How do businesses determine their price to customers?
Some typical methods:
- Charge a bit less than or the same as competitors.
- Charge a bit more than the product or service costs.
- Charge as much as you need to earn to cover your costs (i.e. break-even).
- Charge what you can get away with.
- Charge what you think it’s worth.
- ‘Cost’ the product or service and calculate a mark-up to provide an acceptable profit.
Let’s discuss the merits and pitfalls of some of the above methods.
Follow competitors or the market
The problem with following competitors is that you don’t always know how they calculated their price. It may be unsustainable in terms of the costs to deliver the product or service. You may win sales from them in the short term but, unless you develop a better way of pricing, you are likely to go out of business eventually if the price doesn’t cover costs. They may have cash reserves to cover the shortfall between costs and price for a while and you may not. They can ‘sit it out’ until you go out of business trying to compete and collect all your customers later. This may sound a bit extreme but we see it all the time in business. Look at the airline industry. This is a classic strategy they have employed.
Charge a bit more than the product or service costs
The $64,000 question here is: ‘How much does the product or service cost?’ If you have looked closely at financial reports you will have seen the term ‘COGS’ (Cost of Goods Sold). This is purely the cost of getting the product or service out of the door. COGS does not include overheads such as administrative staff, advertising, office rent, stationery, etc. You can see the danger then of charging a bit more than the product or service costs. You still have to cover the cost of overheads, and these need to be factored into the price. The danger is that if you don’t work out your ‘break-even’ situation you may be making a gross profit, but after paying overheads you are making a loss. Break-even analysis is the practice of calculating how much revenue you need to cover COGS and overheads. It is an absolute ‘must’ in business to know your ‘break-even situation’.
Charge as much as you can get away with
This is a great strategy so long as it covers your COGS and overheads. It may work at first, but if you don’t keep a close eye on COGS and overheads and they ‘creep up’, it may turn out to be unprofitable in the end.
Charge what you think it’s worth
Worth is an interesting concept. It can mean different things to
different people. What the customer thinks it’s worth may be quite different to your perception. Again, if this figure at least covers the COGS and overheads, that’s OK – but most of us are in business to make a profit. You still need to keep a close eye on costs to ensure your margin is not being eroded by increased costs.
Issues relating to price:
- Get the price right
- Know thy costs
- Keep the price right
In order to get the price right you need to:
- Determine the cost of delivery of the product or service to customers, excluding overheads.
- Know your overheads so that you can work out your ‘break-even’ situation and how much you need to sell.
- Decide how much profit you want and factor this into the Price.
- Know your margin and report on it regularly to ensure it is not being eroded by increased costs.
- Know your customer satisfaction levels. Dissatisfied customers won’t pay any price.
- Regularly review pricing and do small increases to cover increased costs. It is much easier to do small regular price increases than irregular large ones.
Keep the price right
Price increase can be a controversial subject. Many business owners fear increasing prices because they think customers will go elsewhere. Where else would they go?
There are examples where a price increase combined with a small decrease in revenue may not be such a bad thing. This scenario can have a positive impact on both profit and cashflow. It is often more difficult to increase revenue than to increase prices. Many customers don’t even notice a small increase and fully accept one to cover CPI rises. For many businesses, failure to incorporate this into their price means they are absorbing increased costs and eroding margins.
Next time you are travelling in the country, check the prices of some ‘National Fast Food Outlets’ compared to those charged in city locations. You will see that their prices are different. It may only be a couple of cents and most people don’t even notice it. This is due to higher costs in City areas such as rent and staff wages. In order to be profitable they have to account for this in the price calculation.
Sue Hirst is a director of CAD Partners, a nation-wide mobile CFO “On-Call”/financial control/business accounting service for SME owners.
Photo: Ellievanhoutte (Flickr)