How to set a price
There are four ways you can increase your profits. You can cut your costs, you can sell more, you can change your product mix or you can increase your prices. Clearly, your aim should be to set your prices initially at the level that gives you your highest profits possible. Needless to say, as with everything else to do with your business, it is easier said than done. There is no clear-cut or agreed method of establishing a price for your product.
Some people use the level of costs as a way of fixing price. This may seem a straightforward calculation but it has drawbacks. For example, if your costs are very low, does it automatically mean that your prices should be low too? And even working out the cost can be fraught with possible errors.
Other people argue that the price should be set by what the market can bear. But there are no quick and simple calculations that can tell you what this should be. Instead, you have to establish the price by looking at the market you are in and the particular part of it your product appeals to. How does your product rate against others competing in the same marketplace? There are also different strategies you can adopt depending on whether your product is a new or old one. Often overriding all your plans can be the effect that your competitors’ pricing policy has on yours.
It is probably more realistic to think in terms of a range of prices. The lowest price you should consider setting will be fixed by the cost. You should not go below this price; if you have to, it would be better not to be in business at all. There are a couple of exceptions, where temporarily it may make sense (p. 182). The highest price will be the highest the market can bear without sales disappearing altogether. Between the two will be the price that will give the highest possible profits.
The price range
There is a range of prices open to you to charge for your product or service. Your aim should be to get as near as possible to the price that is going to give you the biggest profit. But this is a long-term strategy; there may be short-term considerations that imply another price is appropriate.
The highest price
This strategy means you have decided to go for the cream at the top of the market. In marketing jargon, it is called price skimming or prestige pricing. You are pricing your product to appeal to those of your potential customers with the highest incomes or those seeking the snob value of a high-priced item. You can also carry out price skimming if you have a product with a genuine technical advantage or if it has novelty value.
Adopting a price-skimming policy usually implies that you are accepting that you could make bigger profits if you lowered the price, because you would sell correspondingly more. Nevertheless, this strategy can be very appealing to small businesses. To sell more you may need to invest in bigger production facilities or employ more staff. This could involve raising funds to be able to do so. And you may find that this bigger business is harder for you to control. Creating a specialist niche could be ideal for the self-employed and small business owner. While it may not give the highest possible profits, it could make you a very acceptable living.
A pitfall to watch out for is that high prices attract competitors. Your profitable niche may soon be invaded by those offering lower prices or a better service or product. You need to allow for this competition in a price-skimming strategy. This applies particularly if you are adopting a price-skimming policy because your product is new with a technical innovation. It is unlikely to remain unique for long. Your strategy needs to involve either reducing prices in the longer term or concentrating on other advantages or benefits so that your product establishes its own image. This allows it to carry on commanding a higher price even when the technical advantage no longer exists.
The lowest price
The lowest price you should consider accepting for your product is the one that covers your direct costs and contributes something to the cost of your overheads. But this must be regarded as a last resort and not to be accepted if you can obtain business at a higher price.
How is it worked out?
You need to find the direct costs of your product or service. Direct costs are the costs that you would not have if you were not producing that particular item. Your business will also have other costs, indirect costs or overheads. You will still have to pay these whether you produce the item or not.
Example
Sidney Smith knows that the cost of producing his stationery pads is as follows:
| Direct materials (paper, glue) | 10 pence |
| Direct labour | 5 pence |
| Total direct costs | 15 pence |
The lowest price Sidney should consider accepting for his stationery pads is 15 pence plus something towards the costs of overheads, for example, 16 pence a pad.
Note that the terms direct costs, indirect costs and contribution to overheads are explained in much more detail in the Break-even point section (p. 324).
When should you use this price?
As little as possible must be the answer. You would need to sell very large volumes of your product to have enough contribution to cover the cost of your overheads, never mind make a profit.
The main circumstance in which you can justify selling as cheaply as this is if you have spare capacity, with very little prospect of using it for product or services selling at a higher price. If this is the case, anything you sell that helps to contribute to the cost of your overheads should be considered.
However, making this decision can have longer-term effects that must be considered. If you are operating in a market that is very competitive or in one in which your customers tend to be in contact, you may find that you are being forced to sell all your products or services at this very low price. Raising or maintaining your prices can be very difficult in these circumstances.
Selling your product at the lowest price, even on a one-off basis, can have an even worse effect on your business if it triggers price-cutting by your competitors. This could well occur if customers use your low price to force the competition to lower their prices.
The moral is only sell something at this contribution price if it is a one-off product, perhaps not part of your normal range of goods, and if you are very confident that it will not lead to secondary effects on your other products or the competition. You must only consider this price if you have spare capacity. If you do not have any spare capacity, choose the price that gives you the biggest contribution.
Can you go lower than this price?
Only in exceptional cases, such as if you need to clear excess stocks or low-selling lines. If this is the case, try to clear these outside your main selling channels so that it can have no counter-effect on your normal selling activity.
Why you should not use cost as a basis for establishing your normal price
Many businesses work out their prices by calculating what it costs to make the product or service and adding on what they consider a suitable profit margin. But this approach is not satisfactory for two reasons:
- It is surprisingly difficult to work out what it costs to produce an item.
- The cost of an item tells you nothing about whether customers will buy it at that price at all or whether they would have paid much more.
There are various different ways of working out the cost of something, but very often businesses use some variation of a standard costing system. Typically, it looks something like this:
Of course, various discounts may be offered on this price.
The problem with this system is the difficulty of working out how much of the indirect costs and overheads should be added to each product to work out the cost. To attribute a certain percentage to the product, you need:
- some idea or forecast of the total amount of overheads and indirect costs for the year; and
- some idea of the total amount of product you will sell during the year.
In other words, a pricing system based on cost is based on your best forecasts. Obviously, forecasts can be wrong. You may find that you have not sold at a price high enough to cover the costs of overheads, because either your sales are lower or your overhead costs higher than your forecast.
The problem is multiplied if you have more than one product or service. How do you decide how much of the indirect costs and overheads should be apportioned to each product? There is no clear-cut answer.
Setting a price
There are several influences that will determine how near the top or how near the bottom end of the price range your product should be placed:
- how your product compares with competing products;
- the life-cycle of the product; that is, how new or mature;
- how price-sensitive your customers are;
- what price conveys to your customers;
- what position your product has in the market.
How your product compares with competing products
Assuming that you face competition in your chosen market, it is realistic to assume that the price you can place on your product will, to a certain extent, depend on the competition. This does not mean that if your competitors price very low, you have to follow suit. But it does mean that you should analyse your product carefully in relation to the others. The sort of characteristics you should look at include:
- what your product looks like and how it compares with the others;
- how it is packaged and presented;
- what the availability is;
- whether your delivery and after-sales service is better or worse than that offered by your competitors;
- how customers pay;
- whether your product has a better image or reputation.
If your product compares favourably with the others, you may be able to justify a higher price than the competition, even if you are relatively new into the market. Do not be afraid of putting a higher price than the competition. If your product really does have benefits, such as better delivery and service, or a better image, the marketplace may well accept that your price should be higher.
The life-cycle of the product
If it is a new product, one not before produced, there are two possible strategies to adopt. One possibility is a price-skimming policy (p. 180), which goes for a high initial price. The other is to try to secure a very large share of the market for your product before the competition appears on the scene. This would be achieved by setting a low price, known as the penetration price (p. 188).
How price-sensitive your customers are
If you put up your prices, do you have any idea how many of your existing customers would switch to another supplier? Or if you dropped your prices how many new customers you would acquire? How great an effect change in prices has on the amount you sell is called price sensitivity (or elasticity of demand). If customer response to price changes in your product is not that great, you can push nearer the upper end of the price range.
Broadly speaking, if your product is not bought that frequently – that is, one purchase will last quite a long time – the sales of it will not be so sensitive to price changes. On the other hand, if it is bought at regular intervals, sales may react much more strongly.
If it is difficult to differentiate one product from another in your market, this also implies that it will react much more strongly to price changes. If, on the other hand, your product can be differentiated from others by perceived benefits such as image and delivery, sales will be more resistant to price changes.
What price conveys to your customers
Price alone can conjure up ideas about your product in your potential customers’ minds. The consumer often associates higher quality with a higher price; paradoxically, a high price can help the image or reputation of your product. If this applies to your market, a lower price will not generate more sales.
In general terms, a product that has the greatest market share is unlikely to be the cheapest. These products may generate high sales, because despite their high price they are thought by consumers to offer the best package of benefits (or best value for money).
What position your product has in the market
Often, your ability to set prices may be limited by the market in which you operate. There may be a going rate established in the market and, unless your product becomes the market leader (see below) or is definitely a better product, it may be difficult to establish any other price.
The price of your product needs to fit the market position planned for it. This is the place that the product occupies, compared with competitive products, in the eyes of your existing or potential customers.
A guide to setting prices
- Analyse the position your product holds in the market. Are your target customers those who are looking for reliability? Has your product already achieved an established image in the eyes of the market? Do buyers view it as good quality, prompt service, stylish, say?
- Analyse your product. Are you planning modifications or alterations that could alter its reputation or relative position in the marketplace?
- Analyse the competition. How do their products rate against yours? What is the relative price structure in the market?
- Decide your pricing strategy. Where in the price range are you going to pitch your price? Is it going to be average for the market, 5 per cent less than the average, 5 per cent above the average or a premium price, 25 per cent above the average?
- Choose some specific prices. Estimate volume of sales, profit margin and costs to forecast the level of profits for each price.
- Choose your price.
- Would you be able to test-market the price in a small area of your market? This would allow you to gauge customer reactions.
Price near the top of the range
There are two possible reasons why you may be able to justify a price near the top end of the range:
- The product is the market leader.
- The product is set apart from the competition by non-price benefits.
Market leader
The market leader will be the biggest-selling product in the market. There are several advantages to being the market leader, so it is a position worth aspiring to. The advantages include being able to charge a higher price than the average, making greater sales, having more power over your suppliers and competitors, and being less risky in poor economic conditions.
There is no easy way to become the market leader. Some of the guidelines to achieve the premier position are:
- try to be one of the earliest entrants into the market (not necessarily the first);
- develop, by careful marketing, selling and advertising, what is different about your product or business;
- be ruthless about efficiency and costs;
- be sensitive to changes in the market;
- compete intensively on all sales;
- look for profits over a long period, not the short-term fast buck – so lengthen your horizon.
Non-price benefits
The price you put on the product tells prospective customers something about it. On the whole, a higher price implies high quality, a lower price low quality. You are unlikely to build a business offering a low-quality product at a high price; on the other hand, you are throwing away profits if you offer high quality at a low price. You have to decide where your product is placed in the market compared with competitors and price accordingly.
You will be able to justify a higher price, near the top end of the range, if you decide to offer a high-quality product. You must not be frightened into thinking that the only thing that matters to buyers is price; they are interested in other aspects of your product too.
In your marketing and selling, build an image or reputation for quality, efficient service, reliability, prompt delivery, and effective sales and technical literature. This will allow you to raise prices and generate higher profits.
Price near the bottom of the range
There are three main reasons why your pricing policy might be near the bottom end of the range:
- Fear (because you mistakenly believe that the main factor in buying is price – but see above).
- A strategy of grabbing market share.
- Severe price competition.
Market share
A legitimate strategy for a business is to sacrifice the level of profits in return for an increased market share. To achieve this, you would pitch the price near the low end of the possible price range (in marketing jargon, a penetration price) in return for selling more of the product. The intention in the strategy is to increase your market share, consolidate your position and increase your prices gradually while retaining the share you have established. Essentially, the aim is eventually to become the market leader with higher unit sales at a higher price. A number of dangers are inherent in this strategy:
- You may find it exceptionally difficult to raise your prices without demonstrating an improvement in the product in compensation.
- You may find that new customers do not remain faithful to you when you increase the price but return to their original supplier.
- You may trigger off a price war with your competitors.
The likeliest use of the strategy occurs when you are introducing a new product this is a long-term strategy; there may be short-term considerations that imply another price is to the market, and the competition is weak. In this case, you can establish a large market share without attracting strong competition because of the large profits to be made.
Few small firms will have the financial and managerial resources available to achieve this strategy of establishing a large market share successfully; it is really too risky to be considered. Instead, they should look more closely at devoting the available resources to promotion or advertising.
If this is the strategy you want to follow, you must raise significant funding from venture capitalists or by crowd finding.
Facing severe price competition
Low prices or a price-cutting war is an advantage to very few people: you do not want it, other small competing firms do not want it; in the long run, customers do not want it, if it means a reduced number of suppliers and less choice. It may only be in the long-term interest of a large company, if that is your main competitor. So, whatever you do, try to avoid triggering it off.
If one of your competitors cuts prices, what should you do? Try to avoid the instant reaction of following prices downwards. Instead, try to concentrate your customers’ minds on the non-price benefits (see p. 187) of doing business with you. If you have carried out some market research, you will know which are the non-price factors that buyers rate most highly, and these can be emphasised.
However, if you operate in a market that is very price-sensitive and does not differentiate between products, there is little choice but to match the price cuts. In this case, your survival will depend on savage reduction in your costs.
Selling at more than one price
If you have a range of different customers, you may be able to sell your product at a higher price to some of them and a lower price to others (called ‘price discrimination’). For example, a solicitor or accountant might have one rate for individuals and another for corporate customers; an entertainment provider might have a reduced rate for, say, children, students and elderly people; a farmer might have different prices for sales direct to the public, sales to distributors, and sales to firms that are going to further process the product; a supermarket in a large town where there are many competitors might charge less than one in a rural area with far less competition; you might have to charge less for overseas sales than for sales in the UK.
Price discrimination is possible where you can divide your likely customers into distinct groups that are willing to pay different amounts. Yours must also be the sort of product or service that cannot be readily resold. This is more often the case with services. For example, if you are a landscape gardener, there is no real way for one customer to purchase the work you have done for another. In general, unless you have a monopoly over the supply of your product (which is unusual for a small business), you can discriminate on price only if other suppliers are doing the same – otherwise, by charging a higher price, you will simply lose customers to your competitors.
Successful price discrimination should boost your revenue above the level you would have had charging a single price to all customers. This is because setting a single price would lose customers unwilling to pay that much and give an unnecessary discount to others who were willing to pay more.
Pricing with more than one product
If you have more than one product, the sales could be interlinked if they are:
- competing with each other; or
- complementary to each other.
You need to ensure that your pricing policy is consistent across the range of your products. With competing products, the prices need to make sense. There needs to be a recognisable gap in the prices if one is a high-quality product while the other is of lower quality.
The pricing considerations are different if your products are complementary, that is, if you sell one, you are likely to sell the other. Once your customer is hooked, there will be lots of scope for charging high prices on a complementary item, as long as it is not so blatant that it puts buyers off the starting product.
Summary
- There is a range of prices that you can charge.
- The lowest price is set by the contribution to overheads that it makes. Never go below this price. Only accept this price if you have spare capacity and there is no prospect of selling your product or time at a higher rate. If you have little or no spare capacity, choose the sale that gives you the biggest contribution.
- Do not use costs as the basis for setting your prices, at least not without first trying to price the product according to what customers will pay.
- If you go for the highest price possible in the market, you will restrict the amount you can sell. It will not give you the maximum possible level of profits. However, a specialist niche of this type can be attractive to a small business.
- When it comes to setting a price, you have to compare your product with others, establish how responsive sales are to a change in prices, work out your strategy if it is a new product or coming to the end of its life, analyse what price conveys to your customers and decide what position your product is aiming for in the market. Use the guide earlier in this chapter (p. 186).
- The market leader has several advantages; the main one is that it means you can achieve more sales at a higher price than the competition.
- Justify a higher price by stressing non-price benefits, such as quality, reliability and delivery.
- Avoid pitching your price too low through fear or misunderstanding of what buyers are interested in.
- A strategy of increasing market share through low prices is dangerous for a small business.
- If you are facing severe price competition, try to distract attention from price by emphasising the product benefits.
- If your customers can be divided into distinct groups, you may be able to increase revenue by charging several different prices.