Pricing is magic. They don't teach much about pricing in business schools because good pricing is one of those concepts that you recognize when you see it, but is hard to define. While there are some common pricing methods used by business planners to set pricing strategies for startup businesses, none of them work that well, and none of them are automatic or easy.
In my 30 years of working with entrepreneurs I've learned to recognize what make a good pricing strategy. In those years I've seen one very common error that seems to occur all the time, and one common, potential big win that you might be able to apply to your own business plan. I'll discuss both of these with you, in addition to some common methods you can employ to help define your pricing strategy.
Three Common Pricing Methods
I know of at least three common methods for setting prices for a new business, or for a new product or service within an existing business:
- Cost-based pricing: Set your price as a multiple of cost, or cost plus a determined amount. An example would be a book store selling each book for 150 percent of whatever amount the store paid for it. Another example is a clothing boutique selling items for twice what it paid to buy them.
- Value-based pricing: Base your price on what your product and service is worth to the buyer. Computer software, for example, is often priced according to the time-savings and productivity gains, rather than the direct cost. Some would say airlines use a value basis to price the same flight differently for different travelers; they're cheaper for budget-minded consumers who buy with a lot of advance notice, and more expensive for the business traveler who has to go somewhere today.
- Market-based pricing: Let the market determine the price. This is the most common and most realistic pricing method for small and medium businesses. If everybody else charges $15 for a haircut, you charge $15 for a haircut, or some price related to $15 depending on your strategy. Maybe you want to be a low-cost provider, for example, so you charge less (which leads us to that very common pricing error).
The #1 Pricing Error
The most common pricing error in startup business plans is pricing too low--way too low, in many cases. I see this all the time. Entrepreneurs think every new business has to offer lower prices than the competition, and that somehow a low price is related to success.
I think this mistake comes from a common misunderstanding of a basic economic principle called elasticity, which says that for uniform commodities, sales volume should go up as the offering price goes down. The problem with elasticity is that it applies to uniform commodities only, not to any real business that any of us knows or imagines. In the real world, a lower price generates higher sales volume only when wrapped in an overall business strategy that suits it. So very large and well-known discounters can generate high volume on a large scale, but the local business on the corner can't. Without the related marketing, low price just sets low expectations.
Think about it. Do you always go to the cheapest restaurant when you go out to eat? Do you buy the cheapest car or the cheapest clothes? Do you live in the cheapest housing?
Because of this common error, startup businesses fail to cover costs, they fail to generate capital to grow, and they just plain fail because they're pricing too low.
A Pricing Win
What I most like to see in a pricing strategy is pricing as positioning. Use your pricing to send potential customers a message about the quality and value of your product or service. For example, if your restaurant serves better meals than others, then charge more than others for each meal. Many people (okay, not all, but many) believe that you get what you pay for. Look at how successful Starbucks became by charging a little bit more for a good cup of coffee. Consider the success of high-end restaurants, performance automobiles and designer clothes labels. Charge more, not less, for your business. It's a pricing strategy your customers are sure to buy if you have the quality to back it up.
The author is an Entrepreneur contributor. The opinions expressed are those of the writer.