Here are five things to consider when you set the price for your product.
6 min read
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Pricing your product is one of the most important decisions you’ll make when launching a business — yet it’s also one of the most neglected. All too often entrepreneurs spend hundreds of hours designing their products, and not enough on the nuts and bolts of the economics involved.
It may seem like a straightforward process, but the business impact is critical. Price affects everything in your business from profit margin to cash flow to hiring, so it’s vital to put in some serious thought. It may sound easier to slap on a number and fix it later, but shooting out of the gate with improper pricing can lead to poor margins, future challenges and even failure.
There’s no simple formula for getting it right, so be sure to review some proven pricing strategies to see what’s out there. Here are five things to consider when you set the price for your product.
1. Understand the value of your product.
The best way to learn the perceived value of your product is to do some market analysis, aka speak directly with customers via focus groups or online surveys. There are two different paths to take — and you’ll want to try both. The first is an aided question, something like: “What would you think if we charged X amount?” The second is an unaided question like: “What would you be willing to pay for this?” You can reconcile the two sets of answers to get closer to a target price.
Over time your customers will also speak with their wallets. Apple is a great example of this — its newest iPhone models incorporate popular features at a lower entry price point than the previous generation, yet the top-of-the-line models are more expensive than last year. Apple clearly believes, based on its data, that its customers will pay more for those innovations.
2. Research the competition.
Value isn’t the whole package. You also have to know what your competition is doing. After all, how much they charge can also impact your prices. So look at your competitors; what do they charge and how are their products different? Their prices can provide a baseline for how much you charge your customers. You might set your prices lower to try to attract some of their customers, or if you consider yourself a luxury brand, you might set your prices higher to signal elevated quality and status.
As you evaluate competitors, don’t forget to look at close substitutes. For example, if your company is Uber, Lyft is your competition, but the bus plays in as a close substitute — one that shouldn’t be overlooked when considering your price point.
3. Determine your costs.
Before you price your product, you need to know how much you spend to create it. That means calculating every cost that goes into manufacturing or acquiring each item. If you purchase products and resell them, add up the costs of buying and shipping the items. If you make the products yourself, include creation costs like materials, development, manufacturing and overhead.
Once you know how much you spend on products, you have your break-even cost, or the minimum amount you must sell the products for to earn back the money you’ve invested in them.
4. Build a basic price model.
Before you set a price, it’s wise to put some basic numbers behind it so you can see how various factors contribute to your bottom line. A basic pricing model looks like this:
(Price – cost) x quantity = profit
So let’s say you want to sell custom hats. Your hats cost $10 to make, and you’re not sure whether to sell them for $15 or $20. Plug in the numbers for each option:
- ($15 – $10) X Quantity (20) = 100
- ($20 – $10) X Quantity (10) = 100
Looking at those two options, you’d have to sell twice as many of the $15 hats to achieve the same profit as the $20 hats. In other words, decreasing prices just 25 percent (from $20 to $15) means you’d need a 100 percent increase — or a doubling — of the number of hats you sell. That’s a big difference, even with our small sample quantities. Do you think you can sell that many? Is the effort involved worth it? Yes, you can charge a lower price to gain users, but then you trade profit and still have to attract more buyers.
5. Move to behavior numbers.
Finally, once you have a price range, use your intuition and move to “behavior numbers” like $99 or $10 to finalize pricing. That means pay attention to round numbers and not underestimating the left-digit effect: Consumers, who read from left to right, pay more attention to the first digit they see. When you see the first digit is a 1, then the overall price of the item seems much less than if the first digit were a 2, even if the price is only one penny or one dollar apart. The overall effect of rounding up to an even amount makes the item seem more expensive.
Economics and the power of price
Product pricing can make or break your small business. If you set prices higher than what customers are willing to spend, you’ll lose sales. But, if you set prices too low, you won’t earn at as much as you could. The right price point will fall somewhere in the middle to generate the most revenue — but finding the right balance is tough. It’s important not to price yourself into a corner. Flexibility is critical; otherwise you might find yourself at a competitive disadvantage and unable to react quickly. Putting it all together is an art form, but once you’ve done it well, you’ll have a masterpiece for your small business.