Every time he closed a sale, Kris Simmons kicked himself. That's because Simmons, president of Fire Eye Productions, a video production company based in Chattanooga, Tenn., knew he'd done it again: He'd set his price way too low. A client would ask for a quote, and Simmons would toss out a number based on some combination of his company's cash flow at the moment, his own fear of losing a customer, and what he'd begun charging when he founded Fire Eye four years earlier. "Basically, I'd throw a price out there and see what they'd take," he says.

From the outside, Fire Eye looked like a big success; Simmons was even nominated for the 2004 Young Entrepreneur of the Year Award given by Tennessee's small-business administration. But inside, the company was falling apart. Working 18-hour days to keep up with demand, Simmons had no time to make sales calls, which meant that cash flow was always erratic. He would hire employees, let them go when receivables dipped -- and then hastily hire them back when the work flowed in again.

By August 2004, Simmons was fed up and exhausted. He knew what he had to do. He had to raise prices. A price hike would mean he could work fewer hours, earn more money, hire employees, and buy new equipment. On the other hand, if he raised his prices too high -- and who knew how high was too high? -- he would risk alienating his longtime customers. If he lost them, Simmons knew, Fire Eye would not survive. "These clients are my bread and butter," he thought. "If I make them mad and they leave, then I'm in a whole different kind of bad situation."

There's no more important number than the one on your price tag, and nothing provokes a case of the cold sweats like the thought of raising it. After years of almost no inflation, relentless downward pressure from places like China and India on the price of almost everything, and comparison shopping at the click of a mouse, it's more competitive than ever out there. It's easy to see why fewer than one-third of business owners surveyed by the National Federation of Independent Business reported in February that they had increased their prices over the previous three months.

But that could be a big mistake -- especially today, which might be the best opportunity companies have had to raise prices in some time. In March, the consumer-price index rose 3.1% over the previous year. If you're holding prices steady at a time when they are generally increasing nationwide, you may be surrendering more of your margin than you need to. "This is a very important time for everyone to review their prices," says Brent Lippman, CEO of Khimetrics, a pricing consultancy in Scottsdale, Ariz.

On the other hand, you can't raise prices if you haven't set them appropriately in the first place. Ask entrepreneurs how they arrived at their prices, and once you get past the usual stuff about optimization, segmentation, and market conditions, you'll often hear things like "it was pretty arbitrary" or "we go by our gut." Unfortunately, the gut often gets it wrong. "Entrepreneurs tend to keep prices too low," says Reed K. Holden, founder of Holden Advisors in Concord, Mass., and the co-author of The Strategy and Tactics of Pricing, a widely used text on the subject. Robert J. Dolan, dean of the Ross School of Business at the University of Michigan and co-author of Power Pricing: How Managing Price Transforms the Bottom Line, agrees. "You're likely leaving money on the table," Dolan says.

How do you make sure that money ends up in your pocket instead? Every industry has a dynamic of its own, and it would be hard to find two businesses that take the same approach to pricing. Still, there has been plenty of recent research into how consumers behave, examining how they assign value to goods and services and how smart managers can alter those perceptions. These insights can be valuable for any entrepreneur, in any industry.

But before we get to that, a quick primer on the wrong way to set prices: Many business owners base their prices on their costs, adding in a certain profit margin on top. "They say, 'Hey, if I could get my costs, plus 20%, that's not a bad business," says Dolan. Well, it could be a better business -- if you could get a 40% margin. Others look at what their competitors charge and seek to bring their own prices in line or charge less. That may be your only option if your product or service is identical to that of the competition. But how do you know that your rivals know more about pricing than you do? And if you undercut them, you risk sparking a margin-killing price war. Then there are those who consult with customers before arriving at a price. But customers, obviously, have a powerful incentive to get you to keep your prices as low as possible. Setting prices based on what your salespeople report back can lead to similar problems. "Salespeople want to close deals, and they use price as a way of doing that," says Holden. "But that can be inconsistent with the real need of the business -- profitability."

Of course, you can't make smart pricing decisions without taking your costs, competitors, customers, and salespeople into account. But nearly all experts agree that making any of those factors the primary basis for your decision is a big mistake. Instead, the right price for a product or service should rest on one thing -- the value that a product or service provides.

When determining your prices, says John Gourville, a marketing professor at Harvard University who studies pricing, the first question to ask is this: How much would a rational consumer be willing to pay for your product, assuming the consumer had a perfect understanding of its actual worth? It sounds easy. But while most business owners spend a good chunk of their time touting the benefits of their products and services, "they haven't tried to monetize those benefits," says Brent Lippman. The first step toward creating a pricing strategy, then, is to do just that -- think through the benefits of your product and make a rough calculation of what you think they're worth in dollar terms.

Marc Cenedella went through this process in 2003, when he was setting subscription rates for his start-up, TheLadders.com, an electronic job-search service that lists only positions paying more than $100,000. Most career sites allow job seekers to search for free and make money by charging employers. Cenedella's strategy is different: He charges job seekers and lets employers list their six-figure positions for free. After many meetings with "way too much pizza," Cenedella and his team arrived at their value figure: somewhere between $10,000 and $40,000. Their assumption was that a job seeker who used their site would find a position at least one month faster than one who didn't. Since that job would pay $100,000 or more, the value of the company's service translated to roughly one month's take-home pay, or somewhere between $10,000 and $40,000, depending on the job.

Fair enough. Of course, it's hard to imagine anyone coughing up tens of thousands of dollars for a weekly e-mail newsletter. And indeed, you'd be hard-pressed to find a pricing expert who would suggest that as an appropriate price.

That's because there are two kinds of value: objective value and perceived value. The former is what Cenedella came up with: the price of a product or service assuming the customer has a perfect understanding of its value -- and understands it in the same way the seller does. Think of objective value as the most that you could rationally charge for a product. At the other end of the spectrum, the least you could rationally charge for a product would be the incremental cost of producing it -- a breakeven price. Somewhere between the two lies what is known as the perceived value of your product -- that is, what a person actually is willing to spend. In a perfect world, your customer would see the value of your offering and be willing to fork over the full amount. But in many circumstances, there's a disconnect, and what people are willing to pay is very different from your product's objective value. (In those cases, you'll have to use marketing and other tricks to try to change your customer's perception of value. But more on that later.)

How do you determine what people are willing to pay? Study after study has demonstrated that when it comes to purchasing decisions, people are irrational. In one classic study, researchers asked consumers whether they would be willing to travel an additional 20 minutes to save $5 on a calculator that costs $15. Most said yes. Then they were asked the same question about a $125 jacket. Most answered no. Now, rationally, $5 is $5, whether you're buying a calculator or a jacket. But it's seldom that simple, according to Richard H. Thaler, a professor at the Graduate School of Business at the University of Chicago and author of "Mental Accounting Matters," an article published in 1999 in the Journal of Behavioral Decision Making. "People make [purchasing] decisions piecemeal, influenced by the context of the choice," writes Thaler, who won a Nobel Prize for his work in behavioral economics.

As it happens, the greatest influence on the context of a purchasing decision is whether the consumer believes the price is fair. Expectations play a big role in this. In a 1985 study conducted by Thaler, people were asked to consider the following hypothetical situation: You're lying on a beach on a hot day and you crave a cold beer. A friend offers to get one and wants to know what you're willing to spend. When she offers to go to a small grocery store, the median response is $1.50. But if the friend is buying the same beer at the bar of a fancy resort hotel, the price jumps to $2.65. Context and expectation drive the price up nearly 80%. Because we expect to pay more for a beer at a resort, we're willing to pay more.

The real trick in setting prices, then, is to understand -- and try to shape -- your customers' expectations. One of the key ways people set their expectations is to base them on what they've paid for similar products or services. Academics call this the "reference price," and it's one of the easiest pieces of competitive intelligence to gather. Simply shop your competitors.

Overcoming the power of the reference price is not an easy thing to do. At TheLadders.com, for example, the maximum objective value was $40,000. The product's reference price, however, was quite a bit lower: zero, since most job-listing services are free. There's a lot of room between nothing and $40,000, and free is the most difficult reference price to overcome. But it can be done. Satellite radio companies, for example, have been able to charge annual subscription fees of as much as $142 -- even though most listeners are accustomed to getting radio for free. How do they do that? Primarily through marketing, which in this context means taking the customers' reference price and making the case that they offer more value.

But starting at zero definitely limits how much you can charge. Cenedella priced a monthly subscription at $50 -- a number he admits to pulling out of thin air. Unsatisfied with the number of people signing up, he cut it to $35, and finally settled on $25. TheLadders.com now has nearly 300,000 subscribers, but Cenedella is far from satisfied. "From our point of view, we're charging only a fraction of the value we provide," he says. But he's stumped as to how to fix the situation.

Plenty of entrepreneurs are in the same boat. "The price you get for a product is a function of what it's truly worth -- and how good a job you do communicating that value to the end user," says John Gourville. If Cenedella, for example, could guarantee customers that subscribing would shave a month off their job searches, he might be able to charge more. Or he could try to change his customers' reference price. E-mail newsletters may have a going rate of zero, but a good career counselor can cost hundreds, if not thousands, of dollars. If your marketing can convince people to put you into a different price category, it'll be a lot easier to charge more money for it. It's also important to remember that different customers have different expectations and reference prices. Cenedella might, for example, offer a special newsletter for investment bankers at a higher price than he would for, say, marketing executives.

Sam Calagione, president of Dogfish Head Craft Brewery in Milton, Del., is a master at playing with pricing expectations. Dogfish Head's revenue grew 52%, to $8 million, in 2004 -- in large part because of Calagione's approach to pricing. Some Dogfish Head beers retail at about twice the price of most microbrews and four times that of most mass-market brands. How does Calagione do it? He encourages customers to use fine wine, rather than competing beers, as their reference price. "Wine customers," he says, "understand that an amazing bottle of pinot noir should command four times the price of an average bottle." He conveys this message, in part, with smart packaging. The company, for example, sells its premium Pangaea beer in 750 milliliter cork-finished wine bottles -- at a cost of $14 a bottle. That's well above an average beer drinker's price expectation. But it's right in line with that of a wine connoisseur.

Calagione borrows more than the wine industry's packaging. He shuns the consumer advertising used by competing brands, instead hosting "beer dinners" attended by beer enthusiasts, early adopters who are likely to spread the word about new products that excite them. Calagione expected to host 18 such dinners in May alone. Taking another page from the wine industry, every time he launches a new product, he makes sure that there's not enough of it to satisfy demand. "We're not a commodity," he says. "By not satisfying demand initially, we create more demand for the future." People understand that a scarce product commands a higher price.

Calagione segmented his market by eschewing the typical American beer drinker and going after customers with high reference prices. Doing so enabled him to do something most businesses only dream about: align prices with objective value. And though he didn't think of it in those terms, that's precisely what Kris Simmons needed to do at his video production company, Fire Eye. His first step was to figure out what his competitors were charging -- the reference price. He learned that he was charging about one-third less than most of his rivals. That was good news. Because his customers' reference prices were a good deal higher than Fire Eye's, a price hike would not seem unreasonable.

Simmons acted immediately. Fire Eye's prices, he decided, would go up 25% across the board. Had he done more research -- say, conducting an in-depth value calculation akin to what Cenedella did at TheLadders.com -- he might have selected a gutsier number. But 25% was the most his nerves could take. "I didn't want to alienate myself from my customers," Simmons says. "And I thought it was a fair increase." His heart pounding, he began meeting with clients to break the news. He explained his company's situation. He argued that he could be a stronger vendor if he could invest in his infrastructure and hire new, experienced staffers. He also said he'd understand if clients wanted to take their business elsewhere. Simmons had made his play. How would his customers react?

Determining your new, higher price is one thing. Actually selling it to customers is something else. Simmons's approach -- simply explaining the situation -- is among the most effective. "People are actually very sensitive to what they think something costs to make," says Gourville. When costs increase, and a company cites that as a reason to justify a price hike, few customers react badly. Indeed, just as people appreciate a fair deal for themselves, they also tend to understand that a company has to stay in business as well.

Some customers may even urge you to raise prices: "We want you to be around."

In some cases, customers may even urge you to raise prices. That's what happened to Henk Keukenkamp, CEO of Scope It, a software company in El Dorado Hills, Calif. In 2003, Keukenkamp pegged the price of his project-costing software to that of a similar product offered by Microsoft: $795 per user, per year. When no one balked at the figure, he boosted it to $995. Even then, he found customers were shocked at the low price -- so shocked that Keukenkamp began to feel foolish. "We thought the value we were providing was comparable to Microsoft," he says. "We were wrong. Our customers thought our value was nothing like Microsoft." A pricing theorist would call this a case of misperceived reference price. Finally, Keukenkamp recalls, a customer took him aside and said, "Look, $995 isn't very expensive. How are you going to make any money? We want you to be around to handle updates." Over the next 12 months, Keukenkamp raised the price of a license to $2,295 a year. "I still think we can push it higher," he says.

Keukenkamp's customers had a powerful motivation to keep him in business -- they wanted him around to service the software. It's an enviable situation. But even if you're not as fortunate as Keukenkamp, you can still raise prices. You just have to do a better job explaining the reasons for the move. "It makes sense to try to justify why your prices are what they are," says Gourville. "It's better than having consumers feel like they're getting ripped off." And it's not necessary to raise prices across the board, all at once. Sometimes, a wise step is to test out new prices with small samplings of your customers.

If you don't trust your communication skills -- or if you're reluctant to confront clients directly -- you can slide a price hike in through the back door. One way is to eliminate discounts or change your terms and conditions. "People are more sensitive to list price than to discount terms," says Robert Dolan. Eliminating a discount of, say, 2% to clients who pay within 30 days, for example, is much easier to sell than a 2% increase in prices. (See "Do You Offer Discounts?" page 76.) Or, conversely, you can raise prices but offer discounts to your most important customers.

You can also stop the gravy train and begin charging for add-on services you currently provide gratis. Another option is to keep prices constant but reduce the amount of product or service you're providing. If you're smart about it, according to Dolan, many customers won't notice the difference. Dogfish Head, for example, sells some of its beer in four-packs, rather than six-packs, which boost the price per bottle. Price hikes also can be masked by bundling an array of products or services together. Studies have shown that people think they're getting a better deal when they cannot determine the costs of the individual items they're purchasing.

Just keep in mind that psychology can also work against you. "People are going to use your past price as a reference point," says Dolan. There are two ways around this. You can convince customers that the new, higher price is accompanied by greater value. Or you can "destroy the reference point," Dolan says -- through, say, a redesign or relaunch. If that's not possible, introducing "premium" versions of your service can help raise reference prices across the board. Every time Calagione releases a new product, for example, he charges more than he has in the past, a move that increases Dogfish Head's average selling price while adding to his customers' reference prices.

Six months after his own price hike, Fire Eye's Simmons couldn't imagine why he didn't do it sooner. Apparently, he did a good job explaining the increase to his customers -- not a single one jumped ship. "They were very understanding," Simmons says. He's invested his newfound profits into four new employees, freeing himself to pitch new customers. He's landed some large corporate clients, who, he's since learned, didn't take him seriously at his previous price. That's not the only change. In the past, Simmons routinely failed to charge for overtime. Now, if a project requires 10 more hours, it's added to the bill -- and those terms are explicitly spelled out in his contracts. He also altered his billing policies, asking for 50% payment up front rather than taking all of it upon a project's completion. This reduced the cost of his receivables, giving him a subtle increase in margin. "It's been rebirth, a new beginning," Simmons says.

Of course, there has been some fallout. Prior to the price hike, Fire Eye closed about 80% of the projects it bid on; today, the number is closer to 40%. On the other hand, today's deals are coming with far better margins, which is steadily improving the overall health of the company. "I'm only spending time with people who want to play my way," Simmons says. "I'll still work with clients on their budgets. But for the most part, I'm in business to make my life better. These prices are making life better for me."

Do you offer discounts? (Maybe you shouldn't)

Nearly every company offers discounts, promotions, incentives, and giveaways. Such tactics are time-honored ways of keeping clients happy -- and luring new ones into the store.

But you might be giving away the store if you're not careful. And you'd be surprised at how many savvy managers are anything but savvy when it comes to discounts, says Robert J. Dolan, dean of the University of Michigan's Ross School of Business and a business consultant. The problem, Dolan says, is that discounts are offered by different departments at different times for different reasons. Sales and marketing execs give breaks to help close deals, for example, while inventory managers cut rates to move excess stock. It adds up fast. The consulting firm McKinsey studied this phenomenon in 2003, dubbing it the "pocket-price waterfall" -- that is, the amount of money you actually pocket per transaction drips away bit by bit until the small leak turns into a deluge.

How to avoid a soaking? First, get a handle on all of the discounts you offer. Next, think about the customer behavior you're trying to encourage -- or discourage. Do you want people to pay by cash instead of credit? Settle accounts by the end of the month? Don't give away a penny without a clear understanding of what you're trying to accomplish. Another big mistake: grandfathering in discounts forever. Companies often offer discounts to close a particular deal, only to have the client insist on the same low price in the future. What was supposed to be a one-time incentive becomes official company policy. Let customers know when they're getting a special deal. After all, a discount that's expected isn't much of a perk.

Get the price you want -- and avert the dreaded price war

Every salesperson has met one: the customer who cares only about price. High quality? Tell it to the other guy. Superior service? Forget it, the customer says. I won't pay a dime more than I have to.

Reed K. Holden, founder of Holden Advisors, a pricing strategy firm in Concord, Mass., calls them "price buyers," and they're particularly prevalent in the purchasing departments of large corporations -- where they'll often release a request for proposal with a set of specs, pick the lowest bid, and call it a day. Such buyers are a huge pain to deal with. For one thing, they're not particularly loyal because they're always ready to drop you for a lower bidder. They're also not afraid to spark price wars. "These companies want their vendors to beat their brains out," says Holden.

If you have too many of these kinds of clients, you'll never have strong margins. But there are ways to cope. The key is to do business with a price buyer only when you can do it profitably -- if you have excess inventory, for example, a price buyer might be exactly what you're looking for. (Case in point: Airlines often sell excess capacity to vacation-tour operators but don't create extra capacity to serve that market.) Another option with price buyers is to sell only what they're buying. "If people want a lower price, always be willing to give it to them," says Holden. "But be sure to take away some value." An electronics company that Holden worked with, for example, gave one customer the price it demanded -- but only on older technology. Newer, more innovative products were reserved for those willing to pay for them.

Whatever you do, don't tell yourself that you'll take a hit on one sale and make it up the next time. Price buyers rarely change. If you're in the grip of one, walk away. It may seem scary, but remember: If you must get a price buyer back, you can always do it by lowering your price.

Contributing editor Alison Stein Wellner is a New York City-based freelance writer.