Pricing Strategies: How do I know how much to charge?

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One of the hardest decisions a new business owner makes is how much to charge. In calculating the “right” price, there are a number of variables to consider.

elasticFor starters, let’s re-visit Intro to Microeconomics and ask, is your product elastic, or inelastic? Elastic products are those goods or services in which demand is closely tied with price. In other words, demand on an elastic product will increase with a decrease in price, and vice versa. The demand for inelastic goods is steadier, and less dependent on price.

For example, a specific brand of chocolate chips is a highly elastic good. If the price increases too much, customers will just purchase a different brand of chocolate chip (or decide to bake a different type of cookies, or just buy the pre-made cookies outright). Though I might really like Ghirardelli brand chocolate chips, I don’t really need them, and there are plenty of ready substitutes available.

A very inelastic product would be gasoline. The price tends to be relatively uniform within a geographic area, and most people are heavily reliant on it in their day-to-day lives. Even when the price surges, consumers still have to purchase a certain amount. Likewise, even when gasoline is very cheap, people don’t necessarily start driving and purchasing significantly more.

If your product is elastic, you don’t necessarily have to have one set price. You could employ “surge” pricing, a la Uber, and charge more when your goods or services are in greater demand. You can also try to generate increased demand through temporary price drops. (Perhaps some of you are old enough to remember “blue light specials”.) If you want to keep steady prices, or if you’re good is inelastic, there are other variables to consider.

To develop a pricing strategy, you should know your variable expenses, how to calculate profit margin, and have a general idea of market price (competitors’ prices).

Maybe you have a surface familiarity with the terms “variable expenses” and “profit margin”, but aren’t 100% clear on how they’re calculated. For your benefit, we’ll have a quick accounting lesson.

mathVariable expenses are those expenses which are directly tied to the production of each unit of a product, and might include such expenses as raw materials, labor hours, and shipping costs. In other words, variable expenses increase (or vary) as production increases. Costs of Goods Sold (or COGS) are variable expenses.

To calculate your profit margins, divide your net profit (sales – COGS) by your sales. Playing with these formulas at different prices can help you determine a feasible price for your product.

As far as competitive pricing, it is good to be in a range with your market competitors, though you don’t necessarily have to be the cheapest, or even on the lowest end. Trying to win customers on price alone can cause a big hit to your profit margins, and will not bring you long-term success. If you cannot safely price your competitors out, beat them with a distinguished product and superior customer service.

Finally, there are discounts to consider, particularly “friends and family” pricing. Special pricing is fine, as long as you can still maintain healthy margins. Never sell at a loss, even for those close to you. You do not want to have to raise prices on friends and family later, so set them at a level you can maintain indefinitely. If you price yourself out of business, you really aren’t doing your loved ones any favors.

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