As a small business owner, you must understand how relevant a product’s price can be to its success. There is a lot of psychology that can go into pricing. How customers perceive a price can be as important as the price itself.
There are a few different pricing strategies available for you to choose from. In this article, we’ll provide an in-depth look at one of them, price skimming. A price skimming strategy involves adjusting the fee for a product or service over time.
After reading this article, you should have a better understanding of how price skimming works and whether it’s the right strategy for your small business’s new product.
What is price skimming?
Price skimming is a type of product pricing strategy in which a company will charge a high initial price to early adopters and then lower it incrementally over time across the product’s life cycle.
When employing a price skimming strategy, firms will charge the highest initial price that someone will pay for the product.
During this time, companies will experience high margins, as they’ve set their price point artificially higher even though the cost to produce the product did not increase. As we’ll detail below, price skimming strategies also allow companies to recoup initial costs rather quickly.
After it’s clear that the product has met the demand of the first customers, or competitors have begun to enter the market, the firm will lower the price to attract more price-sensitive customers.
The process repeats itself continually until the company elects not to lower the price anymore.
At this final low price, companies may not see fantastic profit margins on a product. But, they may see an increase in consumers willing to buy the product, thereby selling more units than before.
The best way to think about skimming pricing is much like skimming cream from the top of milk. In this case, the company is skimming customer segments like layers of cream.
While price skimming can be an effective way to maximize profits on new products and offerings, businesses need to understand all the potential benefits and drawbacks before employing this technique. Let’s start with the benefits first.
Pros of price skimming
What makes the skimming pricing strategy so advantageous? Consider some of the “pros” below.
Increased quality perception
As we mentioned, consumer psychology has a lot to do with setting prices. It should come as no surprise that quality is a crucial factor customers consider when making buying decisions.
Although the product’s price is not the only way to measure quality, it’s one of the easiest ways. Customers may believe that because the price is so high, the product must be good. As the price decreases, customers feel as though they’re getting a high-quality product at a bargain.
So price skimming can serve as a marketing tool that can increase a customer’s perception of the product.
Higher return on investment and cost recovery
If your company spends a significant amount of money on product development, employing a price skimming strategy can be an excellent way to recoup those costs.
Development costs for new innovations can be expensive. With price skimming, you have the chance to gain back this investment in your first few sales.
Then every sale you make after that allows you to achieve maximum profits. An initial high price will enable you to reach your break-even point more quickly.
This price strategy would work well for market innovators who do not have any competitors, as they can recoup the high research and development costs it likely required for them to create a product that does not have any competition.
Benefits from early adopters
While traditional pricing strategies appeal to all segments of the market, price skimming tends to aid in capturing early adopters. These buyers are willing to pay a higher rate in exchange for being one of the first people to own a product.
Not only do early adopters contribute to your bottom line, they also act as brand ambassadors, encouraging others to try out your goods and services.
Once early adopters have spread the word about your products to other audiences, the firm can lower prices to capture these buyers. The goal is to drop your prices before a copycat company comes in and attempts to undersell you.
Early adopters could also be advantageous because they allow you to change your product before reaching the rest of your consumers.
Early adopters make up a small segment of the market, as there aren’t many people who are willing to pay a premium for a brand new product.
If you get feedback from early adopters, you can figure out what you need to do to improve your product. This feedback could prove invaluable and could make a difference in the success of your product once it reaches the wider market.
Cons of price skimming
Of course, price skimming is not without its drawbacks. Here are some notable ones to carefully consider.
Requires an inelastic demand curve
One of the biggest cons with price skimming strategies is that they only work with an inelastic demand curve. An elastic demand curve is one where a change in price has a more significant impact on product demand.
If you have an elastic demand curve, then setting a high price could do more harm than good.
An inelastic demand curve is one where demand doesn’t change, no matter whether the price rises or falls. Having an inelastic demand curve is what allows you to set different prices and catch customers at each price point.
You can determine price elasticity by dividing the percentage change in demand by the percentage change in price. If this ratio is between zero and one, you have an inelastic demand curve.
You may need to use industry-wide information and data to help determine this. Taking time to understand the demand curve can help you better determine whether a price skimming strategy is feasible.
Competition from sub-premium dealers
Firms considering price skimming need to be aware of threats from competitor businesses. As a company raises its prices, sub-prime competitors may swoop in and undercut sales.
In the long run, competitors can reduce sales volume and force businesses to abandon price skimming in favor of providing goods at lower, less profitable margins.
The nature of price skimming is that some customers are paying far more for goods and services than others. As a result, businesses can expect to incur some negative feedback as they lower their prices, especially from consumers who just purchased your goods at a previously higher price.
If a company engages in price skimming regularly, it may eventually affect customer loyalty, which can give competitor businesses the opening they need. Additionally, companies that maintain high prices for too long may wind up losing the interest of their prospective marketplace.
Lastly, if you utilize price skimming frequently, customers may figure out your strategy. They may be less likely to purchase the product at a high price, knowing that it’s going to eventually drop.
Businesses best suited for price skimming
Certain companies and industries are better suited for price skimming than others. Because price skimming is only useful if certain customers are willing to pay top value for products, a business needs to ensure that its target audience has enough disposable income to pay its desired price.
Additionally, the strategy is better suited for luxury items like high-end cars, electronics, and new technologies that usually stir up considerable interest in early adopters.
Along with evaluating customer interest, companies considering price skimming should determine the roles their competitors play.
If your business has a large number of competitors, they can easily step in and undersell you when your own rates rise. For this reason, price skimming is most effective if your company has few competitors or your product has a great deal of name recognition.
A real-world example of price skimming
One of the most obvious examples of price skimming is seen in Apple products. Apple routinely sets the price of iPhones higher than those of smartphones. Apple has a strong brand of loyal followers, which is what makes their price skimming strategy so unique.
Apple will eventually lower the price of a phone, but it may take them a while to do so. For example, it may take two new models of the iPhone for Apple to reduce the price of a previous version.
What’s more interesting is that Apple seems to “lower” the price of previous phone models by increasing the price of later models. For instance, a fully-loaded new iPhone 11 costs $1,249.00. This is significantly more than the $749.00 starting cost for the previous model, the iPhone XR.
By raising the price on the iPhone 11, the older iPhone models now looks more attractive. People may feel they’re getting much better value if they purchase the iPhone XR instead of the iPhone 11.
The strategy, by and large, has worked. Apple dominates the smartphone market in the United States. The company has a 41% market share. The next leader is Samsung, which only has a 21% market share.
Is price skimming for you?
If you’re planning to launch a new, high-value product in the coming months, price skimming may be an ideal strategy. It’s crucial, however, that you keep tabs on interest levels and gradually lower your rates as sales drop off. The goal is to skim each layer of the market until even the most penny-pinching buyers decide to give your item a chance.
Price skimming is just one approach to a sound pricing strategy. Options like penetration pricing and price discrimination could be more suitable for your company. If you need more advice on how to price your goods or services, start with this 10-step list.
Featured Image Credit: jacoblund / iStock.