Beware the Risks of Premium Pricing

I recently had an interesting experience gathering quotes from a bunch of roofing contractors to replace the aging shingles on my home.  First, I was amazed at the lack of consistency among the estimates I received.  Some were fairly low, several were grouped closely in the middle, and a few were extremely high.  One contractor in particular really captured my interest when his quote was more than double compared to all of the other estimates I had received.  I was aware that this particular contractor had a well known reputation for being expensive.  However, I was still shocked when I received his price quote.  The contractor made no apologies about being the most expensive roofing company in the area – in fact, he was somewhat boastful about it.  Of course, I got the requisite speech about how the company uses only the “highest quality materials” and delivers “superior service and craftmanship.”  I would have considered giving him the job had his price been only somewhat more than the others; but, I was hard pressed to justify a price that was more than double everyone else.  So, in the end I went with another roofing contractor who did a terrific job, with similar materials at a much lower cost.

Interestingly, the expensive contractor was upset when his company did not get the job; and during our discussion he shared how his business has been struggling because more and more people are balking at his premium prices.  With his high operating costs (that fleet of shiny custom painted trucks are nice but expensive), it became clear that his business might be in a bind.  I started to wonder if the contractor is truly willing to make the strategic decisions necessary to keep the business viable.  Time will tell.  This experience got me thinking about pricing strategies; and in particular, how challenging it can be to maintain a premium pricing strategy.

A premium pricing strategy is the practice of setting a price for a product or service much higher than the prevailing average market price, with the expectation that customers will purchase it with an assumption that it must have unusually high quality or reputation.  Interestingly, in some cases, the product quality may not actually be better, but the seller has invested heavily in the marketing needed to give the impression of high quality.

Premium pricing works best in the following circumstances:

  • There is a perception among consumers that the product or service is a “luxury” product, or has unusually high quality.
  • There are strong barriers to entry. These barriers might include such factors as a large marketing expenditure to gain notice among consumers and/or significant start-up and operational costs.
  • The seller can easily restrict the amount of product sold, thereby giving its products an aura of exclusivity.
  • There are no easily attained substitutes for the product or service.
  • The product is protected by a patent, and the company is aggressively maintaining its rights under that patent.

Advantages of Premium Pricing

The following are advantages of using the premium pricing method:

  • Entry barrier. If a company invests heavily in its premium brands, it can be extremely difficult for a competitor to offer a competing product at the same price point without also investing a large amount in marketing.
  • High profit margin. There can be an unusually high gross margin associated with premium pricing. However, a company engaging in this strategy must consistently attain sufficient volume to offset the hefty marketing costs associated with it.

Challenges of Maintaining a Premium Pricing Strategy

Maintaining a premium pricing strategy is not easy.  There are several challenges a company will likely face when employing a premium pricing strategy; such as:

  • Branding cost. The costs required to establish and maintain a premium pricing strategy can be large, and must be maintained for as long as this pricing strategy is followed. Otherwise, the premium brand recognition by consumers will likely falter, and the company will have difficulty maintaining its price points.
  • Competition. There will be a continual stream of competitors challenging the top tier pricing category with lower-priced offerings. This can cause a problem, because it increases the perception in the minds of consumers that the entire product category is worth less than it used to be.  Also, without a clear measurable differentiation in both quality and service, consumers are likely to give their business to a lower cost competitor (this is especially true during slow or declining economic conditions when consumers become increasingly cost conscious).
  • Sales volume. If a company chooses to follow a premium pricing strategy, it will have to confine its selling efforts to the top tier of the market, which limits its overall sales volume. This makes it difficult for a company to pursue aggressive sales growth and premium pricing at the same time. The strategy can be followed as long as the company is expanding into new geographic regions, since it is still pursuing the top tier in these new markets.
  • High unit costs. Because the company using this strategy is restricting itself to low sales volume, it can never generate the cost reductions that a high-volume producer would be able to achieve.

A premium pricing strategy can work great for a company when many of the challenges listed above don’t exist or are minimal.  However, it is critical for a company to anticipate potential business environment and/or competitive scenarios, and then plan for the adjustments that would be necessary to survive if their premium pricing strategy starts to falter – – becoming less of an asset and more of a burden to the organization.

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