Small business owners are often stymied by the concept of pricing. The other elements of Marketing; namely, Product, Promotion and Place, typically receive more attention to the detriment of many a business. Since this is such a critical topic for business success, Cybertary will be featuring a different aspect of pricing over the next several newsletters. We will cover the factors that contribute to setting your pricing, the different strategies you may choose to employ, and some of the pitfalls and things to avoid in your pricing strategies.
In this, the second article in the series, we are taking time to cover some strategic elements that you may want to consider as you develop your Pricing.
Whether you are selling a service or a product, using a brick and mortar storefront or a glitzy on-line presence, the one fundamental lesson in business is ‘if you don’t make a profit, there really is no reason to be in business’. The business of business is making money.
There are three fundamentals that need to be taken into account when you set your prices. They are:
• The direct cost of the product or service—what it actually costs you to supply the product or service
• The amount of “other” costs that need to be covered to achieve break even. Your total cost would include all other direct and indirect costs, many of which may have a variable component based on volume. This would include Marketing expenses, Costs for office space, Equipment, Technology, Advertising and promotion, Staff (include taxes, benefits, as well as salary!), Owner or principal salary and benefits (including taxes), Insurance expenses, and to quote Yul Brynner, etcetera, etcetera, etcetera. Here is where you really need to get the calculators smoking or hire a good Cost Accountant to help you understand all of the fixed and variable components that go into running your business.
• The competitive forces in your market that may throttle, either up or down, your margin—this would take into account the prevailing prices in the marketplace that could influence your profit.
Once you have your cost structure understood, then you can explore the various methods for setting your price. Here are some of the classic methods:
Cost Plus
With Cost plus pricing, you take all of your costs, both fixed and variable, and allow for a profit margin. For example, if the product costs $10 to manufacture (fixed) and your variable overhead is $5 per unit and you want to operate at a 20% margin, you can sell the product for $18 each. As long as you accurately predicted your costs and volumes, you will be able to operate at a profit with the cost plus methodology.
Target Return Pricing
With target return pricing, you are achieving a specific Return on Investment or ROI. For example, let’s assume that you have $100,000 invested in the company for your product that costs you $15 to produce. Your expected sales volume is 10,000 units in the first year. You want to recoup all your investment in the first year, so you need to make $100,000 profit on 10,000 units, or $10 profit per unit, giving you a price of $25 per unit (vs. $18 with cost plus).
Margin or Mark-Up
Margin is different from mark-up but most people use them interchangeably. To understand the differences you need to get proficient in the use of percentages. With percentage Margin, the percent of the final selling price that is profit is the target; a markup is the percentage that you add to the cost basis for the product to derive the selling price. With margin pricing you divide your cost by 1- target %; markup is the cost times the target percent.
A selling price with a margin of 25% results in more profit than a selling price with a markup of 25%. Here is an example: If the product or service costs you $100 each, a 25% margin results in a price to the consumer of $133 versus the 25% markup yielding a price to the consumer of $125.
Value Pricing
Price your product based on the value it creates for the customer. This is usually the most profitable form of pricing, if you can achieve it. The most extreme variation on this is “pay for performance” pricing for services, in which you charge on a variable scale according to the results you achieve or a negotiated incentive. Let’s assume that your product saves the typical customer $1,000 a year in technology costs. In that case, $50 seems like a bargain – but it may fall into the category of “too good to be true”. If your product reliably produces documented cost savings of 2 to 3 times its price to the consumer, you could easily charge $200, $300 or more for it. The customer would realize the tangible return of paying for the product in a matter of a few months and thus, would gladly pay it.
Psychological or Perception Pricing
This type of pricing is based on factors such as the perceived quality of the goods or services and may take into consideration other factors, such as popular price points and what the consumer perceives to be fair. This is one of the reasons that a high popular steak house can charge upwards of $40 for a filet that you may be able to purchase and cook on your backyard grill for $10. The perceived value of the aged, corn fed, organic beef purveyed by Morton’s or Ruth Chris from their exclusive sources supports prices that we may otherwise consider to be outrageous for a hunk ‘o meat. Of course, they combine the meat itself with an overall dining ‘experience’ to help validate our perceptions.
Rule of Thumb Pricing
Some industries use a specific mark-up based on historical trends in that industry. For some industries, the seller simply takes their wholesale cost (let’s say $50) and charges 100% mark up, resulting in the price of $100. This is a simplistic method, but one that may not be appropriate for all businesses. Typically, the more mature the business or industry, the more likely they may employ this methodology, as it is often the result of years of experience.
We have only covered the typical methodologies that most businesses employ to set their prices. Some businesses cobble together variations of multiple methods. You can see that there are many approaches to small business pricing, some more scientific and systematic than others. But the bottom line is that they all consider the competition, the market climate, quality and quantity of inventory, uniqueness of the product or service and the effective value to the customer or client relative to alternative products or services – not to mention the cost of producing the product or service.
Be prepared to test your small business pricing strategy and be open to change it if the situation warrants.
*Many thanks to JoAnn Forrester, President, S.I. Business Associates, for sharing her wealth of insight and knowledge on pricing as well as the title for this series.
