Getting your price right is a key challenge to most business owners.
Striking the right price is critical in fact as it has a direct result on profitability, cashflow and ultimately the success and survival of your business.
If you set your prices too high, then people won’t buy from you.
If you set your prices too low then people may not buy from you because they think your product or service is inferior.
Then you have the post sales experience and whether you have provided equal, more or less value to your customer or client. This is where a lot of businesses fail.
If customers are delighted then you are providing too much value and that is costing you profit to supply that level of profit.
If customers are disappointed, then referrals and recommendations don’t follow.
What you need is an optimal price.
But getting your pricing optimal is hard, very hard.
What you need to ascertain is the price which can cover your costs whilst delivering a profit and also satisfying the customer’s needs.
That’s the hard part, getting the value exchange right as it is entirely subjective.
Two price setting methods are commonly used by entrepreneurs, namely ‘cost-plus’ and ‘value-based’,
As the name suggests, cost-plus involves working out your total costs so that you understand how much you need to make to break even. Once you know this, then you add your desired profit level and that becomes your selling price.
Value based pricing sets the price exclusively on the perceived value of your product or service to the customer rather than the actual cost. If you use this method of pricing then you need a sound knowledge of your market.
One thing is certain though, never match a competitor’s price.
Price competition creates a commoditised market and where that exists, then the price will only ever go one way, down.
Let’s explore the two pricing strategies in some more detail.
Cost-plus pricing
As we said, cost-plus pricing involves adding your desired profit to your break even figure, usually as a percentage of costs and this differs from industry to industry.
For example, if your direct costs (labour, goods etc) were £1,000 and your industry average markup is 50%, then your sales price is £1,500.
Whilst you may know your cost base, knowing your industry can become difficult as you will not know your competitors cost base and merely matching sales price will only ever lead to price competition. Remember what we said above about that…
You can also add in all of your fixed costs to create a true break even figure. But this will be based on your estimated sales volumes, hence changes in sales volumes can distort your profit, even causing a loss.
Remember though, customers may attach more value than your cost-plus unit pricing. So whilst it is simple, it does have inherent limitations.
Value-based pricing
Value based pricing means basing your price on the perceived value that customers attach to your product or service.
To understand this, then you obviously need to know your potential customers, intimately. You need to know how valuable they consider your product or service to be.
Value based pricing can yield a far higher profit as it is down to you to differentiate and add value. Such differentiators can be low to zero cost, such as guarantees and position your business ahead of the competition.
However, value-based pricing is difficult to establish is your product is commoditised. In this instance, it is up to you as the business owner to convey value through your other promises. Think about John Lewis here, you can always purchase a new TV or fridge cheaper elsewhere, but when you buy your TV or fridge from John Lewis you know that if that is from another high-street shop then their ‘never knowingly undersold’ price match will kick in.
Value-based pricing is common in many niche markets though (such as consulting, design, retail and automotive) and we are increasingly seeing more businesses differentiating based on value. However, be aware that many industries have ‘going rates’ which automatically reflect the perceived value that customers attach to those services.
Price tactics
It is often beneficial to employ pricing tactics to either attract or retain customers. To understand this aspect of pricing think of how large retailers offer incentives such as discounts, loyalty rewards, limited time offers and 2for1 deals. These price tactics are often driven by loss leaders to entice you in when demand is slow. By bringing you in to spend money they are increasing revenue and this helps to contribute to the overheads. Hence whilst not making the same margin on the product, then they are at least turning cash and gaining income to contribute to the overheads of the business.
Within your portfolio it is often beneficial to keep margins modest on some products or services to be able to achieve higher margins on others.
Conclusion
We advise to market your business based upon value and set your prices accordingly. However, unless what your offering is unique or new then carefully consider what your competition is offering. You need to continually assess your prices and be prepared to make changes when necessary in order to keep demand constant.
Takeaway
Profit is the difference between revenue and costs. you can minimise your costs quite easily to become more profitable but many business owners only do this when cashflow becomes tight.
Very few business owners address price as a route to profit and we advise this first and foremost over reducing costs. Setting a price that is attractive to customers whilst also offering a profit is the big challenge as an entrepreneur.
When costs are increasing, the only way to way to maintain profit is to increase costs, but many entrepreneurs are reluctant to do this for fear of losing customers. Instead, they seek to find new customers whilst reducing costs, however finding new customers is costly and the increased workload can reduce quality and/or customer experience.
Instead look at fair and reasonable price increases.
Communicate with your customers and give them advance notice, citing reasons why. Your good customers will stay and price sensitive ones will leave. Remember, they’re the customers that cost you more and offer little profit, so if they leave then you have excess capacity to serve your loyal customers better or find more like them.