The importance of pricing cannot be underestimated as incorrect pricing can often result in the failure of a business. New businesses often make the mistake of either charging too little or too much for their product pr service. To help you avoid making a pricing mistake, the following section outlines some of the guiding principles for determining price.
1. Perceived value
The customer’s ability and willingness to buy strongly influences the price charged for your product or service. Ability to pay is determined by the customer’s income level and where your product/service ranks on each customer’s level of importance. A customer’s willingness to buy is determined by taste, need and perceived value.
The customer may also have a perception of your product or service that may largely be attributed to its price. Test yourself: What is your perception of a diamond ring that sells for $100 versus one that sells for $1000? What is your perception of a meal that is $50 versus one that is $10?
You can determine the perceived value of your product or service by asking your customer how much they would be willing to pay for the same service in different surroundings. Or if you are contemplating adding a benefit to your product or service, ask them how much they would be willing to pay with the improvement. Restaurants can charge higher prices if they provide an atmosphere of elegance versus a fast food outlet. In any business, it is perceived value that decides the price customers are willing to pay.
2. Competition
Some business owners use the competition’s prices as starting points for their own. If your product or service is an improvement, you can sometimes price it above the competition, as long as you communicate to your customers the reasons for the higher price (improved service, choice of colour). For example, some convenience stores generally charge higher prices than do large grocery store or retailers. They can do so because the benefit of convenience is valuable to their customers.
Caution must be exercised when attempting to price below the competition. This strategy could lead to a “price war,” which could be hazardous if the competition has more financial resources to withstand a “price war” than you have.
If you do not have direct competition, you may be able to charge higher prices than you could otherwise. However, if the prices you charge are too high and your profits are exorbitant, competitors may be attracted to enter the market. Instead, keeping profits and prices at a reasonable level may discourage the entry of other businesses.
3. Costs
Your price must cover all costs of goods/services sold, including production costs of supplies, materials, fixed overhead, time/labour, and generate a profit.
Use this simple formula in setting a price (per unit):
Total Cost of Production per Unit + Desired Dollar Profit per Unit = Price per Unit
Businesses can set varying profit rates, for example 15 per cent profit on supplies and materials, 20 per cent profit on labour/time, and 25 per cent profit on overhead. These more complicated approaches to pricing usually emerge in response to the special needs of a particular business.
If your research reveals that similar products or services are available on the market at a cost much lower than what you could offer, you may have to either adjust your profit margin, the return you expect, or decide to provide enough specialized service or selection that the market will pay extra money for the additional service. Alternatively, you may be forced to conclude that you cannot afford to make this item or provide this service; and, look for something else with a better rate of return.
NOTE: Remember to document cost materials at their replacement prices, NOT at their original prices; include salaries as a business expense; include interest in your business cost calculations-interest that could have accrued had the money used for the company been invested elsewhere (i.e. a bank)-make allowances for future refunds, servicing, bad debts, amortization of capital costs of equipment or machinery.
Many retail stores use a simple mark-up system to price their products or services; using the cost of the product or service and adding a predetermined mark-up to this base. Mark-ups vary by product or service, determined largely by the sales volume of the product. The mark-up on large, low volume items (autos, appliances) is generally higher than on high volume goods (food items).
There may be situations when it is advantageous to set prices below cost. For example, stores lower prices drastically to clear space for new products or services or simply to move out products or services that are not selling. But, these are situational and happen under specific circumstances.
Break even pricing involves the firm determining at which price they will cover their business costs. The break-even point is where the price at a certain sales volume covers both variable and fixed costs.
In the following example, the only figure that changes is the price. It is determined that at a price of $18.00, selling ten units, the company will break even.
Alternatively, the price may be determined for a service organization, such as bookkeeping. The break-even may look as follows.
The only variable that changes in this example is the number of hours.
When using this method, you must consider the impact that price has on sales volume to realize the target profits and the likelihood that you will achieve that sales volume based on that price.