3 Essential Tips for Pricing Your Product or Service
Pricing is HARD.
Raise your hand if you have ever questioned your pricing, or maybe you question it regularly, or maybe you are just starting to price your product or service and don’t know where to start.
You are in the right spot!
Pricing is one of the most complex aspects of running a business. There is no “perfect guide” to price your product. What people are willing to pay changes, the economy changes, the cost of goods and labor changes. Your price also needs to change.
I love pricing – and I love it because of the complexity. It’s not as simple as “crunching” numbers to get an answer (nothing is). You must combine research, analysis, and customer feedback and even then, it still takes time to get to the right price.
I hope that by the end of reading this article, you can use these 3 tips to either come up with a starting price or evaluate your existing pricing. And my even bigger hope is that you implement that pricing and make more revenue!
3 Tips to get the right price:
Know your margins!
Use a method (or all 3)
Test it, talk to your customers, and test it again!
#1: Know your margins!
Knowing your margins is all about answering these questions:
What price do you need to charge for your business to be profitable?
And
For every $1 I make, how much does it cost me to earn that $1?
It might be surprising but it’s very common for businesses to be paying for sales that never earn them a cent. Instead, it costs them money to make those sales. And I’m not just talking about venture-backed startups with $30M in the bank. Far too many owners don’t understand what it costs to make a sale, or their gross, or contribution margins.
There are 3 numbers you want to figure out to understand and answer these two questions:
Gross Margin
Contribution Margin
Customer Acquisition Cost is the amount of money it costs to acquire a customer.
Check out this earlier blog for all you need to know to understand CAC.
The simplest way to understand this is to add up all $$ spent on marketing & sales and divide it by the number of new customers in a particular period. It’s not a margin, but I’m including it here because it does go into your net margin and it’s an often-forgotten metric that can provide a tremendous amount of insight.
Gross margin = Revenue - Cost of Goods or Cost of Sales
This is what most people think of when they think of margin. It’s an important metric, often over-emphasized in my opinion, but necessary for all businesses. The good thing about gross margin is that it can be benchmarked to other businesses in the same industry and give you a sense of where you fit with similar business models. You can use it to see where you might need to improve your business.
One of the downsides of gross margin is that it leaves out the entire bottom half of the P&L (also known as operating expenses or maybe just expenses depending on how you have things categorized). Another downside is that what goes into COGS (or Cost of Sales) varies by business, not just by industry, but business to business. Unless you require GAAP compliance or SEC compliant, you don’t have to track COGS (you should though!) so it can get messy and be unclear what your true gross margin is.
Contribution Margin = Revenue - variable costs of the business
There are MUCH more complex ways to look at contribution margin and if you google search it, your head will spin. At its core, it tells you how much of each sale will cover the fixed costs of running the business.
Fixed costs = Costs that you incur regardless of your sales volume (I.e. office rent)
Variable Costs = Costs that are directly related to your sales volume (i.e. commissions)
For example - let’s say you pay a sales commission for each product or service you sell and each product makes you $100 in Revenue.
You would subtract that commission.
Let’s call it $20 (easy math). $100-$20 = $80 which means that each sale contributes $80 of revenue to the business to cover the fixed costs.
Then you can start to determine how many products you need to sell to cover your fixed costs.
So, if you have to pay $1000 / month for rent and you make $80 of contribution margin per sale then you need at least 12.5 units to cover your fixed costs. Once you sell 13 units you’ve past your breakeven point.
Here’s the math again:
$100 Revenue Per Unit
$20 Variable Costs (commissions)
$100-$20= $80 Contribution Margin (or 80%)
Fixed Costs = $1000 / Rent
$1000 / $80 = 12.5 units
You must sell 13 units per month to break even.
Margins (and CAC) matter a lot in pricing! Do not skip this step. I recommend that businesses review their margins and CAC quarterly at a minimum – most should do it monthly unless there aren’t many changes happening in your products.
#2: Use a method* (or all 3)
*as a starting point
I want to heavily emphasize that these 3 pricing methods I’m about to explain are only a starting point. Too many people get caught up in finding the “right” number, but the only right number is the one that combines what your customers have told you they would pay and the amount that gets you to a profitable business. Outside of that, no method is going to be 100% accurate.
The biggest flaw that ALL these methods have is pricing psychology. Once you get beyond the number crunching you start to realize that price conveys value and status much more than most people realize. Price isn’t even really about the numbers, but you still should “crunch the numbers” to know if your business is profitable. That’s where most people get caught up. As people, we are driven by the comfort that analyzing numbers gives us and once we start to get out of the zone of what the numbers say we freeze and don’t think we can charge any more money.
If you studied finance, sales, or marketing you may have come across at least one or all 3 of these methods: Cost Plus, Value-based, Comps (or comparables)
Cost Plus:
This is the easiest of the methods but the hardest to raise prices from. This method tends to anchor people to price because they start to say things like “Well it covers the cost” and they stop getting customer feedback or raising prices.
Here’s the method in its simplest form:
Add up all the costs to build your product or service
Add a mark-up to that cost
Example:
Membership to Community Costs (per person):
Software for the platform: $130 / year
Food for events: $300 / year
Sales Costs: $500 / person
Welcome gift: $50
Total Cost: $980
Ongoing: $430 / person /year
On-time cost: $550 / person
You expect members to stay for 2 years, the total cost for two years = 430x2 + 550 = 1410
You want to have a 40% Margin (I’m making this up, Gross Margin needs vary greatly but product & industry)
You price your membership at $987 / year
This is equal to = $1410 / 2 = $705 / year + 40% margin = $282
$705+$282 = 987
There’s nothing wrong with calculating your price this way – in fact, at some point, you need to do this. This is very similar to looking at your gross margin and then adding the margin you want to get to your price. Two small notes I will add:
1- I would not include “Sales Costs” in Cost of Goods Sold on my P&L– so do be sure to look at ALL costs not just what you have in COGS to understand your true price. (i.e. look at gross margin and contribution margin).
2- This also considers the one-time costs of the product (welcome gift and sales cost). Sometimes these are overlooked costs that people don’t consider when pricing their product. Pay attention to those little hidden costs that add up.
In the way I did the calculation above, I assumed that members will stay for 2- years. When you’re first pricing something you need to make these assumptions off of gut--not real data. But – a better way to price would be to assume members DON’T stay 2 years and price those one-time costs into a 1-year fee. That would make it = $980 + 40% markup = $1,372 - which sets your business up for success in a much better way.
They may still stay for 2 years, but now you’re covered when they don’t. Until you have data- er on the side of more cancelations, and more issues than not so you’re covered when 50 members don’t renew for year two.
Another downside of this is that it DOES not consider the fixed costs of running the business (i.e. contribution margin). The next step here would be to see if that 40% markup (or $392 / member) covers the day-to-day costs of running your business such as your salary, taxes, software, etc. Another way to think about the Cost-plus is to include your fixed costs on some level and then price your product. In this case, you wouldn’t add 40% margin, but closer to 15-20% and you would call this a profit margin.
Lastly, the $1372 may be mathematically correct, but does it portray the right value to your customers? And what do the members want from the group? I’m going to get repetitive here, so I’ll be brief- price conveys value to the right audience. Often, people underprice their product or service because they haven’t done the work to identify their target client and understand the motivations of their customers. I’ll get into this more in the next two methods.
The big takeaway with Cost Plus is this: add up all your costs and then add a margin either gross or profit. Use this to make sure you can run a profitable business, but don’t let it be your final price.
Value-based pricing:
This is a hard method to get right because before you can price, you need to understand the value that you’re giving to your clients and that takes data which takes time. When you’re very early in your business or launching a new product, this is one method I might suggest skipping and coming back to later.
To get to the right price - it takes a lot of synergies between your brand vision and finance team.
The idea behind this is that you aren’t adding up pennies behind the scenes and then making sure you make a little more than those pennies. You are pricing your product in a way that shows the value of the item or service.
This is evident in luxury goods. There’s a reason there are sunglasses that are priced at $7,000 and it’s not because those sunglasses cost that much to make. It’s because the customers are buying status, and they value that status at $7,000.
With services, what you typically see is a flat rate of $10K for branding rather than an hourly rate.
The value isn’t in dollar value, but because your price is that’s how we’re going to talk about it here.
So how do you come up with value-based pricing? I’m going to keep this brief because I could easily write 3000 words on how to get there.
First, you need to understand what you’re selling and who you’re selling to.
Second, you need to understand what pain you take away from them.
I’m no branding expert, but in my journey to understand my pricing and value I’ve learned this – humans will pay to avoid pain and that’s all we ever buy. Ways to avoid pain. It sounds morbid and I don’t mean it to be shallow, but you must understand the problem you are solving with your business to understand what your customer is willing to pay to avoid pain. With branding the goals it convey the pain that your product or service will remove from your customer
Third, What’s the value of their pain- avoidance?
Service-based example:
Most people don’t want to be audited by the IRS. CPAs exist so that business owners and individuals can file a return with less likelihood of being audited. CPAs are selling “taxes” they are selling the peace of mind that you are less likely to have an IRS agent knock on your door.
What’s the price you would pay to avoid that situation? Most CPAs don’t charge enough
Product-based example:
Value-based pricing with physical products can be hard to wrap your head around. What’s the value of a pair of shoes? Well – A LOT. Think about running shoes – they are competing with SO many other running shoes. They must be based on value. What would you pay to not have your feet hurt after your run? Or to be less likely to get injured?
The takeaway here is that value-based pricing looks at the value of the pain you are removing for your customers. It’s not going to spit out an exact number, but thinking holistically about the value you bring will help you tell your story better and get you to a more accurate price.
Comparables or Comps
This is the easiest one to start with (if there’s data!) because it is simply looking at what competitors are charging and then using that as a starting point.
The downside here is that not every product has a 1:1 competitor, sometimes you can’t find pricing, or your competitors might be underpriced.
To get to comps, you simply research similar products and services, review them, and see what you might charge based on this. In my particular industry, I ask other CFOs what they charge. And you know what? They all are happy to share, I’m happy to share, and we’re all in a better space because we shared. So don’t be scared about sharing your price. Price isn’t an advantage. If you’re competing on price alone – then you’re in trouble (a post for another day).
#3: Test it test it and test it again
The biggest value in pricing is to test it. At the end of the day, your customer determines your price by what they are willing to pay. That’s why luxury brands can charge $7,000 for a pair of sunglasses and make a 17500% margin (made-up numbers). It’s because the customer is paying for status, not the cost of the product (i.e. value-based pricing).
This is why pricing is hard.
It’s not straightforward and no AI tool will help you pinpoint what customers really want because you don't know until you're in front of a customer telling them the price. And some people will pay $7,000 for sunglasses- I am not one of them. I will pay $25 max because I have kids under 7 who steal them and break them. There's no value to me paying that much for sunglasses, but there’s a HUGE value to another customer.
How to test:
Start selling,
Review your pricing
Sell more, see what happens
Ask your customers!
We’ve talked a lot about being underpriced, but how do you know if you’re overpriced?
Before I get there let me say this: - just because people aren’t buying doesn’t automatically mean your product or service is overpriced. It can mean you’re UNDER-priced because your price doesn’t convey value, it can mean you’re talking to the wrong people, or it can mean an issue with branding and messaging.
But for those that are overpriced – You can tell with metrics. Sales Metrics.
For those doing sales calls to close deals, if you’re close rate is under 50% you are likely overpriced. If your close rates are above 50%, you might want to start raising prices.
For product-based business doing direct sales- I don’t have up-to-date info on that, but if you use similar metrics for online ads, you’ll get a good idea. If you have good data on this – please email me and I will add it to this blog!
I covered a lot in this post! If this helped you – will you shoot me a quick email and let me know? Hello@financefightclub.com
Remember:
Only your customers know the value of your product or service so please talk to them!
