Most small business owners understand the importance of choosing the right price. It has a direct effect profit, the ability to cover your expenses and customer expectations. In this article, we will discuss the most common approach to determining a selling price, and also various pricing strategies you can implement once you’ve determined a safe selling price.
You’re affected by the price:
• A buyer is willing to pay
•A seller is willing to receive
• That’s competitive in the market
There exist several formulae and tools to help you establish a selling price of products/services for your small business. There is however no be-all-and-end-all solution that will give you the perfect price for every situation. In the world of business, it all comes down to how much a buyer wants to buy versus how strongly the seller wants to sell. What you need to do is evaluate your final price against the ‘safe price’ that will cover all expenses. In this way, you will be able to measure the effects of your pricing strategy. Keep in mind, the strategy you eventually decide to go with doesn’t really matter, because the formula stays the same.
When a selling price is too low you risk running your business at a loss, and when it is set too high there’s a real danger of driving customers away. The goal is to strike a balance with your selling price that benefits you as much as the buyers.
Using software like Okumm gives you a more complex take on the price calculation, ensuring that your total volume of sales, as well as your monthly revenue target, is always taken into account in order to cover your overheads and guarantee a profit come month-end.
The cost price is what it initially costs your business to make a product or deliver a service. This not only includes raw materials for manufacturing, but time, labour, and equipment as well. Think about every step of the process required to make your product/service available to customers, and then calculate the cost of all these resources. This is your cost price and it will form part of your total cost of sales.
Once you’ve determined your cost price you can now determine exactly how many products you need to sell/services you have to deliver each year to cover your annual overheads, salaries, and direct costs/raw materials. Knowing how to draw up a budget will help you keep up with this intricate process. For instance, to determine the percentage overhead you need to allocate, you first need to establish your volume of sales. If your retail price is too high, you will have to make certain changes. Maybe cut costs? Or perhaps cut margins in your wholesale and retail prices?
Becoming a millionaire overnight is anyone’s dream, but in business, you have to be realistic with your profit expectations. Think about the contract we mentioned before between buyer and seller – you need them as much as they need you. A price too high will drive customers away, too low and your business suffers. Consider the profit you want on each product sold at wholesale price. Are you looking to create a niche market, low/high volume, bargain deals? It’s a good idea to establish early on the kind of business you want to run. Always be aware of your target demographic as well as the competition you will be up against in your market. In this way you will be able to settle on a profit that ensures you will achieve targets by selling your product/service in the volumes required, while also remaining competitive in your industry.
When it comes to gross margin percentage your own judgement underscores the entire process. There is no one-size-fits-all formula that can be applied to varying situations. Instead, you will have to think about the needs of your business, your customers, and your competition in many different ways.
Firstly, your business must generate enough profit to cover overheads and break even. Gross profit margin is determined by dividing your overheads and product margin with your volume of sales. Generally speaking, a business should have a stable gross profit margin, with the only exception being when changes are made to the company’s business model.
Next, it’s important to consider the type of people making up your market area, along with their buying choices. Getting to know your customers will help you figure out what it is they want, and what they’re willing to pay to get it. Keep in mind though, that the prices set by competitors will directly limit how much you are able to charge for your similar product/service.
Revenue = Cost of Goods Sold (COGS) + Overhead + Profit
Gross Profit Formula:
Gross Profit = Revenue – COGS
At the same time, your gross profit must be enough to cover your overheads as well as the desired net profit. Therefore:
Gross Profit = Overheads + Net Profit
And that brings us to:
Gross Margin Percentage = Revenue/COGS
Using what we’ve established above –
Price = Product Cost x Gross Margin Percentage
e.g. Revenue = R120 000
Overheads = R60 000
COGS = R40 000
Gross Margin Percentage = 120 000/40 000 = 3
Product 1 Cost = R120
Product 1 Price = R120 x 3 = R360
This is a very basic breakdown of how to determine your cost and selling price. For a more detailed breakdown, have a look at this cost price article.
If you’re not comfortable with complex calculations around your finances, please sign up for our BETA. The easy to use tool will allow you to determine your costing, margins and sales targets. Modelling various pricing strategies to see which will result in the highest net gain for your business will become easy to complete.
You know your pricing strategy works when it helps you establish the price point where profit on sales is maximized. A business owner has to consider several factors when setting a price, for example:
Therefore it’s clear that price – just as much as product, place, and promotion – can have a huge impact on the success of your small business.
Cost Plus Pricing is a cost-based method for setting the price of products or services. The direct material, labour and equipment cost is determined first. The gross margin is allocated thereafter to make sure costs and profit is covered. As a small business owner, using your cost-plus pricing method before looking at any other strategies will give you an idea of where your break-even point [link to break-even article] lies.
This pricing method involves setting your selling price according to what the competition is charging for similar products or services. This is a common and popular method for two reasons:
1. It guarantees your pricing is always relevant to the current market
2. It sets you apart from your competition – either giving the impression of having a prime product if priced fractionally higher or giving your business the competitive edge if discounting to below the competition’s price.
Okumm software facilitates the comparison between your safe price and the prices of competitors so that you can rest assured your price points provide optimal positioning within your given market.
This pricing technique involves appealing to the emotional side of customers instead of the logical. A watch priced at R1999 attracts more customers compared to R2000. The difference is negligible but could make or break a sale. In our example, it means the customer feels as if they are getting a bargain deal with the $199 watch. This is the goal of psychology pricing – to create increased demand by making customers feel as if they are getting more value, even when that isn’t the case.
Penetration strategies look to hooking customers with low prices as you enter the market, only to raise the prices later. It works well to attract attention and draw customers away from competitors. Be aware it also can have a negative impact on initial income for the business. However, after establishing their business/product, companies raise prices to reflect their market position, which drives profits in the long run.
Here we price a product with no regard to production costs, overheads, or anything aside from the perceived value it has for the customer. This strategy works well when the value of a product far exceeds the cost of producing it. For example, a software-CD costs the same to make regardless of the type of software it holds. Yet, prices vary between software types (and brands) depending on how valuable they are thought to be to customers.
The value-based strategy is directly influenced by the availability of alternatives – using a competitor’s software, executing the task without the software, or not doing the task at all. When using this pricing strategy, it’s important to be aware of your customers’ business, your own business costs, as well as the possible alternatives available.
This pricing strategy is designed to make customers choose to buy a more expensive product and feel like they’ve made the right decision. When a seller offers at least three products, two of them should be similar or equal in price, and more expensive than the third product. With these two products, one should be clearly less attractive than the other. When faced with a choice of two similarly priced products, customers will almost always go for the better looking one, even though it may be priced a little higher.
A business promotes discounted or low-priced products as a way to attract customers, who then have options between the promotional products as well as the regular-priced products. Customers take advantage of the promotion, but often also end up purchasing higher-priced products as well.
The term loss leader (or leader) refers to a product that sold at a very low price, usually at or below cost. The customers’ attention is drawn to encourage a sale on this below cost item, and then to lead them to make more sales on items with a higher profit margin. This pricing strategy is most commonly used by retailers, who always limit the amount of loss leader products to safeguard the company from losing out too much. They also work hard to punt higher-priced products after the low-cost product has attracted customers.
This dynamic pricing strategy is ingenious in its flexibility, made possible by technological advancements. These days we can gather endless customer data, including where they live, what they like to buy, when, how much, and what they’ve spent on recent purchases. In reaction to this data, companies can offer personalized pricing deals to any individual online that exponentially increases the possibility of a sale. The airline industry is a successful example of this pricing strategy at its best – where most passengers pay different ticket prices for the exact same flight.
It’s clear that your selling price plays a pivotal role in the success of your small business, and a good pricing strategy is where this success begins. With Okumm software you’ll have everything you need to achieve this right at your fingertips. Maximize profits, reduce costs, and develop your business to become a worthy player in your market.
The rate at which small businesses run into financial trouble and inevitably fail is unnecessarily high. By taking steps to control and manage your pricing in a responsible way, you safeguard your company from the common pitfalls to which small businesses are often prone. At first, a selling price might seem like just a number you place on a product to cover overheads and (hopefully) make a profit. But as we’ve explained, your price can attract customers or drive them away, and it also determines your position in the market. In short, determining your price isn’t something that should be taken lightly. Okumm allows you to make decisions that are best for your business.