Deciding what to charge your customers is one of your most important--and difficult--decisions as a new business owner. Set your prices correctly, and you'll not only make a profit, you'll bring new customers in the door. Choose the wrong price and your business may be doomed from the start.
How do you decide what price is best? Unfortunately, there are few easy answers to that question. Each company must find a balance between financial concerns (such as costs and cash flow) and marketing factors (such as consumer demand and market conditions). Small-business experts agree, however, that there are some common mistakes you should avoid when you're setting your price:
1. Ignoring the customer. One of the most dangerous pricing mistakes is ignoring the needs and buying habits of potential customers. Without an understanding of how customers perceive the value of your product or service, it's almost impossible to set a price they'll be willing--and able--to pay.
"Pricing is a marketing issue," says David Newton, associate professor of entrepreneurship finance at Westmont College in Santa Barbara, California. "Your price needs to be customer-oriented. You need to ask yourself, `What market am I competing in? What are the advantages of my product? What are customers willing to pay? What will the demand be?'"
Newton adds that, while they should take them into consideration, start-ups shouldn't automatically match their competitors' prices. Large companies often have lower manufacturing costs due to large-scale production, which allows them to set a lower price. In many cases, smaller firms can't achieve the same degree of cost savings.
Instead, Newton suggests entrepreneurs look for ways to add value to their product or service. Consumers may be willing to pay a slightly higher price for added benefits like superior service, better terms of sale and good return policies. Joel McIntosh, owner of Prufrock Press, an educational publishing company in Waco, Texas, says, "We add value through our credit terms and policies."
McIntosh has researched his primary market, teachers and schools, quite extensively. That research identified which benefits, such as a lifetime warranty and mail order service, would appeal to his customers. It also helped to gauge the potential risks of offering those benefits. "We know that teachers are reliable," McIntosh says. "They pay their bills on time. That lets us extend better credit terms and charge prices with higher margins."
2. Inaccurately estimating costs. No one starts a business expecting to lose money, but that's just what happens to many entrepreneurs who fail to accurately estimate all the costs associated with their product or service before they set their prices. Break-even analysis (determining the dollar amount of sales you need to make to break even over a period of time) and cost-plus pricing (adding a percentage of profit to the cost of producing your product) are only as reliable as the cost estimates used to develop them. (See `How to Figure Your Break-Even Point,")
Some costs, such as those of raw materials, packaging and office space, are fairly obvious. Others, however, are not as apparent. For example, Bill Fioretti, director of the Small Business Development Center at the University of Cincinnati, notes that many service businesses fail to consider what it would cost to hire someone to provide the services they handle.
"They make the mistake of saying, `I can do it at a lower cost because I'll do the work myself,'" says Fioretti. "Then, when the business expands and they need to hire help, their pricing formula doesn't allow for labor costs."
Other easily overlooked expenses are sales, distribution and warranty costs and the terms of sale offered to customers. "You can't pay your bills with accounts receivables," says Michael Leahy, adjunct professor of entrepreneurship in the Owen School of Business at Vanderbilt University in Nashville, Tennessee, and president of Tejano Corp., a syndicate company specializing in Spanish-language entertainment programming. "You need to consider the terms of the sale as well as the dollar price attached to a product."
Leahy notes that offering extended payment terms to customers can dramatically impact a new company's cash flow. "Cash is king, if you start with modest financing. The only way you can maintain control over cash flow is to generate cash from sales. In the pricing process, you need to ask, `Can I get positive cash flow from this transaction and this price?'"
3. Underpricing your product or service. "New entrepreneurs tend to set their prices low because they assume that, because they're new, customers won't pay more," says Heller.
Newton observes that service businesses are particularly likely to undervalue the benefits of their services to customers.
Linda Calder, of Calder & Calder Promotions in Topsfield, Massachusetts, knows firsthand how easy it is to fall into the underpricing trap. When she was setting up her business, which produces trade shows featuring products and services geared toward parents and children, she based her price on a low average of what other trade show production companies charged exhibitors, believing a low price would give her a competitive advantage.
Calder notes, "My fee was so low, everyone loved it. I sold out, but did not make a profit." In her second year of business, Calder tried to increase her fees but found clients didn't welcome the change. "I only got half the business."
Fioretti suggests new businesses take a long-term approach to pricing. "To get your foot in the door, you may need to offer a lower price initially," he acknowledges, "but offer it as a discount or introductory offer. Put a time limit on it and make sure the customer knows that it is an introductory price." Fioretti explains that this approach gives you the chance to prove yourself with customers, while allowing you the flexibility of charging more once the introductory period has passed.
McIntosh cringes when he recalls his start-up pricing. "Our first product was a little monthly periodical that I originally priced at $10. We also gave away a free book to those who subscribed. The same product today is a quarterly journal and sells for $55. I learned very quickly what our average gross margin for our entire product line needed to be."
Your gross profit margin is the difference between your total sales and the costs of marketing those sales. It indicates how much money will be contributed toward your net profit before your operating costs are deducted. To compute your gross profit margin, subtract the cost of goods sold from your total sales and divide by your net sales.
To calculate an industry-wide average, do some research to see what percentage of gross profit margin other businesses like yours commonly achieve. Information about the average margins for your industry is available from trade associations and journals or the reference section of your local library.
"Network with other companies in your industry," McIntosh advises. "I'm not hesitant to call others for information and advice."
Leahy also stresses the importance of high margins for small-business success. "Research studies have shown successful entrepreneurial companies tend to be built on high-value, high-margin products."
Another reason new ventures often end up underpricing themselves, Fioretti warns, is they rely too heavily on cost-plus pricing. "Think of the cost-plus price as a minimum," he says. "Cost-plus pricing and break-even analysis are only part of the pricing formula. You also need to evaluate your customers' needs, the competition and the market niche you're in."
4. Not thinking of price as a strategic issue. "Pricing shouldn't just happen," says Heller. "It should be part of your business plan and made with thorough market research."
McIntosh agrees. "Your price must fit with the goals and missions of your company. If your mission statement is clean enough, it should include what you're about and your pricing should come from that."
What works for your company may not work for another. But if you know the most common mistakes start-ups make, you'll be better able to develop a pricing strategy that enhances your company's chances of success.
Carolyn Z. Lawrence is an MBA with over 15 years' experience in marketing.