What is a pricing model? Choosing the best approach for your business

Successful businesses don’t set their prices randomly. They rely on a model that helps them determine what their prices should be.

Businesses can choose from many pricing models. These models take into account various factors, such as production costs, market demand, and the competitive landscape.

Although each model considers these factors to varying degrees, their goal is to set prices that most accurately reflect customers’ perceived value of the product or service. The closer pricing is to the perceived value, the more profit a business can make.

A pricing model provides the structure and formula for calculating prices. However, it doesn’t have much input on the broader question of how pricing is used to achieve business objectives. This is where a pricing strategy comes in.

For example, a business might use a penetration pricing strategy, where they set their prices low at first to attract enough customers to successfully enter the market. Think of a pricing model as a way to calculate prices and a pricing strategy as a reason for calculating them that way.

Think of your pricing options like a bell curve. If you price your products at cost, you make no money regardless of how much you sell. If they are priced too high, nobody will purchase from you and you’ll make no money. Somewhere between those two extremes is the optimal price—the highest price where the maximum number of customers are willing to pay.

The right pricing model is the best tool you have to align your prices with how your customers perceive your product or service’s value.

The pricing model you choose will give you a more concrete set of considerations to use when determining prices. Even so, every model should take the basics into account to some degree. These basics include things like production costs, market demand, and the pricing used by your competitors.

The most effective pricing strategy comes from understanding your customers. Their willingness to pay for your product’s overall type and where they believe it fits into the competitive landscape will determine the optimum price for your products and services.

The pricing model types below are some of the most common and cover a broad range of needs.

Cost-plus pricing

This is a relatively simple pricing model that guarantees a given profit margin. However, it might not accurately reflect market value or customer demand.

To use this model, simply add up the total cost of producing a product and add a fixed percentage or margin to it.

It’s important to calculate the total cost of production accurately. For this, you’ll need to consider all costs, including materials, labor, and any overheads.

Value-based pricing

This pricing model is only concerned with input costs insofar as the price needs to be high enough to avoid a loss.

It involves pricing a product or service based on the perceived value to consumers—not the cost of production. Often, this can lead to much higher margins than a simple cost-plus pricing model.

This model carries certain risks. You’ll need to carry out careful research to understand what consumers value and how much they value it. Otherwise, you could misalign your pricing with customers’ willingness to spend at great cost to your business.

Hourly pricing

This is a very common pricing strategy in service industries. It’s a straightforward and transparent model that charges clients a fixed hourly rate based on how long the job takes to complete.

This model ensures compensation for time and effort. It’s particularly useful if you can’t accurately predict how long something will take, and it allows for a flexible scope. For example, the scope of a web development project might expand, and the hourly pricing model ensures that your web development agency is paid for the time your employees spend on the project.

On the flip side, this can lead to unpredictable costs for clients. This model doesn’t incentivize efficiency, which can lead to customers feeling ripped off if you aren’t open, transparent, and honest.

Fixed pricing

Fixed pricing is on the opposite end of the spectrum from hourly pricing. Where hourly pricing can be unpredictable and lead to inefficient workflows, fixed pricing is very predictable and encourages you to work efficiently.

In fixed pricing, you would charge a predetermined price for a product or service regardless of the time or resources involved in completing it. Here, the company takes on the risk of unforeseen complexities that increase the time or resources needed, so careful planning is crucial.

Flat-rate pricing

This pricing model is nearly identical to fixed pricing, except that you would charge it for ongoing services or subscriptions rather than one-off projects.

Flat-rate pricing is commonly used in telecommunications, utilities, and subscription-based businesses. An example is current mobile phone plans, which generally charge a fixed fee rather than charging by the minute of talk time or gigabyte of data.

Performance-based pricing

Performance-based pricing ties the compensation to the results achieved rather than the effort expended. It’s common in the marketing field.

For example, a marketing agency may take a percentage of the increased sales they generate. This model aligns the interests of the company and its clients in the most direct way and incentivizes high performance.

Competition-based pricing

This pricing model relies heavily on following the competition. It sets prices based on what competitors are charging, enabling you to position your company competitively in the market.

It’s a good way to get close to optimal pricing if your competitors have done their pricing homework. However, it doesn’t account for any unique value proposition that could justify higher prices.

Penetration pricing

Setting your prices low can help you attract new customers quickly when you’re just starting out. The model’s name comes from the fact that companies commonly use it to get a foothold in new markets.

Once market penetration has been achieved and value has been established, you can raise your prices by switching to one of the other pricing models.

Premium pricing

For companies who create high enough quality products and services to justify it, premium prices set a high price that helps communicate value to customers. It establishes the company as a go-to brand for well-off individuals who don’t mind spending extra on quality.

This pricing model is as much a branding strategy as it is a method of determining pricing.

Geographic pricing

This pricing model is common in industries where the buyer’s location greatly impacts the costs involved or the perceived value of the product or service. It factors in variables such as local market conditions, cost of living, transportation costs, and regional demand.

This model is especially common in the global market. Some cultures may place a higher value on a product than others, and customers in specific regions may be able to afford higher prices than in others.

Determining a pricing strategy is all about knowing when to use a specific pricing model to meet a specific business need. Below, we discuss five broad categories of pricing models and when each is the best option.

When to use freemium

This pricing model allows users to consume certain features within your product for free, with the option to use more features at a cost. It’s popular in the software-as-a-service (SaaS) industry and among other types of digital products, such as mobile apps.

This model works when the customer lifetime value (CLV) is potentially high, but the cost of serving a user is minimal. If you can deliver your product at minimal cost and demonstrate its value quickly, the freemium model might work for you.

For this model to work, you must have a clear path to upsell customers to paid plans and provide sufficient incentives for them to do so.

When to use tiered subscriptions

Your product might be rich in features, but do your customers need to use all of them all the time?

A tiered pricing model allows users to pay only for the features they need. This makes it an excellent way to maximize revenue for products that have enough depth to appeal to both budget-conscious users with simple needs and less thrifty customers with more advanced needs.

If your product has a range of features that appeal to different market segments, this is a great way to let your customers start off with more affordable plans and upgrade as their requirements grow.

When to use flat-rate subscriptions

Flat-rate pricing is one of the easiest pricing models. It’s the best choice for products that offer consistent value to all customers.

With flat-rate subscription pricing, all customers pay a single, recurring fee to gain access to a product’s complete set of features.

This model is common for streaming services, subscription boxes, and online memberships. It works well when you can communicate your value in a simple way, which makes your customer’s decision-making process around purchasing your product easier.

When to use bulk pricing

Bulk pricing can be a great option to increase sales if your product or service is something customers frequently purchase in large quantities. The pricing model is ideal for consumable products, particularly those with a long shelf-life.

By offering discounts on larger orders, you can incentivize customers to purchase more at once. When calculated correctly, it makes up for the decrease in price by increasing overall sales volume.

When to use market pricing

This is a highly flexible pricing model that continuously adjusts pricing to align with factors such as demand, competition, and customer behavior. The flexibility allows you to respond to real-time changes in the market. It’s useful for products and services where prices fluctuate, such as travel, hospitality, and e-commerce.

If your business is in a highly competitive market, the ability to adjust prices rapidly can help you remain competitive.

For the most effective pricing, this model requires you to have the technology to track and respond to market trends quickly.

The common pricing strategies below will enable you to get a clearer picture of how they help businesses determine the pricing model that best aligns with their goals and current market realities. For each strategy, we’ll look at a successful company or product that uses it.

Dynamic pricing strategy: The Chicago Cubs

Sports teams like the Chicago Cubs make great use of dynamic pricing.

People are willing to pay more when the team is playing a strong opponent or rival. They are willing to pay less in poor weather conditions.

The ability to adapt pricing based on these kinds of factors helps the Cubs fill seats no matter the conditions of the game.

Freemium pricing strategy: HubSpot

HubSpot has developed a product that can greatly enhance a business’s workflow. They can get businesses hooked on the value they provide from the start of their journey by offering the core set of features for free.

As the business grows, its needs grow along with it. This allows HubSpot to upsell additional features that will meet those needs.

In situations like this, freemium is a valuable tool for acquisition and upselling.

Penetration pricing strategy: Netflix

Netflix wasn’t always a streaming giant. To get there, they took an alternative approach to pricing and growth.

In the beginning, when their library was small and not very original, they used a low price point to draw in customers. As their catalog grew and their brand became more unique, they capitalized on that new value to increase their prices without sacrificing customer loyalty.

Premium pricing strategy: Away

Away is a premium luggage brand, and they want their pricing to reflect the product’s premium quality.

Because they have high-quality, stylish luggage, they can charge a price to reflect that. At the same time, the premium pricing attracts the type of affluent customers the company wants by increasing the perceived luxury and exclusivity of their products.

In this way, pricing serves as a tool for profit maximization and branding.

Competitive pricing strategy: Shopify

This pricing strategy is the opposite of premium pricing—nearly.

Rather than pricing their products on the higher end of the spectrum to increase the perception of premium quality, Shopify prices their plans as affordably as possible, creating a perception of value. By doing this, they can attract a wide customer base and remain competitive in a crowded market.

Project-based pricing strategy: Courtney Samuel Events

This successful wedding planner takes a project-based approach to pricing. This is a common method of pricing when one project varies significantly from another in terms of size and scope.

Rather than a set of one-size-fits-all packages, a project-based approach allows the company to fit a customer’s exact needs. This means they can better cater to clients’ needs and capture their full value.

Value-based pricing strategy: INBOUND

INBOUND is HubSpot’s annual sales and marketing conference. Each year, INBOUND features a set of renowned speakers, exclusive content, and opportunities for attendees to network with others in their industry.

By pricing admission to the event based on the perceived value of the specific year’s lineup, the company aligns prices with the benefits attendees expect to receive.

Bundle pricing strategy: State Farm

State Farm is a large insurance company offering many insurance products. They insure automobiles, homes, tenants, and pets, among other things.

Under any other pricing strategy, customers may use State Farm for one type of insurance and a competitor for another. However, by offering bundles to customers who purchase multiple policies at a discounted rate, they are more likely to make those extra sales.

This pricing strategy increases a customer’s lifetime value, improves the marketing return on investment (ROI), and decreases the risk of churn.

Geographic pricing strategy: gasoline

Gasoline is a product where input costs vary greatly based on geographic region. Transportation costs, local taxes, and regional demand all factor into what it costs to get gasoline to customers and what drivers are willing to pay.

Gasoline companies can maximize revenue across diverse markets by charging higher prices in areas with increased demand or less competition and lower prices elsewhere.

We’ve seen how important the right pricing model is to your business’s success. Now, let’s take a look at two common tools businesses use to determine the correct pricing model for their goals.

1. Global survey panel

A global survey panel gathers input from a diverse group of respondents that represent different regions and demographics. The results provide a comprehensive understanding of how various potential customers perceive value.

You’ll learn what your potential customers are willing to pay and what price points resonate most strongly across different markets. Regional cultural and economic differences mean one-size-fits-all pricing rarely works, even if prices are properly localized to a given region’s currency. This type of survey can illuminate those differences.

Tools like Dovetail can help you organize and analyze customer surveys.

2. Research services

Professional research services can be a big help when you want to ensure you are pricing your products optimally—but you’ll need to be willing to pay for these services.

Some companies specialize in doing a deep dive into pricing strategies and market analysis, helping you determine the perfect spot on the bell curve to place your prices.

These are firms that know the intricacies of pricing, perceived value, and regional variations far better than the average person. They can use that knowledge to provide you with an optimal pricing strategy.

They can also tell you which aspects of your product customers are likely to value most, enabling your marketing team to push that value proposition across its communications.