The pricing community has evolved a language of it’s own to describe the various ways to help a business realize a higher selling price, better margins, and higher profitability. We’ve compiled this guide to the more common terms in the pricing profession.
Pricing Terminology – Methods of Setting Price
One of the most basic approaches to setting the price for a product. Cost Plus pricing involves adding up the price of a product and marking them up by a specific amount (percentage or fixed amount per unit) to generate a selling price.
- Easy to calculate, easy to explain, easy to enforce using systems and reporting
- Leaves money on the table – customers may be willing to pay higher margins
Value Based Pricing
Setting price for a product based on the perceived value to a customer. Involves assessing how much a particular product or service is worth to a customer, relative to their goals or other options, and setting the price to capture a greater share of the value relative to competing options.
- Requires deep knowledge of product and competitive alternatives
- Requires good segmentation of customers, channels, and purchasing events / triggers
- Best opportunity to realize full pricing opportunity
- Can often be reduced to simpler guidance for sales team with software and analytics
Competitive Pricing / Market Based Pricing
Uses competitor prices on similar goods and services to set prices at an appropriate level. With good perspective on competitor pricing, we can set prices at levels where we are likely to win the business.
- Requires reliable intelligence on competitor pricing and product offerings
- Comparisons can be very tricky – “similar terms”, “similar circumstances”, “similar services”. Competitors may structure their deals differently and make exceptions for specific accounts.
- Customers and Sales Representative often manipulate comparisons to ask for concessions
Prices are set relative to the published price of a commodity, often given as a markup on the index price. Commonly used for highly competitive commodities such as plastics, oil, and metals. Prices move up and down with changes in the published index price. Index pricing schemes are often preferred by powerful procurement organizations, since it helps ensure they receive a price decrease if raw material costs fall.
- Often very simple to implement: published index +/- X amount
- Creates a very transparent marketplace (NOT always a good thing for sellers)
- Restricts seller’s ability to use market increases to improve margins over time
Manufacturer’s Suggested Retail Price
A widely published price from manufacturers intended to guide resale price by retailers. Sometimes will be printed on a product (pre-priced items) or published on official documentation or the manufacturer’s website. Generally functions as the maximum possible resale price by a retailer within the marketplace.
Increasing your price on products and services which are sold on the basis of convenience, often on smaller items that are not the core of a customer’s spend. This strategy takes advantage of the lack of alternatives for a customer due to the cost involved in finding another supplier. Some examples:
- Charging $1.50 for a candy bar at a gas station that would be $.50 if purchased in bulk at a mass market retailer; the extra $1 spares the customer a trip to Wal-Mart and a $10 bulk purchase.
- Charging higher prices on a custom product; rationalized as extra services and inventory costs, although the item is generally manufactured using the same machine as the standard product.
- Charging higher prices on non-essential items for a business customer, justified as saving the customer the cost of finding another supplier, finding the item, and building a minimum order.
Line Pricing / Price Lining / Price Points
Often done in consumer retail, the act of pricing multiple items at the same price point. Can be done for a specific retail offer (“Your choice, $5!”), an entire aisle (“$1 aisles”), or even an entire store (“five and below”). Generally prompted by a couple of considerations:
- Consumer attraction to certain popular price points
- Ease of advertising, promotion, and pricing administration – many items, at the same price
- Very difficult to change price points once established, especially if part of branding efforts
- An example of psychological pricing; consumers react to a specific amount ($1, $5, etc.)
Pricing Terminology – Pricing Perspectives
Where the price of a product or service is set specifically for each transaction, driven by current market conditions and the dealer’s inventory position. Common for certain types of commodity products which are sold based on price and availability.
- Requires prices to be set transaction by transaction
- Very easy to adjust pricing levels; just change pricing guidance for the next transaction
The prices of a product is governed by a long term understanding with a customer. This usually includes both a list of prices and a list of contract terms that govern the other elements of the relationships. These can be either informal (buying guide or quote) or a formal legal agreement.
- Easier to maintain – set initial price list and publish updates as needed (increases / decreases)
- Can be challenging to adjust prices – price increases can provoke customer into shopping business
The practice of offering deals which bundle multiple items or services together and offer them at a single price. Can be motivated by multiple reasons:
- Acquire a larger share of a customer’s total spend on related products.
- Offer a discount on a highly visible portion of the bundle where the customer is price sensitive and seeking to earn higher prices on other items they are expected purchase (service contracts).
- Take advantage of efficiencies in selling or fulfilling additional units in the same transaction
Retail term. The act of pricing a highly visible item at a loss to generate attention, traffic, and overall customer interest as a result of the promotion. The seller offering a loss leader is hoping to generate enough additional business to offset the profits lost on the loss leader item.
A version of bundle pricing, offering multiple units of the same item for a single price. Often used with lower price items or as part of an effort to encourage customers to stock up on a commodity item.
Customer Lifetime Value
Estimating the future profits from a customer; requires predicting customer loyalty, likelihood of buying other products or responding to promotions, and understanding price / cost of future transactions. Often used for B2B relationships and subscription products to understand how much you can invest in acquiring a new account.
- Need to invest time in analyzing customer behavior and forecasting pricing
- Risk of being over-confident about future events
- Allows you to stay competitive in pursuing relationships with high repeat business
Often used to describe fees and penalties in a deal which may or may not be charged to a particular relationship. The seller is often at an advantage in pricing these items; consumers are over-confident about their ability to avoid penalties and comply with the terms of a deal. Similarly, consumers usually overestimate or underestimate the odds of an event occurring. The seller can do statistical analysis that gives them a better prediction the likelihood of an event happening and set prices to their advantage. This is an example of using asymmetric information between buyer and seller to set prices.
A broad set of pricing schemes where the price of an individual transaction is determined at the time of the transaction using software, analytics, or pricing rules. This can be in response to shifts in demand, supply, buyer circumstances, or the seller’s available inventory and production efficiencies.
Yield management is a variable pricing strategy which uses insights into consumer behavior and response to incentives to maximize the total revenue and profits from a fixed, perishable resource. The text book example is generally either airline seats or hotel room reservations, although these ideas can be applied much more broadly across a wide range of industries.
Pricing Compliance / Pricing Discipline:
Strategies for improving the degree to which prices and pricing actions are consistently implemented within an organization. Organizations without a central pricing organization and good pricing tools are often inconsistent in how they price business and react to market events very slowly. This can also result in excessive discounting, pricing mistakes, and margin erosion over time. Pricing discipline initiatives aim to reduce the amount of margin lost through inconsistent pricing execution and failures to take full advantages of the opportunities offered by industry-wide price increases.
Pricing Terminology – Measuring Price | Pricing Model Design
List Price / Price Book Price
A published reference price for a product, sometimes specific to a particular channel or market segment. Intended for use as a reference price, as a starting point for discounts and other rebates.
Guidance provided to the selling organization about where to price products and services. Frequently developed with an eye to customer segmentation.
The minimum price which the selling organization is allowed to accept. Generally attached to various system triggers and reports to alert management to the situation.
The amount actually printed on a customer invoice, in the customer’s purchasing system. Denotes the starting point for calculating price on a particular transaction.
Off Invoice Allowances
Amounts which are immediately deducted from the list price on an invoice. A highly visible form of price concession.
Specific definition varies by organization, but this is usually invoice price less terms discount, rebates, and other deductions from payment. This is the actual “cash amount” paid by a customer for an item, once all the relevant bills and disputes are settled.
A deeper version of net price. Starts with net price and deducts any extra servicing cost, “unauthorized” discounts, disputes, “one-time” investments in product or channel support, contingent expenses, special staff, etc. Attempts to identify anything that reduces what you can pocket from a block of business. Intended to catch costs and deductions that the organization could have diverted into other accounts.
Pocket Price Waterfall
An itemized view of the various deductions, used to analyze the sources of leakage between the target price for an organization and the amount which is actually pocketed from a transaction. Can be used as a starting point to coach the selling organization and rally margin improvement efforts.
Price Band Analysis
Statistical analysis examining the distribution of a group of similar customers by net price. You can get insights from the shape of the distribution and the consistency of pricing charged to similar accounts.
Price Quality Relationship / Price Value Relationship
Mapping of similar products comparing the price of the product with the quality or value of the item. Used to evaluate competitive positioning of the products.
The printed or “officially listed” price for an item, if published. Generally refers to financial instruments or other products the quality of which can be easily denominated in currency.
Pricing Terminology – Pricing Strategy
The least exciting of the three competitive pricing strategy options; parity pricing seeks to keep your prices generally in line with competitors.
Penetration Pricing (Pricing Below Competition)
Setting the price of your product below prices offered by typical competitors in an effort to gain market share. This is expected to increase your market share in the long run.
Price Skimming (Pricing Above Competition)
Setting the price of your product above prices offered by typical competitors in an effort to harvest additional margin from the value of your brand. In the long run, this will reduce your growth rates.
A vendor can create significant value by customizing it’s solution for a specific customer. This can be an opportunity to increase your margins by doing one of three things:
- Adding features to your product to increase it’s value to that particular account
- Removing features from a standard product that the customer isn’t willing to pay for
- Adding complexity and switching costs to your item that makes it harder for a customer to change suppliers in the future; this gives you leverage to improve your margins in future price increases.
Splitting up transactions into comparable groups for use in optimizing pricing. Generally involves using multiple factors, including:
- Customer segmentation – understanding buying needs, end use, and price sensitivity
- Relationship / Circumstances – spot buys vs. promotions vs. repeat purchases
- Product segmentation
- Services Offered
- Selling Model
- Distribution Channel
Setting different prices for similar items sold to different customers, intended to capture differences in the customer’s willingness to pay. The practical application of a pricing segmentation system.
Legal methods of communicating your pricing intentions to your customers and the industry and interpreting similar signals from other companies. Includes announcing price increases, retailer promotions, and other publicly visible actions.
Related to bundle pricing above; takes a pair of related products, such as a piece of equipment and a consumable supply, and prices them to maximize the total profitability of the system. This frequently involves setting the equipment price at a low level to maximize your installed base and ensuring your consumable item is priced at a high enough level to more than cover your initial discount. A version of this pricing strategy can also be found in software (initial installation, service / licensing packages) and consumer products (razors and blades).
The strategy of setting prices so that the total amount of a transaction falls within the authority of a particular decision maker in the target organization. This is common in B2B SAAS: purchases under $5,000 can often be approved by a line manager, purchases over that amount must usually go through central procurement and a competitive evaluation process. The latter dramatically increases your selling cycle and reduces your odds of winning a deal. In a discrete pricing strategy, you build your product and price so you can keep the deal below a specific – easily approved – amount to facilitate the sales process.
Introductory Pricing / Honeymoon Pricing
The practice of offering a product at a reduced price for an introductory period. Commonly found on items with relatively high switching costs and a locked-in ability to drive repeat purchases. This is offered as a strategy to generate as many relationships as possible, in anticipation of being able to retain enough of the volume after the honeymoon expires to generate a reasonable profit.
Price Increase Strategies
Price increases are a source of risk and opportunity for a business.
- If competitors have raised their prices (or signal they are raising prices), a price increase campaign represents a chance to capture additional margin without risking sales volume.
- If costs have increased, a price increase provides an opportunity to recover this cost.
- If your price increase is greater than the market, you risk losing customers
- An industry price increase can also provide an opportunity to address inappropriate pricing levels within your customer base and product mix (low priced customers get a full increase, over-priced customers get less of a price increase).
Pricing Terminology – Industry Specific Concepts
Commonly used in the outsourcing industry; involved a purchase commitment for a specific base volume of services or staffing with an adjustment mechanism to reflect higher or lower usage of services.
Everyday Low Price
Retailer Strategy of NOT offering promotions or discounts to a customer to train them to not wait for sales. Has been implemented successful by Wal-Mart; varying results at other retailers and channels.
Hi Low Pricing
Generally found in a retail store, the strategy of rotating products between “low” prices during promotional periods and significantly “higher” prices in other periods (via a sale or special promotion). Usually executed across many brands in the same product category, creating a rotating calendar of “weekly deals” to get consumers excited. The downside of this approach is consumers become aware of this process and shift their purchase to the promotional periods.
Experience Curve Pricing
For new products, particularly new technology items, accepting your initial orders at a lesser profit relative to current production costs with the expectation that the manufacturing process will be much more efficient after you build up demand. While similar to an “economy of scale” based strategy, this differs in that the expectation is that company will get “smarter” about making the item vs. merely capable of larger production runs.
Performance-Based or Guaranteed Pricing
Pricing schemes where some or all of the price is placed at risk of meeting certain objectives. This can be found in consulting arrangements and legal services. At the extremes, can loosely be associated with “working on contingency” (pure performance based pricing).
Peak and Off-Peak Pricing
The practice of letting the price vary over time, raising prices during periods of peak demand and letting them fall during quiet periods. This takes advantage of changes in price elasticity. Spot market rates will often reflect these dynamics (if a spot market exists).
Tiered pricing is a pricing strategy where you split your offering into different packages of features, each at a different price point. A good tiered pricing strategy seeks to capture the differences between different customer segments without outright price discrimination.
For example, a software development tool might have a hobbyist tier (single user, basic features) at a very low price and an elaborate “agency” plan with features aimed at making teams more productive. Since the intrinsic value of the team features is far higher to a potential customer who owns a business, this is an effective way to capture a higher price without losing casual users.
Keystone pricing is a very simple method of setting the retail price where you double the wholesale price of the item. Items priced via keystone pricing at a 50% profit margin.
The risk of keystone pricing is this simple method may not accurately reflect market price for the item, especially if the market condition is relatively competitive. It can work for small items and non-competitive retail price setting.
Direct Cost represents the costs involved in the manufacture or acquisition of the product. This includes raw materials, labor, and freight (often). Direct Cost is part of Variable cost.
Variable Cost is the share of costs which are deemed to flex with changes in unit volume. This includes direct costs plus portions of the administrative budget which are sensitive to sales volume. As a general rule, any price should at least cover the variable cost of the item.
Overhead Costs represent the fixed costs of operating the business facility and its staff. This would include things such as rent, administrative personnel, IT, and other items. While you can ignore these costs in special situations, in the long run, a business will need to cover its overhead costs to stay in operation.
A slightly more comprehensive view of overhead costs. These are the costs which the business must pay regardless of sales volume.
Marginal Cost is a key concept in pricing and business development. If we acquire (or shed) additional business, what is the cost per unit of the incremental volume?
Marginal cost can be tricky in manufacturing, since there is a setup cost for any production process and the direct cost of additional units can sometimes be very low. Furthermore, as the machine produces more units in a long run, it will often become more efficient (faster).
Want to Know More about Pricing? Check out These Articles!
- Strategic Pricing – 5 Real World Ways To Earn Higher Margins
- Using Customer Profitability For Good and Not Evil
- Target Pricing – Setting The Correct Focus With Your Sales Team
- Using Yield Management To Improve Overall Performance
- Aligning Pricing Tactics With Your Process
- Measuring Pricing Performance
Need help applying this to your business? Drop us a line – we are pricing consultants.