When setting price, do you track everything that goes into your product or service? You should. While setting price can be difficult, according to Charles Toftoy, Associate Professor of Management Science at George Washington University, it is “probably the toughest thing there is to do” in business, you have to do it. And do it well.
If you price correctly, your business will likely prosper, but if you fail to price correctly, your business will struggle to compete and may eventually be forced out of the market. I learned this lesson but I learned it too late.
Don’t do what I did
As a bottled water, juice, and soda distributer, I sold my products across Atlanta and made thousands of dollars every day. I was selling at or below my competitors’ prices, but I had no idea how to set price. I arbitrarily chose a number and that was my price, and since I was making lots of money, I thought I was a successful businessman with a prosperous company. I later learned I was wrong about both.
The market tightened, and as a result, I could not pay my suppliers. I was great at sales—but bad at business—so I thought the way to turn things around was to sell more product, and it was not until the demise of my business was inevitable that I realized the more product I sold, the faster I was putting myself out-of-business. My price was too low.
When setting price, begin by listing everything it takes to produce your product or service—equipment, labor, raw materials, etc.—then add overhead, which includes fixed costs like rent and shipping. Combining these costs gives your total cost. If you sell at this price, your break-even price, you will only make enough to cover expenses.
Add to total costs the amount of profit you want from each sale. Profit margin is expressed as a percentage, so if your product sells for $10 and you make $1 of profit with each sale, your margin is 10%. How much should your profit margin be? It depends on your industry, so find-out your industry average and find-out what your competitors’ margins are.
Don’t go too low
Be strategic when setting price. If your costs and profit margin are in your price, and your price is the lowest in the industry, charge it! But if you think lowering price to undercut the competition is a good idea, reasoning you will attract more customers who will offset the lower price, think again.
Having the industry’s lowest price certainly gives your business a competitive advantage, but it does you no good to price yourself out of the market. Laura Willett, small-business consultant and faculty member in the finance department at Bentley College in Waltham, Massachusetts, says, “Many businesses mistakenly underprice their products attempting to convince the consumer that their product is the least expensive alternative hoping to drive- up volume, [but] reducing prices to the point where you are giving away the product will not be in the firm’s best interest long-term.”
If your competitors’ prices are lower than yours, it is almost certain their costs are lower than yours, so they can afford to charge a lower price. Here is an example. Assume it costs you $5 to produce your product but $3 for your competitor to produce theirs. They can sell at $3, though they would make no profit, but you cannot. Taken a step further, they can sell at $4 or $5, make a profit, and still undercut your price. You could sell at $5 but you would simply break-even.
Profit is good
While most people have no problem lumping all their costs in their price, some people are uneasy about having too much profit in their price. You do not want an artificially-high profit margin because it raises your price and makes you less competitive, but if your profit margin is reasonable, plug it in and set your price. You are in business to make money, after all, so do not shy away from a healthy profit margin.
In addition, when you are faced with a financial challenge—industry sales could dip, for example—your profit margin becomes the umbrella that allows you to weather the storm.
The most-common misconception about price is that it, alone, drives sales. “The first thing you have to understand is the selling price is a function of your ability to sell and nothing else,” says Lawrence L. Steinmetz, co-author of How to Sell at Margins Higher Than Your Competitors: Winning Every Sale at Full Price, Rate, or Fee. Sales ability—not price—drives sales, so if your sales and marketing strategies are effective, and you have set the right price for your product or service, you have no reason to worry about competitors charging a lower price.
Marvin Carolina Jr. is a vice president for JE Dunn Construction. He can be reached at firstname.lastname@example.org.