How To: Set Prices
One of the earliest--and trickiest--decisions for new business owners is determining what to charge for their products or services. Some entrepreneurs use elaborate computations. Others just guess. But if you calculate or guess wrong, you'll soon be out of business.
"Setting prices is an art, not a science," says Edith Quick, partner with her husband, Roy, in Quick Tax & Accounting Service in St. Louis. The art is in striking a balance between the money you need to stay in business and the customer's perception of what your product or service is worth.
Here are nine methods commonly used when setting or rethinking your prices. (Yes, rethinking. You should evaluate and adjust your prices at least once a year to accommodate changes in competition, the economy, consumer tastes and your company's needs.)
1. Compare with the competition. Find out what products and services similar to yours cost in your area, advises Andi Axman, coauthor with David H. Bangs Jr. of Launching Your Home-Based Business (Upstart Publishing, $22.95, 800-245-2665).
"Prices vary from big cities like Boston or New York to rural ones like mine," says Axman, who owns a marketing communications firm in Epsom, New Hampshire. If nearby competitors won't reveal prices, try calling similar businesses in other communities similar to yours, she suggests.
Shahid Kinnare's Timezone store in Memphis, Tennessee, has numerous watch and jewelry retailer competitors nearby. "So I look at what services they don't have," Kinnare explains. "I give free jewelry cleaning for a lifetime. I give a lifetime guarantee on all my watches."
2. Check industry standards. Axman recommends asking trade associations, chambers of commerce or other industry groups for pricing studies, surveys or related information. She also notes many industries have helpful pricing books on the market. For example, desktop publishers can turn to Robert Brenner's Pricing Guide for Desktop Services (Brenner Information Group, $34.95, 800-811-4337).
3. Figure by formula. The owners of Huckleberry Mountain Co., a Jackson Hole, Wyoming-based specialty manufacturer of candies and preserves, determine wholesale prices by multiplying ingredient costs by two, then adding 20 percent, says Judy Johnson, co-owner with her husband, Doug. The 20 percent covers distribution and sales commissions; the doubling of ingredient costs covers labor and overhead.
Posh Impressions, which sells decorative rubber stamps and scrapbook supplies over the Internet and at retail stores in Irvine and Brea, California, sets its stamp prices at cost times two, says co-owner Warren Gruenig.
Many entrepreneurs find such formulas easier than trying to figure out all their costs or surveying their customers. However, use any formula with caution. It may not cover all your actual costs--a quick path to financial disaster. Or you may cheat yourself out of some profits because customers may be willing to pay more than the formula dictates.
No formula can substitute for the one number you must know: how much it costs to make a product or deliver a service. This is your break-even point and your price floor.
4. Calculate backward. Some service providers and consultants start with the annual income they want, then calculate backward, says Roy Quick. If you work 40 hours a week all year and take a two-week vacation, you'll put in 2,000 hours. However, service businesses can't bill for every hour. In the first place, it's virtually impossible to schedule clients for every single hour of every single day all year. Second, you must do administrative tasks, marketing, bookkeeping and other duties for which you can't bill any customer.
The rule of thumb is that you will have 1,000 billable hours a year. If you want to gross $50,000, you have to bill $50 an hour. If you want a $50,000 profit, you must carefully calculate your costs and add that amount into your hourly rate.
5. Add wiggle room. Roy Quick recommends service providers add a little to their hourly rate "so you don't nickel and dime your clients to death. If a client calls us with a question that takes five minutes, we don't charge for that, but we do track those calls. Then if a client complains about the bill, we point out all the free services we gave all year."
6. Use "magic numbers." Psychology plays a role in pricing, says Kinnare of Timezone. "I go for magic numbers. All my watches are $19.99. When I first started, I charged $20.99, but they didn't sell as well as [at] $19.99."
Many retail items are priced at a digit less than a round number, such as $9.99 instead of $10 or $999 instead of $1,000, because the mind tends to perceive the difference as much greater than just a penny or a dollar.
7. Use introductory or limited-time pricing. Another quirk of the mind is that customers perceive your original prices to be the correct value for your products or services. If you start low and try to raise prices later, customers will balk. If you price high at first, you can always reduce prices or add extras later to attract more customers.
Homebased entrepreneurs sometimes run into customers who think their prices should be cheaper because they don't pay commercial rents, Axman says. But homebased businesses still have overhead that must be included in their prices.
Besides, Edith Quick adds, if you lowball your prices, then eventually move into a commercial location, you'll have to raise prices--and that can drive away customers.
8. Charge what the market will bear. The prices you calculate using formulas or adding up costs plus profit margin are your ideal prices. "We have to balance our ideal with what the market will pay," says candy-maker Johnson. "We do about 40 trade shows a year and see what customers are paying. If we're 40 percent higher [than the competition], then we'd better have something really special or drop our prices."
Just as your costs put a floor on your prices, consumers will establish the ceiling. Do market research before investing thousands of dollars in mass production, distribution and advertising. If you invent a product, make a prototype; then survey potential customers about the price they would pay for the item.
If your survey indicates people won't pay your break-even price, look at ways to cut your expenses. Or look for ways you can add value, such as better performance, higher quality, faster delivery time--whatever will make the product or service worth more in the customer's mind.
If you can't make your product or deliver your service for less than customers will pay, you're not ready to go into business.
9. Charge what you're worth. Many new business owners suffer from "lack of courage in pricing," says author Axman. But underpricing can backfire, she adds, because if your product or service is too cheap, clients may assume it's of poor quality.
Roy Quick agrees: "You have to bill at the rate you're worth. We tell [service business] clients `If you're as busy as you want to be, your prices need to go up.' Many start-ups aren't charging enough to succeed."
The art of pricing means achieving what you need by delivering the goods and services your customers want.
Add It Up
To price your product or service accurately, you must calculate your costs. Here's how:
1. Add up all costs.Fixed costs are constant no matter how much or how little you sell; they include rent, property taxes, insurance, advertising, depreciation and interest on loans. Variable costs fluctuate based on the amount you sell; they include labor, sales commission, office supplies and sales tax. Semivariable costs include telephone, electricity and postage.
2. Determine your break-even point.
BP = VC + FC + SC (break-even point equals variable costs plus fixed costs plus semivariable costs)
Example: If variable costs = $1,000, fixed costs = $1,000, and semivariable costs = $1,000, then break-even point = $3,000.
3. Calculate your cost per unit (products) or per hour
P = TC+M/N
Price equals total costs plus markup divided by number of units you expect to sell or hours it will take to complete a project
Example 1: total costs = $3,000; markup = 50% ($1,500); number of units = 10,000; price per unit = 45 cents.
Example 2: total costs = $3,000; markup = 50% ($1,500); number of hours to complete a project = 50; price (hourly rate) = $90
(Note: If market research indicates consumers won't pay this price, you have to cut costs, and/or reduce your markup, and/or increase the number of units you sell or reduce the time it takes to complete a project.)
Andi Axman, (603) 736-8056, email@example.com
Huckleberry Mountain Co., P.O. Box 15270, Jackson Hole, WY 83002, fax: (307) 739-9355
Posh Impressions, (800) 421-POSH, http://www.poshimpressions.com
Quick Tax & Accounting Service, fax: (314) 631-6722.