Pricing Products and Services

Overview

Attaching a fair and accurate price tag to your products and services can be a tricky balancing act. It should come as no surprise that many business owners have an ongoing struggle with setting their pricing strategies. Some use inappropriate approaches, for example, attempting to always be the lowest-priced player in the market, while others fail to change their approach to capitalize on market changes.

As you know, the success of your products and services relies directly upon your ability to sell them, which in turn is dependent upon your pricing strategy. If your prices come in too low, you won't make a reasonable profit. Go too high, and you may weaken the demand for your offerings. But the truth is you don't have to be a magician to get pricing right.

There are some simple, yet definitive measures you can take to accurately price your product or service. By exercising creative judgment and a keen awareness of consumer motivations, you can greatly increase your chances of owning the market. The following road map will guide you through the pricing maze and set your company on the road to accurate pricing.

Outline:

  1. The Importance of Accurate Pricing
  2. Conducting Market Research
  3. Pricing Models
  4. Pricing for a Service or Consulting Company
  5. Raw Costs for Services and Consultants
  6. How to Determine If Prices Are Working for You
  7. When to Raise or Lower Prices
  8. Prices and the Law
  9. Resources

I. The Importance of Accurate Pricing

Up until now, your pricing strategy, like that of many entrepreneurs, may have been rather elementary: Determine what your competitors are charging, then charge a little less. Being the lowest-priced product or service on the market, however, does not guarantee success. In fact, it could create just the opposite effect, because for most customers, buying a product or service isn't just about price, but rather about value.

Customers want the best value for their money, and thus they will almost always do a quality comparison and make purchases based on the best price for the best value. To illustrate, put yourself in your customer's position. Suppose you go into an office-supply store to buy a ream of paper for your printer, and you find that there are dozens of options to choose from. As you scan the shelves, you notice that most reams cost about $7.99, but you notice one ream for $5.99. You may be tempted to pick it up, but if you're like most consumers, you automatically think to yourself, "Why is this so cheap? Maybe the quality isn't as good, and maybe it will jam my printer. Or maybe the ink will bleed through." To ease your mind, you likely buy one of the higher-priced reams.

You also don't want to price your product too high because consumers may think it's unreasonable and, therefore, will not buy it. Remember, you assign a price tag to your product or service because you want and need to sell it. If customers aren't willing to pay for your product or service simply because you have priced it out of the ballpark, you may be left with a warehouse filled with product that you can't move - and a company that is heading for financial woes.

As with most rules, however, there are exceptions when it comes to pricing. For example, if you have a product or service that is in exceptionally high demand, you will usually be able to get away with selling it at a higher price. Remember a few years back when Mazda came out with the Miata, and the little sports car sold like hotcakes? Mazda was able to capitalize on that boom and raise the car's price because the demand was so great that consumers were willing to pay the extra money. Similar circumstances happen every year around Christmas with must-have toys for children, as was the case with Cabbage Patch Dolls in the late '80s and Tickle-Me Elmos in the 1990's. When you have such products that are "all the rage," you can set your own prices.

Another time you may get away with overpricing is if your product or service is perceived by the public to be worth more because of your company's brand name. For example, a bottle of perfume may have $10 worth of perfume in it, but add the name "Calvin Klein" or "Chanel" to the bottle, and suddenly the perfume sells for $50. These are situations in which the highest-priced products will be purchased by status-seeking consumers because of their perceived value, whether it is a reality or not.

Additionally, if you are in an industry where the products change quickly, such as high-tech, you may have to set prices a little higher, knowing that you only have a small window of opportunity in which to sell. The computer industry is a prime example of this: What is on the market today may well be defunct in a year or two. Thus, this is one of those rare cases where you may have to overprice in order to sell quickly and make a profit.

At the other end of the spectrum, by setting prices too low, you not only risk hurting your profit margin, but you also risk customers perceiving your product or service as inferior to others on the market. There are situations, however, in which consumers will go with the lowest-cost product without question of value, as is the case with some generic-brand items and products found at discount-shopping centers and outlets. If you find that your customers value low prices over high quality, a lowest-price approach may be appropriate for your company.

Remember this golden rule when setting prices: perception is everything. How customers view your product or service and what they are willing to pay for it is based upon those perceptions. In the end, customers will tell you loud and clear through their purchasing behavior whether or not your prices are too high, too low or right on the money.

Self-Assessment

The following questions are designed to help you determine whether or not you have set accurate prices for your product or service.

  1. How do my customers perceive my product or service, in terms of price and value?
    ________________________________________________________________________
  2. How do my prices compare with my competitors?
    ________________________________________________________________________
  3. What values and benefits do my customers get from my product or service?
    ________________________________________________________________________
  4. Are my prices consistent with those benefits and values?
    ________________________________________________________________________
  5. What is the current supply-and-demand relationship of my product or service?
    ________________________________________________________________________
  6. Am I in an industry where the demand for my product or service has a short life cycle, and thus I need to cash in quickly?
    ________________________________________________________________________
  7. Do I have a product with a recognizable name that allows me the luxury of overpricing?
    ________________________________________________________________________

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II. Conducting Market Research

Market research is required if you intend to gain a competitive advantage through pricing. You'll want to use research to determine what competitors are charging for products or services similar to yours and assess how your offerings measure up in terms of quality compared to those competitors. Knowing this will help you determine a fair price.

There are many ways to conduct market research, including the Internet, trade publications and trade shows. You can also go out and physically shop the competition, or if you are too busy or too recognizable to do so, you can hire professional shoppers to do it for you.

When conducting market research, don't be afraid to go straight to the customer. One company that performs valuable market research with customers is multimedia sound technology innovator Bose Corporation. When Bose introduces a new stereo speaker, for example, the company often takes it right into retail stores to show it to prospective buyers. Company representatives use the opportunity to ask potential buyers what they would expect and be willing to pay for a speaker of that caliber. This firsthand information gives the company a good idea of the price they should set when they introduce that product to the market.

For additional help on this topic, see Conducting A Market Analysis, Identify Your Target Market and Analyze Your Competition.

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III. Pricing Models

While the beat-the-competition pricing approach may work for some, there are many other complexities involved in establishing a pricing strategy. In addition to the market value of your product or service, your prices will, to a degree, be influenced by external factors that are out of your control. For example, if you are bringing a product to the market for the first time, you will have some start-up costs that you will want to recoup. These expenses will include research, manufacturing, staff, machinery, equipment and packaging.

To illustrate how these costs affect your product's cost, consider the following example. Let's say that you start a company selling handmade dolls, and your start-up costs are $200,000. We'll assume that it costs you $2 in time and materials to produce each doll. For the purpose of this exercise, we will assume that supply and demand are equal, and you can sell the number of dolls that you can produce. Let's also say you can produce 100,000 dolls per year at a cost of $2 per unit, which equals another $200,000. If you add this number to your original start-up cost, the total is $400,000. Now, to determine your price, you must decide if you want to break even — recoup all of your original costs and nothing more — or if you want to make a profit. If your plan is to break even during the first year of operation, then you will need to price the dolls at $4.

$400,000/100,000 units = $4

If a profit within the first year is important to you, you must add into the equation exactly how much profit you intend to make and adjust your price accordingly from there. For example, if you want to make $100,000 in profit during this time period, you would need to raise the price to $5, and the equation would look like the following:

$400,000 + 100,000 = $500,000

$500,000/100,000 units = $5

It is important to remember that pricing models aren't etched in stone. As you move through the production phase, you may incur some unanticipated costs. It is crucial that you add these costs to the equation in order for it to be accurate, so you won't be surprised or disappointed down the line.

It's important to note that pricing models are the same for services, including consulting, as they are for products. While you may not have the huge start-up costs with service companies, you will still most likely need to put out some money up front. Say you are a management consultant, and you must rent office space, furnish it, and buy supplies. You may also need to pay a salary and benefits to a secretary or receptionist, and you may have some advertising costs. It is all of these hidden, often forgotten costs that must be factored into your pricing model. Remember, the key here is to list every penny you will spend up front, then figure in how much profit you want to make in a year, and then you will have an accurate price for your product or service.

Self-Assessment

Whether you own a product or service business, use the following self-assessment to insure you have the proper equation for your pricing model.

  1. Have I accurately figured my start-up costs? If so, what are they?
    _____________________________________________________________________
  2. What is my cost-per-unit?
    _____________________________________________________________________
  3. In determining my cost-per-unit, have I figured in all money spent, including labor, supplies and packaging?
    _____________________________________________________________________
  4. How many units can I produce or services can I provide in a year?
    _____________________________________________________________________
  5. Do I want to make a profit in the first year, or will I be content to just break even?
    _____________________________________________________________________
  6. If I want to make a profit within the first year, what is an attainable profit goal? Has that number been added to my pricing equation?
    _____________________________________________________________________

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IV. Pricing for a Service or Consulting Company

Determining prices if you own a consulting or service-oriented business is not much different from determining prices for a product-driven company. The main difference is that your service or your time is your product. To get started, you must evaluate what your competition is charging for similar services, then determine where your services fit in. Can you, for example, offer the same service at a higher quality? If so, you will probably be able to charge more. But if your competitors are offering more to the consumer than you are capable of, you may want to set your prices lower.

You will also want to look at the market itself to determine what the market will bear and what effect your geographic location has on your pricing strategy. A manicurist in New York City, for example, could probably charge more than a manicurist in Idaho simply because people in metropolitan areas are more willing and able — because of the relative higher costs of all products and services in those areas — to pay a higher price than folks living in rural areas.

Similarly, the principle of supply and demand applies to service companies. If there are several other businesses in your area performing the same or a similar service, the demand will probably be less because the supply is greater. Hence, you may have to charge less. On the other hand, if you own a dry-cleaning service, and you are the only dry cleaner in town, you can charge higher prices than you could if there were several dry cleaners located very close to you.

A final thing to consider in pricing a service is reputation. If you have a stellar reputation, people will most likely be willing to pay more for your service since their perception will be that they are getting more. If you own a printing service, and you have a reputation as someone who can take on big jobs at the last minute, perform high quality work, and deliver on schedule, you will be able to charge premium prices. If you are a consultant, you must consider all of the above and add into the mix your credentials. For example, if you are a financial advisor, what is your degree? Do you have an M.B.A. from Harvard? The higher your credentials, the more you will be able to charge. Remember, when consulting, a good part of what people are buying is your experience.

Self-Assessment

  1. Do I have a clear idea of what my competition is charging?
    ____________________________________________________________
  2. What market position to I aspire to obtain? (i.e., am I going for lower quality and prices, or am I aiming to be the best and charge premium prices?)
    ____________________________________________________________
  3. Do I have an overall understanding of what the market will bear for my service or time?
    ____________________________________________________________
  4. Have I closely examined the supply-and-demand ratio for my service or time?
    ____________________________________________________________
  5. Do I have an established reputation within the marketplace as someone who consistently performs quality work?
    ____________________________________________________________

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V. Raw Costs for Services and Consulting

If you own a consultant or service-oriented business, you may tend to think that pricing is not as complicated as product pricing, since what you are offering is less tangible, but appearances can be deceiving. If you look closely, you will see that there are many raw costs that must be factored into your pricing strategy. Say you are a hair stylist, for example. Your raw costs will probably include the following: rent and utilities, equipment (including chairs, hair dryers, combs and brushes, sinks, mirrors, towels, washers and dryers, etc.), products (assorted shampoos, conditioners, hair spray and hair color), insurance, and staff salaries and benefits. Also, what about insurance, should a customer slip and fall? So while your service may be hair styling, you must carefully examine everything you will need up front in order to perform that service. Some of these costs, like equipment, will be one-time start-up costs. But others, like shampoo and conditioner, will need to be purchased on an ongoing basis. You must carefully and continuously list every expense. Once you have determined your raw costs, you can then set up an effective pricing model and figure how much you will need to charge for your service or time in order to break even and/or make a profit.

Again, the crucial thing to remember when constructing a pricing model is to list absolutely everything. For example, are you going to offer coffee and tea to your customers? If so, don't forget to add in the price of the coffee, tea, cream and sugar, cups, stirrers and napkins. It may not seem like much, but over time, these little things add up and eat into your revenues. You therefore not only stand to lose profit by ignoring raw costs, but you could also be at a deficit when it comes to keeping up with ongoing expenses.

Keep in mind that pricing models for every service or business will be a little bit different. If you have an auto transmission business, your raw costs might also include training for your auto mechanics. As a consultant, you will probably incur many of the above raw costs such as rent and utilities, equipment (such as computers) and supplies (including furniture like a desk and chairs). The key to success is to factor in all of your raw costs, no matter how small and insignificant they many seem.

To compute your prices as a consulting or service company, use what you have learned in this section and apply it to the pricing model in Section III: Pricing Models.

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VI. How to Determine if Prices Are Working for You

Once you have set your prices, it will be extremely easy to see if they are working for you. The first thing you want to look at is whether or not you are reaching the goals you set in your model. Even though the model is usually based on a year, you need not wait until the end of the year to see how things are going. In fact, it's a good idea to check your sales on a monthly basis after you have set or changed a price. This way, if you find the results lagging behind what you anticipated, you will be able to make some adjustments before they become too serious. You may, for example, decide you need to lower your prices to sell more and bring in more profit.

At this point, it is critical that you also look at the supply and demand for your product or service and make sure they are equally balanced. Picture in your mind an intersection where two roads come together perfectly perpendicular to one another. In that scenario, supply and demand should meet directly in the middle of where the two roads cross. If you have too much supply and too little demand, your prices may be too high, and you may want to adjust them to get your product moving. On the other hand, if the demand is so great that you can't keep up with the supply, this may mean that prices are too low. You will want to meet the demand, in order to keep from losing customers. Note that supply-and-demand inequalities can result from many other factors as well, so it's important to look at your pricing strategy within the context of your entire business strategy.

Self-Assessment

The following questions will help you determine if your prices are indeed working for you as planned.

  1. Have I kept tabs on my pricing model? How have my sales been affected by it?
    ________________________________________________________________________
  2. Am I prepared to change my prices if I determine they aren't working for me?
    ________________________________________________________________________
  3. Am I on schedule according to the goals I defined in the pricing model?
    ________________________________________________________________________
  4. Are my products moving, or is there more or less demand than I anticipated based on research? Could any inequalities be resolved by varying my prices?
    ________________________________________________________________________

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VII. When to Raise or Lower Prices

From time to time after developing price structures, external factors beyond your control may come into play and make you re-think your pricing strategies. These factors can include changes in economic conditions, supply and demand, and competitor's prices - all of which will have a dramatic affect on how you price your product or service.

Like it or not, you may be forced to raise or lower your prices based on the information at hand. (Note: the following is a general discussion of the theory of price alterations. It is recommended that you consult a financial professional about your own particular circumstances.) Economic conditions, such as inflation, a recession, a boom, and rising or falling interest rates will directly impact how you price your product or service at certain times because they affect both your production costs as well as how much money your customers are willing and able to spend. Obviously, in times of recession, people will spend less money, especially if they perceive your product or service to be a luxury. It is during these hard times that you may want to consider temporary price cuts to help get you through the rough period.

There are several other circumstances that may lead you to consider lowering your prices. One is excess capacity. Simply put, this means that you need to generate additional revenue but can't seem to do it through increased sales efforts or product improvements. You may also choose to initiate a price cut to gain market share through lower costs. While you may be hesitant to cut prices because you fear that it will further reduce your profit margin, it may in fact raise revenues through higher volumes of sales.

It is also possible that in time, you may discover new ways to produce your product cheaper. You will then have a choice: keep the extra money as profit or pass along the savings to your customers. Strange as it may seem, by putting that money into your customer's pocketbooks, you could actually increase your sales because you could gain more customers, which in the end could of course translate to even more profit.

It is also likely that at some point in time, at least one of your competitors will lower their prices. When this happens, you must re-examine your pricing strategy. In order to stay competitive, you may be forced to lower your own prices. This will be especially true if other competitors slash prices to follow suit.

There are a few creative ways to make customers believe you are lowering your prices when in reality you are not. For example, if you sell a television set for $300, and you drop the price to $295, even though it is only a $5 reduction, customers psychologically place that television in the $200 range. There are many variations on this strategy; for example, pricing products at $29.99 or $29.95 has been shown to be much more appealing to consumers than $30.

You may also choose to lower prices temporarily through discounts and coupons. This is the best way to lower prices, because when the discount period has passed, you are free to go back to your normal prices. You may consider buy-one-get-one free promotions, rebates, percentages off, select customer appreciation sales, and so on. It is important that you not overuse this tactic, as it is very hard to go back to original prices once customers get used to the discounts. They will view the return to normal prices as a price increase, which may lessen their interest in purchasing.

At times, there is no way around raising prices. You must approach this gingerly, knowing full well that many of your customers will resent it. In fact, you may even lose customers because of it. But don't apologize for doing what you have to do to maintain a healthy business. For a small increase in price can mean a considerable increase in profits. What are some circumstances that might force you to raise prices? The most common one is inflation. Rising costs, unequaled by productivity gains, put a big squeeze on profit margins. In order to reach the profit goal set in your pricing model, raising prices may at some point become inevitable.

Another circumstance that can lead to raising prices is an increased demand for your product or service. In this situation, an increase in prices may be necessary to cover the costs of meeting customers' needs, including purchasing more inventory, hiring more staff and/or leasing new office space. If you find yourself having to raise prices for these or other reasons, you should always let customers know the reasons behind the decision. Most consumers will be understanding, especially if you have won their loyalty with quality products and services.

Whether you raise or lower your prices, there is another group directly affected by your decision: your competitors. You must assume that there are at least a few companies watching your moves, just as you watch them. Once you make a move, they will most likely react strategically to retain or gain market share. Other competitors may join in the race and change their prices to be more in line with yours, sparking an all-out price war.

Self-Test: Are Your Prices Where They Should Be?

Ask yourself the following questions regarding your prices.

  1. Do I need to generate more revenue that I can't achieve from product or service improvements?
     Yes No
  2. Do I want a higher market share that will lead to lower costs through higher volume?
     Yes No
  3. Is the economy suffering a downturn or a recession?
     Yes No
  4. Have one or more of my competitors recently lowered their prices?
     Yes No
  5. Are my prices set according to the quality of my product or service as compared to that of my competitors?
     Yes No
  6. Is my revenue level suffering because of the effects of inflation?
     Yes No
  7. Is the economy enjoying an upturn or boom?
     Yes No
  8. Is my product or industry likely to be obsolete a year from now?
     Yes No
  9. Have one or more of my competitors recently raised their prices?
     Yes No
  10. Is there a greater demand for my product or service than I can supply?
     Yes No

If you answered yes to any of questions 1-5, you may want to consider lowering your prices. If you answered yes to any of questions 6-10, you may want to consider raising your prices. If you answered no to all or nearly all of the questions, chances are your prices are at the right level.

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VIII. Prices and the Law

When it comes to setting prices, there are certain strictly enforced rules and regulations that you should be aware of. They include:

Price Fixing -- As a business owner, you should never agree upon or even discuss your prices with other companies. Additionally, if you are a manufacturer that sells products to retailers, you cannot tell these companies what prices they should set for your products. You may suggest prices, but ultimately they have the right to sell your product for whatever price they decide.

Price Fixing by Purchasers -- If purchasers join together in order to demand prices from their suppliers, this too can be considered price fixing. You may want to have a legal professional review any such plans just to be on the safe side.

Exchanging Price Information -- You can keep your eye on competitors and their pricing strategies through market research, but you cannot have any direct conversations with them about prices. It is up to you to make sure that no one in your company (yourself included) gives out information on prices or receives any in return from competitors. Even if you don't do anything with the information, if you are caught, it is an offense that will be taken seriously.

Bid Rigging -- If your company is bidding on a contract, you must not discuss your bid with any competitors; nor should you enter into any kind of an agreement with another bidder to make an identical bid. Letting the process follow its natural course, and allowing the chips to fall where they may, will keep you out of trouble.

Parallel Pricing -- In some instances, you can be charged with price fixing even if you have never spoken a word with your competitors, simply because your pricing strategies are the same. On occasion, it may be considered normal for competitors to have similar prices, but don't chance it. The law is extremely complicated in this area, so consult a legal professional for advice.

Price Squeezes -- A classic "squeeze" involves setting wholesale prices too high for small-sized orders. Big chains are usually the culprit of price squeezing, as it's designed to drive small business owners who can't compete with high prices out of business. If you suspect that this is happening to you, report the companies you believe to be responsible.

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XI. Resources

Books

Stephen Broydrick, "The 7 Laws of Customer Value: How to Win Customers and Influence Markets" (Irwin Professional Publications, 1996)

Entrepreneur, July 1995: "Pricing Guide for Desktop Services: Street Smart Pricing for the Small Business" (Brenner Information Group, 1995)

David Frigstad, "Customer Engineering: Cutting-Edge Selling Strategies" (Oasis Press, 1995)

Earl Naumann, "Creating Customer Value: The Path to Sustainable Competitive Advantage" (Van Nostrand Reinhold, 1994)

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