy of the General Physics Corporation and Chasm Institute
Normally, companies have a Penetration strategy while targeting Early Adopters and in the Bowling Alley, move to Skim for the Tornado, and then slip into Market Following for Late Majority Markets. That’s fine. But each change needs to be a conscious choice and needs careful planning.
Pricing Strategy Checklist
Additional Resources from Steven Forth
- You Can’t Price Software Without FocusPicking a number is actually the last step in a successful pricing process. Steven breaks down what you need to do first. Read more.
- The Secret to Boosting Your Software Pricing PowerSteven explores the surprisingly powerful role emotion plays in setting the right price for your software. Read more.
- B2B Pricing Black Magic: Appealing to Economic AND Emotional NeedsSteven explains how to achieve a potent, irresistible B2B pricing formula by aligning economic and emotional value along the technology adoption lifecycle. Read more.
- How to Disrupt Your Market with an Innovative Pricing ModelGoing up against an established competitor? A disruptive pricing model can be one of the most effective tools you use to differentiate yourself. Read more.
Photo by: Ranger56112