How to Price Your Products
Pricing a product is "probably the toughest thing there is to do," according to an expert. Here's how to tackle it.
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One of the secrets to business success is pricing your products properly. Price your products correctly and that can enhance how much you sell, creating the foundation for a business that will prosper. Get your pricing strategy wrong and you may create problems that your business may never be able to overcome.
"It's probably the toughest thing there is to do," says Charles Toftoy, associate professor of management science at George Washington University. "It's part art and part science."
There are a variety of different types of pricing strategies in business. However, there's no one surefire, formula-based approach that suits all types of products, businesses, or markets. Pricing your product usually involves considering certain key factors, including pinpointing your target customer, tracking how much competitors are charging, and understanding the relationship between quality and price. The good news is you have a great deal of flexibility in how you set your prices. That's also the bad news.
The following pages will detail how to meet your business goals in pricing products, what factors to consider when pricing, and how to determine whether or raise or lower your prices.
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How to Price Your Products: Meeting Business Goals
Get Clear about Making Money
The first step is to get real clear about what you want to achieve with your pricing strategy: You want to make money. That's why you own a business. Making money means generating enough revenue from selling your products so that you can not only cover your costs, but take a profit and perhaps expand your business.
The biggest mistake many businesses make is to believe that price alone drives sales. Your ability to sell is what drives sales and that means hiring the right sales people and adopting the right sales strategy. "The first thing you have to understand is the selling price is a function of your ability to sell and nothing else," says Lawrence L. Steinmetz, co-author of How to Sell at Margins Higher Than Your Competitors : Winning Every Sale at Full Price, Rate, or Fee (Wiley 2005) and a business consultant in Boulder, Colo. for 40 years. "What's the difference between an $8,000 Rolex and a $40 Seiko watch? The Seiko is a better time piece. It's far more accurate…. The difference is your ability to sell."
At the same time, be aware of the risks that accompany making poor pricing decisions. There are two main pitfalls you can encounter – under pricing and over pricing.
- Under pricing. Pricing your products for too low a cost can have a disastrous impact on your bottom line, even though business owners often believe this is what they ought to do in a down economy. "Accurately pricing your product is critical at any point in the economic cycle but no more so than in a recession," says Laura Willett, a small business consultant and faculty member in the finance department at Bentley College in Waltham, Mass. "Many businesses mistakenly under price their products attempting to convince the consumer that their product is the least expensive alternative hoping to drive up volume; but more often than not it is simply perceived as 'cheap." Remember that consumers want to feel that they are getting their "moneys worth" and most are unwilling to purchase from a seller they believe to have less value, Willett says. Businesses also need to be very careful that they are fully covering their costs when pricing products. "Reducing prices to the point where you are giving away the product will not be in the firm's best interest long term," Willett says.
- Over pricing. On the flip side, overpricing a product can be just as detrimental since the buyer is always going to be looking at your competitors pricing, Willett says. Pricing beyond the customer's desire to pay can also decrease sales. Toftoy says one pitfall is that business people will be tempted to price too high right out of the gate. "They think that they have to cover all the expenses of people who work for them, the lease, etc. and this is what price it takes to do all that," he says. "Put yourself in the customer's shoes. What would be a fair price to you?" He advises taking little surveys of customers with two or three questions on an index-card-sized form, asking them whether the pricing was fair.
Understand Your Other Business Priorities
There are other reasons to go into business. Understand what you want out of your business when pricing your products. Aside from maximizing profits, it may be important for you to maximize market share with your product -- that may help you decrease your costs or it may result in what economists call "network effects," i.e. the value of your product increases as more people use it. (A great example of a product having network effect is Microsoft's Windows operating system. When more people began to use Windows over rival products, more software developers made applications to run on that platform.)
You may also want your product to be known for its quality, rather than just being the cheapest on the market. If so, you may want to price your product higher to reflect the quality. During a downturn, you may have other business priorities, such as sheer survival, so you may want to price your products to recoup enough to keep your company in business.
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How to Price Your Products: Factors to Consider
"There are many methods available to determine the 'right' price," Willett says. "But successful firms use a combination of tools and know that the key factor to consider is always your customer first. The more you know about your customer, the better you'll be able to provide what they value and the more you'll be able to charge."
Know Your Customer
Undertaking some sort of market research is essential to getting to know your customer, Willett says. This type of research can range from informal surveys of your existing customer base that you send out in e-mail along with promotions to the more extensive and potentially expensive research projects undertaken by third party consulting firms. Market research firms can explore your market and segment your potential customers very granularly -- by demographics, by what they buy, by whether they are price sensitive, etc.. If you don't have a few thousand dollars to spend on market research, you might just look at consumers in terms of a few distinct groups -- the budget sensitive, the convenience centered, and those for whom status makes a difference. Then figure out which segment you're targeting and price accordingly.
Know Your Costs
A fundamental tenet of pricing is that you need to cover your costs and then factor in a profit. That means you have to know how much your product costs. You also have to understand how much you need to mark up the product and how many you need to sell to turn a profit. Remember that the cost of a product is more than the literal cost of the item; it also includes overhead costs. Overhead costs may include fixed costs like rent and variable costs like shipping or stocking fees. You must include these costs in your estimate of the real cost of your product.
"Come up with X first. X is your cost of raw materials, labor, rent, and everything it took to make the product so that if you sold it you would break even," advises Toftoy. "Y becomes what you think you need to make on it. That may depend on your business. Restaurants overall make about 4 percent, which is pretty low. If you want 10 percent then you factor that into your costs and that is what you charge."
Many businesses either don't factor in all their costs and under price or literally factor in all their costs and expect to make a profit with one product and therefore overcharge. A good rule of thumb is to make a spread sheet of all the costs you need to cover every month, which might include the following:
