Knowing how much a product should cost is one of the trickiest factors for startups to get right. Set prices too high and customers may buy elsewhere – go too low and your profit margins don’t add up. So what’s the best approach?
It’s all about knowing exactly what your products cost to produce and how they fit into the marketplace. Guesswork won’t cut it in the long run, so be prepared to do your research before you arrive at the right prices.
Product prices shouldn’t be set in stone either: there are lots of factors that will affect your pricing over time. Competitor pricing, material costs and market pressures can all impact how much you charge. When you first start out, your market entry price will likely look very different to your longer term price too.
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Here are three steps you can take to develop a pricing strategy for your startup.
Step one: Understand your costs
How much does it cost to make your product? This is the first question that many startups ask themselves when they set out on their pricing strategy journey. It’s a good place to start as it helps you understand the profitability of your business.
Determining the direct cost of producing your products is also known as the cost of goods sold (or COGS for short). COGS includes direct costs that go into making your products – like materials and labour – but excludes indirect costs like rent and marketing.
You’ll need to understand COGS for your products, as this is deducted from your sales to calculate your gross margin and gross profit. In short, the higher your COGS, the lower your margins.
There are also other indirect costs that go into the end cost of your product, like utilities, rent, sales and marketing and distribution. While these don’t impact COGS, you need to track them closely as they have an impact on your net profit.
To summarise:
- Gross profit is your sales revenue minus the cost of goods sold
- Net profit takes off the cost of goods sold as well as any other business operating costs
Step two: Considering the bigger picture
While it’s important to understand all the costs that go into making your products, this shouldn’t be the only information you consider when setting your prices. The price of your products needs to be in context with what’s going on in the wider market, or you could end up looking out of touch.
Consider the following factors when it come to your prices:
Competition
Identify your main competitors and track what they charge for similar products. Plot out the value of your product against theirs – do you have a unique selling point (USP) that allows you to charge more?
It’s also important to look at how much competition you have. If competition is fierce, you might need to undercut your competitors until you build up loyal customers. On the flipside, if your product has very little competition, you could be in a stronger position to push your prices higher.
Target market
Researching your target market should always be a priority, and it should complement the research you’ve already done about your competition.
This is all about understanding how much need there is for your product. Find out more about your potential customers:
- In person: talk to them at events, pop-ups or on the street
- Online: through social media, forums or groups
- Through desktop research: run online surveys and analyse reports
Once you know who is in your target market and how your product can help them, it’s time to compare your results to the information about your competition. If you’ve identified a high need and low competition, you’ve hit gold and should be able to charge more.
Customer perception
This is all about how customers perceive the value of your product. Often, customers have no true understanding of how much a product costs to make, so they instinctively decide what they think it’s worth.
Customer perception can be hard to qualify, especially when you’re starting out – but it can also be disastrous if you get it wrong. Underprice a product that customers perceive to have a high value and they’ll write you off as cheap. Overprice and they’ll feel like you’re trying to rip them off. It’s a tricky balance to achieve.
This is the part of pricing where your branding and marketing come into play. If customers view your products as luxury goods, for example, they will expect high-quality packaging, glossy photos and sleek branding.
Step three: Deciding your pricing strategy
Now that you know what your products cost to produce and you understand the wider context you’re selling in, it’s time to consider which pricing strategy is best for your business.
Here are some of the most common pricing strategies. Remember, you might need to adopt different strategies at different times.
Cost-plus pricing
Also known as markup pricing, this is the simplest way to set your prices. It involves adding a percentage on top of the cost of your product.
Advantages of cost-price pricing: Simple to calculate and works well for businesses with many competitors offering the same product, where the only differentiation is price.
Disadvantages of cost-price pricing: It doesn’t take other factors into consideration, like customer perception, which could lead to higher returns.
Competitive pricing
This strategy involves plotting your prices against your competitors and is sometimes called “going rate pricing”. Using the market leaders’ prices as a benchmark, you can then price your product lower than theirs to gain customers.
Advantages of competitive pricing: This is a useful tactic for larger retailers, which sell mostly the same products and can only differentiate on price. It’s often used to negotiate lower unit prices from suppliers and tie it in with a cut-price promotion.
Disadvantages of competitive pricing: With lower prices come lower profits, so this isn’t a sustainable approach for smaller businesses and is less likely to suit startups.
Value-based pricing
This type of pricing is based on customer perception rather than how much the product actually costs to produce. It looks closely at your customer’s needs and works on the assumption that customers are willing to pay more for something if they really want or need it.
Advantages of value-based pricing: For companies that have unique or luxury products, this strategy can lead to much higher profit margins. It works well for fashion brands selling designer goods, as well as beauty, tech, art and medicines.
Disadvantages of value-based pricing: You need to establish a solid brand that customers recognise and admire or you risk losing customers to competitors offering a cheaper alternative. This is difficult for new businesses and usually requires a big investment in branding and marketing.
Penetration pricing and discount pricing
Penetration pricing is based on the theory that offering a discount will encourage customers to buy. This can be used in a number of ways: new businesses often offer short-term discounts to give their products momentum, or more established brands use tactics like sales, special offers, vouchers and seasonal markdowns.
Advantages of penetration pricing: A good way to attract new customers or sell off surplus stock.
Disadvantages of penetration pricing: If you use it too often, the customer perception of your products will drop, lowering the value of your brand.
Price skimming
This is an approach that works well for companies whose new products are innovative or in great demand, such as tech (think Apple’s latest iPhone or Sony’s latest PlayStation console).
It works by initially setting the highest price a customer will pay for your product and then gradually lowering it as demand falls and other similar products are introduced to the market.
Advantages of price skimming: Great initial profits for highly coveted products and reinforces a respected brand image.
Disadvantages of price skimming: This strategy won’t work if your product isn’t innovative or in demand. It may also attract imitators and competitors if your product can be easily replicated.
