Pricing for profit is critical to the health and success of your business, yet most small business owners just don’t realize the impact that pricing has. When you set your prices correctly, you gain a significant edge over your competitors. By contrast, when you set your prices incorrectly, it can be very hard to recover.
So, how do you set your prices correctly?
Setting Prices Correctly Is Key to Your Firm’s Success
Many business owners don’t realize that pricing is the top driver of profitability for almost every kind of business, including small businesses. Study after study by many different consultancies has confirmed this fact.
- A 1% increase in price can yield an increase in profits of between 7% and 11%.
- By contrast, a 1% reduction in fixed costs improves profitability by only 1.5% to 2.7%.
- Likewise, a 1% improvement in revenue raises profitability by only 2.5% to 3.7%.
Biggest Mistakes to Avoid in Setting Prices
I think the single biggest mistake businesses make is setting prices too low, and then having to raise their prices after they’ve been in business a while.
A second significant mistake is offering one and only one price. Businesses that are effective at pricing, without exception, give their customers choices in their prices. Take the Starbucks model, for example: you have multiple size options—tall, grande, and venti. FedEx and UPS also offer a variety of options—standard overnight, priority overnight, two-day delivery, and so on.
Businesses should give their customers price options because there is a range of acceptable prices a customer is willing to pay based on the value they perceive in what they’re purchasing. On the other hand, if your business offers only one choice, it’s difficult for your customer to establish a context around the price. Multiple price options based on what’s being sold help the customer establish that context and choose the product or level of service they desire.
Key Difference Between Cost-Based Pricing and Value-Based Pricing
This is one of my favorite topics, because it’s so misunderstood. I’ve found that most people think price should be based primarily on cost. In fact, often business owners think only about cost when it comes to setting price. In the vast majority of cases, however, cost should not be the number-one driver of price!
So what should the primary driver be? The primary driver should be the perceived value the customer places on the product or service. That’s not to say that value is the sole determinant of cost — pressures from your competitors as well as other factors also get considered when setting price. However, in my experience, most people think cost is the top driver in setting price, when in fact value is the top driver.
This concept is known as value-based or value-led pricing. Central to this concept is the idea that the value to the customer of your product or service enables you to set a price, and then the price you can get justifies your costs.
How to Set Prices Based on Value-Led Pricing Model
The first concept that businesses adopting value-led pricing need to absorb and act on is that there is no such thing as the objective value of a product, service, or knowledge being sold. Value is entirely subjective to the customer, and — to some extent — the circumstances and situation at hand.
That means that in order to properly set the price, business owners need to understand what the subjective value to the customer is. Let’s take a simple example: A bottle of water an individual buys at a sports stadium (especially on a really hot day) is worth a lot more to that consumer than the same amount of water they pour into a glass from their kitchen faucet.
A second key change in mindset is to understand that your business should price your customers — not your products or services. For example, professional services firms such as accountants might price individual customers based on the value to the customer of the firm’s services. A multinational cell phone carrier, meanwhile, will price a large segment of customers they want to target.
How Much Time Should You Devote to Tracking Your Competitors’ Pricing?
Naturally, you need to be aware of what your rivals are charging for their products and services, and you want to understand the contexts they’re establishing that help their customers determine value. But very few small businesses should devote much time and resources to monitoring competitors’ prices.
It’s more important to figure how to differentiate what you do compared to your competitors and to make what you sell truly different.