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.
Penetration Pricing Definition
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 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 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 find out – a little too late – that aggressive pricing actions have created substantial volume losses that fall way below sales expectations. It may be that you’re 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 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 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, pricing skimming applies to novel product because business 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 I-phones 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.
Take for example the Iphone. 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 most startups!
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 the 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 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?