In a recent tutorial, we looked at the main
strategies for your small business. We looked at three main strategies:
- Cost-based pricing
- Customer-based pricing
- Competitor-based pricing
Think of that as the foundation for setting
your prices. But no matter which of those strategies you choose, there are many
different ways in which you can present those prices to your customers.
You could use price bundling, for example,
or price skimming, or a freemium model, or many others. It’s those different
pricing structures that we’re going to look at in detail in this tutorial.
You’ll learn the ins and outs of seven popular pricing structures, with
examples of when each one might be effective.
By the time you’ve finished reading this
tutorial and the last one, you’ll be confident that you know how to set prices
for your small business in the most effective and profitable way.
1. Price Bundling
My wife hates it when I go to the
supermarket. I always come back with bags full of things we don’t need. When
she looks questioningly at the twelve avocados I’m unpacking, I say
defensively, “They were on special offer! Three for the price of two.”
OK, I admit it. I’m a sucker for price
I’m not the only one, though. Bundling
multiple items together and offering an enticing price for the bundle is a
tried and tested way of increasing sales. Customers love to feel that they are
getting good value, or something free (“Buy one, get one free!”).
The downside of price bundling, of course,
is that you reduce the average selling price of each item, and so you cut into
your profit margins. But if you hit the sweet spot, you can still make a good
profit. It’s particularly effective if you have a large inventory of products
that you need to reduce. Price bundling can clear inventory and bring revenue
And, despite my avocado example, this kind
of pricing can also be genuinely good for your customers. It can give them a
good deal on products they actually want and/or need, and the possibility of
getting similar deals in the future can keep them coming back to your business.
2. The Freemium Model
If you’ve spent any time on the internet,
you’re likely familiar with this model. In fact, you’re experiencing it right
Here at Envato Tuts+, we give away
thousands of free tutorials, and we charge people $15 a month for premium video
courses. The idea is that the free tutorials give people value and encourage
them to use and recommend the site, and then some percentage of those people
will sign up for the premium version. Here’s our full pricing structure. The tutorials are
“free”, and the courses are “premium”, and the combination of the two words
creates a “freemium” model.
The advantage of this model is that you can
acquire new customers very quickly. People are more likely to try a product if
it’s free, and if they like it, they’re more likely to recommend it to their
friends. “Hey, check out this free app!” is something we all like to say.
In the early days of Skype, I remember how
amazed people were when I told them you could talk to people on the other side
of the world, and it was free!
Although millions of people only ever used the free part, it didn’t matter,
because they acted as salespeople for Skype. Enough people signed up for the
premium features to convince eBay to buy Skype for $3.1 billion in 2005, just
two years after it started. Not bad!
Although it can lead to explosive growth,
the freemium model doesn’t always work. This Wall
Street Journal article gives some telling examples of freemium fails, and
it also quotes startup accelerator founder David Cohen as saying that typically
only 1% or 2% of customers will upgrade to a premium version.
For the freemium model to work, you need to
achieve significant scale, you need to be able to cover the cost of a lot of
free users, and you also need to get the right balance between the “free” and
“premium” elements. The free part needs to be valuable, but the premium part
also needs to offer something clearly different and worthwhile to convince
people to upgrade.
If you’re not careful, you can end up with
a lot of people using your product and costing you money, but very few of them
ever signing up for the premium version.
3. Dynamic Pricing
When you go into your local supermarket,
there’s one price for every item, printed clearly on a label on the product or
the shelf. Imagine how angry you’d be if you were charged $10 for your pack of
frozen pizzas, but the person behind you in the checkout line got the same pack
for only $5.
Yet a very similar thing happens all the
time in certain industries. It’s particularly common with things like airline
and hotel bookings. The prices change all the time based on fluctuating supply
and demand, so it’s quite possible that the person sitting next to you paid
half your fare.
The dynamic pricing model makes sense for
the companies, though. They know that an empty plane flying across the Atlantic
has a hefty fixed cost attached to it, so their priority is to fill up as many
of those seats as possible.
So if bookings are slow, the prices will go
down to encourage more bookings. On the other hand, if lots of people are
booking and the flight is filling up, the prices will rise so that the company
gets maximum profit out of each new customer. Usually, all of this is done
automatically, based on preset computer algorithms.
You could easily apply the same model in
your small business. If you’ve hired the local town hall to run a seminar or
other event, for example, you might offer cheap tickets early on to get the
place filled up. Then, later, you could raise prices as seats are becoming
scarce—or run special last-minute discounts if you’ve still got too many empty
You could even use dynamic pricing for your
main products or services. For example, a web design studio could raise prices
when it already has a lot of business, and lower them if things get slack.
Just don’t forget that pizza example. You
don’t want your customers to be confused or angry when they see other people
getting better prices. Clear, honest communication is key, so that people
understand the rationale for your pricing.
4. Subscription Pricing
Instead of selling products or services
individually, why not create a subscription model, where customers get access
to a wide range of them in exchange for a regular monthly or annual fee?
Envato, the company that runs this site,
recently introduced a subscription service called Envato Elements. It sells things like
graphics, fonts, and web templates—the same kind of products as Envato’s
existing marketplace, Envato Market.
The difference is that, whereas Envato
Market sells items individually, Envato Elements offers unlimited access to its
entire library for a single monthly
fee. It’s the subscription model in action.
The main advantage of the subscription
model is that it creates recurring, relatively predictable revenue stream. And if
it’s done right, the Lifetime
Value of a Customer can be higher with the subscription model.
The downside is that it can sometimes be off-putting
to new customers because it involves more of a commitment. And there’s always
the danger that people join for a short time, download everything you’re
offering, and then leave.
To keep customers subscribed for the long
haul, you either need to have a punitive cancellation policy, which customers
hate (remember that gym membership you’re still paying off?) or you need to
keep offering them more and more value and giving them reasons to stay (which
is the approach Envato Elements is taking).
5. Price Skimming
Price skimming involves having a high
initial price for a new product, and then reducing it over time.
The idea behind it is that different
customers are willing or able to pay different prices for the same product. In
that way, you could see it as a variation of dynamic pricing. But price
skimming is more specific: the price always starts high and goes down later.
Price skimming is often used with new
“must-have” gadgets or luxury items, where certain customers are willing to pay
a higher price to be among the first people to own them. It’s also common in
the book industry, where expensive hardcover books are published first, and a
cheaper paperback edition comes out months later.
If you do it right, you get the best of
both worlds: higher profit margins from the early adopters, and then a bump in
sales when you reduce the prices later on for the more cost-conscious
This approach works best when you’re launching a product that you know people are anticipating eagerly and will value highly. If you can create a buzz, then people may be willing to pay those higher initial prices.
The downside is that if you price your product too high, you may turn potential customers away. And those customers may never come back, even when you reduce the price later on. Or, as with dynamic pricing, you may get a backlash from customers who see others getting the same product more cheaply. To follow this strategy successfully, you need to have a lot of confidence in the appeal of your product and, again, communicate your pricing very clearly.
6. Loss Leader Pricing
As a small business owner, why would you
ever sell a product at the same or even a lower price than you bought it for?
Surely that’s a recipe for bankruptcy!
Yes, it would be a disaster if you followed
that strategy on a regular basis. But businesses do it all the time on selected
products, as a way of getting customers in the door.
The idea is that you offer one product at
an amazing price, so cheap that customers can’t resist. They flock to your
store, and while they’re there, they notice some of the other things you’re
selling (at regular prices), and they buy some of those too.
It’s commonly used in physical shops, but
small online businesses can use it too. Customers often comparison shop online, and if they see
you selling the product they want cheaply, they may choose your store when
otherwise they would have gone elsewhere. And while they’re on your site, they
may buy more—especially if you design your sales process to offer them other,
related products during checkout, perhaps incorporating price bundling.
The danger of loss leader pricing is that
people could end up not making those extra purchases. They come and buy your loss
leader, and then leave. In that case, all you’ve made is a simple loss.
7. Decoy Pricing
This is an interesting one—it involves
offering customers a buying option that is completely unattractive. Why would
you do that? To make another option look better, of course!
I touched on this in my tutorial on the psychology
of pricing. I mentioned a
famous example of decoy pricing highlighted by behavioral economist Dan Ariely.
The Economist magazine at some point offered three subscription options:
- Web only: $59
- Print only: $125
- Print and web: $125
Can you spot the decoy? It’s option 2, of
course, where you get only the print magazine but for the same price as both
print and web. It’s clearly bad value.
Here’s the interesting part. In an
experiment, Ariely found that the existence of that decoy price made people
more likely to choose option 3, the expensive print and web option. That’s
because it looked like a good deal compared to the decoy, option 2.
But when option 2 was removed, people’s
behavior changed. They were faced with just two options, and they mostly chose
the cheaper one. So including a completely unattractive buying option actually
resulted in more revenue.
If you want to use decoy pricing in your small
business, the key is to offer a buying option that’s close in price to the one
you actually want people to choose, but is clearly worse value. If you structure
it right, your decoy should make the real price look more attractive, resulting
in an increase in sales.
In this tutorial, you’ve learned about
seven common pricing structures you can use in your small business. You’ve seen
how they work, you’ve got an idea of the pros and cons of each one, and you’ve
seen some examples of when you might want to use them in your business.
Pricing is a huge area, so in these
tutorials I’ve tried to keep it simple by sticking to a few of the most popular
strategies and structures. If there’s another aspect of pricing that you’d like
us to cover in a future tutorial, please leave a comment below!
A good next step at this point would be to
delve into the psychology of pricing. Academics have done a huge amount of research into how
consumers respond to different types of prices, and some of the results are
distinctly counter-intuitive. The following tutorial will teach you how to
profit from some interesting cognitive biases.
And if your newfound insight into pricing
means you now need to raise your prices, here’s how to do it without losing
Finally, don’t forget to check out my
previous tutorial on pricing strategies if you haven’t seen it yet.