Product Pricing

There are a variety of different types of pricing strategies in business. However, there's no one definite, formula-based approach that suits all types of products, businesses and/or markets. Pricing your product usually involves considering certain key factors, including identifying your target consumer, competition analysis and understanding the relationship between quality and the price.

The Basic Rules

No matter what type of product, the price charged to the consumer will have a direct effect on the success of the business. Though pricing strategies can be complex, the basic rules of pricing are straightforward:

• All prices must cover costs (and profits).
• The most effective way to lower prices is to control (if not lower) costs.
• Review prices frequently to assure that they reflect the dynamics of cost, market demand, competition, and profit objectives.
• Prices must be established to assure sales.

Know The Costs

Know the costs of running your business. If the price for your product or service doesn't cover costs, the cash flow will be cumulatively negative, which means, the financial resources will exhaust and the business will in due course not succeed and that is no reason to start a business, no one invests to fail; unless that is your way of spending on charity. Good Luck!

A good idea is to add a %age profit in your calculation of costs. Treat profit as a fixed cost, like a loan payment or payroll, since none of us is in business to break even.

The Right Time

When is the right time to review your prices? When:

• Introducing of a new product or product line;
• Costs change;
• Deciding to enter a new market;
• Competition changes prices;
• The economy experiences either inflation or recession;
• Change in sales strategy.

Pricing - In One Of Four Ways

Cost-Plus Pricing

Many manufacturers use cost-plus pricing. The key to being successful with this method is making sure that the "plus" figure not only covers all overheads but also generates the percentage of profit you require. If the overhead figure is not accurate, you risk profits that are too low. The following sample calculation should help you grasp the concept of cost-plus pricing:

  

Cost of materials	$ 50.00
+ Cost of labor	30.00
+ Overheads	40.00
Total Cost	120.00
+ Desired Profit (20% on sales)	30.00
= Required Sales Price	150.00

Demand Price

Demand pricing is a method in which consumer response to various price points in a range of prices is analyzed to arrive at the highest acceptable price. Also called value oriented pricing.

Demand pricing is determined by the optimum combination of volume and profit. Products usually sold through different sources at different prices e.g. retailers, discount chains, wholesalers, or direct mail marketers etc. are examples of goods whose price is determined by demand.

A wholesaler might buy greater quantities than a retailer, which results in purchasing at a lower unit price. The wholesaler profits from a greater volume of sales of a product priced lower than that of the retailer.

The retailer typically pays more per unit because he or she are unable to purchase, stock, and sell as great a quantity of product as a wholesaler does. This is why retailers charge higher prices to customers.

Demand pricing is difficult to master because you must correctly calculate beforehand what price will generate the optimum relation of profit to volume.

Competitive Pricing

Competitive pricing is generally used when there's an established market price for a particular product or service. If all competitors are charging $100 for a replacement windshield, for example, that's what you should charge and here the profitability is managed through lower/controlled operating costs.

Competitive pricing is used most often within markets with commodity products, those that are difficult to differentiate from another. If there's a major market player, commonly referred to as the market leader that company will often set the price that the smaller companies within that same market will be compelled to follow.

To use competitive pricing effectively, know the prices each competitor has established. Then figure out your optimum price and decide, based on direct comparison, whether you can defend the prices you've set. Should you wish to charge more than your competitors, be able to make a case for a higher price, such as providing a superior customer service or warranty policy. Before making a final commitment to your prices, make sure you know the level of price awareness within the market.

If you use competitive pricing to set the fees for a service business, be aware that unlike a situation in which several companies are selling essentially the same products, services vary widely from one firm to another. As a result, you can charge a higher fee for a superior service and still be considered competitive within your market.

Markup Pricing

Used by manufacturers, wholesalers and retailers, a markup is calculated by adding a set amount to the cost of a product, which results in the price charged to the customer. For example, if the cost of the product is $100 and your selling price is $140, the markup would be $40. To find the percentage of markup on cost, divide the dollar amount of markup by the dollar amount of product cost:

$40 / $100 = 40%

This pricing method often generates confusion and not to mention lost profits, among many first-time small-business owners because markup (expressed as a percentage of cost) is often confused with gross margin (expressed as a percentage of selling price). The next section discusses the difference in markup and margin in greater depth.

Pricing Basics

To price products, you need to get familiar with pricing structures, especially the  difference between margin and markup. As mentioned, every product must be priced to cover its production or wholesale cost, freight charges, a proportionate share of overhead (fixed and variable operating expenses), and a reasonable profit. 

Factors such as high overhead (particularly when renting in prime mall or shopping locations), changeable insurance rates, shrinkage (shoplifting, employee or other theft, shippers' mistakes), seasonality, shifts in wholesale or raw material, increases in product costs and freight expenses, and sales or discounts will all affect the final pricing.

Overhead Expenses

Overhead refers to all non-labor expenses required to operate your business. These expenses are either fixed or variable:

• Fixed expenses

No matter what the volume of sales is, these costs must be met every month. Fixed expenses include rent, depreciation on fixed assets (such as cars and office equipment), salaries, insurance, utilities, membership dues and subscriptions (which can sometimes be affected by sales volume), and legal and accounting costs. These expenses do not change, regardless of whether a company's revenue goes up or down.

• Variable expenses

Most so-called variable expenses are really semi-variable expenses that fluctuate from month to month in relation to sales and other factors, such as promotional efforts, change of season, and variations in the prices of supplies and services. Fitting into this category are expenses for telephone, office supplies (the more business, the greater the use of these items), printing, packaging, mailing, advertising, and promotion. When estimating variable expenses, use an average figure based on an estimate of the annual total.

Cost of Goods Sold

Cost of goods sold, also known as cost of sales, refers to the cost to purchase of products with an intention for resale or to add to the cost to manufacture products. Freight and delivery charges are customarily included in this figure.

Accountants segregate cost of goods on an operating statement because it provides a measure of gross-profit margin when compared with sales, an important yardstick for measuring the business' profitability. Expressed as a percentage of total sales, cost of goods varies from one type of business to another.

Determining Margin

Margin, or gross margin, is the difference between total sales and the cost of those sales. For example: If total sales equal $1,000 and cost of sales equals $300, then the margin equals $700.

Gross-profit margin can be expressed in dollars or as a percentage. As a percentage, the gross-profit margin is always stated as a percentage of net sales. The equation: (Gross-profit / Sales) = Gross-profit margin

Using the preceding example, the margin would be 70 percent.

When all operating expenses (rent, salaries, utilities, insurance, advertising, and so on) and other expenses are deducted from the gross-profit margin, the remainder is net profit before taxes. If the gross-profit margin is not sufficiently large, there will be little or no net profit from sales.

Some businesses require a higher gross-profit margin than others to be profitable because the costs of operating different kinds of businesses vary greatly. If operating expenses for one type of business are comparatively low, then a lower gross-profit margin can still yield the owners an acceptable profit.

The following comparison illustrates this point. Keep in mind that operating expenses and net profit are shown as the two components of gross-profit margin, that is, their combined percentages (of net sales) equal the gross-profit margin:

	Business A	Business B
Net sales	100%	100%
Cost of sales	40	65
Gross-profit margin	60	35
Operating expenses	43	19
Net profit	17	16

Markup and (gross-profit) margin on a single product, or group of products, are often confused. The reason for this is that when expressed as a percentage, margin is always figured as a percentage of the selling price, while markup is traditionally figured as a percentage of the seller's cost. The equation is:

(Total sales - Cost of sales)/Cost of sales = Markup

Using the numbers from the preceding example, if you purchase goods for $300 and price them for sale at $1,000, your markup is $700. As a percentage, this markup comes to 233 percent:

($1,000 - $300) / $300 = 233%

In other words, if your business requires a 70 percent margin to show a profit, your average markup will have to be 233 percent.

You can now see from the example that although markup and margin may be the same in dollars ($700), they represent two different concepts as percentages (233% versus 70%). More than a few new businesses have failed to make their expected profits because the owner assumed that if his markup is X percent, his or her margin will also be X percent. This is not usually the case.