Are your prices right?

Here are three approaches to pricing your products or services.

By Bonnie Kreitler

Setting the "right" price for a product or service is one of the most important decisions facing business owners. Proper pricing affects the bottom line far more than many business owners realize, says Robert G. Cross, author of the recently released book Revenue Management (New York City: Broadway Books). "A 5% price improvement can create a 50% improvement in the bottom line."

Since there’s more than one way to set prices, we asked several experts, including Cross, which approaches they recommend. Here are their suggestions.

Know your break-even point

Most businesses use a simple cost-based pricing strategy, says Dennis Gruell, director of the Connecticut Small Business Development Center in Storrs. With this approach, the most important thing to do, Gruell says, is to calculate your break-even point. That’s the volume of sales that will cover both your fixed costs (rent, salaries, interest on loans and other costs that don’t change as production increases) and your variable costs (labor, materials, shipping, commissions, and so on, which do change as production increases). Once you pass that point, you start making a profit.

The classic formula for figuring the break-even point is:

Sales = Fixed Costs + Variable Costs

where Number of Units x Price Per Unit = Sales

Gruell recommends studying your market carefully and asking yourself several questions:
• What segment of the overall market are you focusing on?
• Within that segment, what is the price range from lowest to highest?
• What do customers buy at these various price points?
• How do prices appear to affect sales volume?

Obviously, the more accurately you can project sales volume at various price points, the better able you will be to set the "right" price — that is, the price that will not only surpass your break-even point but also maximize profit. That requires having good past sales data to analyze or good business intelligence into competitors’ prices and sales volume.

Jack Krichavsky, partner in charge of the commercial service group of Arthur Andersen LLP in Hartford, notes that many business owners set prices poorly because they don’t take all of their costs into consideration. They forget to count development and marketing costs, for instance. "Small businesses also frequently fail to take future growth into account," Krichavsky says. The guy starting out in his garage may not be able to earn a profit later on when he has to hire labor and rent production space if his initial price was not set with those normal costs in mind.

Focus on variable costs

Marketing strategist Gordon Landwirth, of The Growth Strategies Group in Orange, believes it’s essential to profitability to focus on variable costs when setting prices. This is particularly true for companies with multiple products. "A common mistake I see," he says, "is inappropriately allocating fixed costs to individual products when making pricing decisions. The result is pricing that doesn’t maximize profits."

Landwirth first looks at each product’s individual contribution to the bottom line (its "contribution margin"), totals the contributions from all products, and then subtracts fixed costs:

Price Per Unit - Variable Costs = Contribution Margin

Contribution Margin Per Unit x Units Sold = Product’s Contribution to Profits

Profit Contributions From All Products - Fixed Costs = Total Profit

This fine distinction can make a big difference on the bottom line, says Landwirth. As an example, he cites a product with a $10 variable cost. Suppose a company allocated $2 of fixed costs to the product and sold it for $13. Suppose sales research projected that cutting the cost to $12 would double sales volume. Most companies probably would not sell the product for $12 because they would argue that price eliminated their profit margin.

In reality, Landwirth points out, they would actually be reducing their contribution margin from $3 per unit ($13 - $10) to $2 per unit ($12 - $10). The price cut would actually increase profits because the one-third reduction in contribution margin would be more than made up for by the doubling in volume.

Analyze what people are buying

Cross, who helped the airlines design the demand-sensitive pricing system that dramatically boosted carrier profitability, says that when businesses focus on costs to set prices, they are looking in the wrong direction. "Cost is irrelevant to price," he says. "The market sets the price.

"Consumers don’t care about a business’s costs," he declares. "They care about value. And there is no average consumer," he says. "All consumers are different."

The business owner’s challenge, says Cross, is to analyze what it is that customers are really buying and to segment them according to their different demands. Then the business owner should set different prices to meet different demand levels.

Revenue Management describes the experience of Cross’ hometown barber. She refused to take appointments because no-shows eroded her bottom line. Cross was tired of waiting two hours for a haircut on Saturday, the only day the busy entrepreneur could go. He convinced her to try charging more on Saturday for people like him who needed Saturday cutting time, while charging less on Tuesday, her slowest day, to attract current Saturday customers like retirees or school kids who would prefer a cheaper haircut. Using demand-sensitive pricing principles, the barber not only satisfied more customers but also boosted revenue by 20%, Cross says.

Revenue management’s guiding principle is that some people want the cheapest price, while others will pay more for what they perceive as added value. Focus on what people are actually buying, not on what you are selling, says Cross. The barber’s customers, for example, were not just buying haircuts. They were buying the ambience of her shop, her pleasant demeanor, and the convenience of having a barber available in their rural town.

The bottom line

While the experts may wrangle about which factor is the most important driver of pricing decisions, they all agree that pricing is a crucial profitability variable. Boosting the bottom line to its maximum requires balancing sales volume (demand), price, variable costs and fixed costs in some optimum way.

As to the question of whether to discount, Krichavsky offers this comment: "I never saw anyone go out of business because they priced their product too high."

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