Pricing is a sensitive game. Contrary to popular belief, winning does not always depend on the lowest price. In fact, I would caution heavily against simply pricing your product the lowest as low pricing is not a strategy. You might be thinking “that’s not true, what about Wal-Mart.” True, Wal-Mart does have low prices, but I would argue that Wal-Mart is pursuing a low cost strategy which is not the same as simply a low price. Small business, especially, should take note as they have competition from larger players with deeper pockets that can play the 'low price' game much better and longer.
To find the perfect price, it is important to find a price that is supported by the 3 pillars of pricing: economics, marketing and accounting.
Economics
It's as simple as supply and demand: raise the price, quantity demanded goes down; lower the price, quantity demanded goes up. The trick is finding the profit maximization point, the price and output that yield the highest profit. In pricing strategy it is important to take into consideration the price elasticity of demand (Ep). Price elasticity of demand is the percent change in quantity demanded of a product for a percent change in price (Formula: Ep= (▲Qd/Qd)/(▲P/P). To find out your price elasticity, set a price for your product for one week and see how much product you sell (that will be your P1 and Qd1), then for the next week chose a different price and see how much you sell then (P2 and Qd2). This is not a perfect science, as other factors are at play, but it will give you a good idea. Plug those values into the formula Ep= (▲Qd/Qd)/(▲P/P) = [(Qd2-Qd1 )/((Qd1+Qd2)/2)] /[(P2-P1)/((P1+P2)/2)] and you will get that product’s Ep. The value you get is referred to in absolute terms (>0). If the number is between 0 and 1, your product is “inelastic;” meaning, that a change in the price will likely not change quantity demanded all that much. This is characteristic of products with a low number of substitutes. If your calculated Ep is >1, your product is said to be “elastic;” meaning, a small change in price will likely drastically change the quantity demanded. Of course, if you don’t have the time to spend calculating your Ep for your product there are industry websites where you can find the Ep for specific products. This will help speed up the process. A good practice is to do both and compare answers, which will add more certainty to your calculations.
After you have calculated your Ep, it is now important to find your marginal cost. Marginal cost (MC) is the additional cost of producing one more unit of good. When you have your MC and your Ep you can calculate your Markup Price to maximize profit using the formula: (P - MC)/P = 1/ -Ep. Plug in your values of Ep and MC and solve for the Price, P.
This price will give you your profit maximizing price. But, of course, we aren’t finished. This is but one of the three pillars in pricing. Let’s move on to marketing.
Marketing
When you have found your profit maximizing price, it is important to compare that price in the marketplace. How does it align with your competition or industry trends? Performing an in depth market analysis is your next step.
Start with an industry analysis. There are tools to help you with this: PEST Analysis for industry trends as well as Porter’s Five Forces: Bargaining Power of Supplier, Bargaining Power of Buyers, Threat of new Entrants, Threat of Substitutes, and Rivalry Among Competitors. These tools will give you a good idea of what kind of industry in which you compete. If it is a saturated industry with negative trends, price may be an important factor. Or alternatively, if it is an industry with positive trends and a small number of competitors, price may not be an issue. Know your industry as it will help with your pricing strategy.
After you have figured out your industry, perform a competitive analysis. I would start by outlining the key success factors of the industry followed by creating a chart comparing how well you and competitors are performing those key success factors. Then, you should complete a SWOT Analysis to give you a good idea of how your company matches up. Knowing how well your competition performs is important when setting a price. For example, if post-purchase service is a key success factor in your industry and your company is beating all your competitors, then you might be able to charge a higher price for that service.
After completing a detailed analysis make a pricing chart comparing your profit maximization price with the prices of your competitors for the same product. Taking into consideration industry forces and trends, how competitive is your price? Can it go higher? Should it go higher? Do you need to lower it? However, before making any drastic changes let’s take a look at how accounting plays into the equation.
Accounting
Accounting is a crucial pillar in pricing strategy. Yes, pricing your product at the profit maximization point in addition to being aligned with your customers and competition is important, but maybe not as important as covering costs and making and accounting profit. This is were breakeven analysis and cost accounting come into play.
First thing to do is to allocate all the costs that go into the production of the product: (i) Direct Material, (ii) Direct Labour, (iii) Overhead (indirect material, indirect labour: like the foreman’s time spent overseeing the product’s production). Break down those costs for the product into per unit costs (based on actual unit production), then add them together. You might be thinking to yourself: why would I include the foreman’s time on the product? When selling your product it is very important to cover all the costs; so, in cost accounting we allocate all costs directly to the product itself to ensure that each product covers its own costs. Once you have you’re per unit cost, decide how large of a mark-up you can have (taking into consideration marketing and economics) and add that to the price.
Now you might be thinking: wait a minute, hold on! The profit maximization and marketing price I calculated is lower than the per unit cost. Don’t worry there is another way to look at it. Instead of a breakeven based on per unit costs you can perform a volume breakeven based on total costs. What I mean is, if you found out a profit maximization price that fits well with the industry and against competitors you can take that price and calculate how many units you will need to sell to breakeven. Once you breakeven, based on volume, every unit you sell above that specified volume is profit.
What is important is to find a price that is supported by all three pillars. This price will be more sustainable for your company than an arbitrarily low price. If you find you need to raise your price to cover costs, you can rearrange your Ep formula to see how that affects quantity demanded. If you need to lower your price based on market trends and competitive pressures then you can solve for your new volume and increase sales support and marketing to ensure you hit your new volume target. The idea is to change your price until you find the perfect price that is supported by all pillars.
Finding a price which is supported by all three pillars is pivotal in your company's success!
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