Factors to Consider in Your Pricing Strategy

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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How did you decide how much to charge for your product or service? Did you base it on the competition? Some margin above your cost? Or did you throw a few numbers in a hat and pick one? A crystal ball, perhaps?

I've seen many companies that didn't seem to give their pricing much more thought than that. Outside of a few industries, such as retail and energy, in which pricing is heavily studied and practices are well-established, pricing is often an afterthought, based on only one main factor plus some gut feeling, rather than the many factors that should be considered. The price of your product is more than just a number you plug in to your forecasting spreadsheet. It's an essential part of your marketing strategy.

These are some of the strategic factors you need to consider regarding your pricing.

1. Positioning

You know the old saying, "You get what you pay for." Your price affects the perception of your product in the market. For example, you could position yourself as the low cost leader, like Wal-Mart has done with their "price rollback" promotions and their new slogan: "Save money. Live better." By contrast, consider Acura's recent "Excuses" campaign: "There are excuses for spending money on luxury, and then there are reasons." On an exclusive luxury product, a low price may signal lower quality.

2. Cost

You're in business to make a profit, and you probably have a good idea just how much profit you'd like to make on your investment. If you have outside investors, they certainly do. Calculate the variable cost per sale and the fixed overhead costs. What price do you need to be at in order to achieve your desired profitability based on your sales projections? Be sure to combine this with your demand curve data, i.e., keep in mind that changing your price will change your sales forecast.

3. Environmental Factors

Are there any external constraints that could affect pricing? For example, most cities set a standard rate for taxicabs. In the medical field, insurance companies and government programs will only reimburse a certain price. Also, consider how your competitors may react to your pricing. Will too low a price from you trigger a price war, or at least a new price point that may reduce your competitive differentiation?

4. Demand Curve

Generally speaking, all other things being equal, a lower price will increase demand and a higher price will reduce demand. Any time you change pricing, track the demand changes closely. In most industries, you can't be constantly changing pricing, but you will still, over time, gain insights that will allow you to optimize your profitability. You can supplement this with market research, asking research participants if they would buy the product or service at various price points

5. Market Control

A good demand curve model can help you optimize your pricing for maximum profitability, but that may not always be your best strategy. For example, lower prices when you first launch may be critical to help you gain market share against established competitors. And higher revenues at a slim profit, or even a loss, signal that the company will likely reach profitability later by achieving economies of scale, volume discounts from suppliers, or upsells to existing customers of higher-profit products. Consider Amazon.com, which was posting record-breaking revenues, but took six years to achieve profitability because they had held their prices low in order to achieve market penetration. On the flip side, lower prices can be used by an established business to hedge against competitive threats from newcomers.

6. Psychological Factors

Even if you don't have any direct competition, customers will have a concept of what constitutes a fair price based on other things they are familiar with. For example, I wonder if peanut butter and jelly would have been so successful if one cost five times what the other did. Remember that you're not only competing against your direct competitors, but potentially against everything else they can spend their money on. Also, there are often key price points that will make a significant different in people's willingness to buy. For example, whenever a consumer electronics product breaks the $100 or $50 price point, there's usually a surge in sales. And yes, ".99" pricing really does seem to work (typically about 10% more buyers), even though logically it shouldn't.

7. Value

What is your product worth to your customers? Does it make or save them money? If so, its value should significantly exceed its price. If it does, you can base your pricing more on its value to them than what it costs you to produce it. If it doesn't, you probably need to rethink your offering!

As you've probably realized by now, because there are so many different competing factors, there are a lot of different ways to calculate the actual number for your price. I recommend you run several pricing calculations so that you're fully aware of the range of possible prices. At an absolute minimum, you must consider:

• Cost-plus pricing. You have to be able to turn a reasonable profit, period.
   
• Fair pricing. No matter your cost, no matter the value, if people don't perceive it as fair, they won't buy.
   
• Value pricing. This should be your upper limit. If it's not the highest number you calculate, something's wrong.

In addition to these, consider the other strategic factors and find the number that provides the best balance among them. With a decent offering and a solid business model, you should be able to come up with a price that's well above your cost, a little below the "fair" price, and well below the perceived value.

Pricing is an essential element of your marketing strategy. Don't pull a number out of thin air. Give it the time and consideration it's due.