Who is involved in setting product and service prices?
There’s no single standard formula for pricing all products and services. Instead, you’re dealing with an inexact science that has to be tailored and sometimes drastically modified to multiple factors, including your brand image, specific market, target customers, competitors, production quality, and of course, your own labor and production costs.
In other words, one person doesn’t really decide how to price products and services. Customers, competitors, employees, branding pressures, and in some cases, even government regulators, all factor into the final decision.
Step-by-step guide for setting prices for products and services
The following is a step-by-step guide to help you determine the prices for your products or services. The process for both is mostly similar, but some parts also cover certain aspects such as labor and time costs that are particularly important for pricing services.
1. Calculate and streamline production costs
The most basic factor in setting prices for products or services will be your total cost of goods sold. This is the overall cost that your creation entails in terms of material expenses, labor costs and other direct expenses.
You can keep this process as simple as possible by using cost-based pricing, which means tallying up all of the labor, time and material costs that go into creating and distributing your product or service, and then dividing this on a per unit basis. You then choose a markup on top of this amount per item or service unit.
The costs of your products and services can be broken down into two essential categories: direct costs and indirect costs. Although both are important, indirect costs are usually trickier to factor into pricing. Here’s a breakdown of the two categories:
Direct costs
- Production materials
- Direct production labor
- Inventory purchases
- Shipping, packaging and storage expenses
Indirect costs
- Office and production space rent (or mortgage)
- Utilities
- Equipment depreciation and maintenance
- Insurance costs
- Advertising and marketing costs
- Indirect labor expenses for non-production employees
- Administrative expenses
For most products and services, you should also leave room for the additional markup caused by taxes, especially if you’re selling commodity goods in a competitive market.
2. Examine your competitors’ prices
Although you will have to keep competitor prices in mind, this doesn’t mean that you must follow them for your own price rubrics. In fact, if your only rule for setting the consumer prices of your services and products is to follow along with what the competition does, you risk falling into a race to the bottom where you fail to understand your market and separate yourself from the competition by innovating in unique ways.
To avoid this, instead of focusing on competitor prices, carefully examine what your competition offers at what price so that you can better understand how to make your own offer stand out so it can be attractive to customers.
Even in commoditized markets for products like mass produced staple goods or foods, knowing your competition enough to create a perception of uniqueness and differing value will allow you to be more independent in your pricing. This will let you increase earnings and build a more stable business.
3. Keep basic pricing methods in mind
Once you have your production costs quantified and understand how your competitors are pricing their specific value propositions, you should work to understand specific basic pricing methods before pricing products or pricing services.
To give a quick overview, key basic pricing strategies include:
- Cost-plus pricing. This pricing scheme calculates all production costs as described above and then determines what price to apply for the desired profit margin. For example, if your total costs per product were $20 and you want to have a 50% profit, you’d set your price at $30. How high a markup you can justify should also take your brand position into account, not just cost-plus calculations.
- Targeted Return. This pricing mechanism sets prices based on the specific investment return that you want. In short, if total business investment costs break down to $20 per product or unit of service sold, and you or your investors want a 20% return, then you’d price your product at $24 per product or service provided.
- Value Pricing. With value pricing, you use customer psychology and the success of your marketing strategy to obtain the maximum return on your sales. In other words, you set prices based on the worth your customer believes your products or services have. This is a technique commonly used by many luxury brands or boutique services firms. To be sustainable, high pricing also needs to be backed by genuinely high quality.
- Competitive pricing. With competitive pricing, you base your own prices on those of your competitors and try to keep production costs as low as possible. Competitive pricing is very common for highly commoditized markets but can become a major weakness in any niche where customers don’t consider price as their deciding factor.
4. Understand your customers
Regardless of your products, services or prices, your customers must be willing to pay for what you offer. Ensuring this outcome means understanding your clients, their needs and what drives their decision-making.
If what you’re selling is a commodity product in a competitive market, communicate with customers via surveys, questionnaires and focus groups, or through direct conversation via your social media accounts, to find out what they still think is lacking in your particular niche. If you can offer that, or even its perception, then you can set your prices much more flexibly than your competition.
Remember that underpricing and overpricing can devastate your reputation. Regardless of your market, if you simply set your prices too low without making sure that customers understand what specific qualities this delivers to them, you can easily be perceived as cheap and lose customer trust and sales volume in your specific value proposition.
Overpricing can cause the same effect for the opposite reason; by setting an abnormally high price for your product or service without first creating a perception of elevated value, or a concrete value proposition that justifies that higher price, you’ll lose the trust of potential customers. This can happen because they may view your brand as unjustifiably overpriced.
5. Keep time investment in mind
Time is a precious resource that rarely receives the appreciation it deserves. However, it still represents a crucial aspect to take into account. If investing in the production of your products or services cost you a great deal of time, then at least some part of this amount should be included in your pricing strategy.
Pricing products with time outlays factored in can be especially plausible if your strategy relies on perceived luxury or craft value by customers. The knowledge that every one of your products took a long time to produce because their quality is superior can be added to your marketing plan to justify luxury markups. The same applies to services; by presenting them as customized, high-end offerings, you can factor time investment more effectively into your price of delivery.
6. Aim for your ideal profit margin
If you’re selling a product or service, then your fundamental long-term goal is presumably to build a lucrative business. This means that you want to set prices that deliver profits but not just by maximizing them per sale. Instead, you want your prices to increase your sales volume for higher overall earnings, even with a lower per-unit profitability. The price that delivers this balance between increased sales and acceptable per-item benefits will be your ideal profit margin.
It’s worth mentioning that sales volume alone shouldn’t take center stage, either. High sales that pick up inertia because you’ve set prices below your profit margins can turn into a disaster for your business if price increases become unpalatable to existing customers, or production costs can’t be adjusted downwards later without ruining the level of quality.
7. Create a perception of luxury value
Remember that while prices are vital, they aren’t the most important factor that drives sales. Instead, it’s your ability to market your creations and sell them at a perceived value to your ideal customer base. This perceived value isn’t always strictly monetary either.
For example, a Prada handbag and a Coach handbag both offer the same basic functionality and high production quality, but the first of these costs 10 times as much as the latter. Marketing and the perception it creates for customers is an essential part of pricing in ways that don’t reflect straightforward production costs and profit margins.
How to set prices for handmade items?
Handmade items should be priced based on the same basic principles as manufactured items in terms of material costs, but giving much more weight to the time investment per product. These goods aren’t being produced industrially through a factory process; on the contrary, you’re using your own labor or that of trained artisans on an individual basis. This is a fact that you should explicitly promote for any handmade item as part of its value proposition.
The easiest way to take the above mentioned into account to price your handmade goods correctly is by using the service-based approach with hourly labor costs factored in as well.
An effective formula for pricing handmade goods is to set the hourly rate you believe to be fair for your own skilled labor (or that of your artisans), and add it to the cost of materials as a multiple of hours spent per product. For example, if your hourly rate is set at $20, you can apply the following formula: cost of materials + (hourly rate x production hours) = price.
If this is difficult because each item takes a variable amount of time to make or results in a price that’s too high to be interesting for customers, you can average prices out by applying a uniform number of hours worked for each similar product. This would result in the following calculation: cost of materials + (hourly rate x 3) = price.