Pricing a Product - Explained
How to Price a Product
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Table of ContentsWhat is Product Pricing?Pricing for FeasibilityPricing MethodsOther Factors in the Pricing Process
What is Product Pricing?
Product pricing hinges upon the concept of customer value. That is, what is the value of your product or service to customers in the market? Value is a relative to word to the entrepreneur and his or her intended audience.
The entrepreneur will recognize an idea as an opportunity when the idea has the potential to create the type and level of value desired.
Value could be measured in money, social impact, importance or prestige, etc. Likewise, the prospective customer or client will evaluate the entrepreneurs value offering (product or service) and subconsciously make a determination as to whether the value the client or customer receives from the product or service is worth the value required.
Typically the required value from the customer is money or the price of the good - though value can also take other forms. A customer may be willing to pay a certain amount for a product but is not willing to do what is necessary to travel to a given location to physically purchase the product (travel), to put the product together (IKEA), to use the product on an electronic device (Kindle book), etc.
All of these things represent something of value to the customer that they have to give up or forgo in exchange for the value provided by the product.
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How to Price for Feasibility?
Early in the business planning process, you do not necessarily have to set a price for your product. Rather, for the purposes of a feasibility analysis, you are trying to project what your customers (each customer segment) would be willing to pay.
You can average the prices across multiple customer segments to determine what the average market price that customers are willing to pay for your product or service. Later, if the idea proves feasible at a the average market price, you will undertake a strategic analysis to determine at what price you will maximize your return above costs.
Remember, you may or may not position your product to serve all customer segments. I may be more beneficial to target a single segment. On the other hand, it may be beneficial to have multiple product or service lines (varying features) that address all segments.
In any case, if customers are willing to pay an amount for your product or service that exceeds your cost by a sufficient amount, the business idea may constitute a valid business opportunity.
What are Pricing Methods?
Pricing is a very difficult issue for an innovative product or service. You have to estimate what the market is willing to pay without any actual sales information. Below I introduce a number of methods that businesses use to set their prices. Each of these methods is useful in particular situations. The primary methods are as follows:
- Cost-Plus This method involves estimating the cost of manufacturing the product and then adding a specified margin or markup above cost.
- Revenue Target This method involves estimating the price you would have to charge in order to bring in a certain amount of revenue.
Target costing has four steps:
Step 1. Design a product that provides the features and price demanded by customers.
Step 2. Determine the company’s desired profit.
Step 3. Derive the target cost by subtracting the desired profit (from step 2) from the desired price (from step 1).
Step 4. Engineer the product to achieve the target cost (from step 3). If the desired target cost cannot be achieved, the company must go back to step 1 and reevaluate the features and price.
- Competitor Prices This method involves looking at the price of competitors goods or the price of similar goods purchased by your target customer segments.
- Primary Market Research The market research method deals with conducting primary research on your target customer segments.
The primary market research method is the most effective way of accurately estimating what individual customer segments are willing to pay for your product. Marking competitor prices is often inaccurate because prices for products generally go down over time and based on the availability of substitute or competitive products. Using a competitors prices may cause you to overestimate the price. The revenue target methods may supply an entrepreneur with a target price based on the projected sales that he or she must charge in order for the business to be feasible. Unfortunately, this method does little to indicate the value that different customer segments are actually willing to pay. The cost-plus method sufferings from the same drawbacks at the revenue target method.
Other Factors in the Pricing Process
As stated above, you are attempting to determine what the average customer in the target market will pay for your product. This will give you a picture of your products economic feasibility. However, you will eventually need to make a strategic determination of how to price your product or service. The above stated methods are examples of how you can set your price. However, you will also take into consideration multiple other issues that affect how you position your product strategically in the market. Below are some questions that help illustrate this point.
- What are the top 1 or 2 most important benefits for the customer?
Note: This will help you determine that actual value of the product or service to the customer. If the product or service fulfills a very important need or want, then the value to the customer is higher.
- What is the markets perception of the amount of benefit that they receive from you and the customers?
Note: This brings up the question of branding. Do you want to be considered the low-cost alternative? Do you want to be the premium product or service that is worth the higher cost? Do you want your product to be perceived as useful in lots of situations or the best product for a given situation? All of this can have an effect on pricing.
- Who are the real competitors and what are their prices?
Note: If you can identify the competitors that fulfill this exact same need or want (even if in different manners) then you have an adequate point of comparison as to what customers are willing to pay for the product or service.