There are dozens of methods used to determine a selling price for a product or service. This is a basic approach I often use to help owner-managed companies pick a practical and realistic one.
Identify the floor and ceiling for the potential price, and then use a level of creativity to appeal to the customers you are targeting.
Know your costs: The Floor
You have to know what your costs are in order to charge a price that ensures you make money. This involves estimating variable costs such as labour and materials, and the relevant portion of the company's overhead, which is all other costs necessary to run the business, such as rent and insurance.
It's easy to make mistakes. For example, let's say an existing company is launching a new service, and it purchases equipment to get into this business. All depreciation should be allocated to the estimated cost of that new service. However, most companies lump depreciation into general overhead and a small portion is applied to the new service. Your costs of the new service are now higher than you think, and you risk losing money on every unit sold.
I've seen this happen to some degree with nearly every client. Get your costs right and you'll have a true understanding of your floor.
Know what people will pay: The Ceiling
If the lowest you can charge is your actual cost, the highest you can charge is the most people will pay.
Customers will be driven by emotion when buying, and they rationalize their purchases based on perception of value. This is not just a retail consumer issue. Even in industrial settings, engineers that procure equipment may be risk-adverse and willing to pay a premium to a company with a reputation for reliability.
Estimating the ceiling is complex. It is difficult to understand the emotions another human being will experience when purchasing your product. It is also difficult to understand what benefits people will perceive as valuable when your product is compared with alternatives.
Once you understand the floor and the ceiling, you have a pricing window to work with.
There are several reasons to avoid always pricing at the ceiling. Two market segments might have different price ceilings, for example. Pricing at the ceiling for one market segment might make you overpriced in the other.
A second reason has to do with how the market views your product relative to your competitor's price. Let's say you own a landscaping company and your competitor lowers its price. You might have to follow suit to retain customers.
Price is also interrelated with other business decisions, such as the product attributes you are offering. Be creative. Put yourself in the customer's shoes and work backward to design the pricing structure – including incentives and payment options – the product or service you offer, and the experience people will have with your company.
Using the landscape business example, you might have options. Can you offer free landscape design rather than dropping your price? Chances are the most price-conscious customers would move to your competitor and you'd retain the higher-margin work.
Careful thought when setting prices can have a dramatic impact on your bottom line.
Special to The Globe and Mail
Brent Banda, MBA, is a strategic marketing consultant who has operated Banda Marketing Group since 1997. His work primarily involves helping owner-managed companies launch new products, enter new markets, and retool existing marketing and sales plans.