What we’re talking about
This is about deciding how much you want customers to pay for whatever it is you’re selling. The basic idea is that you come to a figure (or range of figures, if you have multiple products) that covers your costs and leaves room for profit – and that your customers broadly agree with. Deciding on a pricing strategy might not sound like the most creative of activities, but it’s a critical aspect for your business – it’s both an art and a science. You’ll need to be inventive, adaptable and open to experimentation.
Why it’s important
Though your product or service remains the most important thing, how much you charge for it is essential to consider. A study by global management consultancy McKinsey suggests that having an effective pricing strategy can lead to a 2% to 7% increase in your return on sales. Beyond the fundamentals of making enough money to cover your costs, the way your product or service is priced affects how people perceive it – as well as if, when and why they would buy it.
If your price is too high, you’ll miss out on sales. Regardless of whether you’re making a hefty slice of profit each time or barely covering your costs, no one likes to feel ripped off. If you set your prices too low – which is more common – you’ll sacrifice revenue for no reason. You might even find your product is ‘cheapened’ for the long run – regardless of any subsequent price hikes.
Things to note
The main two distinctions are between cost- and value-based pricing. Cost-based pricing involves working out how much you (as the business) have to pay to provide a service or offer a product, before adding a percentage on top for profit. Value-based pricing is a little more elusive, and involves taking a step back and working out the perceived value of what you’re offering. It’s more likely to be used for services, software and goods perceived as having luxury or emotional value. When a person buys a sculpture, for example, they pay far more than the price of the raw materials and labour.
But there are lots of sub-strategies. The sheer quantity of pricing strategies can be overwhelming, so it’s helpful to think of these as avenues to explore rather than models to swear by. Some of the most relevant for small businesses are:
• Competition-based pricing: the price you set is based on the going market rate and what your competitors are doing.
• Dynamic pricing: the price of your product or service rises or drops in keeping with demand. A bed and breakfast, for example, may charge more per room during peak periods.
• Penetration pricing: setting a very low price to attract customers when you first open or launch.
• Freemium pricing: offering some stuff for free and some for a fee.
• There are several more – all of which, if used correctly, can enhance your reach and revenue.
You don’t need to earn the same profit on everything you sell. Think of your suite of products or services overall, not one by one. There might even be things that lose you money, but generate value in other ways. Maybe people come into your cafe because of its dirt-cheap but tasty filter coffee, and pick up a pricey cupcake or salad on the side.
Don’t underestimate psychological factors. Pricing items at $0.99 instead of $1 might be one of the oldest tricks in the book, but there are other ways of harnessing customer psychology to your advantage. Don’t get carried away with this, but you might try experimenting with deals, discounts and flash sales, letting customers spread costs or operating a subscription service with a free trial.
How to set a price for your product or service
1. Be clear on who your customer is. First, double down on who your target customer is. Traditional demographic information – such as age, income, education, geography and gender – is useful up to a point, but you should focus especially on people’s lived experience of the problem you’re solving. Why does this problem matter, who does it matter to and how do they currently deal with it? Are there alternative solutions people are using that show a ‘cash value’ of that problem?
2. Get an idea of how much they’re likely to pay. Now that you’ve identified the kind of customer you’re working with, engage them in conversation. There are some handy tips on how to do this in our guide on user research – although you’ll need to tailor your research to pricing specifically. Be thoughtful about how you phrase things in conversations and surveys, and avoid leading questions. Ask people about times they’ve purchased similar things in the past, rather than being completely hypothetical. Try to find out how much a change in price would affect demand for what you’re selling.
3. Check out what your competitors are doing. If you’re offering something totally new, you can be much more flexible with your pricing. But if you’re entering a saturated market – where lots of people are doing something similar – you can’t ignore your competitors. Benchmark your business against other options that speak to a similar customer base, based on your intuition, and get an idea of the major players. Ask yourself what you do differently from them, and how much more or less valuable this is in financial terms. Customers may flock to you if you offer a similar service at a lower price; or they may be prepared to part with more cash for improved speed, convenience, quality, etc. Be vocal about these strengths in your marketing if you’re going to charge more because of them.
4. Consider your long-term plan. Once you’ve collected info on the here and now, think about your longer-term expectations. Do you expect your product to be accessible to all corners of society? Do you expect demand to skyrocket or shrink within the next few years? If you’re buying into a trend, you might want to price as high as you can and cash in in the short-term. But if you’re in it for the long haul, you might be able to raise your prices, and therefore profits, over time.
5. Work out your costs. You need to know the cost of producing whatever it is you’re looking to price before adopting any pricing strategy. It might be worth bringing in external expertise in the shape of an accountant, but you can still get somewhere on your own by working out your fixed and variable costs. If you’re selling physical goods, for example, one important calculation is working out your unit cost (Investopedia goes into that here). Whatever type of business you’re operating, you need to understand what your break even point is – ie, the amount you need to recoup on your product or service for you to not lose money.
6. Land on your pricing strategy. With your research done, it’s time to decide what kind of pricing strategy you’ll opt for – and how much profit you’ll look to make. Whether it’s cost-based or value-based, think about the pricing sub-strategies that might be suitable, taking into account when they’re particularly useful and their main pros and cons. You should be in a position to set initial prices for your products or services.
7. Compensate for discounts. Consider whether you’re willing to lower your price to sell more. It’s useful to anticipate future cuts to the best of your ability when setting initial prices. For each product or service that you’re selling, decide what kind of discount you’d be open to offering and how long for. You need to make sure that, within this framework, you’re still making profit overall. Try it with this helpful discount calculator from Omni Calculator.
8. Check you’re not breaking the law. At this point, do a quick check to see you’re not going to unwittingly land yourself a criminal record. It’s unlikely, but there are some laws around pricing in certain sectors. In Scotland, for example, all alcohol must be sold for a minimum of 50p per unit. It also might be worth considering price transparency, which is a way that more and more brands are using to gain customers’ trust – particularly if you’ve gone for a cost-based pricing model.
9. Consistently review your prices and update if necessary. Your business and the environment around it will naturally change over time. It’s important to adjust your pricing strategy accordingly. Your costs might increase or decrease because of government policies or subsidies; you might introduce a new range; your biggest competitor might go bankrupt. Even if there’s no obvious reason to, it’s worth doing a comprehensive review of your pricing every six to 12 months.
• There’s more than one factor at play when it comes to landing on a pricing strategy – you need to consider your costs, what competitors are doing and what your target customers are happy to pay.
• It’s not simply a case of picking a well-trodden pricing model and hoping for the best. Focus on making your product or service excellent, and use strategic pricing as an additional bonus.
• The prices you set aren’t fixed, but bear in mind that the pricing choices you make earlier on are likely to influence how your product or service is perceived in the long term.
Perspective. Accountant Sally Farrant spent many years at large corporates, but now specialises in giving small businesses clarity on their numbers through her jargon-free Pricing Queen podcast.
Example. There are several case studies in this round-up from Startups.co.uk, including the story of coconut water brand Vita Coco, which launched at a high price to cultivate a premium image.
Tool. HubSpot has a great (and free) pricing calculator. You can play around with nine different strategies, and work out exactly how they would affect your bottom line. Download the Excel template here.