Deciding on Your Price

“Pricing is actually pretty simple…Customers will not pay literally a penny more than the true value of the product.” – Ron Johnson, former CEO of JCPenny

When starting a business, one of the most challenging decisions (and yet most important) is figuring out how to price your product/service in order to attract customers. In business, two pillars for making are profit and sales, both influenced by price. This can be the difference between success (profit) and failure.

There are many factors to consider when setting your price, but the most important principle is that the price must cover the cost – i.e. your business ought to make more money from the sale than you spent to do so. In accounting, this is better known as the “Cost of Sales”, the total cost that goes into selling the product or service to the customer. These costs are different from “running” costs of the business (like rent, electricity etc.) – and are specifically related to the product or service itself. It is incredibly important to understand and forecast these figures as accurately as possible. Failure to do so could have a huge impact on your business, so take as much time as needed.  

Before getting into pricing strategy, try and consider the following items to understand the Cost of Sales of your product: What was the cost of materials or supplies? What was their delivery cost? What does your product cost to manufacturing or assemble? Are there any costs to store your inventory? How much does it cost to deliver the product to your customer? If you are selling a service, then consider costs like employment, commissions, transport, or any sales equipment. The cost of sales can also help you establish your “breakeven point” – the lowest price you can sell your goods for in order to cover their cost.

While cost of sales is a good place to start, it’s only the first step in price setting. You now need to decide how much markup (or margin) you can apply to the base cost of your product/service, which will allow you to arrive at the eventual selling price. (Remember that “margin” is not the same as profit. Your margin, less other operating expenses – like rent, electricity and office supplies – gives you your profit before tax. It is also important to account for these ongoing costs when deciding on how much markup to apply – but be careful not to push the price too high or you’ll fail to attract customers).

Factors to consider when deciding on markup:

• Volume: How many items are you realistically to sell per week? Typically, the higher your sales volume, the lower your margin can afford to be. Selling higher volume also allows you to start low, before raising your price in the future.
• Competition: If you have a lot of competition in your industry, customers may already have a point of reference for pricing – and are unlikely to pay more for what they can get elsewhere. The only way you can justify a higher price is to make your offering unique.
• Demand: If there are few competitors (a low supply), and a high demand for your product, you can afford to charge more. But be aware that if this is the case, there will be competitors entering the market – so set a reasonable enough price to cater for future competition (who might undercut your price).
• Perceived Value: If a customer gets massive value from your product/service, you can justify charging them well above what cost of the item.
• Industry Standards: Certain industries (particularly retail) set standard markups for their products. Try and understand what these are for your industry.
• Pricing for Discounts: Because most industries are very competitive, one way for a new business to gain traction is to offer discounts. However, you need enough margin to ensure that you can still discount your product and cover your base cost at the same time. Failure to do this will put pressure on how long you can run your offer for.
• Pricing Power: How sensitive are your customers to price changes? You want to be able to raise your prices over time to cater for the increases of inflation and cost of supplies, without losing too many of your customers. In certain industries (like luxury goods) businesses can increase their prices and even increase the perceived value of their goods – but this is not the norm. It’s useful to experiment with your prices in this area to “test” how sensitive your customers are to price increases.

How to support your price:

An important truth is that your business or product must be able to support the price you set if your customers are to accept it. You’ll need to “prove” that the value your product or service is worth the cost. In order to do so, consider the following principles:

• Competitor Comparison: Do research into what products/services like yours are priced in your area. What is the next best alternative? Find a similar offer and set your price close to what’s being asked. You can either set a higher price (if you can support your uniqueness) or set a lower price to “beat” your competition. But, lowering your price can be an unsustainable method in the long run, unless you sell massive volumes of products.
• Cost of Replacement: What would it cost to replace or create a product/service like yours. By estimating how much it would cost (including time), you can support the price that you set. Customers are willing to pay for convenience.
• Value Comparison: This is the most important element to consider and ought to be supported by the others. It has to do with understanding the value of your offer to a specific group and entails discovering how much your offer is worth to your target customers. You (typically) cannot set a price that pleases everyone – so understanding who your ideal customer is – and ensuring that the value meets their needs, can justify a higher price. Example: The price of a protein shake may seem high to a normal person but may easily be considered a reasonable price to pay for a competitive body builder.

Many of the above factors can also serve as the key drivers of your marketing and sales strategies – allowing you to position your business differently to your competitors. When starting a business, take the time you need to adequately research your competition and customers in order to set your price fairly. As the business grows, and you increase your sales volumes, you can then focus on decreasing your costs even further – which will increase your profit.

Remember, pricing is (very) important, but great businesses thrive beyond setting the right price. In the words of Jack Ma, the founder of Alibaba and for many years the richest man in China, “Never ever compete on prices, instead compete on services and innovation.”

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