There are many different pricing strategies businesses utilize. Most of these we have come to use over time, albeit unwillingly. Many business owners use one or more of these pricing strategies as a combination, whether they know about these terms that define them or not. I have laid them out in alphabetical order for you convenience and have also provided a real world, restaurant industry or other industry example to help you better understand these strategies. I hope light bulbs go off for you as you look at these, and perhaps new doors can be opened for a better pricing strategy for your business.
1. Absorption pricingis a method of pricing in which all costs are retrieved by sharing the fixed costs between all the products that are sold. The fixed costs are absorbed into the price of the goods because the price of the product includes the variable cost of each item plus a share of the fixed costs.
So a restaurant example of this would be, since we roast all our chickens fresh, we use a lot of gas. This natural gas is burned up roasting our chickens, and since it is extremely difficult to determine exactly how much each chicken uses since we continue to heat the ovens even when chickens are not roasting. So the fixed costs of the gas burning is factored into the price of each chicken sold.
2. Incost-plus pricing, a company first determines its break-even price for the product. This is done by calculating all the costs involved in the production, marketing and distribution of the product. Then a markup is set for each unit, based on the profit the company needs to make, its sales objectives and the price it believes customers will pay. For example, if the company needs a 15 percent profit margin and the break-even price is $1.00, the price will be set at $1.15 ($1.00 x 1.15).
It would be good to point out here that healthy profit margins in the restaurant industry are usually 20% and up. 35%-40% is excellent profit margins, provided other costs are being well managed and maintained. That is to say, if your rent and other fixed costs are too high the business won’t survive even with healthy profit margins. You would just be slave to the landlord, a form of legal indenture. Keep a keen eye on fixed costs always so that the profit margin pays off.
3. Price skimming: In this strategy we sell our highest quality, high in demand items at higher prices so that fewer sales are needed to break even. This is a situation where it’s a specialized product and you aren’t trying to sell it to everyone.
An example of this is rib eye steak. This is a special dinner that takes a long time for a chef to prepare. Not only does it have to be cooked perfect but the meat that is used (ribeye) is a very expensive raw material for the restaurant. Does everyone want a rib eye steak? No but that is not the point. The point is, for those who do, the specialized crowd, they get to have what they want and they are willing to pay a premium for it. Another example might be lobster tail. If you ever go to Red Lobster, many of their dishes are fairly priced. They are not very expensive. However for those that want a Lobster tail and steak (surf and turf), these are usually customers that don’t mind paying extra.
4. Decoy pricing: Method of pricing where the seller offers at least three products, and where two of them have a similar or equal price. The two products with the similar prices should be the most expensive ones, and one of the two should be less attractive than the other. This strategy will make people compare the options with similar prices, and as a result sales of the most attractive choice will increase. (Wikipedia)
So an example of this would be showing a few products and making the expensive one help make the cheaper one seem like a better bargain.
5. Freemium: This is a business model that works by offering a product or service free of charge (typically digital offerings such as software, content, games, web services or other) while charging a premium for advanced features, functionality, or related products and services. The word “freemium” is a portmanteau combining the two aspects of the business model: “free” and “premium”. It has become a highly popular model, with notable success.
What would a Freemium pricing strategy in the restaurant world look like? Well if you’re going to open a cafe, you may wish to offer premium wifi service free to paying patrons. In exchange they will pay a high price for premium coffee and high-profit margin baked goods. If you are running a bar or club, you may offer entrance free without a door charge, but the drinks will be expensive. In the example for Zankou, garlic sauce and extra pita is “free”. The customer doesn’t mind paying a premium for the best quality food, knowing that the side condiments, garlic sauce, hot sauce, chills, etc are free.
6. High-low pricing: Method of pricing for an organization where the goods or services offered by the organization are regularly priced higher than competitors, but through promotions, advertisements, and or coupons, lower prices are offered on key items. The lower promotional prices are designed to bring customers to the organization where the customer is offered the promotional product as well as the regular higher priced products.
An example of this might be Whole Foods. They routinely charge more than their competition, but they offer a few items on sale and have limited coupons distributed through their small, magazine-like publication. Customer may come in to use those few coupons, but the vast majority of their other items are premium-priced, so the customer always ends up spending more on the high-priced products.
(References: http://en.wikipedia.org/wiki/Pricing_strategies; http://definitions.uslegal.com/a/absorption-pricing/)
The Other Pricing Methods soon to be expanded on. This was from wikipedia and my additions to the definitions are in bold. I give examples and other stories taken from the restaurant industry.
Limit pricing: A limit price is the price set by a monopolist to discourage economic entry into a market, and is illegal in many countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition.
The problem with limit pricing as a strategy is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm’s best response. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time. In this strategy price of the product becomes the limit according to budget.
Main article: Loss leader
A loss leader or leader is a product sold at a low price (i.e. at cost or below cost) to stimulate other profitable sales. This would help the companies to expand its market share as a whole.
In business, the practice of setting the price of a product to equal the extra cost of producing an extra unit of output. By this policy, a producer charges, for each product unit sold, only the addition to total cost resulting from materials and direct labor. Businesses often set prices close to marginal cost during periods of poor sales. If, for example, an item has a marginal cost of $1.00 and a normal selling price is $2.00, the firm selling the item might wish to lower the price to $1.10 if demand has waned. The business would choose this approach because the incremental profit of 10 cents from the transaction is better than no sale at all.
Setting a price based upon analysis and research compiled from the target market. This means that marketers will set prices depending on the results from the research. For instance if the competitors are pricing their products at a lower price, then it’s up to them to either price their goods at an above price or below, depending on what the company wants to achieve.
In this type of pricing, the seller tends to fix a price whose last digits are odd numbers. This is done so as to give the buyers/consumers no gap for bargaining as the prices seem to be less and yet in an actual sense are too high, and takes advantage of human psychology. A good example of this can be noticed in most supermarkets where instead of pricing at $10, it would be written as $9.99. This pricing policy is common in economies using the free market policy.
Pay what you want
Main article: Pay what you want
Pay what you want is a pricing system where buyers pay any desired amount for a given commodity, sometimes including zero. In some cases, a minimum (floor) price may be set, and/or a suggested price may be indicated as guidance for the buyer. The buyer can also select an amount higher than the standard price for the commodity.
Giving buyers the freedom to pay what they want may seem to not make much sense for a seller, but in some situations it can be very successful. While most uses of pay what you want have been at the margins of the economy, or for special promotions, there are emerging efforts to expand its utility to broader and more regular use.
Main article: Penetration pricing
Penetration pricing includes setting the price low with the goals of attracting customers and gaining market share. The price will be raised later once this market share is gained.
Main article: Predatory pricing
Predatory pricing, also known as aggressive pricing (also known as “undercutting”), intended to drive out competitors from a market. It is illegal in some countries.
Premium decoy pricing
Method of pricing where an organization artificially sets one product price high, in order to boost sales of a lower priced product.
Main article: Premium pricing
Premium pricing is the practice of keeping the price of a product or service artificially high in order to encourage favorable perceptions among buyers, based solely on the price. The practice is intended to exploit the (not necessarily justifiable) tendency for buyers to assume that expensive items enjoy an exceptional reputation, are more reliable or desirable, or represent exceptional quality and distinction.
Main article: Price discrimination
Price discrimination is the practice of setting a different price for the same product in different segments to the market. For example, this can be for different classes, such as ages, or for different opening times.
Main article: Price leadership
An observation made of oligopolistic business behavior in which one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following. The context is a state of limited competition, in which a market is shared by a small number of producers or sellers.
Main article: Psychological pricing
Pricing designed to have a positive psychological impact. For example, selling a product at $3.95 or $3.99, rather than $4.00. There are certain price points where people are willing to buy a product. If the price of a product is $100 and the company prices it as $99, then it is called psychological pricing. In most of the consumers mind $99 is psychologically ‘less’ than $100. A minor distinction in pricing can make a big difference in sales. The company that succeeds in finding psychological price points can improve sales and maximize revenue.
Pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production. The target pricing method is used most often by public utilities, like electric and gas companies, and companies whose capital investment is high, like automobile manufacturers.
Target pricing is not useful for companies whose capital investment is low because, according to this formula, the selling price will be understated. Also the target pricing method is not keyed to the demand for the product, and if the entire volume is not sold, a company might sustain an overall budgetary loss on the product.
Main article: Time-based pricing
A flexible pricing mechanism made possible by advances in information technology, and employed mostly by Internet based companies. By responding to market fluctuations or large amounts of data gathered from customers – ranging from where they live to what they buy to how much they have spent on past purchases – dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a dynamic pricing success story. In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.
Main article: Value-based pricing
Pricing a product based on the value the product has for the customer and not on its costs of production or any other factor. This pricing strategy is frequently used where the value to the customer is many times the cost of producing the item or service. For instance, the cost of producing a software CD is about the same independent of the software on it, but the prices vary with the perceived value the customers are expected to have. The perceived value will depend on the alternatives open to the customer. In business these alternatives are using competitors software, using a manual work around, or not doing an activity. In order to employ value-based pricing you have to know your customer’s business, his business costs, and his perceived alternatives. It is also known as Perceived-value pricing.
Other pricing approaches
Other pricing strategies include Yield Management, Congestion pricing and Variable pricing.