Section Three: Pricing Strategies

Pricing Strategy

Price is a measure of what your customers must exchange in order to obtain your goods or services. Price is also an indicator of value to your customers. Your prices should be based on your customers’ perceptions of what you offer and the value they perceive in your product or service.

Your pricing strategies will depend on your target markets and the life cycle stage of your product.

The minimum price that must be demanded is the cost price. The cost price is based on:

1. Unit cost:

The unit cost is the average cost of material and labour directly related to the development, operation, distribution, and promotion of your product or service.

2. Overhead:

Overhead includes your fixed expenses (such as rent and administrative salaries) and your variable expenses (such as overtime pay or commissions).

Before progressing to setting your prices and pricing strategies you need to calculate the cost of providing your products and services.

Determining Your Costs

It is not the price of the product that makes the profit, it’s the cost to produce. Therefore, accurate costing of the products/services you provide is one of the most important ingredients in operating a successful business. If you don’t ask enough for your product or service you won’t make a profit and you may even lose money. However, it is just as dangerous to charge too much, since it could encourage potential customers to patronize your competition and result in lost sales. There are three elements to consider when calculating costs:

  • Materials
  • Labour
  • Overhead

Material Costs

When determining the costs of materials, include only the items that go directly into the particular service/product that you are costing.

Raw Materials are any product that you convert into another item by cutting, joining, forming, shaping. For example, a woodworker’s raw materials would include lumber and a seamstress would cost out fabric as a raw material.

One important thing to remember when estimating the costs of raw materials is to add extra for scrap and waste. This is a real cost of producing and, as such, must be calculated into the formula. Also, by identifying the amount of scrap you have allocated in your costing formula, you can monitor it to ensure that it doesn’t become excessive.

Completed parts are items that are not altered, that is, they are used as purchased. An example is a zipper used in a garment or drawer pulls used on a piece of furniture.

Finishes are any products used to finish your product. They would include things such as the stain and lacquer applied to a piece of furniture or the spray starch used in pressing a garment.

Packaging Materials must also be included when determining total material costs. These include anything used to protect a product while it is being shipped and/or stored.

Click on Worksheet 4.3 to calculate your material costs.

Labour Costs

To determine the cost of labour you must first establish an hourly rate. This can be done by using the hourly rate you would pay a worker to perform the job. Consider standard industry rates and the level of skill you will require when hiring someone. Also remember to add in the costs of benefits that you would have to pay on behalf of your worker.

Next, you must determine the time it actually takes to do the job. This is often more difficult to do than establishing an hourly rate. Ensure that you have considered the time it takes to prepare to do the job as well as to finish the job. For example, a seamstress would include the time it takes to pin and cut out a garment right through to the time it takes to package the garment for delivery.

If you are uncertain of the length of time to allocate, you may want to actually time the process. However, you should account for variances between labour allocation for producing one item versus producing for larger orders, if you will be handling larger contracts.

An alternative to timing the process would be to use pre-determined time standards which are available for common jobs such as auto repairs, sewing and welding. These can be acquired through industry associations. Be sure to allow for scheduled (e.g. coffee breaks) and unscheduled (rest room visits) breaks.

Once you have determined your hourly wage and the time allocation, you simply multiply the two to determine the labour costs.

Click on Worksheet 4.4 to estimate your labour costs.

Overhead Expenses

The third ingredient to consider is overhead expense. These are the remaining expenses associated with running your business. You should take care to ensure that you have considered all overhead expenses and that they are broken down in detail so that at year end you can review your actual expenses and compare variances with your projections.

There are two categories of overhead expenses:

Operating Expenses:

Operating expenses include all expenses incurred in order to operate the business such as rent, leasing costs, vehicle costs, utilities, interest payments, bank charges, professional fees, telephone, salaries, insurance, depreciation, etc.

Marketing Expenses:

Marketing expenses include all costs associated with marketing and promoting your business, products and services. These may include business cards, brochures, trade shows, commissions, advertising, etc.

Click on Worksheet 4.5 to estimate your overhead expenses.

Putting It All Together

The last step in determining your minimum selling price based on the costs of your business is to put the material, labour and overhead cost all together and allow for a reasonable profit.

The total cost per unit or hour is calculated by adding your material, labour and overhead costs and multiplying by the per cent age expected profit.

The following worksheet will help you to estimate your minimum selling price.

Click on Worksheet 4.6 to estimate your minimum selling price.

Once you calculated your minimum selling price, you can determine the various pricing strategies to use to set your price. Table 3 presents some pricing strategies.

Table 3: Pricing Strategies

Strategy Description
Cost Plus
  • Percentage for profits added to the cost price
  • Most common method
Target Market Share
  • Price lowered to increase market share
  • May be advisable if:
    • customers are price conscious
    • price reduction would increase market awareness
    • you have excess capacity
    • lower price not perceived as indication of poor quality
    • it will discourage competition
Prestige
  • Price set higher than that of competition to sell a quality image or status product
  • Example of use:
    • Rolls-Royce, Gucci and Abercrombie & Fitch
Demand Oriented
  • Price based on estimate of what customer is willing to pay
  • Example of use:
    • candy bars, toys, convenience goods
  • Need to work backwards to see if price charged will cover costs
Meet the Competition
  • Price set to match that charged by other similar businesses
  • Not usually recommended
    • “I can do it cheaper’ is not a good reason to start a business
  • If you can’t charge more for your product or service than your competitors, it’s a me-too business.
High Price
  • Price set well above costs of production
  • Often called “skimming the cream”
  • May be suitable if:
    • your product is distinct and unique with little competition 
    • you are not sure what price to charge (easier to bring price down than to increase it)
    • your production capacity is limited
    • market segment relatively insensitive to price
    • high price will convey quality
    • little economy of scale in producing more
Low Price
  • Price set just above production costs in attempt to gain quick access to market, shelf space in stores, and achieve high volume of sales rapidly
  • Referred to as “market penetration” pricing
  • May be suitable if:
    • “fad” product (eg. hula hoops, superballs)
    • customers are price sensitive
    • unit production costs can be reduced by producing more
    • low price would discourage competition from entering market
  • New customers attracted by special offer may only buy at special price

New Product Pricing

New products are hard to price. You might be tempted to set a high price to recoup your research, production and introduction costs as quickly as possible. You should also take consumer perception into consideration. Also, a high initial price can lead to a reaction from your competition.

Common Mistakes in Pricing

As an entrepreneur, you should be aware of two common mistakes in pricing:

1. “I can do it cheaper”

A small business can rarely manage to charge less than a larger enterprise. Production costs are usually higher due to a smaller output.

You usually can’t take advantage of volume discount or supplies.

If you can enter an industry and sell cheaper than your competitors, chances are others can too.

2. Timid undercharging

Undercharging often occurs where services are provided personally by an entrepreneur. The beginning entrepreneur may believe that lower prices compensate for lack of experience and furnish a security blanket for gaining market acceptance.

Usually low prices are set during the early months of operation, with the idea the prices can be raised as more customers are attracted. During start-up, new businesses usually have to rely heavily on a core group of loyal repeat customers.

If you continue to undercharge, you are saying to your customers, “I can’t do this as well as my competitor, so I’ll charge less”.

Click on Worksheet 4.7 to determine pricing strategies for your business.

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