Pricing Methods And How To Use Them
by Tom Egelhoff
One of the first sales jobs I held, early in my career, was selling furniture in a small town mom-and-pop retail store. At the time I was hired, I was sharing my very first bachelor pad with a friend. We had elegantly furnished our domain with our respective families hand-me-downs. In fact we bought our first sofa at a second hand store for $5.00...including delivery.
As you may have guessed this was my introduction to furniture pricing. When I began my first day as a furniture salesman, I was given a tour of the store. Three stories worth. As I looked at sofas and chairs that cost a months pay, I decided that I would fail miserably at this job. Not because of my ability, but because no one could possibly afford this stuff. How on earth did they stay in business?
As I gained more experience in the workplace I learned that people could afford that stuff. They could afford a lot of it. But the most important lesson I learned was this, ...price is a matter of perception by the customer.
What Makes Something Valuable?
Information. We can't make a decision or determine value without some information about the product or service. We need a frame of reference to put the product and the price in the proper prospective. Let my use an example that I use in my seminars.
I show the class my "Cross Pen." I ask them to estimate the retail value. Most guess correctly, having seen them at Staples® or some other office supply outlet, at around $25.00. Next, I tell them the pen is used, still in good shape but not new. They often drop the price to $5.00 or less. Next, I tell them it doesn't work at all. Now how much is it worth? Most say -zero dollars-. Next, I tell them it doesn't work because the ink cartridge is filled with one ounce of solid gold. Now it's suddenly a bargain at the original price. It's a bargain at ten times the original price.
The point of this exercise is that every time I gave the class new information, their perception of the value changed. I took them from a starting price of $25.00 to near zero to several hundred dollars just by adjusting the information.
So every time a customer walks up to you and asks, "How much?" without getting the information that justifies the price, you are doing that customer a disservice if you give them the price.
Doesn't Demand Dictate Price?
The most common marketing theory is that demand for your product or service determines cost. If there is a huge demand for your product the public will pay more to get it. If they don't you should lower the cost to increase sales.
In my opinion, this is a major mistake that people make who are new to business. Because what they do is easy for them, they find it hard to ask for a reasonable price for their services. Doesn't lowering the price give the perception that quality may be lacking?
How can one barber in one part of the country charge $10.00 for a haircut and another charge $100.00? Are haircuts in demand at the $100.00 place? Are people lined up around the block for haircuts? Are they camping out in front of the business to get the first haircut? No, not usually.
There is, however, a price perception of the value of the $100.00 haircut in the mind of the customer. That perception was not created by the customer but by the business owner. The business owner decided that haircuts would be $100.00. The business owner set the price.
How Prices Are Determined
In this article I'll explore four methods of establishing prices for products or services. Cost-plus pricing, demand pricing, competitive pricing and markup pricing.
Cost Plus Pricing
This is one of the most effective ways of pricing items that you make yourself. For example, if you make furniture or some type of custom crafted product, it insures that you can cover costs, make a profit and continue to produce your products in the future. Here's how it works:
It's a pretty simple formula on paper but not in the real world. Cost plus simply means that you ad up all your costs in making your product. This would include materials, your time, overhead (heat, rent, etc.), delivery plus the amount of profit you wish to receive for your efforts.
One of the biggest problems with cost-plus pricing is that you forget a cost somewhere along the way. Each cost that is not included cuts your profits.
This can be an effective way of pricing because hand-made items are hard for the customer to compare. That frame of reference I mentioned above is missing. Sell the craftsmanship, the quality, the one-of-a-kind and it's easy to justify the price.
This is one of the toughest methods for most new businesses to master. You will most likely learn it by costly trial and error. Here's how demand pricing works.
Using the example above, you create one-of-a-kind coffee mugs. You begin by selling some to local retail stores. They may only buy in threes and fours.
Word gets out and suddenly Target® and Wal-Mart® want to carry your mugs. They want several hundred...perhaps thousands. Are you going to sell to Target® or Wal-Mart for the same price as the retail store? No. Volume of that kind usually demands a lower per item cost. Your overall profit is more but your per piece profit is slightly smaller. The mass merchant will probably sell it for less than the local retailer to move the larger volume.
In demand pricing you may have several price lists. One for retailers, wholesalers, discount stores, department stores and mail order. Volume and pricing are hard to structure because of all the variable costs involved. Shipping, billing, inventory, and material costs all come into play and each can have a positive or negative effect on profits if not handled correctly. It is not a method for the inexperienced business person.
Should I be priced the same as the other guy? Competitive pricing means that there is a commonly perceived price for a product regardless of brand. Coke and Pepsi are usually about the same price.
Later on in my sales career, I spent some time working at Circuit City®, the electronic retail giant. At the time they were doing a billion dollars more than their nearest competitor with fewer stores. Pretty impressive. One of the duties that each salesperson had was to drop by the competition and make a list of the products they carried and the prices. If a competitive manager caught you they would politely ask you to leave. The other salespeople were pretty sympathetic because next week we would see them in our stores doing the same thing.
The common defense for this type of pricing was to carry similar but not exactly the same products. For example, if we had a XYZ330 video recorder the competition might carry the XYZ 333 for a slightly lower price. The two units looked exactly alike on the outside. But inside some feature was either added or missing to raise or lower the price.
Trying to go head-to-head with the leader in a product category is usually not a wise decision. If they carry Coke, you carry Pepsi. If they carry Hoover you have Eureka. Be different by being the same...just not exactly the same.
This is probably the most common method of computing the price of an item. It is very similar to the cost-plus pricing but is most commonly used when you purchase a product to re-sell to the consumer. In this scenario you have a fixed price. The cost of the sofa and the shipping.
If the cost of your product is $100.00 and your selling price is $150.00 then your markup is 50%.
$100.00 cost divided into $50.00 = 50% or
$100.00 X 1.5 = $150.00 selling cost.
The Last Word On Pricing Methods
I'm sure by now you have probably selected one of the above as the method that will fit your business best. Before just adopting one of these methods try several scenarios.
Assume whatever can go wrong will go wrong. Don't accept a method at face value. Make sure it works in all kinds of situations. It's nice to make a profit, so do your homework.
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Based in Bozeman, MT, Tom Egelhoff is the author of How To Market, Advertise & Promote Your Business Or Service In A Small Town, and The Small Town Advertising Handbook: How To Say More And Spend Less. He is also a seminar and workshop presenter and trainer. He may be reached at 888-550-6100 or PO Box 271, Bozeman, MT 59771-0271
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