Pricing products or services is one of the most important decisions entrepreneurs make for their businesses. And, unfortunately, getting this right can be tricky. But paying attention to the five items below will help you to navigate these treacherous waters more smoothly.
1. Perceived value of your offering
What does your customer base perceive to be the value of your offering? This will establish the maximum price you can charge because a rational person will not pay more for something than the value he or she perceives.
Remember that it's perceived value that matters, not actual value. If the actual value of your offering exceeds perceived value, you may be able to change perception with a well-crafted marketing communication program. However, until the perception is changed, that factor will cap what you can charge.
2. Competitors' prices
If you’re selling a commodity (e.g., gas offered by two stations next door to each other), you won’t be able to charge meaningfully more than the competition. In this example, a difference in price of only a few pennies per gallon will shift significant volume.
But if your product or service is differentiated from your competition's in a way that at least some portion of the market finds desirable, you may be able to charge a premium vis à vis your competitors' price. One reason companies spend so much on marketing is to make sure that customers understand the things that differentiate their offering. This enables them to price much more closely to the product's or service's full value.
3. Cost structure
Focus first on variable costs. These are costs that go up as revenue increases (e.g., raw material, direct labor). Except in the case of loss leaders, the variable cost sets the floor for price. If you price below variable cost, you will lose money on every unit sold, and you can’t make that up in volume. Price minus variable cost is variable contribution (i.e., the amount of money you make on each unit you sell).
Next, focus on fixed costs. These costs remain constant as revenue grows (e.g., rent, utilities and overhead, such as accounting). Admittedly, all costs are variable with a large enough increase in revenue, but we’re talking about more modest changes. Fixed cost divided by variable contribution equals the number of units you have to sell to reach the break-even point (if you run a service business, think of units sold as hours billed).
If it isn’t reasonable for you to believe that you can sell this number of units, you’ll need to increase your price to survive.
4. Profit targets
Add your profit requirement (or target) to fixed cost and divide variable contribution to calculate the number of units you need to sell to achieve your profit objective. If it is reasonable to believe that you can achieve this number of units at the price you are planning to charge, great. If not, you may need to adjust your price either up or down.
Profit = Unit Volume X (Price – Variable Cost) – Fixed Cost
Economic theory says that as price goes up, volume will decrease. Over time, you can make adjustments to price and observe the impact on profit. If you lower price a bit, does your volume go up enough to result in a profit increase? Alternatively, if you raise price, can you maintain enough volume to increase profit? Continue to adjust your price until you find the point at which the profit is maximized.
5. Competitive response
Remember, you don’t make pricing decisions in a vacuum. Competitors will respond. So, reducing price may drive increased profit for a short time. However, if competitors match your price reduction, the result may be reduced profit for the entire industry. When making pricing decisions, be sure to factor in what you think your competitors will do.
Pricing your product or service can be tricky, but paying attention to these important factors can make the difference between a profit and a loss.