Pricing

2. Pricing

As we have discussed, pricing is one of the biggest decisions you need to make about your business. To a great extent, the prices you charge determine the amount of profit you make, so getting the price right is vital to your business success.

There are two ways to arrive at your prices:

• cost plus
• market-based price

Cost plus

In this method, you add together all the costs to produce your products or services. This includes materials, labour, packaging, etc. You then add a percentage on top of this cost as profit for you.

Market-based price

In this method, (also known as value-based pricing) you estimate what the customer is likely to pay for your product or service based on competitors’ prices.

Use this setting my prices template (MS Word 13kb) to establish the prices for your product or service. List the tactics you will use in your pricing.

3. Cost-plus pricing

In this method of price setting, you add together all the costs to produce your products or services. This includes materials, labour, packaging, etc. You then add a percentage on top of this cost to represent your profit.

Many start-up businesses focus on cost-plus pricing. It is relatively simple to calculate and profit margins are constant.

However, as we have discussed, a number of other factors affect pricing decisions. Here are some disadvantages of cost-plus pricing:

• it ignores the level of demand for your product or service
• it does not take into account how price sensitive your market is – and the customers’ willingness to potentially pay more
• if your costs are high relative to competitors, you may find your price is also uncompetitive
• allocation of overheads is often arbitrary and may distort prices
• it takes no account of the image and market position you are aiming for

4. Market-based pricing

The alternative to cost-plus pricing focuses on what customers are willing to pay. This means you have to understand how much value customers attach to your product or service. You also need to understand your market and the economic conditions.

Here are some examples of market-based pricing:

• someone may pay more for a carton of milk from a small local shop late at night than they would for the same product in a large supermarket because it is more convenient at that time of night
• a brand name product may be considerably more expensive than an unbranded equivalent because people want to own or be associated with the brand
• some people pay a premium price for the latest fashion or gadget because they want to be amongst the first to have it
• this may be on a worldwide basis, but could also be in a local context, for example, “the only supplier of x in Carmarthen”
• the price of a painting by a major artist depends completely on how much someone values that artist’s work and how many others may also want the same picture – again a local connection may have a big influence in this situation
• tickets for a sports event or pop concert can be at a high price if there are more potential customers than seats available
• if your business is in a city, you may be able to set prices higher than if you are based in a rural location. This is because potential customers in the city may have higher rates of pay and, therefore, greater spending power

However, if there is a great deal of competition for your product in the city, you may have to set prices lower, whilst a rural-based business with little competition can charge more.

Here’s how to set your prices using market-based pricing:

1. Check out competitors’ prices. You want to understand what their selling strategy is, so find out what promotions they offer, if they use seasonal discounts or if they keep some prices low to attract sales on other lines.
    
2. Understand your customers. Review your market research and establish where, when, why, how and how many they buy. Which products or services do your customers think are the best value and why?
    
3. Combine the information you’ve gathered about competitors’ products and your customers’’ views and establish a benchmark for your product or service.

Hints and tips for setting prices

Don’t simply match your competitors on price without first calculating your own costs and making sure you can make a profit.

If you are not sure, it’s always a good idea to set your prices higher. It is easier to reduce them later than raise them.

Remember, a low price often represents poor quality and service in the customer’s mind.

Finally, be prepared to lower your prices if you don’t achieve your predicted sales volume or if your cashflow is under pressure.

5. Differential pricing

Although you’ve now set your price, you may decide that it is beneficial to adjust your prices for different customers and different circumstances. This is called differential pricing.

Here are some examples of differential pricing that you may consider using:

• seasonal demand: holidays are more expensive in the summer or during public holidays when demand is higher
• distribution channel: you may have different prices for products sold online against those sold through distributors or through department stores
• products in a farm shop may be a different price from those sold through the local supermarket
• key accounts: you may negotiate a different price with a national account such as a major supermarket chain
• regional variations: prices in a small seaside town may be different from those in large cities
• volume: you may offer a discount to customers buying a large volume
• timing: a plumber can charge a higher price for an emergency call-out and a printer may charge a premium for a fast turnaround.

Whenever you use differential pricing, remember, there must be a justifiable reason for the price difference.

6. Different pricing tactics

There may be times when pricing is influenced by factors other than costs or perceived value. Tactical pricing can be used to achieve specific objectives.

Consider some of these pricing tactics – each one has a different impact on how many sales you make and on your profit:

• odd value - popular in retail, this is when a product is priced at £9.99 instead of £10 with the intention of creating a favourable impression for cost-conscious customers
• loss leaders - this is when you sell some products at a loss, so that you can win new customers. Supermarkets use this tactic on frequently purchased products such as bread or baked beans with the aim of getting people to come into the store. You may choose to offer a product at a loss for first-time buyers, increasing the price for subsequent purchases
• price skimming - this is when you sell a new product at a high price to customers who “must have it” right at the start. The price is then dropped once the initial demand has been satisfied
• penetration pricing - this is the opposite of price skimming and involved introducing a product at a low price and getting as many customers as possible before the competition catches up. This helps to create market share and can also build brand loyalty
• discounting - a dangerous tactic to use too often, but one that can be effective if you want to increase sales in the short term or reward loyal customers
• bundling - this involves offering a number of products together as a bundle, usually at a lower price than if they were purchased individually. For example, a computer, printer and software bundle, or a surfboard and wetsuit package. This is useful for extending the purchase to complementary or linked products, and can be used for overstocks or slow-moving items

If you provide a service, bundling can be a useful tool as it prevents the customer from negotiating an hourly rate. You can bundle several services together, for example, consultancy and mentoring, or offer a combination of service and product, for example, a complete kitchen bundle – planning and layout, selling the kitchen units and installation and fitting.

Payment terms

Payment terms and payment options are important parts of your pricing strategy. There can be big benefits to both you and the customer, but be sure you understand how much the various options cost you in terms of administration.

Depending on the nature of your business, you may consider:

• asking for payment up-front, either part-payment or full payment
• asking for a deposit followed by staged payments
• requesting payment on completion

Value Added Tax (VAT)

If you are a VAT-registered business, you must charge VAT at the appropriate rate on the goods and services you supply. Remember to include VAT in your pricing calculations. Make it clear to your customers whether your prices include or exclude VAT.

Full details of current VAT thresholds are available on the HMRC website.

For further information see our Managing your Finances guide.

Next: How do I survive until my business is off the ground