A great business idea alone doesn’t guarantee success. To sell your product effectively, you’ve got to price it well. That means fully understanding the costs you incur to run your business, as well as the going market rate for the product or service you’re selling.
There are a variety of pricing models to choose from – flat rate, hourly charges, tiered pricing, and bundles – that may or may not be attractive to your customer and effective for your bottom line. Pricing your product right could mean earning optimal profits and repeat customers. Price it wrong, however, and you could alienate buyers – or even go out of business.
To turn a profit, your product sales need to exceed your business expenses. That requires a full understanding of each and every one of your costs before you set any prices.
Gross Profit Margin
Your gross margin represents the percentage of revenue left from product sales after you cover direct product expenses. If your gross profit margin isn’t high enough, there won’t be enough cash left over to cover other general expenses and earn a profit.
Your target gross profit margin depends on the type of business you run. Business Insider notes that manufacturers typically aim for a margin of 50%. Wholesalers try for a profit margin of 10% to 15%, and retailers try to make between 30% and 50%. The difference is based on what general expenses each type of business incurs and the amount of product they move.
Gross profit is sales revenue less cost of goods sold. Gross profit margin is gross profit divided by sales revenue. If you’re manufacturing inventory yourself, cost of goods sold is direct labor, direct materials, and manufacturing overhead expense. If you’re a reseller, cost of goods sold is the price you paid for the inventory you’re reselling.
For example, say you have $40,000 in sales revenue and cost of goods sold is $10,000. Your gross profit is $30,000, and your gross profit margin is 75%.
Once you come up with a target gross margin, you can price your product to hit it. To compute the selling price you need to earn a specific gross margin, divide the cost of the product by the difference of the number one minus the gross margin.
For example, say you’re a wholesaler and you buy widgets from a manufacturer for $10 each and your target gross margin is 30%. To calculate the selling price for that margin, divide the widget cost ($10) by the number 1 minus the gross margin, which is 70% (or 0.7). That means you need to charge $10 divided by 0.7, or $14.29 per widget, to get a 30% gross margin.
Your business may operate at a loss for the first couple of years, but eventually, your sales revenue needs to exceed all the general and administrative costs your business incurs. Breakeven analysis lets you know how many units of inventory you need to sell before your business can “break even” financially. In other words, it calculates the precise sales volume at which you have no profit and no loss.
If you absolutely need your business to become profitable after a certain period of time, knowing your breakeven point is essential. It tells you the amount of product sales it will take to turn a profit.
Breakeven point equals fixed expenses divided by your product’s contribution margin.
- Fixed expenses are those that do not change, even when sales increase. Rent, business licenses, administrative salaries, professional fees, business insurance, and interest tend to be fixed.
- Variable expenses, in this case, include inventory cost and any other expenses that increase as production and sales increase. Potential variable expenses include commission for your salespeople, shipping, postage, and transportation expense.
- Contribution margin is the product sales price less variable expenses per unit of inventory.
Say your annual fixed costs are $10,000 per year and your contribution margin is $2 per product. At that margin, you must sell 5,000 products to break even financially. Play around with your product price until you hit a break-even point that feels doable for your profitability time frame.
A word of warning: The breakeven point calculation works well up to a certain point. But as your sales volume rises significantly, fixed expenses also increase. For example, you may have to hire additional staff, upgrade your fixed assets, rent more space, and you may pay more in professional fees to consultants as your business becomes more complex. Be realistic and increase your estimated fixed costs when you’re looking at really high levels of production.
A sure-fire way to price your products profitably is cost-plus pricing. This involves calculating the total cost it takes to create the product and adding a predetermined profit margin to arrive at a sales price.
Cost-plus pricing is similar to gross margin pricing in that the goal is for sales to exceed costs by a certain percentage. However, what’s different about cost-plus pricing is that all your costs are considered, not just direct product costs. That means whatever predetermined margin you choose for your cost-plus pricing formula will be pure profit.
To determine the cost-per-unit of inventory, add every cost you expect to incur in order to stay in business. Include direct product costs along with fixed overhead costs such as salaries, insurance, benefits, office expenses, and consultant fees. Divide your total expenses by the number of units you realistically think you can produce and sell annually to find your product cost.
For example, say you calculate total expense as $50,000 if you sell 1,000 units of inventory, and you want a 20% profit margin. Your cost per unit is $50 and your sales price would be $50 multiplied by 1.2 (100% plus 20%), or $60.
You must price your product at or below what your customers are willing to pay. Knowing competitor rates and understanding your product’s price sensitivity can help you do that.
Your competitors’ prices are a good benchmark of what you can charge for a product. To price your product competitively, choose a number that’s similar to products and services that have the same quality level and value.
If your product has more functionality or a longer life than those of your competitors, you may be able to price it a bit higher. Conversely, if your competitors sell the high-end version of a product and you sell the value version, you can undercut their prices.
Price Transparency and Sensitivity
Depending on the nature of your product, you may or may not have flexibility to increase your prices from the going market rate. If product prices are transparent and your product is relatively fungible, its price should be pretty close to the going market rate. For example, according to Entrepreneur, if you own an auto shop and each of your competitors charges $100 for a replacement windshield, that’s what you should charge.
However, if you sell a product with lower price sensitivity, your exact sales price doesn’t matter as much. Price sensitivity, also known as “price elasticity of demand,” represents whether or not customers shop on price for a certain product.
Branding Strategy Insider notes that lower price sensitivity is typically attributed to services with high switching costs (the cost incurred to change to a competitor’s service), those for which average prices are not commonly known, and products with few substitutes. Additionally, it can be attributed to items and services that don’t take up much discretionary income, as well as absolute necessities.
For example, bottled water at a theme park has low price elasticity because it has few substitutes, doesn’t take much discretionary income, and it can be an absolute necessity. A unique business consulting service for which there are few competitors and prices are relatively unknown also has low price sensitivity.
Do you want your product to be considered top of the line, or merely serviceable? Either is a viable business model, but your choice affects how you set prices.
Cost Leadership or Differentiation
In his book “Competitive Strategies: Techniques for Analyzing Industries and Competitors,” economist Michael Porter contends that pricing strategies tend to fall into one of a few basic categories. One is cost leadership, which involves keeping costs as low as possible and undercutting competitors. The other is to differentiate your product, which allows you to sell it for top dollar. Within the electronics arena, Dell is a cost leader for laptops, while Apple is a differentiator.
Cost leadership can be hard for small businesses. That’s because in order to succeed you need extremely low costs that typically come with economies of scale. You also need to sell products in large quantities to make up for your low profit margin.
To differentiate your products, you’ve got to offer your customers a quality or service that your competitors don’t. Kissmetrics notes that a great way to differentiate your company is to build strategic partnerships with businesses that offer complementary services. For example, if you’re a physical therapist, integrating a chiropractor and a massage therapist into your practice could differentiate your business and warrant a premium rate.
The traditional rule of pricing is to always sell your product for more than it costs to make – that is, unless you want to make your product a loss leader. Loss leader pricing is the act of pricing a product below cost in order to lure customers away from your competitors. You then use the loss leader product to attract customers to more profitable purchases.
To execute a loss leadership strategy successfully, you need to sell an additional product that complements the loss leader or makes it fully functional. For example, HP discounts printer prices so it can make profits on the sale of cartridges. Amazon sells Kindles for a discounted price because it makes back the profit on the ebooks that customers purchase.
There are a few pitfalls in the loss leadership strategy to be aware of. Manufacturers aren’t always happy if you sell their products at a drastically discounted price, so consult with them before doing so. Furthermore, some states prohibit retailers from selling products at a loss. Check out predatory pricing laws before you proceed.
Sales, Discounts, and Promotions
It can be tempting to offer discounts to lure in new customers and move product. But sometimes, offering a discount isn’t worth it in the end, as in some cases discounts can lower customers’ perceived value of your product and brand.
Offering discounts usually brings in customers who are buying based on price. That makes it hard to raise your prices in the future or even convince customers to pay full price. Price Intelligently has some pretty convincing data showing that discounts do not lead to sustainable revenue.
Harvard Business Review notes that, at times, it can make sense to offer customers a discount for buying in bulk because it helps you secure customers in a competitive market. It also encourages customers to make larger orders, which tend to be more profitable than a series of small orders. It’s easy to overuse volume discounts though, so think long and hard about whether it’s really necessary before you decide to do it.
Instead of offering a negative discount, focus on adding value to your product. Try a two-for-one strategy over 50% off so your customers get more product when they take advantage of the offer. A limited-time promotion that offers an extra month of service or an add-on product can go much further than simply slashing prices.
Sometimes, how you structure your prices is more important than what the actual selling price is. Certain pricing models encourage customers to buy more, while others create more risk for you as business owner.
Tiered pricing involves selling several products at different price points. A classic example of this is car options: You can get a base model car for a low price, pay slightly more for a few upgrades, or purchase a luxury edition with all the bells and whistles.
Tiered pricing is appealing to consumers because they can find an option that fits their needs and budget. It also works well when you want to capture a large market share because you’re providing options for a wide range of consumers.
For a tiered pricing structure to work, each option has to deliver a level of value that’s consistent with its price point. If you want customers to upgrade from the base level, the price jump has to be low enough that they feel they’re getting value. Options and add-ons that have a narrow appeal but deliver high value should go into higher pricing tiers.
Hourly Rate vs. Fixed Rate
As the owner of a service-based business, pricing your services at an hourly rate makes sense. You know you’ll be compensated for the actual time and effort you put in. Your customer, however, may be more comfortable with a fixed rate or flat-fee contract. This can come into play if your client is part of a business with a specific budget for a project.
A fixed rate contract increases your risk as a business owner. It means that, if the project takes much longer than expected, it becomes less profitable. To compensate for this risk it’s good to price fixed-rate contracts higher than you would hourly-rate contracts. For example, if you normally charge your clients $50 per hour, charge $60 per hour when you’re building a quote for a fixed rate contract. Alternatively, you can ask to cap the number of hours devoted to the client, after which your time costs extra.
Businesses can benefit from selling services on a subscription basis rather than charging on an hourly basis. Price Intelligently recommends offering customers both a monthly and annual subscription option. Monthly subscriptions are popular with customers because they have a relatively low upfront cost and a low barrier to entry.
However, if possible, get customers to opt for an annual plan. Discount your annual plan by 15% to 20% as an incentive to sign up. It costs a lot of time and money to acquire new customers, and annual plans reduce customer churn. Also, you get a large chunk of cash upfront from an annual subscription, which improves cash flow.
By offering a discount on a bundle of products or services you can get your customers to purchase more than they might normally buy. Forbes notes that product bundling is a good strategy, citing research that Nintendo sold the greatest amount of product when it bundled video game consoles and games together.
If you are going to bundle, though, be sure to also offer the products à la carte. Customers are more willing to buy a bundled product if they also have the option to buy each component individually, assuming the bundle offers a discount.
Small details in your pricing model matter. For most product categories, consumers prefer odd prices over even ones. That means you’re better off pricing your product at $9.99 or $9.95 compared to $10 flat. Pricing research as cited by Fast Company also suggests that consumers purchase more when the word “dollars” is spelled out than they do when the price has a dollar sign attached to it.
Pricing your product isn’t just about following a formula – it requires a thorough understanding of your costs, the nature of your product, market prices, and how your customers perceive value. And once you set your prices, don’t rest on your laurels. As the business environment changes, your prices should to. Keep up with market trends, business costs, and competitor rates, and make adjustments as necessary.
Do you have any additional suggestions for pricing products and services?