Pricing Strategy

How much should you charge for your product or service?

By Scott Allen
Entrepreneurs Expert
One of the most difficult, yet important, issues you must decide as an entrepreneur is how much to charge
for your product or service. While there is no one single right way to determine your pricing strategy,
fortunately there are some guidelines that will help you with your decision.
Before we get to the actual pricing models, here are some of the factors that you need to consider:
Positioning - How are you positioning your product in the market? Is pricing going to be a key part of that
positioning? If you're running a discount store, you're always going to be trying to keep your prices as low
as possible as (or at least lower than your competitors). On the other hand, if you're positioning your
product as an exclusive luxury product, a price that's too low may actually hurt your image. The pricing
has to be consistent with the positioning. People really do hold strongly to the idea that you get what you
pay for.
Demand Curve - How will your pricing affect demand? You're going to have to do some basic market
research to find this out, even if it's informal. Get 10 people to answer a simple questionnaire, asking
them, "Would you buy this product/service at X price? Y price? Z price?" For a larger venture, you'll want
to do something more formal, of course -- perhaps hire a market research firm. But even a sole
practitioner can chart a basic curve that says that at X price, X' percentage will buy, at Y price, Y' will buy,
and at Z price Z' will buy.
Cost - Calculate the fixed and variable costs associated with your product or service. How much is the
"cost of goods", i.e., a cost associated with each item sold or service delivered, and how much is "fixed
overhead", i.e., it doesn't change unless your company changes dramatically in size? Remember that your
gross margin (price minus cost of goods) has to amply cover your fixed overhead in order for you to turn
a profit. Many entrepreneurs under-estimate this and it gets them into trouble.
Environmental factors - Are there any legal or other constraints on pricing? For example, in some cities,
towing fees from auto accidents are set at a fixed price by law. Or for doctors, insurance companies and
Medicare will only reimburse a certain price. Also, what possible actions might your competitors take?
Will too low a price from you trigger a price war? Find out what external factors may affect your pricing.
The next step is to determine your pricing objectives. What are you trying to accomplish with your
pricing?
Short-term profit maximization - While this sounds great, it may not actually be the optimal approach for
long-term profits. This approach is common in companies that are bootstrapping, as cash flow is the
overriding consideration. It's also common among smaller companies hoping to attract venture funding
by demonstrating profitability as soon as possible.
Short-term revenue maximization - This approach seeks to maximize long-term profits by increasing
market share and lowering costs through economy of scale. For a well-funded company, or a newly public

company, revenues are considered more important than profits in building investor confidence. Higher
revenues at a slim profit, or even a loss, show that the company is building market share and will likely
reach profitability. Amazon.com, for example, posted record-breaking revenues for several years before
ever showing a profit, and its market capitalization reflected the high investor confidence those revenues
generated.
Maximize quantity - There are a couple of possible reasons to choose the strategy. It may be to focus on
reducing long-term costs by achieving economies of scale. This approach might be used by a company
well-funded by its founders and other "close" investors. Or it may be to maximize market penetration particularly appropriate when you expect to have a lot repeat customers. The plan may be to increase
profits by reducing costs, or to upsell existing customers on higher-profit products down the road.
Maximize profit margin - This strategy is most appropriate when the number of sales is either expected
to be very low or sporadic and unpredictable. Examples include custom jewelry, art, hand-made
automobiles and other luxury items.
Differentiation - At one extreme, being the low-cost leader is a form of differentiation from the
competition. At the other end, a high price signals high quality and/or a high level of service. Some people
really do order lobster just because it's the most expensive thing on the menu.
Survival - In certain situations, such as a price war, market decline or market saturation, you must
temporarily set a price that will cover costs and allow you to continue operations.
Now that we have the information we need and are clear about what we're trying to achieve, we're ready
to take a look at specific pricing methods to help us arrive at our actual numbers.
As we said earlier, there is no "one right way" to calculate your pricing. Once you've considered the various
factors involved and determined your objectives for your pricing strategy, now you need some way to
crunch the actual numbers. Here are four ways to calculate prices:
Cost-plus pricing - Set the price at your production cost, including both cost of goods and fixed costs at
your current volume, plus a certain profit margin. For example, your widgets cost $20 in raw materials
and production costs, and at current sales volume (or anticipated initial sales volume), your fixed costs
come to $30 per unit. Your total cost is $50 per unit. You decide that you want to operate at a 20% markup,
so you add $10 (20% x $50) to the cost and come up with a price of $60 per unit. So long as you have your
costs calculated correctly and have accurately predicted your sales volume, you will always be operating
at a profit.
Target return pricing - Set your price to achieve a target return-on-investment (ROI). For example, let's
use the same situation as above, and assume that you have $10,000 invested in the company. Your
expected sales volume is 1,000 units in the first year. You want to recoup all your investment in the first
year, so you need to make $10,000 profit on 1,000 units, or $10 profit per unit, giving you again a price of
$60 per unit.
Value-based pricing - Price your product based on the value it creates for the customer. This is usually the
most profitable form of pricing, if you can achieve it. The most extreme variation on this is "pay for
performance" pricing for services, in which you charge on a variable scale according to the results you
achieve. Let's say that your widget above saves the typical customer $1,000 a year in, say, energy costs.

In that case, $60 seems like a bargain - maybe even too cheap. If your product reliably produced that kind
of cost savings, you could easily charge $200, $300 or more for it, and customers would gladly pay it, since
they would get their money back in a matter of months. However, there is one more major factor that
must be considered.
Psychological pricing - Ultimately, you must take into consideration the consumer's perception of your
price, figuring things like:

Positioning - If you want to be the "low-cost leader", you must be priced lower than your
competition. If you want to signal high quality, you should probably be priced higher than most
of your competition.
Popular price points - There are certain "price points" (specific prices) at which people become
much more willing to buy a certain type of product. For example, "under $100" is a popular price
point. "Enough under $20 to be under $20 with sales tax" is another popular price point, because
it's "one bill" that people commonly carry. Meals under $5 are still a popular price point, as are
entree or snack items under $1 (notice how many fast-food places have a $0.99 "value menu").
Dropping your price to a popular price point might mean a lower margin, but more than enough
increase in sales to offset it.
Fair pricing - Sometimes it simply doesn't matter what the value of the product is, even if you
don't have any direct competition. There is simply a limit to what consumers perceive as "fair". If
it's obvious that your product only cost $20 to manufacture, even if it delivered $10,000 in value,
you'd have a hard time charging two or three thousand dollars for it -- people would just feel like
they were being gouged. A little market testing will help you determine the maximum price
consumers will perceive as fair.

Now, how do you combine all of these calculations to come up with a price? Here are some basic
guidelines:

Your price must be enough higher than costs to cover reasonable variations in sales volume. If
your sales forecast is inaccurate, how far off can you be and still be profitable? Ideally, you want
to be able to be off by a factor of two or more (your sales are half of your forecast) and still be
profitable.
You have to make a living. Have you figured salary for yourself in your costs? If not, your profit
has to be enough for you to live on and still have money to reinvest in the company.
Your price should almost never be lower than your costs or higher than what most consumers
consider "fair". This may seem obvious, but many entrepreneurs seem to miss this simple
concept, either by miscalculating costs or by inadequate market research to determine fair
pricing. Simply put, if people won't readily pay enough more than your cost to make you a fair
profit, you need to reconsider your business model entirely. How can you cut your costs
substantially? Or change your product positioning to justify higher pricing?

Pricing is a tricky business. You're certainly entitled to make a fair profit on your product, and even a
substantial one if you create value for your customers. But remember, something is ultimately worth only
what someone is willing to pay for it.

Competition-Based Pricing
In economics, competition is the rivalry among sellers trying to achieve such goals as increasing profits,
market share, and sales volume by varying the elements of the marketing mix: price, product, distribution,
and promotion. Merriam-Webster defines competition in business as "the effort of two or more parties
acting independently to secure the business of a third party by offering the most favorable terms. It was
described by Adam Smith in The Wealth of Nations (1776) and later economists as allocating productive
resources to their most highly-valued uses and encouraging efficiency. Smith and other classical
economists before Cournot were referring to price and non-price rivalry among producers to sell their
goods on best terms by the bidding of buyers, and not necessarily to a large number of sellers or to a
market in final equilibrium.
Competitive-based pricing, or market-oriented pricing, involves setting a price based upon analysis and
research compiled from the target market. With competition pricing, a firm will base what they charge on
what other firms are charging. This means that marketers will set prices depending on the results from
their research. For instance, if the competitors are pricing their products at a lower price, then it's up to
them to either price their goods at a higher or lower price, all depending on what the company wants to
achieve.

Competitive Market Pricing

Status-quo pricing, also known as competition pricing, involves maintaining existing prices or basing
prices on what other firms are charging.

One advantage of competitive-based pricing is that it avoids price competition that can damage the
company. Disadvantages include that businesses have to attract customers in other ways, since the price
will not grab the customer's interest. The price may also barely cover production costs, resulting in low
profits.
Source:
Boundless. Competition-Based Pricing.
Boundless Business. Boundless, 21 Jul.
2015. Retrieved 23 Sep. 2015

Cost Plus Pricing

Cost plus pricing is a cost-based method for setting the prices of goods and services. Under this approach,
you add together the direct material cost, direct labor cost, and overhead costs for a product, and add to
it a markup percentage (to create a profit margin) in order to derive the price of the product. Cost plus
pricing can also be used within a customer contract, where the customer reimburses the seller for all costs
incurred and also pays a negotiated profit in addition to the costs incurred.
The Cost Plus Calculation
ABC International has designed a product that contains the following costs:

Direct material costs = $20.00

Direct labor costs = $5.50
Allocated overhead = $8.25

The company applies a standard 30% markup to all of its products. To derive the price of this product, ABC
adds together the stated costs to arrive at a total cost of $33.75, and then multiplies this amount by (1 +
0.30) to arrive at the product price of $43.88.
Advantages of Cost Plus Pricing
The following are advantages to using the cost plus pricing method:

Simple. It is quite easy to derive a product price using this method, though you should define the
overhead allocation method in order to be consistent in calculating the prices of multiple
products.
Assured contract profits. Any contractor is willing to accept this method for a contractual
agreement with a customer, since it is assured of having its costs reimbursed and of making a
profit. There is no risk of loss on such a contract.
Justifiable. In cases where the supplier must persuade its customers of the need for a price
increase, the supplier can point to an increase in its costs as the reason for the price increase.

Disadvantages of Cost plus Pricing

Ignores competition. A company may set a product price based on the cost plus formula and then
be surprised when it finds that competitors are charging substantially different prices. This has a
huge impact on the market share and profits that a company can expect to achieve. The company
either ends up pricing too low and giving away potential profits, or pricing too high and achieving
minor revenues.
Product cost overruns. Under this method, the engineering department has no incentive to
prudently design a product that has the appropriate feature set and design characteristics for its
target market (see the target costing method). Instead, the department simply designs what it
wants and launches the product.
Contract cost overruns. From the perspective of any government entity that hires a supplier under
a cost plus pricing arrangement, the supplier has no incentive to curtail its expenditures - on the
contrary, it will likely include as many costs as possible in the contract so that it can be reimbursed.
Thus, a contractual arrangement should include cost-reduction incentives for the supplier.

Ignores replacement costs. The method is based on historical costs, which may have changed. The
most immediate replacement cost is more representative of the costs incurred by the entity.

Evaluation of Cost plus Pricing

This method is not acceptable for deriving the price of a product that is to be sold in a competitive market,
primarily because it does not factor in the prices charged by competitors. Thus, this method is likely to
result in a seriously overpriced product. Further, prices should be set based on what the market is willing
to pay - which could result in a substantially different margin than the standard margin typically assigned
using this pricing method.
Cost plus pricing is a more valuable tool in a contractual situation, since the supplier has no downside risk.
However, be sure to review which costs are allowable for reimbursement under the contract; it is possible
that the terms of the contract are so restrictive that the supplier must exclude many costs from
reimbursement, and so can potentially incur a loss.

Pricing Technique: Value in Use

Thomas H. Gray

Value in Use pricing means the price is based on the products value to the customer, not the
manufacturers cost of production. For example, if a normal saw blade is priced at $7, and you create one
that lasts 4 times as long, the value to the customer of the long-life blade would be $28, aside from saving
the time involved in changing blades. What price should you set for the long-life blade?
Assuming the blade-changing effort is minimal, you will want to set your price below $28, since that is the
point where the customer is indifferent to one of your new blades vs. four of the old blades. A price level
somewhere between $14 and $21 seems reasonable if there is no competition for your new blade. If you
price it at $17, the buyer and the seller each take half the increase in value. The difference is large enough
to get the buyers attention and make him consider changing his habitual purchase behavior.
Using $17 as a test price level, you can then consider your development costs and any production cost
difference between the old and the new blade, to see the effect of this price level on your margins. The
price you choose should be low enough that customers see significant value, but high enough to generate
premium margins while leaving room for price cuts when competitors match your innovation.
Obviously, this is not cost-based pricing, and it is not pricing to competition. The price is based on the
value to the customer who buys the long-life blade. Only after establishing that value do you consider
your cost and potential competitive responses.

Provide an Upgrade Path

Many customers will quickly understand the higher value of the higher-priced long-life blade. But may not
need this value yet. To widen the market, consider an upgrade path for those not yet ready to change.
To illustrate, we need to change our example. Consider a server equipped with new software enabling it
to work so fast that it can do the work of four servers. You want to set prices for three customer groups:
1. Data-Hogs: Buyers who need to buy more than two servers.
2. Entrants: Those who think they need to buy only one or two servers
3. Upgraders: Those who already own one server, and then realize the need to add one or more new
servers.
Assume the old server price is $10,000, and you decide to price the new hardware/software package at
$20,000. This is great deal for data-hogs, and delivers high margin for the seller. Smaller data users, the
other two segments, are attractive for their numbers and future growth, but $20,000 is a much higher
price than your competitor offers for an old-style server adequate for their current needs.
The solution is to continue to offer your old server at $10,000, like the competition, but enhance its value
vs. the competition by offering to equip it with the new four-times-faster software when the customer is
ready. This is an upgrade path.

How would you price this software-only retrofit? The upgrade price should be more than $10,000, to avoid
competing with your new server priced at $20,000. It should be less than $20,000, because otherwise the
customer who already has one server could just buy two more old servers from you or your competitor,
and see no price difference. A reasonable price for the software-only upgrade would be 1.5 times the
price of an old server: $15,000.
This table summarizes a value in use pricing plan for this example:

Those who buy the package pay $20,000, while those who buy in two steps pay $25,000. Yet previous
customers get the new technology for $5,000 less than new buyers, recognizing the value of the current
customer base.
Offering the choice of a software-only upgrade sets a value for the software. Here is a side benefit. The
retrofit choice actually defines the value of the package offer as a better deal: new hardware for half the
old hardware price, plus growth at no cost.
By offering the upgrade as an alternative to the package offer, the seller is actually enhancing the
perception of the package offers value. This is a good example of the decoy effect that results from
offering different alternatives.

1.

2.

What is Advertising?Advertising is any paid form of nonpersonalpresentation and

promotion of ideas, goods, orservices by an identified sponsor.Philip Kotler

3.

Advertising not only plays a vital role in promotingour economic growth but it is a colorful
anddiverting aspect of life.Peter Drucker

4.

Classification of AdvertisingObjectives:
Informative Advertising
Persuasive Advertising
Reminder Advertising
Reinforcement Advertising

5.

6.

Mission
Increase Sales
Brand Building

7.

Money: Factors affecting budget decisions

Stage in product life cycle
Market share and consumer base
Competition and clutter
Advertising frequency
Product substitutability

8.

Message:
Message generation
Message evaluation and selection
Message execution
Social-responsibility review

9.

Media:

Reach, frequency, impact

Major media types
Specific media vehicles
Media timing
Geographical media allocation

10.

11.

Media Timing Pattern

Continuity
Concentration
Flighting
pulsing

12.

Measurement
Communication impact
o Consumer feedback method
o Portfolio test
o Laboratory test
Sales impact