Pricing

Many businesses believe that pricing is the most critical component of their new venture. It isn't; it is one of many. Without a clear identification of customers and competitors, pricing can be erroneously set and either repel customers or attract competitors.

A price is the amount or conditions required to consummate a transaction. If the price for a tube of toothpaste is $2.99, that's what you must pay the owner (store) to make it yours. If the price for a new car is $25,000 plus your old car, that's what it will cost you to complete the transaction. Some purchases have additional conditions, such as approval of a law, lender, or other authority. You cannot purchase alcohol, for example, unless you are of the legal age in your state.

It is critical that your business plan includes specifics on how you will price your products and or services. Yes, your lenders want to know your pricing structure; however, you also need to define it. Without appropriate pricing, your business may not be profitable. You need to establish pricing guidelines, make certain they are competitive, and make pricing easy to implement while being adjustable to meet changing business conditions.

Pricing Guidelines

Business schools teach the four Ps of marketing: product, promotion, price, and place (location). Three of the four are expenses; only price generates revenue. Pricing can be critical to the success of any business, though the most successful ones focus on value-added service so that price is less an issue.

How can you establish an effective pricing policy for your business? You must consider all the consequences of pricing to your business success. In the early history of business, keystone pricing was done at all levels because it was easy to calculate. It simply doubles the price you paid. For example, a shopkeeper would set a retail price that is double the wholesale price. A wholesaler would double the manufacturer's price. Easy pricing. However, as business has become more sophisticated, so has pricing. Following are some of the most common methods of computing a selling price:

  • Break-even point

  • Cost-plus pricing

  • Rate-of-return pricing

  • Demand pricing

Each has its own advantages and disadvantages. Depending on the type of business you are starting or growing, one may be more common than others.

Break-Even Point

The break-even point is when the income covers the expenses. If your retail store has to sell 120 widgets to cover the wholesale and overhead costs of a 400-widget order, that's the break-even point. Your profit will begin when you sell the 121st widget. Break-even calculations are more common to retail stores that buy large wholesale lots, such as dollar or bargain stores, though a break-even analysis can be calculated for any product. Chapter 19 will cover break-even calculations in greater detail.

Cost-Plus Pricing

Cost-plus pricing is more common among smaller businesses. Products are priced at a predetermined percentage above the direct costs to achieve an expected gross margin. To understand this method, some terms need to be defined.

The gross margin is the relationship of the profit to the cost. A widget with a wholesale cost of $6 is sold at a retail price of $10. Calculate: (10-6) / 10 = 40%, the gross margin.

The markup is the relationship of the profit to the selling price. It's the percentage added to the cost to get the retail price. Consider another widget with a retail price of $5 and a wholesale cost of $2. Calculate: (5-2) / 2 = 150%, the markup.

In the real world, most retailers use a variety of gross margins and markups. Primary merchandise may have one gross margin or markup while an impulse department or one that has less local competition may have a higher gross margin or markup.

Should your business use gross margin or markup? They are two ways of looking at cost-plus pricing. Many businesses prefer using markup; it's easier to calculate. For example, if the wholesale cost is $4 and the markup is 100 percent, simply add 100 percent of the cost to the cost to get a retail price of $8. Margins and markups are explained further later in this chapter.

Rate-of-Return Pricing

Your business plan will help you calculate a rate of return on your initial investment (ROI, Chapter 4). For now, let's use a rate of return of 12 percent. That means a $100,000 investment should pay back $12,000 a year or $1,000 a month in interest from the profit. The same method can be used to calculate a price as long as all other fixed and variable expenses, including payroll and your salary, are already factored in.

Retailers and wholesalers with large sales volumes, such as $1,000,000 a year or more, frequently use ROI pricing. It's also more common with stores that require an extensive initial investment in land, fixtures, and other costly components. Many service business, too, use ROI pricing.

My business is seasonal. How can I establish profitable pricing?

Though your business operates seasonally, it will probably have overhead costs during the off season. These costs must be factored into your overall costs so that your business will still be viable when the next selling season arrives. As you establish prices, calculate annual overhead costs including any ongoing labor needed to keep the business in operation.

Demand Pricing

Airlines are notorious for demand or yield pricing. Buy the ticket well in advance and the price is lower than if you walk up to the counter on the day of the flight. Retailers, wholesalers, and service businesses can't use this method as easily unless they sell hot/cold merchandise. If your store gets the hottest new widgets in and everybody knows that supplies are initially limited, your price can be high—maybe even higher than the manufacturer's suggested retail price (SRP). When supply catches up and the market is saturated with these widgets, prices will slide until they hit the clearance table at prices barely above wholesale.

There are many other types of pricing methods. As you research and develop your own business, you will find ones that are most popular for your venture. Remember that the key to pricing is profitability more than ease of use. That's why there are hand-held business calculators and software to do the figuring for you.

Competitive Pricing

Many businesses begin by simply pricing their products or services at levels below that of their competitors. That's okay, if your costs are lower or you are willing to make a lower profit in order to build your business. To establish competitive pricing, you must know what your competitors are paying to buy or produce what they sell. That isn't always easy. If you have been employed by your competitor or in a similar business, you may have some insight into their costs and pricing structure.

Need an example? Following is the Competitors’ Pricing summary for Widgee World Retailers (Appendix A):

We have conducted extensive investigations into the pricing for competitors’ products throughout the metropolitan area. The following table represents the average pricing for all four of our competitors.

Our pricing is defined as competitive. Some items will be priced slightly higher and others slightly lower. Ultimately, we are very similar to most competitors in pricing. We look to make customer service and loyalty the most defining distinctions between Widgee World and the competition. And we will work to promote the “made in the USA” recognition.

It is imperative to note these price comparisons serve to establish the range within which each product category is to be found. In most instances, Widgee World will open storefronts where most competitors are not located.

Smart businesses don't get caught in the “I'll beat any competitor's price” trap. A competitor with deep pockets or a special purchase can drain your profits by setting up a few products that are offered at under cost—called loss leaders. Instead, sell your products and services based on perceived value.

Perceived Value

How much is a house worth? Whatever a buyer and a seller agree it is worth. On a specific day, the price may be $200,000. The perceived value a year later may be higher or lower, depending on market conditions that impact the buyer and seller. A seller may be in a hurry to get rid of the home or the buyer may see an investment opportunity that can lower the perceived value of the house.

You can test perception pricing by offering a few products or services at higher prices and tracking results. Do the higher prices drop off sales for those items? Do the increased profits cover the lower sales levels? Let your customers help you establish the most profitable pricing for your business.

Perception is a belief based on outside influences. Perceived value is what someone believes the worth of a product, service, or benefit is. Commodity products, such as toothpaste, are sold by price, though the manufacturer attempts to increase perceived value—our brand is better than their brand—through advertising. Services are priced based on the relative value of benefits to the buyer. If the service will save the buyer $1,000, the service price will be set at a fraction of that. An intelligent buyer won't pay $2,000 to save $1,000, for example.

Be sure that your business plan considers the various ways that products and services are priced, and establishes a pricing structure that offers long-term profitability.

Service businesses define pricing differently, as illustrated in this example from Appendix B:

The cost for professional organizing services is based on several key factors including skill, experience, and the self-worth of the individual organizer. The fees charged in this industry are diverse. Hourly rates typically vary between $60 and $150 per hour, with several in the profession earning as much as $1,000 per day.

Though personal organizing is a relatively new industry sector, demand for the service is growing. ATMC will offer introductory, discount pricing for the first six months of operation. Anticipating positive results, the price structure will then be increased to a more customary rate.

PRICING STRUCTURE

Type

Discount

Customary

Business—Single

$30

$60

Business—Group

$165

$200

Residential

$25

$50

Group rates are noted in the table above to represent an approximate median of the range from $150 to $175 hourly for 3–10 individuals. The exact price charged within the group rate depends on the number of participants and materials used to provide the service. For ease of calculations, the group medians listed in the table above are implemented in the financial projections.

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