Here’s a story about
how I earned a few beers some months ago.
I was talking to two friends, both of them entrepreneurs. Lucy offers graphic web design services and Dan offers installation and maintenance of whirlpools. We had a conversation about their businesses and eventually ended up discussing their prices. Both of them mentioned that they didn’t really have a pricing strategy. In fact, it turned out that neither of them could tell how exactly they determined their prices. Lucy said:
“I usually feel bad to ask my clients for ‘so much’ money for my services, but after the job is done, I always think I should have charged them much more.“
I have heard a number of entrepreneurs and startups stating the same. Many of them appear to struggle with finding a price they know they have chosen for a reason. But if this is a problem, as it seems, then the question becomes; how to determine a price?
In the following, I explain what I told Lucy and Dan. After having talked to them, they were happy to buy me a beer.
Why is setting a “good” price so important?
It is very important to get the price right for your product or service. Here’s why:
Profit = Sales – Cost
For more Profit, you have to either increase your Sales or decrease your Cost, or do both.
Now let’s look at the sales part of the equation.
Sales = Volume * Price
This means that if you want to push your Sales, you have to increase either your Price or Volume, or both. However, if you increase your Price, Volume will likely decline. If you want to increase your Volume, you probably have to lower the Price.
Hence finding the best possible balance of Volume and Price is important, because it will maximize your Sales and thus, Profit. This, of course, is simple micro economics and assumes that all things but Price remain unchanged. While Price is the subject of this article, it is clear that Volume can also be affected by other factors, such as marketing.
Three ways to determine a price
The three basic ways to determine a price are:
1. Cost-based pricing
2. Competitive pricing
3. Value-based pricing
Cost-based pricing is determining your price on the basis of how much it costs to produce, sell, and ship it. If this total cost is, say, 10 dollars, then your price should be 10 dollars plus margin. Margin, or mark-up, is what you get to keep and use to cover additional costs (like insurance if not included in the total cost of product) and future investments or pay yourself a salary.
Sometimes the cost of your offering is difficult to calculate. This is often the case if you offer a service or information-based products. Services can be carefully defined events, such as a 30 minute long foot massage and all-away haircut, or rather abstract such as maintenance of a football field, selling medical treatment information, or designing a website. While an estimate of the cost for such services can be calculated based on average hourly wages and other indicators, basing the price on such estimates can be risky. This is when competitors’ prices might be helpful.
Competitive pricing is determining your price based on that of your competitors. By comparing your product or service with the existing ones on the market, you can find your own category and price range. You can then set your price around the same level, a bit higher or lower depending on the features you offer compared to those competitors against which you benchmarked. For example, if your location is more central or customer support faster, your price can be at the higher end within your category.
If you orient to your competitors’ prices, which is possibly the easiest way to determine a price for your own offering, you should still always consider the total cost of your product. Your competitors might be established companies with deep market knowledge, strong customer relationships, and lower costs due to economies of scale. They might start a price war when they realize that you are a threat. This raises the question of why to go on the market with a similar product anyway? Wouldn’t it be better to have something different, or something superior?
Value-based pricing means determining your price on the basis of potential customers’ willingness to pay. This method typically includes arguments involving emotions, brand value, prestige, quality, and novelty that are reflected in the comparably high price. If you are offering for example a high-tech product or unique services, you might want to use value-based pricing.
Although using this pricing method has many advantages over the other two, it can be difficult to know how much potential customers are willing to pay for your offering. While in some cases there are relatively clear reference points you can rely on (for example competitors), sometimes there is not much, especially if your product or service is very novel or complex. In such a case, it is useful to look into analogies (past instances in other industries), test with different prices on the market, or simply, ask the potential customers directly. The latter can be done for example by using monadic tests such as the Gabor-Granger technique.
Price-Quality Strategy Matrix
Whatever price you set for your offering, it is important to remember that there is no price that everyone will like. Some potential customers will always be turned off while others might think a it’s perfect price.
Therefore, it is extremely important to define your target market, or target customer group. They are the ones who should think your price-quality-relationship is a good deal. For analyzing this ratio and your market position relative to the competitors, you can use the very useful Price-Quality Strategy Matrix by Philip Kotler1.
In sum, entrepreneurs often find it hard to come up with an ideal price for their offering. In this post I elaborated on three ways that can be used to determine a price: cost-based, competitive, and value-based pricing methods.
Which method you can or should use depends mainly on your offering, sector, and strategy. In addition, it is useful to compare your price-quality strategy relative to your competitors to analyze different market positions perceived by the customers.
While these methods help you determine your general price, there are several different pricing strategies that can be used to boost your sales. You can learn more about those techniques here.
Sometimes, these pricing methods can be used in a way that provides the fundament for a business model innovation.
1Kotler, P. 1988. Marketing Management: Analysis, Planning, Implementation and Control, 6th Ed. Prentice-Hall Inc., Englewood Cliffs, NJ.