Definition of Price Skimming
Price skimming is the practice of selling a product at a high price, usually during the introduction of a new product when the demand for it is relatively inelastic. This approach is used to generate substantial profits during the first months of the release of a product, usually so that a company can recoup its investment in the product. However, by engaging in price skimming, a company is potentially sacrificing much higher sales that it could garner at a lower price point.
Eventually, a company that engages in price skimming must drop its prices, as competitors enter the market and undercut its prices. Thus, price skimming tends to be a short-term strategy.
When you engage in price skimming, the market size is small, since only early adopters are willing to pay the high price. Once early adopters have bought the product, sales volume usually declines, since the remaining potential customers are not willing to purchase at the price set by the seller.
Example of Price Skimming
ABC International has developed a global positioning system that can lock onto GPS satellite signals even from several feet underwater. This is a substantial improvement over existing technology, so ABC feels justified in pricing the product at $1,000, even though it only costs $150 to construct. ABC holds this price point for the first six months, while it earns back the $1 million development cost of the product, and then drops the price to $300 to deter competitors from entering the market.
Advantages of Price Skimming
The following are advantages of using the price skimming method:
- High profit margin. The entire point of price skimming is to generate an outsized profit margin.
- Cost recovery. If a company competes in a market where the product life span is short, price skimming may be the only viable method available for ensuring that it recovers the cost of developing products.
- Dealer profits. If the price of a product is high, then the percentage earned by distributors will also be high, which makes them happy to carry the product.
- Quality image. A company can use this strategy to build a high-quality image for its products, but it must deliver a high-quality product to support the image created by the price.
Disadvantages of Price Skimming
The following are disadvantages of using the price skimming method:
- Competition. There will be a continual stream of competitors challenging the seller's extreme price point with lower-priced offerings.
- Sales volume. A company that uses price skimming is limiting its sales, which means that it cannot lower costs by building sales volume.
- Consumer acceptance. If the price point remains very high for too long, it may defer or entirely prevent acceptance of the product by the general market.
- Annoyed customers. Early adopters of the product may be highly annoyed when the company later drops its price for the product, thereby generating bad publicity and a very low level of customer loyalty.
- Cost inefficiency. The very high profit margins engendered by this strategy may cause a company to avoid making the cost cuts required to keep it competitive when it eventually lowers its prices.
Evaluation of Price Skimming
This approach is useful for earning back an investment in short order, but does not position a company to compete in the industry over the long term, since it never lowers costs by building unit volume. Thus, this approach may work best for companies that focus on research and development, and produce a constant stream of new products without any intention of becoming the low-cost provider.