How to develop a pricing strategy

The effect of pricing on sales and profits

The prices you charge for your products or services can have a dramatic effect on sales and profits. Your pricing strategy also determines how customers view and respond to your product or service. So it’s important to consider the different options when it comes to pricing, to make sure your strategy is effective. Consider these two pricing factors:

1. What the market says

You can get valuable guidance by conducting research on the market reaction to similar products or services as your own.

  • Which are seen as offering the best value?
  • Which are likely to be the most successful?
  • What do customers expect to pay for them?
  • Is there an established market price for similar products or services?

Compare buyers’ risk on each product or service you research. You could charge a higher price if you can reduce or reverse the risks of your product or service.

2. Your competitors

To some degree, your price will depend on the competition. Look at your competitors, the key benefits and features of what they offer, and any points of difference you can see in your own product or service.

If you’re able to offer more (for example, better quality or more features), you can afford to charge a higher price.

The main pricing options

An appropriate pricing strategy complements the position of your product or service. For example, a high price will likely suggest a premium value to your customers.

3. Cost plus pricing

This is really an essential starting point to avoid selling at a loss. What you're aiming to do is calculate all the costs in producing your product or service, then add a margin for your profit. It's a good idea if you get your accountant to check you haven't missed anything, including that your price includes enough profit to grow your business.

For example, if you’re selling outdoor furniture, you need to add up all the costs of manufacturing the furniture – raw materials, labor costs etc. – then add your profit margin on top.

What cost-plus pricing doesn't do is take into account demand, what the competition is charging or market expectations.

4. Margin retail

Let’s say your business manufactures costume jewelry, and the cost to you to make a necklace (including raw materials and the time you spend actually making it) is $25. You also need to factor in an amount for overheads. The best way to do this is to add up all you overheads, and divide that by your estimate of how many sales you expect to make. So you’d look at adding a margin of 100%, and selling the necklace for $50. Can you sell them for that much?

5. Hourly rate

This is what you’d probably work on if your business is service-based, such as gardening and lawn mowing. What you need to do here is work out how much you’re going to charge your customers per hour. For example, a lawn-mowing business would need to take into account wear and tear on the mower, gas costs for both the mower and travelling to the customer’s property, and the cost of their own labor.

So if you work on a base of $5 for mower gas and wear and tear, plus another $5 to travel to the customer. You might be charging your labor at $25 per hour. You then need to add overheads, so if yours are $50,000 and you can work 2,000 hours a year, you'd add in $25/hour for overheads. Then you need to add profit. If you've decided you want a salary of $100,000, then at 2,000 hours that's $50.

So now the charge out rate is $50 profit + $25 overheads + $25 labor and petrol.

If $100 is way over the market rate, then you can look at lowering your overheads and variable costs. Or you could work longer hours, and reduce your profit margin.

6. A mix margin retail and hourly pricing

Combining margin retail and hourly rate pricing is something you’d do if your business offers both a product and a service. So if you’re manufacturing entertainment units that are custom-built for a client’s home, including installation, you would need to charge your customer for both the unit and the time it’ll take you to install it.

7. Benchmarking your costs

It’s useful if you can benchmark your costs against industry averages, like gross profit and net profit margins. If your margins are below industry norms, it could suggest your costs are too high or your prices are too low.

Industry margins also give you a rough guide to the prices you could achieve when considering new products. Consult your accountant for help with benchmarking figures.

8. Discount carefully

Most accountants warn against discounting. Once you actually work out how much extra you need to sell to cover a discount, their concern becomes understandable. This is why you never start a discounting battle against stronger competitors – nobody wins except the customer.

However, discounting can work in certain circumstances. For example, clearance discounts can help you sell off old stock, release working capital and improve cash flow.

Continually review your prices

  • Review prices regularly to ensure you’re keeping up with trends in your industry and the overall market.
  • Under-pricing your product can be even more dangerous than over-charging. Remember, while prices are low, so are your margins.
  • If you cut prices, customers may not respond if they perceive new prices as signaling low-quality or a lack of confidence and experience.
  • Changes in turnover can signal a problem or an opportunity. For example, if you sell products with high or growing market share, you could increase prices. Similarly, if you tender for business, too high a success rate suggests you’re under-pricing.
  • If both your margins and market share are low, you need to change something – or consider discontinuing the product.

Increasing your prices

Increasing prices and therefore margins can sharply increase your profits – even if your turnover drops. However, you should always explain to your customers why you’re increasing prices and give them fair warning, especially if they need to budget for the increase.

  • Use the price change to re-emphasize the benefits you offer. Good relationships with your customers can help to improve their value perception and lower the risk of them trying alternatives.
  • Always increase the price by more than the cost of improvement.
  • In general, always consider increasing prices when demand is high.

Summary

Review all the options and decide which one suits your business best. When you’re deciding on your strategy, it’s a good idea to consult with your accountant, to make sure you’re not missing anything out, and that you’re charging enough. What you don’t want is to fall into the trap of thinking that if you can sell your product or service at the cheapest price, you’ll generate more sales – it doesn’t work that way.

Unless you’re planning to seriously disrupt the market, you should be aiming to charge as much as you can.

Next steps

  • Research customer reaction to prices of comparable products and services. Consider whether your business can justify higher prices.
  • Seek help from your accountant with developing your pricing strategy.
  • Schedule regular pricing reviews to keep on top of changing demand, market expectations, seasonal trends, industry trends, and changing production costs.
  • Communicate any price increases to your customers and use the opportunity to re-emphasize the benefits your product or service offers.

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