Ok, maybe it’s both.
No matter what you sell, the price you charge your customer or clients will have a direct effect on the success of your business.
The moment you make a mistake in pricing, you’re eating into your reputation or your profits.
The 4 Rules of Product Pricing
First, let’s talk about the 4 rules of product pricing. (by the way, if I say product just assume from now on I’m talking about services 2.)
- Pricing Rule 1: All Prices must cover the cost of producing the product or service, profits, and taxes.
- Pricing Rule 2: You should review your prices and costs frequently
- Pricing Rule 3: The most effective way to lower prices is to lower costs.
- Pricing Rule 4: Review your competitors’ pricing frequently.
Before we start discussing how to figure out pricing we should look at the different types of Pricing Models. That way we can easily figure out which one may work better for you.
4 Pricing Models That Will Help you Price Your Products
Understanding the different pricing models will help you figure out which ones will work for you and your business.
Cost Plus Pricing
The cost-plus pricing model is generally used by manufacturing. Because they are producing physical products and selling them more at a wholesale cost. With the cost-plus model, you want to make sure you capture the plus figure so that it covers ALL the overhead and can still generate a profit for you. I love examples so check out the table below.
| Cost of Material | 50.00 |
| Add the Cost of Labor | 15.00 |
| Add Your Overhead/Expenses | 20.00 |
| Total Cost to Produce | 85.00 |
| Now Add Your (5%) Profit (or whatever % you want to set aside) | 4.25 |
| Add In Your Pay (50%) This is what you will live on) | 42.50 |
| The Minimum Price for this Product | $131.75 |
Demand Pricing
Demand pricing is pricing that is a combination of volume and profit. Generally, this means that the product is sold through various sources at different prices. For example at a Walmart store or online through a discount retailer. Your local brick-and-mortar store will probably pay more per product because they are unable to stock, and sell a large quantity of the product. Which is why retailers charge high prices to customers. Just remember that demand pricing can be very difficult to master and may not be the best place to start until you have a great understanding of your current market.
Markup Pricing
Markup pricing is used by wholesalers, and retailers to price the goods for retail suppliers to customers. Markup is calculated by adding a set amount to the cost of a product. For example, you buy a product for $100 and then add $40.00 to the price to sell it. To find the percentage divide the cost by the amount you want to add on to the product.
$40/100=40%
This can be very confusing, for many small business owners because the markup is often confused with the gross margin. But really all it really means is that you are adding the overhead expenses, profit, and your pay to how much you actually paid for the product from a wholesaler. Don’t worry we’ll go over the Pricing Basics next so you can see how this will work for you.
Now on to the rules…..
Rule 1: Products Must Cover Cost, Overhead and Profits
Now that you know the rules surrounding product pricing you need to figure out the costs involved in running your business. If the price of your product doesn’t cover costs, you will eventually run out of money and you’ll exhaust your savings…. eventually, your business will die out.
Quit worrying that’s why you are here, isn’t it ……?
To price products, you’ll need to get familiar with pricing structures, especially the difference between margin and markup. Remember every product must be priced to cover creation and business operation costs. Things like a high overhead, insurance, inventory and sales, and discounts will affect the final price. This brings us to Step 1.
Figure out your business costs and expenses
Do you have…
- Property
- Equipment
- Loans
- Inventory
- Utilities
- Employees (Wages, Salary, or Commissions
If you’re a business that also has material products you’ll want to add the following to your list.
- Markdowns
- Discounts
- Returns
This is by no means an exhaustive list of potential expenses but it’s a great place to start.
Types of Expenses
Fixed Expenses. No matter the volume of sales, fixed expenses must be met every month. Fixed expenses include expenses like rent, utilities, membership, subscriptions, insurance, etc.
Variable expenses. These are expenses that can fluctuate in price from month to month. For example Marketing. Marketing may change depending on the season, supplier inventory, and office supplies.
Cost of Goods Sold. Every time I see a description of the cost of goods sold it can get very confusing. I’m going to put a brief description here but I want you to review our article on Figuring out your Cost of goods in this article. This will be more helpful and hopefully, explain it in a more clear and more concise manner. But for now…..
Cost of goods sold, also known as the cost of sales, refers to your cost to purchase products for resale or to your cost to manufacture products. Freight and delivery charges are customarily included in this figure. Accountants segregate the cost of goods on an operating statement because it provides a measure of gross-profit margin when compared with sales, an important yardstick for measuring the business’ profitability. Expressed as a percentage of total sales, the cost of goods varies from one type of business to another.
Normally, the cost of goods sold bears a close relationship to sales. It will fluctuate, however, if increases in the prices paid for merchandise cannot be offset by increases in sales prices, or if special bargain purchases increase profit margins. These situations seldom make a large percentage change in the relationship between the cost of goods sold and sales, making the cost of goods sold a semi-variable expense.
Rule 2: Figure in Your Profit including Your Pay
Yes, you heard me right for every product or service you sell you need to figure out how much you want to pay yourself and place that as a part of the expenses. If you never get paid, what for Pete’s sake is the point of doing any business at all?
Again, you heard me right for every product or service you sell you need to figure in your profit. If you don’t know what your profit should follow the table below.
Andrea's Tip
If you are not making any money or just opened your doors follow the lowest profit in the table at 5%. You can always raise your prices once you’ve established your sales goals.
Competitive Pricing
Competitive pricing is usually set when there is already an established market price for a product or service. For example, if all your competitors are charging $100.00 to, let’s say, clean your air conditioner, it may be difficult to charge $200.00. If this is the case you may need to look at lowering your costs in order to make a greater profit. If you still think that you can charge a higher price then you should look at the value that you are providing if you could add a warranty policy or awesome customer service.
If you use competitive pricing to set the fees for a service business, be aware that, unlike a situation in which several companies are selling essentially the same products, services vary widely from one firm to another. As a result, you can charge a higher fee for superior service and still be considered competitive within your market.
Rule 3: The Most Effective Way to Lower Prices is to Lower Cost
Let’s say you make high-end desks for home offices. Your competitors seem to be lowering the price of their products. You want to review the costs associated with building your desks. You’ve been religiously using the profit tracker or some other system that keeps track of your expenses and you realize that you are spending double what you used to on lumber. Maybe you need to change your supplier? Maybe you need to use a different type of wood.
Just for simplicity’s sake you go back to your supplier and say hey man we need to discuss and maybe renegotiate the price I’m paying for lumber. The supplier says sure we can do that.
And with that one sentence, you can lower your prices because now your lumber is lower than it used to be.
Andrea's Tip
It’s a good idea to review your supplier contracts each quarter to see if there is room to negotiate.
Pricing takes time and a lot of research. Most business owners use the “Set it and Forget” and then pray for the best. But if you don’t review the numbers then most likely you will risk your profits and not know if there is a way to reduce costs or increase prices.
When should you review your prices?
- Each Month
- Each Quarter
- Annually
- You Introduce a New Product
- Your costs change
- Your competitors change their pricing
- Business seems to be slowing or Business is increasing (yeah great problem to have)
Putting it All Together
Whew, there you have it, how to price your products and services so you have plenty of cash in your business. Make sure you follow the rules.
As Always if you have questions or need a consultation you can always talk to us.
Cheers!
Andrea
