The price is right

For many businesses, coming up with a product or service that is innovative or meets the requirements of a niche market can seem the most important steps towards success.

Business, however, is about more than offering a product or service: it is about making a profit. Which is why setting the right price charged for those products or services is vital.

Price evaluation is as important for mature businesses as it is for start-ups.

Assessing the correct price to charge will be determined both by the quality of the product or service and the competition it faces in the marketplace.

Balancing cost and value

The starting point of any price setting policy is the relationship between the cost of producing an item or service and its value to customers.

The cost represents what a business must invest - in materials, time, expenses, research and development - in order to deliver the product or service. The price is the amount of money the business reaps from selling the product or service. While the value, a rather less well-defined part of the equation, is the worth that customers themselves attach to the product or service.

Should the worth of the product or service to the customer be high, then the price they are prepared to pay may itself be far higher than the cost to the business.

That is why a pricing policy should consider not just adding a percentage of the cost to price in order to produce profit but should factor in customer value. Value can boost profitability by a considerable margin.

And that is why, in turn, businesses should assess the value of the benefits - quality, reliability, convenience, innovation, speed of delivery - they offer their customers before deciding on the true price of their products or services.

Costs

Most businesses face two sorts of cost: fixed and variable.

There is little a business can do about fixed costs. They are the overheads it must always meet: wages, rental, loan repayments, hire purchase agreements.

Variable costs fluctuate. They hinge on the success of the business. The more it produces, the more costs it must meet in buying additional raw materials, in spending on delivery, in hiring extra people, in expanding premises.

The golden rule here is to make sure that the price exceeds those variable costs. That means each sale generates the money needed not only to meet fixed costs but also to contribute to profits.

Price levels: cost or value?

Pared down, a business will have two fundamental pricing policies open to it.

It can base its prices either on the actual costs of the product or service or on the perceived value of the product or service.

Which route it chooses will depend in large part on the nature of the business.

Firms that operate in a price-driven market or that rely on high volume sales will usually evaluate the cost of the product or service and then add a percentage of that cost to come up with a price that can both withstand the demands of the market and still create a profit.

Firms that sell and market themselves on the added value of their products or services can price according to the benefits they believe they offer their customers.

In other words, the business makes a judgement about the amount customers are prepared to pay for the quality and reliability of the product or the market innovation and level of client back up of the service where those features are regarded as real benefits.

Planning prices

The majority of businesses will need to tread a relatively thin line between the two: cost-based pricing and value-based pricing.

This is because, unless you happen to be a brand that has built its reputation on high cost innovation and premium quality, or on huge sales volumes, you will be competing for a broad(ish) range of customers.

Charge too little, and profits vanish. Charge too much, and, save in those cases where a business can demonstrate a truly unique business offering, customers vanish.

It is important to be sure of the type of customer you wish to attract and the level of pricing the market will tolerate. If a business is confident that its offering is distinct from its competitors and that its potential customer base will both understand and be willing to pay for that difference, however it may be defined, then it can afford to adjust its prices accordingly. If a business is operating in a price-sensitive environment, then it may choose to look only to adding a percentage increase on its costs to produce a profit.

Pricing tactics

There are a number of different pricing tactics that all businesses can employ to boost their profit margins.

One of these is discounting. It may involve cutting prices to clear out old stock. Or it may involve offering lower prices to customers who buy on a regular basis or who buy on a bulk basis or who buy related products and services. Such orders will probably push up profits because they mean lower sales costs. Businesses should beware, however, that repeated discounting does not encourage customers to regard them as a cheaper supplier: pushing up prices, perhaps to meet increased variable costs, may become more difficult in the future.

Loss leaders are products that are sold at a price that fails to generate a profit but are priced in such a way as to encourage the sale of other, maybe associated products, that are profitably priced.

Skimming is a tactic used by businesses that are fortunate enough to have products and services that are truly distinctive. The prices charged are high, reflecting the confidence the business has in the value of its product or service.

Other businesses opt to set their prices low in an effort to win a significant share of the market ahead of their competitors. With a loyal customer base in position, the business will then look to ease up prices in the future.

Changing pricing structures

On occasions, businesses will need to alter the prices they charge. This may be the result of increased costs or improvements in the product or service.

In either case, the business must consider the impact of the price change on the number of sales it will make and on the amount of profit that individual sales generate.

A rise in prices can still deliver improved profits even if the overall volume of sales declines. It is always a good policy to explain to existing customers why the price has gone up, which, in itself, may be an opportunity to re-affirm the values a business adds to its products and services.

Price increases can be smuggled in through the introduction of new or improved products and services as older lines and offerings are discontinued.

A reduction in prices should only be introduced if circumstances are particularly challenging (a market-wide trend, for example) and if the decision does not give competitors an advantage over a business. Even then it is essential that reductions do not push profits nose to nose with costs. It is a far better policy to focus on raising profits rather than on pulling down prices in an effort to push up sales.