Key Takeaways
- Price skimming can maximise early profits when customers see strong value and are willing to pay more.
- Use price skimming when the product is differentiated, demand is strong, and early customers have a higher willingness to pay.
- Price skimming can limit market size, attract competitors, and encourage customers to wait for lower prices.
- Test customer value, demand elasticity, product life cycle, and market conditions before setting a high initial price.
When a manufacturer, distributor, or retailer enters the market with a new product, it can be particularly difficult to know which pricing strategy will maximise sales and margins. Should they choose a price skimming strategy or a penetration strategy? Should they set an initially high price to recover the cost of capital assets quickly? Or should they set an initial price low to drive market share and exclude potential competition?
This is one of six core approaches to pricing strategy. See the full picture in our guide, What Is Pricing Strategy?
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Many B2B and retail businesses make the mistake of falling in love with their products. They believe that because their new product is faster, better and more unique than anything on the market, the world will be beating a path to buy it. Not the case. The world is brutal, and people donāt care as much about your products or services as you do.
In this article, Iāll show you how to price your product like a pricing pro and explain the strengths and weaknesses of a price skimming strategy.
What is Price Skimming?
Price skimming is a basic pricing strategy for a newly developed product or service. Price skimming involves setting a price so high that most potential customers will decline to buy the new product. Typically, unit sales of a skim-priced item will be low. However, the high per-item profits make price skimming a potentially viable strategy.
The high price of a product or service aims to generate a profit by appealing to customers who are willing to pay more or who understand its value. A high price can also eliminate price-sensitive customers or customers that do not understand the value.
When a business enters a new market with a differentiated or innovative product, price skimming can be one option for capturing a higher willingness to pay from early customers. Usually, they do this by applying a higher percentage markup to costs to set a higher price than they typically would. This is one way businesses may apply a cost-plus approach to price skimming.
When entering an emerging economy, some businesses may start with the home-country price and adjust it for exchange rates, customs duties and taxes. This is a more complex cost-plus pricing approach for setting an initial price.
Examples of products that have used a price-skimming approach include Appleās iPhone and Microsoftās Xbox consoles. These companies can take advantage of the fact that customers want to get their hands on the latest products, so they are willing to pay more for them initially.
When Should You Use Price Skimming?
Price skimming can be a good fit when a business launches a new product and wants to generate higher per-item profits from customers willing to pay more. It is especially relevant when a product is genuinely new, unique, or ahead of its time, and some customers understand its value.
Use price skimming when:
- The business wants to obtain profits quickly in the short term.
- A high initial price can create an image of luxury or exclusivity and act as a barrier to competitors.
- The business has considered customer value drivers, product life cycle, capital requirements, and early demand elasticity.
It may be a poor fit when the priority is rapid, high-volume sales, when price-sensitive customers make up a large part of the market, or when customers are likely to wait for price reductions. It is also risky when market conditions do not support a high initial price, since lower-priced competitors may enter.
The key is to test how customers value the product before deciding whether price skimming is right. These trade-offs lead to the next question: how do you make sure you are not underpricing or overpricing your new hit product?
You need the Right Numbers for Pricing! š Podcast Ep. 66!
What are the pros and cons of using price skimming for a new product?
The primary benefit of using price skimming as a pricing strategy is that it allows companies to generate profits quickly. The high initial prices can also act as a barrier to competitors. It also helps companies create an image of luxury and exclusivity, which can be appealing to certain customers.
However, there are some drawbacks associated with price skimming as well. Price skimming limits the potential market size because it is not suitable for all demographic segments. Those on lower incomes may be unwilling or unable to pay the higher prices. Additionally, many customers may be turned off by the high prices and choose to wait until further price reductions are made.
Therefore, it is important for companies to consider both the pros and cons of price skimming before making a decision. By understanding these different aspects of pricing strategy, companies can make more informed decisions about how best to launch and price new products.
Price Skimming: How Do You Make Sure You Are Not Underpricing or Overpricing Your New Hit Product?
If you intend to sell products quickly in the market, price skimming might not be the best approach for you. In this instance, you may be better off choosing a penetration strategy and setting the price of your newly developed product low to tap into a high-volume market. Typically, your per-item profits will be lower than they would be under a price skimming strategy. However, you will be able to push more volume quickly and penetrate the market.
If you believe your product is better than the competition, demonstrate it and charge more than rivals based on value. But donāt get too hung up on whether your product is better or worse than your competitorsā. Look at the variety of cars on the road, for example; not everyone wants to drive a Porsche even if they have the money to buy one. Donāt worry if your product isnāt as good as the competition.
Think about the probable length of the productās life cycle. Consider the amount of capital needed to get the product off the ground, customer value drivers by product and segment, and a detailed analysis of the elasticity of demand during the early life of the product. These are just a few things a dedicated pricing function should be doing.
Once you feel confident in your price skimming strategy, evaluate the approach across different channels. Carefully consider your online play, for example. Customers are exposed to offers from a variety of well-known brands, all competing for their attention. Like you, your competitors are also promising great value to customers and offering discounts. Sometimes, they offer products for less than half of what customers would have paid to encourage them to buy newly developed products.
Price Like a Pro Using Price Skimming
To be confident that price skimming is right for your business, think about how your company currently sets prices for its products:
- Is a markup on costs the best way to calculate your initial price for a price skimming strategy?
- Do you think a general price skimming approach exposes the business to margin risk? What are these risks? Document and evaluate them.
- Is there an opportunity to understand how your customers value your products and services before you decide on a price skimming strategy? How do you determine value? Is there a better way to define and quantify the amount you should set as your initial price?
Price-sensitive customer segments need to be approached differently from more mature customer segments in established markets. It is not as simple as deciding on an approach and then implementing it. You need to test and learn how customers value your products before you know whether price skimming is right.
Many businesses make the mistake of setting initial prices based on costs or relying on the tangible qualities of their products to demonstrate value when in fact customers pay more for risk avoided. This will not give you the results you expected. We find that when a business offers a product or service that is either unique or ahead of its time, customers take more time to understand the value of its offer. You want to encourage customers to buy from you, especially when a product is genuinely new and unique.
Implications
In considering a price skimming strategy, it is important to make strategic decisions to avoid margin risk. You need to spend much more time thinking about the right pricing strategy to win customers over. Some customers donāt always want to buy the best or pay for value, while others will. Will a price skimming strategy work for all your customers? Probably not. Think about the early adopter curve, that is, early adopters versus laggards. Most people take longer to buy an unknown, novel product than you think.
See how pricing breaks in practiceA superficial price skimming strategy based on cost-plus price-setting calculations is not enough to drive profitable outcomes. In fact, youāll probably end up either underselling your product or service or overcharging the very customer groups you want to attract.
Think about the longer-term impact of price skimming on the market. If market conditions and price sensitivity data do not support the strategy, donāt use it. You may be inviting lower-priced competitors to enter the market and push you out.
Online is an important channel for reaching customers and creating revenue opportunities. Most businesses spend much more time thinking about in-store or catalogue pricing than their online strategy. The channel mix is changing rapidly. The business with the best online price strategy will reap more revenue opportunities than competitors with a traditional focus and fixed pricing.
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Bottom Line
Price skimming is a useful strategy, but it can be risky too since there is no guarantee of long-term success. It’s important to consider the customer base and the competitive environment when choosing a pricing strategy in order to maximise profits while still keeping customers happy.
The key takeaway from price skimming is that companies should strive to find the right balance between profits and customer satisfaction. To do this, they must keep an eye on the market and competition to ensure their prices remain competitive. By adopting a well-thought-out pricing strategy, companies can ensure that they are meeting customers’ needs while maximising profits in the long run.
The consequences of applying the wrong pricing strategy are hard to miss. Customers will struggle to access vital services when they need them. Manufacturers will consistently miss out on revenue opportunities because of non-strategic (unprofitable) thinking. Donāt lose another dollar by implementing the wrong pricing strategy. Download our free guide here on all things related to pricing strategy.
For a comprehensive view and marketing research on integrating a high-performing capability team in your company, download a complimentary whitepaper on Future Proof Your Pricing Strategy.
Are you a business in need of help aligning your pricing strategy, people, and operations to deliver an immediate impact on profit?
If so, please call (+61) 2 9000 1115.
You can also email us at team@taylorwells.com.au if you have any further questions.
