The pricing of goods and services is almost always determined by demand, which creates the market or confirms an offering as legitimate, by competition, which lowers prices when present and increases them by its absence, and, finally, by the cost of producing the item or providing the service. A good deal of mythology and mystification surrounds the subject of pricing, but these fundamental relationships enable the business owner to price his or her goods correctly without either gouging or leaving too much on the table.
At the most fundamental level a sale is the consequence of an auction in which the price is set by bidding. If the highest bid is not high enough, the seller will not sell. If no one bids, there is no price. The rarer and the more valuable an object is (i.e., the higher the demand relative to supply) the higher the price. The more common the good and the more sluggish the demand for it, the lower the price—but objects will not be sold below the seller's cost except under unusual circumstances.
Bidding for every little thing in an open auction is, of course, very inefficient. For this reason pricing methods have evolved but still represent, as it were, a kind of ritualized and very slow-motion auction. Prices will rise or drop depending on demand. Demand will rise and fall depending on supply. But while this happens instantly in live-auctions, it takes place almost imperceptively in normal commerce.
PRICING A GOOD
The price of a good or of a service (hereafter we'll mean both by simply saying "product") is its total cost for the seller plus a profit margin over and above this cost the purpose of which is to keep the business in business. The cost will be the cost, of course. The profit margin will depend on the strength of the demand and the intensity of the competition. To be sure, pricing is dynamic. If a seller discovers that consumers like a product but will not pay the price, this often acts as feedback. The seller will attempt to reduce the cost as much as possible while attempting to maintain quality high enough still to command consumer interest. One modern technique of cost-reduction is to buy goods from regions where labor costs are low—and this strategy has created the discounting and outsourcing phenomena so prevalent in the mid-2000s.
Ideally the seller will select a location and an "ambiance" appropriate to the products sold. Ideally the seller will understand his or her turnover of goods well enough to know which lines sell sufficient quantities to maintain the store in business and which products, even if slower-moving, provide the extra margin of profitability. Ideally the seller will be sufficiently aware of the effective competition, namely that likely directly to compete with him or her, and the prices charged by that competition.
Common mistakes in pricing arise from careless tracking of overhead costs, product mix, changing consumer preference, and competitors' behavior. If the out-of-pocket costs of products sold have been declining and the merchant is in the habit of marking things up by a standard percentage, the new pricing may not absorb the total overhead, especially if overhead has been growing. The merchant may also overprice if costs have been rising; a standard mark-up will now produce more than overhead costs and the usual profit—but customers may no longer buy as readily. In service operations where bidding on jobs is common, careless and mechanical methods of estimation may sometimes result in seriously underbidding difficult jobs because the owner or salesperson didn't want to bother getting the ladder out and climbing a roof—or an analyst has failed to make five preliminary phone calls to really understand how easy or difficult it will be to get the information a customer wishes to have collected.
Good pricing behavior is therefore dependent on—
- Detailed and up-to-date knowledge of costs beyond the cost of the actual item, i.e., overhead cost and how it is changing. Increases in rent, salaries, benefits, utilities, and services must be noted immediately and a running overhead rate must be available monthly in updated format.
- Product knowledge including, in some categories, the "service" costs a product is likely to demand after its sale. Selling a computer installation may require a certain number of hours spent on the telephone after installation just in holding customers' hands. This cost must be known in advance.
- Careful and detailed estimating of technical and services sales, sometimes including quick studies and tests and/or visits and close inspections in order to understand jobs fully.
- Current knowledge of competitor pricing.
- A deep understanding of the product mix sold with special attention to that mix of products which carries the business. A specialty grocer may "carry" the store by selling dairy products, bread, cereals, soups, and fresh produce. The expensive meat counter with expert butchers may simply be paying for itself but may be the very reason why customers put up with the limited parking. The real profit may come from the company's extensive line of wines for which its customers are willing to pay a premium. For good pricing strategy, all this must be known.
- Close and detailed knowledge of vendors' offerings to identify unusual opportunities.
Pricing itself is a form of communication. Not surprisingly, many different kinds and flavors of pricing strategy exist. Major categories include the following.
Manufacturer's Suggested Retail Price
Many small businesses prefer to price their goods in accordance with the manufacturer's suggested retail price. In some cases this is forced on the business because the price is prominently printed on the packaging. Going below it is possible, but going above it is almost impossible. Where such pricing is literally suggested, not printed, the business adopting this approach without analysis can make mistakes.
This is the practice of giving the customers the option of buying several items or services for a single price. A furniture retailer might offer customers a sofa and love seat combination at a price somewhat lower than the two goods would cost if bought separately. Similarly, a landscaper might lure customers by offering two free months of lawn maintenance with any major landscaping job. These approaches, all pricing approaches, depend on precise pricing, at least for internal purposes, of each item—and good ability to predict volume changes due to the strategy.
Similar to price bundling, multiple pricing is the practice of selling multiples of a unit for a single price—two for the price of one, $10 for 10, and endless combinations. This sort of pricing is used for moving low-cost items in that few people will buy three cars for the price of two—even if offered.
This method is the standard method of pricing everything initially, as described above. It combines all direct costs, apportions overhead to each product, and then adds the necessary profit margin, the "plus." Cost-plus should be the foundation on which all else is based.
Some small business owners choose to base their own prices on the prices of their principal competitors. Business owners who choose to follow this course, however, should make sure that they look at competing businesses of similar size and strength. Competitive pricing among service-oriented businesses is more difficult to achieve, first because competitive pricing is difficult to discover and second because service jobs are more more variable than identical products spat out three a second by an automated system.
Pricing Above Competition
Oddly enough this strategy is used both in very up-scale and in rather poor areas. In the first the high income of the population permits an upward bias and is in part justified by providing convenience and ambiance. In poor neighborhoods prices are frequently higher than in middle-class neighborhoods because accessible outlets are few, the population has less access to transportation, and the merchant can therefore use his or her presence alone as a wedge and leverage. "Ghetto" pricing tends often to be of this nature, alas.
Pricing Below Competition
Pricing below competition is the practice of setting one's prices below those of its competitors. Commonly employed by major discount chains such as Wal-Mart—which can do so because its purchasing power enables it to save on its costs per unit—this strategy can also be effectively used by smaller businesses in some instances (though not when competing directly with Wal-Mart and its ilk), provided they keep their operating costs down and do not spark a price war. Indeed, the smaller profit margins associated with this pricing strategy make it a practical necessity for participating companies to: exercise tight control over inventory; keep labor costs down; keep major operational expenses such as facility leases and equipment rental under control; obtain good prices from suppliers; and make effective use of its pricing strategy in all advertising.
Companies that engage in this practice are basically hoping to attract a specific segment of the community by only carrying products within a specified price range. Here, again, very high-end retail (Cartier, Furla, Tiffany & Company) and very low-end ("Dollar stores") ultimately use the same strategy. Advantages sometimes accrued through price lining practices include reduced inventory and storage costs, ease of merchandise selection, and enhanced status or large volume. Analysts note, however, that this strategy frequently limits the company's freedom to react to competitors' pricing strategies, and that it can leave businesses particularly vulnerable to economic trends.
Odd pricing is used in nearly all segments of the business world today. It is the practice of pricing goods and services at prices such as $9.95 (rather than $10) or $79.99 (rather than $80) because of the conviction that consumers will often round the price down rather than up when weighing whether to make a purchase. This little morsel of pricing psychology has become so universally employed that many observers rightly question its value. Everybody rounds up, not down. But the practice remains widespread and is practiced worldwide.
Other commonly used pricing policies include penetration pricing and skimming pricing (for manufacturers) and loss leader pricing (for retailers). Both subjects are discussed in more detail elsewhere in this volume.
REAL PRICE AND NOMINAL PRICE
For national accounting purposes and to help all sectors of the economy calculate adjustments to pensions, changes in prices for the same goods or services are calculated by using the Consumer Price Index (CPI), prepared and published at monthly intervals by the U.S. Bureau of Labor Statistics. CPI is calculated by systematically pricing all manner of goods and services in the dollars of the day, the actual dollars charged. This is then labeled the "nominal price." The nominal price today is compared with prices for identical "shopping baskets" of goods and clusters of services (e.g., rents, education, fuels, etc.) in an earlier period. If one basket is priced in 2006 and another in 1996, the total price will be different yet will have purchased the same goods and services. CPI data, therefore, can be used to calculate inflation or deflation between two periods. If a dollar's worth of purchases in 1996 cost $1.27 in 2006 (the actual change between the years), the inflation rate has been 27 percent. Thus a couple who received $40,000 in pensions in 1996 would have to have $50,800 in 2006 to have the same standard of living. Using simple arithmetic, it is thus possible to express prices at any time in the past in dollars comparable to any other time. This is called "real price," i.e., price with inflation removed. Real dollars are always associated with a year. Thus when people speak of real 2000 dollars, they mean that all values are expressed in values of the dollar as it had in 2000. Because inflation is increasing, someone earning $75,000 in 2006 earned only $64,500 in 2000 dollars because of the inflation between the two years.
Small business owners are often reluctant to raise prices once a good baseline price has been established. They worry that a price increase will alienate customers and drive them to the competition. "Faced with such resistance, a lot of businesspeople are tempted to forgo price increases altogether, or at least put them off for as long as possible. If you do either one, however, you're making a big mistake," Norm Brodsky wrote in Inc. "Your profit margins will be shrinking'¦. You're gradually undermining the perceived value of your services or products." Brodsky noted that many of a small business's costs—such as payroll, insurance, and utilities—tend to rise every year, slowly cutting into profit margins. In addition, customers tend to associate price with quality. A business that does not increase prices to keep up with the competition risks being regarded as the cheap alternative in the marketplace.
When price increases are implemented gradually and cautiously, small businesses may be able to keep their customers happy while also keeping their profit margins intact. Customers typically base their purchase decisions on more than just price. Other factors influencing the decision process include quality, features, guarantees, and personal desires. In addition, people will always pay more for good, reliable customer service. In order to make an effective price increase, the business owner should be ready to explain the increase to the customer if asked. The more straightforward and justified the answer, the more effective it will be to cause a customer to nod—not with pleasure, to be sure.
SURVIVING COMPETITORS' DISCOUNT PRICING STRATEGIES
Major discount stores such as Wal-Mart, Sam's Club, Target, Kmart, Office Depot, Staples, Best Buy, and Circuit City have gained control of large blocs of the American business world over the last several years on the strength of their one-stop shopping and discount prices, the latter a result of their ability to buy goods at bulk rates. Many small business owners have felt the impact of these stores—indeed, cautionary tales concerning the impact that such stores can have on formerly vibrant downtown shopping areas have proliferated in recent years.
Surviving such assaults may not always be possible for the small business. A fundamental rule of pricing is that no one who is sane continues to sell below cost. When the "Big Box" moves in next door, the small business can only survive by changing—and sometimes only by changing radically. Hopeful observers suggest that small businesses innovate their way out of such competitive difficulties. They should offer more personal service, develop a niche the "Big Box" has neglected, segment the market more effectively, and/or adopt similar strategies. Yes, change is possible—but difficult if the small business cannot extract the assets invested in the business or if it was not wildly profitable and thus doesn't have reserves of cash. The best defenses are alertness, anticipation, and action before the inevitable happens. On the first news of the "Invasion of the Boxes," the business owner should be dusting off contingency plans and getting ready to liquidate, to move, or to change the business into something very different. The big retailers greatly increase traffic in and around their operations. One possibility of radical response may be to put up something nearby to tempt the masses drawn by low prices produced by Chinese labor. An ice cream shop, perhaps? It's a big change from running a family lumberyard, but entrepreneurs are endlessly creative!
Baker, Michael. The Marketing Book. Butterworth-Heinemann,
2003. Brodsky, Norm. "Street Smarts: Raising Prices." Inc. May 2000.
Campanelli, Melissa. "Price Point: Score with a pricing strategy that keeps customers coming back." Entrepreneur. November 2005.
Hitt, Lorin M., and Pei-yu Chen. "Bundling with Customer Self-Selection: Simple approach to bundling low-marginal-cost goods." Management Science. October 2005.
Perryman, Bruce. "Business Sense: Pricing Products for Profit." Stitches Magazine. 22 February 2006.
Plack, Harry J. "Price Hikes Not Always a Bad Thing." Baltimore Business Journal. 14 July 2000.
U.S. Bureau of Labor Statistics. "Consumer Price Indexes." Available from http://www.bls.gov/cpi/home.htm. Retrieved on 1 May 2006.