Most entrepreneurs struggle with figuring out how to price their product or service. Price too high and you can count your customers on one hand. Price too low and you risk never making a profit. Here are three simple rules that we have used at Farmivore that can help you get started:

1. Know Thy Market

If you operate in a market that is highly competitive, chances are you have little ability to price above the going rate for your product. (Think laundromats, butter, or celebrity magazines.) But most entrepreneurs launching a new product or service are aiming at market segments where pricing is more flexible because customers perceive non-price differences in the products.

Here is where it gets tricky. A McKinsey study showed that 80-90% of poorly-chosen prices are actually too low, meaning companies systematically underestimate what they can charge. Pick your culprit: fear of competition, increasing price transparency via the internet, aggressive market share objectives, etc. Such mistakes can be very costly. Underpricing by only 1% can reduce operating profits by 5-10%!

Analyzing the competitive dynamics of your market is the critical first step to give you guidance on how much pricing flexibility you have.

2. Know Thy Customers

Why do customers want to buy your product? Are you solving a problem that was never solved before, or are you making incremental improvements to a product category that already exists?

While many entrepreneurs believe that their product is truly innovative, the majority of new product launches fall into the incremental improvement bucket. Consider Square, the high-flying Silicon Valley startup leading the way with simple-to-use, mobile-enabled credit card processing.

Instead of pricing its service at a premium to traditional POS solutions, Square offers it at a discount. Why? Square's solution, while innovative, is an incremental improvement for most retailers who have many payment processing options to choose from. Therefore, the fastest way for Square to drive customer adoption was to focus on one of its customers' biggest pain point, which is the expensive fees that typically get paid to credit card processors.

3. Know Thy Cost Structure

The last critical piece to solving the pricing puzzle is understanding how much it costs to provide the product or service. Sounds simple, but often entrepreneurs underestimate actual product costs by excluding relevant costs (e.g., R&D) or making unrealistic assumptions about scale economics.

Once you have an accurate read on your costs, you can look at cost-plus pricing scenarios to figure out the minimum price required to generate an acceptable margin or ROI. This analysis is critical! The startup landscape is littered with companies who failed to properly estimate their long-term cost structure and were never able to turn a profit.

Test, test, test!

Okay, so now you've analyzed your target market and competitor prices, you've done your customer research to understand how (or if) they value non-price differentiators, and completed a thorough cost analysis to figure out your minimum pricing. All set for a big product launch, right?

Not quite. Even armed with all of this information, you still won't really know whether your price point is resonating until you actually try to sell your product! If possible, start with beta customers and validate what they will pay. Make sure that your results do not get skewed by picking outlier customers instead of representative customers.

And above all else, test, test, test! At Farmivore we conduct pricing tests monthly to assess how our market, competitors and customers have evolved. Pricing should never be thought of as a static analysis where you set the price and walk away. Keep the Three Rules in mind to help your business thrive over the long-term.

Published on: Aug 25, 2014