Enterprise behavior: How to price a product profitably

April 17, 2018

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Pricing products is one of the single biggest challenges of a small business owner. There’s plenty of math involved, but there’s also a need for anticipating customer’s emotional responses to price. This issue is so complex that many product verticals regularly provide Manufacturer’s Suggested Retail Pricing (MSRP) to guide merchants on a pricing strategy.

This post examines the most common models for calculating retail prices, namely Cost Plus Pricing, Demand Pricing, and Competitive Pricing.

Read on to learn how to make these calculations, and what the numbers can tell you about your pricing plans. Before diving into the three pricing models, let’s start by defining two key concepts: cost versus expense. These are both cornerstone numbers for any pricing model calculation.

1. Cost

What it tells you: Cost, in this context, means the amount of money it takes to have the product for sale. This includes materials, manufacturing, and any shipment charges.

If we imagine a store that sells customized widgets, there will be three factors in calculating the cost per widget.

Materials: $18.00
Shipment: $1.50
Customization: $7.00

Cost = Materials + Shipment + Customization
Cost = $18.00 + $1.50 + $7.00 = $26.50 per widget

How to use it: It’s crucial to know your hard costs when you plan your pricing. Regardless of which pricing model you employ, you need to be exceedingly clear on your product cost.

2. Expense

What it tells you: Expenses include all the other costs of you running a business that allows you to sell your customized widgets. This includes (but is not limited to) rent and utilities for retail or workshop space; equipment required to customize the widgets; delivery fees for mail orders; financing costs (like interest on a small business loan); employee wages; et cetera.

But that’s not all. Also important to factor in are employee discounts offered, marketing budget, insurance costs, and the cost of damaged or unsold merchandise. These are all factors that can sap your bank account without necessarily translating to revenue. This may be your most difficult calculation in the pricing process, but take your time and do it properly.

It can be a bit tricky to calculate expenses per widget, but you need to have that information. Think conservatively about how many widgets you think you’re going to sell in a given month. Then divide the total expenses by the number of widgets.

Rent: $1350
Utilities: $245
Equipment: $87
Financing: $58
Wages: $9,500
Damaged goods: $53
Marketing: $350
Insurance: $210
TOTAL: $11,853

Number of widgets sold in a month: 495

Expense = Sum of expenses per month ÷ Number of widgets sold per month
Expense = $11,853 ÷ 495 = $23.95 per widget

How to use it: A lot of people refer to selling product “at cost,” but they don’t always factor in the expenses a business incurs to keep the lights on and the doors open in a business. If you sell a product for less than the sum of cost and expense, you will be operating at a loss.

3. Cost Plus pricing

What it tells you: Nobody starts a business with the hope of breaking even, so building profit into your pricing model is a very important step. The Cost Plus pricing model adds either a percentage or a flat figure profit to the cost and expenses of a widget to determine the price.

Price = [Cost + Expense] + Profit
Price = [$26.50 + $23.95] + Profit = $50.45 + Profit
Price = $50.45 + $10.09 (20% profit) = $60.54

How to use it: Calculating a Cost Plus price allows you to plan for financial success, but also creates a buffer if your sales are slightly lower in volume than expected. A 20% profit might be a wonderful goal, but perhaps in some months that figure is lower. You can offer coupons at this price and still be protected from losing money on your transactions.

4. Demand pricing

What it tells you: Moving away from the Cost Plus pricing model, demand pricing is best for unique goods and services with limited availability on the market. This is particularly useful for pricing things like haircuts or spa services. (If you notice a particular employee is always booked up in advance, try raising the price per service).

In the case of our widgets, let’s say your customizations separate them from other widgets on the market. Sales go from the anticipated 495 units per month to over 700 per month, and you’re having trouble keeping up with production. Try increasing the price to see what the market will sustain. If people are happy paying $75 for your customized widgets, let them!

Let’s calculate the new profit assuming you sell 495 units at $80 (it’ll be higher if you sell more).

Profit = Price – [Cost + Expense] Profit = $75 – $50.45 = $24.55

Percent Profit = Profit ÷ [Cost + Expense] = $24.55 ÷ $50.45 = 49%

How to use it: Demand pricing can be very sensitive, but if you notice that you can’t keep up with demand for your product, you may be undercharging. Try raising things incrementally and observing how sales numbers and profits are affected. You should definitely use Clover Insights to help analyze your data and track performance when calculating demand pricing.

5. Competitive Pricing

What it tells you: Competitive pricing is key when other retails or service providers offer the same wares as you. If you are offering similar products, it’s important to stay in a similar price range. However, if you are offering a higher-end product, pricing should reflect that. The same is true if you are offering a lower-cost alternative to a similar product.

There are no special calculations for competitive pricing, but you need to use your cost and expense information to make sure you stay within healthy margins. Your research should encompass both the theoretical and practical. Start by searching for “profit margins for [your business type]” to find reputable sources like these posts on profit margins for bar inventory and profit margins for coffee shops. On the practical side, go shopping in your neighborhood. What do your local competitors charge for products similar to yours? What factors might explain any variance?

How to use it: Often times competitive pricing leads to lower sales prices at higher volumes. When you want to maximize your profit, it’s important to keep your cost and expenses as low as possible. To that end, you can use your calculations along with research on your competitors to try to negotiate better deals with your suppliers, landlord, etc. Just make sure you don’t let yourself get so caught up in competition that you lose track of your own profitability.

No matter how you look at it, pricing is a complicated issue. But if you work carefully and observe the effects of your decisions on your bottom line, you’ll learn a lot. A little bit of math goes a long way.

Want to deepen your knowledge and understanding on this topic? Fill out this worksheet to put these ideas to practical use.

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