Making Pricing Decisions

Last Updated May 29, 2007 7:41 PM EDT

There are several factors to consider in any marketing mix, but price is one of the first things a customer considers in making a buy decision. Setting a price too high can result in lost sales, while undercharging can eat into your profits and possibly lead to being unable to deliver on your contracts. This article contains advice on how to go about setting prices that recognize your costs but also position your product line as competitive.

What You Need to KnowWhat is the quick definition of price and cost?

In its simplest form, the cost of producing your product or service is the sum of the costs for the business, both direct and fixed, divided by the quantity of products that you sell. The price that you charge is your determination of what the customer must pay to acquire your product or service. The difference between price and cost is profit—or loss!

What is the most that I can charge?

Pricing is more an art than a science. Be sure to research the market carefully in order to determine the maximum price that you can charge. Price too high, and demand for your product will sag; price too low, and you may trap yourself into a downward revenue spiral. Gather as much information as you can before making your pricing decisions; review the prices charged by your competitors, and study your own market research with potential customers. Once you are in business, pricing becomes easier, since you can adjust your prices and immediately review the effects they have on demand. In time, your pricing strategy will evolve.

Will charging less than my competitors always succeed?

Having the lowest price, especially when you are a small business, is a gamble. Many people have difficulty calculating the cost of their products or services and, as a result, find it easy to let their competitors effectively set the price. They simply assume that if they merely keep prices below their competitors, success will always follow. The truth is, having the lowest price often fails for small businesses since they lack the economies of scale necessary to make the price competitive and end up losing money as a result. What you must do is set the right price.

What is gross profit?

This term is, defined simply, the selling price minus the direct costs involved in making the product or delivering the service. Direct costs (often called variable costs because they vary with the output) include such items as raw materials, purchased components, and subcontracting. Fixed costs (sometimes known as overhead—items such as rent, taxes, depreciation, and insurance) are then deducted from the gross profit, resulting in the net profit. Focusing on gross profit helps you get a big picture view of your competitive position. Obviously, you need to sell enough at your chosen price to cover your direct and fixed costs and make a profit as well. But cost plus mark-up is only one of the ways you can determine pricing.

What is "break-even?"

This is the point at which the income from sales exactly equals all your costs. More sales will result in a profit; fewer sales will result in a loss. There are a number of variables you need to consider when you try to establish your break-even point.

Once my price is set, can I change it?

Of course. A price can always be changed, but there is often customer resistance to the raising of price, especially if the rise is too great or if you change it too frequently. The marketplace assumes (sometimes erroneously) that prices have been set after extensive research and deep thinking. Thus, when prices go up frequently, it leaves an overall negative impression. This should provide you more motivation to research and think through your pricing strategy.

What to DoFollow the Two-step Process

There are two steps in setting price: First, determine the costs of delivering a product or service; second, set a price that is high enough to cover the costs, but low enough to be competitive. Of course, you'd like to make sure that you are "profit pricing" your products.

Perform Market Research

Do you need to spend time and money on market research? Yes. It is necessary to have a sensible estimate of likely sales volumes, otherwise you will not be able to calculate direct costs. This is less important if you are selling a service in which there are low, if any, direct costs; but it is very important if you are in manufacturing, particularly if the direct costs (such as raw materials) are of a high value. Market research will not only help you set a price for your products now, it will help you estimate what effect a price increase will have on your sales. Market research is the best way to provide some logic to your pricing strategy.

Determine Your Costs

A key requirement for setting prices is to know all the costs—direct and fixed—for an expected level of sales. Include equipment and other capital depreciation and factor in your tax deductions if you are self-employed. Only after you have established the cost of manufacturing a product will you have the bare minimum price for a given level of sales.

Provided the cost is less than the price that you projected when you did market research, you will earn a profit—assuming, of course, that you sell the volume of product that you predicted.

Analyze Your Break-even

Your break-even is the point at which your costs and your revenues are exactly the same. There are many ways to arrive at this number.

One way to calculate break-even is to draw a graph that shows sales volume on the horizontal axis and money on the vertical axis. To begin, show the overhead costs: This will be a horizontal line since these costs are, generally, fixed for all volumes of production.

The direct costs can then be added onto the overhead costs to give total costs for a given volume of output. A line representing total costs can then be plotted. Now, plot the sales income to show how much income will be generated for a given volume of sales. Remember that sales income starts at zero, unless you have certain pre-manufacturing sales to include.

The point at which sales income equals total costs shows the break-even point. You can use this chart to determine, roughly, how price changes will reduce or boost sales and profits.

Set Reasonable Targets

Once you have ascertained the correct price and defined the break-even volume that you need to sell, your next step is to set an annual target, broken down into monthly increments, designed to generate a reasonable profit. To determine what's reasonable, you should also have research showing the profit rates attained by your competitors, or, at least, by those with similar manufacturing profiles to your own.

It can often be helpful to plot the targets for sales and actual sales on a graph to monitor progress regularly. If the business does not achieve its targets, you will need to take remedial action.

Check and Double Check

Review your sales volumes and income regularly. Be sure that you are making a profit; if you are not, you will need to take corrective action. Your two basic options are, of course, to reduce costs or to raise prices.

What to AvoidYour Prices Are Lowest

Be careful: It's always hard to raise prices once the marketplace is attracted to your product. Thus, having the lowest price might get you early sales, but it is hard to keep customer loyalty when you have to move prices higher in order to break-even or make a respectable profit.

You Don't Know Your True Costs

Oddly, many businesses will do enormous market research yet fail to spend any time researching their own costs. This is operating blindly. It is impossible to price strategically without knowing your cost basis.

You Forget to Factor in All Assets

Are you calculating everything you should in your cost basis? Many businesses buy expensive equipment and fail to include all the depreciation when they are estimating costs. Any time you invest in your business, it's imperative that you find ways to recover that cost.

Where to Learn MoreBook:

Mohammed, Rafi. The Art of Pricing: How to Find the Hidden Profits to Grow Your Business. New York: Crown, 2005.

Web Sites:

Bizpeponline: www.bizpeponline.com

Professional Pricing Society: www.pricingsociety.com