Making Smart Pricing Decisions

Strike a perfect balance when setting your prices to make a higher profit.

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."

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