It is critical that you fully develop appropriate pricing. Without it, your business may not be profitable. You need to establish pricing guidelines and make certain they are competitive. Your pricing system should be easy to implement and easy to adjust to meet changing business conditions.
Business schools teach the four P's 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 — and competition — has become more sophisticated, so has pricing. The following are some of the most common methods of computing a selling price.
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 means that the income covers the expenses. It's easier to understand break-even point in retail than in a service business. For example, if a 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. Its profit will begin when it sells 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 or service. Consultant services can also use break-even pricing, identifying the day of the fiscal year when all annual expenses are paid and all future income is profit.
Cost-plus pricing is more common among smaller businesses. Products or services 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.
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 in more detail later in this section.
In the real world, most small businesses use a variety of gross margins and markups. Primary merchandise or services may have one gross margin or markup while an impulse product or service or one that has less local competition may have a higher gross margin or markup.
A key element of business planning is calculating the return on investment (ROI). It's the ratio of the money gained or lost on an investment relative to the amount of money invested. For example, a $10,000 investment that earns a profit (or interest) of $1,000 has an ROI of 10 percent (1000 ÷ 10000 = 0.10).
This is the number that all of your business investors — including you — are looking for. They will then compare it to ROIs for opportunities with comparable risks. If they can get a 10 percent ROI on a less risky investment (less chance of loss), they will invest there.
Your consulting business can set pricing by calculating a rate of return on your initial investment. As an example, 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.
Most consulting services profit from the value of time rather than of physical assets, so ROI and rate-of-return pricing isn't as useful to them. However, they can use it as a double-check against other types of service 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 consulting business can offer the latest in-demand services, your price can be higher. When supply catches up and the market is saturated with people offering these services, prices will slide until they are unprofitable to offer and you drop them.
My business is seasonal. How can I establish profitable pricing?
Though your business operates seasonally, it probably will have overhead costs during the off-season. These costs must be factored into your overall costs so that your consulting 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.
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.
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, then, you must know what your competitors are paying to produce the services 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 that business's costs and pricing structure.
Smart businesses don't get trapped in the “I'll beat any competitor's price” trap. A competitor with deep pockets can drain your profits by setting up a few services that are offered at under cost — called loss leaders. Instead, sell your services based on 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 $300,000. 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.
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 your consulting business considers the various ways that products and services are priced and establishes a pricing structure that offers long-term profitability.