4.3.2 - Pricing strategies
Price affects how customers view a product, how much they buy and the return a business earns on each sale. Learn cost-plus, penetration, competition, skimming and promotional pricing, and the conditions that make each suitable. All business examples and data in this lesson are illustrative.
Cost-plus pricing
Cost-plus pricing sets a selling price by adding an amount or percentage to the cost per item.
Cost-plus pricing
Cost-plus pricing adds a markup to a product's cost to determine its selling price.
A business first identifies the relevant cost per item, then adds its desired markup. If the supplied cost includes only direct production costs, the added amount must also help cover other business costs. Cost-plus pricing does not guarantee profit merely because the price exceeds one selected cost measure.
For a percentage markup on cost:
Markup is calculated on cost, not on selling price. Use the cost measure stated in the task; express the final price in the supplied currency.
An illustrative small furniture maker has an average cost of $40 per stool and uses a 25% markup on that cost. The added amount is $40 × 0.25 = $10, so its selling price is $50. Equivalently, $40 × 1.25 = $50. The $10 is 25% of the cost but 20% of the $50 price: markup and profit margin have different denominators. If the average cost estimate is accurate and the stools sell, the price leaves $10 per stool above that cost. Unsold output, changing costs or omitted expenses can still reduce actual profit.
Cost-plus is straightforward and can help a made-to-order business quote consistently. However, it ignores what customers are willing to pay and what competitors charge. A quote well above rival prices may lose orders; a quote below customers' willingness to pay may miss an opportunity. Costs can also rise if output falls and fixed costs are spread over fewer units. The business should check demand and competition rather than assume that the calculated price will be accepted.
Penetration and skimming
Penetration and skimming are contrasting ways to price a product when it enters a market.
| Strategy | Meaning and suitable conditions | Benefit and risk |
|---|---|---|
| Penetration pricing | Set a low initial price to attract customers and build market share. Particularly useful when many substitutes exist and customers respond strongly to price. | Can encourage trial and a larger customer base, but produces little return per sale and customers may leave if the price later rises. |
| Skimming pricing | Set a high initial price for a new product, then reduce it over time as the initial opportunity changes. Most suitable when the product has distinctive features and early buyers are willing to pay more. | Can earn a high return per sale and help recover development costs, but limits early sales and can attract rivals. |
An illustrative small streaming service entering a crowded market might offer a low initial subscription price. Customers have familiar alternatives, so the lower price gives them a reason to try it. If they value the service, some may stay when the introductory price ends. However, a low price must still be affordable for the business: acquiring many customers is unhelpful if revenue cannot cover the costs of serving them. Penetration is an entry strategy; it is not simply any low price at any time.
A large electronics business with a distinctive new device might skim the market. Early adopters value its new features enough to pay a high price, allowing the business to recover some development expenditure from those buyers. It may later lower the price to attract more price-sensitive customers as rival products appear. Skimming is less suitable when customers see the product as interchangeable with a cheaper established alternative. A permanently high premium price is not automatically skimming; the initial launch and later price pattern matter.
Both choices depend on demand, differentiation, competitors, costs and objectives. Rapid share growth may favour penetration; early return from a distinctive product may favour skimming. Neither method guarantees higher total profit, because total sales and costs change as well as the price.
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