One of the most common pricing strategies is to set the price of your product or service according to the price of similar products or services on the market. In a highly competitive market, you will find companies that charge a premium price, and companies that are aiming to charge the lowest price. It’s important to understand the range of prices available to consumers/clients before setting your own prices. It is not always the best strategy to charge the lowest price, nor is it best to simply match competitors pricing. This is the most common pricing strategy only because it is the easiest.

Sometimes it is possible to rationalize the value of your product or service in dollar terms and set prices accordingly. For example, you may offer a service that saves your clients’ time. If you can estimate the client’s hourly billing rate or hourly staff cost, you may construct a model of economic value to the customer. Similarly, you may have a product that results in less wasted fuel for a transportation company and be able to estimate savings in a dollar amount. You should validate your assumptions with several clients before setting prices this way. Additionally, you should assume that the customer will want to keep a large portion of the value generated for themselves (perhaps 90% of it!).

Beware, some aspects of value to the customer are less rational. Perceived value may be much higher or much lower than the rational value. For example, an established enterprise software company may be able to charge more just based on their brand value, and a consumer may choose a higher priced option for a product depending on the setting and even the time.

The cost plus pricing model ignores the target customers completely, and simply examines the costs incurred by the business in delivering the product or service. It can involve cost of goods sold, and any other costs the business analyst wishes to include. From there, a fixed percentage is applied to set prices that will achieve the desired profit margin. It is important to understand the cost-plus pricing model as an input to pricing decisions and to evaluate whether or not a venture will be profitable. However, while it seems the most concrete and practical pricing approach, business owners should consider that there are many subjective decisions about what to include in the cost estimates – assumed volume of sales, what counts as a fixed cost or semi-fixed cost, etc.. A cost-plus pricing based on subjective estimates is still subjective.

Price skimming is a strategy to maximize profits at a given sales volume by capturing those customers with the highest willingness to pay (see above) with a high price, and lowering the price to capture other consumers with lower prices.

In the context of a new technology or a new market, this may make sense as it supports the innovators until efficiencies can be achieved. Ultimately, new competitors will enter the market and naturally drive the average price of a product down.

There may be ethical concerns about use of AI and computer algorithms to predict an individual’s willingness to pay and set the price for them individually.

The procedure for setting price is simple to describe, but is not often completed properly by business leaders.

1. Start with the cost-plus pricing model; this should be your price floor. If you cannot make a reasonable profit by entering the market with this as your lowest price then you should consider changing your offering (i.e. lowering the cost of inputs by some innovation) or walking away.
2. Next determine customer willingness to pay; this should be your price ceiling. If you set your price higher than your target customers are willing to pay, then you’ve already lost. Talk to as many customers as possible, and/or set up some A/B/C price points and test them with your customer base. There are only a few ways to do this right and get usable information. Please ask us if you need help if you don’t have experience with it. If you do this right, you’ll understand something about the sensitivity of customers to price.
3. Determine economic value to the customer; this exercise will help you determine the dimensions (speed, quality, customer service, etc.) upon which your customers place value on your offerings and your competitors’ offerings. It will help you construct price packages that scale with value – for instance certain features might be optional/premium.
4. Conduct a competitor analysis; this will help you separate the competition based on the dimensions of value, and the price points that they charge. It will give you a sense of price range, and how to differentiate your offering.
5. Implement a price point and repeat the above steps at least annually.

If you are starting with a cost-plus pricing analysis, you must start with a thorough understanding of your costs. Please contact us about accounting services to gather the data. Our CFO services team will be happy to work with you through the rest of the analysis and pricing exercise.