Many businesses adopt a simple pricing strategy: They research the market, determine what the competition charges for similar products or services, and then meet or slightly under-cut those prices.
This strategy can be effective when the economy is booming, but since many customers make purchasing decisions based on considerations other than price, a low-cost (or slightly lower-cost) provider can struggle to attract customers who are concerned with more than price. In truth, your pricing strategy may have to be modified depending on competition and economic changes to your served market.
Before developing a pricing strategy, gather data and determine:
- Current prices and pricing strategies used by competitors
- How customers perceive the products and services they receive (is the item or service a commodity, a custom item, a luxury item, etc.?)
- The benefits customers derive from those products and services
- The fixed costs you incur or will incur (overhead, rent, utilities, fixtures, etc.)
- The variable costs you will incur (discretionary wages, product costs, fulfillment, etc.)
When you've gathered all your data, you should understand your business model and operating costs, as well as the current pricing strategies and price points in your market.
Then you can apply one of several pricing methods:
Cost-plus: Determine your production or product costs and then apply a target profit margin. For example, if a product costs $20 to manufacture, and you wish to make a 20% profit, set your price at $24. (Please note that this calculation does NOT include overhead costs, rent, vehicles, office supplies, administrative staff salaries and benefits, etc. If you wish to make a 20% net profit and your overhead costs are 15% of your total annual sales, then you will have to add an additional 15% of your price, or $3, making the total price $27).
Targeted return: Determine investment costs and then apply a targeted rate of return to deliver the return you require. For example, if you estimate investment costs at $100 per item, and you want a 20% return on investment, your price should be $120 per item.
Value: Value pricing applies a price to the value customers receive. For example, if you are a business advisor and you can help a client determine a long-term marketing strategy, the value of that service is based on the value the customer receives. Value pricing is fairly subjective; the key is to determine what value your customers will place on what they receive, not the value you assume the service will have.
Psychology: Psychological or emotional impact is used to determine final pricing. For example, customers may respond more positively to a product with a price of $299 than to the same product priced at $300.
Then layer in any other business strategies that could affect price. You may decide you need to adjust prices because you seek to:
Maximize current profits: Higher prices, at least in the short term, can help improve overall profit margins. (Of course, over time those high prices may result in significantly fewer sales and thus reduce long-term revenue).
Maximize cash flow: Lower prices can increase overall revenue and boost cash flow but typically at the expense of profitability. (Once you lower prices, it is often difficult to raise them).
Maximize profit margins: Higher prices yield higher profit margins but, like seeking to maximize current profits, could affect the quantity of sales.
Maximize sales quantity: Lower prices or product bundle discounts can increase the total number of items sold, which could create discounts or rebates from suppliers or wholesalers (which has a net effect of increasing profit).
Pricing strategies should also be tied to company objectives. The following are common business goals and the effect on pricing:
Serve different market segments: One-size-fits-all prices can turn away customers at both ends of the demographic scale. For example, if you sell a maintenance service, a standard monthly fee of $85 may be too high for small customers, while too low for customers who want additional services and faster response times. A standard price may not be right for any individual customer; if that is the case, building pricing tiers based on different levels of service could be a sensible strategy.
Serve different market verticals: A company that sells individual products to retail customers may decide to sell products to larger organizations interested in making bulk purchases. Different pricing strategies should take into account volume sales, delivery costs and other factors unique to servicing larger clients.
Generate new customers: Flat-fee pricing often generates additional customers, especially if a flat fee is perceived as cheaper than an a la carte purchase. Subscription and time-based purchase agreements are common ways of generating new customers. Typically, a business will develop pricing strategies to generate new customers at a low profit margin and then seek to provide additional services for higher margin fees.
Create additional sales opportunities: Existing customers, especially satisfied existing customers, are a perfect place to look for additional sales opportunities. Tiered pricing systems for services, and ancillary or complementary products for existing products, are great ways to generate additional revenue per existing customer.
Minimize credit sales: Retail sales are based on cash (or credit card) payments on an up-front basis. Service businesses typically bill after at least a portion of those services have been provided, which requires the company to, in effect, extend credit. Some businesses develop service plans that include up-front deposits or that require up-front payments. For example, most cable companies charge for services ahead of service delivery; the bill delivered on January 15, for instance, may cover the time period running from February 1 to February 28.
Minimize barriers to purchase: Time-based pricing can make an initial purchase more attractive. This pricing tactic can be used in a variety of ways. One example is the variable pricing approach often used for products purchased from television direct marketers: "Three easy payments of $49.95 each!" That same tactic can be used for a service, (instead of a product), but it looks a little different. A business could offer a service for a reduced rate during the first three months, charging a higher rate for subsequent months. However, most companies that use this approach require a minimum time commitment to use the service that is longer than the "introductory" period or customers are told that at the end of the introductory pricing, their monthly service fee will increase. The goal of variable or introductory pricing is to reduce resistance of new customers to make a purchase or commitment.
Keep in mind the best pricing strategies are flexible and allow a company to respond to changes in supply or demand, new competition, changes in technology and other market factors. Constantly evaluate and test your market strategies to make sure you maximize return on sales, while meeting other operational and financial objectives.