Factors that limit the range of prices a firm may set are known as pricing

What Is Price Skimming?

Price skimming is a product pricing strategy by which a firm charges the highest initial price that customers will pay and then lowers it over time. As the demand of the first customers is satisfied and competition enters the market, the firm lowers the price to attract another, more price-sensitive segment of the population. The skimming strategy gets its name from "skimming" successive layers of cream, or customer segments, as prices are lowered over time.

Key Takeaways

• Price skimming is a product pricing strategy by which a firm charges the highest initial price that customers will pay and then lowers it over time.
• As the demand of the first customers is satisfied and competition enters the market, the firm lowers the price to attract another, more price-sensitive segment of the population.
• This approach contrasts with the penetration pricing model, which focuses on releasing a lower-priced product to grab as much market share as possible.

How Price Skimming Works

How Price Skimming Works

Price skimming is often used when a new type of product enters the market. The goal is to gather as much revenue as possible while consumer demand is high and competition has not entered the market.

Once those goals are met, the original product creator can lower prices to attract more cost-conscious buyers while remaining competitive toward any lower-cost copycat items entering the market. This stage generally occurs when sales volume begins to decrease at the highest price the seller is able to charge, forcing them to lower the price to meet market demand.

Skimming can encourage the entry of competitors since other firms will notice the artificially high margins available in the product, they will quickly enter.

This approach contrasts with the penetration pricing model, which focuses on releasing a lower-priced product to grab as much market share as possible. Generally, this technique is better-suited for lower-cost items, such as basic household supplies, where price may be a driving factor in most customers' production selections.

Firms often use skimming to recover the cost of development. Skimming is a useful strategy in the following contexts:

• There are enough prospective customers willing to buy the product at a high price.
• The high price does not attract competitors.
• Lowering the price would have only a minor effect on increasing sales volume and reducing unit costs.
• The high price is interpreted as a sign of high quality.

When a new product enters the market, such as a new form of home technology, the price can affect buyer perception. Often, items priced towards the higher end suggest quality and exclusivity. This may help attract early adopters who are willing to spend more for a product and can also provide useful word-of-mouth marketing campaigns.

Price Skimming Limits

Generally, the price skimming model is best used for a short period of time, allowing the early adopter market to become saturated, but not alienating price-conscious buyers over the long term. Additionally, buyers may turn to cheaper competitors if a price reduction comes about too late, leading to lost sales and most likely lost revenue.

Price skimming may also not be as effective for any competitor follow-up products. Since the initial market of early adopters has been tapped, other buyers may not purchase a competing product at a higher price without significant product improvements over the original.

Finding your ideal price

So how do you get to an ideal price, the “sweet spot” that will deliver the most profit given your circumstances?

Effect of price on profit

As you raise your price (moving left to right), your profitability goes up—to a point. It’s at the point where you’ve raised your price by too much that your profitability goes down.
Source: Eric Dolansky

“Pricing is one decision that shouldn’t be driven by accounting,” says Dolansky. He says that arriving at an ideal price means taking into account factors that some entrepreneurs may overlook.

Finding the right price range

Your customer needs to find that your price falls within their range of what’s acceptable, and your ability to price is constrained by your costs.

In the chart below, the floor of your pricing is your total costs for what you’re selling. The ceiling, or highest price, is the number at which your customer values your offer. Above this price, you lose the sale because the customer feels that your price exceeds the value he or she gets from your offer.

Between the floor and ceiling sits a price your customer will find acceptable.

Price floor and price ceiling

Source: Eric Dolansky

To choose the right price within your customer’s acceptable range, consider the main factors that affect price:

• operating costs
• scarcity or abundance of inventory
• shipping costs
• fluctuations in demand
• your competitive advantage
• perception of your price

Choosing the right pricing strategy

1. Cost-plus pricing

Many businesspeople and consumers think that cost-plus pricing, or mark-up pricing, is the only way to price. This strategy brings together all the contributing costs for the unit to be sold, with a fixed percentage added onto the subtotal.

Dolansky points to the simplicity of cost-plus pricing: “You make one decision: How big do I want this margin to be?”

The advantages and disadvantages of cost-plus pricing

Retailers, manufacturers, restaurants, distributors and other intermediaries often find cost-plus pricing to be a simple, time-saving way to price.

Let’s say you own a hardware store offering a large number of items. It would not be an effective use of your time to analyze the value to the consumer of each nut, bolt and washer.

Ignore that 80% of your inventory and instead look to the value of the 20% that really contributes to the bottom line, which may be items like power tools or air compressors. Analyzing their value and prices becomes a more worthwhile exercise.

The major drawback of cost-plus pricing is that the customer is not taken into consideration. For example, if you’re selling insect-repellent products, one bug-filled summer can trigger huge demands and retail stockouts. As a producer of such products, you can stick to your usual cost-plus pricing and lose out on potential profits or you can price your goods based on how customers value your product.

2. Competitive pricing

“If I’m selling a product that’s similar to others, like peanut butter or shampoo,” says Dolansky, “part of my job is making sure I know what the competitors are doing, price-wise, and making any necessary adjustments.”

That’s competitive pricing strategy in a nutshell.

You can take one of three approaches with competitive pricing strategy:

Co-operative pricing

In co-operative pricing, you match what your competitor is doing. A competitor’s one-dollar increase leads you to hike your price by a dollar. Their two-dollar price cut leads to the same on your part. By doing this, you’re maintaining the status quo.

Co-operative pricing is similar to the way gas stations price their products for example.

The weakness with this approach, Dolansky says, “is that it leaves you vulnerable to not making optimal decisions for yourself because you’re too focused on what others are doing.”

Aggressive pricing

“In an aggressive stance, you’re saying ‘If you raise your price, I’ll keep mine the same,’” says Dolansky. “And if you lower your price, I’m going to lower mine by more. You’re trying to increase the distance between you and your competitor. You’re saying that whatever the other one does, they better not mess with your prices or it will get a whole lot worse for them.”

Clearly, this approach is not for everybody. A business that’s pricing aggressively needs to be flying above the competition, with healthy margins it can cut into.

The most likely trend for this strategy is a progressive lowering of prices. But if sales volume dips, the company risks running into financial trouble.

Dismissive pricing

If you lead your market and are selling a premium product or service, a dismissive pricing approach may be an option.

In such an approach, you price as you wish and do not react to what your competitors are doing. In fact, ignoring them can increase the size of the protective moat around your market leadership.

Is this approach sustainable? It is, if you’re confident that you understand your customer well, that your pricing reflects the value and that the information on which you base these beliefs is sound.

On the flip side, this confidence may be misplaced, which is dismissive pricing’s Achilles’ heel. By ignoring competitors, you may be vulnerable to surprises in the market.

3. Price skimming

Companies use price skimming when they are introducing innovative new products that have no competition. They charge a high price at first, then lower it over time.

Think of televisions. A manufacturer that launches a new type of television can set a high price to tap into a market of tech enthusiasts (early adopters). The high price helps the business recoup some of its development costs.

Then, as the early-adopter market becomes saturated and sales dip, the manufacturer lowers the price to reach a more price-sensitive segment of the market.

Dolansky says the manufacturer is “betting that the product will be desired in the marketplace long enough for the business to execute its skimming strategy.” This bet may or may not pay off.

Risks of price skimming

Over time, the manufacturer risks the entry of copycat products introduced at a lower price. These competitors can rob all sales potential of the tail-end of the skimming strategy.

There is another earlier risk, at the product launch. It’s there that the manufacturer needs to demonstrate the value of the high-priced “hot new thing” to early adopters. That kind of success is not a given.

If your business markets a follow-up product to the television, you may not be able to capitalize on a skimming strategy. That’s because the innovative manufacturer has already tapped the sales potential of the early adopters.

4. Penetration pricing

“Penetration pricing makes sense when you’re setting a low price early on to quickly build a large customer base,” says Dolansky.

For example, in a market with numerous similar products and customers sensitive to price, a significantly lower price can make your product stand out. You can motivate customers to switch brands and build demand for your product. As a result, that increase in sales volume may bring economies of scale and reduce your unit cost.

A company may instead decide to use penetration pricing to establish a technology standard. Some video console makers (e.g., Nintendo, PlayStation, and Xbox) took this approach, offering low prices for their machines, Dolansky says, “because most of the money they made was not from the console, but from the games.”

Misconceptions of penetration pricing

“Businesspeople think ‘If I sell more, I'll be more successful,’” says Dolansky. “That’s only true if your margins are sufficiently high. It’s important to remember that penetration pricing serves a strategic need, that there is a reason why you benefit from greater volumes in and of themselves, so that selling more units helps attain your goal of making the most profit.”

The risks of penetration pricing

• Your customers may expect constant low prices.
• Price-sensitive customers can be disloyal.
• A price war with your competitors may ensue.

Ask yourself if you can sustain this pricing for the long term without endangering your business.

5. Value-based pricing

In value-based pricing, the perceived value to the customer is primarily based on how well it’s suited to the needs and wants of each customer.

Dolansky says a company applying value-based pricing can gain an advantage over its competitors in a couple of ways:

• The price is a better fit with the customer’s perspective.
• The pricing brings more profit, allowing you to acquire more resources and grow your business.

When a price doesn’t work, the answer isn’t just to lower it, but to determine how it can better match customer value. That may mean altering the product to better suit the market.

In an ideal world, all entrepreneurs would use value-based pricing, Dolansky says. But entrepreneurs who sell a commodity-like service or product, such as warehousing or plain white t-shirts, are more likely to compete on low costs and low prices.

For entrepreneurs offering products that stand out in the market—for example, artisanal goods, high-tech products or unique services—value-based pricing will help better convey the uniqueness they’re offering.

How do you set a value-based price? Dolansky provides the following advice for entrepreneurs who want to determine a value-based price.

• Pick a product that is comparable to yours and find out what the customer pays for it.
• Find ways that your product is different from the comparable product.
• Place a financial value on these differences, add everything that is positive about your product and subtract any negatives.
• Make sure the value to the customer is higher than your costs.
• Justify the price to customers, which might include reaching out to them.
• For an established market, its current price range will help educate you on customers’ price expectations.

Pros and cons of different pricing strategies

Can you combine pricing strategies?

Some of these pricing strategies can co-exist as your product evolves through its lifecycle in the market; some elements must coexist. You need an overall price strategy (e.g., cost-based or value-based), you need to determine generally how high or low the price will be (skimming and penetration pricing), and you need to respond to competitors (competition-based pricing).

For example, you may want to initially price your product using a value-based approach, then switch to a skimming strategy and conclude with penetration pricing.

How does pricing strategy fit into your marketing strategy?

Pricing is one of the most important and visible aspects of your market strategy, which also includes promotion, placement (or distribution) and people (the classic four “Ps” of marketing).

The price you offer, Dolansky says, must be consistent with “how you would like to be seen among your competitors, and consistent with your promotional messages, your packaging and types of stores that your product is in.”

Let’s say your product is a premium olive oil. It needs to have a premium price that reflects the refined packaging, distribution in better grocery stores and upscale promotional messages.

All pricing strategies are double-edged swords. What attracts some customers will turn off others. You cannot be all things to all people. Just remember that you want the customer to buy your product, which is why you must use a strategy that’s appropriate to your target market.

What factors must be taken into consideration to determine the right price for a product select all that apply?

Which two strategies can be used as part of a firm's profit objectives?

What are two profit oriented approaches to setting a price?

Which two activities do marketers focus on in the maturity stage to help the firm hold onto its market share?