In earlier posts, I have discussed how differentiation and lowering your costs may affect pricing strategy. I have just a few more comments to make about pricing strategies:
- Penetration pricing strategies. In early stages of a start-up, you need to convince yourself and others that you are viable and scalable. If the only way you can sell product entails losing money on every sale (i.e., price does not cover cost of goods sold), your company is a non-starter. So, make sure you do not set prices below cost of goods sold in an attempt to penetrate the market. So called penetration pricing rarely works for start-ups.
- Covering your fixed costs. Let’s say you can capture sales from competitors by underpricing them, and your price is higher than your COGS, so you do have positive gross profit. Make sure you understand the sales volume you must achieve in order to cover all your other (fixed) expenses, so the company can achieve breakeven. If raising the price slightly is necessary to make you profitable, but reduces your sales volume and thus makes you unprofitable, you may need to adjust other assumptions (like your target market, your sales model, etc.), or you may not have a viable business.
- The long tail. Made popular by Anderson [AND06], the long tail is a business strategy in which much of a company’s revenues relies on selling low-volume (perhaps customized, perhaps expensive, perhaps exclusive) products to niche customers while simultaneously selling high-volume (perhaps low price, perhaps free, perhaps low margin) products. The claim is that if inventory costs are near zero (e.g., for storing music or software) and/or if customization costs are near zero (e.g., with the appropriate proprietary software in some cases or with mass customization in other cases), that selling small quantities of a very large number of unique products can be as profitable as selling massive quantities of identical popular products.
- Low price as sole business strategy. Many companies, especially ones selling commodity products similar or identical to competitors, compete based on low price. The secret to competing this way is to have lower costs than competitors. To have lower costs than competitors, you must either have a lower cost of goods sold (i.e., a cheaper source of supplies), or lower operating expenses. As a general rule, a start-up is not going to compete with established companies with identical products and customer experience using just a low price strategy. You simply do not have the scale.
- Dangers of low pricing strategies. Although no business strategy is without pitfalls, relying on low price as your only strategy comes with a unique set of dangers: (a) you will likely have very small margins, so the slightest increase in your costs will make you unprofitable; (b) if you are new to entrepreneurship, you likely have missed some significant expenses in your calculations; once those expenses appear, your low prices may no longer be feasible; (c) established companies struggle with cash flow all the time; even if you can remain profitable, you may not have enough cash to stay afloat; and (d) if you have in fact figured out a unique way to reduce your costs, what will happen when your competitors figure out the same way?
- Low pricing as part of a business strategy. Just about every start-up that succeeds competes with a differentiation strategy (using some combination of unique products, better features, better customer service, more convenient shopping, etc.), and it may or may not offer low prices. Prices could be set low initially (to help convert early adopters) or could be set high if the value of the additional product or service is significant (see next paragraph).
- Value pricing strategies. Value pricing means establishing a price for your product based on what you believe the customer gains as a result of having your product (regardless of what it costs you to produce the product). When you sell a product, you are making an exchange of a product for $x of cash. You want two goals to have been fulfilled after the transaction:
– Goal #1: You want customers to feel that they would rather have the product in their possession than $x in their pocket. This is the essence of value pricing.
– Goal #2: You would rather have $x in your bank (and the happy customer in your list of customers) than the product in your inventory.
The above extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle or paperback formats at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE.