All business owners must eventually decide how to price their product or service. This decision is pivotal to the success of any business, and without any standard formula to rely on, it is incredibly complex. Fortunately, there are some successful pricing models you can use as a framework for your own business. Check out this infographic from Fundera for a breakdown.
Every CEO, owner, founder and entrepreneur faces the complex question of how to price their product or service, and it’s a decision that can make or break your business. Unfortunately, there’s no set formula for this calculation, and experts hold vastly different opinions on the matter. You might have heard the popular maxim that pricing is more art than science, and our research bears out this principle. Not to worry—we’ll walk you through each factor to consider as you determine price, so you can settle on the model that’s right for your enterprise.
For those who’d rather skip the detailed explanations and get straight to the bottom line, jump to the infographic at the bottom of this post.
Compute Your Costs
The first step in deciding how to price your product is to establish how much it costs to make your goods or provide your service. After all, your goal is to turn a profit—which is impossible if your expenditures aren’t covered. Expenses fall into three categories: materials, labor, and overhead. Add these together, and you’ll arrive at an accurate figure for your total cost of output.
Materials
Materials constitute the raw components of production. For example, if you make clothing, your materials might include cloth, buttons, and thread. If you provide a service, you might still have material costs, depending on the industry. A janitorial business, for instance, requires items like mops, buckets, and other cleaning supplies. If you resell commodities produced by another entity, your materials are the items you acquire from the initial seller, plus anything required for repackaging.
The fiscal outlay in the above illustrations may seem obvious, but calculating the cost of materials is not always straightforward. If you run a tech company, consider the value of your computers and servers. Such devices might fall under materials if they comprise part of your actual product—i.e. your business sells technical components. On the other hand, if your computers are merely tools to enhance a service, they are overhead, which we’ll discuss below.
Labor
Labor measures all physical and mental manpower necessary to create your product or service. Whether it’s a worker on the factory floor or the receptionist in your office, if you hire someone who adds value to your business, that person becomes part of your labor calculation.
Don’t forget that salary isn’t the only cost associated with labor. You may need to pay for benefits like insurance and retirement plans, as well as payroll taxes for social security and Medicare. Be sure to include all these expenses in your computations.
Remember also to account for the time that you invest into your business as an entrepreneur. Many business owners underestimate the value of their time and undercharge for their services. One way to avoid this error is to document each step in the processes you complete daily for your enterprise. Then step back and examine the amount of knowledge required and energy expended on each task. You may be surprised by the extent of your contributions and your expertise, and you can be less partial as you price your own work.
Finally, if you’d like some objective data, consult the U.S. Bureau of Labor Statistics to compare the average price of labor by industry and by geographical area. This tool might provide some perspective as to whether your costs are in line with similar businesses.
Overhead
Overhead is a catchall term for all expenses that aren’t covered under materials or labor. These expenditures can either be fixed or variable.
Fixed Overhead
These are the costs that one must pay every month—no matter whether your company is in the red or in the black—and the amount remains relatively constant each month. Fixed overhead includes rent, insurance, salaries, depreciation on equipment previously purchased, payroll costs, some taxes (others are variable based on revenue, etc.), and utilities.
Variable Overhead
These expenses vary month to month, and depend on factors like seasonal change and fluctuations in profit. Such costs include marketing, shipping, office supplies, and travel. This category also encompasses what are typically one-time expenditures necessary for starting up, such as security deposits, equipment purchases, and fees for state and local licenses. To calculate variable expenses for the purpose of pricing, use an average monthly figure based on an estimate of the annual total.
If you’d like some guidance to compute your total costs, use this worksheet from the Small Business Administration.
Determine Your Desired Profit
You can calculate your desired profit as the dollar amount above costs that you wish to make per unit or per customer, or perhaps as the percentage of revenue that’s actually profit once you deduct all your expenses—a figure also known as the profit margin. Your profit goal might be somewhat arbitrary, although you can look to professional associations in your industry for guidance. Many of these organizations publish free or low-cost anonymized financial information.
If you’re unable to find such information, you can purchase an annual statement study from Risk Management Associates. RMA is a nonprofit organization comprised of the major lenders around the world that uses data collected by these institutions from small and medium-sized businesses to create annual reports on the financial health of many industries. If RMA covers your industry (and with 2,330 choices, the likelihood is high), you can measure how your current or desired profit margin compares with others in your field.
Know Your Customer
To determine how to price a product, it’s important to know your target market and to understand what motivates them. You can pay a research firm to gather such data, or you can collect a lot of it yourself—through your personal and social media networks.
An informal survey conducted in person among contacts and colleagues or given online can unearth a goldmine of information, if you ask the right questions. Should you have access to a relevant email list or have an existing customer base to consult about a new product—or if you simply want to sample all your friends—SurveyMonkey and Google Surveys are simple and inexpensive ways to compile and aggregate statistics via the web.
Here are some topics to cover and questions to ask that should help you to better understand your customer and to determine what they might pay for your goods or service:
- Demographics: What is their gender, age, general location, and income level?
- Competitive intelligence: What are their favorite products or services that are similar to yours? List some options for them to select.
- Budget consciousness: How important is the price of an item when they make a purchase? Allow them to rank this preference from 1-10.
- Motivation: When they make a purchase, which do they prioritize—price or convenience? How about some of the other unique features of your merchandise or service? Pit various options against each other to see what matters most to your consumer.
- Status: When selecting among products, how important is the brand name of the item? Again, provide the ability to rank this priority from 1-10.
- Psychological susceptibility: Are they more likely to buy a product that is priced at $9.89 than one priced at an even $10?
These answers should help you decide whether your client base focuses primarily on cost, comfort, feature set, or luxury. If their priority is cost, bundling products or services or tiered pricing may appeal to their frugality. If comfort is of utmost concern, you can charge more and emphasize the amenities that set you apart from the competition.
Should your customer prefer a robust set of features, subscription-based pricing might work well—as it allows for a constantly evolving and ever-changing product. And if your customer is all about prestige, avoid pricing your product too low; such individuals associate the cost of an item with its quality.
Research Your Competition
Now that you understand the priorities of your customer, it should be easier to differentiate your direct competition from other potential competitors. Who offers a product or service similar enough to yours that your customer likely faces a choice between you and them? What do they charge?
You can unearth a wealth of competitive data online, and not just on a company’s website. Use Google Alerts to stay abreast of the latest news on any business, product, or industry. Google Trends reveals the popularity of all search terms—like the name of a possible competitor—and the locations from which that query is most often entered. This tool also displays related search terms and the respective popularity of each one. With this knowledge, you can further hone your list of direct competitors.
Follow the social media accounts of your future rivals. You’ll learn about their target demographic, their marketing strategies, and whether they’ve found a niche. Do they have a large online audience? If so, pay close attention to their tactics—especially when they involve price. Watch what type of promotions they offer and when, and consider whether you can match or exceed such discounts.
If your internet efforts don’t yield the results you need, play detective the old-fashioned way. Call or visit possible competitors. You can also ask your current or potential future customers about the competition, as we discussed above.
Common Pricing Models
We’ll now explore some of the prevailing and most successful models that businesses use to set price. Remember, though, that a model is just that: a framework to help guide the decision-making process, not a definitive blueprint. Given the numerous variables involved, it’s unwise to adhere exclusively to one methodology to determine price.
Cost-Plus Pricing
This is the textbook model of how to price a product that we referred to above: calculate your costs, add your desired level of profit, and voila—you have your price. Some sellers determine how to price a product simply by doubling their costs, which is a simplified version of cost-plus pricing. Although this methodology is common, as we’ve seen, it fails to account for factors like customer preference, brand image, and competition. It also ignores the laws of supply and demand.
Even if you adopt this model, cost-plus pricing might not be a realistic option out of the gate; it might be impossible to cover all your costs right away, especially if you’ve just started out and have accrued significant one-time expenses.
Finally, if you use this approach, be certain to include all your costs in these calculations. If you overlook hidden costs like inventory markdowns or holiday pay, you may undercharge your customers and neglect to produce the profit you require to stay afloat.
Market Share Pricing
The goal of many pricing models is to maximize profit. However, it might be just as (if not more) important to maximize market share—which measures the percentage of an industry that your business controls—particularly if you’re new to that market. To gain market share means that you gain customers, which should eventually produce a net increase in revenue, even if you must first lower prices to grow that market share. (Think volume over price.)
A boost in market share may also result in what is called a network effect, where the value of your product rises as more people use it, which might allow for a price hike down the road. The Windows operating system created by Microsoft is an excellent example of the network effect. As Windows became an industry standard, more developers created applications that ran on Windows, which increased its inherent value to the consumer and thus customers tolerated a surge in price.
If you have a low market share in a fast-growing industry, the goal should be to increase market share or to penetrate the market, as they say. Consider a lower price than your competitors to encourage customers to try your product or service, and perhaps to switch for good. You can raise your price slowly once you establish brand loyalty with your new client base, although that might not always occur. A consumer who changed companies once because of price is more likely to do so again, so this strategy might only take you so far.
Dynamic Pricing
Dynamic pricing is also called demand pricing, which means that the cost of a product or service varies based on when and where it’s offered or sold, and to what extent the demand for the item is on the rise.
For instance, you might find your favorite fashion at various prices, depending on where it’s sold. The apparel industry consists of retailers, discount chains, wholesalers, ecommerce sites, and more. Each of these vendors will pay a different price for the same item, and will likely pass that cost on to the customer.
If the style you seek is not in vogue, i.e. demand is low, the production house may hawk the clothing to a wholesaler, who buys inventory in larger quantities and for less than a retailer. The wholesaler may then unload that inventory to a discount chain or an ecommerce site, where the customer can acquire the piece at a reduced price. Conversely, if the item is on trend and sells quickly, you’ll need to pay full-price at a primary retailer to obtain the same style.
Surge pricing is a type of dynamic pricing most commonly observed with rideshare services like Uber and Lyft. When demand rises during inclement weather or during rush hour, for example, the price of a ride increases significantly.
A dynamic pricing model requires you to keep tabs on the demands for your time and the popularity of your product, and to raise prices commensurately. If you operate a service, try scheduling or project management software to determine how many clients you’re juggling and how much work each one expects. If the sum total is more than one individual can handle effectively, you might hike your prices to weed out customers or to cover the costs of outsourcing some responsibilities.
Competitive Pricing
In some markets where it’s difficult to distinguish between products, like in the airline industry, businesses use a competitive pricing model. There’s often a market leader who sets the standard, and competitors follow suit. If one company raises or lowers prices, other companies feel compelled to follow.
In a competitive pricing model, if you wish to charge more than your rivals, you must convince the consumer that you provide a superior product or service. This brings us to the principle behind the final model we’ll explore.
Value-Added Pricing
As discussed above, if your target market is not budget conscious, they might accept a higher price when they perceive added value in your product or service. Here are some potential ways to boost customer benefit and to justify a price hike:
- Facilitate convenience: Some consumers would rather pay more than go out of their way to find what they need or wait a long time to receive it. Thus, a neighborhood corner store can charge more for the same item than a supermarket can, or an ecommerce retailer can add a surcharge on top of the actual cost incurred for expedited shipping.
- Brand your product: It’s worth going the extra mile to ensure that your brand becomes well-known in its industry, as many individuals will shell out more money for a name that they know and feel like they can trust.
- Set a trend: Certain customers are early adopters, and are the first to own the latest gizmo or the hottest fashion. If your product might fall into this category, market accordingly and consider partnerships with influencers that speak to your target demographic.
- Create scarcity: Ticket resellers use this technique when they purchase a large number of seats to a highly anticipated event and drive up the prices for that show. This approach can backfire, however, if consumers grow frustrated with the steep markups that ensue.
- Find a niche: If you’re one of the only suppliers of a product or service, you have carte blanche to set high prices.
- Provide unparalleled customer service: Many clients will spring for a smooth and efficient online shopping experience, for instance, or for the assurance that they can return a product any time, no questions asked.
Monitor Your Prices
It’s unlikely that you’ll set prices only once. Watch for changes in the market, and keep an eye on your competition. Track your costs to ensure they don’t rise astronomically without your knowledge, and mind your revenue as well. Note whether the public perception of your product changes for any reason, either positive or negative. Any of these issues might signal a need to reevaluate price.
The Final Word on How to Price a Product
A final note on pricing from Norm Brodsky, senior contributing editor for Inc.com:
“The truth is, most people tend to charge too little when they first go into business. It’s not always clear, after all, what customers are willing to pay or how much they value what they’re getting. So there’s uncertainty, and there’s also fear. First-time entrepreneurs usually feel as though they need every customer that they can get just to survive. They’re afraid that if they ask too much, they might lose a customer’s business. Or they worry about setting their rates so high that they’ll price themselves out of the market, even if a particular customer does go along with the price they’re asking for. As a result, new business owners tend to undervalue whatever they’re providing. By that I mean they charge less than their customers would willingly pay.
Carefully weigh all the factors we’ve laid out here, but when all is said and done, err on the side of higher prices. It’s easier to lower prices than to raise them, and the market will provide a quick correction if you overshoot the mark. Whether you’re brand-new to business or a seasoned veteran, your effort and your ingenuity are probably worth more than you realize. Set your prices accordingly.
