Finding the right selling price for your products is a delicate process with many moving parts. Here are some tips to help you better understand that process.
Regardless of the product or service, every company must have the best pricing strategy suited for their business. With a lousy pricing model, even the best companies can find themselves in a difficult position financially. And even worse, the wrong pricing strategy could cause a company to fail.
To adopt a pricing strategy that works, companies must take measures of several factors. These include:
- The industry in which they compete
- The type of business conducted (manufacturing, service, blended, etc.)
- The competition
- The mode of production (make to order (MTO), make to stock (MTS), assemble to order (ATO), etc.
- Size of the enterprise (small, medium, large, startup)
These considerations, and others, will inform a company of the pricing method that is best suited for them.
What is a Selling Price?
For any good or service, the selling price is the amount the company charges its customer. But it is also more than that. It is also a tool with which companies enter new markets or remain competitive in existing markets.
The selling price calculates the cost of goods sold (COGS) and the costs incurred in sales, marketing, and R&D, plus other indirect costs. In addition to this number, the company must also settle on the amount above the cost to achieve a desired level of profit.
The selling price may not be a static number. It may fluctuate based on seasonality, spikes or drops in demand, and direct pressure from larger and smaller competitors. Not all goods sell through the same distribution channels. Some manufacturers sell direct as well as to retailers and wholesalers. Because of this, consumers may find the same product, or close versions, at different prices.
One example would be name-brand high-end sneakers, sold directly from the parent company to consumers. However, the identical shoe may sell for several percent less at online retailers, a few percentage points higher at brick-and-mortar retailers, and fluctuate during holidays.
The selling price may also be affected by the product lifecycle. Examples would be consumer electronics or appliances that start at a high sales price before migrating to a stable continuing price through the entirety of that product’s lifecycle.
These examples indicate that prices may vary within specific classes of goods, such as those mentioned above. Thus, many companies track the average sales price to capture these fluctuations and ensure that sales on average remain at a level that maintains profitability. In this way, the average sales price indicates pricing for an entire class or line of products.
Calculating the Selling Price
Just as pricing fluctuates across classes of goods, it is also different from industry to industry. Commodified goods often operate using fractions of a penny in their costing and sell at shallow margins. They do this because the product is mass-produced so efficiently that it is easier to measure it in kilograms, liters, tons, etc., than in “each.” Other industries produce high-end make-to-order (MTO) or engineer-to-order (ETO) goods that are high-end or complex in design and command a higher price per individual unit.
Because of this, they would employ different pricing formulas to reach their profit target. How a manufacturer calculates the pricing formula for their products will depend on this and many other factors. And it may even vary within industry depending on enterprise-scale, location, or cost of raw material.
Selling Price formulas
There are many different pricing calculations available for manufacturers. Here is a look at the most common and how they apply to specific product types.
1. Cost Plus Pricing – Cost-plus pricing is also referred to as markup or markup pricing. Cost-plus is one of the most common methods for price calculation and is also the simplest. In cost-plus pricing, a company adds all costs associated with producing units and then adds the desired profit margin on top. It includes all direct costs like labor and materials and indirect labor, overhead costs, and any fixed costs such as rent, etc.
Example: In a textile company, a manufacturer of towels produced by the pound would add raw materials such as cotton and dye; direct labor for weaving, spinning, and dying; indirect labor for warehousing, scheduling and management and other associated variable costs such as equipment cost, rent, utilizes, etc. to determine that the cost per pound of towels is $2.50. If the producer is in a tight market with many other commodified competitors, they may settle for a 4% margin for a sale price of $2.60 because they have orders for several million pounds.
2. Planned Profit Pricing – Planned profit pricing is a more complex form of cost-plus pricing. It leverages explicitly the power of volume purchasing for raw materials for the manufacturer against volume orders from customers to ensure total profit given specific volumes. To determine the planned profit price, a company will first conduct a break-even analysis. This analysis determines the number of units that should sell at each volume level to cover the direct and overhead costs. In this way, lower volume orders will have higher prices than those for higher volume from, say, big-box retailers.
Example: A company producing plexiglass office desk shields that protect against COVID-19 may conduct an analysis that shows that one unit’s cost through full production is $50.00. With a 20% markup, the sale price would be $60.00. However, because the company also gets a volume discount on raw plexiglass and increased operational efficiency of mass cut pieces, the analysis finds that on orders of 20 plus, the cost is $35.00. The markup of 20% then yields a price of $42.00 per shield. Both pricing tiers deliver the same margin by utilizing the volume break in raw materials’ direct cost.
3. Whatever the Market Will Bear – This pricing calculation, also referred to as WTMWB, relies on a couple of critical points for sales. In one case, there may be no competition or the competition may be scarce. On the other, the demand or brand reputation may have such a lure to consumers that the company can charge much higher prices than other goods classes. The strategy is tempered by an understanding that aiming too high may encourage competition to enter the space at much lower pricing to “buy the business” and shift market share away. However, many products are so sought after that consumers are willing to bear the burden of higher prices.
Example: In early 2021, because so many people seek to be outdoors to escape lockdowns while still socially distancing and protecting themselves against COVID-19, snowmobile companies are sold out for the year across all product lines. The market will bear price increases, and long waits as the value is perceived as overriding the price.
4. Gross Profit Margin Target (GPMT) – Few numbers are as scrutinized in any company as the gross profit margin. Defined as the sales revenue percentage left after subtracting the cost of sales and production, the gross profit margin can be used to find the best sales price to maintain that margin. It is a good strategy for a company that carries several classes of different products and seeks to hold a specific margin across each category or class.
Example: A small appliance company may produce specialty microwaves, coffee makers, fryers, and other kitchen appliances. Because they desire to compete in the kitchen appliance space, they may seek to hold a 30% margin on all devices.
5. Most Significant Digit Pricing – Also known as “psychological” pricing, most significant digit pricing relies on the way people’s brains process numbers to perceive value. This is often seen in the use of the number “9”, where a product may advertise at $12.99 instead of $13.00 because people perceive it to be cheaper.
Example: A bakery sells cakes for $14.00 each. By marking the price as $13.99, shoppers perceive the cost to be $13.00 and buy the cakes faster than those marked $14.00.
Finding the right balance
Pricing is at heart a strategy used to generate the highest sales and the most significant margin for each product. Companies must cover fixed, variable, overhead, and other costs to maintain profitability regardless of the cost. However, there are many factors in play, and they vary from industry to industry and product to product.
No strategy can outrun what a buyer is willing to pay. Suppose costs dictate that a product sells at a specific price, and the consumer isn’t ready to pay. To address this, the company will need to improve efficiency, reduce cost, renegotiate raw material or find some other way to close the margin gap.
The same is true for what the seller is willing to accept. In the age of online shopping and significantly discounted merchandise, many manufacturers may find it difficult to produce goods at the retailer’s price. In these cases, the producer, or seller, may need to seek other channels for distribution.
What matters is what is competitive in the market. If five major producers sell a class of goods at or near the same average price, it makes no sense for new market entrants to price at double that average. Likewise, if new entrants come in too low, they may find themselves losing money during heavy holiday season buying when everyone is “expected” to lower prices.
Finding the right selling price is more than just a number. It is a strategic and well-thought-out calculation taking many variables into account to arrive at an optimal number.
- The selling price is what a company charges its customers for a product or service.
- Regardless of what is being sold, every company needs to have a well-thought-out pricing strategy.
- When finding the right selling price for their products, companies have to account for their business expenses including both direct and indirect costs. They also need to consider their industry specifics, the type of business conducted, the competition, the mode of production, the size of the company, etc.
- The selling price may also vary seasonally, in different sales channels, or throughout the product’s lifecycle.
- There are several ways to calculate a product’s selling price, some of which are: Cost Plus Pricing, Planned Profit Pricing, Whatever the Market Will Bear, Gross Profit Margin Target (GPMT), and Most Significant Digit Pricing.
- Whichever pricing strategy is implemented, a company cannot outrun what the customer is ready to pay. Instead of asking the buyer to cover the expenses, sometimes companies need to improve their processes and cut costs to instead reduce the price of their products.
- Conversely, sometimes companies cannot accept the terms retailers set and have to seek other channels to sell their product, such as Direct-to-Consumer (D2C).
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