What is Pricing

 Pricing is the method a company uses to set the price its product. There are various factors that may come into play. The price of the same or similar product of your competition, the type of market you want to buy your product ( low income to high income), location of the market, seasonal adjustments and other outside factors can all affect price. Outside factors may include economic stability or instability, as we see in the economy today, weather related incidents, and even basic supply and demand. Usually, the idea is to set the price high enough to make a profit but low enough to attract consumer demand. However, some prices may be set artificially low to make the product a "loss leader" that helps get more people into a store.

There is a continuum that is used to develop a pricing strategy. On one end is your cost to develop the product and your profit targets (margins). Customer demand, competition, and other market forces define the other end of the continuum.

COST-PROFIT VARIABLES

Margin: A margin, the ratio of profit to revenue of a particular product, can be used to measure the financial success of a product. To calculate margin, take the profit associated with a product (sales price less total costs) and represent it as a percentage of the selling price (i.e., revenue).

Your product sells for $1,000.

Your total cost to produce that unit is $700.

Your margin is $300, or 30 percent.

In developing your pricing strategy, the target margin (usually set by your CFO, Marketing Director) serves as a floor for pricing the product. If, as a company, you must meet 30 percent margins on all products and it costs you $700 to produce a product, the lowest price you could offer would be $1,000.

Gross Margin: Quite a few companies determine their pricing strategies based on the "gross margin" of the product. A gross margin measures only the variable costs to produce the product.

The variable costs, also referred to as the costs of goods sold (COGS), include any cost directly associated with producing and selling one incremental product unit.

Typical variable costs include:

Ø  Technical cost to produce/acquire the unit sold

Ø  Sales commission on the sale

Ø  Marketing cost to acquire and retain the customer shared over the number of units purchased

Ø  Cost of professional services to service customer (e.g., salaries)

Your product sells for $1,000.

Your variable cost is $400.

Your gross margin is $600, or 60 percent.

Net Margin: Calculating the "net margin" for a product can be illuminating. The net margin includes the fixed and variable costs associated with producing a product and therefore is much lower than the gross margin.

 Typical fixed costs include:

Ø  Development labor and materials required to build the product

Ø  Human (e.g., product manager) and technical infrastructure (e.g., servers) required to build and maintain the product

Ø  Non-variable sales and marketing costs (e.g., print collateral)

Ø  Overhead from general and administrative

 To determine the net margin for a product, take the fixed costs, amortize them over the expected life of the product, then add the variable costs. For traditional companies, fixed costs are often spread over three years. For companies for which products are usually out of date shortly after their release, these costs should be amortized over 9-12 months.

 Your product sells for $1,000.

Your fixed cost is $500,000.

Amortize your fixed costs over 12 months.

Given that you expect 1,000 customers in those 12 months ($500 fixed cost per customer), your net cost is $900 ($500 fixed costs + $400 variable costs).

 Your net margin for your first year is $100, or 10 percent.

 Market Variables

 While margins are important in determining the floor in pricing a product or service, understanding market variables is critical to setting the ceiling, or likely price. These are key questions in crafting the overall strategy for setting your price:

Ø  What is the potential size of the product's market?

Ø  What are customer expectations for pricing?

Ø  What is the competition charging for similar services?

Ø  How do you want to position the company?

 Customer Demand

Revenue = Number of Customers x Product Price

 So the smaller the market for your product, the higher the price for the product will need to be to achieve your revenue goals.

 In reality, few companies put much effort into sizing the market for a product. "Build it, and they will come," product managers typically proclaim. Management regularly accepts this as a satisfactory answer, reasoning: “There will always be more potential customers than can possibly be acquired, so why bother accurately sizing the market?”, “We only need 1,000 customers to break even, and there must be at least that many potential customers out there.”, “We already have three customers who have asked for this product, therefore, there must be 300,000 more.”

 The bottom line is that it is a pain to properly size a market for a product. You need to be able to define who your target customer is and then do the necessary research to see how many people/companies out there fit this description. This can be expensive and time consuming.

 If you are 90 percent sure that the market is big enough to supply the revenue you need for a few years and you are in a crunch to introduce a product to market, it is probably safe to skip this exercise. However, you should still clearly define your target customer. You will need to know your customer to understand his or her expectations for pricing.

 Customer Expectations

Customers have expectations for pricing that they use when they make purchasing decisions. Understanding these expectations is key to setting a successful pricing strategy. Typically, customers associate a product type with a price range. For example, CDs cost from $10 to $20. It costs $7 to $10 to see a movie. Even if your product is first to market, you will likely find that the majority of potential customers have a sense of what it should cost based on what the product or service is replacing. For example, the price of Web-based training is associated with the price of classroom training. Defining this price range is particularly useful when you are looking for ways to price products for immediate sale. If customers expect a CD to cost $10 to $20, you know that at $9, you are likely to see a lot of transactions.

 Competitive Landscape

Competitors are typically the largest driver of customer pricing expectations. If customers are accustomed to seeing your competitors selling CDs for $10 to $20, they will expect you to offer your CDs in the same price range. Even if there are no other companies offering the exact product as you, clues for pricing can always be found by looking at other companies. No product is unique or without peers.

 Positioning

Positioning adds a little twist to the pricing game. Because customers have expectations about pricing, the price that you charge for a product affects a customer's impression of your company or the product line. Do you want to be known as a premium company or a "good value for the money" company? Both have advantages.

 Defining your positioning for pricing goes to the very core of your organization. Like margin goals, positioning goals need to be considered at a company level for they have a significant influence on the overall success of the company. In looking for the right positioning, seriously consider the strengths of your product and organization. If you can't provide a premium-quality product or service, don't try to price your products as premium, or your customers will have a negative experience. Likewise, don't waste resources building a premium product if you aren't planning to charge for the added value.