Adapted from content excerpted from the American Express® OPEN Small Business Network
Whether you sell a product or service, the price you charge your customer will have a direct impact on the success of your business. Unfortunately, pricing is one of the least understood facets of running a small business. Many small business owners calculate their basic costs, and then pick a price arbitrarily. Arbitrary prices, however, mean arbitrary results. Taking the time to evaluate all the factors that will impact your price - from your expenses to your image to your customers' prices - will help ensure you develop an effective pricing strategy.
- I've heard that a small business needs to follow certain pricing formulas. What are they? Are they effective?
- What expenses should I factor in when determining my costs?
- How can I determine what the market is willing to pay for my product or service?
- I have a wide range of competitors whose prices fall into an equally broad spectrum. How do I know whether to come in high or low?
- I'm looking to get in the door at a new, potentially lucrative customer. Should I lower my price to make my business look more appealing?
- Should a service business price by the hour or by the job?
- I'm afraid I may do a lot of work for my client and then get burned when I bill them. Is there anything I can do?
- How do I set marketable wholesale prices?
Two commonly used pricing formulas are direct costs-plus-overhead-plus-profit, and doubling wholesale price.
Unfortunately, formulas can be problematic. Here's why:
- They don't consider all the hidden costs and other factors you should look at when determining prices.
- They don't take into account that the price you charge for anything is tied to what customers are willing - or expect - to pay. A lot of people forget that no matter how much your product or service is worth in your eyes, if people won't pay that much for it, it won't sell.
- They don't calculate the "psychological" component. Customers do not always make their purchasing decisions on the basis of logic. For example, sometimes customers will equate quality with price - if your price is too low, they may be suspicious that they're getting something not quite up to standard and avoid buying at your "bargain" price.
What expenses should I factor in when determining my costs?
Obviously, you need to factor in the basic direct costs like cost of goods and supplies and cost of labor. But many small businesses forget to factor in other indirect costs. Here are some categories to look at:
- Furniture and equipment
- Stationery, business cards, office supplies
- Magazine subscriptions
- Membership in professional organizations
- Postage, express mail delivery, messenger services
- Telephone and fax charges
- Travel and transportation fees
- Consultant fees
- Your time
Once you determine what it will cost you to sell your product, it's time for research. You need to find out what the prices are for similar items or services. This will mostly likely be a matter of shopping or calling your competition. Be careful to examine what your competition offers along with the product. Do they provide personalized attention, a liberal return policy, or free delivery? All these factors are part of the package consumers look at when making a purchase decision and thus are important in pricing strategies too.
If you become a low-priced vendor, you will likely be offering few frills and make your money on volume. Many experts contend this is dangerous ground for small businesses, because it puts them into the arena with larger price merchants who have greater buying power and can afford to undercut on price. For instance, a small stationery store or independent hardware store probably can't make money by offering the same prices as a large "category killer" like Staples or Office Depot.
If you decide to go for the high end of the pricing spectrum, you will need to add value to what you are selling. This means providing extra services, products, or resources along with your product. You may think you cannot afford to offer anything extra, but oftentimes, adding value means bringing attention to something you already offer such as guaranteed online service, quick turn-around, high quality products, or extra features. Bringing attention to these in your marketing is often enough to justify a higher price to consumers.
Many service businesses use pricing strategies where they work for less than they would like to because they want to develop a relationship. This may not be a good idea. Once you become a low-priced alternative, it is very hard to break out of this mold. In other words, if you condition your customers to respond to price, they usually won't let you change. Instead, look at other ways to set yourself apart - whether through superior service, superior quality, or other value-added elements.
Using an hourly rate or charging by the project usually depends on your business - different industries have different precedents, so you should research what is common in your business. Here are some examples of circumstances in which one method is better than the other:
- If the job is one where your client may want to make changes to the project after the fact or mid-job, you're better off charging by the hour. Say you're a word processor and you spend a few days typing a lengthy thesis for a graduate student. After you've finished the work, he comes back to you with several revisions that he wants you to make in the finished paper. If you'd been charging by the job, you would be in for hours more work at no more money. If you charged by the hour, you would be compensated for the extra time added to the original job.
- If your quoted hourly rate might make a customer balk, a project rate may be the way to go. For example, if you're writing copy for an ad brochure and you know it will take you two hours, quoting R125 an hour may sound too high. But negotiating a flat rate of R250 may sound more reasonable.
Knowing how long it will take you to do a certain job is critical to figuring out how much to charge. If you don't yet have the experience to know how long a job will take, find others in your line of work and ask them for an estimate.
This is a common dilemma for service business, since there is usually no way to take back a service once you've given it. That's why many service businesses require a portion of their payment up front. The usual method for doing this is to request one-third of a payment at the contract signing, one-third half-way through the job, and one-third on completion.
Like any pricing question, determining what to charge retailers who will resell your product requires some homework. In general, retailers will not buy from you if they can get the product for less from someone else. Retailers also have to be able to double the price that you are charging them (the general retail price formula = wholesale x 2) and still get customers to buy.
In order to make sure you meet these requirements, use the following pricing strategies to set your wholesale prices:
- Investigate your competition at the wholesale level by calling them for prices, attending trade shows, and talking to trade associations.
- Talk to retailers. Ask shop owners where they purchase and what they pay. Or go to stores and divide the retail price by two to determine wholesale price.
- Call the association for the retailers you want to sell to and find out what the typical mark-up rate is. That will help you determine what the retailers you'll be selling to will be willing to pay.
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