Please note: This post is the second post in a five part series on the main pricing methodologies, highlighting the pros and cons of each. Check out the first post on cost plus pricing.
We’re beginning every one of these posts with the same statement: “Pricing is the most important aspect of your business.” No other lever has a higher impact on improving profits. We elaborated on this assertion in a previous pricing strategy post, but realize that a 1% improvement in price optimization results in an average boost of 11.1% in profits. That’s a huge boost!
Competitor based pricing can help you get there if done correctly. Remember, pricing is a process that works to eliminate as much doubt as possible for a key stakeholder to make a profit maximizing decision. Think of pricing as a game of darts where you’re trying to hit a bullseye with the perfect price, but there’s all that extra space to “distract” your dart. Data eliminates that space, paring down the dartboard as much as possible to guide your dart.
Last time we learned that cost plus pricing provides some data for the pricing process, but overall it’s a pretty weak pricing strategy even in the retail industry where it’s primarily used. Fortunately, competitor based pricing is a little bit better, but as we’ll learn not perfect.
To understand competitor based pricing, let's take a look at what competitor based pricing entails, uncover the methodology's pros and cons, before exploring who should and shouldn't utilize competitor based pricing.
Competitor based pricing: Ethical, but ineffective plagiarism
Competitor based pricing is a lot like a bad case of plagiarism in a college class. You’ve partied a little too hard the night before, forgot about the paper you were supposed to write, and then think it’s a good idea to paraphrase the wikipedia article you found on Botswana economics. Obviously the market doesn’t dole out suspensions for copying prices, but the processes of swiping an essay and competitor based pricing are pretty similar.
Also called strategic pricing, this method involves looking at the prices set by other businesses in the same sector, and then adopting those numbers, plus or minus a few percent according to how your product looks that day. The dartboard gets smaller, because there’s more data here, allowing you to rely on your competitors to do the work for you (as long as you trust they actually know what’s going on in the market).
Another way to think about it: imagine stacking all of your competitors on a totem pole with the most premium or luxury brand on top and the bargain brand on the bottom. You then decide where on the pole you fit, place yourself in there, and set your price accordingly. Wait though, isn’t that a bit arbitrary? Of course it is, which is why we’ll take a look at the pros and cons of competitor based pricing next.
Pros of competitor based pricing
1. It’s fairly simple.
If you’re in an industry with even one or two direct competitors you can implement a reasonable competitor based pricing strategy. In most industries marketing and product managers will then have to do relatively little research to find a price. It is also possible to make adjustments in prices by following tweaks made by competitors. Keep in mind though that this gets much more complicated when you’re not comparing congruent goods, which is often what happens in the software space.
2. It’s low risk.
It’s rare to royally screw up using this form of pricing. If you have a fairly solid grasp on your product’s quality, target audience and cost of production, this method will most likely never lead to bankruptcy. It’s kept your competitors afloat, so similarly, it should do the same for you.
3. It can be accurate.
In saturated industries like retail, competitor based pricing can be fairly accurate. After all, for most consumer products there are millions of customers and enough data to move pricing closer towards a market based methodology. Unfortunately, software doesn’t tend to have this same luxury.
Cons of comeptitor based pricing
1. It leads to large missed opportunities.
The most common ways businesses raise profits are by increasing sales, decreasing cost of production, and lowering overhead. Pricing is often neglected, which is a shame, because it’s their main consideration (sometimes an incentive but more often a barrier) before purchasing your product. Simply copying your market’s prices leads to a lot of wrong prices and lost profits, even if you do think you’re doing well. The goal of your business should be to maximize revenue and profits, even if it does take a little bit of extra work on the pricing front.
2. It’s done by everyone, which creates pricing group think.
Competitor based pricing operates off the assumption that businesses already in the market have the correct answer and that every decision competitors’ make is intelligent. This can be a fair strategy if only one business determines its price after taking into consideration the variety of prices existing at the time. However, if a large portion of companies all use this tactic, then with time competitor based pricing can lead to the entire industry losing touch with demand. You’ll end up either keeping the same price forever, because competitor A hasn’t changed her price or you’ll simply raise or lower prices in response to trigger happy competitors.
Remember though, it’s your business, your product, and your revenue. Every customer a competitor serves is an opportunity lost for you. Why would you let fellows in the other end zone determine the baseline for your price?
3. It can lead to tunnel vision and a race to the bottom.
Maintaining a lower price than your competitors isn’t always the best way to attract consumers, but competitor based pricing exacerbates that idea by simplifying price as a barrier that constantly must be lowered. Yet, the lowering of prices in most industries leads to doubts about quality and lower revenue from tiny profit margins even though customers would be willing to pay more.
As we alluded to before, competitor based pricing also gives you too much of a “set it and forget it” mentality. Pricing is a process that requires data and attention. If you’re not changing your prices and differentiating your product over time, you’re like a shark who’s stopped swimming: dead in the water.
Summary: Competitor based pricing should be a part of everyone’s pricing process, but not the central pillar
To summarize, certain businesses need to use competitor based pricing extensively, because consumers price compare and their switching costs from buying a product at store X or store Y are exceptionally low. Yet, for most businesses, especially in the software or SaaS space, competitor data should not be the central tenet of your pricing strategy, because there are too many other variables to consider when you’re not comparing congruent products.
Look at the help desk space. Zendesk, Help Scout, Fresh Desk, Salesforce, and the dozens of other competitors are all drastically different and geared towards different customer personas. As such, Help Scout shouldn’t peg their prices with Zendesk and vis versa. Of course, the two should keep an eye on one another, but only to guide their market strategies.
To learn more, check out our Pricing Strategy ebook, our Pricing Page Bootcamp (it’s free!), or learn more about our price optimization software. Also, check back in next week to learn about value based pricing.