This is what we’re going to cover: The 10 things you need to consider when setting your pricing:
The cost to produce and deliver the product
The price of your competitor’s products
The lifetime value of a customer
The customer acquisition cost
The price elasticity of your customer (volume vs price)
Your cash flow
Terms of sale
The pricing of your other products
How To Set Pricing: The cost to produce and deliver the product
When you’re setting your pricing you obviously need to consider the cost of producing and delivering your product.
Some people like to keep everything extremely simple.
It’s very common for a lot of business owners to just calculate the cost of producing and delivering a product or service and then add a standard markup.
For example, you ask me to give you a quote to create a website that has a list of specific features.
If my designer needs to do 100 hours of work at $50 per hour that would be $5,000 and if my developer has to do 20 hours of work at $100 per hour then that would be $2,000 so that total for me to produce the website would be $7,000.
If my standard markup was 100% I would quote $14,000 for the job.
You can use this method if you want to keep things simple but I would encourage you to use a lot of the other methods I’m about to discuss if you want to optimize your pricing rather than just arbitrarily setting your pricing or just using some industry standard.
How To Set Pricing: Break-Even Analysis
The simple starting point for setting pricing is understanding your break-even point.
How many units of your product or service do you need to sell at a specific price point in order for you to be able to cover all of your costs.
When I say, all of your costs, I literally mean all of your costs. At some point in time, all entrepreneurs, including myself, have made the mistake of underestimating their costs.
If you have a financial reserve then you can live to fight another day if you get this wrong but, if you have a very tight budget with minimal margin for error then you need to take this analysis very seriously because, getting it wrong could ruin your business and, in some cases, it might even ruin your life.
In order to figure out your break-even point, you need to calculate your total fixed monthly costs and your total variable monthly costs.
Your fixed costs include things like rent.
These costs remain fixed regardless of many sales you made in a month. Variable costs include things like sales commissions.
The more you sell, the higher the cost.
This is the simple way to do it in a spreadsheet.
Enter your fixed monthly cost as an absolute dollar amount. Enter your variable costs as a percentage of sales.
Enter the price. Then you can just enter the number of sales to see how your revenue compares to cost.
If you want to test price, then just leave the number of sales constant and test different price points.
I’m just showing this to you in order to explain the concept.
Of course, you create a simple spreadsheet like this just to play around with some numbers but, your real break-even analysis for a real business is something that will be part of your financial projections and your business model.
What I mean, is that you will need to break down all of these fixed and variable costs and break them down month by month.
How To Set Pricing: The price of your competitor’s products
Your customers will always compare the price of your product to the price of your competitors’ products.
This part of your pricing analysis is pretty simple.
If you believe that your product is better than your competitors you can charge more than your competitors and vice versa.
How To Set Pricing: Unique features
If you have developed a unique product or you offer a unique feature then you have much more pricing flexibility.
But the important you need to think about is this – a unique product or unique feature may not be enough to justify a high price.
The question you really to answer is: “how valuable is my unique feature to my customer?”
If the unique feature is something that your customers think is just a gimmick, then you have no justification for increasing your pricing.
If your customers think that the unique features are nice to have but absolutely necessary, then you then should consider using the same pricing as your competitors and using the unique feature as a way to differentiate yourself based on the same price point.
If your customers think that the unique feature is necessary, now you can justify increasing your pricing.
In this case, how much higher should your price be?
This should be based on the value that you are creating.
For example, if you are saving your customer $1,000 you can justify increasing your pricing by anything from $1 to $999 and your customer will come out ahead.
It goes, without saying that, if you only increase the price by $1 you will be leaving a lot of money on the table and, if you increase it by $999 then your price will chew up almost all of the benefits you’re providing to your customer.
You know that the optimal price is somewhere between $1 and $999 so the best way to approach this situation is to set up three tests where you sell your product at high, medium, and low price points and see which one wins.
How To Set Pricing: The lifetime value of a customer
The lifetime value of a customer is the total revenue you will generate from a customer before they cease to be a customer.
In some cases, you will collect ongoing revenue from a customer because you’re selling a subscription or maybe you know that customers who buy one product are likely to buy various other products.
Over time, you will discover what a customer is really worth to your business and this is an important number to consider when you set your pricing.
If you know that you will generate additional revenue from a customer after the transaction then you can consider lowering the price of the first transaction in order to acquire a customer and then get that money back later when the customer spends more money on products from your business.
How To Set Pricing: The customer acquisition cost
The customer acquisition cost is obviously the amount of money you need to spend to acquire a customer.
The reason I mentioned Lifetime Customer Value first is that, if you know your customer’s lifetime value, then you have the information you need to decide on how much you are willing to spend to acquire a customer and how much you should charge your customer.
Or, to put it in simple terms, your pricing and your customer lifetime value, and your customer acquisition cost all influence each other.
For example, if you sell a subscription for $100 per month and your average customer remains a customer for 12 months, then your customer lifetime value is $1,200.
This means that you can afford to spend $1,200 before hitting your breakeven point
How To Set Pricing: The price elasticity of your customer (volume vs price)
The general assumption is that the higher the price of a product the lower the demand and the lower the price, the higher the demand.
Price elasticity measures how much the demand for a product changes as the price changes.
If you want to see where I discuss the price elasticity formula and how to calculate it, check out the links in the description.
The point that I want to make here is just to remind you that higher prices do usually lead to lower unit sales but this doesn’t mean that you should lower your price.
If you’re feeling like you need to use a low price point I strongly suggest you postpone that thought for now until you’ve reviewed everything we’re discussing in this framework.
How to set pricing: Cash Flow
Your cash flow will influence your pricing.
For example, if you sell a product for $100 per month and you know that the average customer will remain a customer for 24 months then the lifetime value of your customer is $2,400.
You could decide to spend $1,200 acquiring customers while knowing that you will generate $2,400 from this customer.
You might have done some testing and figured out this is the optimal combination of price and customer acquisition cost.
But, if you spent $1,200 acquiring the customer you will need to wait 12 months in order to recover the $1,200 you spent to acquire the customer.
You can only make this work if you have the cash to cover the first twelve months.
If you don’t have the cash flow to make this possible then you need to adjust your customer acquisition cost or your pricing to change these numbers to something that matches your cash flow requirements.
For example, instead of charging $100 per month for a downloadable software product, you might decide to sell it for a one-time payment of $500.
It will result in much less revenue over time but it will be 5X your upfront revenue.
You can use this pricing strategy for as long as it takes to improve your cash flow then switch to the optimal pricing when your cash flow allows it.
For most of you, scenario one is a theory, and scenario two is reality.
How to set pricing: Terms of sale
This is also a cash flow issue. For example, it’s typical for vendors to offer their customers 30 day payment terms.
This simply means that the product or service is delivered today and the payment is due within 30 days.
But, if you’re a new business or a small business, this is not so simple.
If a vendor decides to give you 30 days to pay, then they are effectively extending credit to you.
By extending credit, I mean, they are giving you a 30-day loan. As with any loan, they will only give you 30 days to pay if they think you are a credit-worthy customer.
They might ask you for financial statements and review some external databases to analyze the financial position of your business before deciding whether to give you 30 days to pay.
The reality is that new businesses and many small businesses will not qualify for these 30-day terms.
On the flip side, if you sell to large businesses they will expect 30-day terms from you.
So, you could be in a situation where you have to pay your vendors immediately after a product is delivered but your customers will take 30 days to pay and your cash flow will become the victim in the middle.
Some businesses solve this problem by stating a lower price for customers that pay early and a higher price for customers that late.
The obvious conclusion to draw from this little story is that, if you are in the B2B space you need to carefully review the timing of your cash inflows and outflows and think about whether you need to adjust your pricing to incentivize to pay early or get paid more if they pay late.
How to set pricing: Market positioning
When we talk about positioning we’re talking about where your product fits in the market.
Is it the simple option, the budget option, the well-designed option, the advanced option, or maybe the luxury option?
Your pricing influences your position in the market. In fact, in some cases, your pricing is the only thing that positions you in the market.
If your price is high then people in the budget category won’t be interested but people that are interested in the advanced option or the luxury option will be interested.
In almost every case, people will assume that a high-priced product is better than a low-priced product.
This is what I mean when I say that your pricing positions you in the market.
This is very interesting I strongly suggest you think about this very carefully.
These customers are not as price sensitive as the budget customer.
They don’t want to hear a pitch about how cheap your product is, they want to learn more about how good it is and what it will do for them.
Competing on price is always a race to the bottom.
Even if you discover a way to produce a product or a service more efficiently and use it to compete on price, this opportunity will still just be temporary.
Your primary focus should always to be make your product or service better, not make it cheaper.
How to set pricing: The pricing of your other products
You should also keep in mind that your pricing of one product influences the pricing of your other products.
If you offer three versions of your product or service customers will compare them to figure out which one is best for them.
They will judge the value of one compared to the other.
This gives you an opportunity to lead them in the direction that you really want them to go.
For example, if you’re a SAAS company might offer two levels of access to your app like “Free” and “Pro”.
You want people to buy “Pro” because it will generate revenue.
You can create a third level called Premium” that is much more expensive than Pro and it could result in more sales of “Pro” because people will think that they’re getting a good deal compared to that super expensive “Premium” option.
In the meantime, the 80/20 rule tells you that 20% of your potential customers are prepared to pay a lot more than the rest.
You shouldn’t ignore them because they only represent 20% of your potential customers.
You should create a premium product that they will buy.
The number of sales of the premium product might not be high but it will still increase your revenue and it will make the standard product seem more attractive to everyone else.