Last Updated May 3, 2007 2:11 PM EDT
Setting the price of a product or service is both a financial and marketing issue. Clearly, the price has to cover all the costs you have incurred. It also has to generate a profit—the business won't survive otherwise. Then again, you should never gouge your customers or you will lose any chance of their repeat business. This article looks at some basic issues to consider when setting your prices.
This is generally done in two stages. First, you need to factor in all of your costs and then divide this figure by the number of products, or days of service, that you expect to sell. This gives a minimum price based on elementary cost-per-unit calculation, or the cost basis. However, this amount is only that at which your business can break even without making a profit. Thus, the second stage is just as critical: you need to research the market to determine the maximum price that could be charged for your product or service. You can then set your actual price somewhere between the two measures.
Many believe that if they set their price lower than their competitors, then they will win greater market share. Such thinking is only partly correct. Small businesses (which often have a relatively higher cost basis) are usually too small to achieve the economies of scale necessary to enable them to fix a really competitive price. If you are in this position, you need to differentiate your product or service in order to secure a competitive edge. For example, your business could provide better quality, better service, or quicker delivery. You may find that quicker delivery is an especially attractive benefit for which your customers are willing to pay. For any major product or service, most customers do a cost-benefit analysis, just as you (hopefully) do.
Sometimes you have to take this step, especially if your cost basis rises. Fixing a price is a juggling act between strategy, pricing, and cash flow. Set prices too low and the income may not cover all your costs. If the price is too high, even with a well-differentiated product, you may have difficulty convincing customers that what you have to offer is worth it. Pricing is effective when you have determined the right balance between managing costs and setting a reasonable profit expectation. The challenge, always, is to find the right balance.
Whenever you do change prices, the differential will probably cause a change in demand. Small businesses often find that they can raise prices without losing too many customers, thus increasing profitability. This happens, usually, because of the strong relationship between a small business and its customers. But it's important to understand the potential effect that a price change will have on your customers. Always warn them that prices are going to rise and explain why. This is the best way to keep the good rapport you have with your customer base.
The amount of flexibility that you have largely depends on the way that your product or service is perceived in the marketplace. A cost leadership strategy—one in which you have the lowest prices of all competitors—gives you almost no flexibility, because you have to respond to the price set by your competitors. A differentiated strategy is based on demonstrating how your product or service is special as compared to your competitors. Thus, you can change prices in direct proportion to your ability to rationalize the value of your product or service in the buyer's mind.
It's certainly something to consider, and it's done widely. Used carefully, offering existing or prospective customers free access to your product or service can be the best way to attract further interest. For example, existing customers will be thrilled that you think so highly of them, and this will engender increased goodwill.
Prospective customers like promotional giveaways as they can try out new products without risk. The key is to make them want to stay with you after the free trial period. Do you truly have the best option around? If not, what can you do to change that situation? In short, the value of giving away your goods or services at no cost is that it gives prospective customers the chance to enjoy something they can get nowhere else. Once they try what you have to offer, the reasoning goes, they'll never go back. Unless that reasoning seems truly genuine to you, free samples will cost you more than you'll gain.
All businesses must focus on their marketing mix, which is often referred to as the four Ps (product, position, price, and promotion). The marketing mix conveys your marketplace message to the customer.
Your price is paramount in the mix and needs to reflect the position that you want to adopt in the marketplace. If you adopt a position of quality, you will want (and will probably need) to charge a premium price. If your product or service is regarded as mass-produced, and therefore of basic quality, then the price should be lower.
There are a number of possible pricing strategies that you could adopt. Here are the main ones:
- Cost-based pricing happens when total costs are calculated and a simple mark-up is added to yield the required profit. The mark-up is usually a percentage of the cost.
- Skimming happens when you initially charge a relatively high price to recover investment costs quickly, if the product is new and unquestionably unique. If and when competitors enter the market, you lower the price.
- Negotiated prices occur when customers help to set the price based on the quantities they are prepared to buy. For example, you may have a suggested retail price that can be altered if someone buys your product in high volume.
- Expected price is similar to negotiated price, only it is hinged on the attitude of customers toward your product or service. If your customers believe that they are buying "the best," then you have latitude to set and keep higher prices. (For example, a "premium" hotel chain usually charges higher prices, in part because their customers know they are not staying at a discount chain.)
- Differential pricing happens when you charge different segments of your market different prices for the same service. How can this happen? It's not as unusual as you might first think: Businesses often offer discounts to loyal customers who sign up for club membership, to senior citizens, or to those who are willing to buy during a slow season.
- Lifetime pricing is done when you believe you can convince your customer that, while the initial price may be dramatically higher than the competition, it will prove to be the best buy over the long haul as your product endures and performs while your competitor's product wears down or out. Also, you may be able to show that the cost of maintaining your product is lower, thus reducing the annual cost.
Undercutting your competitors is sometimes perilous; cost leadership is a difficult strategy for small businesses to pursue. Instead, aim to differentiate your product or service.
You must sell enough products at your chosen price to cover all of your costs and to generate a profit. Keep a careful eye on your income to make sure that your projected sales (what you used to determine your cost basis) are enough to justify your chosen price. If not, take remedial action quickly.
You should regard price as one part of your marketing mix, rather than a straight financial calculation. Consider all the parts of the equation carefully. Research the market thoroughly and make sure that you are familiar with your competitors' pricing strategies and your customers' needs. Determine your pricing only when you have a convincing pricing strategy.
Professional Pricing Society: www.pricingsociety.com