What Should You Consider When Making Pricing Decisions?

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.

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.

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:

1. Do they offer the same level of quality and service?
2. 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.

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.

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.

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