Your customer needs to find that your price falls within their range of what’s acceptable, and your ability to price is constrained by your costs.
In the chart below, the floor of your pricing is your total costs for what you’re selling. The ceiling, or highest price, is the number at which your customer values your offer. Above this price, you lose the sale because the customer feels that your price exceeds the value he or she gets from your offer.
Between the floor and ceiling sits a price your customer will find acceptable.
Price floor and price ceilingEnlarge the image
Source: Eric Dolansky
To choose the right price within your customer’s acceptable range, consider the main factors that affect price:
Choosing the right pricing strategy
1. Cost-plus pricing
Many businesspeople and consumers think that cost-plus pricing, or mark-up pricing, is the only way to price. This strategy brings together all the contributing costs for the unit to be sold, with a fixed percentage added onto the subtotal.
Dolansky points to the simplicity of cost-plus pricing: “You make one decision: How big do I want this margin to be?”
The advantages and disadvantages of cost-plus pricing
Retailers, manufacturers, restaurants, distributors and other intermediaries often find cost-plus pricing to be a simple, time-saving way to price.
Let’s say you own a hardware store offering a large number of items. It would not be an effective use of your time to analyze the value to the consumer of each nut, bolt and washer.
Ignore that 80% of your inventory and instead look to the value of the 20% that really contributes to the bottom line, which may be items like power tools or air compressors. Analyzing their value and prices becomes a more worthwhile exercise.
The major drawback of cost-plus pricing is that the customer is not taken into consideration. For example, if you’re selling insect-repellent products, one bug-filled summer can trigger huge demands and retail stockouts. As a producer of such products, you can stick to your usual cost-plus pricing and lose out on potential profits or you can price your goods based on how customers value your product.
2. Competitive pricing
“If I’m selling a product that’s similar to others, like peanut butter or shampoo,” says Dolansky, “part of my job is making sure I know what the competitors are doing, price-wise, and making any necessary adjustments.”
That’s competitive pricing strategy in a nutshell.
You can take one of three approaches with competitive pricing strategy:
In co-operative pricing, you match what your competitor is doing. A competitor’s one-dollar increase leads you to hike your price by a dollar. Their two-dollar price cut leads to the same on your part. By doing this, you’re maintaining the status quo.
Co-operative pricing is similar to the way gas stations price their products for example.
The weakness with this approach, Dolansky says, “is that it leaves you vulnerable to not making optimal decisions for yourself because you’re too focused on what others are doing.”
“In an aggressive stance, you’re saying ‘If you raise your price, I’ll keep mine the same,’” says Dolansky. “And if you lower your price, I’m going to lower mine by more. You’re trying to increase the distance between you and your competitor. You’re saying that whatever the other one does, they better not mess with your prices or it will get a whole lot worse for them.”
Clearly, this approach is not for everybody. A business that’s pricing aggressively needs to be flying above the competition, with healthy margins it can cut into.
The most likely trend for this strategy is a progressive lowering of prices. But if sales volume dips, the company risks running into financial trouble.
If you lead your market and are selling a premium product or service, a dismissive pricing approach may be an option.
In such an approach, you price as you wish and do not react to what your competitors are doing. In fact, ignoring them can increase the size of the protective moat around your market leadership.
Is this approach sustainable? It is, if you’re confident that you understand your customer well, that your pricing reflects the value and that the information on which you base these beliefs is sound.
On the flip side, this confidence may be misplaced, which is dismissive pricing’s Achilles’ heel. By ignoring competitors, you may be vulnerable to surprises in the market.
3. Price skimming
Companies use price skimming when they are introducing innovative new products that have no competition. They charge a high price at first, then lower it over time.
Think of televisions. A manufacturer that launches a new type of television can set a high price to tap into a market of tech enthusiasts (early adopters). The high price helps the business recoup some of its development costs.
Then, as the early-adopter market becomes saturated and sales dip, the manufacturer lowers the price to reach a more price-sensitive segment of the market.
Dolansky says the manufacturer is “betting that the product will be desired in the marketplace long enough for the business to execute its skimming strategy.” This bet may or may not pay off.
Risks of price skimming
Over time, the manufacturer risks the entry of copycat products introduced at a lower price. These competitors can rob all sales potential of the tail-end of the skimming strategy.
There is another earlier risk, at the product launch. It’s there that the manufacturer needs to demonstrate the value of the high-priced “hot new thing” to early adopters. That kind of success is not a given.
If your business markets a follow-up product to the television, you may not be able to capitalize on a skimming strategy. That’s because the innovative manufacturer has already tapped the sales potential of the early adopters.
4. Penetration pricing
“Penetration pricing makes sense when you’re setting a low price early on to quickly build a large customer base,” says Dolansky.
For example, in a market with numerous similar products and customers sensitive to price, a significantly lower price can make your product stand out. You can motivate customers to switch brands and build demand for your product. As a result, that increase in sales volume may bring economies of scale and reduce your unit cost.
A company may instead decide to use penetration pricing to establish a technology standard. Some video console makers (e.g., Nintendo, PlayStation, and Xbox) took this approach, offering low prices for their machines, Dolansky says, “because most of the money they made was not from the console, but from the games.”
No matter what type of product you sell, the price you charge your customers or clients will have a direct effect on the success of your business. Though pricing strategies can be complex, the basic rules of pricing are straightforward:
Before setting a price for your product, you have to know the costs of running your business. If the price for your product or service doesn't cover costs, your cash flow will be cumulatively negative, you'll exhaust your financial resources, and your business will ultimately fail.
To determine how much it costs to run your business, include property and/or equipment leases, loan repayments, inventory, utilities, financing costs, and salaries/wages/commissions. Don't forget to add the costs of markdowns, shortages, damaged merchandise, employee discounts, cost of goods sold, and desired profits to your list of operating expenses.
Most important is to add profit in your calculation of costs. Treat profit as a fixed cost, like a loan payment or payroll, since none of us is in business to break even.
Because pricing decisions require time and market research, the strategy of many business owners is to set prices once and "hope for the best." However, such a policy risks profits that are elusive or not as high as they could be.
When is the right time to review your prices? Do so if:
Prices are generally established in one of four ways:
To use competitive pricing effectively, know the prices each competitor has established. Then figure out your optimum price and decide, based on direct comparison, whether you can defend the prices you've set. Should you wish to charge more than your competitors, be able to make a case for a higher price, such as providing a superior customer service or warranty policy. Before making a final commitment to your prices, make sure you know the level of price awareness within the market.
If you use competitive pricing to set the fees for a service business, be aware that unlike a situation in which several companies are selling essentially the same products, services vary widely from one firm to another. As a result, you can charge a higher fee for a superior service and still be considered competitive within your market.
$40 ? $100 = 40%
This pricing method often generates confusion--not to mention lost profits--among many first-time small-business owners because markup (expressed as a percentage of cost) is often confused with gross margin (expressed as a percentage of selling price). The next section discusses the difference in markup and margin in greater depth.
Overhead Expenses. Overhead refers to all nonlabor expenses required to operate your business. These expenses are either fixed or variable:
Cost of Goods Sold. Cost of goods sold, also known as cost of sales, refers to your cost to purchase products for resale or to your cost to manufacture products. Freight and delivery charges are customarily included in this figure. Accountants segregate cost of goods on an operating statement because it provides a measure of gross-profit margin when compared with sales, an important yardstick for measuring the business' profitability. Expressed as a percentage of total sales, cost of goods varies from one type of business to another.
Normally, the cost of goods sold bears a close relationship to sales. It will fluctuate, however, if increases in the prices paid for merchandise cannot be offset by increases in sales prices, or if special bargain purchases increase profit margins. These situations seldom make a large percentage change in the relationship between cost of goods sold and sales, making cost of goods sold a semivariable expense.
Determining Margin. Margin, or gross margin, is the difference between total sales and the cost of those sales. For example: If total sales equals $1,000 and cost of sales equals $300, then the margin equals $700.
Gross-profit margin can be expressed in dollars or as a percentage. As a percentage, the gross-profit margin is always stated as a percentage of net sales. The equation: (Total sales ? Cost of sales)/Net sales = Gross-profit margin
Using the preceding example, the margin would be 70 percent.
($1,000 ? $300)/$1,000 = 70%
When all operating expenses (rent, salaries, utilities, insurance, advertising, and so on) and other expenses are deducted from the gross-profit margin, the remainder is net profit before taxes. If the gross-profit margin is not sufficiently large, there will be little or no net profit from sales.
Some businesses require a higher gross-profit margin than others to be profitable because the costs of operating different kinds of businesses vary greatly. If operating expenses for one type of business are comparatively low, then a lower gross-profit margin can still yield the owners an acceptable profit.
The following comparison illustrates this point. Keep in mind that operating expenses and net profit are shown as the two components of gross-profit margin, that is, their combined percentages (of net sales) equal the gross-profit margin:
Markup and (gross-profit) margin on a single product, or group of products, are often confused. The reason for this is that when expressed as a percentage, margin is always figured as a percentage of the selling price, while markup is traditionally figured as a percentage of the seller's cost. The equation is:
(Total sales ? Cost of sales)/Cost of sales = Markup
Using the numbers from the preceding example, if you purchase goods for $300 and price them for sale at $1,000, your markup is $700. As a percentage, this markup comes to 233 percent:
$1,000 ? $300 ? $300 = 233%
In other words, if your business requires a 70 percent margin to show a profit, your average markup will have to be 233 percent.You can now see from the example that although markup and margin may be the same in dollars ($700), they represent two different concepts as percentages (233% versus 70%). More than a few new businesses have failed to make their expected profits because the owner assumed that if his markup is X percent, his or her margin will also be X percent. This is not the case.