Pricing your products or services can be very tricky. Setting prices too high will scare off customers, but pricing too low will throw away potential profits. Here’s what you need to know about this delicate balancing act.
Where do I start?
Three things will affect how you price your services or products:
Your costs – It may sound obvious, but you’ve got to cover your costs and also make a profit.
Your customers – You need to know how much your customers are prepared to pay. Ask a range of prospective customers what they’d typically pay for your type of product or service and workout an average price.
Your competitors – You need to know what your competitors offer and how much they charge. Do your research – look at their price lists or get someone you know to ask them for an estimate.
How can I use my costs to work out my prices?
Pricing starts with knowing your costs.
Start by working out your fixed costs (also known as overheads). These are costs that will be the same no matter how much business you do, e.g. rent, insurance, business rates, salary, equipment, etc.
Next, estimate your variable costs. These are costs which change according to how much business you do. if your business is making things or manufacturing, variable costs would be raw materials, electricity, packaging, delivery, etc.
If you’re in retailing, these would include the stock you buy in. If you provide services, these would include materials, fuel, expendable items, etc. You’ll probably need to work out different options for your variable costs, which take into account stocking and selling varying numbers of units, or providing differing hours/days of service, or using differing amounts of materials. And don’t forget to include VAT in your costings if you’re registered.
It’s very easy to overlook costs, so make sure you take account of all of these, including credit card fees, fees for professional services, such as accountants and solicitors, pension costs, salary, etc.
Adding your fixed costs to your variable costs gives you a breakeven figure – the amount you need to generate simply to cover your costs before you make any profit.
A traditional way of pricing is cost-plus. This is done by adding a ‘mark-up’ to your breakeven figure, usually as a percentage that depends on your industry sector. This mark-up is your profit.
An advantage of cost-plus pricing is that you can work this out based on information you have close to hand.
Disadvantages of cost-plus pricing for a retailer are:
it’s based on an assumption you’ll sell all of your stock – if you don’t, the profit will be lower
it may not take into account what customers are prepared to pay. For example, if you charge £150 a day for your service (£120 costs + £30 mark-up) but customers are only prepared to pay £120 a day for the service, you’ve got a problem. And if they’re only prepared to pay £100 a day you’ve got an even bigger problem!
it doesn’t take into account what your competitors are charging. If your prices or charges are significantly higher, there needs to be something extra about what you’re offering that justifies the difference.
Conversely, cost-plus pricing can lead to under-charging, for example. if you don’t face much competition you can probably charge more.
What is ‘value-based’ pricing?
As the name suggests, value-based pricing is about the value a customer places on your goods or services (as opposed to what they cost you to provide). Different factors can add to something’s value.
How do I position myself in the market through my pricing?
You need to decide which end of the pricing scale you fit. Are you in the business of piling things high and selling them cheap, or do you provide exclusive and expensive products or services? Or perhaps you’re somewhere in-between?
There’s no one right approach – it depends on the nature of your business and the products or services you sell. But whatever approach you take, you need to understand the mechanics of your pricing strategy. For example, if you source a product for £1 and price it at £1.50 you need to sell three times as many to make the same profit as selling it for £4.50.
If you’re providing a premium product or service you can aim for a very high profit margin, but you must ensure that your quality meets, or exceeds customers’ expectations.
Setting prices to charge more or less the same as your competitors
Isn’t the easiest way to set my pricing to charge more or less the same as my competitors? On the face of it, simply matching what your competitors charge can seem to be the easiest thing to do. But care should be taken. Take a look at the example shown in the panels below.
Ryan knows what his competitor, Gwen, charges per hour for carpentry services, so he decides to match her price.
Ryan and Gwen’s businesses are very similar. They both work for approximately the same number of days each year, for similar types of customers. They have roughly the same sort of equipment, use comparable volumes of materials, and do approximately the same number of miles. Despite this, Gwen’s business is more profitable than Ryan’s, and he’s finding it a struggle. How can this be?
The reason is that Gwen has lower overheads. She owns her tools outright, whereas Ryan has bought his with a loan he pays off in monthly instalments. Similarly, Gwen owns her van, while Ryan has a lease purchase agreement for which he makes regular payments. Gwen uses her home garage as a workshop, whereas Ryan rents business premises.
The two businesses have different levels of profit: Ryan’s has more costs.
To make the same profit margin as Gwen, he’s going to need to reduce his costs, increase the number of days he works, put up his prices, or do all of these things.
Putting up his prices now is unlikely to go down well with his customers, unless he can persuade them that he’s offering something extra.
Don’t copy your competitor’s prices unless you’re sure you can afford to. Just matching your competitors’ prices means you might not be charging as much as you could. If you bring more value to your customers, such as providing additional benefits, higher quality, or better reliability, they may well be prepared to pay a higher price.
Should I price low and see if I can gradually increase this or vice versa?
Usually it’s better to go in too high than too low. Be ready to reduce your price if you don’t achieve the volume you require. Customers usually react more favourably to a price reduction rather than an increase. If you seriously under-charge in the present, you’re going to have a steep hill to climb in the future to get customers to accept price hikes.
A new business may be tempted to charge low prices in an attempt to build sales. In a competitive environment, an established business may reduce prices to try to maintain sales. But high levels of sales don’t necessarily result in high profitability. Dropping your price can be a risky tactic as there’s usually a competitor who will do things cheaper. Keep your focus on profitability.
Whatever you decide, you should regularly review your prices, and those charged by the competition. Very few prices are fixed for the long-term. And if you find that you’re having difficulties making a profit on an item or service, you need to think seriously about dropping it.
Should I aim for the same profit margin across the different products or services I provide?
There’s no need to aim rigidly for the same profit margin across different products or services. In fact, having different margins can be a way of attracting and retaining customers.
For example, a tradesperson who charges a justifiably high hourly or daily rate, might add little or no mark-up on materials or parts and use this as a marketing tactic.
In retailing, it’s common to have different mark-ups for different types of products. For example the same business might have different mark-up rates for sportswear and jewellery.
There are a number of online calculators of profit margin, including this one from Calculator Soup.
Checklist: What types of pricing techniques can I use?
Here are some tactics for pricing products and services. Login to save this checklist to your profile for future use. (To register to join and enjoy the benefits of membership click on the link at the top right of the page. It will only take a few minutes to create your profile).