How to develop a pricing strategy
Setting an effective pricing strategy is key to the success of your business. Pricing impacts:
- Your ability to make sales - set your prices too high and sales will suffer. Your pricing needs to be affordable and competitive relative to others in the market and the relative quality of your products or services.
- Your profitability - set your prices too low and sales may be great, but you could find you're operating at a loss.
- Customer perception - the price you're charging needs to be aligned with the quality of your product or services and where you're positioned in the market.
Pricing strategy is as important for mature businesses as it is for start-ups and something that needs to be reviewed on an ongoing basis to keep your business on track. This guide will help you develop your pricing strategy - getting the balance right between cost and value and boosting your profitability.
The first step is to make sure you understand the end-to-end cost of your products or services. This includes:
Variable Costs - these are the costs that depend on your production and sales levels. Determining these depends on your business type. For retailers they include the cost of buying stock. For manufacturers these include the cost of materials and the direct labor costs associated with production. For service providers they include the salary or wages apportioned to a particular service / project - such as the hourly rate of any temporary staff or contractors /consultants.
Fixed Costs - these include all your business costs that are fixed in the short term - salaries, wages, rent, loan repayments, leases and hire purchase agreements.
It's important not to confusing your own pay (as an owner manager) with profit. How much would you expect to be paid for your own time and effort if you were managing the business for another owner? This needs to be included within your fixed costs - not treated as business profit. Sustainable businesses make a profit on top of your costs as a manager. Whatever pricing strategy you employ - understanding your costs is critical.
The next step involves understanding what value your customers or clients give your products / services. This may involve estimating the additional profits your client can make, or the amount of time or effort they will save.
Often your estimates are improved by conducting customer services, accessing industry reports or surveys and by identifying your peers or competitors and surveying their pricing. However try to avoid simply copying competitors' pricing - they may have different operating models resulting in much lower overheads, may have better buying power - or may simply be operating at a loss.
If you're part of a longer distribution channel - e.g. a wholesaler supplying retail businesses, you need to take into account the profit margins, mark-ups and sales commissions that sit between your selling price and the price charged to the final customer. Otherwise your pricing won't be viable.
Whether your a new business or already well established - you should base your estimates on your ideal customer type. This keeps your pricing strategy aligned with your overall business goals.
This step involves assessing your core competencies and competitive advantages. Are you able to operate at the premium end of your market? Do your products or services offer something to justify this - higher quality, unique features, better reliability, more convenience or better customer service? And are you able to reach customers who'll value this and are able to pay a premium.
Or are you able to operate at the volume end of your market? Do you have better buying power, good control over your overheads and the process efficiency that lets you operate a high volume low margin business?
If neither of these apply - positioning "in the middle" can be difficult. Can you tailor your products or services to cater for a particular market niche? And will this allow you to move more towards the premium or volume end?
It's important to avoid under-pricing a premium product to try and dominate the market. Firstly your customers may assume your service or product is inferior. Secondly your competitors may respond by lowering prices too, and may have greater reserves to sustain this strategy. You should also avoid pricing in a way that allows customers to price shop without differentiating your product/service. Your pricing strategy needs to be supported by an effective marketing and sales strategy.
You now need to pull together steps 2 and 3 to estimate how your sales volume will be impacted by different pricing levels. Starting from your current sales volumes and selling prices, try to estimate how sales volumes would be impacted following (for example) a 2%, 5% and 10% increase and decrease in selling prices.
When making your estimates - be mindful of the "pitfalls" mentioned in the previous steps; e.g. don't bother estimating prices that are incompatible with your market positioning, or that would leave others in the distribution channel unable to apply any markup themselves. For some markets there may be very limited opportunity for price variation - e.g. retail of "commodity" products or services where customers can easily shop around. But if you can differentiate or target a niche market there may be a greater range of feasible prices.
Where possible your estimates should be based on actual experience - supported by ongoing experimentation with your pricing. You may have valuable data available from past price promotions, or from the sales impact following your last price increase.
Next review the variable costs from step 1. Multiply your different selling prices by their estimated volume and subtract your variable costs (for that volume of sales). You now have your gross profit level for a range of different selling prices. Your optimal selling price is the one with the highest gross profit.
The next step is to compare step 4 with the fixed costs from step 1. Your products or services are only viable if the estimated turnover covers all costs and still generates a profit for the business.
Viable products or services
If this analysis shows your product or service is viable - all that remains is to check that you have the operational capability to support those sales volumes. If you don't have the operational capability you need right now then consider:
- In the short term - increase your selling price, using step 4 to find the selling price that will reduce sales volume to a level you can support at your current operating capacity. This gets you the optimal net profit for your current operational capability.
- In the longer term - think about what you can do to increase your operational capability. For example hiring additional staff (assuming the cost will be absorbed by the additional turnover), or investing in improved plant, equipment or facilities (assuming the increased turnover will generate an adequate return on investment, after any interest on new borrowing).
It's likely that increasing operational capability will require funding - both to provide extra working capital, and potentially to fund investment. In which case your analysis is a great starting point towards putting together a compelling business case for lenders or investors.
Non-viable products or services
If the analysis shows that the estimated turnover from step 4 won't cover your costs from step 1 then you need to consider how to revise your plans. You should revisit each step in the analysis - for example to see if you can eliminate or reduce costs or reposition yourself in the market at a higher price point, by including free servicing or a better customer experience.
If you have a mix of viable and non-viable products, consider consolidating your product line to focus attention on the profitable core of your business. Be careful however with your analysis of overheads - it's likely that a lot of overheads allocated to your non-viable products will remain business costs and need to be absorbed by your more profitable product lines. Ideally consolidation would be a short term measure, since business risk is higher with a less diverse product mix, but may be useful as a temporary measure - giving you time to developing new lines.
Multiple products or servicesThe steps above apply whether you're selling a single product / service or a wide range. But the analysis becomes more complex as the product mix becomes more diverse. Often variable costs can be matched or allocated to individual products and services, but overheads need to be apportioned to different products. This should be done in a pragmatic way based on the estimated volumes for each product type from step 4.
Multiple distribution channelsIf you sell through a variety of distribution channels (e.g. selling products wholesale to retailers, and directly to customers via online sales) it's important that you avoid "channel conflicts". For example - it would likely harm your overall profits if you set your online selling price at a level that didn't allow your wholesale customers to compete on price after adding their own markup. This would only be a viable strategy if you were confident your online sales channel could expand to absorb customers lost as your retailers abandoned you.
Dynamic pricingYour pricing strategy needs to be monitored and adjusted on an ongoing basis:
- To adapt to changes in your cost base - e.g. inflation.
- To adapt to changes in your market - e.g. changes in demand due to a new competitor, or changes in customer trends.
- To help manage stock - using discounting to clear out old stock as part of your working capital management.
- To smooth cashflows or make sales more predictable - e.g. by discounting during "out of season" periods, or to reward loyal customers and encourage regular repeat business.