Products & Services
How to Determine the price of Your Products
In this article we will talk about a few different pricing strategies that are commonly used to determine pricing for your products.
Markup Strategy
There are several strategies to consider when setting prices. Each strategy has advantages and disadvantages, and they are based on different theories about consumer purchasing behavior. The strategies you will learn about are cost-plus markup, value-based pricing, premium pricing, price skimming, and penetration pricing. You will also learn the concepts of psychological pricing and the perceived price/quality relationship.
The difference between the cost to produce a good or service and its selling price is called markup. It reflects the amount of profit made by selling the item.
Cost-Plus Markup
Cost-plus markup is a business strategy that entails determining the costs to purchase or produce a product, and then adding on an amount of profit to reach the final consumer price. Cost-plus markup is an easy and common way to set prices.
Fixed Amount
The easiest method for determining markup is the fixed amount method. For example, you may decide that you want to make $200 on every item that you sell. In this scenario, a product that costs you $700 to produce will be priced at $900 ($700 + $200), and a product that costs you $300 to produce will be priced at $500 ($300 + $200). This method of markup is not always effective because it ignores customer preferences and perceptions.
Percentage
Another way to determine markup is to use a percentage. Percentage markup is almost as easy to calculate as fixed amount markup, but it is much more effective because the markup is proportionate to the cost of the item. For example, if you choose to implement a 50% markup, then a product that costs you $300 to produce will be priced at $450 ($300 + $150). If you choose a 200% markup, the same product will be priced at $900 ($300 + $600).
A common percentage markup in retail is 100%; this is called “keystone” markup. With keystone markup you simply double the cost amount. Using this method, the product that costs you $300 to produce will be priced at $600 ($300 + $300).
Although the percentage markup strategy does not directly take customer preferences into account, the common markup rates usually fall within customer preferences.
Value Base Pricing
Value based pricing is an alternative to cost-plus markup, and can be a more helpful and effective form of pricing because it takes customer preferences directly into account. In this method, you obtain information from potential customers about the price they would be willing to pay for your product. Then you analyze their answers to determine the optimal price.
The Price Sensitivity Meter (PSM)
The PSM is one method for determining the highest and the lowest prices you should charge for your product. This is done by gathering information from potential customers. You should ask the following questions of at least 30 potential customers. The more people you ask, the more accurate your results will be.
Questions
Q1—Too Cheap: At what price would you consider this product/service to be priced so low that the quality must be poor?
Q2—A Bargain: At what price would you consider this product/service to be a bargain or a great deal?
Q3—Getting Expensive: At what price would you consider this product/service to be getting expensive, but you would still purchase it?
Q4—Too Expensive: At what price would you consider the product/service to be so expensive that you would not even consider purchasing it?
Analysis
After you collect your customers’ answers, you can analyze the information to determine the most appropriate price for your product. First, organize the information so that you know how many customers will pay what price. This can be done by sorting the answers to the above questions into a chart like the one below. In this example, 5 customers answered that they would consider the item to be too cheap at $3.00.
| Price | Too Cheap | A Bargain | Getting Expensive | Too Expensive |
| $3.00 | 5 | 4 | 0 | 0 |
| $3.50 | 4 | 4 | 0 | 0 |
| $4.00 | 4 | 3 | 0 | 0 |
| $4.50 | 3 | 3 | 1 | 0 |
| $5.00 | 3 | 3 | 1 | 1 |
| $5.50 | 2 | 2 | 2 | 1 |
| $6.00 | 2 | 2 | 2 | 2 |
| $6.50 | 1 | 2 | 2 | 2 |
| $7.00 | 1 | 1 | 3 | 3 |
| $7.50 | 0 | 1 | 3 | 3 |
| $8.00 | 0 | 0 | 3 | 4 |
| $8.50 | 0 | 0 | 4 | 4 |
| $9.00 | 0 | 0 | 4 | 5 |
Next create two graphs, either on a computer or on paper. The x-axis (the horizontal line) for each graph is the dollar amount that your customers said they would pay. The y-axis (the vertical line) is the number of people that would pay that price. Your graphs will look something like this:
On the first graph you will plot the information for questions 1 and 2 (“Too Cheap” and “A Bargain”). The “Too Cheap” data will be plotted exactly as it appears in your table, for example, 5 customers said they would consider the item to be too cheap if it were priced at $3.00 so you will draw a point at the intersection of 5 customers and $3.00. Plot all the data points and then connect the dots. The “Too Cheap” answers are represented by the blue line on the following chart.
The question 2 information must be inverted before you plot it on the chart. In our example, the largest number of customers in the “Too Cheap” column is 5; therefore we will normalize the data to a common scale by subtracting each of the numbers in the “A Bargain” column from 5. That is, the first number in the “A Bargain” column is 4 so we will subtract 4 from 5 and plot a 1 on the $3.00 line. Continue down the “A Bargain” column, subtracting each number from 5 and plotting it on the chart. The result is the red line shown on the chart below.
The intersection of the two lines indicates the lowest price that you should charge. In this example, the lowest price you should charge is about $5.25.
The second graph will contain the data for questions 3 and 4 (“Getting Expensive” and “Too Expensive”). As with the previous chart, one set of data points must be inverted. Plot the “Too Expensive” data as is, and invert the data in the “Getting Expensive” column, following the steps from the previous chart. The resulting graph shows the highest price that you should charge.
A third graph can be made that compares the data from columns 1 and 4 (“Too Cheap” and “Too Expensive”). Do not invert either data set. The intersection of these two lines is the estimated optimal price for your product, or the price at which you are most likely to have the greatest number of customers. It looks something like this.
In this example, the optimal price for the product is $6.00.
By looking at the three charts from this example, you can see that the price charged for this item should be somewhere between $5.25 and $6.75, and that more customers will purchase it as the price gets closer to $6.00. As you adjust your price closer to either the highest or the lowest price, you will likely lose some customers. It may be the case, however, that you can bring in more profit by charging a higher price and losing a few customers; you will have to make that determination.
Mixing Value Based Pricing and Cost-Markup
Value based pricing works especially well if a business offers only a few products or services. A business that offers many products, such as a grocery store, would find it impractical to survey customers about every one of their products. If you will offer many products, you may wish to use an approach that combines value based pricing with cost-markup. In this approach, you analyze customer responses for a few products and use that information to determine a percentage markup for the rest of your products.
For example, let’s say that a produce stand can procure apples for $0.50 per pound. The owner uses PSM and determines that the optimal price at which to sell apples is $1.30 per pound. This means that the apples will be marked up 163% ($1.30 / ($1.30 – $0.50)). The produce stand might then decide to try out a 163% markup on all produce.
