The most frequent question I am asked is how a business owner determines pricing for his/her products/services that is competitive, profitable and allows for future expansion. The first question I ask is, "What is fair in a free market society?"
I know it may sound like I am avoiding their question, but it really is the beginning of how we will determine the pricing for their product. The typical response to the question is a price that can be afforded by as many people as possible and allows the company to remain competitive. That makes sense, but how do you determine what that price is?
A customer in need of a pair of shoes can go to Payless and pay $59 or they can go to Bob Ellis and pay $599. Which would you consider the more reasonable price? Initially you would assume the lower price shoes have the greatest appeal, but what if I told you the $599 shoes were 50% off of their normal price, does that change your perspective?
The point I am trying to make is you can’t be everything to every buyer; having a pricing structure that reaches a broad spectrum of buyers works well in a business with high sales volume, but may drive a small company out of business. Walmart’s average profit margin is 3%, but when you put that in the context of $256 billion dollars in sales, you can see how having a broad based, low price structure can work.
For a smaller company, you must determine who your target market is and get to know all there is to know about them. What are their spending habits? Where do they live? How much are they paying for similar products now? This is the first stage in determining a "fair" price for your customer.
We all know that a profit is a achieved when the revenue received for a product exceeds the cost of delivering the product, but what is its effect on pricing? For as long as I can remember, businesses have been running on the model of buy for $1 and sell for $2, but does that take into consideration all of the ancillary costs associated with the finished product reaching the consumer?
Strict process analysis is the key to increasing a business’s profitability. Identifying all of the segments that are involved with obtaining the finished product and their associated costs, give the business principle a clear idea of the true costs of goods sold and thereby the percentage of increase necessary over said costs to obtain the desired profit.
With a well-defined target market and a clear costs of goods sold, a business now has to turn its attention to the amount of growth it plans to achieve in the coming months and years. I know you are wondering how this has anything to do with determining a price for a product, but I would ask you to consider the relationship of profitability and expansion.
When a business achieves it’s financial goals, expansion is fueled by greater retained earnings, increased sales revenue and savings from enhanced purchasing power. Each of these factors should be considered when determining the initial price of products and projected pricing over the expansion period.
Using this model may change the traditional pricing scheme from buy for $1 and sell for $2; to buy for $1 and sell for $4, but it will increase the likelihood of long-term success or quickly show your product’s inability to reach your company’s goals.