Pricing To Maximize Profits

SCORE ExpertAnswers

No matter the small business, each entrepreneur faces one similar issue: Pricing. Are you out pricing your customers? Are you under pricing yourself? Is the difference between a year in the red or the black as simple as your price tag? This month SCORE helps you find the answers to these questions.

Few people are better qualified to discuss this issue than Ann Logue, who spent 12 years as a financial market analyst before turning her talents to writing. She also shares her expertise as a lecturer in finance at the University of Illinois at Chicago, teaching both undergraduate and MBA students about corporation finance and international financial markets. Ann will go over the finer points of pricing to help you maximize your pricing for profitability. 

Q:

Pricing is something that all small businesses wrestle with, particularly those just getting started. What are the fundamentals for determining the ideal price for a product or service?

The short answer is, as much as customers will pay. Easier said than done? Yes. The price has to be high enough to cover all of the variable costs and some of the fixed costs of production. It also has to be appropriate to the market. A low price might attract attention, or it might make customers think that the product or service is not good quality. This is as much art as it is economics. 

Q:

What are some good information sources a new business should research when developing a price strategy?

First, you have to do research into the market. What do competitors charge? For a service, what is the cost to customers of doing it themselves? Also look at the perception of value at different prices. Shopping the competition can give you some keys, as will asking around. However, you may not talk to other companies and agree to set a minimum or maximum price for your goods or services. This is collusion, and the government takes a very dim view of it.  

Q:

For a one-person, service-oriented business, the value of time can be difficult to quantify. Any tips for building this into your price structure when you’re starting out?  

A fair value will probably be two or three times the rate that someone would receive per hour on staff. It will be on the higher end if the business requires a lot of equipment, specialized skills, or marketing time, and on the lower end for involves fewer set-up, marketing, administrative time. Note that this rate may end up varying by client. If a client will guarantee a certain amount of work, consider giving a lower rate because of the reduced marketing expense.

Q:

You’ve written that it’s OK for a new business to set low prices to help introduce themselves to customers. What’s the best way to make those prices attractive without compromising your balance sheet?

This gets back to understanding what your costs are. If your price is enough to cover your variable costs per item and making some contribution toward your fixed costs, you can stay in business for a long time. 

Q:

OK, so how long should you use introductory prices before raising them to market levels?

Here, you need to understand the dynamics of your market. How easy will it be for customers to switch from your product to a competitor’s? If it’s really easy, you will lose a lot of customers when you raise the price, so you may not want to feed into a boom-and-bust cycle by undercutting and then raising prices. But if there’s a reason that customers would stick with you, simply make it clear that you are offering a one-time new customer deal, a grand-opening special, or an introductory price.

Q:

To what extent can/should a new small business make pricing part of its long-term planning process, as opposed using a purely reactive approach?

Pricing reflects both economics and strategy, so it is, indeed, a long-term process. If your costs change, your prices may need to as well. What will the market bear? Who are your competitors, and how do they behave? How will things change next season? And how is your value proposition different from that of your competition? These things seem reactive, but if you know that they’re going to happen, you can plan for them. Also, businesses change over time. If you change the mix of products and services that you offer, you can change your pricing structure.

Q:

Why should an entrepreneur consult with a SCORE small business mentor about developing pricing strategies and policies?

It’s useful to have someone go through your costs to make sure you have your variable and fixed costs are properly considered. Have you included everything, and do you know which costs are which? It is also helpful to make sure that your perceptions of the market match the reality.

Q:

How often should you review your price structure/policies? What key factors should you look for?

This is part of ongoing cost accounting as well as ongoing market research. It’s hard to get people to part with their money. Part of research is figuring out what it takes to get them to do that. Though businesses vary, there are some common things to look at such as how people balance price and features. Are customers willing to pay a higher price for features? Do competitors differentiate themselves on quality, service, and benefits, or is all the differentiation based on price? How much do customers need what you’re selling, and how easy is it for them to find something else? 

Q:

When a price increase becomes necessary, what kind of information—if any—should you share with your customers?

This depends on several factors. What is your relationship with your customers? How easy will it be for them to switch? Is there a natural point to increase prices, such as the launch of a new product line or a new season? You really need to understand your market first, then determine how prices fit into that. The customer doesn’t really care if you are covering your costs or not, especially if there are other providers to turn to.

Q:

What are some keys to incorporating “value-added” factors into your pricing that will resonate with customers?

Many customers will pay more for better products and services, but you first need to figure out if the customers for your products will. The key, again, is doing the research to understand your customer. If you charge a higher price, you’d better be delivering on the additional value, too.

Q:

Is it improper to ask people in the same type of business what they charge, even if you don’t compete with them directly?

No one likes to talk money in our culture, so if people think you’re really asking about how much money they make, they will see it as improper. You also need to make sure that you’re not implying collusion. 

Q:

Many businesses offer incentives for customers to pay in advance or purchase more, and disincentives for late payments. Do you have any favorite strategies?

Discount for early payment is one that makes customers happy and improves cash flow for the business owner. A late fee tends to annoy customers, and at that point, your cash flow is already in trouble. That being said, I have had more success charging late fees than asking for discounts for early payment.

Q:

What large-business pricing strategies/policies can a small business use or refer to in maintaining a competitive strategy?

The strategy is pretty much the same regardless of business size: know your costs, know your market, know your customers. 

 
Q:

What piece of business advice have you found to be most applicable and enduring for small businesses?

You’re going to screw up, but it’s not the end of the world. It’s like learning to ice skate—you are going to fall down, but that means you’re learning and trying new things.

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About the Author

Ann Logue - Author and Business Analyst

Ann Logue is a freelance writer and consulting analyst who is fascinated by business and technology. She has a particular interest in regulatory issues and corporate governance. She is the author of Emerging Markets for Dummies, Socially Responsible Investing for Dummies, Day Trading for Dummies, and Hedge Funds for Dummies, and has written for Barron’s, InvestHedge, Newsweek Japan, and BusinessWeek Chicago, among other publications. As an editor and ghostwriter, she worked on a book published by the International Monetary Fund and another by a Wall Street currency strategist. She is a lecturer in finance at the University of Illinois at Chicago. Her current career follows 12 years of experience as an investment analyst. She holds a B.A. from Northwestern University, an M.B.A. from the University of Chicago, and the Chartered Financial Analyst designation.