When you’re starting a business, pricing can be a tricky issue.  The prices you charge for your products or services can have a dramatic effect on sales and profits.  Your pricing strategy also determines how customers view and respond to your product or service. Pricing can also mean the difference between success and trading at a loss.

Here are two factors to consider before you develop your pricing strategy.

1. What the market says

Conducting some research on the market reaction to your products and services can provide valuable guidance:

• Which products do customers see as offering the best value?
• Which products are likely to be the most successful?
• What do customers expect to pay for your product or service?
• Is there an established market price for similar products or services?

Buyers’ risk can be one of the most important factors in getting a higher price.  Would you feel confident buying a cheap parachute?  What risks might a buyer see in your product?  What might happen if something goes wrong with the product?

Once identified, check if you can take steps to reduce or reverse the risks so you can charge a higher price, for example, by offering a better guarantee than your competitors.

2. Your competitors

To some degree, the price of your product will depend on the competition:

• Who are your competitors and what do they offer?
• What are the key features and benefits of their products?
• How does your product or service compare?
• Do your products have a clear point of difference or competitive advantage over competitors?

If you’re able to offer more, such as better quality, more features, a better guarantee or free installation, you can afford to charge a higher price.

Your pricing strategy

An appropriate pricing strategy will depend on how you want to position your product or service.  For example, a high price will likely lead to customers seeing a premium value in your product or service.

You may want to charge different prices for different customers.  For instance, one-off sales generally carry significantly higher costs than repeat business, so customers who purchase regularly, or buy add-on or related products, are more valuable.  Customers who are always demanding special features or service are expensive to satisfy and will be less profitable, unless you can charge them higher prices to justify the time and effort involved.

Cost-plus pricing

A cost-plus approach to pricing is a useful and necessary starting point to ensure you aren’t undercharging for your product or service.  It simply involves calculating all your production costs in and then adding the amount you need to make a profit.  The trick is to include all of your costs so get your calculations checked by your accountant.

Although cost-plus pricing can’t definitely determine what your prices should be, it will tell you whether the prices are viable.  If you charge less than your variable costs (the direct cost of making a sale), you will make a significant loss.  If you charge more than your direct costs, each sale will make a contribution towards covering your fixed costs (also known as business overheads) and ultimately towards making a profit.  The contribution each sale makes towards covering your fixed costs tells you what volume you need to sell to reach break-even.

The disadvantage of the cost-plus approach is that it doesn’t take into account three important factors:

1. The level of demand.
2. What competitors charge.
3. Market expectations (what customers expect to pay).

You’ll need to consider these three issues before making your final pricing decisions.

Benchmarking your costs

Reviewing changes in your costs is always important.  It becomes even more useful if you can benchmark your costs against industry averages – for example, gross profit and net profit averages for your industry.  If you discover your margins are below industry norms, then this could suggest your costs are too high or your prices too low.

When considering new products, industry margins also give you a rough guide to the prices you may be able to achieve.  Your accountant can help you with finding these benchmark figures.

Price differentials

Varying your prices can increase your profitability.  Some typical tactics include:

• Charging lower prices for high-profile products to capture customers who will also buy higher margin products - this is usually called a loss leader.
• Charging different prices at different times of the day, week or year to reflect changing demand or the changing value to customers of your product.
• Charging different prices for different levels of service or product specification.

Discount carefully

Most accountants warn against discounting because of the effect on your profits.  Once you actually work out how much extra you need to sell to cover a discount, their concern becomes clearer.  You don’t want to start a discounting battle against stronger or more established competitors – nobody wins except the customer.

Discounting can be worthwhile in certain circumstances, but only if it achieves your aims. For instance, clearance discounts can help you to sell off old stock, release working capital and improve your cash flow.

Introductory discounts can encourage customers to try a new product, but they may create the wrong image for your product or generate sales that are not repeated when the discount is removed.  These discounts can also cause resentment among current customers.

If you offer discounts, make the terms very clear - are they one-off, short term or related to a specific event like prompt payment?  For example, a cash payment discount can encourage early payment and improve your cash flow, but some customers may try to delay payment and claim the discount anyway.

Other pricing tactics

Special pricing tactics may work in particular situations.  For example, bundling additional products together and charging a package price can work well if the customer sees a greater increase in value than your actual additional costs.

Setting prices at recognised psychologically attractive ‘price points’ is a well-established tactic in retail businesses.  For example, $49.90 or even $49.99 is seen as a price break.  Customers see the price as being considerably less than 10c or 1c cheaper than $50.  But make sure you have a plan that allows you to increase your prices above this price break, or you may be stuck with it forever.

Continually review your prices

Review your prices regularly to ensure they are optimal and that you’re keeping up with trends in your industry and the overall market.

Any changes in turnover can signal a pricing problem or an opportunity.  For example, if you sell products with high or growing market share, this may give you an opportunity to increase prices.

If you’re a service business and sell your time, then getting in more business than you can deal with may be a signal to increase your pricing.  Similarly, if you pitch or tender for business, too high a success rate suggests you’re under-pricing.

If both your margins and market share are low, you need to change something – or consider discontinuing the product.

Limited trials of price changes can give you valuable information at reduced risk.  For instance, you can change the price for a sub-sector of your market or introduce a new product at the new price while continuing to offer the old product.

Increasing your prices

When considering a price change, analyse the potential impact on your profit:

• What will the effect be on sales volumes?
• What will the effect be on profit margins?

Increasing prices, and therefore margins, can sharply increase your profits, even if your turnover drops.  

Always explain to your customers why you’re increasing prices and give them fair warning, especially if they need to budget for the increase.  Use the price change as an opportunity to re-emphasise the benefits you offer, such as:

• You’re improving the specification or quality of the products.
• You’re introducing new, higher priced products with more benefits or functionality that make older products less attractive or obsolete.

It’s wise to increase the price by more than the cost of the improvement.  Good relationships with your customers can help to improve their perception of the value of your product and the risk of them trying alternatives.  On the other hand, trying to hide price increases runs the risk of adverse reactions when customers realise what you’re doing.  

In general, consider increasing prices when demand is high.  For example, the price of paint tends to increase towards spring as people start to think about redecorating.

Aim high

Underpricing your product can be even more dangerous than overcharging.  Remember that while prices are low, so too are your margins.  It’s far easier to reduce prices than to increase them, so if in doubt, try higher prices first.  You may discover that your target market is not particularly price sensitive.

You may be tempted to price lower than your competitors.  However, customers may not respond because low prices can suggest low-quality products or services, or signal that you lack confidence and experience.  Low prices can also attract unprofitable customers or price-sensitive customers who tend to be disloyal when prices increase.

Next steps

• Use the NAB Cash Flow Improvement Tool to experiment with small changes that can make a big difference to your results.