All the years I’ve been following business, strategy and small business—from the late 1970s through today—I’ve always wished for a magic formula for proper pricing. What’s the right price for this service? How should you price a new product? In teaching, writing and answering emails, this question comes up all the time. And, much as I’ve looked for the right answers, they aren’t at the back of the book.
Pricing is magic. There is no formula that works for you, or me, or any generalized group. You set your pricing as a matter of situation, strategy, costs, competition, weather, instinct and all of the above.
While I can’t really tell you how to set your pricing right, I can at least share something that I’ve learned—in classrooms, in making mistakes, in growing my own company—about how NOT to set your pricing.
Here are the three most common pricing mistakes that I see. And, just to be clear, while I wish I could drum up some rigorous research to back me, this is based on anecdotal evidence, common sense, and three decades of dealing with business problems.
1. Trying to be the lowest price provider
One of the most damaging cliches in business is the idea that the lower price gets the highest volume. The whole lower price equals higher volume idea, a fundamental law of economics, is for undifferentiated commodities, not your business or mine.
Successful lowest-price strategies are unusual. They usually take a lot of capital, resources and visibility. What works for Costco and Walmart doesn’t work for the corner store, some discount airlines and gasoline stations, but those strategies usually require a lot of capital and very large scale implementation.
2. Mixing your pricing message
We forget way too often—and too soon—that price is the most powerful marketing message you have. Do you think people don’t buy your work because it’s too expensive? But isn’t it worth it? Don’t you believe in it? It’s about positioning. How are you different from the others? Is what you sell better than the one across the street? Does your price say so?
Would you get a root canal from the cheapest dentist in town? Would you save money by buying two-day-old sushi? And why isn’t the cheapest car made the most popular?
I lost a consulting job I really wanted once when I bid $25k for it and a competitor bid $75k. The guy who gave me the bad news told me everybody liked my proposal, but they wanted the best, so they went for the higher price.
What would you rather have for dinner: a $1 hamburger or a $20 steak? We used to go to a restaurant that had really good food and surprisingly low prices. But I often wished they’d raise their prices so we didn't have to wait 45 minutes or more to get a table. And guess what: they no longer exist. They went out of business. Do you think pricing had something to do with that? I do.
3. Underestimating real costs
Businesses go under when they run out of money. The research on how they run out of money is confusing and ambiguous, and there are rarely single identifiable causes. Still, just betting on what I’ve seen with my own eyes through a lot of years, I think businesses frequently run out of money because they underestimated real costs.
We talk a lot about gross margin in business analysis. That’s your selling price minus your direct costs. So if you buy that widget for $2 and sell it for $6, then the gross margin is $4, and your gross margin percent is 67 percent.
Unfortunately, focusing just on gross margin isn’t enough. Aside from the $4 you paid for that widget, there are all those other expenditures, including your rent, your payroll, your insurance, your electric and water bill, all of your marketing costs, and lots of hidden costs, like the computers and software you’ll need to buy next year. We call that overhead and tend to forget it. Which is a shame, because a lot of businesses forget about it all the way to the business grave. You run out of money.
Tim Berry is Founder and President of Palo Alto Software, Founder of bplans.com, and co-Founder of Borland International. He is a Stanford MBA, and principal author of Business Plan Pro. He blogs at Planning Startups Stories.