Setting the price of a product or service is a crucial step for the success of a company, as it is directly related to the financial health of the business, competitiveness in the market, and communication of the value of the product/service to customers.
However, to do so, it is necessary to take into account some aspects:
Internal financial aspect:
First and foremost, the price practiced should be sufficient to cover all costs for which the company is responsible and still generate a profit margin. These costs include:
- Fixed costs: These are expenses that do not vary with the quantity of product produced and sold (the same applies to services). Examples include: rent for physical space, water bills, internet, salaries, among others.
- Variable costs:
- For products: Vary with the quantity produced and sold. Examples: raw material costs, packaging costs, shipping and delivery costs, among others. The total variable costs divided by the number of units produced allow us to know the production cost of each unit.
- For services: Vary with the quantity of service provided. Examples: materials used in the service, sales commissions, among others. It is also possible to know the cost per service, through the costs incurred by the company each time it is provided.
The e-commerce platform Shopify provides an Excel document: Break-even calculator. By inputting the fixed and variable costs of the company and the average selling price of the product, it allows us to determine how many units need to be sold for the business to become profitable (identified with the term “Break-Even Units”). It’s a way to understand if there is a financially healthy relationship between costs and the price practiced. For a more detailed description of its functioning, access this link: calculator guide
Market aspect:
It is equally important to research the market in which the product or service is positioned. In order for the chosen price to be fair and competitive, it is necessary to:
- Understand market demand: conduct research on the target audience, understand their consumption habits and preferences, in order to know what they expect from the product and what value they would be willing to pay;
- Analyze the competition: understand the strengths and weaknesses of the products or services offered by competing companies, in order to seize differentiation opportunities in relation to them. Identify the standard price range practiced in that market, to establish a competitive price within it;
- Study market trends: be attentive to possible events or changes in the economy that may alter the demand for the product or service. Use that information to try to anticipate market needs ahead of the competition and to be able to make adjustments to the product’s/service’s price.
Profit margin:
To ensure the financial health and growth of the business, it is necessary for the price of the product/service to allow for profit generation. The profit margin (PM) allows us to know the percentage of profit per sale, before taxes, and its formula is as follows:
PM = ((Total Sales - Cost of goods sold) / Total Sales) x 100
To identify the acceptable profit margin for the product/service in question, it is necessary to take into account:
- The profit margins of the competition, in order to have a realistic understanding of the product’s potential profitability;
- The growth objectives and financial stability of the business. A higher profit margin allows for more sudden and profitable growth of the company; however, setting unrealistic goals can lead to an excessive increase in the price of the product, making it uncompetitive in the market.
Once again, the Shopify platform provides a calculator, where by entering the production cost of a unit of product and the desired Markup(1), it outputs the selling price of the product, the profit on each sale, and the profit margin (before taxes and excluding fixed costs, “Gross Margin”). To access the calculator: Profit Margin Calculator
1: Markup – the value added to the cost of producing a unit to generate profit (for a product that costs €20 to produce, if the entrepreneur wants to earn €4 on its sale, we are talking about a markup of 20%, and so the selling price would be €24).
NOTE: If the price charged by the competition is lower than what is required by the internal costs of the company and the expected profit margin, it is necessary to reassess the viability of the business in question. To balance the selling price, it will be necessary to reduce fixed or variable costs of the company, or even accept a lower profit margin.
Pricing strategies:
Now that you know the business costs, the market, and the company’s objectives, the only thing left is to choose the strategy to adopt in defining the price:
Cost plus pricing:
- It consists of simply adding to the production cost the amount of profit (in euros or percentage) desired per unit: Cost + markup = final price
- It is the simplest strategy to calculate and apply.
- It does not take into account the market influence and can therefore lead to prices that are very out of line with the competition (both upwards and downwards).
Competitive pricing:
- Decides considering the prices charged by the competition, in two possible ways:
- Slightly below price: convey the image of an accessible and affordable product/service.
- Slightly above price: convey the image of a product/service above the quality of the competition.
- Appropriate strategy for saturated markets, where products are quite similar and the price can make all the difference.
Penetration pricing:
- Market entry with a significantly lower price compared to the competition. After gathering enough customers and relevance, slowly increase prices over time.
- Appropriate strategy for capturing customers who remain loyal to the product/service even after price increases.
Freemium pricing:
- Part of the product/service is offered for free, while the full or premium version has an associated price. – Strategy that attracts customers to the free version and then tries to convince them to purchase the premium version through its superior features.
Price skimming:
- Enter the market with a higher price and gradually lower it over time.
- Appropriate strategy for high-quality products, especially technological ones, where previous generations lose value when a new device is launched (e.g., Apple).
- It is unlikely to work in a saturated market, as the target audience would opt for more competitive prices.
Value based pricing:
- Takes into account the price charged by comparable products/services and identifies what makes the product itself different and better than others. Then, it associates a cost to that differentiation. In short, it assigns a value to the benefit the product brings to the customer.
- Appropriate strategy if the product/service really offers something different from the competition, which compensates for having a higher price.
Loss leader pricing:
- Sells a product at a lower price, even if it causes a loss to the company, to encourage customers to also buy other products in the store.
- Appropriate strategy for larger-scale businesses that can offset the loss on that sale with the profit on other products.
Bundle pricing:
- Combination of two or more products for only one price, which will be lower than the price of the two separate items.
- This strategy seeks to present an attractive discount to the customer, combining two or more products, knowing that possibly some of them would be harder to sell individually.
Anchor pricing:
- Uses price comparison to make them appear as attractive as possible.
- Examples of this strategy include:
- Presenting the discount price closer to the original price, so that the amount saved by the customer is highly visible.
- Establishing a higher initial price, in order to present a larger and more attractive discount.
Premium pricing:
- Sets prices intentionally high to position itself as an exclusive and high-quality brand. It seeks to communicate luxury and excellence in service.
- Appropriate strategy only if the products are truly of high quality and offer an innovative shopping experience that exceeds customer expectations.
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