Product pricing

- So what can be so hard about pricing a product? Don't you just figure out what your costs are and then add some sort of markup for profit? Oh, that it were that easy. If your price is too high, regardless of your costs, someone in the market will underprice you, assuming that the quality of product or service is similar. In many cases, you will be a price-taker, and you will have to manage your cost so that you can earn a profit given a certain price as determined by the the market. Now, let me say that again. In most instances, you don't price your product to cover your cost. Instead, you determine if given a certain market price, your cost structure is such that you can earn a profit. The biggest mistake new business owners make in product pricing is not considering and covering all of their costs when entering a market. Now, it is true that when you are initially trying to penetrate a market, you may be willing to lose a little money to gain market share, but that strategy is not sustainable over time. Over the long term, you must cover all of your costs. All of your costs. Let's consider the following example. We have a friend who's in the wedding announcement business. The business is operated in a small town out in the middle of nowhere so that there's not much competition in the local area. We'll relax that assumption in a minute. Our friend calculates the production costs of each wedding announcement order and then adds $50 to arrive at a selling price. Since the production costs are $14,000, as seen in the chart here, our friends divides that cost by the 40 orders received in a month to get $350 per order. She then adds $50 to cover other costs and charges $400 per order. Well, as you can see, that strategy isn't working out very well. Our friend is currently losing $3,000 a month. Why? She didn't factor in all of her costs. She's covering her variable costs, but the amount being contributed to cover fixed costs is not enough. Note also that our friend doesn't draw a salary from the business. Instead, she shares in the profits. So, let's set the price so as to cover all of our costs. Since our total costs are $19,000, that's our variable costs and our fixed costs, and the number of orders is 40, we get a cost per job of 475. So let's just add $50 to that number and see how we do. The results are in this table. Looks like if we set the price at $525 per order, we will make $1,400 a month. Awesome. Keep in mind that since our friend lives out in the middle of nowhere and there's no competition in the middle of nowhere, the price of 525 will work. But keep in mind that there is a point where the price will be so high that it would be worth it for people to drive somewhere to evaluate other options. So the price cannot just go up forever. Also of note is that all that hard work for a month resulted in a profit of $1,400. That was a lot of work for $1,400. Our friend certainly has other options worth her time. Does she want to work for 40 hours a week and worry more hours a week than that for $1,400? Our friend most consider her opportunity costs. What else could she do with her time? Assume that our friend could shut down her wedding announcement business and get a job making, after tax, $36,000 per year. That would mean the opportunity cost of running her business is $3,000 per month. Now she can ask the question, I need my wedding announcement business to generate at least $3,000 in profit after taxes each month. What must happen for that to happen? Now she can talk about the following issues. Can I reduce any of my fixed costs and by how much? Can I reduce any of my variable costs and by how much? Can I increase the number of orders per month? How high can I raise my price before it is worth it for customers to travel elsewhere? Now she can do some sensitivity analysis with her cashflow projections to determine what's it going to take to make this business venture worth her time? Again, we see the relationship between all of these topics we've been discussing. Insufficient capital relates to poor cashflow management. Poor cashflow management can relate to poor product pricing and not considering all relevant costs. So if our friend determines that $525 per order is the highest price the market will bear and that she cannot reduce her costs by enough to generate another $1,600 in after-tax profits, she will need to consider other employment options. While that is not her preferred outcome, at least she is making the decision with full information about pricing costs rathe than a gut feel. Now, there's nothing wrong with a gut feel, but a gut feel backed up by market and costing data feels a lot better in the gut than does a wish and a hunch and a gut feel.