One of the most important roles in a business is pricing products and services. This underpins all your attempts to make a profit and all your marketing efforts. This guide gives an overview of what is involved in pricing your product or service.
Pricing is both a marketing and a financial function. If you get it right, customers will feel they have value for money, while you produce enough profits to build your long-term success in business. If you get it wrong, you will have lower sales, higher marketing costs and lower overall profits.
Pricing is also a function of perception – people will sometimes buy an expensive car because they want to be seen to be driving an expensive car, and not buy cheap clothes because cheap implies low quality. Neither perception may be accurate but the pricing has had the reverse effect of conventional wisdom.
Price and sales volume are interlinked. If you price high, you will usually sell fewer products or services. Unfortunately, the link isn’t linear – you can’t increase prices by 20% and expect to lose only 20% of your sales.
Fortunately, you don’t need to be a mathematician to find an answer to the pricing puzzle, though it will make your life easier if you have access to a computer spreadsheet.
To work out a sensible price strategy you need to know just five things:
Variable costs
The first key element is to understand the real cost of your product or service. Include everything that goes into selling it – the cost of manufacture including: electricity and raw materials, packaging, import duties, sales commission, credit card fees, warehousing costs, wastage, delivery and installation costs.
It is always a good idea to cover at least your variable costs when selling. However, there are times when you may wish to override this – for example, in seasonal sales, or when offering something as a ‘loss leader’ to gain market share. Shops do this when they offer ‘Buy one get one free’. Having enticed you in with a good offer, they hope you will buy other things that are more profitable to them. You may also be unable to make an overall profit until you have reached a certain volume of sales.
Fixed costs
Your price must also include a contribution towards your overheads, which you must still pay for even if you do not sell a single thing. Fixed costs include salaries, rent, rates, phone costs, insurance, bank loans and marketing costs.
You may not know all these to begin with, but you can work with realistic guestimates.
How you then allocate overheads is a matter of choice, but one way is to add a percentage (say 20%) to the total variable cost of each product. Multiply this new price by the volume of products you expect to sell in the year. Does the total income cover all your costs – fixed and variable – and provide sufficient net profit? Use cautious sales projections – it is better to over-recover costs than to sell lots at too low a price and not cover your overheads.
As you grow, your costs will also grow, but not necessarily in proportion to the number of units you sell. You may also benefit from bulk buying and economies of scale (for example, the first unit may be disproportionately expensive to produce, but the run-on costs thereafter may be minimal).
The type of customer
You will want to set your price according to your target market. For example, if you make muffins you could find yourself selling to several distinct customer groups:
In each case, you would package your goods accordingly.
You might sell:
While you need to know your primary target, you may find yourself selling to other groups and will have to price accordingly. Premium buyers will expect to pay more for a product with more expensive packaging, for example or exclusive colours (such as metallic paint on cars). On the other hand, you will have to allow resellers to make their mark-up where relevant.
Your competition
Study what your competition is charging. Not only does it already have a toehold in the market, but also it knows, to a certain extent, what the market will bear. However, be aware that you don’t have to charge the same. You can charge a premium if you can differentiate in some way that adds value for your customers, such as increased convenience, quality or service.
Your competitors price is affected by:
On the whole, be wary of charging much less than your competition. As a smaller business, or someone just starting up, you are unlikely to be able to buy for less and your overheads are probably proportionally higher. Plus, you will have higher marketing costs since you are not well known. An exception is where you have used a genuine innovation or new technology to cut your costs of doing business.
Pricing a service or trade
If you’re selling a service or trade, especially as a ‘one-man-band’, you are limited by how much time in a day you have to do things. You could set your prices on what the competition charges or what you think the market will bear. However, you then have no control over your end profits.
Instead, work out what profit you want to achieve and what it will take to get there. If it turns out to be unrealistic, then you will have to change your pricing structure, maybe by changing your service so you can charge more, or by taking on assistants.
First, however, you need to decide what your time is worth. Say you want to take home £20,000 a year. Let’s imagine your overheads are £10,000. Excluding weekends and holidays; there are about 225 working days a year. If you spend only two days a month selling and doing paperwork, you have 200 chargeable days to recover £30,000 or £150 a day or around £20 an hour. If you feel, ‘But I can’t charge that for my time’, then you must find other ways to add value.
The pricing matrix
Sometimes it is more worthwhile to work less for more.
Imagine you plan to offer typing services, which you will sell by the hour and costs include:
Now look at the matrix below.
If you have no idea where to start with pricing, take the prices of four of your lowest-priced competitors. Let’s say these average £6/hour. Do the same for the four top prices in the range, say £15/hour. Enter these in the matrix below and see how they affect your bottom line.
This will help you get a feel for the range within which you can work. When it comes to setting your price, be careful not to try to beat the wrong competitor! If you are not making enough profit, you are not going to last in business.
The pricing matrix | High price | Low price |
Selling price/hour | £15.00 | £6.00 |
Hours/week | 30 | 30 |
Income = selling price x hours | £450.00 | £180.00 |
Variable cost/hour | £1.00 | £1.00 |
Total variable costs (cost/unit x hours) | £30.00 | £30.00 |
Gross profit | £420.00 | £150.00 |
Fixed costs | £100.00 | £100.00 |
Net profit | £320.00 | £50.00 |
In the low-priced example, you can see that you could end up with almost nothing to show for your hard work. You would have to work 84 hours at £6/hour to achieve the same result as you would at £15/hour for 30 hours.
One of the biggest benefits of pricing your service properly is that it allows you to build in time to find the better paying clients who are more profitable. Working 84 hours a week leaves no time at all for living, let alone marketing yourself.
Setting your price
Ultimately, everything revolves around your unique selling point (USP) – why someone should buy your product. A USP in turn usually comes down to one of three strategies:
While these are not mutually exclusive, you would not pay a premium for a hamburger in a fast chain, though you might for a hamburger in a top London hotel. On the other hand, you might also be happy to pay a premium for the pleasure of eating in the company of Snow White at a theme park.
Having set your price, you must monitor your sales performance. If sales volumes drop, find out why:
Go back to those sales leads that didn’t turn into orders and ask them why they went to the competition. If your product or price is wrong for the market, don’t be sentimental – change it. Nothing in business is set in stone. Pricing is an art and a strategy. Much also depends on your marketing and selling abilities. Ultimately, something is only worth what someone will pay for it. It is easier to cut a high price than to raise a low price, particularly if the latter has established a value in your customer’s mind.
The 7 Cs of pricing
Pricing is more than undercutting your competitors or covering your costs plus a profit. There are seven factors that will affect what you charge.
