How Businesses Set Their Prices

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Yellow Belt
The price you charge for your product or service is one of the most important business decisions you will make.

If you're starting a business you need to carefully consider your pricing strategy before you even start. If your prices are too high could limit your growth and cause cashflow problems as you won't have sufficient customers willing to pay your price. Set your prices too low and you also risk cashflow problems.

When setting your prices you must make sure that the price and sales levels you set will allow your business to be profitable. Knowing your competition in this regard is vital.

Knowing the difference between cost and value can increase profitability:

* the cost of your product or service is the amount you spend to produce it
* the price is your financial reward for providing the product or service
* the value is what your customer believes the product or service is worth to them

For example, the cost for a builder to replace a missing roof tile at a customer's home may be £6 for travel, materials costing £7.00 and an hour's labour at £12. However, the value of the service to the customer - who may have water leaking into their house - is far greater than the £25.00 cost, so the builder may decide to charge a total of £50.

Pricing should be in line with the value of the benefits that your business provides for its customers, while also bearing in mind the prices your competitors charge.

To maximize your profitability, find out:

* what benefits your customers gain from using your product or service
* the criteria your customers use for buying decisions - for example, speed of delivery, convenience or reliability
* what value your customers place on receiving the benefits you provide

Wherever possible, set prices that reflect the value you provide - not just the cost.

Fixed and variable costs

Every business needs to cover its costs in order to make a profit. Working out your costs accurately is an essential part of working out your pricing.

Divide your costs under two headings:

* fixed costs are those that are always there, regardless of how much or how little you sell, for example rent, salaries and business rates
* variable costs are those that rise as your sales increase, such as additional raw materials, extra labour and transport

When you set a price, it must be higher than the variable cost of producing your product or service. Each sale will then make a contribution towards covering your fixed costs - and making profits.

For example, a motorcycle dealership has variable costs of £4,000 per motorcycle sold and total fixed costs of £100,000 a year that must be covered. If the company sells 50 motorcycles each year, it needs a contribution towards the fixed costs of at least £2,000 per motorcycle (£100,000 divided by 50) to avoid making a loss.

Using this structure, you can assess the consequences of setting different price levels by taking into account both fixed costs, and variable costs.

Cost-plus against value-based pricing

There are two basic methods of pricing your products and services: cost-plus and value-based pricing. Your choice depends on your type of business, what influences your customers to buy and the nature of your competition.

Cost-plus pricing

This takes the cost of producing your product or service and adds an amount that you need to make a profit, often as a percentage of the cost price.

If your business is dominated by competitive prices then this is probably the better pricing method to use.

But cost-plus pricing ignores your image and market positioning. Customers will often pay more if they are buying a product or service from a better known company with a good reputation.

Value-based pricing

This focuses on the price you believe customers are willing to pay, based on the benefits your business offers them.

Value-based pricing depends on the strength of the benefits you can prove you offer to customers. This method often suits those companies offering a service, such as builders, plumbers, drain cleaning etc.

Bear in mind though that you can easily out price yourself and can alienate potential customers who are driven only by price and can also draw in new competitors.

Pricing strategy

You need to decide whether to use cost-plus or value-based pricing.

It's important to find out what your competitors offer and what they charge. The simplest way is to phone your rivals and ask them for a quote.

If you set your prices a lot lower than your competitors you will just be throwing away profit. If your prices are much higher, you will lose customers.

In many markets, a high price contributes to the perception of your product as being of premium value. Some customers might buy from you on that basis, that they are paying for better quality. But, it will almost certainly deter price-conscious customers.

You can of course charge different prices to different customers, eg to customers who purchase repeatedly, or buy add-on or related products. Repeat business is always something to aim for whenever possible.

The bottom line really is that! You must be careful to ensure you price to cover your costs and deliver a profit.
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