How to Easily Set Your Business's Prices

For new entrepreneurs just getting started, setting the price for your products or service can be a very confusing task.

On one hand, you don't what to set them too high for fear of chasing away potential customers and on the other hand, you don't want to set them too low for fear of leaving money on the table.

Just a quick word of advice before we get into a price setting example: 'It would be better to leave money on the table and set a great first impression in the minds of your customers then to set prices too high; keeping customers from walking through your door (or visiting you online) to begin with.'

There are several schools of thought regarding how to set your prices from basing them on your customers' utility to market conditions and competition to your own business's cost structure and profit requirements.

In this simple example, we will utilize a combination of these methods.

The first thing any new business owner should do is create a business plan - either formally writing one or just jotting down pertinent information in a form the entrepreneur will understand. This should include a simple market analysis detailing how the business's overall market stands up to other markets around the nation or globe as well as how the business's main competition operates (to include how they set their prices). Further, any adequate business plan should detail some type of financial data regarding the costs (both fixed and variable) the business expects to face as well as a solid sales forecast.

Note: It is understood that the information in a business plan is more of a guideline than what will actually happen. But, it is also understood that this information has been researched and is what the business owner will manage for.

With this information in hand, let's get started on a simple example.

A young woman wants to open a music store in her local town. She intends, in the beginning, to sell three main products (music in the form of CDs, books related to the music industry and DVDs about bands, music videos and documentaries).

She wants to know at what price she can sell the CDs for - given that these will be her greatest money maker.

Her research shows that similar stores, within a 50 mile radius, price their main stream CDs for $15.99 on average. Also, her local competition mainly consisting of mega department stores who price their main stream CD products at $13.99.

She knows that she would like to steal customers away from the local mega department stores as well as realizes that, in her area, the average cost of living is 85% of the cost of living in the other surrounding area (within that 50 mile radius). She would like to set her prices under the local Mega store and still turn a nifty profit.

However, to calculate what her profit margin might be and if it is acceptable, she turns to the well research financial data in her business plan.

She has determined that she should be able to sell 500 of these CDs each month. Further, that her direct cost or cost of goods for each CD will be $9.58 and that her entire monthly overhead (including marketing, selling, administration, rent and utilities expenses, etc.) will run at roughly $2,000. Lastly, she anticipates that all CD purchases (revenue) will need to cover 85% of all costs and profit requirements as her other products (books and videos) will only cover 15% of all business overhead expenses.

Given this information and the fact that she would like to make a profit of at least 12% on each item sold - she can easily estimate her price (given her cost structure) at:

- Cost Per Item: $9.58
- Overhead Per Item: $2,000 X .85 (CDs have to cover 85% of total costs) = $1,700 then divide that figure by the number of items expected to be sold (500 per month) = $3.40 each.
- Profit Per Item: Given that total cost per item ($9.58 + $3.40) = $12.98 and that she would like to make 12% profit per item results in a profit per item of ($12.98 X 0.12) $1.56.

Add all of these together ($9.58 + $3.40 + $1.56) and her total (cost plus profit or her minimum pricing level given her cost estimates and profit requirements) is $14.54 per CD.

While this does not get her below the local mega stores prices it does price her lower than other music stores in that 50 mile radius.

Now, she could either set her price at this level and see what happens - see if she is able to sell the 500 required per month and steal customers away from the local mega stores (note that she could also use other methods like a great selection or differentiated products to steal customers) - or lower her profit expectation to bring her price level to that of the mega store.

Lastly, she could always (and she should be constantly doing this) be working on ways to bring her costs (both direct and variable) down. For instance, if, say after a few months in operation, she re-negotiates with her suppliers and gets her cost per CD down to $8.95 each as well as realizes that she can cut back some $200 per month in overhead expenses - then she could either lower her prices (matching the mega stores) or keep prices constant and pocket (profit) the difference - provided sales are meeting her forecast.

It is always easier to set prices for your business's offerings if you have actual past data (sales and cost figures) to work with. But, most new business owners have no real clue as to what their costs and sales are going to be. Thus, if your business is in this situation, keep in mind that you can always adjust prices - up or down - as you move forward and learn more about your business and its operations. This will, in time allow your business to find that equilibrium point or sweet spot for its prices.

Then, continue to work on the cost side to lower overall costs (thus increasing profits) as well as bringing in new higher profit margin products or additional products that your customer will spend extra money on - raising your business's overall revenue level and profits (as long as they are priced to cover your profit requirements).

It really is that easy.

advertisement

Copyright 2007 - 2012 - Business Money Today - All rights reserved