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If you’re wondering how to price a product, here’s an overview. We run through different elements of strategic pricing, including penetration pricing and price skimming.
It can be difficult to know how to price a product, especially when you’re starting out. But if you’ve done market research and know how much it costs to produce and sell your product, you’re almost there.
The science behind pricing involves your costs, as well as other data, including how much your competitors are charging for their products.
But there’s an art to pricing too, which involves the value customers perceive your product to have, as well as your overall business objectives.
That being said, it’s important not to overthink pricing your product. While you should approach changing prices carefully, it’s possible to alter your prices in the future when you have more data.
Your fundamental objective is to price your product so that your business can continue, make a profit, and sustain your cash flow.
Here are strategies to help you price your product and make a profit (and therefore a success of your business). Use this overview to carry out further research if you need to, including a competitor analysis or SWOT chart.
Businesses that sell physical products and carry an inventory will need to know their cost of goods sold (COGS).
Understanding COGS can help you price a product and maintain a steady cash flow.
You only include costs involved with providing a product to customers, excluding those that aren’t directly or indirectly involved in production. Xero says to look for expenses that “only occur when a service or good is provided” or that “go up and down as sales go up and down”.
These are variable costs and won’t usually include rent for your premises, or fixed staff wages, for example.
Variable costs might include:
Once you know the COGS, you can then add your profit margin. This is cost-plus pricing. You can express this purely in monetary terms or as a percentage.
If you’re looking at a 30 per cent profit margin, take your COGS and divide it by one minus your profit margin as a decimal. So if your COGS is £15.50 then the calculation is:
When choosing your mark-up, you should take fixed costs like rent and other overheads into account. You should also know how much money you hope to make.
It’s important to understand your competitors too, because if your mark-up ends up being way more than what others are charging, customers won’t have a compelling reason to shop with you.
The COGS also comes into play in more formal business accounting, having implications for your cash flow.
There’s a specific formula to get to grips with here, also known as the cost to sales formula.
You calculate this over specific time periods, for example monthly or yearly. The cost to sales formula is:
What is penetration pricing? A penetration pricing strategy involves setting a low initial price to drive people to buy your product, potentially with the goal of raising prices in the future.
This strategy can take your competitors off guard. It can encourage customers to switch from your competitors’ products, giving you the chance to build loyalty.
You might make less profit in the short-term but over the longer-term, you’ll benefit from increased market share and recognition built during the penetration pricing phase.
What is price skimming? Price skimming involves setting the highest price that customers will initially pay for your product, then lowering it over time.
The idea is that you target different segments of the market each time you lower the price. If you’ve built word-of-mouth or customer loyalty already, ‘early adopters’ will be happy to pay a high price. After that, your strategy shifts to target more price-sensitive customers.
A competitive pricing definition is a strategy that involves setting prices based on what your competitors are pricing. This also ties into your business strategy. For example, if your strategy involves being the cheapest provider, you’ll set prices slightly lower than your competitors.
And if you pride yourself on your customer service, you have to work out the mark-up that justifies in relation to your competitors.
It helps to have a well thought-out business plan that establishes how your business is going to position itself in relation to its competitors.
This strategy works if there’s a particular price that customers expect to pay for a certain product. You can set your price within a certain range around that point.
For a psychological pricing definition, it’s a strategy that involves tapping into behavioural psychology to set prices. It’s often used more as an advertising and marketing strategy rather than a long-term pricing strategy.
It’s easiest to explain with some psychological pricing examples:
Psychological pricing advantages include:
Psychological pricing disadvantages include:
When you sell physical products to the public, mistakes and accidents can happen. If a product your business designed, sold or supplied is faulty and ends up causing injury or damage, product liability insurance can cover the resulting claim.
Would you like to know more about how to price a product? Let us know in the comments below.
Photograph 1: Ivan Traimak / stock.adobe.com/uk/Photograph 2: amnaj / stock.adobe.com/uk/
Sam has more than 10 years of experience in writing for financial services. He specialises in illuminating complicated topics, from IR35 to ISAs, and identifying emerging trends that audiences want to know about. Sam spent five years at Simply Business, where he was Senior Copywriter.
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