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Product Pricing Can Spell Difference Between Success and Failure

Filed under Packaging & Pricing. Fact checked on May 24, 2012.

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While every small business owner wants to charge as much as consumers are willing to pay, you must find the right price you and customers can agree upon.

The ideal price for any product or service is one that is acceptable to both buyer and seller. From the buyer's standpoint, the right price is a function of product purchase value and other competitive choices in the marketplace. From the your vantage point, the basic concern for almost all small businesses is to price products to maximize both sales and profits, while providing enough margin to take care of applicable marketing and overhead expenses.

We recommend the following steps for determining product pricing for your business:

  1. Analyze the size and composition of your target market.
  2. Research price elasticity for your product.
  3. Evaluate your product's uniqueness.
  4. Select your channels of distribution.
  5. Consider product life cycles.
  6. Analyze your costs and overhead.
  7. Estimate sales at different prices.
  8. Consider secondary pricing strategies.
  9. Select final pricing levels.

Market Size and Composition Affects Pricing Decisions

One of the first calculations you must make to set prices for your product or service is estimating approximately how large your potential sales volume could be, based on a reasonable assessment of your potential market share in the product category, at different price levels. Knowing the size of the existing market is critical to determining if there are enough customers to establish and grow a business.

In an established market, in order to sell your product you must cut into your competitors' market shares. Who will you compete against? What are their strengths and weaknesses? Are any direct competitors vulnerable to your products? Are any competitive products priced too high or not providing product "value" for the price? Secondary market research can help you answer all these questions.

Price Elasticity Factors into Pricing

If demand for your product or service changes significantly with slight changes in price, the product category is considered to be elastic with respect to price. If no significant volume changes occur, even with significant price changes, the category is inelastic.

Example

Grocery store items are often very price sensitive, with +/- 10 percent price changes resulting in significant share and volume changes per brand. In contrast, high-end gourmet food categories are often inelastic. It may require a price increase or decrease of 50 percent to create any perceptible changes in consumers' behavior. Consumers shopping these premium-priced categories are not as value-conscious as shoppers in a regular grocery store environment.

What Does Price Elasticity Mean for Product Pricing?

The greater the price elasticity, the closer you should price your products to similar competitive products and vice-versa. While your product may be unique, consumers will not pay much of a premium for it if there are similar competitive choices at lower prices.

To find out more about price elasticity in your industry, study secondary data sources (e.g., Nielsen, SymphonyIRI Group) for share and volume results correlated with brand pricing reductions. Talk to trade and association experts to obtain a feel for pricing elasticity.

Only Unique Offerings Can Support Premium Pricing

The closer your product resembles competitive products, the smaller the price differences that buyers will tolerate. And the less the product differences between brands, the greater the probability is that the category is price-elastic, and that brand-switching will occur when products go on sale.

It is not enough for a product to be unique. The sources of product uniqueness must be both recognizable and valued by buyers. And depending upon the category, very unique products may or may not be readily accepted by buyers. For example, gourmet food products have many distinct and unique attributes in any given category. Buyers shop for gourmet products because they are often looking for new, unique products—"something out of the ordinary."

However, the majority of products sold through mass merchandise stores, grocery stores, chain stores, and vending outlets are easily substituted from among many similar brands. Sources of brand uniqueness are generally very small differences. Usually, buyers aren't looking for new or unique items in these categories.

What does product uniqueness mean for pricing? Product uniqueness does not guarantee a significant price premium over a competitive product, if the product differences aren't recognizable and meaningful to consumers. And depending upon the category, even recognizable and meaningful product differences may not be enough to get buyers to switch to the new product, even at parity pricing, let alone at a premium price over the competition.

Field testing on a small market basis is highly recommended for questionable new product differences and unique new products.

Product Life Cycles and Product Costs Affect Pricing

Many product categories have significant evolution and life cycles that may affect pricing decisions. For example, with personal computers and software, the trend is toward shorter and shorter product life cycles. In fact, it now takes as little as six to 12 months before new technology and products are introduced in these multi-billion dollar categories. As a result, product pricing cycles have also accelerated to match, with introductory pricing decreasing to significantly lower levels only six to eight months later. These continuously evolving high-tech categories make it difficult for companies to recover development costs, accurately predict sales volume, afford planned marketing support, and price products accurately in relation to a competitor's products.

Pricing Must Do More than Recoup Costs and Overhead

The most common errors in pricing are:

  • pricing products or services based only on the cost to produce them
  • pricing products based only on competitors' prices

Several objectives need to be addressed in determining correct product pricing:

  • Cover the cost of producing the goods or services.
  • Cover marketing and overhead expenses.
  • Provide profit objectives.
  • Afford distribution margin discounts.
  • Afford sales commissions.
  • Be competitive.

Breakeven Analysis

Breakeven analysis is a commonly used method that focuses on the volume of sales at which total revenues will equal total costs. The idea is to set the price of a unit of product or service at a level where it will cover all of its own variable costs (material, labor, marketing etc.) plus its portion of the fixed costs of the company (overhead). At the point where enough units have been sold to cover all fixed and variable costs, breakeven is achieved. After that point, the sales price of a unit sold minus the variable (direct) cost to produce it equals pure profit.

Example

A case of bottled tea beverages in 12-ounce ready-to-drink bottles has a cost of goods of $3.82 per case of 12. Factory price to distributors is $6.54/case. Gross margin (price minus cost of goods) is $2.72/case. If the company's fixed costs (e.g., overhead, factory expenses, etc.) are estimated at $75,000.00 per year, then the breakeven point would be 27,573.5 cases of tea ($75,000 divided by $2.72/case).

For more information on breakeven points, see our discussion of breakeven analysis.

There are different cost dynamics at work for consumer goods pricing than for wholesaling and retailing mark-ups.

Pricing Consideration for Consumer Goods Vary from Wholesale Pricing Considerations

Consumer goods experts suggest the estimated cost of goods should be no more than 15 percent of the suggested retail price because:

  • margins of 55 percent to 65 percent are suggested for gross profit to cover:
    • overhead
    • marketing spending support (e.g., 10 percent to 20 percent of sales)
    • broker commissions (e.g., 5 percent to 10 percent of net sales)
    • your own company profits
  • a 30 percent margin for distributors who sell to retail stores
  • a 30 percent to 40 percent margin for retailers on retail prices
Example

For example, on a 32-ounce bottle of shampoo selling at $2.99 retail, the math would look like this:

$2.99 x 15% = $0.4485 cost of goods per unit

$0.4485 = 35.5% of company factory price (company has 64.5 percent gross margin)

$0.4485 / 35.5% = $1.256/unit factory price

$1.256 / 70% (reciprocal of 30 percent distributor margin) = $1.794/unit for distributor price to retailers

$1.794 / 60% (reciprocal of 40 percent retailer margin) = $2.99 retail price

"Keystone Pricing" Is Common in Many Industries

Many other industries, such as restaurants, other retail establishments, and consulting services, operate on the "keystone" pricing principle:

  • The cost of goods is limited to 33 percent, or one-third of retail prices.
  • Labor and overhead is limited to another 33 percent of retail prices.
  • Gross profits are a minimum of 33 percent of retail prices. (Remember to keep the emphasis on gross. Remember that taxes, interest, and overhead expenses must be deducted before net profits are determined.)

Markups Are the Cornerstone of Wholesaling and Retailing Pricing

Retailers and wholesalers need to consider the issue of markups in their pricing structure, and manufacturers or other product producers need to be aware of the average markup in their industry. A "markup" is the percentage of the selling price (or sometimes the cost) of a product which is added to the cost in order to arrive at a selling price. In contrast, a "markdown" is a percentage reduction from the selling price.

Be aware that there are two different ways to calculate markup—on cost or on selling price. So when you ask someone "what's your markup on that item?" the answer you want is not just "20 percent," for example, but "20 percent of cost" or "20 percent of selling price." In retailing, the industry standard is to compute markup as a percentage of selling price.

Example

Joel received a shipment of clocks that he will sell in his gift store. He paid $12.00 for each clock and plans to make $4.00 on each one. The selling price is then $16.00.

The markup percentage on cost = dollar markup (4.00) divided by cost (12.00) = 33%.

However, the markup percentage on selling price = dollar markup (4.00) divided by selling price (16.00) = 25%.

As a product wends its way through a distribution channel, each step along the journey adds a markup before selling the product to the next step.

Here's an example of how markups work based on selling price:

Level Category $ %
Producer Cost 20.00 80.0

Markup 5.00 20.0

Selling Price 25.00 100.0

Wholesale Outlet Cost 25.00 71.5

Markup 10.00 28.5

Selling Price 35.00 100.0

Retailer Cost 35.00 70.0

Markup 15.00 30.0

Selling Price 50.00 100.0

Markups vary widely among industries. For example, average markups (on selling price in these cases) are 14 percent on tobacco products, 50 percent on greeting cards, 8 percent on baby food and often more than 50 percent on high-end meats.

Markups, like all pricing strategies, depend on three influences — cost, competition, and demand.


Estimating Sales at Different Prices

The probability of significant sales volume differences at different prices depends upon the price elasticity of the market and number of similar competitors.

The first step in this analysis is to determine how many similar direct competitors you have and their pricing differences. Perceived value is also important in many categories: strict price per unit or ounce comparisons may not be meaningful to buyers, if they perceive that one product is of much higher quality than another.

Next, determine price elasticity, or "price sensitivity" for the market. If you have a price-sensitive category and large volume differences occur at various price differences with products on sale, it still may be difficult to accurately measure price versus volume differentials since other factors may also come into play.

The length of time various brands have been on the market, their relative market share, brand loyalty factors, advertising and promotion spending levels, sales support, merchandising efforts, distribution penetration levels/market all have an influence on the pricing versus volume equation.

In addition, internal company objectives need to be addressed, including:

  • cost of goods
  • marketing spending
  • overhead
  • sales commissions
  • distributor markups
  • shipping costs to distributors
  • profit objectives

Pricing at different levels to generate different volume levels may not address benchmark company objectives. Pricing must cover all costs, spending, and margin objectives.

Evaluate A Variety of Pricing Strategies

In addition to the primary goal of making money, a company can have many different pricing objectives and strategies. Larger companies may utilize product pricing in a predatory or defensive fashion, to attack or defend against a competitor.

Example

Maxwell House Coffee introduced a second, low-priced brand into their own dominant eastern United States markets during the 1970s in order to slow and confuse the introduction of Folger's Coffee into their markets. This new product was packaged and designed to resemble Folgers familiar red can, with pricing set below Folgers Coffee. The new temporary product clogged grocer shelves and made it more difficult and expensive for Folgers to introduce their coffee into new eastern markets.

If you have a premium-quality product, with premium packaging, graphics, and unique features and benefits, perhaps a premium price is necessary to reinforce the premium brand image. Higher margins than normal may be one benefit. High prices confirm perceptions of high value in consumer minds.

A good pricing strategy will also indicate guidelines for action in the case of price increases or decreases. For example, "We will price at or near the share leader's pricing on a per unit basis. We will increase prices to follow a share leader price increase, but only to preserve margin objectives."

Strategically, you may want to consider temporarily delaying necessary price increases driven by supplier and ingredient price increases. Take affordable, smaller profit margins if your category segment is price elastic. If competitors are increasing prices and your company decides not to, this could be a temporary advantage for your company since sales volume may increase.

Be sure to consider variations that may come up to affect your pricing. You may wish to use discounting for prompt cash payment or for quantity purchases. Seasonal items may warrant special pricing from time to time. How about senior citizen and student discounts? And promotional incentives may motivate your dealers. These are but a few of many variables you'll want to consider when you formulate your pricing strategy.

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