Q: How
do I figure out what to charge for my products?
A:
Pricing products is something every businessperson thinks about.
You don't want to price yourself out of the market, but at the
same time you want to provide sufficient margin to cover overhead
and generate a profit. Therefore, in pricing your products you must
consider these two factors: what the market will bear and your
profit margins. These factors apply to pricing both products and
services.
To find out what the market will bear, ask yourself this
question: Is my product or service unique? If it is--meaning
there's little in the way of direct and indirect
competition--then you're a market leader and you have more
leeway in setting the prices.
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Just because your product is unique, however, doesn't mean
you can charge very high prices. When you have a unique product and
you set your prices high, your customers can still pick an
alternative product or not buy at all. In addition, your high
margins may give incentives to competitors to copy your product and
then undercut your price. Take, for example, Apple Computer: The
product was unique, the company charged very high prices and it was
the market leader. Of course there were other factors that led to
Apple losing market share, but one factor was that new entrants
like Dell and Compaq offered alternative products at better
prices.
You can be a market leader if you sell a product that is not
necessarily unique, but where you are the only available outlet for
that product. If you've ever been on a cruise ship and visited
the on-board convenience store, you know what I mean.
If you are a market follower--meaning your product is not
necessarily unique and you're not the only outlet--then setting
prices is easy. Your prices simply can't be higher than that of
your closest competitor. The question you should then ask is this:
Should I be selling this product? The answer lies in your profit
margin for this product.
There are three different profit margin calculations one should
consider: direct costs margin, break-even pricing and profit
pricing.
The direct costs margin is the margin generated after paying for
costs that are directly associated with the product or service
being sold. Examples include costs of sales, commissions and so on.
The formulas for direct costs margin and direct costs margin
percent are:
direct costs margin = sales price - total direct
costs
direct costs margin % = direct costs margins / sales price x
100%
You can also use the direct cost margin percent to calculate the
break-even volume as follows:
break-even volume = (fixed costs / direct cost margin %) /
selling price
You must at least cover direct costs to continue carrying the
product. You may accept a price that is greater that direct costs
in the short-term (such as a slow month). Over the long term,
however, you must also cover your fixed costs and generate a
profit--otherwise, you're just trading dollars.
Fixed costs are costs that do not fluctuate with sales volume
like rent, depreciation, administrative employees and so on.
Break-even pricing is related to the break-even point, but instead
of having the volume as the variable, selling price is the variable
as follows:
break-even price = direct costs / unit + fixed costs /
volume
Setting the price at the break-even price will give you a profit
of 0. If you're at least getting the break-even price, at least
you're not losing money on the sale. However, all that work and
investment still won't pay off. Which brings us to profit
pricing, which is calculated as follows:
profit price = direct costs / unit + (fixed costs + desired
profit) / volume
So now you have a price that will make you a profit. Ask
yourself this: Can I sell my products and services at this price
and still be competitive? If the answer is no, then you have two
alternatives: lower your direct costs, fixed costs or desired
profit, or consider not selling this product and focus your
attention instead on products that have a better profit margin or
less competition.
Ian Benoliel is the CEO of NumberCruncher.com Inc., a
developer of budgeting, manufacturing and management software for
entrepreneurial businesses. NumberCruncher combines its accounting
and finance expertise with technological know-how to deliver
software that is affordable and easy to use, yet sophisticated and
powerful. More information on the NumberCruncher's products and
services is available at www.numbercruncher.com. Ian has nearly two
decades of business, accounting and financial consulting
experience. He has advised corporations on business plans,
financial projections and accounting computer systems.
The opinions expressed in this column are those
of the author, not of Entrepreneur.com. All answers are intended to
be general in nature, without regard to specific geographical areas
or circumstances, and should only be relied upon after consulting
an appropriate expert, such as an attorney or
accountant.