Product pricing is a critical decision when launching new products and services. The introductory price shapes the brand image, determines the product’s success in the market, and, of course, drives profitability.

Choosing the right pricing strategy can be challenging. There are many considerations when setting the ideal price. You may wish to create a sense of exclusivity or to attract the greatest number of potential buyers. These two considerations can help companies choose which strategy would be best for their new product or service: penetration pricing or skim pricing.

Penetration Pricing vs. Skim Pricing

Penetration pricing is a pricing strategy where products are initially offered at a low price to attract many customers and sell more units. On the other hand, skim pricing (or skimming) is when companies initially offer their products at a higher price to maximize profits.

Penetration pricing and skimming can be thought of as opposite ends of a spectrum. The question becomes “what pricing strategy should be used in what situation”. Here are three questions to help guide your decision making.

Is my product unique or not?

Late entrants to the market often use penetration pricing. The market may be saturated with competing products or many competitors. If your product doesn’t have distinctive competitive advantages, then you use penetration pricing to initially lure customers and take part of your competitor’s market share. You use penetration pricing as an edge and an opportunity to convince your target clients to switch to your product.

Skimming, on the other hand, is a good pricing strategy when your product is differentiated. With new or unique features and benefits, you may have the leverage to set your price high because there are fewer substitutes available in the market.

Is my goal to increase profit margin or market share?

Another important question to ask is about your goals. Are you aiming for higher revenue, bigger market share, higher total profit, a more efficient profit margin, higher revenue per unit? You can have different goals at different stages of the product life cycle, different target markets, or different business units, but aligning your pricing with goal is critical.

Penetration pricing is often used by to generate network effects when value can be increased when the number of users increases. Social media firms that rely on large numbers of users to provide value to advertisers is an example.

Using penetration pricing, you can expect lower revenue because of the low price, but this can mean a higher market share or revenue from other sources (e.g. advertisers). Consider this trade-off carefully. Lower pricing can be help at the introduction of the product when trying to penetrate the market, but can lead to lower profits over the life of the product.  

This trade-off can be affected by other considerations. For instance, improved manufacturing processes or economies of scale may lead to lower costs and improve margins even for lower priced products. Of course, even at a low price, undifferentiated products are subject to pricing competition and new entrants. Low initial product prices will offer trigger lower prices from competitors.

How price-sensitive are my target buyers?

Penetration pricing is specifically designed to capture customers with lower willingness-to-pay. Price sensitive buyers are more likely to switch to new products that are lower priced. This leads to higher volume or a large number of customers and a scenario where total revenue generated may compensate for the price decrease.

In less price-sensitive markets, skimming may be a better pricing strategy. For instance, luxury goods buyers are less price sensitive and likely to interpret higher prices as signals of quality or exclusivity. Penetration pricing often backfires in this market and there are many examples of companies eroding value by introducing luxury branded products at lower prices.

On interesting exception is new brands in luxury markets. Lexus introduced luxury cars at lower prices than competitors which allowed new consumers into the luxury automobile market. Penetration pricing does not necessarily mean low prices, it means lower prices than competitors.

Quantity demand itself is a closely related issue. How price elastic is your market? If a particular market is inelastic, skimming may be best since a price change will not lead to a big change in quantity demand.

Implementing Your Pricing

Regardless of which pricing strategy you choose, there are things you can do to help insure the success.

1. Start pricing early

Pricing must be something you are already considering from the beginning of product development. This allows you to design and develop the appropriate product for the market at the right cost. Companies that do this are likely to be more successful than companies who think of product price at the last minute.

2. Use internal knowledge

Organizations have huge internal knowledge; however, this knowledge is often with individuals or siloed in departments.  It is important to look at historical quantitative data and qualitative data from internal experts to gain insights on market intelligence and customer preferences. Make this data available to the people who need it.

3. Consider the customer

Validate your ideas externally, especially from the people you are selling your products to – your customers. Market testing and of both products and pricing is important. You can also have a team do a study on your target clients. This will allow you to gauge their preferences and price sensitivity. All this information can help you decide on the right product price.

4. Build robust business cases

Once you have the data, you can analyze how the market will accept your product and consider your competitor’s reaction as well. Creating different scenarios and business cases will allow for an informed initial decision and to guide future decisions. For instance, a competitor’s reaction would be to lower their price as well. How are you going to deal with that? Having some plans prepared ahead will help you respond to these scenarios in a timely manner.

5. Stay focused on your goals

Whatever pricing strategy you choose, you must stay focused on goals. This often means reviewing decisions and even re-educating internal audiences about why decisions have been made. This is critical, so let’s discuss in more detail.

Pricing Strategies for Long Term Success

It’s one thing to get buyers to try your product and another thing to keep them buying in the future. Penetration pricing may be great for attracting customers at the introduction of a product, but consideration must be given to longer-term success. That usually means becoming more concerned about profits.

It is important to note that product strategies can often drive the pricing strategy. In a future post we’ll discuss how simple changes to products or related services can open up entirely new pricing strategies. Products introduced at penetration pricing levels are often simply replaced by new products at neutral price levels as new features are added or brand value grows. Conversely, techniques such as sequential skimming can be used to maximize profits initially but capture buyers with lower willingness-to-pay over the life of the product.

I often see two common mistakes when setting product and pricing strategies:

Never updating strategies to meet goals: In a competitive marketplace, dynamically responding to changing conditions is critical. The strategies that make you successful at the introduction of a product often need to be updated as the market reacts. Penetration pricing may win some customers initially, but new entrants with either lower prices or improved features may make this strategy obsolete.

Drifting from goals: It is somewhat natural to lose focus over time. Changing prices, chasing other markets, and further developing products is tempting. However, without a corresponding change to product and pricing strategies, this is a problem. Consider the most basic competitive advantage: low-cost and product differentiation. Added features and costs to low-cost products or reducing prices for differentiated products erodes competitive advantage. Saying “no” to these kind of drifts can be critical to success.

Both of these mistakes cause issues at every level of the organization as policies, tactics, and culture no longer match corporate goals or market realities. Incentives and measures tend to become misaligned quickly and lead to significant problems.

Penetration Pricing Opportunities

Understanding penetration pricing is essential for pricing and marketing professionals.

Keep in mind the fundamental trade-off between increasing market share and increasing profits and consider penetration pricing strategies when introducing new products or entering new markets.

Consider it as one tool in the toolbox and a key strategy for achieving pricing excellence, Like any strategy, it is important to use appropriately, update when necessary, and abandon when no longer useful.

Ryan Maley is a management consultant with Stratence Partners, a specialized consulting firm that helps companies get the most from pricing by helping optimize strategies, implement pricing excellence, and increase commercial effectiveness.