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Products and pricing go together like two peas in a pod. You cannot have one with the other.
Pricing is an art and not a science. There is no ‘one size fits all’ formula for it. But it does all start with what you sell.
To understand pricing, you need to be clear about the products and services that you are going to sell.
We won’t spend a lot of time on this because even though you are just starting out on your new business journey you are obviously here because you already have an idea in mind.
This will mean that you have already started to define the product or service that you will sell through your business. In the PDF Guide we have included a worksheet for “Defining your solution”. In this worksheet we ask you to consider 6 things which include the:
Having a clear understanding of what you are selling means that you can then start to put together early cost estimates of just how much it will cost to deliver your product or service.
And you will then use this information to get an idea of just how much you need to sell to make your business viable.
The first rule of business is to make a profit. To do this, you need to sell your products or services for more than they cost you to produce it.
And that means that you need to know what they will cost to produce.
How do you calculate Cost of Goods Sold (COGS)?
There are generally two baskets of business costs, variable and fixed. Anything that you spend to deliver your goods or services to your customer will be treated as a Cost of Goods Sold (COGS). If you provide services, then this becomes your Cost of Services Sold (COSS). These will be a variable cost. This is because the actual amount you spend on COGS (or COSS) will go up and down depending upon how much you sell.
Your COGS value is calculated as:
START WITH Purchases of parts, materials or finished products
ADD ON transport and shipping of products
ADD ON storage
ADD ON distribution
TOTAL AMOUNT Cost of Goods Sold
There is question about whether you include labour in COGS or not. It is our belief that you do not. We won’t explain why here but if you really want to know, just ask!
For service based business your Cost of Services Sold (COSS) is calculated as:
START WITH Sales Commissions
ADD ON Contractors
ADD ON Equipment
ADD ON Subscriptions
TOTAL AMOUNT Cost of Services Sold
All of your other expenses will generally be those that don’t directly relate to producing a product or delivering a service. If you are unsure, just ask yourself
“Do I have to pay this expense even if I don’t sell anything?”
If the answer is yes, then it is more likely to be a fixed cost and not part of your COGS.
Why is it important?
Calculating your COGS is an essential part of your pricing strategy. Here’s a couple of ways that you will use this:
- COGS is used to calculate your Gross Profit Margins.
- You use it to work out your target breakeven unit of sales
- Pricing decisions will be more accurate
- You can identify production efficiencies
Methods to Calculate Pricing
OK so we have now talked about your products and your costs to produce it. Now let’s talk about pricing.
A pricing strategy is the method that you use to establish the price for your product or service. The goal is meet consumer and market demand whilst still looking to maximise profits.
You might be wondering why we have spent so much time on calculating the COGS. Although your expense shouldn’t drive your pricing, it must be a consideration (remember Rule #1 above).
There are many different pricing methods that you can use. We will highlight a few of different types here but just remember that you can pick and choose your methods or try them on and see what works.
Cost Plus Pricing: As the name suggests, it involves calculating all the costs relating to a product or service and then adding a target markup rate to the amount. A markup is just a rate of return i.e., cost plus 20%.
Competition Driven Pricing: This is where you review the prices of your various competitors (you should have this research from Chapter 2) and then either:
- Charge a bigger price if you have a better offer. Better is relative and is viewed from your customer’s perspective. So a premium proposition could be a greater convenience or a concierge driven product or service.
- Consider price matching with a competitor if you are in a commoditised industry. If you choose this, consider the reason behind why the customer should do business with you. Cutting prices is a race to the bottom and ideally you want to have a proposition has your customer comparing apples and oranges.
This is where you put together two or more complementary products or services together and sell them for a single price that is usually less than the price of them as individual units. Although the overall profit margin is lower, you would expect to sell more product to make up the difference.
Hourly Based Pricing
This is a form of pricing commonly used by consultants, freelancers, and contractors. This is essentially trading time for money. The calculation of the hourly rate needs to take into account productivity and all expected costs.
Want to know what your time is worth? Download our calculation sheet here.
Project Based Pricing
This is a fixed price model that charges a flat fee per project. When project requirements, deliverables, specifications, and scope are well defined then this model is suitable. It is generally used by consultants, freelancers, and contractors.
This pricing model is used when products or services are priced based upon what the customer is willing to pay. It is based upon what you can charge for the product based upon the perception of value. This is one of our favourite methods or pricing because what you charge is aligned to the value that is gained from achieving the objectives of the product or service. There are clear objectives that can be measured and achievement of these is a win-win outcome.
This is a regular, pre-set billing fee covering a set time period or for a volume of work. There are two types of retainers, rolling and ‘use it or lose it’. You can set your retainer pricing based on any number of different ways.
If you’ve used Uber then you’ll be familiar with surge or demand pricing. It’s a flexible pricing strategy that fluctuates based upon market and customer demand.
This list of pricing strategies is not a complete list. There are a number of other types of strategies such as launch pricing, psychological and geographic.
With all these different strategies, what should you use?
You need to use the one that is most appropriate for you. There are positives and negatives to each type of pricing strategy and there is no one ‘right’ way.
Mistakes to Avoid
If you don’t optimise your pricing and extract the maximum price that the market is prepared to pay, then you are laving money on the table. Here are a number of the more common mistakes that we see when pricing:
- Basing prices on costs, rather than on what the market is prepared to pay
- Believing that the marketplace must dictate pricing
- Applying the same profit margin across different products
- Letting commission based salespeople determine the price at which goods are sold
- Failing to increase prices
Optimising your Pricing
Pricing will influence both your sales volume and your profit margins which are two levers that you can pull in your business which will ultimately affect how much money you can make.
Although you will set your prices at the start, understanding the ‘best price’ will be a matter of discovery. It is a trade-off between maximising revenue and profit and ensuring enough products are sold to cover costs.
This is one area that you should reach out for expert help. Accountants and bookkeepers understand the numbers and you can use their skills and experience to review your numbers.
Now you will have a better understanding of your products, your costs and your likely pricing.
You will need these as we move into the next chapter which is all about small business budgets, Chapter 5: Set Up a Budget and Forecasts.
CTA: Want to join a Pre-Cede workshop about this topic? Sign up here!