Is Your Price Right?
Pricing products is something every businessperson thinks about. You don't want to price yourself out of the market, but at the same time you want to provide sufficient margin to cover overhead and generate a profit. Therefore, in pricing your products you must consider these two factors: what the market will bear and your profit margins. These factors apply to pricing both products and services.
To find out what the market will bear, ask yourself this question: Is my product or service unique? If it is--meaning there's little in the way of direct and indirect competition--then you're a market leader and you have more leeway in setting the prices.
Just because your product is unique, however, doesn't mean you can charge very high prices. When you have a unique product and you set your prices high, your customers can still pick an alternative product or not buy at all. In addition, your high margins may give incentives to competitors to copy your product and then undercut your price. Take, for example, Apple Computer: The product was unique, the company charged very high prices and it was the market leader. Of course there were other factors that led to Apple losing market share, but one factor was that new entrants like Dell and Compaq offered alternative products at better prices.
You can be a market leader if you sell a product that is not necessarily unique, but where you are the only available outlet for that product. If you've ever been on a cruise ship and visited the on-board convenience store, you know what I mean.
If you are a market follower--meaning your product is not necessarily unique and you're not the only outlet--then setting prices is easy. Your prices simply can't be higher than that of your closest competitor. The question you should then ask is this: Should I be selling this product? The answer lies in your profit margin for this product.
There are three different profit margin calculations one should consider: direct costs margin, break-even pricing and profit pricing.
The direct costs margin is the margin generated after paying for costs that are directly associated with the product or service being sold. Examples include costs of sales, commissions and so on. The formulas for direct costs margin and direct costs margin percent are:
direct costs margin = sales price - total direct
direct costs margin % = direct costs margins / sales price x 100%
You can also use the direct cost margin percent to calculate the break-even volume as follows:
break-even volume = (fixed costs / direct cost margin %) / selling price
You must at least cover direct costs to continue carrying the product. You may accept a price that is greater that direct costs in the short-term (such as a slow month). Over the long term, however, you must also cover your fixed costs and generate a profit--otherwise, you're just trading dollars.
Fixed costs are costs that do not fluctuate with sales volume like rent, depreciation, administrative employees and so on. Break-even pricing is related to the break-even point, but instead of having the volume as the variable, selling price is the variable as follows:
break-even price = direct costs / unit + fixed costs / volume
Setting the price at the break-even price will give you a profit of 0. If you're at least getting the break-even price, at least you're not losing money on the sale. However, all that work and investment still won't pay off. Which brings us to profit pricing, which is calculated as follows:
profit price = direct costs / unit + (fixed costs + desired profit) / volume
So now you have a price that will make you a profit. Ask yourself this: Can I sell my products and services at this price and still be competitive? If the answer is no, then you have two alternatives: lower your direct costs, fixed costs or desired profit, or consider not selling this product and focus your attention instead on products that have a better profit margin or less competition.
Ian Benoliel is the CEO of NumberCruncher.com Inc., a developer of budgeting, manufacturing and management software for entrepreneurial businesses. NumberCruncher combines its accounting and finance expertise with technological know-how to deliver software that is affordable and easy to use, yet sophisticated and powerful. More information on the NumberCruncher's products and services is available at www.numbercruncher.com. Ian has nearly two decades of business, accounting and financial consulting experience. He has advised corporations on business plans, financial projections and accounting computer systems.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.