The pricing model you choose for your business directly impacts everything from revenue itself to customer perception and even market positioning.
That’s why it is important to know how to choose the right pricing model for your business. But you don’t have to do it alone. In this article, we’ll provide a guide for you to follow and ensure you understand what a pricing model is, explore the different types available, and what to consider when selecting the right one for your company.
What is a Pricing Model?
A pricing model is the framework a business uses to determine prices for products or services being offered.
The pricing model chosen for a business should reflect the industry itself, market demands, and individual objectives of the business. There are a variety of different models that cater to different types of businesses, market sectors, and even consumer expectations.
What are the Different Types of Pricing Models?
Pricing models come in various types and forms to address different business goals, market conditions, and varying consumer behaviours.
For some businesses, such as software as a service (i.e., SaaS), a subscription model might be the most suitable. On the other hand, for a retail business, a more standard cost-plus pricing is likely the more suitable option.
Cost-Plus Pricing
The cost-plus pricing model is fairly simple. It involves calculating the cost of producing a product or providing a service and then adding a defined markup to ensure that the company makes a profit. In other words, your price point is reflected in the following formula:
Selling Price=Cost Price + Markup
Cost-plus pricing models are simple to calculate and easy to apply to different products and services. It also allows businesses to easily ensure that their operational costs are covered, including both overheads and the cost per unit, i.e., the amount it costs to produce the goods or services.
However, there are some limitations. Cost-plus price modelling does not factor in market demand or competitor pricing. Additionally, it is possible that it does not maximise potential profit for a business if the markup is sub-optimal.
Nonetheless, retail and manufacturing industries commonly use this pricing model to ensure their significant production and operational costs are covered.
Value-Based Pricing
Industries that use value-based pricing modelling incorporate the customer’s perception of value for their products or services and not just the cost of production. Businesses might aim to achieve a specific margin to ensure a level of financial health. Alternatively, the aim might simply be to optimise pricing to maximise profit.
Some businesses will use a strategy called What the Market Will Bear (WTMWB). This approach revolves around setting the highest price the business believes the market (i.e., consumers) will accept.
The benefits of value-based pricing are that it allows for higher profits and strong brand positioning by aligning customer expectations with price tags. However, it can leave businesses more vulnerable to being undercut on prices by their competitors. This is why it is important to conduct in-depth market research to understand customer value perception.
For businesses operating in luxury goods and services, software, and high-end hospitality, value-based pricing is often a go-to.
Competition-Based Pricing
Competition-based pricing is more outwardly focused than inwardly focused. This pricing model takes into account the prices set by competitors as a way of anchoring where potential price points should be.
The advantages of this model are that it keeps one’s prices aligned with market leaders or ensures they remain competitive. In saturated markets, price can be a key differentiator, and therefore this model can help to undercut competitors.
However, there are some disadvantages. For one, it does not consider the unique value of a company’s product or service, nor the individual operating or production costs. Secondly, it can lead to price wars and therefore reduced margins, resulting in lower profitability.
Retailers and businesses working in consumer goods often use competitio-based pricing as the market can be crowded and highly competitive, with price playing a significant role in the minds of consumers.
Freemium Pricing
Freemium pricing is fairly unique. This model uses a two-tier approach of “free” and “premium”. In other words, it offers a basic version of a service for free but requires an upgrade to a premium level of subscription or payment for customers who would like full features, services, or premium versions.
There are many advantages to the freemium model. It can attract a high number of consumers who are enticed by the free entry point and then encouraged to upsell to access the premium features. It allows for fast and significant market penetration and gives consumers confidence that they can “try before they buy”.
Drawbacks to this model include low conversion rates of free users to premium users in some industries. It also requires a fairly strong value proposition to successfully convert users.
Software and digital service industries are common users of the freemium price modelling.
How to Choose a Pricing Model
- Consider what your business objective is. Are you trying to increase market share, build a premium brand, or maximise profit?
- Understand your cost base across production, distribution, and operation to make sure you can generate a profit.
- Research market demand and analyse what price point consumers are willing to pay.
- Research your competitors to consider their strategies and pricing to ensure you are either competitive or sufficiently differentiated.
- Think about your customers or clients. How will your pricing affect not just their willingness to pay but also how they perceive your brand?
- Use the Gross Profit Margin Target (GPMT) to calculate how profitable your pricing strategy is: Gross Profit Margin= Revenue / Gross Profit
Fuel Your Business Success with ScotPac
At ScotPac New Zealand, we specialise in providing tailored business finance solutions that help small and medium enterprises grow and succeed.
If you’re exploring pricing strategies, you might also be interested in our articles on “Ways To Boost Business Cash Flow” or “Cash Flow Management Tools to Grow Your Business”. These resources can provide further insights into how the right financial tools can support your business goals. For expert advice and customised solutions, get in touch with ScotPac today.
