Competitive Pricing 101: How Do You Know If The Price Is Right?

  •    A freelance reporter and writer based in Philadelphia, Pa., Dinah previously worked as a staff reporter for The Associated Press and Dow Jones Newswires.

You may be selling great products or services, but how do you know if the price is right? Are you charging enough to cover costs and turn a healthy profit, or have you overpriced your wares at the expense of greater sales?

While it's certainly possible to scare off potential customers by charging too much, consulting firm McKinsey & Co. estimates the vast majority of all “poorly chosen prices" for new products are too low, which means businesses are missing profits.

When setting prices, several factors should come into play, including material, labor – your own compensation included – and overhead costs, as well as the competitive landscape. Consumer psychology also may come into play.

As Entrepreneur notes, businesses need to calculate all costs and profits into their pricing.

It's vital to tally the various and sometimes overlooked expenses that go into operating your business – utilities, rent, employee compensation, loan payments, equipment, material costs, packaging, storage, shipping and discounts, to name several key areas.

If you want to contain or lower prices, you'll need to trim costs or profit margin.

"When we launch new products we test several price points and look at their respective conversion rates," the number of purchasers divided by visitors," Caeser Chu, founder of The Original Whiskey Ball Co., says.

"Generally speaking, the higher the price rate, the lower the conversion rate so you have to find the sweet spot. Since we are a multi-channel retailer, we have to take a few things into consideration when setting the price. Setting the price too low is a slippery slope," says Chu, whose company uses the Weebly eCommerce platform.

Traditional brick-and-mortar big-box retailers expect to pay half the lowest price at popular online retailers like Amazon so they can achieve a 50% margin on what they sell, Chu says, "so you want to make sure you can achieve your profit margin expectations after that discount." Setting a minimum advertised price for products is really important if you sell to this channel, he says.

Businesses selling products online often need to offer promotional discounts for various reasons, including have retailers promote the items as discounted, he notes.

Costs, Profit and Competition

Businesses take various approaches to pricing.

A company that uses cost-plus pricing totals all material, labor and overhead expenses and adds to that a desired profit to arrive at price. Simply put, if expenses per item work out to $100 and you want a 20% profit, your price would be $120.

Cost-plus pricing carries risks, including miscalculating expenses, but it's important in establishing a product's “lowest reasonable price level," McKinsey says. If consumers won't bite at that price, the firm says, the business will need to reconsider the product's feasibility.

Businesses are wise to explore the competitive environment as well. Knowing competitors' prices can get you in the ballpark and help you decide whether you're able to charge more for exceptional products or services, or offer discount pricing to woo customers.

Depending on your business, you might be able to employ value-based pricing, in which you establish price based on the real or perceived value provided to the customer. This can be a highly profitable pricing approach, entrepreneur Scott Allen suggests in The Balance.

Does your consulting work or product contribute significantly to another company's bottom line? Do your handmade clothing pieces or organic foods carry social cachet valued by consumers? If so, you may be able to price at a premium.

Scott Gerber, founder of the Young Entrepreneur Council, suggests in an Inc. video that business owners consider tiered pricing, which would enable them to offer extra options at higher prices above a base level.

In the same video, serial education entrepreneur John Katzman, who founded The Princeton Review, recommends that small businesses “price higher than they think they should," because their costs are higher than they anticipate and they enjoy a service advantage.

If you're setting prices for services, consider, in addition to your costs and the value you provide, elements such as your experience and professionalism, your prompt attention to client calls and emails, and ability to complete the work on time, Jay Lipe of the University of Minnesota Carson School of Management, advises in The Balance.

Customer Psychology

Pricing might be relatively easy if it involved only costs and profit margin. Consumer psychology often plays a part as well. After all, there's a reason all those late-night infomercials offer products for $19.95.

Budget-minded customers may be focused mostly on price, and if they're your target market, you'll want to price accordingly, looking for ways to curb your costs so you can set an appealing price and perhaps brand yourself as a discount retailer or service.

Many customers, however, are looking for premium offerings for which they're willing to pay more. In fact, customers shopping for luxury products or services may expect or desire to pay more, and higher pricing could be a key part of the marketing strategy for these items, according to Allen.

If you're using “psychological pricing," he writes, you might also consider using attractive “price points," like “under $20," or levels that customers will simply perceive as fair.

Once your product hits the market, consider trimming the price if you're not meeting selling goals, YEC founder Gerber suggests. You may earn a lower margin per unit but will generate more income overall if you make more sales, he notes.

Whatever approach you take to pricing, it's important to prepare well, do your homework and keep in mind the important variables – from product value to company costs to market dynamics to customer perceptions – that go into choosing the right numbers.