If you’ve ever seen a queue of people waiting outside a store for hours (or days!) to be the first to purchase a new product, you’ve probably seen a price skimming strategy in action.
Whether it’s the first launch of a revolutionary new product (like the first Apple iPhone in 2007) or a new version of an existing product, companies “make hay while the sun shines” by using price skimming strategies. This pricing strategy allows them to maximize profits by charging a higher price while a sense of excitement and exclusivity surround the launch before leveling out prices over time to “skim” other market segments.
Let’s take a closer look at the definition of pricing skimming, some examples of this pricing strategy, and the pros and cons of adopting price skimming in your business.
What is price skimming?
Price skimming is the practice of pricing a product as high as the market will tolerate for the initial launch period, “skimming” off maximum profits before decreasing to appeal to the mass market. A price skimming strategy is often used in markets where a group of early adopters is willing to pay above the market price to get their hands on the latest product first. This is the opposite of a penetration pricing strategy, where companies change a below-market price to get a foothold in a new market.
Gaming brands like Xbox and PlayStation notoriously use price skimming to launch each new version of their consoles. Die-hard fans flock to stores worldwide to be the first to own the latest model, even when new features may not represent excellent value.
How does price skimming work?
Price skimming is a pragmatic pricing strategy that allows companies to generate the maximum profit from a new product while still appealing to the mass market over time. They do this with an innovative offering and clever branding and marketing to justify the higher price. For example, Apple generates a lot of hype around a new product, sometimes elevating new releases to “cult-like” status.
First, companies must divide the potential market into segments or layers to be skimmed. This is usually based on things like price sensitivity, key demographic indicators, and competitor pricing. Then they can decide what price each layer will pay for the product to maximize profit per segment, starting from the least to the most price-sensitive customers. This pricing strategy may evolve over time as they learn more about consumer and market behavior. Manually adjusting prices is slow, laborious, and inaccurate, so smart businesses adopt dynamic pricing strategies with tools like Flintfox’s Omnichannel Pricing, to react quickly to market signals, competitor activity, and new opportunities.
A skimming pricing strategy usually only works when a brand or product has a niche group of unconditionally avid fans, and an inelastic demand curve i.e. price doesn’t have a big impact on demand. This means customers are willing to pay higher prices, even if they know prices will drop later.
Once this cohort of early adopters is capitalized, prices are dropped — sometimes in stages to “skim” off profits from each layer — appealing to the broader market. In the case of companies like Apple that regularly use price skimming strategies, customers become familiar with this cycle, and those that are not die-hard fans will wait until prices drop before making a purchase.
Example of a price skimming pricing strategy – Apple iPhone
Launched in 2007, the groundbreaking iPhone by Apple was a first-of-its-kind smartphone that has gone on to change the world. The multi-touch interface, soft keyboard, and integrated iTunes app had people clamoring to be the first to try this exciting new piece of technology, even with its launch price tag of $599. Pitched with much fanfare and a memorable marketing campaign, iPhone went on to sell 1.39 million units in its first year, and there are now over a billion iPhone users worldwide.
Fifteen years later, avid iPhone devotees still form snaking queues outside Apple stores and place pre-orders for subsequent annual releases of the device. Each new version of the iPhone might only have a few new features, but loyal Apple early adopters still believe owning the new device is worth the higher investment. iPhone users that like the device but are not passionate in their devotion are happy to wait until prices come down and the phone is more accessible.
Who should use price skimming?
Like all pricing strategies, price skimming is only effective when certain conditions are met. The tech and fashion industries are notorious for price skimming, though this pricing method can be applied in many other markets. Price skimming strategies can work in the following situations.
Unique or innovative product
Customers are usually willing to pay more for new software or technological hardware that does something no other product can. A skimming pricing strategy is effective when the offering is unique and innovative enough to justify the price. Price skimming is less effective in crowded markets where many similar products compete.
Price skimming strategies are only effective when a sufficient level of inelastic demand exists i.e. demand is less affected by price. While innovative new products may not be “essential,” customers are willing to pay above market price if they deem them “must-haves”. Price skimming will not work in markets with highly price-sensitive customers and similar products. In these situations, they will likely sniff out the best deal, regardless of brand. Unlike premium pricing, a price skimming strategy doesn’t require prices to be permanently high, so businesses are not limited to servicing only the top layer of customers.
Strong brand reputation
Companies that wish to adopt a skimming pricing strategy must cultivate positive sentiment toward the brand to justify higher prices. The best product in the world may only succeed if there is a positive brand image.
For example, customers feel confident paying more for a car from a premium manufacturer like Audi because they trust that the company has high standards of quality and an excellent reputation in the automotive industry. Without this brand equity, they would struggle to justify higher prices, even if the cars were of similar quality. Building brand equity requires time, investment, and expertise. Businesses must be willing to put in the work to reap the rewards.
Affluent target customers
Without sufficient disposable income, customers can not purchase a product. Price skimming requires an ample pool of customers with enough disposable income to buy a product at above-market prices.
Advantages of price skimming
There are several attractive reasons why companies choose to use price skimming. Let’s dive in.
Recover sunk costs faster
Developing innovative products usually requires a significant investment in research and development. Price skimming allows companies to recoup these retrospective costs faster than other pricing methods.
High profit margins
Beyond covering sunk costs, by maximizing revenue from each customer segment, companies can also grow profits at a faster rate.
Quality brand perceptions
Consumer psychology dictates that higher-priced products will likely elicit higher perceptions of quality. Price skimming strategies signal consumers that products have a sense of exclusivity and are of better quality than competing brands. This can have a perpetual positive effect on the business and the brand.
Disadvantages of price skimming
Despite its clear advantages, price skimming doesn’t come without some drawbacks.
Companies must be prepared to invest in research, development, branding, and marketing to make a splash worthy of price skimming. As with the iPhone example, customers are only willing to pay a premium for exclusive access to a product if it’s something revolutionary or they are especially wedded to the brand.
Requires specific market conditions
Price skimming can only be effective with a unique product with limited competition, inelastic demand, and targeting customers with sufficient disposable income. If these market conditions are not met, a company could find itself funneling cash into an investment with very little return.
Healthy profit margins and market domination are attractive outcomes for any fledgling or established business. Price skimming can attract new competitors into the market — some with significant investment — to imitate or even improve on hero products as a better price.
Over time, price skimming causes customers to become familiar with the product pricing cycle, and more may choose to wait until prices drop before making a purchase. After its initial launch, the surrounding hype, and the entry of new competitors, it can be difficult for businesses to maintain above-market prices for each new version of the product.
Implement a smart price skimming strategy in your business today
What to buy, where to buy it, and how much to pay — consumers today have more choice than ever. So how can you reach the right customer at the right time with the right offer? Flintfox’s Omnichannel Pricing tool gives you a full view of your channels so you can pivot your strategy and update prices with the click of a button. Our intelligent pricing platform lets you wave goodbye to spreadsheets (and grey hairs) and say hello to fully automated pricing that gets it right every time.
Get in touch with our friendly team today to discover how we can supercharge your pricing strategy and bottom line.