The Mystery of Pricing

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Before going to market, you need to decide how to price your products and services.  Decisions about pricing should be based on a comprehensive long-term strategy, but for most businesses, the goal is long-term profit maximization.

The pricing decision is critical because it will directly affect revenues, which will dictate profits.  For example, if you sell 1,000 widgets at $50 each, you will have $50,000 in revenues. Alternatively, if you sell 1,000 widgets at $55 (i.e., 10% higher), you will have $55,000 in revenues.  But if you set your price at $50 and want to get to $55,000 in revenues, you will have to sell 1,100 widgets.  Since most businesses find it challenging to increase sales volume by 10%, it makes sense to set your pricing in a way that will maximize revenues.

How do we know when “the price is right”?  Without a complete review of all the factors to consider, I want to focus on just a few.

Cost.  Your cost is a valid consideration, but it should not be the basis for a formulaic approach to pricing.  For example, don’t multiply or divide your cost by a factor to arrive at your price.

Examples:   $40 times 1.25 = $50

                  $40 divided by 0.80 = $50

While a formula seems attractive in its simplicity, it almost certainly will not maximize long-term profits.  That’s because different products and services have different values in the marketplace that are not necessarily a function of cost.  Product X may typically sell for fifty percent more than its cost while product Y won’t sell for more than ten percent more than its cost.  If you stubbornly insist upon selling both products at a 30% markup, you won’t ever sell product Y (because its not competitively priced), and you’ll be selling product X for less than market value.  You’ll never sell enough quantities of product X to make up for the forgone gross margin.

You may conclude that it’s best to discontinue offering product Y because of its low margin.  While that may be a valid consideration, eliminating product Y may damage your competitive position.  For example, your customers may insist on buying from a “one-stop shop.”  If you don’t carry a complete product line, your customers may buy all of their products elsewhere.

Competition.  This is the most important factor in determining pricing.  Ultimately, you want to be competitive with others (although not necessarily on par or lower).  You can justify a higher price if your quality or service is perceived as better than your competition.

For most businesses, there will be a fairly narrow range of “competitive” pricing. Charge too much and you will lose sales. Charge too little and you’ll leave money on the table. Your goal is to determine the combination of pricing and quantity that will maximize profits.

Psychological Pricing.  This is the common practice of ending prices with 99 cents or, for larger ticket items, 99 dollars.  For those of you tempted to discard this convention as silly or manipulative, don’t.  It’s common because it works.  Yes, I know that *you* know that $499 is *really* $500, but we all see something less than $500 in our minds. While there are occasions where you may fairly modify or even reject psychological pricing, in general, you should embrace it.

Price-Point Merchandising.  Using features and strategic price points to “step up” your customers is good for both your gross margin and your bottom line.  Isn’t that worth doing?

Summary.  In pricing, fear is a strong motivator.  If your prices are too high, you know you’ll lose business.  However, the fear of pricing oneself out of the market is largely manageable.  A careful periodic review of pricing is not only warranted, it is necessary.

Chances are, your costs, including labor, rent, utilities, and fuel, have risen since your most recent price increase.  At some point, you have to charge more.  It’s a fact of life, and everyone understands it.  On the other hand, the decision to increase prices requires strategic research and planning to enhance profitability.  Having elements of both art and science, pricing is one of your most critical business decisions and should be approached with care and deliberation.

 

Have you analyzed your pricing recently? To learn how to increase your profitability, contact Counterpart CFO for an expert review and action plan.

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