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The Subtleties of Pricing
When deciding what to charge for their products or services, too many entrepreneurs narrow their focus to their competitors’ prices alone, losing track of other variables. Being aware of the competition is important, but unless it’s part of a larger, disciplined program, it tends to result in mismanaged margins and overlooked opportunities for differentiation. Those are things that small businesses can ill afford.
Pricing requires strategy. It’s part numbers game and part political campaign. Since we don’t know the specifics of your business, it would make little sense for us to give you concrete action-steps. Instead, we’ll pose some important questions that get at the complexities of pricing, and these may help you avoid pitfalls as you’re drafting or revising your strategy. We’ve found that good pricing strikes a balance between three concerns:
1) What do you need to charge? The focus here is on basic principles that determine your bottom line. In essence, how much do you have to make per unit, per hour, or per contract in order to survive?
2) What do others charge? The focus here is on positioning yourself in a field of competitors, with emphasis on what sets you apart. What type of value do you offer customers for their money, and how does that value compare to other, similar products?
3) What do customers want you to charge? The focus here is on managing customers’ expectations. What do people typically spend on a product like yours? What are they willing to spend? Perhaps most importantly, what do they see themselves spending? Sometimes they’re hunting for low prices, and sometimes low prices will scare them away.
What Do You Need to Charge?
Many small businesses, especially those not awash in investor funding, don’t have a choice about covering costs. They need to do it. Otherwise, their lenders will lose faith in them. They can’t rely on moneyed stakeholders to defray their expenses, and they can’t use buying power to create efficiencies of scale and drive out smaller competitors. Unlike some huge companies (more on this below), they can’t afford to maximize short-term revenue at the expense of short-term profits. The typical small business has to cover its costs and show profits early on.
And if you’re a typical small-business owner, you know that conventional wisdom divides costs into three basic categories:
1) Labor. What are you paying your employees? Don’t forget to include fringe benefits and your own compensation.
2) Materials. What are you paying for equipment and/or parts?
3) Overhead. What are you paying for everything that’s not technically labor or materials, like electricity, shipping costs, garbage removal, and paper clips?
Together, these figures give you your cost of goods sold (you can substitute “services” for “goods,” of course). Cost of goods sold is your baseline. It’s the minimum you need to make.
This point is so fundamental that we’ve seen it go completely unsaid, which leads to it being inexactly documented or even forgotten for brief periods—which, in turn, is frightening. Calculating cost of goods sold is critical. Not only because it’s a small business’s threshold of survival, but also because it helps you answer the following question: “If I keep my prices reasonably close to my competitors’, can I cover my present costs within my current business model?”
How much does your business need to bring in if it’s going to keep running? How much do you need to charge to meet that baseline amount? Is your business designed in such a way that it can cover cost of goods sold in the immediate term?
Concentration of Sales
Now for another basic point: in most cases, the more customers you have, the better. More customers usually means more revenue and more security (though not more profit, necessarily). The general rule is that if you’re relying on a single customer for more than 15% of your revenue, you’re in a precarious position. You need to hang on to that customer even while attracting new ones, which means you need to make that customer extremely happy.
If your sales are highly concentrated in one, two, or three customers, then you’ll want to seek out ways of increasing your value to them without inflating your own costs. Can you bundle products and/or services under a single price, offering a slight discount but greater convenience?
Alternatively, do your major customers’ purchase volumes justify slashing certain products’ prices? If your major customers are buying a lot of product A but very little of product B, then you might be able to cut your profit margin on A, leave B alone, and still come out ahead. “There’s no rule, law or commandment that says all products need the same margin,” writes Brad Sugars for Entrepreneur.com (2008). “In reality, slower-moving items need higher profit margins. [And] you can afford a smaller margin based on high sales volume.”
For your product, exactly what sales volume will justify a discounted price? If you increase demand by offering a discount to high-volume customers, will you be able to meet that demand without putting an overwhelming strain on your working capital?
“How much am I selling?” is clearly an important question. When it comes to pricing, you should complement it by asking, “How many customers are buying?”
External Constraints and Changing Conditions
Depending on your industry and location, there may be a limit to how much you can charge for certain products or services. For example, some cities put a cap on the cost of towing an automobile from the scene of an accident. Are there legal restrictions on your product’s prices? Are there legal restrictions that affect how much you pay for labor, materials, or overhead?
If there aren’t, your strategy must still account for other, even more basic characteristics of the financial environment. It must include a plan for adjusting prices based on inflation. It must also adapt to the state of the economy: demanding too much of consumers during a recession can be as disastrous as cutting your prices too deeply. Finally, it must be responsive to changing conditions in the industry, such as the introduction of new manufacturing technologies.
Factors like these affect each business differently, and we won’t pretend to have a checklist that can keep you prepared for any and all eventualities. We’ll simply note that it’s a good idea to ask how much direct control you exercise over your prices. Given constraints imposed by laws or the economy, what sales volume do you require to cover your operating costs? If you’re not at that volume yet, how long will it take you to get there?
What Do Others Charge?
Size of Competition
No business can stop at calculating its own costs: staying informed of competitors’ prices is a universal necessity. But there is no universal rule for responding to competitors. Unfortunately, many entrepreneurs act as though matching or undercutting competitors’ prices were the only logical path available to them. It’s not, and it can be catastrophic.
Everyone’s familiar with the story of independent hardware stores, groceries, booksellers, etc. being driven out of business by gargantuan competitors, competitors whose economies of scale give them the freedom to charge rock-bottom prices. It happens. It’s often sad, but we won’t waste time demonizing big business, because polemics and tirades won’t help entrepreneurs stay afloat. What will help is for entrepreneurs to look at price-matching as an option to be pursued cautiously, after a careful analysis of differentiation and positioning (below).
The influence of size differs from industry to industry; no set of “Small vs. Big” tactics is effective across the board. If you’re running a business, you’ll need to gauge how much of a pricing advantage your large competitors wield, and incorporate that assessment into your own strategy. In some cases, size is a minor issue; in others, it’s the only issue. In your industry, how does size influence buying power and profit-margin flexibility? Do large companies benefit from economies of scale? If they do, how close can you come to your large competitors’ prices without undermining your own ability to do business? What value do your large competitors offer customers? Can you justify higher prices by giving customers something else, something that larger companies are unwilling or unable to provide?
It’s rare for a small business to compete with large companies alone, which means that even a successful “Small vs. Big” pricing strategy will be incomplete. Small businesses need to find ways to differentiate themselves from all competitors, regardless of size. This requires analyzing what, exactly, competitors are giving customers for their money.
How do your competitors provide value? They’re doing something similar to what you’re doing, obviously, or they wouldn’t be competitors at all. But what particular aspects of their product do they associate with their prices? When customers deal with your competitors, where do they think their money’s going? What do they feel they’re getting for their trouble? The answer isn’t just a product—it’s a specific type of product, a product with unique qualities.
Knowing how your competitors add value to their product gives you the chance to present your own business as offering:
1) The same type of value, but even more of it—for example, superior customer service.
2) A subtly different, subtly preferable type of value—for example, a one-price bundle of products in which you offer the same core elements as your competitors but add other fringe benefits.
3) A radically different type of value—for example, an innovative design-and-development process.
Differentiation hinges on perceived value, and customers will find it harder to perceive your product’s value if it’s not reflected in your pricing strategy. What are the unique aspects of your product, the aspects that set it apart from the competition? If they’re not factored into your prices, you’re giving customers a discount they don’t even know about.
What Do Customers Expect You to Charge?
Differentiating your product will help you position yourself in the market. This is the element of your strategy that targets a defined segment of customers, customers who expect prices to be within a certain range. Those who expect prices in the low range look for a certain kind of value; those who expect prices in the high range look for their own, different kind of value.
Who are your ideal customers? Putting it another way, what segment of customers will be attracted to your product’s unique value? If your product offers no-frills serviceability or easy disposability, it may be appealing to bargain hunters, in which case you’ll want to price it near your minimum acceptable margin. If your product offers social status and expert craftsmanship, it may be appealing to upscale consumers, in which case you’ll want your prices to be higher than most of your competitors’.
These aren’t rules, just examples of how differentiation can translate into positioning. Maybe your customers see themselves as shrewd spenders and expect discounts and markdowns; maybe they see themselves as savvy bargainers and expect a catalogue of many options; maybe they see themselves as beyond caring about money and want only the finest or most advanced product, whatever the cost. Some will be drawn to low prices, others repelled by them.
Wherever you position your prices—at the low end of the competition, at the high end, or somewhere in between—you’ll be sending a message about the kind of product you sell. Extremely low prices will work for a discount retailer, but will probably hurt a software-development company; in the latter case, customers will wonder what they’re giving up in quality. Even businesses bidding for federal contracts can’t afford to go too low. If they do, the contracting agency will get suspicious.
Only someone who’s fairly familiar with your business and your industry can tell you the best position for your prices; as we mentioned earlier, an article like this one is confined to asking questions. But questions can provide a useful starting point. How large are your customers? Are they individuals, businesses smaller than yours, or businesses larger than yours? Are they privately owned, publicly traded, or departments of the government? Do you deal with nonprofits, foundations, or community organizations? Do your customers prioritize elite social status, environmental responsibility, or affordability? How do your customers present themselves to their own customers? How do your customers see themselves?
Marketing-related questions like these add depth and focus to a pricing strategy. As an entrepreneur, you’re the one with the best sense of which questions will be most relevant to your business and your industry—you can come up with a more specific list than ours. The thing to remember is that for customers, prices are both expenses and mirrors. Customers want to see their own self-image reflected in what they buy, and price is a major part of that reflection.
As you’re analyzing what your customers want, don’t forget to listen to their feedback and draw your own conclusions. In our practice, we tell clients that if no one has challenged their prices in the past month, they’re probably not charging enough!
Prices speak volumes about what you think of your product, what you think of your competitors, and what you think of your customers, so you want to be sure you’re saying the right things.
In our experience, the best pricing strategies answer three questions: (1) What do you need to charge to stay open? (2) What are others charging, and how does their product’s value compare to yours? (3) What do your ideal customers expect you to charge? Many entrepreneurs already concentrate on covering costs and monitoring competitors’ prices, but those practices are incomplete without ongoing, formal attention to differentiation and positioning.
We can’t provide a strategic template that will work for all businesses at all times, but answering the questions we’ve raised above will give you the information you need to situate your prices at the most profitable level—the level that fits your product’s unique value.
Sugars, Brad. 2008. 7 Biggest Mistakes in Setting Prices. Entrepreneur.com. http://www.entrepreneur.com/startingabusiness/startupbasics/startupbasicscolumnistbradsugars/article196678.html.
 If you don’t have them ready to hand, you should take hard look at your budgeting practices.
Ron Beilin & Paul DelFino are the principals of the consulting firm Opportunity Inc. For nearly 15 years, they have assisted entrepreneurs in growing their businesses, responding to economic downturns, and merger and acquisition activity.