November 1, 2012 | 5-minute read (930 words)
Setting the price point for your product or service is one of your most important business decisions. If you set your price too high, you may limit sales thus hampering the growth of your business. But, set your price too low, and you risk cutting into your cash flow. How’s that for pressure?!
Pricing is an art and a science, not to be entered into lightly. To set the “magic” price, do your due diligence to establish a well-thought out pricing strategy. In particular, consider the following:
Competitive market - Dig into the marketplace. What are your competitors offering, and for how much? Once you’ve done your research and competitive analysis, ask yourself some questions to clarify your approach: How do you want to be positioned within your market? Do you want position yourself as a low-cost provider? Or do you want to establish your company as a high-end product or service provider?
Cost/Price/Value - Make a distinction between cost, price, and value. Your cost is how much money you spend to produce a product or provide a service. The price is what you get. Value refers to how valuable your product or service is to your clients—that is, how much it benefits them and and what they would be willing to pay for it.
Setting price based on cost is called cost-plus pricing and works well only in certain cases (e.g. if your product/service is totally differentiated by cost). Value is often a more important element of the pricing equation than cost, and for most businesses it is the better way to go. Ultimately it doesn’t matter how much it costs you to develop your product or provide your service; what matters is how valuable your customers perceive your offerings to be.
Gross margins - Consider your gross margins and how this fits in with your overall financial plan and objectives. Gross margin is simply your gross profit divided by your total revenue. But this simple calculation yields great insight into your financial statement: which areas of your company are performing well—and which aren’t.
Your goal should always be to consistently increase your gross profit margins. One way to do this is by increasing your pricing. Keep in mind, however, that your gross margin is only one of many important measurement tools to assess your financial status. In other words, you don’t want to sacrifice other areas just to increase your profits.
Contact Early Growth Financial Services for help calculating your gross margins and other financial support.
Market entry - Take into account market entry. Market penetration pricing is particularly used in price-sensitive markets. It’s essentially a quick-entry pricing strategy built on the assumption that a lower price will garner greater sales which will ultimately lead to lower costs. Before you go down this road though, you need to do your due diligence by testing your market and price elasticity and understanding how your competitors will respond (that is, is there a risk of a “how low can you go” pricing war?).
Product life cycle - If you’re selling a product, consider the different stages of the product life cycle: development, introduction, growth, maturity, and decline. As your product goes through these stages, vary your pricing strategy accordingly.
Development - the price you set communicates the value you hope to project to your target customers.
Market growth - as your product gains exposure, you’ll generally want to lower the price point you established during the development stage. Now is the time to finesse your pricing strategy, leaning towards a differentiated product or cost leadership strategy.
Maturity - here price sensitivity peaks. Most of your buyers will be familiar with your product and you may begin to experience greater pricing competition from your competitors. Optimize your pricing through such actions as expanding your product line and unbundling product suites.
Decline - to pull yourself out of decline, take steps to recapture the lost market, for example retrenching to your most successful product line and price or price-cutting.
Economies of scale - How will your costs vary with economies of scale and efficiencies? Economies of scale are the cost reductions that you will gain as your company grows and begins to run more efficiently. Over time, you will be able to reduce your production costs by such things as buying materials in bulk. As your costs decrease, your pricing calculations may shift as well.
As with every business decision, perhaps the real key to pricing is to be flexible. Once you’ve done your research and set your price, keep an eye on it. Monitor your customers and your competitors. And be prepared to rethink and tweak your pricing strategy. After all, the point of your business is to make money, so if you’re not generating enough revenue to make a profit, it’s time to go back to the pricing drawing board.
What is your pricing strategy? Tell us about it in comments below, or contact Early Growth Financial Services for help with pricing and other financial support.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, a financial services firm providing a complete suite of financial and accounting services to companies at every stage of the development process. He's a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.