Like it or not, the success of your business relies on pricing done right.
Price your product or service too high and you’ll struggle to find customers; price them too low and you’ll be leaving money on the table - simple as that.
However, picking the right pricing option is nowhere nearly as simple. There are multiple pricing models you can choose and some of them are better suited than others for different use cases and goals you aim to achieve.
In this article, we’re shedding light on the most common and less common pricing models. By the end of this article, you’ll have a thorough understanding of the options available and which may best suit your specific situation.
Before we get to the point, let’s take a quick look at the basic terms.
What is a pricing model?
A pricing model is a methodology that a business uses to determine the monetary value of its products or services. Simply put: it’s how a business calculates the price.
However, there’s a lot more to pricing models than the mere calculation. They influence market positioning as well as customer perception – in addition to the overall business performance.
Pricing models can vary widely depending on the industry, product type, and business goals. They can be simple (like a cost-plus approach) or complex (like dynamic pricing in e-commerce). The chosen model should align with the company's brand image, competitive model, and target market.
Pricing models vs pricing strategies
In business pricing, there are two pertinent concepts: pricing models and pricing strategies. They have distinct differences, but they are often used together to create a comprehensive pricing approach.
A pricing model often serves as a framework within which more tactical pricing strategies can be implemented. It provides the overarching structure that guides pricing decisions. It allows for the application of specific pricing strategies.
For more information on the differences, refer to our detailed article on pricing strategies.
The main difference is that pricing models provide the overall framework for how prices are set, while pricing strategies are specific tactics used within those models to achieve particular goals. Pricing strategies can often be applied across different pricing models, and businesses may use multiple strategies within a single pricing model.
Understanding cost, margin and markup in pricing models
Pricing is the process of determining the monetary value at which a product or service will be offered to customers. To develop an effective pricing model, it's crucial to grasp the concepts of cost, margin, and markup, particularly if you're considering a cost-based approach. Let's explore these key elements in detail.
Cost: the foundation of pricing
Cost encompasses all expenses directly associated with producing, sourcing, or creating your product. This includes raw materials, labor expenses, supplier fees, and even anticipated losses. It's important to note that cost doesn't cover overhead or operational expenses such as marketing, advertising, facility maintenance, or utility bills.
Margin: the profitability measure
Gross margin represents the profit your business generates after subtracting manufacturing costs from the selling price. This metric is essential for understanding the profitability of each product or service you offer.
Markup: setting the price point
Markup is the additional amount you charge for your product above and beyond the production and manufacturing costs. This element allows you to cover overhead expenses and generate profit.
These three components form the foundation of many pricing models.
It's worth noting that effective pricing often involves a combination of different approaches rather than relying on a single method. As we explore common pricing models, keep in mind that the most successful businesses often employ a hybrid approach, tailoring their pricing to specific products, market conditions, and customer segments.
Let’s now take a look at different pricing models, how they work, and how they are calculated and implemented.
1. Cost-plus pricing model: the basic
The cost-plus pricing model is about determining the price of a product or service by calculating the total cost of producing it and then adding a markup (usually a percentage) to achieve a desired profit margin.
This method focuses primarily on internal costs and doesn’t take into account the external market factors.
How does a cost-plus pricing model work?
It starts with determining all direct and indirect costs associated with producing the product or service. Then, the business decides on a markup percentage or fixed amount to add to the costs. The final price is the sum of the two.
Pros:
- it’s easy to calculate and understand
- it offers a guaranteed profit margin, ensuring a specific profit on each sale if costs are accurately calculated
- it’s an easy-to-justify model: cost-plus pricing can be easily explained to customers based on actual costs
- prices remain relatively stable unless costs change significantly
Cons:
- doesn't consider the market demand and what customers are actually willing to pay
- may result in prices that are not competitive in the market as it often overlooks the competition
- may not incentivize cost reduction or efficiency improvements
- can be challenging when it comes to allocating indirect costs
When this model works best:
- with new product launches, when market data is limited and costs are the primary concern
- with custom or made-to-order products, where costs vary significantly between orders
- in industries with stable costs, where production costs don't fluctuate greatly
Example:
Let's consider a company that offers custom web development services, like ours. Here's how cost-plus pricing could look like in action.
Cost calculation:
- direct labor: 100 hours of developer time at $50/hour = $5,000
- project management: 20 hours at $75/hour = $1,500
- software licenses and tools: $500
- server costs: $200
- indirect costs (overhead): 20% of direct costs = $1,440
Total costs: $8,640
Markup: the company decides on a 30% markup to cover profits and unforeseen expenses.
Final price = Total costs + Markup
= $8,640 + (30% of $8,640)
= $8,640 + $2,592
= $11,232
The company would then quote $11,232 for this custom web development project.
2. Value-based pricing model: how much will your customers pay?
When the price of a product or service is set based on the perceived value it provides to the customer, rather than on the cost of production or market competition, we’re talking about value-based pricing.
This approach focuses on understanding what customers are willing to pay for the benefits they receive from the product or service.
How does value-based pricing work?
A business identifies the target customer segment and determines the unique value proposition of their offering. Based on those, they assess the perceived value to the customer and set a price that reflects this perceived value.
To gauge how much a customer is willing to spend, you could calculate the True Economic Value (TEV).
TEV = Cost of the next best alternative + Value of performance differential
In this formula, the "Cost of the next best alternative" represents the price of the closest competing product or solution. The "Value of performance differential" refers to the additional worth that your product provides compared to this alternative.
Pros:
- higher profit margins, since prices are based on value, not costs
- better alignment with customer needs and preferences
- increased customer satisfaction when value is delivered
- allows for price differentiation across customer segments
Cons:
- requires extensive market research and customer understanding
- can be challenging to accurately determine perceived value
- may lead to pricing inconsistencies across markets or segments
- risk of overpricing if value is not clearly communicated or delivered
- potential for negative customer reactions if perceived value doesn't match the price
When this model works best:
Value-based pricing is most effective for products and services with strong brand equity:
- unique or innovative products with clear differentiation
- high-end or luxury goods and services
- b2b products or services with quantifiable roi
- custom or tailored solutions
Example:
Let's consider a cloud storage service provider entering a market with established competitors. For instance, if the new service offers similar features to Dropbox, which charges $11.99/month for 2TB of storage, the company might price their 2TB plan at $10.99/month to attract price-sensitive customers while still being in line with market rates. They could also offer a premium tier with additional features at $13.99/month to capture customers willing to pay more for added value.
This approach allows the new entrant to quickly establish a competitive price point without extensive market research, though it may limit their ability to capture the full value of their service if it offers unique benefits not provided by competitors.
3. Competition-based pricing model: take a look around
In competition-based pricing (aka competitive pricing), companies set their prices based on what competitors are charging. This pricing model involves monitoring how competitors price their products or services and adjusting one's own prices accordingly, rather than basing them primarily on costs or perceived value.
How does a competition-based pricing model work?
Companies gather data on competitor prices for similar products or services. Then, they decide whether to price their offering above, below, or at the same level as competitors, based on their specific goals and capabilities.
For instance, if your product offers features that competitors don’t have, you could sell it at a higher price. Or, if your product has many alternatives on the market, pricing it lower than your competitors might bring you more customers.
With this pricing model, you have to ensure a regular review and adjustments based on changes in competitor pricing. There are a number of tools that can help you with this.
Pros:
- It's relatively easy to implement and understand
- Prices stay in line with market expectations
- It can help maintain market share by staying price-competitive
- It allows for a rapid response to market changes
Cons:
- This pricing model can lead to a race to the bottom, reducing profitability
- It may not account for a company's unique costs or value proposition
- It can make it harder to stand out based on quality or features
- Relies heavily on competitor actions rather than internal model
When this model works best:
Competition-based pricing model is effective when applied:
- in mature markets, here products are similar and well-established
- with commodity products, when there's little differentiation between offerings
- in price-sensitive markets, where customers make decisions primarily based on price
- in highly competitive industries, with many players offering similar products or services
Example:
Let's go back to our previous example: a company offering cloud storage services, similar to Dropbox. The company would first check the pricing of major competitors like Dropbox, Google Drive, and OneDrive for various storage tiers (e.g., 100GB, 1TB, and 2TB).
They decide to position their product slightly below the average market price to attract price-sensitive customers. If the average price for 1TB of storage among competitors is $9.99/month, they might set their price at $8.99/month.
After that, they would implement a monitoring mechanism to track changes in competitor prices daily and adjust accordingly if need be. However, they would need to ensure that this pricing model allows for sustainable operations and doesn't neglect the unique value propositions of their service.
4. Dynamic pricing model: all about flexibility
Dynamic pricing is a model where prices for products or services are adjusted in real-time based on various factors such as demand, supply, competitor pricing, time of day, customer segments, and other market conditions.
This approach allows businesses to optimize their pricing to maximize revenue and profitability.
How does dynamic pricing work?
Businesses first need to collect and analyze data on various factors affecting demand and supply. The data is processed in real-time by algorithms and machine learning to automatically adjust prices based on predefined rules.
This pricing model requires a solid data environment capable of real-time data processing. It must ensure the right data collection and integration techniques, as not all of them are suitable for enabling real-time data processing. These must be combined with advanced analytics and machine learning, and a scalable data environment – a modern data platform can help businesses check all of these boxes and provide future-proof data analytics mechanisms. Reach out to us for more details.
Pros:
- maximizes revenue and profit potential
- allows for quick adaptation to market changes
- balances supply and demand effectively
- provides valuable insights into customer behavior and preferences
- can increase sales during off-peak periods
Cons:
- may lead to customer frustration if prices fluctuate frequently or dramatically
- requires sophisticated technology and data analysis capabilities
- can be perceived as unfair or discriminatory if not implemented transparently
- may result in negative publicity if perceived as exploitative
- potential for pricing errors if algorithms are not properly calibrated
When this model works best:
Dynamic pricing will generally work well for companies that have a lot of real-time data on customer behavior at their disposal, especially:
- industries with fluctuating demand and limited supply, e.g. travel and hospitality businesses, on demand services
- businesses with perishable inventory or time-sensitive offerings, such as retailers,
- markets with price-sensitive customers
- businesses facing intense competition
Example:
Uber! The company’s dynamic pricing model, known as "surge pricing," is a core element of their business model that balances supply and demand in real-time.
Uber's algorithm continuously monitors ride demand and driver availability in different areas. When demand exceeds supply, prices automatically increase. This higher pricing serves two purposes: it encourages more drivers to move to high-demand areas, increasing ride availability, and it discourages some riders, helping to balance demand with supply.
Users are notified of surge pricing before requesting a ride and can see the price multiplier. Prices update in real-time and can be specific to certain neighborhoods or times, often occurring during peak hours, bad weather, or special events.
The system uses machine learning to predict likely surge periods based on historical data. During surges, drivers earn more, incentivizing them to work during high-demand times.
5. Subscription pricing model for recurring revenue
Another pricing model you’re likely familiar with already – in subscription pricing customers pay a recurring fee at regular intervals (usually monthly or annually) to access a product or service.
Instead of making a one-time purchase, customers essentially "rent" access to the product or service for as long as they continue to pay the subscription fee.
How does subscription pricing work?
Customers sign up for a subscription plan. They are billed at regular intervals (e.g., monthly, quarterly, or annually). They receive continuous access to the product or service as long as they maintain their subscription. The business must give them the opportunity to cancel or modify their subscription at any time.
Pros of subscription pricing:
- predictable, recurring revenue for the business
- higher customer lifetime value
- improved cash flow and financial forecasting
- increased customer loyalty and retention
- opportunity for upselling and cross-selling
- lower customer acquisition costs over time
Cons of subscription pricing:
- pressure to continually provide value to retain subscribers
- higher upfront costs to acquire customers
- potential for high churn rates if customers are dissatisfied
- need for robust billing and customer management systems
When subscription pricing works best:
This particular pricing model is dedicated for products or services that require consistent usage (think of Netflix). They can be applied:
- to products or services with ongoing value or regular update
- in industries with high customer acquisition costs
- by businesses with scalable products or services
- when customers prefer predictable, smaller payments over large upfront costs
Example:
Many global brands use subscription pricing, including Spotify, Netflix, HBO, Adobe, PlayStation Plus, The New York Times, Grammarly, Audible and many others. This approach also allows them to spread the cost of customer acquisition over a longer period, potentially increasing profitability in the long run. The hypothetical example I used here earlier: the company offering cloud storage services and billing their users per month is also one of those cases.
6. Freemium pricing model for rapid customer acquisition
With freemium pricing, a business offers a basic version of its product or service for free, and makes a profit by charging for premium or additional features. The term freemium is a combination of free and premium.
Freemium itself is usually combined with tiered pricing, otherwise a business wouldn’t generate any revenue.
How does freemium pricing work?
A company provides users with a functional, but limited, version of the product or service at no cost. But, it also develops additional, more advanced features or services that add value for users and generate revenue from a percentage of users who opt for those paid plans.
The company has to motivate free users to upgrade to paid plans by showcasing the benefits of premium features.
Pros of freemium pricing
- low barrier to entry for new users
- rapid user acquisition and growth
- opportunity for users to try before buying
- potential for viral marketing and word-of-mouth promotion
- ability to gather user data and feedback from a large user base
- lower customer acquisition costs
Cons of freemium pricing
- risk of high costs to support free users
- potential for low conversion rates from free to paid
- risk of cannibalizing paid offerings
- difficulty in monetizing a large portion of the user base
When freemium pricing works best:
The freemium pricing model is applied when the free version can act as a marketing tool for the paid version. It’s a good option:
- for products or services with low marginal costs (e.g., digital goods, saa tools)
- in markets with network effects or viral potential
- when the product has a broad appeal but also specific power users
- for businesses with a clear path to monetization through premium features
Example:
Coming back to our example of a company that offers cloud storage services, discussed with tiered pricing (the preceding point)
The company could offer its Basic tier as Freemium, if it decided that it wants to build a large customer base to which it could then upsell those priced tiers.
This move would undoubtedly help attract a large user base and showcase the service’s value. It would also enable the company to generate revenue from users who find value in the expanded storage packages.
7. Bundle pricing model: increase your sales volumes
Also a marketing approach, bundle pricing is about combining multiple products or services and selling them together as a single package, typically at a lower price than if the items were purchased separately.
This approach is designed to increase sales volume, improve perceived value, and encourage customers to try new products or services they might not have considered individually.
How does the bundle pricing model work?
Businesses select complementary products or services and determine a single price for a specific bundle. The Idea is to offer a lower price than the sum of individually priced items. You offer the bundle alongside individual product options, but market the bundle as a package deal, emphasizing the value and savings.
Pros of bundle pricing:
- increased sales volume
- higher average transaction value
- improved inventory management
- opportunity to introduce customers to new products
- enhanced perceived value for customers
- simplified decision-making process for buyers
- potential for higher customer satisfaction
Cons of bundle pricing:
- reduced profit margins on individual items
- risk of cannibalizing sales of higher-margin individual products
- potential for customer confusion or overwhelm
- difficulty in determining the optimal bundle composition and price
- may devalue individual products in customers' minds
- limited flexibility for customers who only want specific items
When bundle pricing works best:
- for businesses with complementary products or services
- for industries with high customer acquisition costs
- in markets with strong competition
- for products or services with high perceived value but low marginal costs
- when trying to enter new markets or attract new customer segments
- for businesses looking to increase customer lifetime value
Example:
An online learning platform could offer various courses in digital marketing. They could implement a bundle pricing model where they sell a package of four courses:
Individual course prices:
- Social Media Marketing: $99
- Search Engine Optimization: $129
- Content Marketing: $89
- Email Marketing: $79
Bundle offer: "Digital Marketing Mastery"
- includes all four courses
- priced at $299 (instead of $396 if purchased separately)
- savings of $97 or 24.5%
The comprehensive package would appeal to customers looking to develop a well-rounded digital marketing skill set. The bundle offers significant savings when customers buy a package of four courses, while delivering the value contained in all four courses altogether. Such a pricing approach can lead to higher overall revenue and higher customer retention, as users will likely engage with more content on the platform.
8. Tiered pricing model: for different customer needs
You must have come across products or services that come at different pricing levels, depending on the scope of the offering. That’s tiered pricing, a common pricing model with SaaS, subscription-based services, telecom companies or even products such as gym memberships.
Each tier typically includes a specific set of features or benefits, with higher tiers offering more value at a higher price. This approach allows businesses to cater to different customer segments and their varying needs or budgets.
How does the tiered pricing model work?
A business first creates multiple product or service levels. Each tier is then assigned a specific set of features or benefits. Prices are established for each tier, with increasing price as the value increases. As a result, customers choose the tier that best fits their needs and budget.
Pros of tiered pricing:
- caters to diverse customer segments
- increases customer choice and flexibility
- encourages upselling and cross-selling
- maximizes revenue potential
- improves perceived value for higher tiers
- allows for easy product differentiation
Cons of tiered pricing:
- can be complex to manage and communicate
- may confuse customers if not presented clearly
- risk of cannibalizing higher-tier sales if lower tiers are too attractive
- potential for customer dissatisfaction if tier boundaries are not well-defined
- requires a careful pricing model to maintain profitability across tiers
When tiered pricing works best:
- for businesses with diverse customer bases and varying needs
- when products or services have clear, distinguishable features
- in markets where customers have different willingness to pay
- for businesses with scalable products or services
Example
I’ll use the hypothetical cloud storage company offering services similar to Dropbox - one I’ve already used earlier. Opting for tired pricing would actually be a great choice for the business. The company could implement a tiered pricing model as follows:
Tier 1: Basic ($0.99/month) with 1 GB storage
Tier 2: Pro ($9.99/month) with 10 GB storage
Tier 3: Business ($24.99/month) with:
- 100 GB storage
- Integration with other tools
Tier 4: Enterprise (Custom pricing) with:
- unlimited storage
- dedicated account manager
- custom integrations
- priority support
In this example, our hypothetical company caters to different customer segments, from individual users or small teams (Basic and Pro tiers) to large enterprises (Enterprise tier). Each tier offers increasing value and features, encouraging customers to upgrade as their needs grow.
The free tier serves as a way to attract new users and showcase the product's value, while the higher tiers generate revenue and provide more advanced features for power users and larger organizations.
9. Usage-based pricing to offer a fair option
With usage-based pricing, also known as consumption-based pricing or pay-as-you-go pricing, customers are charged based on their actual usage of a product or service, rather than paying a flat fee or subscription.
This model has gained popularity, especially in the digital and cloud-based services industries. Customers pay only for the resources they consume. This pricing model is typically tied to specific metrics that measure usage, such as data storage, processing power or number of API calls.
How does a usage-based pricing model work?
Start by defining the relevant usage metrics, like gigabytes of storage, or number of transactions. Then set a price per unit of usage (e.g., $0.10 per GB, $0.01 per transaction). Next, simply measure the customer's actual usage over a billing period and multiply it by the per-unit price and the total cost will be determined.
Pros:
- customers only pay for what they use, so they feel it’s fair
- easy adaptation to customer needs
- customers can start with low usage and costs, so there’s a low entry barrier
- usage data can inform product development
Cons:
- your revenue will be hard to predict
- customers may face unexpectedly high bills if usage spikes, provoking churn
- requires robust systems to track and bill based on usage
When usage-based pricing works best:
Usage-based pricing is particularly effective for businesses with variable costs that scale with usage and easily measurable usage metrics. It works well with cloud computing and infrastructure services, especially:
- Software-as-a-Service (SaaS) platforms
- API-based services
- IoT and connected device services
- utility-like services (e.g., electricity, water)
Example:
Let's consider a cloud-based video streaming platform for businesses. Its customer streams 1,000 hours of video, uses 500 GB of storage, and has an average of 50 concurrent viewers. They could charge them in the following way
- $0.05 per hour of video streamed
- $0.03 per GB of storage per month
- $0.10 per concurrent viewer per hour
Their monthly bill = (1,000 * $0.05) + (500 * $0.03) + (1,000 * 50 * $0.10)
= $50 + $15 + $5,000
= $5,065
In the real world, this pricing model is used by multiple digital companies, including
AWS (charges for cloud computing resources based on usage), Google Cloud Platform (offers pay-as-you-go pricing for cloud services), Twilio (charges for API calls and messaging services based on volume), Snowflake (cloud storage service with usage-based pricing for compute and storage), SendGrid (email service with pricing based on the number of emails sent), and many more.
10. Pay what you want pricing model, for when money doesn’t count
Pay what you want (PWYW) is a pricing model where you give the customers full control over the price they pay for a product or service. You may set a minimum price or offer the product entirely for free, allowing customers to pay any amount they choose, including nothing.
What’s the point of this model then, you may ask? Well, it definitely isn’t a popular choice in the world of digital products or services, however, some businesses may find it useful when introducing new MVPs or features for trial, or to conduct market research.
PWYW can be applied across various industries, from digital products to physical goods and services. It's often used as a promotional tool, a way to give back to the community, or as part of a larger business model that includes other revenue streams.
How does the PWYW pricing model work?
The seller offers a product or service without a fixed price. Customers decide how much they want to pay based on their perceived value, financial ability, or desire to support the seller. The transaction is completed at the price chosen by the customer.
There's no standard calculation method for PWYW, as the price is determined by the customer. This model, however, can help businesses analyze:
- average payment amount
- percentage of customers who pay
- total revenue compared to fixed-price models
- customer acquisition costs and lifetime value
Pros:
- focuses on customer goodwill and increases trust
- potential for higher overall revenue if customers pay more than the market price
- lower barrier to entry, attracting more customers
- valuable price information and market research
- positive publicity and word-of-mouth marketing
Cons:
- risk of customers paying little or nothing
- unpredictable revenue streams
- potential for cannibalization of higher-priced offerings
- may devalue the product or service in customers' minds
- challenging to budget and plan for business operations
When PWYW it works best:
PWYW works best for businesses that can benefit from good word-of-mouth and those that want to increase their exposure. It can be applicable to:
- digital products with low marginal costs (e.g., software, e-books, music)
- services with excess capacity (e.g., off-peak on demand services)
- products or services with a social or charitable component
- limited-time offers
Example:
Let's consider an independent game developer releasing a new mobile game. The developer releases the game on app stores with a PWYW model. Players can download and play the full game for free.
Within the game, there's an option to support the developer by paying any amount. The developer sets suggested payment tiers (e.g., $1, $5, $10) or provides an option to add a custom amount.
Players who enjoy the game can choose to pay what they feel it's worth. The developer can then track payments and analyze the data to inform future pricing and development decisions.
In the real world, Humble Bundle offers collections of digital games and books with a PWYW model to support charity donations. Uber’s tipping system also works under the PWYW model.
Find the best pricing mix for your business
Pricing is a critical component of business success, but finding the right model can be a daunting challenge. Whether you're looking to implement a modern data platform or optimize your pricing models, we have the expertise to help.
At RST Data Cloud, we specialize in creating scalable, future-proof data environments that power advanced analytics and pricing models. By leveraging the latest data management and machine learning techniques, we can help you implement dynamic pricing, value-based strategies, or a tailored hybrid approach that aligns with your unique market position and customer needs.
Reach out to our team of data experts today through this contact form and let's explore how a modern data platform can transform your pricing approach and give you a competitive edge in your industry. We’ll be happy to explain how your investment in a data-driven pricing model will give you a competitive edge.
