The price you charge for your products or services is one of the most important parts of managing any business.
Though the price you set can be primarily a way of ensuring that you earn enough revenue to keep your business running, it is also a key strategic, marketing and financial tool for you.
Put simply, how you price your products and services is critical - the prices you set will set the groundwork for whether or not your business is profitable.
Different pricing methods can be used to achieve many different objectives, including:
- increasing cash flow
- attracting or discouraging a certain type of customer
- positioning your business against a direct competitor.
At a minimum, the prices you set will set the groundwork for whether or not your business is profitable.
Setting a price incorrectly will at best, limit your business growth. At worst, it may cause major issues for your cash flow, your profitability, your brand and the effectiveness of your marketing activities.
How to develop your pricing strategy
The creation of a pricing strategy can be broken down into five distinct stages.
1. Estimate customer demand
The price that you set for your product or service will be largely driven by customer demand. Customer demand can be determined by quantifying three things:
- what benefits your customers gain from using your product or service
- what value your customers place on receiving the benefits you provide
- what evaluation criteria do your customers use for making buying decisions against your competitors - for example, speed of delivery, convenience or reliability.
Previous sales records will give you some indication of customer demand however it is advisable that this is validated against some form of market research.
2. Analyse competitors
Your competitor’s market share, and the prices that they are going to market at, will be a significant factor in what strategy you eventually employ for your business. It is therefore important to ascertain where your product or service stands when compared with your competition.
The easiest way of getting competitor pricing information is often the most direct. If you phone your rivals and ask them for a quote, you are likely to get the information you need. Published price lists either online or in print are also a good source of competitive information.
You can use this information as a framework to start building your own pricing strategy.
3. Calculate costs
If you wish to stay in business in the long term you will need to ensure that any price you set at least covers your costs. Accurately calculating your costs is therefore a necessary element to ensuring that you set the correct price.
Costs can be divided into two distinct categories:
- Fixed costs – these are costs that are not affected by how much or how little you sell such as rent, leasing or staff costs
- Variable costs – these are costs that vary according to how much or how little you sell such as stock, overtime, shipping or printing.
When you set a price, it must be higher than the variable cost of producing your product or service. Each sale will then make a contribution towards covering your fixed costs – and making profits.
For example, say a picture framer has variable costs of $200 per job and total fixed costs of $30,000 a year that must be covered. If the framer makes 250 frames each year, he needs to sell each frame for at least $320 per frame. This is calculated as follows:
- $30,000 fixed costs divided by 250 frames per year: $120 per frame
- Plus variable costs per frame: $200
- Total cost per frame: $120 + $200 = $320
Using this structure, you can assess the consequences of setting different price levels.
4. Set objectives
Your business objectives must be one of the primary drivers of how you price your products and services. By aligning your business objectives with the way you set your prices you will give yourself the best possible chance of succeeding. Your high level business objectives should be outlined in your business plan.
Once your business objectives are known, you can set your pricing objectives to help you achieve the optimal result. Some common examples of pricing objectives are shown below:
- Quality indicator – this objective seeks to use price as an indicator of quality. In many markets, a high price contributes to the perception that the product is of high quality. If your potential customers base their purchasing decisions around quality rather than cost, this may be an appropriate strategy to employ
- Profit maximisation – this objective seeks to maximize profit by maximising revenue and minimising costs. This strategy is often best used as a short term objective as this approach can potentially lead to smaller long term profits. It is also best employed for products or services that are “cash cows”
- Revenue maximisation – this objective seeks to maximise revenue with little regard to cost inputs. This objective is often used when building market share is a key priority
- Maximise units sold – This objective is implemented when there are tangible benefits in the medium to long term (eg decrease in the cost of production, or defending a market position from a competitor
Maintain market position – This objective seeks to ensure that existing market position is maintained and market prices are stabilised by keeping prices at a “status quo” level.
Cost recovery – when a market is depressed, it may be prudent to set prices at a level that covers costs. This will enable the business to survive until the market recovers
5. Determine pricing
Once you have set your pricing objectives, you can start to set your prices. There are many different techniques and tactics you can employ to determine your pricing.
Whatever prices you set, you need to make sure that they cover costs and deliver to your objectives.
This article originally appeared on the Ask Us How website. NSW Business Chamber Members can access this site, which features hundreds of practical articles and other resources to help you manage and grow your business.
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