Making Smart Pricing Decisions
It's a question that's critical to your start-up process and a factor that will always be an issue in your operation: How much should you charge for your products or services? The dynamics of today's business environment--fluctuating costs, value-conscious customers, and strong competition--make the pricing decision more challenging than ever.
The consequences of a poor pricing strategy are obvious: Pricing too high may limit your sales, while pricing too low may limit your profits.
S. P. Raj, professor of marketing at Syracuse University School of Management in Syracuse, New York, says it's easy for new business owners to fall into the trap of overpricing. "They often feel their product deserves a higher price than it really does on the market," he says. "There's also the temptation to try and recoup all your expenses as quickly as possible, not realizing that when the product is overpriced, demand goes down." Recognize the influence emotional attachments and financial pressures have on your pricing policies, and balance them with sound business decisions.
Underpricing carries its own set of consequences. In addition to the impact on profits, not charging enough can create the perception of poor quality, Raj says. On the other hand, reducing the financial risk with a lower price could provide the necessary motivation for many new customers to try your product.
As you struggle with the pricing process, you may feel like you're looking for a magic number that will deliver both sales and profits. As frustrating as it may be, take comfort: Effective pricing is more logic than magic.
Understanding the costs involved in running your business is an essential element of sound pricing and profitability. Consider what you must spend to produce what you are selling (also known as the cost of goods sold, which typically includes raw materials, labor and freight) as well as your overhead expenses (facilities, administration, etc.). Once you know the actual cost of each unit, you can determine how much profit to add to arrive at the selling price--and this is the part that gets tricky.
How much you add depends on the pricing strategy you choose. There are four basic methods, all of which apply to both tangible products and services:
- Cost-plus pricing. Once you've calculated the cost of the product, you add the amount of profit you want to make to arrive at the sale price.
- Demand pricing. Using this method, prices are determined by a combination of sales volume (what you actually sell, measured in units or dollars) and desired profit (how much profit you make on those sales dollars after the costs of goods and doing business have been subtracted). The process requires the ability to calculate in advance what price will generate the optimum ratio of profit to volume.
- Competitive pricing. When the market has already established the price for your product, it's wise to operate within that range. Study each competitor carefully to identify the prices they are charging. You should also determine the degree of price awareness among consumers.
- Markup pricing. Some manufacturers, wholesalers and retailers simply add a set amount (the markup, usually expressed as a percentage of cost) to the cost of a product to reach the final price.
You may find the most effective pricing method is a combination of two or more of the basic strategies. Ernest J. Florestano used cost-plus and competitive pricing when deciding what to charge for the magnetic water-treatment devices his Norfolk, Virginia-based company, Descal-A-Matic, manufactures.
"We did market research to find out what our competitors were charging, then did cost-plus calculations," Florestano explains, "and determined we could price our product in the midrange of the market and still achieve our profit goal."
Pricing is More Than Arithmetic
Beyond the numeric calculations, pricing involves a solid knowledge of your industry and a clear picture of the position you plan to take in the marketplace. In fact, pricing is a crucial element of your overall marketing strategy.
"There is a direct and strong relationship between the prices you charge and the image of your company," says Erin O'Donnell of Pepper, O'Donnell & Co. Inc., a marketing and public relations firm in Winter Park, Florida. "For example, do you want to be viewed as a no-frills, low-cost operation, or as a high-end, full-service company? One is not necessarily better--or more profitable--than the other. What is important is that your pricing structure be compatible with the image you want to create."
O'Donnell recalls a client whose sales rose dramatically when he increased his prices. "He was a consultant, and his product was information," she says. "In the lower price range, it had a lower perceived value--that is, his clients thought that what he had to offer couldn't be worth much if he was charging so little for it. But when he started charging more, the perceived value went up, too--and so did his sales."
While it's important to consider the perception of the marketplace, O'Donnell stresses that a strategy of raising prices to increase sales won't work for every product. "Once you've decided on a price, do some market research and testing on a sample market before you do a full-scale product introduction," she advises. "Testing gives you room to make adjustments in either direction if you need to."
Remember that pricing is an ongoing process. Regularly evaluate your prices and be prepared to change them if necessary or appropriate. If yours is a business that includes making written bids and proposals, O'Donnell advises guaranteeing your prices for a specified time.
"Raw material prices can be extremely volatile," she says. "Your business may be able to absorb small increases, but major cost jumps can wipe out your profits. Ask your suppliers how long they will guarantee their price levels, and then do the same for your customers."
Finally, O'Donnell says, if you choose to make price a key selling point, be prepared for fierce competition. "Customers who come to you strictly for price will leave you for a better price," says O'Donnell. "Certainly, most industries are extremely cost-competitive, but give your customers more than price as a reason to buy from you."
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