The price you choose for your products is one of the strongest messages you can send. To use it well, you must decide both your value positioning and the minimum margin you need to meet your goals, before deciding your price.
Positioning means “how the customer thinks of your company” – a mental image or identity that expresses your competitive edge, the benefit you offer. Your company offers some unique benefit which your target customers appreciate, one they prefer to get from you rather than other sources. Otherwise, you should not be in business! See Competitive Analysis and Differentiation: Be Different or Be Gone!
This benefit has value, which should be reflected in your price. If you offer more value, your price should be higher. For example, if your device seldom fails and you have the fastest repair turnaround time, you can charge more than a competitor whose unit fails more often, or who takes weeks to repair/replace a failed unit.
People do not always buy the lowest price alternative. People buy value—the best combination of features/functions and price.
- They buy luxury cars, not just Chevys.
- They buy bottled water even though tap water is free.
- They buy cable TV even though national networks are free.
- They buy their favorite brand even though it costs more.
Why? Because that brand meets their needs best within their price range. Their needs include more than raw functionality. The brand they choose will also meet their needs for style, social acceptance, their need to be sure the product will work as advertised, and others.
When setting a price, know what your customers value, and how you deliver that value better than competitors. Then set your price higher than those who deliver less value. If your offering has value, your pricing should communicate that. Having the lowest price merely communicates adequacy, not value.
Calculating Minimum Margin
Margin is the difference between the price you charge and your variable cost of production. Your price must provide enough margin to cover
- variable costs (e.g. labor, materials),
- fixed costs (e.g. rent, insurance), and
- target profit.
The important point is to set the price high enough to recover more than the variable costs to make and deliver the product. You must collect enough to pay for overhead (fixed costs) and provide the target profit as well.
So you must know what your costs are before setting your price, and you must select a target profit, expressed as a percentage of revenue.
For example, if you want a 15% profit before tax, and your fixed costs are 30% of revenue, then your variable costs can be as much as 55% of revenue (100% – 15% – 30% = 55%). If variable costs are only 45% of revenue, then your profit is 25%, given fixed costs of 30% (100% – 45% – 30% = 25%).
The basic formula is target revenue = variable costs / (fixed costs % of revenue + target profit % of revenue), or variable costs /.45 in the above example. This formula applies for one product, or for the company as a whole.
Value Positioning and Margin are the two basic considerations for pricing. In the next few articles Business Techniques in Troubled Times will explain a number of pricing techniques based on these two concepts, such as margin analysis, shop rate, good/better/best, value-in-use, various price structures, differential pricing, types of promotions, and distributor margins.
Acknowledgement: this article draws on some material presented by Dennis Sester, Phil Grisolia, and the author in the SCORE Fox Valley Pricing Seminar.
Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or firstname.lastname@example.org. See www.tom-gray.com.