How to Create a Suitable Pricing Model for a Business

Determining a suitable pricing model for your business can be a challenge. From the start of the process, you’ll be walking a tightrope, trying to avoid pricing that’s too high or too low while searching for the kind of price points that gel perfectly with your brand identity.

Like any major business decision, your pricing model should be informed by your business’s unique goals and needs, as well as the more inflexible aspects of your industry and your place in the market.

By taking an informed, methodical approach to your product’s price points, you’ll achieve a pricing model that serves your needs and pleases your customers without sacrificing too much or feeling like you’re going in blind.

In this guide, we’ll take a closer look at pricing models, why they’re important, and how you can find the one that serves you best:

What is a pricing model?

Simply put, a pricing model is the method that a business uses to determine the right prices for its products. This can be affected by an array of factors, such as manufacturing costs, the market’s current perception of its value, and the type of product you’re selling.

Across all economic sectors and industries, pricing models are crafted to maximise revenue over time and can vary frequently both from product to product and according to the fluctuations of market factors. Having said that, some products and services are going to require a more flexible pricing model than others, due to one important concept…

Price elasticity of demand

Price elasticity of demand is a ratio used to determine how a product’s change in price can affect demand from consumers.

With some product categories, such as food and fuel, people will generally continue to purchase the product despite price increases. These products are considered inelastic.

Elastic products, on the other hand, are subject to changes in demand as a result of pricing fluctuations. For example, streaming subscriptions, electronics, and clothing.

Whether you’re selling a single product or several, keeping the concept of price elasticity in mind is important for determining how sensitive your product is going to be to price fluctuations, and how your pricing model should be fine-tuned to reflect this.

Price elasticity can be calculated using this formula: 

Price elasticity = % change in quantity / % change in price

As you learn more about price elasticity within your industry, you’ll become more adept at predicting and analysing the behaviour of your target market when your product undergoes a price increase.

Types of pricing models

Now that we’ve understood what a pricing model is, let’s look at a few of the most popular pricing models you may want to adopt for your business.

Competition-based pricing models

Competition-based pricing models, also known as competitive pricing, is a simple and well-vetted approach that’s centred around the existing market rate (aka going rate) of your business’s product or service.

This model generally leaves overheads and consumer demand to one side, and instead stays laser-focused on what close competitors are charging within the same space, using these price points as a benchmark for their own pricing.

If you’re building an online store with a focus on a highly saturated product market, this could be a perfect pricing model for you, as slight differences in price can be a major deciding factor for the customer.

Cost-plus pricing models

A cost-plus pricing strategy, rather than focusing on competitor price points, is centred around your cost of goods sold, or COGS. This is sometimes known as markup pricing, which is in reference to businesses using this strategy to markup their products based on the profit margins they’re hoping to achieve.

pricing spelled in blocks

Source: Shutterstock/FrankHH

When applying the cost-plus pricing model, you’ll need to calculate a fixed percentage for your target margin, and a separate one for the cost of production. Let’s say, for example, that you manufacture and sell wireless headphones. These headphones cost £50 to make, and you want to make £50 from each sale. This would lead you to set a price of £100, giving you a 100% markup.

The cost-plus model is generally used by businesses that sell physical products. If you sell a more intangible product (e.g. a SaaS tool), selling your product will likely bring in far more value than the cost to create it, therefore making it unfit for a cost-plus pricing strategy.

Dynamic pricing models

Sometimes called demand pricing or surge pricing, the dynamic pricing model is a more flexible approach, centred around the way prices fluctuate based on customer demand and other market forces.

Companies such as event venues, utility companies, airlines, and those in the hospitality sector have long been using dynamic pricing, often leveraging algorithms that draw from competitor price points, fluctuations in demand, and similar factors.

These algorithms will track data to calculate things like customer demand, competitor pricing, and other factors, then prompt businesses to change their prices according to what their customers are willing to pay and when they’re willing to pay it. This, hopefully, allows the company to present the right price at the precise moment when customers are willing to pay it. These tools also allow ongoing A/B test pricing to maximise profits.

How to create a suitable pricing model for your business

man balancing coins on scale

Source: Shutterstock/Andrey_Popov

Now that you’ve absorbed an overview of the different pricing models, let's get to the real reason why you’re here! Here are some of the practical steps you need to take in order to create an effective pricing model for your business:

Determine a realistic range

The first step in creating a suitable pricing model is evaluating your company’s pricing potential. This is an educated estimate of the product or service pricing which your business can realistically achieve when it comes to cost, demand, and other factors, which may include:

  • Geographical parameters
  • Fluctuations in demand
  • Operating costs
  • Competitive advantages/disadvantages inherent in your product
  • Your target market’s purchasing power and other demographic factors

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Define your buyer personas

Knowing your customer is an essential part of any business decision, but the importance of it can’t be overstated when creating a pricing model. Factors like your customers’ pain points, their willingness to pay for a quality experience, and their lifetime value, will all have a direct and significant impact on your final pricing model.

You may already have well-defined buyer personas for use in your marketing, but when you come to create your pricing model, you may want to review these personas for insights that will affect your pricing model directly.

Analyse and build upon historical pricing

Whether it’s from your own company or close competitors, analysing past pricing models that have been used in your market and determining their weaknesses (and any untapped potential) can uncover huge opportunities for improvement, especially when looking at disparities in churn data, closed deals, and sold products.

Find a middle ground between your goals and intrinsic value

A good pricing model should help you hit your KPIs, while also offering your customer base a great deal. Though it can be hard to strike this balance, if it’s done correctly, it will ensure higher profits and more predictable cash flow, greater market penetration, and an expansion of your market share.

Beat your competitors

An effective pricing model should encompass a plan to actively beat your competitor’s pricing. There are two ways to do this: either by putting out a similar offering to your competitors at a lower price point, or by offering a higher standard of product to your customers for a higher, but reasonable price.

Even if you’ve considered every other factor thoroughly, without a thorough competitive analysis of your market, your pricing model isn’t going to fulfil its potential, and could even wind up undermining your progress. Make sure you have a full picture of how your business compares to the competition, and keep it at the front of your mind as you formulate your pricing model.

Final Thoughts

We hope this guide helps you as you work towards a greater understanding of your market, and a pricing model that will smash those KPIs, and increase your value in the eyes of your customers.

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10/04/24

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