Penetration Pricing Strategy: Is It Smart For Startups To Lose Money? 🎉
Penetration Pricing Strategy: Is It Sensible For Startups To Lose Money?
Your author has been working with a number of startups in various sectors in recent months. And the question arises – as to which pricing strategy is most appropriate for a business at an early stage in its development. In some regards, startups can be a very strange sector as only 1-2% go on to achieve brand name recognition (through a recognisable logo etc) – but it is those successes that people look at to form their own commercial strategies and when making a business plan.
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Penetration Pricing Strategy: Is It Smart For Startups To Lose Money?
Penetration pricing is a marketing strategy enticing customers to new products or services. By introducing a lower price than its competitors. It attracts customers to switch and to try out their products via discounts, freebies and promotions; and gradually increase its price once the initial promotion lapses.
A good example is the credit card promotion wherein the membership fees are waived in the first year. After that period, the users will be charged yearly.
Penetration pricing is best used when the demand for a new product is projected to be high. And cannot be copied easily by many competitors. The low price keeps the competition away from the initial market – in the hope that their business, brands and products become the new market standard of choice. Then, once the market share is secured, prices can gradually increase as part of a yield management strategy. Or if new similar products are launched by a competitor who is selling their products at a slightly higher price as part of a premium pricing strategy.
Worst case scenario
However, to ensure penetration pricing is working to your advantage, a business ensures ample supply and distribution for the demand. For example, if you’re implementing a purely cost-plus pricing strategy when your freight costs are increasing due to higher demand, you’ll often find that prices go beyond what the market is willing to pay because the percentage increase remains the same (i.e., X% on cost).
When this happens, it is common for sales or category teams to significantly discount prices to re-balance. However, excessive discounting and increasing operational costs can often eat into your EBIT without you even knowing it sometimes. Which means you’ve got to monitor the cost structure and product mix (as well as volume) in order to re-adjust pricing to the right level – or else lose hard-earned volume and margin in the process.
Advantages of a penetration pricing strategy
Typically, companies use penetration pricing to drive up initial sales. And more interest in their products using low prices and discounts – very much like bait. When implemented correctly, the profit margin is acceptable and receive positive feedback from new customers. But only if the product, branding and price positioning aligns to customer preferences and market dynamics.
It is easy to overuse penetration pricing and finds out – a little too late – that aggressive pricing actions have created substantial volume losses that fall way below sales expectations. It may be that your company has a product oversupply and is incurring losses through holding excessive inventory and stock. Alternatively, it could be that your customers perceive heavily discounted products or low priced products as cheap and switch to find better quality elsewhere. Conversely, it could be that your competition has lowered their price to compete with you for market share; and now there’s a vicious price war and cycle of commoditization you’ve got to manage. Unfortunately, if this happens, everyone’s profits will be at risk – a zero-sum game scenario.
If we look at some of the major success stories in the startup sphere we realise that very few of them actually were profitable at the beginning – despite being valued at very high valuations i.e. in the billions. For example:
Amazon – since launch in 1995, Amazon has seen huge revenue growth, but only marginal if any profitability. We could certainly argue that Amazon has pursued a volume seeking strategy to grow market share.
Uber – as at the time of writing, Uber is still considerably loss-making as it seeks to grow market share (after it entered the market in country after country) and follows a penetration pricing strategy versus competitors. Note – Uber practises a number of interesting pricing techniques; including dynamic pricing and surge pricing which we will cover in future blog posts.
What is the difference between Penetration Pricing and Price-skimming?
Well, Penetration Pricing introduces the product at a lower price in the beginning. Whereas, Price Skimming initially prices a product at a high price to maximize profit margins. The price skimming applies to luxury, new or unique products. Rolex watches, Apple iPhone, Innovative Medical Technologies and devices even the introduction of McDonald’s Grand Angus range!
Basically, price-skimming applies to the novel products because businesses want to find customer segments that are willing to pay a higher price for new and novel products – think here about the huge cues for all new Apple iPhones and products – and who want to be first to have it even if the price is significantly higher than other similar products in the category.
However, eventually, the price of the initial product will go down as ‘new’ becomes the accepted norm.
As mentioned, the iPhone is an example. Whenever Apple introduces the latest phone on the market, the initial price is steep. But people are willing to pay for it just to be first to have it. In time, that price will go down after the hype. Or when iPhone with all the bells and whistles is something nearly everyone has. No reason to pay a higher price for something everyone has. This is why Apple desperately tries to pushing product innovation. In simple terms, their high price premiums are dependent on it.
The video below covers 10 major brand names that are loss-making – or were until very recently as they pursued market share through a penetration pricing strategy. This may be fine if you have infinite investors billions to burn – but of course, that is not what most startups do!
Is penetration pricing suitable for your business?
An argument can be made for a penetration pricing strategy if your business model is seeking to gain market share for a number of reasons; potentially if the business is a network business – i.e. where if you lock someone into a product, they will continue to buy more items from you on an ongoing basis. Think of photocopiers and ink in this context or in a more modern setting. Like Apple iTunes and buying movies and music. In the latter case – Apple pursues an ultimate penetration pricing strategy – they give the player technology away for free as the sales of videos, games and movies is so profitable.
In this instance – the penetration pricing strategy makes a lot of sense. The advantages of penetration pricing strategy are, they grow market share and then have a captive audience – or at least a market with real costs of moving who they can make continuing sales to.
A penetration pricing example is an Amazon-style model above. Amazon has grown market share continually (of a seemingly terminally declining book market in developed nations). This growth has been funded in reality by shareholders and investors that are happy to continue buying shares in, and debt issued by the business. Check out a blog here on the latest trends in online business in 2019.
When you are building a startup in tech or offering a new technology – the second option will be a much harder sell when seeking funding from potential investors. If you have seen “Shark tank” or “Dragon’s Den” you will be aware that most investors will finance a penetration pricing strategy for a period of time – only if that will enable them to charge profitable prices at a later point in time.
Penetration pricing uses quick turnover and attract new customers.
Expect a small or non-existing profit margin in the initial run.
Once the curiosity of the customers wanes and the price goes up, they may return to the competitors.
It could force the competition to lower their prices prompting a price war
We are all in business to make a long term profit. Every business needs to have a forecast of when they will break even. Many of the huge internet startups we hear about can be making a loss in their growth years. But they need to be forecasting a profit at some point soon.
Many companies who have achieved many free users, they have found it tricky to start monetising those users or implement higher prices. And many turn to advertising in this area (think Facebook). Growing a huge free user base can be great as long as; it enables marketing strategies to win new paying customers.
It is one thing to attract customers when the service is free – even charging a low initial price can make it much more difficult. See our blog on price floors.
When will your business start making profits?
Using Penetration Pricing to Maximise Market Share 🏆
Can penetration pricing lead to increased market share? Will it gain more entry to the household segment?
In every brand categories in most countries, leading brands have one thing in common, which is being the lead in household penetration. So how come few companies are able to use pricing to boost penetration?
To find a solution, we need to find the problem. Pricing has long been one of the most perplexing challenges for consumer goods companies.
Problems with collapsing ROIs, volatile commodity prices ballooning gross margins, aggressive customer negotiations and sticky retail price points have been the constant thorn for most companies.
It just shows to prove that household penetration is an important factor for growing brands. As a result, more pricing leaders are taking a serious look at their pricing strategies. They know pricing can be used to increase penetration (defined as the percentage of households in a market buying a particular brand in a given year). The problem is, they don’t know the best approach—or even how to begin.
In this article, we’ll show how pricing can increase household penetration.
We’ll explore how businesses use pricing penetration to optimise brand awareness.
It is our belief that pricing deserves a home, one with a dedicated pricing team with an exceptional pricing manager.
When executives analyse their company internally, they often find it to be working against itself. Like many companies, the key players involved in price decisions don’t have a consensus on the pricing’s role.
- Finance wants to increase prices to optimise top-line growth or profits. This in order to cover costs and stay ahead of inflation.
- Sales want to increase market share through discounting to retailers.
- Marketing wants to rely on prices to build brand loyalty, tap into new occasions or fuel marketing investment.
With almost zero alignments on the ultimate pricing objective, it’s little wonder so few executives are satisfied with their pricing efforts.
While many companies struggle with pricing, some are getting it right. They are systematically relying on price as a tool to increase household penetration and growth.
So what are they doing differently? Research shows how winners rely on pricing to extend household reach, not narrow it.
With that, they took a unified approach to penetration pricing:
- Marketing aims to always attract new households, not just those who seem loyal today.
- Sales aim to optimise household reach across all channel customers, not within a particular channel.
- Finance works to increase the total profit margin to reinvest in reach marketing.
Although the pricing strategy may differ across brand portfolios and companies, successful companies analyses penetration pricing across these four dimensions:
1. Pricing strategy: Should I go up or down?
The basic pricing strategy question is this: to maximise household penetration, should I take my average portfolio or brand price up or down?
Microeconomic theory tends to dictate that the only way to increase brand awareness is to lower prices. Yet, pricing up is almost always better than pricing down at the end of the day. Optimising brand awareness requires innovation and marketing. In effect, you need to price higher to fuel investment in both. Competitors will have a much harder time following world-class innovation and marketing than they do lowering prices. Profits in premium categories are twice than those of returns in discount categories.
Consider a leading global cosmetics company. For years, the company held its premium prices steady, fearing the price premium (three to four times higher than mass products) was simply too high to attract new consumers. But after rigorous market analysis, it determined that flat prices were unlikely to attract new households in most markets.
Mass consumers were willing to trade up only if they found a product that was dramatically better for them. So, increases in household penetration would come only from breakthroughs in innovation, the in-store experience and heavy advertising. By raising prices, the company was able to dramatically boost its investments in these true contributors to household penetration. Moreover, its competitors quickly followed, limiting share erosion and expanding the pie for all players.
2. Pricing architecture: When a family pack limits growth
The basic pricing architecture question is this: what will improve incremental household penetration in my category?
In considering the strategic decision to move the brand prices up or down, consumer goods companies must know there are too many products competing within a price band. Also, there are crucial price bands or pack sizes that are underserved. Knowing this will allow them to design new offerings aimed at untapped households.
An example is if you keep making innovations that churn without expanding your business; you might not really understand incremental consumption at a household level. Find what’s most likely to unlock incremental households, and then design a pricing architecture to support it. It can unleash considerable growth.
3. Customer and trade execution: Working with retailers on penetration pricing
The trick to getting the pricing right is to ask the question: how should we change retail prices and the broader retail environment to attract new households?
More often than not, sales teams concentrate more on winning more market share than on winning new households. While there is a link between the two, a shared focus can lead the companies in the wrong direction.
Even with brand loyalty, it is almost impossible to achieve in most categories. Shoppers will more often than not still line up in the aisle to choose which competing brands to buy. As a result, most companies make the mistake of instinctively turning to temporary pricing.
In the case of Temporary Price Reductions (TPRs), or in other words, on-shelf discounts that do almost nothing to attract consumers, its rates often consume more than 50% of a trade budget and do little to truly move the needle.
Often, they are embedded in the sales culture and important to in-year financial results.
So, how do you go about revising the pricing strategies to support the goal of maximising household penetration? The answer involves three tactics:
- Winning companies build a good category management program for both internal and external consumption that does two things: first, it avoids mistakes such as the pantry loading that occurs through buy-one, get-one-free promotions. Second, it attracts new households.
- Winners identify the whole customer experience within and across the customer base to increase awareness of their products and designing strong pay-for-performance programs to capture it.
- Winners use select price increases to fuel the investment required for both of the above.
4. Capabilities: Organising for continual improvement on penetration pricing
Most consumer goods executives complain that pricing changes simply isn’t in line with their organisation.
The reason? It’s one of the few tools used to meet short-term goals. Also, creating solid capabilities requires time and patience. Aside from that, it takes a tremendous effort to attract, train and retain the right talent. In which case, companies need to create a repeatable model to maintain momentum on pricing changes. Companies can see long-lasting results once they break the organisational barriers holding them back.
You will need three strategies to achieve them. Here are three strategies:
Particularly in sales, the best companies revise incentives to reward activities that increase long-term household penetration instead of short-term sales.
That means rewarding better distribution for core SKUs (versus in-and-out new products), consistent feature and display activity, and minimizing TPR activity. Winners establish a closed feedback loop designed to ensure that pricing decisions ultimately deliver on penetration strategy.
Build a business system that delivers your pricing and penetration strategy.
Many companies have business systems (everything from overhead investments to supply chains to IT) that are simply not equipped to provide what is needed. This is either because what is needed is not specified or because it changes every year.
Give pricing a home
Everyone has a stake in pricing, but there’s rarely any collaboration among Marketing, Sales and Finance. That leads to poor decisions.
Pricing deserves a true home: one with a dedicated, cross-functional decision-making pricing team supported by an A-grade pricing manager. In effect, the best companies form a single pricing team to take control of pricing and take charge of the necessary changes that will help them use pricing. This in order to increase household penetration.
When companies take the big step in creating such a team, they improve the science of pricing in the organisation.
Thus, a global pricing team solves the misdirection that hinders so many consumer goods companies. With Sales, Marketing and Finance working together toward the same goal, these companies are steadily expanding to household penetration.
With it, they gain market share from the power of pricing. While their competitors, who often view pricing and penetration as opposing forces, allowed pricing to fall between the cracks. As a result, they are now steadily losing ground.
Taking all of this into account, this is why you should approach the companies with a single question with big implications. Who’s the one executive in the company who owns pricing decisions?
It’s surprising how many companies can’t answer that.
Why penetration matters so much
Most consumer goods executives just don’t know at just how fundamentally important penetration pricing is to growth.
Brand plans include increasing a product’s buy rate by opening into a well-segmented group. Hence, getting them to become loyal shoppers to buy larger and larger quantities over time. Hence, across categories and countries, increasing penetration is the primary way to build big brands.
Research confirms that penetration is more important than the buy rate for growth. In almost every category examined globally, leaders tend to outperform on penetration, not buy rate.
We observe that loyalty across categories doesn’t vary significantly over time but household penetration does. However, penetration is not a guaranteed success, and even top brands can experience churn rates of nearly 50%.
That’s why winning companies continually invest to acquire more new consumers every year than they lose.
Most companies rarely use household penetration in their pricing strategy. Possibly, this is because the key departments like finance, sales and marketing are not collaborating with each other.
Each key department views pricing differently according to their business goals. They should take a unified step to bring pricing to extend the household reach and not stifle it.
Household penetration is the most important factor for growing brands. Therefore, pricing can be used to increase penetration. The problem is pricing managers don’t know how to begin.
Most companies think that the only way to increase brand awareness is lowering prices. But pricing up can create world-class innovation and marketing. Profits in premium categories will double than those of returns in discount categories.
Despite the importance of increasing household penetration, it’s often not considered in pricing decisions. Basically, many companies viewed pricing and penetration as opposite forces that need to be carefully balanced.
Pricing managers know that these pricing and penetration forces work hand in hand. When done effectively, adding the household penetration strategy to pricing tactics increase top and bottom-line returns.
Some businesses need the ability to deliver innovation, while others require packaging flexibility. Almost all of them need to have better insight into promotional spending. A clear growth and pricing strategy gives executives clarity on the right business system changes to make.
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