Understand your pricing choices

written by Tim Berry of Palo Alto Software


There are businesses that can’t set their own prices as easily as others.

Businesses that are regulated by government agencies, or insurance companies, don’t always have much price leeway. Some dentists and doctors set their own prices, and some, based on their relationships with HMOs and insurance programs can not. Some public agencies and utilities require government approval in order to change prices.

Businesses that sell standard commodities also may have price limitations. For example, the service station by a highway exit that has three visible competitors is going to have trouble charging more or less than the others. Movie theaters tend to make certain they have competitive prices. Video rentals have to stay within a certain range to keep volume up.

There is a direct relationship between businesses selling commodities and businesses bound by competition. Gas stations and video stores have trouble raising prices when they have nearby competition. When they get into rural areas where distance is a factor, they have more options.

Sometimes a local supplier can charge a higher price than the more distant competitors.

In most businesses there are some upper constraints based on competition. Look at most products and you’ll see established price points based on competition, positioning, etc. As this is written, a cup of coffee costs about a dollar, a four-door, four-cylinder car costs $12,000-$16,000, a mid- to high-performance computer system costs about $3,000. You really can’t go way over these standard prices without offering some serious additional benefits.

Even in these examples, however, despite the pricing constraints there are still ways you can influence pricing through adding value. A gas station can have promotions on oil changes, or offer hot coffee. A video store may charge less for its older items than new releases, allow five day rentals instead of one, have a larger inventory, or include video games for rent to increase its average price.

Pricing for Product Positioning

Positioning is very important, and pricing is your most powerful tool for product positioning, as we discussed in Chapter 12: Positioning. The best way to price your product is as part of your marketing strategy.

Your pricing sends a message. Some businesses have been extremely successful with very high pricing and matching positioning. For example, some cars with similar specifications sell for much more than others (think of the luxury cars such as Mercedes, Jaguar, and Lexus). Many businesses would sell less, not more, if their prices were lower (luxury shopping stores such as Nordstrom, fine restaurants, and hotels). In addition to offering higher margins, high prices are an important part of the benefits they sell. These higher price points offer prestige and exclusivity and make these products more desirable.

People don’t always want the least expensive product. The original Pillsbury cake mix failed commercially at $0.10 a package (in the early 1950s) and then became an instant success just a year later when it was introduced at $0.25 per package. The initial home hair coloring products experienced the same. When the product was very inexpensive, people didn’t believe it offered value.

As you work with pricing, refer back to your positioning statements often. If you believe that your product or service is as good as it is, then consider pricing it above the competition. If, on the other hand, your business model calls for low prices and discounting, then pull your prices down to match your positioning.

Price Point Determination

Understanding your costs is a critical component in establishing the price for your product or service. Determining the cost “floor” for your product is an important step toward establishing the range of where your price should be. This will help you understand where you can exercise pricing discretion to set your price point.

Know Your Price Floor

Pricing at the floor means that you are not making any money, or margin, on the products you sell. Therefore, the price of your product or service must be greater than your total costs. This may seem like common sense, but many business failures have occurred from not fully understanding the total costs they incur to produce the product or provide the service to their customers. When the price of your product or service is not contributing to your bottom line, you don’t have the opportunity to “make it up in volume.”

Understanding your total costs requires you to conduct an accurate assessment of your variable costs and your fixed costs. Your variable costs are those associated with each product you create. Raw materials and the labor expenses required to create products are examples of variable costs. Fixed costs are those costs that remain constant, regardless of the volume of product that you produce. Rent and utilities are examples of fixed costs.

Fixed costs may be more challenging to assess. Fixed costs may be allocated based on a prorated factor based on the time associated with creating the product or providing the service. This is more complex when multiple products or services are being produced simultaneously or have dramatically different production cycles.

Calculate these costs as accurately as you can to find the price floor. This exercise will make certain that you don’t price your product too low and prevent you from making revenue from each unit sale of your product.

As mentioned before another consideration in pricing too low is the risk of having a low price associated with low quality. This will be based on the customer’s perceived value and its correlation to the price that they will pay to benefit from their purchase. Some products are considered to be price inelastic. Consumers continue to purchase the product regardless of its price. An appendectomy is one example, but we also see examples of this in consumer products from hair coloring to software.

In addition to the cost structure, the price point may be determined by these factors:

  • Level of demand
  • Degree of competitive threat
  • Impact of government regulation
  • Presence of substitute products
  • Product positioning
  • Production and distribution capabilities
  • Overall marketing strategy

You may choose a “skimming price strategy” that will result in higher margins, and usually low sales volumes. A “penetration pricing strategy” often results in a lower contribution margin for each product sold complemented by increased sales volumes.

Customer’s Perceived Value:

Price Ceiling

Highest Price Point – Skimming Strategy

Strategic Price Point – Pricing Discretion

Lowest Price Point – Penetration Strategy

Price Floor

Pricing is MagicEven after you’ve done the analysis, pricing is still a bit of magic. They don’t teach formulas that work at any business school I know of. Although there are some basic parameters, you’ll find pricing is a combination of educated guessing, art, and reality plus a little luck. With that as an introduction, here are some thoughts to consider.Having been a consultant to and participant in small business for years, I believe most entrepreneurs are far more likely to underprice than overprice. Don’t low-ball yourself. If you are a manufacturing company, you should be able to calculate your physical cost of goods and know your real costs, including marketing and administration, and make sure you make a decent profit.
For example, a retail software publisher’s product may benefit by keeping the price slightly higher than its competitors. However, the retailers know their customers, and this sales channel is critical to the software publisher’s success. The retailers may require the products’s price to remain below $100 to keep their sales volume at an acceptable level. In this situation the software publisher must be very careful in their product pricing. One criteria encourages them to price above one point while another criteria requires that they price below it.You can research what others are doing with prices, percentages of gross margin and related information, and from this information you can estimate their pricing structure.The Risk Management Association (formerly Robert Morris Associates) is a membership organization sponsored by banks which publishes an annual listing of standard financial ratios, developed by polling member banks, for actual business results of thousands of different companies in small business.

The RMA has a publication called Annual Statement Studies which is a very valuable source of information. That study showed, for example, that shoe retailers selling less than $1 million per year make an average of 42 percent gross margins, they spend an average of 40 percent on operating expenses, and they net about one percent of sales as profits. As of this writing, this publication sells for $130 to members and $250 for nonmembers, in either hard copy or CD-ROM.

Other pricing resources you can experiment with include direct telephone sales, interviews, and mock products, to see how people react. The Internet also provides opportunity for experimenting.

Tim Berry

about the author

Tim Berry

Founder and President of Palo Alto Software and a renowned planning expert. He is listed in the index of "Fire in the Valley", by Swaine and Freiberger, the history of the personal computer industry. Tim contributes regularly to the bplans blog, the as well as his own blog, Planning, Startups, Stories. His full biography is available at Follow Tim onGoogle +


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