Setting prices right is incredibly important to your business. It is can also be incredibly complicated and sensitive.
Since you need customers to buy your products, they need to be priced logically, or you will scare customers away.
Set prices too high, and your target market may not be able to afford them. You want to be profitable – but there’s no profit if there’s no sale.
Set your prices too low, and you may also scare customers away. You may build an impression that your products or services are inferior. Or, just as bad, you might not be making enough profit to support your business’s fixed expenses and overheads.
Since the selling of your product or service is repeated – hopefully, often – getting pricing wrong will also be repeated, and that may have negative long-term effects for your brand, not to mention your cash flow.
I see most businesses fail the pricing exercise by using a calculator to define their prices, instead of market knowledge. They price their product from the cost up.
Example: A widget costs $10 to make and most businesses in your field make a 20-per-cent margin, so you sell it for $12.50.
Wrong move. Your widget’s fair value is determined by the customer, not your cost.
Another example: You’d like to make about $60,000 a year in your consulting business so, figuring you’ll put in about 2,000 hours, you charge $30 an hour.
Again, wrong move. What you want to earn has nothing to do with what the customer is willing to pay.
I think you can see a trend here. Your pricing should not reflect the cost of your product or what you want to earn, but the perceived value by the customer.
If you want to arrive at the right way to price, ask yourself these questions:
1. What are the customer’s price expectations and my competitor’s pricing?
You have to know what customers are used to paying elsewhere, but you also need to allow for what you have to offer that sets you apart. Remember, you have more to pitch than just a product or service. My convenience store sells sugar at a higher price than my grocery store does, but built into that price is something I see value in – convenience.
2. What would happen if I raised my prices, and by how much?
If you were to raise prices, how would customers react? How much of a price increase would they tolerate, and could you afford some lost sales in the process and still be ahead? You might be surprised by just how much flexibility you actually do have.
For instance, say you raised prices by 10 per cent. That might seem like a lot, and could drive some customers away.
However, with that kind of price increase, if you had been operating on a 30-per-cent gross profit margin, you could actually see sales drop by as much as 25 per cent before you’d start to make any less money.
3. What would happen if I lowered prices, and by how much?
By the same token, how much more in sales could you generate by lowering prices?
If you dropped prices by that same 10 per cent , you’d figure you would immediately trigger more sales. And you likely would.
But, again, if you had been operating on a 30-per-cent gross margin, you would need to see sales increase by 50 per cent to make the same amount of money.
Surprised? Since your costs haven’t changed, the effect on your business is even more dramatic on the way down.
That's why running these scenarios for your own business can be such an eye opener.
4. Does my product or service include benefits that my customer doesn’t see value in, but has to pay for anyway?
See if you can remove the non-value add benefits, lower your cost and price accordingly. The goal here is to make the same or a higher margin while making your product or service more attractive and focused on what the customer really wants.
5. Can I add benefits or features to my existing product or service, and charge more accordingly?
If you do, the customer will get more but will also have to pay more.
6. Can I customize my product or service so the customer can choose from a menu?
Instead of a one-size-fits-all pricing strategy, you might be able to offer something made to order. Many customers will pay a small premium for these options (the parts are usually sold for more than their sum) and your costs align exactly with what you deliver and the customer only pays for what he or she needs.
I guess you do need a calculator after all, but remember the golden rule of pricing: It’s not what it costs your business, but what the customer thinks it’s worth.
Special to The Globe and Mail
Chris Griffiths is the Toronto-based director of fine tune consulting, a boutique management consulting practice. Over the past 20 years, he has started or acquired and exited seven businesses.
Join The Globe’s Small Business LinkedIn group to network with other entrepreneurs and to discuss topical issues: http://linkd.in/jWWdzT
Our free weekly small-business newsletter is now available. Every Friday a team of editors selects the top picks from our blog posts, features, multimedia and columnists, and delivers them to your inbox. If you have registered for The Globe's website, you can sign up here. Click on the Small Business Briefing checkbox and hit 'save changes.' If you need to register for the site, click here.