The Middle Of The Road

Strike a perfect balance when setting your prices to make ahigher profit.

By Jacquelyn Lynn

It's a question that's critical to your start-up processand a factor that will always be an issue in your operation: Howmuch should you charge for your products or services? The dynamicsof today's business environment--fluctuating costs,value-conscious customers, and strong competition--make the pricingdecision more challenging than ever.

The consequences of a poor pricing strategy are obvious: Pricingtoo high may limit your sales, while pricing too low may limit yourprofits.

S. P. Raj, professor of marketing at Syracuse University Schoolof Management in Syracuse, New York, says it's easy for newbusiness owners to fall into the trap of overpricing. "Theyoften feel their product deserves a higher price than it reallydoes on the market," he says. "There's also thetemptation to try and recoup all your expenses as quickly aspossible, not realizing that when the product is overpriced, demandgoes down." Recognize the influence emotional attachments andfinancial pressures have on your pricing policies, and balance themwith sound business decisions.

Underpricing carries its own set of consequences. In addition tothe impact on profits, not charging enough can create theperception of poor quality, Raj says. On the other hand, reducingthe financial risk with a lower price could provide the necessarymotivation for many new customers to try your product.

As you struggle with the pricing process, you may feel likeyou're looking for a magic number that will deliver both salesand profits. As frustrating as it may be, take comfort: Effectivepricing is more logic than magic.

Understanding the costs involved in running your business is anessential element of sound pricing and profitability. Consider whatyou must spend to produce what you are selling (also known as thecost of goods sold, which typically includes raw materials, laborand freight) as well as your overhead expenses (facilities,administration, etc.). Once you know the actual cost of each unit,you can determine how much profit to add to arrive at the sellingprice--and this is the part that gets tricky.

How much you add depends on the pricing strategy you choose.There are four basic methods, all of which apply to both tangibleproducts and services:

*Cost-plus pricing. Once you've calculated the cost ofthe product, you add the amount of profit you want to make toarrive at the sale price.

*Demand pricing. Using this method, prices are determined bya combination of sales volume (what you actually sell, measured inunits or dollars) and desired profit (how much profit you make onthose sales dollars after the costs of goods and doing businesshave been subtracted). The process requires the ability tocalculate in advance what price will generate the optimum ratio ofprofit to volume.

*Competitive pricing. When the market has alreadyestablished the price for your product, it's wise to operatewithin that range. Study each competitor carefully to identify theprices they are charging. You should also determine the degree ofprice awareness among consumers.

*Markup pricing.
Some manufacturers, wholesalers and retailerssimply add a set amount (the markup, usually expressed as apercentage of cost) to the cost of a product to reach the finalprice.

You may find the most effective pricing method is a combinationof two or more of the basic strategies. Ernest J. Florestano usedcost-plus and competitive pricing when deciding what to charge forthe magnetic water-treatment devices his Norfolk, Virginia-basedcompany, Descal-A-Matic, manufactures.

"We did market research to find out what our competitorswere charging, then did cost-plus calculations," Florestanoexplains, "and determined we could price our product in themidrange of the market and still achieve our profit goal."

Pricing is More ThanArithmetic

Beyond the numeric calculations, pricing involves a solidknowledge of your industry and a clear picture of the position youplan to take in the marketplace. In fact, pricing is a crucialelement of your overall marketing strategy.

"There is a direct and strong relationship between theprices you charge and the image of your company," says ErinO'Donnell of Pepper, O'Donnell & Co. Inc., a marketingand public relations firm in Winter Park, Florida. "Forexample, do you want to be viewed as a no-frills, low-costoperation, or as a high-end, full-service company? One is notnecessarily better--or more profitable--than the other. What isimportant is that your pricing structure be compatible with theimage you want to create."

O'Donnell recalls a client whose sales rose dramaticallywhen he increased his prices. "He was a consultant, and hisproduct was information," she says. "In the lower pricerange, it had a lower perceived value--that is, his clients thoughtthat what he had to offer couldn't be worth much if he wascharging so little for it. But when he started charging more, theperceived value went up, too--and so did his sales."

While it's important to consider the perception of themarketplace, O'Donnell stresses that a strategy of raisingprices to increase sales won't work for every product."Once you've decided on a price, do some market researchand testing on a sample market before you do a full-scale productintroduction," she advises. "Testing gives you room tomake adjustments in either direction if you need to."

Remember that pricing is an ongoing process. Regularly evaluateyour prices and be prepared to change them if necessary orappropriate. If yours is a business that includes making writtenbids and proposals, O'Donnell advises guaranteeing your pricesfor a specified time.

"Raw material prices can be extremely volatile," shesays. "Your business may be able to absorb small increases,but major cost jumps can wipe out your profits. Ask your suppliershow long they will guarantee their price levels, and then do thesame for your customers."

Finally, O'Donnell says, if you choose to make price a keyselling point, be prepared for fierce competition. "Customerswho come to you strictly for price will leave you for a betterprice," says O'Donnell. "Certainly, most industriesare extremely cost-competitive, but give your customers more thanprice as a reason to buy from you."

Food For Thought

The Entrepreneur Magazine Small-Business Advisor (JohnWiley & Sons Inc., $19.95, 800-225-5945).

American Entrepreneurs Association (AEA) gives members access tosmall-business information and a network of small-business owners.For information, write to 2392 Morse Ave., Irvine, CA 92614, orcall (800) 864-6868.

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