From the March 1999 issue of Entrepreneur

You've got the product or service that's going to put you on the map. But before you rev up the machinery to produce this potential winner, you have to complete a task that's as important as making the product itself: putting a price tag on it.

Just how important is selecting the right price? It could mean the difference between success and failure, says John Mullins, a former entrepreneur and now an associate professor of marketing at the University of Denver. "The wrong price can put you out of business fast," he says.

The trick is coming up with a price that returns good profits and attracts customers at the same time. Finding that magic number requires careful thought and planning.

Gut Instinct

Claudio Rayes, president of Claudio Rayes Inc., a High Point, North Carolina, designer of sculptured iron furniture, agonized over the price of his products. Rayes, 42, who started his business 20 years ago in Argentina and then moved it to the United States in 1997, wasn't creating ordinary, mass-produced furniture to be sold in discount department stores. His elegant, upscale pieces were intended to be sold in exclusive furniture stores and high-end department stores.

"My [furniture is] time-consuming to design and expensive to make," says Rayes. "To make a fair profit, I have to charge more than [I would for conventional furniture]."

Afraid a premium price tag would scare people off, Rayes almost made the fatal error of pricing his products too low. Although he knew little about marketing techniques, he went with his gut and settled on an average price of $1,500.

"I figured the customers I was trying to reach would associate the price with the true value of the product," Rayes explains. "So I tested the price and quickly saw customers didn't question it. If I charged less, I think it would hurt the image of my product."

He was right, according to Timothy Stearns, a professor of entrepreneurship at California State University, Fresno. A ridiculously high price can kill a product, but so can a very low price, he says. The well-heeled customers Rayes was going after would most likely have been turned off by a low price.

"The price of a product tells consumers what kind of value and quality to expect before they even buy it," Stearns explains. For example, customers who can afford it don't think twice about plunking down an eye-popping amount of money for a Mercedes, Porsche or Jaguar because they associate extraordinary quality and value with the prices of these cars. "In a consumer's mind, a higher price often connotes high quality," he says. "Conversely, a low price means poor quality."

Down to Basics

Beyond using price as a marketing technique for separating your product from those of your competitors, Mullins says setting the right price is also an effective way to build cash flow. "A critical goal for a start-up is to grow quickly," he says. "It's more difficult to raise cash from conventional sources such as banks and venture-capital firms when the business has no track record. So the goal should be to price your product at an attractive margin."

But take a hard look at your long-range goals before deciding to price your product based on margin alone. You need to first ask yourself whether you're trying to increase profit margins or market share, Stearns says. "If you're solely interested in boosting profit margins rapidly, you'd do better with a higher price," he says, "but if your goal is to build a big company and capture market share, you'd do better with a lower price."

Long-term growth and increasing his market share were certainly goals of 29-year-old Burtch Maruflu when he launched Xodiac Technologies in 1996 to promote iCatch, an in-house product display system. Maruflu didn't actually start producing his electronic displays, which are sold to mass merchandising chains, banks, trade show exhibitors and retail stores, until February of 1998. Unlike Rayes, Maruflu didn't have to worry about separating himself from his competition--because he had virtually none.

Unlike gigantic outside signs that flash messages at passersby, Maruflu's products are 25-inch or 40-inch portable displays meant for indoor use. The device can alternately flash three different messages, and the graphics can be changed.

Maruflu was right in assuming his product's uniqueness was the engine driving its market appeal. His prices of $499 for the 25-inch system and $799 for the 40-inch version were based on production costs, i.e. mass-production methods that yield volume production and maximum margins, as well as what he thought his customers could afford to pay.

A significant part of Maruflu's pricing equation was determining what its potentially broad customer base would pay for the display system. "Since our customers range from large corporations to smaller businesses like banks and small restaurants, we were careful [to create] a price neither small nor large companies would question."

Indeed, while production costs are critically important, it's your potential customers who ultimately decide the price of your product. "Most start-ups face some kind of competition," says Mullins. "You have to assume someone is already satisfying your potential customers' needs. It may not be with the same product, but it could be something pretty close. You must give serious thought to what customers are already paying for a similar product, compare the benefits of your product, assess what you think they'll pay for it, and then charge them as much as you reasonably can for its differences."

Fee for Service

Pricing a product isn't easy, yet pricing a service is harder still because you're dealing with an intangible, according to Stearns. "How you price a product you can see and touch is a lot easier than pricing a service, where value is often not immediately apparent," he explains. "You often have to work harder to convince people that the price they're paying is a good one."

Nonetheless, Stearns says that the principle of connecting high price with value and quality also applies to pricing a service. "It doesn't really matter whether it's a computer repair, accounting or management consulting service you're pricing," he says. "Customers associate a high price with quality."

Stearns offers these principles for pricing a service.

  • Identify target customers, and find out what they have paid or what they're willing pay for a comparable service.
  • Determine your true costs. Many entrepreneurs mistakenly discount their time. "They consider their time as free when they should be factoring it into the total amount of time consumed by a client. That includes travel expenses such as tolls, auto depreciation and the time it takes to get to and from a client's location," says Stearns.
  • Be flexible. It's always best to price high and then lower the price if the situation calls for it. "It's always best to give your price some leverage," says Stearns. "This can't be done if you underprice your service." To capture a client, for example, Stearns says you can offer a volume discount if the client wants you to repair several machines or provide the identical consulting service to several departments.

Whether you're pricing a product or service, one thing is sure: It will have a lasting impact on your business. Don't approach it lightly, or you could be sounding the death knell for what could have been a successful venture.

Add It Up

6 tips for pricing a new product or service.

John Mullins, an associate professor of marketing at the University of Denver, offers these tips for choosing a price that will get the cash register humming:

  • The principal determinant of price is the value your intended customer perceives for what you offer. If the customer thinks your product delivers benefits worth $15, you can't sell it for $25.
  • Customer value depends on how your product or service is superior to the product the customer is already buying. Thus, your competition, whether direct or indirect, is key.
  • Expect competition. Virtually every product and service on the market has some competition. Assume your target customers' needs are already being met. Try to identify and pursue market segments for which your competitive differences are likely to be of value to the customer.

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  • There are only two ways to build sustainable competitive advantage: Your product or service must be either better or cheaper. Better is often sustainable, if your differences are demonstrable; cheaper is typically not, unless your cost structure is sharply lower than that of your competitors.
  • Don't set your price too low if you want to grow. The best source of cash for growth is attractive gross profit margins on the products or services you sell.
  • Price can be altered. You can always lower your price if you've priced your product or service too high. Raising that price, after setting it too low, is more difficult. When in doubt, choose the higher price.

Contact Sources

California State University, Fresno, (559) 278-2326, timothys@csufresno.edu

Claudio Rayes Inc., (336) 884-0000, fax: (336) 884-0099

Xodiac Technologies, (888) 8-I-CATCH, http://www.icatchsystems.com