Building Your Business Operations & Success Accounting What Should You Consider When Making Pricing Decisions? By Dennis Najjar Dennis Najjar Twitter Dennis Najjar, CPA, is a certified public accountant with over 25 years experience. Along with starting his own accounting firm, he founded the company AccountingDepartment.com. learn about our editorial policies Updated on September 13, 2022 Fact checked by Hilarey Gould In This Article View All In This Article Cost Perceived Value Competition Spoilage Risk Loss Leaders Economies of Scale Bundling Psychological Pricing Goal Frequently Asked Questions (FAQs) Photo: Thomas Barwick / Getty Images Pricing strategy is a science that requires you to consider many factors if you want to maximize the profits for your small business. From cost and value to what the competition is doing, here's what you need to think about when making pricing decisions for your products or services. Key Takeaways Pricing decisions for products and services should first be based on how much it costs you to make or how much time it costs you to do the job.After that, consider what your competitors are doing with their pricing strategy. If you're able to offer a better rate, you could increase your sales.Psychological pricing is also a factor to consider. Pricing items in a certain way could be more appealing to customers. Cost Obviously, cost needs to be one of your first considerations when making pricing decisions. No business can sustain itself when costs exceed sales. The simplest pricing models use a "cost plus" approach, in which you add a standard percentage to your costs to determine your price. For example, if it costs you $5 to make one T-shirt, you could sell your T-shirts for $10 each, covering the cost to make plus an additional $5. This will guarantee profitability as long as you maintain sales, but it may not maximize your profitability. Perceived Value Customers are willing to pay what they think something is worth and don't really care about your costs. If your costs push prices above their perceived value, they simply won't buy. If the perceived value is much higher than your costs, they'll happily pay a price that gives you a huge margin. One of the best examples of this is in retail clothing. Average markups start at about 100% of the cost, and high-end shoes can be sold for as much as five times what the retailer paid for them. For example, some Nike sneakers cost around $25 to make, yet they retail for over $100, according to an analysis by shoe review website Solereview. Note While perceived value is mostly in the customer's mind, you can influence the perception by increasing your levels of service or positioning yourself as a higher-end brand. If you're looking to sell more volume at a lower margin, you might position yourself as a fair-price alternative that is accessible to everyone. Competition Competition is another key factor in pricing. Open and free markets are very price-sensitive, while monopolies have virtually unlimited power to raise their prices. Ask two questions about your competitors: Do they offer the same level of quality and service?How much does it cost the consumer to switch to a competitor in terms of time, gas, or shipping costs? The more you can differentiate yourself, the more power you'll have to set monopoly-like prices. Even with commodities, such as gas and groceries, you can still find differentiators such as being on the right side of the road during the evening commute. If you fail to differentiate yourself and are seen as equivalent to your competitors, you'll always have to compete on price. Spoilage Risk You also need to consider real and effective spoilage risks. A real risk is when perishable or dated items, such as milk or calendars, go bad or are no longer useful. An effective risk is when unsold seasonal items, such as holiday decorations, could be sold next year but the costs of storage lead you to scrap unsold items. Note When there is spoilage risk, you either need to be more conservative when setting initial prices or faster to give discounts to prevent waste from unsold merchandise. Loss Leaders You don't need to earn a profit on every item. Some items can be listed at a loss to drive customers to your store in the hope that you more than make up the loss when they purchase additional, higher-margin items. Costco is one of the industry front-runners when it comes to loss leaders. The company sells hot dogs at $1.50 each, and the price has not changed for years. It's an example of a loss leader, according to food economist David Ortega. Costco's rotisserie chickens are another example. Executives believe that customers who come to the store knowing they can pick up a quick meal will purchase additional items, grow more loyal to the store, and spur the sale of more memberships. Economies of Scale Early-stage companies have the problem of needing to cover their fixed costs with fewer sales and not having the purchasing power to reduce their variable costs by negotiating for volume discounts from their suppliers. You have two options in this situation. The first is to keep prices above costs knowing that your higher prices may make it harder to pick up market share and then reduce prices as you scale production. The second is to set your price based on your projected break-even point and take a loss on early sales in a more aggressive push to gain market share. Bundling Bundling has long been a favored strategy of cable, internet, and phone companies. But Walmart's $3.3 billion acquisition of Jet.com in 2016 is another good example of how bundling is a pricing strategy that can benefit a company. While Jet.com now redirects to Walmart.com, it used to work like this: Each time a customer added an item to their cart, the price of all the items in their cart dropped by a few cents to represent the company's cost savings and increased profits from larger orders. Bundled pricing can help increase your average sale and overall profits when customers might otherwise be inclined to only purchase one item at a time. Psychological Pricing Sometimes, the price isn't about the actual cost but how consumers view it. This is why car dealerships like to negotiate based on monthly payments rather than the full sale price. Customers might feel better about paying only $100 per month than $1,000 per year, and $99 sounds a lot less expensive than paying the three-figure sum of $100. At the same time, customers looking for a higher-end product or service may feel better paying a higher price than a lower one. Note Pricing is just as much in the presentation as it is in the actual numbers. Goal The biggest question to answer is what end goal do you want to achieve? Are you trying to build market share, put competitors out of business, maximize profits, raise quick cash to survive another month, or position yourself as the low-cost alternative? Your end goal will guide what pricing strategy you pursue and how aggressively you follow it. Frequently Asked Questions (FAQs) What is a pricing strategy? A pricing strategy is a way you decide how to price your products or services so that you can make a profit. There are several different types of pricing strategies that could help you maximize profits. Not every pricing strategy will work for every business, so consider cost, value, goals, and more before choosing the pricing strategy that is right for you. What is dynamic pricing? Dynamic pricing is when prices are automatically adjusted up or down at a regular cadence. A few examples of where you may experience dynamic pricing include airline tickets, hotel rooms, and Amazon. This pricing strategy is often seen online with e-commerce retailers. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Mercer County Community College. "Managerial Accounting, Chapter 8: Pricing." Solereview. "What Does It Cost To Make a Running Shoe?" Twitter. "@NPR, June 28, 2022 at 12:02 p.m." Organisation for Economic Co-operation and Development (OECD). "Glossary of Statistical Terms: Economies of Scale." Walmart.com. "Walmart Agrees To Acquire Jet.com, One of the Fastest Growing e-Commerce Companies in the U.S." RetailWire. "Jet.com Beats Amazon and Walmart on Price." U.S. Small Business Administration and Ascent. "Practice Your Pricing Techniques." McKinsey and Company, "The Do's and Don'ts of Dynamic Pricing in Retail."