Pricing: 4 steps to Price for Profit

There are plenty of ideas about how to calculate the perfect price for your products or services, but none are very interesting or useful for your small business.

If you are looking for something to put you to sleep, reading about “price theory” is perfect.  You could learn to set prices using games, options, alternatives, arbitrage, value, and even something called “Austrian pricing” (cool name, but not important).

Instead of academic theories, ask yourself three simple questions:

  1. What does it cost me to produce?
  2. What does it cost me to stay in business for one month if I don’t sell anything?
  3. What are other companies charging for similar products?

Answer these questions as objectively and carefully as you can, because the answers form a “best price” for your particular product or service.  To get there, however, we must first understand your Possible, Reasonable and Average prices.  Ready?

STEP ONE: FIND A LOWEST POSSIBLE PRICE.   The answer to question #1 is the absolute lowest Possible price you can sell at. This is the price you would sell to your mother, but not to a customer.  Not even your best customer.  Any non-mother sales at this price will put your company in danger.

STEP TWO: CALCULATE THE LOWEST REASONABLE PRICE.  The answer to question #2 helps you find the absolute lowest Reasonable price you can sell at.  How?  Take the answer to #2 and divide by the number of units you sell in an average month. The resulting value is called the contribution marginAdd the contribution margin to your answer for #1 to get your lowest reasonable price.  Make this the lowest price you will ever offer to your very best customers… with a coupon… after Christmas.

STEP THREE: SET A LOWEST AVERAGE PRICE.   Watch out.  The lowest Reasonable price ignores the most important aspect of business.  Profit.  Time and again, business owners slash prices and neglect to include profits that will keep the business growing.  Treat your company like a vendor – count on paying it out of every sale.  How much profit is enough depends on many factors, but adding 30% to the lowest reasonable price (above) is the bare minimum.  When you’ve included sufficient profit, you’ll have your lowest Average price.

Note that I used the word “lowest” to describe these prices.  This is a cost-based or “bottom-up” way of setting minimum prices.  Your best price is higher.

STEP FOUR: IGNORE THE COMPETITION.  Question #3 is a trick question.  The answer can help you better understand your customers and your competition, but relying too much on competitor’s prices is only important if you sell something exactly the same as your competitor – commodities like gold, oil or pork bellies.  In most cases, having a different price than your competition is actually a good thing.  Different prices actually set you apart and attract new customers.

Note that your customer’s price can give you a important signals.  If the competitor’s price is already below your lowest reasonable price, you have a real challenge: perhaps your overhead is too high or your product is too fancy.  You can try to reduce costs, or go for the high-end customer who is willing to pay for your “luxury” product

At this point, you have the correct financial price.  There are also marketing considerations to price.  Price sends a signal to the buyer about the value of your product.  (A Mercedes does not really do anything very different than a VW, but it has a higher price and a higher “perceived value”.)  If your marketing message (and the quality of your product) can support this perceived value, a higher price might actually generate more sales and more profits for you.

Price is a powerful tool.  Used correctly it can attract customers, boost profits, and differentiate you from your competition.  When neglected, however, prices have a tendency to fall – every body loves a sale – and that turns the power of pricing against you.  No company can survive prices that are not covering costs.

For a healthy and happy business, understand, set and respect your lowest minimum price levels and then work to keep your prices higher.

Originally Published

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