Guest post from Gembah
Understanding how to price a product – especially in the eCommerce world – can seem like a mysterious process. It’s dangerous to set a price point too low out of risk of devaluing the product. Setting a price too high can prevent sales velocity and decrease the returns on your time and monetary investments.
Setting the correct initial cost is a highly impactful decision for the future of your business. It’s harder to raise the price of a product than it is to lower it, after all.
Prices don’t exist in a vacuum, regardless of where you set them initially. The market sometimes dictates that rates change, and other times, non-market forces dictate the same. The most educated guess you can make is the best guess you can make at the outset.
There are some best practices to follow to make this process a little more tactical and less of a shot in the dark.
Five Strategies to Follow When Figuring Out How to Price a Product
There are five specific strategies to follow when setting your price point:
- Understand your competition
- Understand your customers
- Get to know your cost of goods sold and the role that plays
- Choose a pricing method for your business
- Communicate the reasoning behind the pricing method you choose
Let’s take a look at these one-by-one.
Pricing Products to Beat Your Competition
One of the core principles of business is to know your competition better than you know yourself. If you don’t have a clear picture of how your competition in business operates, how do you know your competitive advantage against them?
Your competition sets a price that works for them. They likely went through the same pricing analysis you’ll go through in finding a price that fits your business goals, and the expendable income of your target customer.
To understand your competition, you have to analyze what they are doing, and why they do it. Competitive pricing analysis can be time-consuming and highly detailed, but the return on that time investment is always worth it. Understanding your competition’s motivations allows you to set a price point that capitalizes on their weaknesses, and leverage your competitive advantage.
You never want to bring new product ideas to the market without doing your due diligence when it comes to the competition. If you do, you’re just throwing a price against the wall to see what sticks. That’s not a good use of your time and resources.
Setting a Price Point Your Customers Will Love
Your customers have unique motivations that form their behavior. These motivations form the backbone of the study of consumer psychology.
There’s a reason why consumer psychology is one of the most often written about subjects in business and psychological literature. Due to the vast number of variables involved, it’s highly sophisticated and intriguing.
Luckily, we’re not psychologists. We’re Amazon sellers or small businesses that sell online, so focusing on just a few of these variables is enough.
It’s vital to consider your customer’s buying expendable income, buying habits, tolerance for price fluctuation, and how they attach perceived value to a product.
The irony of customer behavior is customers will tell you they behave in one way, and proceed to act in another. To some extent, this is human nature. Our level of self-awareness varies. To that end, your job as an eCommerce seller or small business person is to make sure a customer’s actions match what they consider to be their motivations.
This matching isn’t easy, but it’s a core part of any pricing process.
The Role of Costs of Goods Sold (COGS)
The final version of any product includes many component parts. Labor goes into manufacturing those parts just as it does in finishing raw materials to make components.
The cost of goods sold (COGS) of a product are the direct costs a company absorbs throughout this process, and sometimes, via marketing and advertising a product to prep the product for launch.
Calculating your COGS for any new product launch includes three variables:
- Materials – everything you needed to create your product
- Labor – the cost of the work done by people working on the product
- Overhead – both business and manufacturing costs associated with the creation of a product
All of these factors go into what it takes to create your product. Once you know what it takes to create your product, you can position it in a way to ensure you make the margins you need to stay profitable.
Finding the Pricing Method That’s Right For Your Business
Once you’ve evaluated what your competitors are doing, what your customers want, and factor in your COGS, deciding which pricing method to use is your next-to-last step.
There are a wide variety of pricing methods out there. Each has its strengths and weaknesses, and some ways are better for some markets than others. It ultimately comes down to how you address your business goals through pricing.
Here are four of the most common pricing methods:
- Cost-based
- Cost-plus
- Competition based
- Dynamic
Let’s take a look at these individually.
Cost-Based Pricing
The cost of producing innovative products places the most emphasis on the cost of producing the product and the role that plays in setting an initial price.
Cost-based pricing adds a percentage (commonly called the pricing element) to the cost of making the product to determine the product’s selling price for eCommerce stores or retail outlets.
This method also takes into account the price floor and price ceiling of any given product. Given operational and manufacturing costs, the price floor is the lowest product price. The price ceiling is the highest price the product can reasonably expect to command given market position, brand recognition, and level of competition for the product.
Cost-based pricing is accessible because it’s relatively simple. There aren’t a lot of moving parts, and changing a product’s price within this method is straight-forward.
Cost-Plus Pricing
Cost-plus pricing is widespread in the eCommerce world. To use cost-plus pricing, you add a markup to the price of your product that accounts for production and product manufacturing costs to develop the product.
It’s that simple. One of the risks of cost-plus pricing is that it may not always cover all of your costs. Because manufacturing and development costs can fluctuate somewhat depending on market forces and demand curves, pricing with cost-plus can sometimes leave you in the lurch.
Regardless, its simplicity often outweighs potential complications. Especially when you’re trying to rush a new product design to market to meet consumer demand.
Competition-Based Pricing
Competition-based pricing does what it says. This method largely ignores manufacturing and production costs and instead considers how your competition prices similar products as a reference for pricing.
Because of a lot of the baseline grunt work of establishing the price has already been done for you, competition-based pricing is low risk and a light lift. It can lead to missed opportunities; however, if you don’t take the necessary time to consider whether your competition is right in setting the price they set.
What if they didn’t price the product high enough? In pricing it too low, you could be undercutting your own margins. If the opposite is true, you could be inadvertently gouging your customers, which will also hurt your potential sales velocity.
If you’re going to use this method, some due diligence is still required.
Dynamic Pricing Method
Last but not least is the dynamic pricing method. Dynamic pricing is more complex to pull off than the previous three because of the variables involved.
This method is also known as surge pricing because it requires prices to be changed as there’s a rush on a product or a drop in sales. Most often, as demand increases for a product or service, dynamic pricing will cause the price of the product to grow. It’s simple supply and demand economics.
One example is the surge pricing we all experience with ridesharing services like Uber and Lyft at peak times, or how ticket prices tend to plummet just before sporting events or concerts that have sold below expectations.
Because complex pricing algorithms drive it, dynamic pricing isn’t as typical in the eCommerce world, but some more established retailers and online brands use it as their method of choice.
Communicate the Reasoning Behind the Method You Choose
After you choose a pricing method, it’s time to explain your choice to everyone with a stake in your business.
If you’re a one-person show, give yourself a pat on the back for a job well done. Chances are, though; other people will be directly affected.
Get everyone together in the same room (post COVID-19, obviously) and layout your thought process. Walk people through the calculations. Show your work, and you’ll see that people will appreciate how careful your considerations were in setting your product’s initial price.
Setting a price for your product is just one part of the complicated equation of bringing a new product to the market. With decades of experience in eCommerce and product innovation, Gembah provides entrepreneurs and small businesses with the tools and knowledge to take on the product development life cycle with confidence.
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