Using a penetration pricing strategy: Overview and examples.
New businesses rely on clear and powerful differentiators to stand out from the competition. For many consumers, nothing makes their buying decision easier than price. A penetration pricing strategy is built on this concept.
By entering the market with a low price, businesses aim to attract customers quickly — then gradually raise their price. Many high-profile startups have used this strategy to disrupt industries and become today’s market leaders.
Learn the ins and outs of using a penetration pricing strategy. We’ll explain how it’s different from similar pricing tactics, provide examples, and cover the advantages and disadvantages of penetration pricing.
How does a penetration pricing strategy work?
A penetration pricing strategy prioritizes market share over profits for a given time period. The goal is to generate demand, rapidly build a customer base, and maximize brand loyalty in a short time.
Penetration pricing is when businesses introduce a low price for their new product or service. The initial price undercuts competitors, forcing them to match the offer or quickly apply other strategies. Competitors' customers may switch over to the cheaper offer, and new customers buy in too. After a period of growth, the business typically raises prices to increase profits and reflect the product’s rising value.
If it’s an innovative product, this theory works the same way. Price is removed as a barrier to get people to try the new product or service. The company sets a price that’s a bargain for its unique value, while still being cheaper than the familiar options. Competitors have less time to respond before the company amasses market share and becomes the new standard of choice.
Penetration pricing is generally used when demand for a new product or service is projected to be high. The hope is that the sales volume will make up for the below-average cost.
Price elasticity also plays a role. Businesses selling price-elastic products — meaning their customers' buying habits shift based on price — also use the penetration strategy. High prices could hurt sales and limit growth during the crucial launch period. A low price is the foot in the door for many new businesses.
Penetration pricing vs. loss leader pricing vs. predatory pricing.
There are a few pricing strategies that sound similar to penetration pricing, but have very important differences. Here's a look at each.
- Penetration pricing: With this pricing strategy, a business sets a low price on a new product or service in an attempt to gain significant market share quickly. The business plans to increase prices in the future, often setting a time limit on the introductory rate.
- Loss leader pricing: Loss leader pricing is a slightly different marketing strategy and is illegal in half of U.S. states. Companies sell a product or service at a loss — or narrow margin — to attract more customers. In theory, customers buy these “loss leaders” and then spend the savings on the company’s other, more profitably priced goods.
- Predatory pricing: Predatory pricing is illegal in the U.S. A firm practicing predatory pricing lowers costs dramatically to drive competitors out of the market. Unchecked or unregulated, the firm attains a monopoly. Then, the firm raises prices above market levels to recoup losses and maintain their position. Predatory pricing removes the possibility of healthy competition and doesn’t benefit consumers.
When choosing your pricing strategy, be sure to take any legal considerations into account.
Netflix: An example of penetration pricing.
Netflix is a powerful example of using market penetration pricing to edge out a major competitor. In the late 1990s and 2000s, DVD rentals were becoming mainstream. Although Blockbuster dominated the home entertainment market, it was also associated with late fees and limited selections.
Netflix had a unique proposal. If customers could wait a day or two for their DVDs to arrive, they could access a better movie library without any late fees. From the outset, Netflix emphasized ease and affordability to attract Blockbuster customers.
In 2000, Netflix users could rent four movies at a time with no return-by dates for the $15.95 subscription plan. That put rentals at or below $1 per DVD for regular movie-watchers, where Blockbuster charged about $4.99 for a single three-day rental.
Penetration pricing — and an innovative idea — allowed Netflix to build its subscriber base and reach profitability in 2003, five years after opening.
The low initial price point let customers test their new service and make the switch. In 2007, the company’s convenient online streaming service propelled it into the future. Heavy competition from Netflix and Redbox, another new rental company, contributed to Blockbuster’s bankruptcy filing in 2010.
More penetration pricing examples.
Companies utilize the penetration pricing strategy in different ways. In addition to setting a low price for their main product, some companies also use discounts, promotions, and other giveaways to attract customers. Here are a few examples.
- Internet and cable providers: It’s common to see cable companies offer free streaming services or extra channels to draw in new subscribers. Although there’s usually a time limit attached, perks like these are still effective. These incentives and bonuses help companies stand out in a saturated market.
- Food and beverage companies: Snack and drink manufacturers sometimes introduce new products and flavors at low prices so customers will give them a try. Take the newly popular hard-seltzer market as an example. A new business could make a splash by offering their lime flavor for $1.50 cheaper than standard options.
- Cell phone carriers and smartphones: Some carriers offer customers inexpensive or free smartphones in return for a long-term contract. Technology companies creating the phones employ this strategy too. Android phones are often priced low so customers build brand loyalty and Android achieves greater market penetration. Apple, on the other hand, practices price skimming. They charge as high a price as customers will pay and slowly lower it. The initial high cost builds their luxury brand reputation, and they “skim” price-sensitive customers from competitors over time as the price of the product slowly drops.
Entrepreneurs use these pricing and marketing tactics to grab the attention of new customers and generate recurring business.
Advantages of the penetration pricing strategy.
Penetration pricing is an effective way to enter the market for some companies. Let’s go over a few of the strategic advantages.
- Fast adoption: A low price tag can help speed up how fast customers will test and accept a product or service. Customers may view the purchase as less risky and be more likely to try it.
- Economies of scale: Switching over as many customers as possible is one of the central goals of a penetration pricing strategy. This is especially true for a product designed for a mass market. Penetration pricing can increase the volume of sales to offset the risks of a low price. In addition, suppliers may offer bulk discounts if a product is moving quickly.
- Goodwill: Customers value a good deal. By starting with an inexpensive initial price, new companies can build goodwill with a large number of prospects and customers. Price-sensitive customers are more likely to switch, and potentially promote the product through word-of-mouth marketing.
- Less competition: A new market entrant with a low price point sometimes catches competitors unaware. (This is more likely with a stealth launch.) In the early launch period, your business could face less competition and opposition marketing.
- Cost control: By nature, penetration pricing requires diligent budgeting and forecasting. With this strategy, your company may discover areas to improve cost efficiency, lower marginal costs, and control business expenses.
Disadvantages of penetration pricing.
There are also drawbacks to using a penetration pricing strategy in the short-term and long-term. Let’s go over a few of the disadvantages.
- Less customer loyalty: Penetration pricing includes the risk of dealing with frequent customer turnover and growing a core customer base of “switchers.” These are customers that switch for bargains and leave once prices increase. Businesses need to announce and implement price raises carefully to avoid this outcome.
- Low brand reputation: Alternatively, consumers may perceive very low prices and generous introductory offers as suspicious. Companies using the penetration pricing strategy may have to protect their brand image from negative assumptions about the quality or utility of their products.
- Narrow margins: Pricing low puts pressure on sales. Businesses selling products also have to keep a close eye on inventory levels and avoid oversupplying. Otherwise, a business can incur losses through excessive stock. In addition, business owners have to follow through on planned price increases if they're going to become profitable with this strategy.
- Aggressive competition: While penetration pricing may catch other market players off guard, it could also cause them to simply lower their prices. Competing with established businesses for market share in a "price war" could be challenging for a new venture.
Starting low, aiming high.
Market penetration is a challenge for any business, especially entrepreneurs attempting to change the face of an industry. A penetration pricing strategy aims to achieve adoption by growing a customer base with low initial prices.
It can be an effective way to amass buyers, build goodwill, and stand apart from other market competitors. But it can also lead to noncommittal customers and thin margins as a business is starting out.
If you’re considering penetration pricing, a break-even analysis could help you determine whether it’s the right strategy.