Pricing

Intelligent pricing is one of the most important elements of any successful business venture. Yet many entrepreneurs fail to educate themselves adequately about various pricing components and strategies before launching a new business. Smart small business owners will weigh many marketplace factors before setting prices for their goods and services. As the Small Business Administration (SBA) indicated in The Facts About Pricing Your Products and Services, "you must understand your market, distribution costs, and competition. Remember, the marketplace responds rapidly to technological advances and international competition. You must keep abreast of the factors that affect pricing and be ready to adjust quickly."

Cost Factors and Pricing

There are three primary cost factors that need to be considered by small businesses when determining the prices that they charge for their goods or services. After all, price alone means little if it is not figured within the context of operating costs. A company may be able to command a hefty price for an item, only to find that the various costs of producing and delivering that item eliminate most or all of the profit that it realizes on the sale. It should also be noted that service businesses often find it more difficult to accurately gauge their costs, especially in the realm of employee hours. A freelance copyeditor may find that one 2,500-word article takes twice as long to complete as another article of the same size because of differences in quality that are often difficult to anticipate ahead of time.

LABOR COSTS. Labor costs consist of the cost of the work that goes into the manufacturing of a product or the execution of a service. Direct labor costs can be figured by multiplying the cost of labor per hour by the number of employee-hours required to complete the job. Business owners, however, need to keep in mind that the "cost of labor per hour" includes not only hourly wage or salary of the relevant employees, but also the costs of the fringe benefits that those workers receive. These fringe benefits can include social security, retirement benefits, insurance, unemployment compensation, workers compensation, and other benefits.

MATERIAL COSTS. Material costs are the costs of all materials that are part of the final product offered by the business. As with labor, this expense can apply to both goods and services. In the case of goods, material costs refer to the costs of the various components that make up a product, while material costs associated with services rendered typically include replacement parts, building parts, etc. A deck builder, for example, would include such items as lumber, nails, and sealer as material costs.

OVERHEAD COSTS. Overhead costs are costs that cannot be directly attributed to one particular product or service. Some business consultants simply refer to overhead costs as those business expenses that do not qualify as labor costs or material costs. These costs include indirect expenses such as general supplies, heating and lighting expenditures, depreciation, taxes, advertising, rental or leasing costs, transportation, employee discounts, damaged merchandise, business memberships, and insurance. A certain percentage of employees usually fit in this category as well. While the wages and benefits received by an assembly line worker involved in the production of a specific product might well qualify as a labor cost, the wages and benefits accrued by general support personnel—janitors, attorneys, accountants, clerks, human resource personnel, receptionists—are included as overhead.

Overhead expenses are typically divided into two categories—fixed expenses and variable expenses. Fixed expenses are regular (usually monthly) expenses that will not change much, regardless of a company's business fortunes. Examples of fixed expenses include rent, utilities, insurance, membership dues, subscriptions, accounting costs, and depreciation on fixed assets. Variable expenses are those expenses that undergo greater fluctuation, depending on variables such as time of year (for seasonal businesses), competitor advertising, and sales. Expenses that are more heavily predicated on company revenues and business owner strategies include office supplies, mailing and advertising, communications (telephone and Fax bills), and employee bonuses.

COST OF GOODS SOLD. One of the most important tools that accountants and entrepreneurs use to gauge the health of businesses is the "cost of goods sold." This figure is in essence the business's total cost of manufacturing the products it sells or—in the case of retail firms—its total expenditures to purchase products for resale. Delivery and freight charges are typically included within this equation. Cost of goods sold provides business owners with a rough measurement of their gross profit margin. The figure usually bears a close relationship to sales, but it may vary significantly if increases in the prices paid for merchandise cannot be offset by increases in sales prices, or if profit margins swell because of special purchase deals or sudden surges in product popularity.

Pricing Strategies

Small businesses have many different pricing strategies from which they can choose, but they need to select carefully. An ill-considered decision can place a heavy burden on the business.

MANUFACTURER'S SUGGESTED RETAIL PRICE. Many small businesses prefer to simply price their goods in accordance with the manufacturer's suggested retail price. They thus eliminate costs associated with making their own pricing decisions or pursuing more proactive pricing strategies. Critics note, however, that this strategy—such as it is—is utterly heedless of the competition, which may be able to offer a lower price for any number of reasons.

PRICE BUNDLING. This is the practice of giving the customers the option of buying several items or services for one price. A furniture retailer, for example, might offer customers a sofa and love seat combination at a price that is somewhat lower than what the two goods would cost if bought separately. Similarly, a landscaper might lure customers by offering two free months of lawn maintenance with any major landscaping job. Leonard Berry and Manjit Yadav noted in Sloan Management Review that bundling has several advantages, especially for service-oriented businesses: "The cost structure of most service companies is such that providing an additional service costs less than providing the second service alone…. A second benefit of bundling that appeals to customers is purchasing related services from one service provider. They can save time and money by interacting with an paying one provider rather than multiple providers. Third, bundling effectively increases the number of connections a service company has with its customers."

MULTIPLE PRICING. Similar to price bundling, multiple pricing is the practice of selling multiple units of an item for a single price. A grocery store that offers two boxes of macaroni and cheese at a single price, for instance, is engaged in multiple pricing. Whereas price bundling is more commonly employed for big-ticket items, multiple pricing is usually used to sell inexpensive consumable items such as razor blades, shampoo, household cleaning products, and food and beverages.

COST-PLUS PRICING. This methodology, popular with manufacturers, involves adding together all labor, material, and overhead costs (the "cost") and then adding the desired profit (the "plus").

COMPETITIVE PRICING. Some small business owners choose to base their own prices on the prices of their principal competitors. Business owners who choose to follow this course, however, should make sure that they look at competing businesses of similar size and strength. "It's very chancy to compete with a large store's prices," noted the SBA's The Facts About Pricing Your Products and Services, "because they can buy in larger volume and their cost per unit will be less. Instead, price products based on your local small-store analysis, then highlight other competitive factors, like personalized customer service and convenient location." Competitive pricing among service-oriented businesses, meanwhile, is a hazier proposition, since the nature and quality of services offered can vary so widely from business to business. Still, it is often employed, if only as a general pricing guideline.

PRICING ABOVE COMPETITION. If a business is operating in a community in which low prices are most customers' primary concern, then this pricing strategy is obviously doomed to failure. In settings in which price is not the customer's most important consideration, however, some small businesses can do quite well employing this strategy. The key to making "pricing above competition" work, say experts, is to provide customers with added benefits that justify paying the higher price. These benefits can take the form of: 1) convenient or exclusive location; 2) social status; 3) exclusive merchandise; and 4) high level of service. The latter can take the form of home or office delivery of goods, service and/or product knowledge, speed of service, attractive return policies, and friendly atmosphere.

Some business owners also boost prices in markets that have few competitors, reasoning that the community has little choice but to buy from their businesses. Such prices rarely reach outrageous levels, but they can become sufficiently high that enterprising entrepreneurs will recognize an opportunity to undercut the business with more inexpensively priced goods or services.

PRICING BELOW COMPETITION. Pricing below competition is the practice of setting one's prices below those of its competitors. Commonly employed by major discount chains such as Wal-Mart—which can do so because its purchasing power enables it to save on its costs per unit—this strategy can also be effectively used by smaller businesses in some instances (though not when competing directly with Wal-Mart and its ilk), provided they keep their operating costs down and do not spark a price war. Indeed, the smaller profit margins associated with this pricing strategy make it a practical necessity for participating companies to: exercise tight control over inventory; keep labor costs down; keep major operational expenses such as facility leases and equipment rental under control; obtain good prices from suppliers; and make effective use of its pricing strategy in all advertising.

PRICE LINING. Companies that engage in this practice are basically hoping to attract a specific segment of the community by only carrying products within a specified price range. This strategy is often employed by businesses whose goods/services or location are likely to attract upscale buyers, though others use it as well. Advantages sometimes accrued through price lining practices include: reduced inventory and storage costs, ease of merchandise selection, and enhanced status. Analysts note, however, that this strategy frequently limits the company's freedom to react to competitors' pricing strategies, and that it can leave businesses particularly vulnerable to economic trends.

ODD PRICING. Odd pricing is used in nearly all segments of the business world today. It is the practice of pricing goods and services at prices such as $9.95 (rather than $10) or $79.99 (rather than $80) because of the conviction that consumers will often round the price down rather than up when weighing whether to make a purchase. This little morsel of pricing psychology has become so universally employed that many observers question its value; still, the practice remains widespread across the United States (and elsewhere).

Other commonly used pricing policies include penetration pricing and skimming pricing (for manufacturers) and loss leader pricing (for retailers).

Factors in Arriving At a Pricing Strategy

Entrepreneurs encounter numerous considerations that should be weighed when assigning a price to their goods or services. These considerations range from the needs and desires of target consumers to general economic conditions. The SBA cited the following factors as among the most important to consider when arriving at a pricing strategy.

• Is the price of the good or service of significant importance to target consumers?
• How popular is the product or service being offered?
• What pricing and marketing strategies are compatible with the business's other characteristics (location, service reputation, promotions, etc.)
• Does the owner enjoy final pricing authority?
• Are there opportunities for special market promotions?
• What are competitors charging for similar goods or services?
• Should competitors' temporary price reductions be matched?
• What level of markup can be achieved for each product line or area of service?
• Will prices generate a satisfactory profit margin after calculating operating expenses and reductions?
• When reducing prices on goods or services, do you consider competitors' likely reactions?
• Are there legal factors to consider when establishing price?
• Should "odd pricing" or "multiple pricing" practices be introduced?
• Should marketing efforts highlight sales of selected high-profile products to attract customers?
• If coupons and other discount measures are offered, how will they impact on net profits?
• Will characteristics of the product sold (handling costs, installation requirements, alterations, etc.) meaningfully add to operating costs?
• Will product quantities be unduly reduced as a result of spoilage, breakage, employee theft, or shoplifting?
• Will services such as home/office delivery, gift wrapping, etc. be included in the purchase price?
• Are economic conditions in area of operation particularly good or bad?
• Will employees receive discounts on store items that they purchase?
• Will senior citizens or students receive discounts on goods or services?
• What markdown policies are in place?

Revisiting Pricing Strategies

Since pricing is one of the single most important factors in determining whether a business will be successful, small business owners should continuously review their pricing policies to make certain that they remain in keeping with marketplace realities. Business environments can change quickly, and the successful entrepreneur will learn to change his or her pricing strategies accordingly. William Cohen, author of The Entrepreneur and Small-Business Problem Solver, described six different circumstances in which small business owners should review their pricing and make changes if necessary: 1) when introducing a new product or product line; 2) when testing for the best price; 3) when attempting to break into a new market;4) when competitors change their prices; 5) when general economic conditions become inflationary or recessionary; 6) when weighing major changes in sales strategy. Indeed, any significant change in any aspect of a business's operations—from rising costs of raw materials to changing insurance premiums—should spark a review of company pricing strategies.

Real Price and Nominal Price

Economists, business owners, and other people engaged in the world of commerce have long recognized that historical events can help business owners evaluate current business plans and propose future strategies, including pricing strategies. Indeed, as Robert Pindyck and Daniel Rubinfeld observed in Microeconomics, "we often want to compare the price of a good today with what it was in the past or is likely to be in the future." Such comparisons are meaningless, however, unless those prices are measured "relative to the overall price level. In absolute terms, the price of a dozen eggs is many times higher today than it was 50 years ago, but relative to prices overall, it is actually lower. Therefore, we must be careful to correct for inflation when comparing prices across time. This means measuring prices in real rather than nominal terms." Pindyck and Rubinfeld go on to define the nominal price of a good (its "current dollar" price) as its absolute price, noting that the nominal price of a quart of milk was 40 cents in 1970 and about 80 cents in 1990. The real price, however, is defined as the price relative to an aggregate measure of prices (usually the Consumer Price Index-CPI). Percentage changes in the CPI measure the rate of inflation in the economy.

Raising Prices

Small business owners are often reluctant to raise prices once a good baseline price has been established. They worry that a price increase will alienate customers and drive them to the competition. "Faced with such resistance, a lot of businesspeople are tempted to forgo price increases altogether, or at least put them off for as long as possible. If you do either one, however, you're making a big mistake," Norm Brodsky wrote in Inc. "Your profit margins will be shrinking…. You're gradually undermining the perceived value of your services or products." Brodsky noted that many of a small business's costs—such as payroll, insurance, and utilities—tend to rise every year, slowly cutting into profit margins. In addition, customers tend to associate price with quality. A business that does not increase prices to keep up with the competition risks being regarded as the cheap alternative in the marketplace.

When price increases are implemented gradually and cautiously, small businesses may be able to keep their customers happy while also keeping their profit margins intact. After all, as Harry J. Plack wrote in the Baltimore Business Journal, customers typically base their purchase decisions on more than just price. Other factors influencing the decision process include quality, features, guarantees, and personal desires. In addition, people will always pay more for good, reliable customer service. In order to make an effective price increase, Howard Scott of Nation's Business recommended conveying the reasons for the increase to customers and giving them a perceived increase in value for their money. "The message for companies is clear," Scott wrote. "Those that differentiate their products from the competition's and are able to articulate that difference to customers are more likely to be able to raise prices—and keep them raised—above the competition's."

Surviving Competitors' Discount Pricing Strategies

Major discount stores such as Wal-Mart, Sam's Club, Target, K-Mart, Office Depot, Staples, Best Buy, and Circuit City have gained control of large blocs of the American business world over the last several years on the strength of their one-stop shopping and discount prices, the latter a result of their ability to buy goods at bulk rates. Many small business owners have felt the impact of these stores—indeed, cautionary tales concerning the impact that such stores can have on formerly vibrant downtown shopping areas have proliferated in recent years.

Many observers believe, however, that some small business failures that occurred in the wake of these titans' arrivals could have been avoided if small business owners had adopted different strategies to deal with the new competitive environment in which they were operating. Indeed, economists and business analysts agree that most small businesses cannot compete with large chains in the area of price; the bulk-rate buying power advantage that the big stores enjoy is simply too great to overcome. But they contend that many small businesses can still co-exist with these titans if their owners outmaneuver the big stores in other areas. Effective strategies that can be used to help negate the discount pricing strategy employed at the big chains include:

• Emphasize value and personal service rather than price
• Offer attractive ancillary services (home and office delivery, generous return policies, etc.)
• Define your market segment or niche and devote energies accordingly
• Control inventory
• Streamline to eliminate less profitable areas of business
• Target advertising and promotions to reach the most likely customers
• Steer customers to the most profitable aspects of your business
• Establish your business's industry knowledge as an additional resource for customers
• Build strong relationships with vendors
• Meet or beat prices of big discounters on selected lead items or services
• Make intelligent use of price strategies such as price bundling.

Of course, pricing remains a very big component in determining a company's success or failure. "The key to success," concluded the SBA in its Pricing Your Products brochure, "is to have a well-planned strategy and established policies and to constantly monitor prices and operating costs to ensure a profit." Finally, the SBA cautioned entrepreneurs to "remember that the image of your business is crucial to obtaining and keeping the clientele and that your pricing structure and policies are a major component of your image."

Further Reading:

Brodsky, Norm. "Street Smarts: Raising Prices." Inc. May 2000.

"Case Study: How to Price Your Products to Increase Profits." Business Owner. May-June 1995.

Cohen, William A. The Entrepreneur and Small-Business Problem Solver. 2d ed. Wiley, 1990.

"The Delicate Art of Price Hikes." Business Week. November 6, 2000.

The Facts About Pricing Your Products and Services. Small Business Administration, 1996.

Marn, M.V., and R.L. Rosiello. "Managing Price, Gaining Profit." Harvard Business Review. September-October 1992.

Meyer, Peter. "Is the Price Right?" Across the Board. July 2000.

Pindyck, Robert S., and Daniel L. Rubinfeld. Microeconomics. 2d ed. Macmillan, 1992.

Plack, Harry J. "Price Hikes Not Always a Bad Thing." Baltimore Business Journal. July 14, 2000.

"The Power of Smart Pricing." Business Week. April 10, 2000.

Pricing Your Products. Small Business Administration, n.a.

Scott, Howard. "The Tricky Art of Raising Prices." Nation's Business. February 1999.

Walker, Bruce J. A Pricing Checklist for Small Retailers. Small Business Administration, n.a.

Winninger, Thomas J. Price Wars: How to Win the Battle for Your Customer. St. Thomas Press, 1994.

See also: Loss Leader Pricing; Penetration Pricing