Not strictly objective
The most common pricing method, cost-plus pricing, considers the cost of materials, labor and overhead (which includes such items as rent, utilities, insurance, depreciation and advertising) and takes that number to determine a net profit margin. Your target margin should provide you with a fair rate of return and good value for your customer. Depending on the industry, this could be anything from 2% to 20% (though single-digit margins are more typical).
Your competitors' prices provide another benchmark. But don't automatically assume that, if you charge less than competitors, customers will choose your products. When it comes to pricing, perception of value is critical.
Customer relations
Indeed, actual production costs and target profit margins mean nothing if customers perceive your company's machine parts as cheaply made or your clothing as unstylish. Even if you charge less per hour than the personal fitness trainer a few blocks over, people might happily pay a premium for his services if they believe he gets better results. Effective branding and marketing can help customers understand why your product or service is worth the price you're asking.
But you also need to listen to what your customers tell you, because the definition of "value" varies according to industry, product niche — even ZIP code. Those who shop at a discount furniture store, for example, may value low prices over cutting-edge design. Meanwhile, customers of a wholesale organic produce supplier may be willing to pay a higher-than-market rate if they're guaranteed the freshest vegetables.
Finally, consider location and convenience. Customers may be willing to pay $5 for a soft drink at a movie theater or ballpark, but would balk at that price in the supermarket.
Review and revise
It may take some tinkering, but eventually you should arrive at prices that meet your target profit margin and reflect the market's perceived value. Don't get too comfortable. What works on paper may flop with actual customers.
If you're constantly offering sales and promotions to move units, your prices are probably too high. If your primary competitor recently increased prices by 10%, it may be safe to do the same and still retain customers. Pricing is a constant work in progress. To win the game, you need to keep your eye on the ball at all times. •
Other articles in the June 2012 Edition of Business Matters: