The price applied to a product or service is one of the most critical decisions a business owner or manager makes. Pricing obviously affects the company’s profitability, but it also has an impact on sales and marketing, staffing levels, competitiveness and a host of other factors. A low price might increase sales but the organization could struggle to keep up with the volume due to reduced cash flow. A higher price could mean fewer, higher-value sales and more resources to serve those customers.
Trouble is, many businesses invest relatively little time and energy developing a pricing strategy, instead settling on a price that they think the market will bear. This can be a recipe for disaster, and spell doom for an otherwise viable business model.
There are two key factors to consider when determining price. The first is profitability. Sales volume is of little importance if you’re losing money on every transaction. Business leaders need to have a firm grasp of the fixed and variable costs needed to produce and deliver the product or service.
Fixed costs include salaries, rent, debt service and other static amounts paid each month, while variable costs include the “cost of goods sold” (e.g. raw materials, products bought for resale, third-party services) that are directly attributable to the product or service. All variable costs and an appropriate proportion of fixed amounts must be reflected in the price in order for the business to be profitable.
The second consideration is competitor pricing — this helps you determine how much of a markup you can apply over and above your fixed and variable costs. This is where pricing transcends simple accounting and becomes a strategic decision. Do you want to position your business as the low-cost provider or a premium service worthy of a premium price? How many competitors are there and what is the range of pricing? How price-sensitive are your customers?
The key here is to not simply match your competitor’s price. Another company’s profitability equation is likely to be very different than yours. If the prevailing price in the marketplace is too low for you to turn a profit, you will need to rethink your operations and/or differentiate your business as a premium provider.
As you perform your analysis, it’s important to understand the difference between markup and margin. Markup is gross profit divided by the cost of goods sold. Margin is gross profit divided by gross revenue. A 25 percent markup may yield only a 5 percent margin depending upon your fixed costs. So you’ll have to go back to your profitability figures and determine what you need to do to obtain the margin you desire.
Developing a pricing strategy is an iterative process that must be revisited frequently. Costs will change over time, and the competition will evolve with businesses entering and leaving the market. The Internet has made pricing transparent across industries, so you need to continuously monitor prices and market conditions.
Pricing your product or service isn’t easy. Armed with the right data, however, you can make a more-informed decision that will help make your business more profitable and competitive.