Thursday, July 11, 2013
10 Considerations for Pricing a Product or Service
When introducing a new product or service to the market a key, and often critical, consideration is the price for this offering. I have seen folks simply take the cost of production and use a percent mark up as a pricing model. This is the simplest model and it provides a good example for the need to consider other pricing model options.
Here are 10 things to consider before setting a price for your product or service:
· Mark up Based on Cost Vs Retail. In the opening paragraph I gave the example of a model being used that marked up a product by a percent over the cost. The cost used here is generally direct cost or labor and materials. If someone wants a 30% of the asking price to be the mark up, then using 30% of cost won’t provide the desired outcome. Simply put, it is the wrong math. If something costs $1 to make and it is marked up by 30% for a selling price of $1.30 then the profit of based on the asking price is 23.07%. To arrive at a 30% mark up based on the selling price it is necessary to divide the cost by the complement of desired percent of the selling price (this recognizes that the cost is 70% of the desired selling price). In this case $1 divided by the complement of the desired percentage of the selling price(100%-30%) or 70%. Thus $1/.7 = $1.43. Here the mark up is $.43 and is equal to 30% of the selling price. I know this seems simple but I can tell you that it is a common mistake that is made by a lot of business pricing strategists.
· Competition. It may not matter what you want to charge if your product has competition from similar offerings in the market place with similar capabilities. The price offered by the competition will have a significant influence on the price you will be able to charge unless you can find a way to differentiate your company or the product from the competition. Offering financing, volume pricing or other supporting programs such as training or superior support services can accomplish this. If differentiation is not an option then a review of the manufacturing and marketing processes may allow a reduction in the cost structure that, in turn, allows a greater profit per product sold even in a competitive environment.
· Alternative Options. One of the major drawbacks of focusing on the cost of producing a product is the lack of focus on the alternatives that may be available to the customer. This can work for or against a pricing strategist. For example, in one company we developed a process for providing a service to deliver printed circulars in the newspaper and through the mail for considerably less than could be provided by any competitor offering the same service. One thought was to price the service with a small markup above our direct costs. This would certainly have drawn a lot of customers to our service but would have overlooked the possibility of pricing just below the competition or possibly above the competition and maximizing our profits. In the end we priced slightly below the competition, maximized our profits and won the majority of the customers in the market.
· Budget. In every pricing situation the customers’ budget has to be a major consideration. If, for example, the typical customer spends 2% of their budget on products or services that you offer and your products requires most or all of the 2% you will be forcing potential customers to evaluate the potential expenditure very carefully. Many times to justify a large budget allocation will require more marketing and support expenses on your part in order to clearly demonstrate the value of your offering. The question here is whether this approach will provide more profits or a larger market share (more profits) than competing with a lower price.
· Knowledge. In the early stages of a product life cycle the consumer may not be aware of alternatives to your product or service and may allow the ability to charge a premium price. As you know premium pricing and high profits will attract competition and competitors will work hard to educate consumers on alternatives to your offerings. To the extent you can hold on to the “knowledge differential” through patents or other protections such as capital requirements, you will be able to enjoy premium pricing. Be prepared to have a strategy when this advantage is lost. Some companies will schedule new product launches at the point where their patents expire.
· Cost to Produce. As mentioned earlier, a clear understanding of the costs involved in producing and delivering your product or service plays an important role in pricing. Understanding the costs well enough to find alternatives to production or distribution costs can have a significant impact. Back in the days of phone modems, transferring data resulted in huge long distance telephone bills which was a key cost component driving our pricing. One option I found was to work with Western Union and use their satellites to disseminate information around the country. This was done by using a local phone connection to Western Union and a small monthly charge for the use of the satellite. In another situation I found that I could use strategic allies in other markets to rep my firm’s products and services thereby avoiding costs for expanding to other markets. This reduction in cost allowed us to attract customers that wouldn’t have been interested in the higher pricing that would have been necessary with the higher cost structures.
· Cost to Market. Marketing costs can easily represent fifty percent of a product’s cost. Finding the most efficient means to distribute and promote the product or service can provide a real competitive advantage in pricing. Grass roots marketing through local community groups have provided some firms a way of introducing products to key individuals that become fans and product promoters.
· Funding for Operations. One of the drawbacks to pricing a product based on its direct costs of labor and materials is the inability to properly consider the cost of ongoing administrative, manufacturing and support operations. Here the lack of understanding costs can result in charging a price for a product that does not cover the associated increase in administrative costs, repair and maintenance or capital expenditures. One solution is to include an overhead cost factor into the direct cost calculations for each product.
· Market Positioning. It is important to remember that the price can suggest value to the consumer. Priced too low a product can be viewed as poor quality and of limited value. High pricing can support the image of a high quality product for discerning customers if all of the other marketing components are aligned properly.
· Availability. An important consideration in pricing is the availability of the product or service and the ability to find substitutes. If there are markets that do not have easy access to products then a premium pricing strategy can be employed. Retailers routinely have higher mark ups in rural areas where competition and product variety is limited.
Product pricing can be critical to a product and ultimately a company’s ability to survive and succeed. Approaching pricing as a minor marketing tool can be dangerous. It is almost never a mistake to take the time to consider all of the factors affecting a product’s pricing strategy.