How to price your product: a step-by-step calculation
- What exactly is product pricing?
- Competitor analysis
- Pricing strategy 101
- Take these strategies for a spin
One of the ultimate secrets to business success is pricing your products properly. The approach you take to pricing affects how much you sell–and nearly every other aspect of your business. Yet, many entrepreneurs consider pricing as an afterthought.
It’s common to arbitrarily select prices, to guess, or to copy competitors. And while these approaches sometimes work, they typically aren’t based on any substantive strategies that maximize your chances of success. The good news is that there are lots of research-backed pricing strategies out there that can ultimately serve as powerful catalysts for growth.
In this guide, we’ll review these strategies so you can make informed decisions on how exactly to find your pricing sweet spot.
What exactly is product pricing?
Product pricing is the process of deciding upon the quantitative value of a product. How you price your products has major implications on the success of your business, as it affects customer demand, cash flow, and profit margins.
If you set your prices too low, you’ll miss out on revenue. And if you set your prices too high, you’ll miss out on valuable sales. Price optimization is really about finding the best price you can charge without compromising sales.
Competitor analysis should be the first place you start when you are trying to figure out how to price your products. It entails researching your competitors to develop an understanding of their products, how they conduct sales, as well as their marketing strategies. It’s kind of like when a well seasoned sports team studies their competition before a game. And just like with scouting reports, competitive analysis helps you learn all about how your competitors work (and where you can improve) so you can figure out how to outcompete them.
How to conduct competitor analysis?
Create a comprehensive list of competitors.
Identifying both direct and indirect competitors is a great place to start. Direct competitors offer products similar to yours and tend to target the same audience. Conversely, indirect competitors offer different products than you do, but their offerings solve the same problem that your business solves.
Analyze your competitors’ tactics one by one. Study their product catalogs and how they position and price their products. Do a deep dive into their social media channels, website, and press coverage. Track your findings in a spreadsheet so you can analyze the data in one place. You may also realize that there are gaps between what you and your competitors offer and what customers want–which can help inform your future product decisions.
Be on the lookout for industry trends.
Be on the lookout for past, present and upcoming industry trends. This is critical data to have but be sure you don’t make a decision simply because everyone else is doing it. Following your competition without taking into account your own place in the market is not advisable.
Analyze strengths and weaknesses–yours and your competitors.
Figure out why customers turn to your business for a product they can get anywhere else. Ask yourself how your business and your products compare to your competitors. Where do your competitors have an advantage? Where do you have the leg up? What could you each be better with? Add your conclusions to your spreadsheet.
Knowing what sets you apart from competition (and what holds you back) is valuable data to have. To maintain a competitive edge, it’s smart to regularly update your competitor analysis spreadsheet.
Keep in mind:
It’s important to note that competitive analysis is not about copying your competitors, but rather about understanding your place in the market, knowing what trends are worth following, and leveling up your offerings.
Pricing strategy 101
There are a lot of resources out there devoted to product pricing, but it can be difficult to cut through all the noise. So, whether you’re pricing products for the first time, or it’s not your first rodeo but you’re wanting an extra hand with the process, we’ll walk you through some of the most popular ways to price products.
1. Cost-plus pricing
This strategy focuses on the cost of producing your goods. It doesn’t take into account competitor pricing. To apply this strategy, add a fixed percentage to your product production cost. You then add an amount to that number based on how much you’d like to profit. The total number is the selling price.
The formula looks like this: Material + overhead costsOverhead costsThese are indirect expenses that cannot be directly attributed to a specific product or service. Those can include rent, utilities, insurance, and office supplies. + cost of laborCost of laborTo calculate the cost of labor, multiply the number of hours worked by the hourly wage, including any applicable taxes and benefits. (1 + the markup amount)
Let’s say you sell perfume. Here’s the equation in action:
Material costs: $10
Labor costs: $30
Overhead costs: $15
The total production costs add up to $55. You want to make a 50% profit, so that equation looks like this: Selling price = Production cost x (1+.50)
Here’s the formula with a 50% markup:
Selling price=$55.00 x (1+0.50)
=55 x (1.50)
=82.50 for every bottle of perfume.
- Quick and straightforward: Unlike other pricing strategies, cost-plus pricing doesn’t require a lot of research or time. It’s a quick and easy way to spit out informed prices.
- Easy to justify: This strategy is fair and easy to justify. If you increase your product prices, it’s simply because your production costs went up.
- Potential loss of profit: One downside is the potential for loss of profit. If you switch suppliers and end up getting your hands on cheaper materials, your costs will decrease. With cost-plus pricing, this means your selling prices (and revenue) would also decrease.
- Could be off market value: Since this strategy doesn’t take competitor pricing into consideration, there’s a risk that your selling price is way off market value. This is because this strategy doesn’t respond to competitor prices or consumer demand.
2. Dynamic pricing
Dynamic pricing is a strategy that applies variable prices (instead of fixed prices) in order to adapt to the constantly changing market and customer demand. Airlines, hotels, and event venues apply this pricing strategy by using algorithms that take into account demand and competitor pricing. These algorithms shift based on the state of the market and how much consumers are willing to pay for their product or service at that very moment. In other words, if the demand for an Elton John concert surges, so too will the ticket prices.
To determine if this pricing strategy suits your business, ask yourself the following questions:
- Can your business gauge how and when demand shifts? If you don’t have an idea of how and when the market changes, you won’t be able to alter prices to suit changing demand.
- Will your customers be okay with non-static prices? You won’t be able to use this pricing model if your customers aren’t willing to pay a bit more from time to time.
- Is your company a market leader? If a really small business in a popular industry raises prices frequently, customers will likely switch to a competitor.
- Do your industry peers use dynamic pricing? It’s important to confirm that dynamic pricing is common in your industry. If it’s uncommon, that means your competitors haven’t validated its efficacy.
- Earn more: This strategy enables you to earn more while selling more. Higher demand, higher prices.
- Generates consumer insights: This strategy helps generate consumer insights in determining the minimum and maximum price a customer is willing to pay for a particular product or in a particular season.
- Requires technical capabilities: This strategy requires technical capabilities. Many well established airlines companies, for example, use artificial intelligence and machine learning to adjust their prices.
- Negative consumer perception: It can create negative consumer perception. Many people find this strategy to be exploitative while fixed prices give people a sense of control and predictability.
3. High-low pricing
High-low pricing is when businesses first introduce a product at a high price, and then when demand decreases, they gradually lower the price. This strategy is regularly applied in the smartphone industry. Virtually all smartphones are introduced at a high price point and then gradually are discounted as interest decreases and new models are introduced. This is a particularly useful pricing strategy when you don’t have any sales history to base pricing decisions off of and when you want to keep foot traffic steady in your store year round.
- More profit: Customers shopping for discounted items oftentimes end up also buying full priced items in the same go.
- Sale hype: Sales oftentimes create a lot of buzz thanks to the “buy it while it’s on sale” energy.
- Low prices, low quality: Frequent discounts may give customers the impression that your products are of low quality.
- Consumers may play the game: Your customers may catch onto your pricing strategy and therefore wait to make purchases until specific products come on sale. This might hurt your revenue.
4. Freemium pricing
A combination of the words “free” and “premium”, this model offers customers free and paid services. The free options are typically basic versions of the service while the paid options are upgraded versions with more functionalities.
Examples of freemium pricing in action include free apps with ads that require customers to pay to skip the ads and online publications that allow customers to read a set amount of free articles per month before they have to pay. Businesses that use this pricing model hope to lure in customers with the free option, and then subsequently convince them to upgrade their subscription to the paid version.
It’s important to note that while this strategy can draw in a substantial user base, the vast majority of users who sign up for the free versions don’t end up upgrading to the paid version. However, this model gives you access to the customer which can be just as valuable as making a lot of money on the initial customer acquisition.
- Lower customer acquisition: There’s a lower customer acquisition cost involved in this model. It’s easier to attract people to a free product than a paid one.
- Attract larger user base: It will be easier to attract a larger user base. The reason? Because free stuff is universally loved.
- High cost: There is a high cost involved in supporting non-paying users.
- High rates of churn: High rates of churn associated with customers who disengage after trying the free plan or premium customers who revert to the free plan.
5. Penetration pricing
Penetration pricing takes place when a business enters the market selling products at incredibly low prices, thereby capturing the attention of potential customers that ordinarily would be buying from competitors. As articulated by Product Plan, “Because this strategy requires companies to slash prices to almost below market value, it’s usually employed by new businesses in a high-growth phase that are prepared to absorb initial losses. These losses are viewed as a necessary sacrifice to gain market share and entice customers away from competitors.”
This strategy aims to disrupt an established market and keep competitors out. And while it can bring businesses enormous success, it really is only a short term pricing strategy as businesses can’t make substantial profit when prices are so below market value. Television and internet providers are notorious for their use of penetration pricing. Companies like Comcast, for example, regularly offer steeply discounted introductory rates for TV channels–which later evolve into steep price hikes.
- Faster adoption: This strategy welcomes faster acceptance and adoption; low prices enable the product to penetrate the market quickly and easily.
- Bulk materials for less: High sales volume means your business can buy bulk materials at a discounted rate, thereby reducing production costs.
- Potential churn: Although this strategy can initially lure in new customers, it can also result in churn when the business increases the price. This is why it’s not a sustainable long-term approach.
- Negative brand image: With penetration pricing (like with many other similar pricing strategies), you risk developing a negative brand image. Customers may feel let down when businesses suddenly increase their prices. You may also harm your relationship with other local small businesses.
6. Value-based pricing
Value-based pricing is a customer-centered approach where businesses set prices based on a consumer’s perceived value of a product. All industries that use this model take into account three realities of value-based pricing:
- The market influences how much a consumer is willing to pay for a product.
- The benefit that the customer derives from the product impacts the product value.
- Competitor pricing can also impact how valuable consumers perceive a product to be.
Scenarios in which this model is implemented include when the demand for the product is so high that a cheaper price would have minimal impact on sales and when businesses want to promote exclusivity and prestige of their product.
A prime example of a company that uses this model is Starbucks. Few companies have a more loyal customer base than them. The value of their product lies in the urban appeal of the product (the social points that come along with having a cup of Starbucks in your hand in any given social situation), the warm and inviting shop interiors, the ability to socialize and connect with others on site, and the premium outlook the company projects. Over time, Starbucks has increased their prices, but their customer loyalty has been unwavering.
- Great when products are “hot”: This model is great for sellers when products are seen as prestigious or very “in”. In these scenarios, consumers don’t care about production costs, but rather how much value they ascribe to it.
- Increased brand value: With this model, you’re likely to experience increased brand value. When your business sells expensive products, the brand value increases in the eyes of your customers.
- Unstable model: This model is not stable. Perceived value practically changes by the day due to cultural and economic factors outside of your control.
- Involves a lot of guesswork: It can be difficult to evaluate the perceived value of a product or service. In other words, there’s not really a science to decide upon your price point. It involves a lot of guesswork.
7. Competition-based pricing:
This basic pricing strategy uses competitor prices as a benchmark. Many businesses use this strategy to assess the market rate for their products, then price their products accordingly. If for instance a store sells sneakers for $99 and their competitor sells the same sneakers and prices them at $95, they are using this pricing strategy.
In order to calculate your price, group your competitors together according to relevance in ascending order and determine where your product fits in the range. After figuring out where you fit in the market, you can choose one of three pricing methods:
- Go above competitor pricing: This is done when you feel your products are higher quality than your competitors or when you simply want to increase sales by setting a higher price.
- Match competitor pricing: Here, your main focus should be on the added value your product brings to the table, even though your product is the same as your competitors.
- Go below competitor pricing: Being one of the lower cost options in the market can be strategic when executed well. However, you must figure out how you want to eventually migrate customers to higher profit options.
- Easy to calculate: With simple competitor pricing analysis, you can determine your product price without any complex calculations.
- Low risk strategy: It’s a low risk strategy if you have a solid understanding of your target audience, product quality, and production costs. If it’s kept your competitors in business, it should do the same for you.
- Ignores consumer demand: This pricing model ignores consumer demand altogether. It assumes that competitors are well informed and are pricing their products accordingly. This only works if a few businesses in the industry are using it.
- Could hurt financial health: This model isn’t great for earlier stage small businesses. If they price their product too low, this could cut into profit and hurt the financial health of the business.
Take these strategies for a spin
Pricing your products can be complex and require a lot of planning and research. And we know we just threw a bunch of information at you, and there are even more pricing strategies out there. But the good news is you are now equipped with some of the most widely used, reputable ways to price your products. We recommend you take a few of these different strategies for a test run and see which ones are the best fit for you and your business.
Need more help starting your business?Learn how to create a business plan