It’s no surprise that most business owners struggle with pricing. Price your product too high and you lose business. Price your product too low and your profits go out the window. If you’re struggling with pricing, you are not alone. Below are some best practices when pricing for profit, along with some things to know to help make the pricing process easier.
Understanding Your Market
If you are operating in a market that is highly competitive, for example a grocery store or shoe store, you are typically confined in pricing by whatever the going rate is for the products you sell. If you are launching a new product, however, you will have more flexibility with your pricing because competition is less or even nonexistent. Also, since customers understand there are no other prices to compare to, they will typically pay more.
Unfortunately, even though they can set their own price, many business owners choose to set their initial price too low. In fact, according to Inc., a McKinsey study showed that 80 to 90 percent of the initial prices set by business owners were actually too low. They report that companies systematically underestimated what they could actually charge. This type of mistake can prove costly too, since under-pricing by only 1 percent can reduce operating profits by 5 to 10 percent.
Which Type of Pricing Is Best?
Before looking at the best practices when pricing for profit, it is important to understand how price points are actually created. According to Iowa University Extension and Outreach, the price of a product is generally determined in one of three ways.
This type of pricing focuses on how customers value a product and how they respond to different price levels. The amount you can charge and the profit you can make is mostly dependent on what the market will bear, or rather, what the customer is willing to pay. This is based on the perceived benefit of the product. Customer-based pricing allows little room to price a product for profit because the customer determines how much you can reasonably charge.
Competition-based pricing is considered one of the most difficult pricing strategies for businesses to overcome because it focuses on what competitors are offering similar products for and at what price. Unless your product differs enough to make it unique, the amount of profit you can make with competitor-based pricing is determined by how many competitors are in the market and how much of the product is available.
While profits are typically lower when prices are set at the same price as competitors, business owners may choose to set prices even lower still. Knowing that in doing so they will receive lower profits but perhaps make up the difference by attracting potential new customers and, over time, gaining a share of the market.
Of the three ways to create price points, cost-based pricing is considered the most effective when pricing for profit. Unlike customer-based pricing and competition-based pricing, cost-based pricing looks at the actual cost of the product. It also factors back-end costs associated with the product, such as federal and state taxes, overhead costs, manufacturing costs and labor costs.
One of the biggest advantages to this type of pricing is that when you find ways to cut your overhead costs, you can actually increase your profits. As an example, by providing customers with an automated payment choice, your administrative costs, or rather, your overhead costs go down, meaning the amount you make on each item goes up. As an added benefit, since this method of payment is more efficient, it not only puts more money into your pocket, but also helps to increase customer satisfaction.
Note that using cost-based pricing does not take into consideration what a customer will give for the product, nor does it consider what the competition is pricing the product at. Instead, it uses the actual cost and the gross margin or markup as the way to create the price.
Determining Margins and Mark-Ups
Once you have determined the actual cost of your item, you have what is known as your break even price. This is the floor or minimum price that you could sell the item for without taking a loss. When pricing for profit, you can either add a markup or calculate the gross margin of your actual cost to arrive at your price.
Calculating the gross margin costs is actually easier to understand when you realize that it is actually the gross profit that you make on an item. To determine your gross margin, subtract the desired margin you wish to use from 100 percent, then divide your actual cost by that number. For example, if your desired margin (profit) is 25 percent and your actual cost is $5, the price you would need to charge to achieve this margin is $6.66 ($5 / $75 = $6.66).
Markup pricing is a pricing method generally used by retailers, wholesalers and manufacturers. It is one of the easiest ways to create a profit because you are simply adding a set amount to the actual cost of the product, and the two amounts together are what you will charge your customer. If the cost of your product is $10 and you sell it for $15, your markup cost is $5. That is a markup of 50 percent, or a $5 profit.
While this method is effective for pricing, it is important to realize that this percent is not the same as the gross margin percent, and the two percentages are calculated differently. Without taking this difference into account, many new businesses fail to reach their expected profits because they assumed that if they use a percent for their markup, there gross margin is the same. Unfortunately, this simply is not the case.
Putting it all together
As you can see, pricing for profit is not really all that difficult. It just takes some practice to get it right. Once you have it mastered, not only will your business benefit, but so does your bottom line.
Once your products are priced it is best to do an overall break even analysis to check your businesses overall profitability if you are in start up phase. Additionally it can be used to work out the number of units to be sold to obtain your return on investment if you are selling a new product line. You can read about how to do a break even analysis as well as download our free template here.
Generate Cash Flow
Now the pricing for profit phase has been completed, the next step is working out how you are going to be paid. Or if you have an existing merchant account, it may be time to shop around for a better deal to reduce your overheads. At IntegraPay we provide clear fees for our merchant services so you know what you are in for and you can factor these in to your profit margins. You can as well choose to pass on the merchant fees to your customers. With payment solutions across direct debit, credit card and BPAY we make it easier for businesses to get paid. To find out more please don’t hesitate to contact us and speak to one of our payment solution specialists.