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Prices Compared to Costs

July 6, 2010

1. What is the difference between price and cost? The cost of producing your product or service is the total costs for your business, both direct and fixed, divided by the number of products or service lines that you sell. The price that you charge depends on what the market will bear, i.e., on what the customer(s) will pay. The difference between price and cost is profit –or loss!

2. How do I determine what I should charge? You need to research the market carefully in order to determine the price that you can charge. This will be a challenge when you are starting a business, since you will have little information on which to base your pricing decisions … other than reviewing the prices charged by your competition, and your own market research with potential customers. (In the case of a retail business, many manufacturers provide Suggested Retail Prices [SRP]). Once you are in business you can adjust your prices and monitor the effects they may have on customer demand.

3. Isn’t charging less than my competition an obvious strategy to gain customers?. Many start-up businesses have difficulty calculating the costs of their products and services and, as a result, let their competitors effectively set their prices.  They think that as long as they undercut that price, they will succeed. This might be feasible to gain market entry and customer acceptance, particularly in a market that is price sensitive. However, price leadership is a strategy that often fails in a small business.  A small business typically lacks the size and volume necessary to utilize economies of scale to make the price really competitive over an extended period of time. And as a start-up venture, it takes some time to establish the true costs of doing business that can be translated into a reasonable pricing strategy. Simply pricing your product or service below the competition is a money losing proposition.

4. Is pricing strategy more art than science? It’s both. The fundamental trick is knowing how much to charge to exceed what you spend. Therefore, when developing or reviewing your pricing strategy, follow these basic principles:  

  • Prices must cover costs. Even if you love what you do, it’s a hobby unless you make money. Calculate how much you spend to make your product or provide your services … and you have a solid figure to start with.
  • Prices should include “added value.” What makes your goods and services worth more than your costs. What’s special about what you do or the way you run your business. (“Customers will go out of their way to buy a superior product….and you can charge them a toll for the trip.” -Frank Perdue)
  • Prices should reflect the market. The sticker you put on your product or your service should take into account demand, customer needs, changes in customer tastes, the life span of the item or services provided, and how it is going to be used.
  • You must lower costs when making long-term price cuts. Cutting prices doesn’t mean cutting profit. Remember the simple formula: price equal cost plus profit margin. When you lower prices, lower your costs not your profit –to maintain that margin.

    Prices should meet your business goals. You may need to adjust prices to get new business or improve cash flow. (For example, you might offer discounts during the off season; you might offer lower prices for customers who pay their bills quickly or in bulk; or maybe you have a policy of matching a competitor’s price). These procedures are fine, but have a firm ‘no lower than’ figure in mind when you cut prices. Stick with it.

  • Prices must be attractive. Gauge what your competitors are willing to charge. You may be making the world’s best mousetrap, but if the price is too high, few will buy it. On the other hand, don’t charge less than what customers are willing to pay.
  • Prices need to be competitive. It’s not enough to match or undercut the competition. Buy their products and use them. Size up their customer service.  Do they do what they promise?  Do they follow-up after the sale?  How effectively do they resolve problems/issues? You may have competitive advantages that allow you to charge more. Price isn’t always the first thing on a customer’s mind.
  • Prices must move inventory. Beating the competition isn’t the sole pricing strategy. Your inventory of product or man-hours needs to move and your prices should be set as high as possible while still accomplishing this goal.

Prices must be reviewed. You may find that you set your prices too high or too low, or that economic conditions have changed or that you miscalculated demand.

5. What is gross profit? The gross profit is the selling price minus the direct costs in making the product or delivering the service.

  • Direct costs (also known as variable costs) include such items as raw materials, purchased components, man-hours involved in the production or delivery process, and sub-contracting.
  • Fixed costs (also known as overhead costs, which include rent, taxes, depreciation of vehicles and equipment, advertising, insurance, etc.) are then deducted from the gross profit, resulting in net profit. So you need to sell enough of your products or services at your selected price to cover all the direct and fixed costs to make as profit.

6. What is the break-even point? The break-even point is the point where the income from sales exactly equals all the costs incurred by the business. More sales will result in a profit; fewer sales will result in a loss.

7. What are some factors that affect the price people are willing to pay for a product or service? A number of wide ranging perception factors may trigger a customer’s impulse or decision to buy a specific product or service. Some examples include:

  • Ability to solve a problem — Invisible Fence
  • Ability to make life easier — cruise control
  • Degree of competition — pizza shop, cable company, etc.
  • Brand image — Lexus, BMW
  • Quality image — Lexus vs. Kia
  • Seller’s exclusivity — Nieman Marcus, Tiffany
  • Seller’s merchandising — Lands End, Bass Pro Shops
  • Seller’s environment — exclusive resort, restaurant, theater
  • Seller’s Availability — Sears, Penny’s, McDonalds
  • Seller’s assortment – local store vs. Amazon
  • Design image – Mercedes, IKEA
  • Warranty or service — Maytag appliances, Sears Craftsman tools
  • Price comparisons — retail malls vs. outlet stores vs. internet
  • Delivery time — UPS, FedEx, US Postal System
  • Location — local provider vs. internet

8. What are some other general factors affecting pricing?

  • Economic Forces. This includes the national economy and the local economy, as well as competition. These factors directly impact the supply and demand for your products or services, and therefore your pricing strategy. Generally, when supply exceeds demand, prices will fall. The converse is also true: when demand exceeds supply, prices will rise. Unemployment rates; factory closings or openings; mall openings, housing starts … all are important signs of the market health.
  • Market Issues. This includes primarily customer perceptions and behavior. Successful pricing is based on a clear understanding of the specific needs and nature of the target market. The culture and maturity of the market may also affect pricing decisions, so if there is an acceptance of a particular type of pricing structure or approach, then strategies will follow. If the market is in decline, then prices may need to be cut, simply to compete for a dwindling number of available customers. Also remember that customer needs, tastes, and perceptions are continually changing. What is trendy today may be passé tomorrow; so monitor the various trends in your marketplace/market space.
  • Market Competitiveness. Competition clearly affects pricing decisions. If there is a large number of direct competitors, pricing can be a valuable tool, or a non-factor.  If the market pricing is stable and generally accepted by customers, then there may be little flexibility.  On the other hand, when few direct competitors exist, there often is a greater flexibility/differentiation for pricing decisions.
  • Product or Service Issues. Product and service costs are fundamental to setting prices. Sometimes products or services may be sold at a loss to establish market-entry, expand market-share, or out-sell competition. But more important are the products or service benefits and value they provide to the customers.  

9. To establish my pricing strategy, what do I need to know about my customers and my
    competition?

  • Customer Base Analysis.
    • Customer type–What type of market are you targeting?
    • Consumer market segments
    • Business and industrial market segments
    • Governmental agencies
  • Geographic characteristics. At what level of geography will you target your customers?-Location: International, National, Regional, State, County, City or all (Cyber space)-Density: Urban, Suburban, Rural.
  • Demographic Characteristics. What major common characteristics do the members of this market share?
    • For the Consumer Market, examples:
  • Age, Ancestry, Births, Children, Computer ownership, Deaths, Disability,  Education, Elderly, Families, Fertility, Foreign born, Gender, Grandparents, Health insurance, Hispanic origin, Household Income, Journey to work, Labor force, Language use, Marital status, Migration, Occupation, Overseas US population, Poverty, Race / Ethnicity, School costs, School districts, School enrollment, Voting / politics, Wealth, Well-being, Work-at-home.

    For the Business or Industrial Market

    •  
      •  
        • Size of business as measured by employees or sales levels, the industry sector:
  • Mining, Utilities, Construction, Manufacturing, Wholesale trade, Retail, transportation, warehousing, Information, Finance, Insurance, Real estate, Professional, Scientific, Technical services, Education, Health care, Social assistance, Arts/Entertainment, Recreation, Food services.

    Psychographic factors What psychographic [lifestyles] characteristics will you use to segment your target market?

  • Status seeking, Trend-setting, Conservative, Purchasing patterns, Socially responsible, Family oriented, Fun seeking, Good housekeeper, Technically adept, Environmentally conscious

      Competitive Analysis With whom will you compete?

  • Who are the four most substantial direct competitors?
  • Who are your indirect competitors?
  • What is the status of their businesses –Steady? Increasing? Decreasing?
  • What have you learned from their operations and advertising?
  • What are their strengths and weaknesses?
  • How does your business, product, or service differ from theirs

10. What other pricing issues should I consider?

  • Is your market price sensitive? If so, then you need to address why your company is either a price leader or a price follower. You also need to assess price sensitivity in terms of customer loyalty and product differentiation.
  • Do your customers perceive a difference between your products and your competitors, other than price? If not, then explain how changing prices will affect demand.
  • Are your prices competitive?–Are they based on an industry-standard mark-up?
  • Is there perceived value inherent in higher prices?–(e.g., It costs more therefore it must be better.)
  • Does your product / service line have a price curve such as “high-end” and “low-end”?-If so, what is it and why?
  • Does the sale of your product or service depend on the sale of another product or service?-If so, do you have control of that? 
  • Do your operating costs vary with price?-If so, which ones and by how much?
  • What break-even point do you need to reach?
  • What effect do price reductions have on your profit?
  • Will your prices help you reach your sales volume goals?
  • Do you have all the facts and records for your business and your competition that you need to help you to set a pricing strategy?
  • Do your competitors respond to your prices? And if so, how?
  • Are your products / services vulnerable to product / service substitution? And if so, which ones?
  • How are you pricing other items such as service and credit terms?

Sources:SCOREand SBAMaterial; The Ultimate Small Business Guide, Bloomsbury Publishing (2004); Legal Guide for Starting and Running a Small Businessby Fred Steingold (2003); The Unofficial Guide to Starting a Small Businessby Marcia Layton Turner (1999); e-tailingby Bernadette Tiernan (2000); The Art of the Startby Guy Kawasaki (2004); Rain Makingby Ford Harding (1994); Herbein+Co; SBDC

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One Comment leave one →
  1. November 9, 2010 3:30 pm

    Good reading, thanks.
    Prices must be attractive and prices must cover costs – almost there is perpetual conflict. But it can be too designed in such way by selling one piece really cheap and obtain therefore other market segment with good profit.

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