Setting a price is one of the most important yet difficult decisions to make when starting a business. Price sends a message about the value, quality, longevity and scarcity of a product or service.
Setting a price should be based primarily in logic, although, it isn’t an exact science and it may take some trial and error to find a strategy that works for your business. There is often a delicate balance between sales, profits, and what your competition is doing. As the business grows and shifts, so will your price so constantly evaluate if your pricing strategy is working for you. Setting a price too low won’t generate profits or cover your costs; setting a price too high might drive potential buyers away.
Industry trends and costs, market segmentation, goals and objectives of the business, and distribution methods all impact price.
Have a rationale or formula behind your prices by basing it off one of three basic types of pricing:
- Cost-based: price = costs + margin
- Value-based: price = costs + worth of product to a particular market
- Market-based: Price = Based on competitors
The difference between the cost of the product and the price is called the margin.
In order to decide which type of pricing best serves your goals, consider four main factors: cost, competition, customer and cash flow.
What costs are incurred by producing and delivering your offering? If you have multiple products or services, start with three you think will be the most profitable.
- List your variable costs – costs that change relative to volume and easily break down to cost per unit.
- List your fixed costs – costs that are generally the same throughout the year, paid in lump sum and are easy to predict, but often hard to determine how much to attribute to each unit.
- Do not to charge anything less than your breakeven point – the variable cost per unit + fixed cost per unit. You do not make money at your breakeven point.
Prices can be set based on the perceived value of the offering, in addition to the cost. The more innovative your product is, the harder it will be to determine value. Value-based pricing asks these questions in the following order:
- What segment am I targeting? Every segment will have a different understanding of what value my product brings.
- What is the next best alternative if my product was unavailable?
- Compared to the next best alternative, what features do I have that are unique or superior?
- What are those features worth, in dollars?
Existing competitors provide an idea of prices the market is familiar with. Depending on how many competitors you have, customers may have many options to choose from or only a few providers. Once you analyze your competitors’ price and value, think about where you want to position yourself relative to them. This is called benchmarking.
Setting your price in the same range is best when you have an established client base or if you know you will have a large piece of the market or when there are many competitors with a few main leaders. This is also called the going rate.
Higher prices are justifiable when your product differs significantly from what others are offering. Customers often associate a high price with quality but may not believe that the benefit is worth the expense. Price skimming is often practiced with innovative and higher priced products by first targeting the most affluent customers and moving down as you saturate each income level.
Lower prices attract customers who want to save money. It is a good strategy to use when you are trying to break into a market. If your price is too low; you run the risk of having to increase it later and convince customers to accept this change. Customers may associate a low price with poor quality. If you want to move large volumes, lower prices will play to your advantage.
Customers have access to an infinite amount of research, reviews and other information. This is why segmentation is a key activity of setting a price. Customers are motivated by different values, beliefs, experiences, and access to resources like money and time.
Offering different versions of a product at different price points to appeal to a wider range of customers is called versioning. A new buyer may choose the lowest priced good or service but eventually prefer an increased level of quality and/or value. Many lawyers and accountants implement this strategy.
Offering a variety of prices for the same product or service to various groups of customers is called differentiation. An example of differential pricing is restaurants’ charging senior, student or child pricing for the same offering.
Offering multiple products or services for one attractive comprehensive price and package is called bundling, and is a good way to increase sales when you need to reduce inventory or upsell. Some customers perceive economic advantage when buying in bulk and is most beneficial for higher priced items. An example is charging for cell phone bills, internet and TV subscription all together.
Some businesses have loss leaders, which is a product or service that actually loses money, but requires or convinces the buyer to purchase additional products or services to fully experience the loss leader. The profits from the additional products or service cover the cost of producing the loss leader. An example of this is the iPhone and the subsequent earphones, chargers, apps and protective cases that you may purchase in addition to the phone.