Pricing
For Profitability
Market Driven Pricing
Pricing for profitability is paramount to
your survival as a new business. It is generally not advisable
to price below your costs in order to gain market share. It
is critical, therefore, that you understand your own internal
cost structure and that you price your products or services
at a level that not only covers your costs but also generates
a profit for your firm.
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Understanding your cost structure is not
enough, however. A businesses price strategy will not be determined
by its cost structure. Ultimately, a firm's pricing strategy
will be determined by the market itself. The price you charge
for your products or services should be consistent with what
the market will bear.
If customers are generally unwilling to
pay you a price which covers your costs, then you must find
a way to reduce your cost structure to bring it in line with
the cost structure of those businesses which are operating
profitably in your market. If you fail to bring your costs
into line with those of your more frugal competitors, then
you will be forced out of business.
In economic terms, most firms are considered
"price takers". That is to say that most businesses - and
particularly small businesses, must go into the market and
"take" whatever price is given them. In other words, they
have no control or influence over general market prices. There
are very few businesses that are large enough to influence
market prices. As a general rule, the only thing that a small
business can control is its internal cost structure. It is
incumbent, therefore, on you as a small business owner to
understand and manage your firm's costs to ensure profitability
given market price levels.
Benchmark Pricing
Prices for similar or identical products
or services will often vary rather dramatically from city
to city and state to state. It will be important, therefore,
that you conduct a thorough investigation in your market to
determine the competitive price range for your product or
service. If you will be selling nationally you should use
the prices that other national companies are asking for similar
products as a benchmark for your own pricing strategy.
The Internet can be a rich source of national
pricing information. Be aware, however, that many companies
selling products on the Internet will be pricing at or near
cost in order to establish a market position. If you intend
to sell to a local or regional market you will be better served
to benchmark against local and regional competition. While
competitive pricing information is not always readily available,
you will be surprised at the amount of information you will
be able to uncover with a little work and creativity.
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Markup Pricing
In the retail and wholesale industries there
are well-established markup guidelines. Suggested wholesale
and retail markup information can often be obtained from manufacturers,
wholesalers or other suppliers. Monitoring the in-store and
advertised pricing activities of your competitors will yield
similar pricing intelligence.
Value Pricing
"Value" of course embodies the concepts
of quality and price. For most products and services there
is an implicit tradeoff between quality and price. As the
quality of your product or service declines relative to that
of competitive offerings, your price must be commensurately
reduced in order to satisfy a customer's "value" requirement.
Conversely, if you are capable of providing
superior quality, you should expect to be able to charge a
higher price than your competitors without violating the "value
contract" with your customers.
At some point, however, the relationship
between quality and price becomes non-linear. That is, there
will generally be a point where, for any given product or
service, price considerations will begin to override quality
considerations. A declining tradeoff between value and price
will be observed, such that incremental quality improvements
become less valuable in the eyes of prospective consumers.
Developing Your Initial Pricing Strategy
Developing initial target prices will take
a good deal of effort. In the early stages of your business,
much of your price intelligence will come to you through the
trial and error process of market interaction. As you begin
to deal with potential customers, you will quickly develop
a sense of average price thresholds for your market area.
Your ultimate objective should be to establish
a price structure that attracts customers while generating
an adequate profit for your firm. Pricing should be viewed
as a continuous process. Once you feel satisfied that you
have established an optimal price structure you should continue
to periodically review your prices and benchmark them against
the competition to ensure that you are always in touch with
the market. Do not assume that prices will remain constant.
It is not unusual to see significant price swings (either
up or down) in a market over time. The price you charged last
year may no longer be appropriate this year.
Inflation Adjustments
As a general rule, do not expect prices
to move in lockstep with inflation. The fact that the Consumer
Price Index (CPI) goes up 3-4% does not necessarily give you
license to raise your prices by a similar percentage. Competitive
pressures generally constrain such actions. At the very least
there is usually a lag effect. On the other hand, you should
not feel unjustified in scheduling periodic price increases
if you believe they are warranted. Let prudence guide your
decisions. It is usually easier to establish a higher price
level on new business than to initiate an across the board
price increase on existing customers (regardless of how justified).
Custom Pricing
When a current or prospective customer requests
a product modification or a special service which goes beyond
what you consider to be "normal" you will have to determine
whether you will charge a premium for the extra measure of
service you will be providing.
If the client is large and the volume of
business is significant, you may decide that some extra service
is justified. Likewise, if competition for the account is
keen, you may be willing to throw in some additional benefits
at no extra cost in order to secure the business.
On the other hand, you do not want to get
into the habit of routinely agreeing to product or service
exceptions without additional compensation. What may seem
like a small request to the client can often mean the difference
between operating at a profit and operating at a deficit.
You should not feel guilty for charging a little extra for
the additional time and effort that will result from a special
request.
Unfortunately, there are no really good
rules of thumb regarding special requests. Each request must
be evaluated individually. Your evaluation must include an
assessment of what you feel the extra services will actually
cost you. Your calculation should also provide for a normal
profit margin.
Pricing is not always an exact science.
There will often be a range within which you may comfortably
operate. The idea is to develop a sufficient understanding
of your customers, your market and your underlying cost structure
to be able to derive a price that is in the right ballpark.
Pricing for Profitability
Consistently undercharging for products
and services is a common problem among small business owners.
Charging a fair rate for your time or the time of your employees
is generally not sufficient. In addition to the profit margin
that your company is entitled, you must not ignore the fixed
overhead costs which you incur each month to support your
ongoing business activities.
Even if you begin by operating from your
home, you will have incremental overhead expenses such as
telephone, utilities, automobile, printing and equipment expenses.
The price of your services must always include an allocated
portion of your fixed overhead expenses.
Additionally, your price must account for
all variable costs of providing products or services to your
clients.
In developing your price strategy you should
always be mindful of your underlying cost structure which
consists of the following:
- Variable Costs: All incremental
costs of providing services to the specific client (i.e.
labor, delivery expenses, materials, payroll taxes, employee
benefits, etc.)
- Fixed Overhead Allocation:
A fair share of fixed overhead expenses (i.e. rent,
utilities, your salary, equipment, other administrative
overhead expenses, sales & marketing expenses, etc.)
- Profit Margin:The portion
of the total price allocated as a fair profit for your market.
You
Know You've Overpriced When ...
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