The Basics of Pricing
Price is the value placed on a product so that it can be exchanged for something else, normally money (although barter is popular).
Price is especially important to businesses because it is the major controllable contributor to the gross margin (gross margin = sales – cost of goods sold).
If your gross margin isn’t healthy, you’re going to go out of business.
At the same time, consumers have limited income and this affects their ability to purchase.
The higher the price, according to economic theory, the less the average consumer will buy.
If income rises at the same time as price, the consumer is no worse off. Depending on the product, if income doesn’t rise at the same time, price can (and often does) become a major consideration in the choice of some products purchased.
So the challenge for any business is to price their product so that they sell enough units to generate a healthy profit. There are different ways that businesses set out to do this – and some of the more common are discussed below.
Of all the disciplines in marketing, pricing is the hardest since it is the most subjective. There is no “right” answer. Experts can’t agree if it’s an art or a science but everyone agrees it is critical to try to get it right.
You must price to make profit, and try for as much profit as the market will bear.
How To Price Products
Many factors influence your choice of pricing model and the pricing techniques you use to reach your financial goals.
There are some outcomes that your pricing must achieve:
- It must cover your variable costs and contribute to your fixed costs as well. In fact, it needs to cover these costs sufficiently that your costs are still covered in the event there is a decline in sales volume.
- It must represent value for money for your customer. This is so they will buy sufficient of your product to enable you to pay all costs and generate a profit.
- Pricing must be robust enough to withstand competition. The best way to achieve this is to use other brand activities (including image) to support it.
- You must be able to earn a decent living from it (assuming that’s your primary objective).
Some of the factors you will consider in reaching a decision about price include:
YOUR PROFIT OBJECTIVES:
Are they short or long term? Are you looking to build market share slowly or rapidly? Are there economies of scale requirements that set your pricing path? Do you just need to survive?
If you’re a no-frills brand, your pricing will be low; if you’re a premium brand it will be higher; or you may be somewhere in the middle like most competitors.
PRICING TABLE 1: Examples of product attributes to consider when setting above the market price:
DEMAND FOR YOUR PRODUCT.
Are you happy to sell to a few customers and charge more, or do you want to sell to lots of customers at a cheaper price.
The less volume of product required to reach your profit goals, the lower the variable costs. But you’ll need a higher price to achieve it. The reverse is also true. Ultimately you must know your costs and your pricing needs to cover them.
COMPETITION OR OTHER INDUSTRY REQUIREMENTS.
Competition sets benchmarks for pricing. In other instances, industry standards apply to pricing.
Setting Pricing Objectives
There are some strategic questions you will need to ask yourself in setting your own pricing strategies.
- Which end of the market do you want to be in? Are you a low price supplier or selling the premium product? (If you want to be the low price supplier, make sure you have a very good understanding of your margins, financial stability to cover the rough patches, and are scalable for managing high volume.)
- Do you want to service few customers at a higher price or many customers at a lower price? (High volume businesses tend to be easily scalable but require bigger investment upfront. Low volume businesses tend to offer better lifestyle options and require less overhead.)
Factors in Choosing the Pricing Model
Whichever pricing model you choose will have advantages and disadvantages.
Common pricing models are covered off in more detail below and include:
- Cost-Based Pricing
- Competition-Based Pricing
- Customer-Based Pricing
- Value-Based Pricing
If you are a store with different types of products, you may decide to run different pricing models for different products (although there is extra effort required to manage this option).
Calculating Price Using Common Pricing Models
Pricing that starts with the total costs of the product. This generally is some derivative of using the product costs as the basis to form a retail price by adding a percentage.
How to calculate your price using cost-based pricing:
STEP 1: Calculate your per unit costs (head to the Quick Pricing Calculators for help)
STEP 2: Add a percentage markup (sufficient to contribute towards fixed costs)
STEP 3: The answer is your price.
There is a pricing model whereby you price either the same as your competition or below your competition to win market share.
How to calculate competition-based pricing:
STEP 1: Find out what competitors charge (look for RRP if available)
STEP 2: Charge the same or very similar.
The intent of customer based pricing models is to use price to attract customers. It can be executed through a myriad of pricing techniques including tiered pricing levels, bundling, discounting, quantity discounts, segment driven pricing. (More about these and other techniques in Pricing Models Explained.)
STEP 1: Determine your product’s price elasticity. The greater the price elasticity, the closer you should price your product to your competitor’s product. (If your product is a genuine commodity, you have no option but to price relative to your competitors.)
STEP 2: Evaluate your brand positioning and how your brand is perceived in the market versus its competitors. (By the way, this is not how you think your brand is perceived, this is how your customers tell you your brand is perceived.) This should give you some insight into the degree of flexibility you have to charge a premium for your brand.
STEP 3: If your pricing is elastic (that is, demand is sensitive to price) look at pricing techniques that make it difficult to compare prices in the first instance. Techniques such as bundling, quantity discount or offering pricing discounts for contract commitment may be options to explore prior to price matching competitors.
The value-based pricing model tries to determine what the customer would be willing to pay for the benefits that your product offers them.
STEP 1: Know thy customer.
STEP 2: Attempt to quantify the benefits the customer values from using your product.
STEP 3: Use this figure as the basis for price setting.
READ: More about pricing strategy.