Some typical approaches used by businesses include:
- Charge a bit less than or the same as competitors.
- Charge a bit more than the product or service costs.
- Charge as much as you need to cover your costs, i.e. break-even.
- Charge what you can get away with.
- Charge what you think it's worth.
- ‘Cost’ the product or service and calculate a mark-up to provide an acceptable profit.
Do these approaches ensure you price right for maximum profit? Let's discuss the merits and pitfalls of some of the above pricing strategies.
Follow competitors or the market
The problem with this method is you don't always know how they calculated their price. It may be unsustainable in terms of the costs for your business to deliver the product or service. You may win sales in the short term but unless you develop a better way of pricing you are likely to go out of business if the price doesn't cover costs.
Your competitors may have cash reserves to cover the shortfall between costs and price . They can afford to sit tight and collect all your customers once you go out of business! This may sound extreme but we see it all the time in business. This is a classic strategy employed by the airline industry, for example.
Charge a bit more than the product or service costs
The $64,000 question here is ‘How much does the product or service cost?'. If you have looked closely at Financial Reports you will have seen the term COGS which stands for ‘Cost of Goods Sold'. This is purely the cost of getting the product or service out of the door. COGS does not include overheads such as admin time, advertising, equipment or stationery.
The danger, then, of charging a bit more than the product or service costs is you still have to factor into the price of other overheads.
If you don't work out your break even situation you may be making a Gross Profit, but after paying overheads you could be making a loss.
Break even analysis is the practice of calculating how much revenue you need to cover COGS and overheads. It is an absolute must in business to know your break even situation.
Charge as much as you can get away with
This is a fine strategy so long as it covers your COGS and overheads. It may work at first, but if you don't keep a close eye on COGS and overheads, they could creep up, ultimately making your business unprofitable.
Charge what you think it's worth
‘Worth’ is an interesting concept that means different things to different people. What the customer thinks may be quite different to your perception. Again, if this figure at least covers the COGS and overheads, that's okay, but most of us are in business to make a profit. You still need to keep a close eye on costs to ensure your margin is not being eroded by increased costs.
Tips for getting the price right
In order to get the price right for maximum profit you need to determine the cost of delivery of the product or service to customers excluding overheads. You also need to know your overheads so that you can work out your break-even situation and how much you need to sell.
Next you need to decide how much profit you want and calculate this into the price. Also, know your margin and report on it regularly to ensure it is not being eroded by increased costs.
It’s important to know your customer satisfaction levels - dissatisfied customers won't pay any price.
Also, regularly reviewing pricing and doing small increases to cover increased costs is easier to do than irregular, large price increases.
“ The danger of charging a bit more than the product or service costs is you still have to factor into the price of other overheads. ”