Every entrepreneur faces the complex question of how to price their product or service, and it’s a decision that can make or break your business. Unfortunately, there’s no set formula for this calculation, and experts hold vastly different opinions on the matter.
You might have heard the popular maxim that pricing is more art than science, and our research bears out this principle. Not to worry—we’ll walk you through each step you can take in order to learn how to price a product, so you can settle on the model and strategy that’s right for your enterprise.
For those who’d rather skip the detailed explanations and get straight to the bottom line, you can jump to the infographic at the bottom of this post.
Although figuring out how to determine the price of a product seems like it should be a simple process, it can be one of the most time-consuming aspects of your initial small business marketing. After all, you’ll want to take time to set your prices carefully, as they’ll play a large role in the number of sales you make and the revenue you earn.
This being said, learning how to price a product may be a little different based on your unique business and the goods you’re selling—generally, however, you can follow these six steps to get started:
The first step in deciding how to price a product is to establish how much it costs to make your goods or provide your service. After all, your goal is to turn a profit—which is impossible if your expenditures aren’t covered. Generally, your expenses fall into three categories: materials, labor, and overhead.
Let’s break each of these components down.
Materials: Materials constitute the raw components of production. For example, if you make clothing, your materials might include cloth, buttons, and thread. If you provide a service, you might still have material costs, depending on the industry. A janitorial business, for instance, requires items like mops, buckets, and other cleaning supplies. If you source products from another entity, your materials are the items you acquire from the initial seller, plus anything required for repackaging.
With these examples, determining the cost of your materials may seem simple, but it’s not always so straightforward. If you run a tech company, for example, you’ll need to consider the value of your computers and servers. Such devices might fall under materials if they comprise part of your actual product—i.e. your business sells technical components. On the other hand, if your computers are merely tools to enhance your service, they’ll fall under overhead, which we’ll discuss below.
Labor: Labor measures all physical and mental manpower necessary to create your product or service. Whether it’s a worker on the factory floor or the receptionist in your office, if you hire someone who adds value to your business, that person becomes part of your labor calculation.
Don’t forget that salary isn’t the only cost associated with labor. You may need to pay for benefits like insurance and retirement plans, as well as payroll taxes for social security and Medicare. You’ll want to be sure to include all these expenses in your computations.
Additionally, you should remember to account for the time that you invest into your business as an entrepreneur. Many business owners underestimate the value of their time and undercharge for their services. One way to avoid this error is to document each step in the processes you complete daily for your enterprise.
Then, step back and examine the amount of knowledge required and energy expended on each task. You may be surprised by the extent of your contributions and your expertise, and you can be less partial as you price your own work.
Finally, if you’d like some objective data, consult the U.S. Bureau of Labor Statistics to compare the average price of labor by industry and by geographical area. This tool might provide some perspective as to whether your costs are in line with similar businesses.
Overhead: Next, overhead expenses are a catchall phrase for expenses that aren’t covered under materials or labor. These expenditures can either be fixed or variable.
Fixed overhead is the costs that you must pay every month—no matter whether your company is in the red or in the black—and the amount remains relatively constant each month. Fixed overhead includes rent, insurance, salaries, depreciation on equipment previously purchased, payroll costs, some taxes (others are variable based on revenue, etc.), and utilities.
Variable overhead expenses, on the other hand, are expenses that vary month to month, and depend on factors like seasonal change and fluctuations in profit. Such costs include marketing, shipping, office supplies, and travel.
This category also encompasses what are typically one-time expenditures necessary for starting up, such as security deposits, equipment purchases, and fees for state and local licenses. To calculate variable expenses for the purpose of pricing, use an average monthly figure based on an estimate of the annual total.
Once you’ve calculated each of these three different types of costs, you can add the numbers together to arrive at an accurate figure for your total cost of output. This number will be important to ensure that the selling price of your product will allow you to make a profit.
The next step in learning how to price a product is determining your desired profit.
You can calculate your desired profit as the dollar amount above costs that you wish to make per unit or per customer, or perhaps as the percentage of revenue that’s actually profit once you deduct all your expenses—a figure also known as your profit margin. Your profit goal might be somewhat arbitrary, although you can look to professional associations in your industry for guidance. Many of these organizations publish free or low-cost anonymized financial information.
If you’re unable to find such information, you can purchase an annual statement study from Risk Management Associates. RMA is a nonprofit organization comprised of the major lenders around the world that uses data collected by these institutions from small and medium-sized businesses to create annual reports on the financial health of many industries.
If RMA covers your industry (and with 2,330 choices, the likelihood is high), you can measure how your current or desired profit margin compares with others in your field.
Once you’ve evaluated your costs and desired profit, you’ll want to think about your target audience and perform some research to understand what motivates them—as this information will play a large role in how you’ll price your products.
To learn about your potential customers, you might pay a research firm to gather data, or you can collect it yourself—through your personal and social media networks.
As an example, an informal survey conducted in person among contacts and colleagues or given online can unearth a goldmine of information, if you ask the right questions. Should you have access to a relevant email list or have an existing customer base to consult about a new product—or if you simply want to sample all your friends—SurveyMonkey and Google Surveys are simple and inexpensive ways to compile and aggregate statistics via the web.
This being said, here are some topics to cover and questions to ask that should help you to better understand your customer and to determine what they might pay for your goods or service:
These answers should help you decide whether the customers within your niche market focus primarily on cost, comfort, feature set, or luxury. If their priority is cost, bundling products or services or tiered pricing may appeal to their preferences. If comfort is of utmost concern, you might decide to charge more and emphasize the amenities that set you apart from the competition.
Should your customer prefer a robust set of features, subscription-based pricing might work well—as it allows for a constantly evolving and ever-changing product. And if your customer is all about prestige, you’ll want to avoid pricing your product too low; such individuals associate the cost of an item with its quality.
Now that you understand the priorities of your customer, it should be easier to differentiate your direct competition from other potential competitors. Who offers a product or service similar enough to yours that your customer likely faces a choice between you and them? What do they charge?
As you’re figuring out how to determine the selling price of you products, evaluating your competition will be extremely helpful. Of course, you won’t want to completely mirror what your competitors do, nevertheless, looking at their strategy will likely inform how you develop your own.
This being said, in order to perform a thorough market analysis of your competitors, you can start with an online search. You can unearth a wealth of competitive data online, and not just on a company’s website.
You might use Google Alerts to stay abreast of the latest news on any business, product, or industry. Similarly, Google Trends reveals the popularity of all search terms—like the name of a possible competitor—and the locations from which that query is most often entered. This tool also displays related search terms and the respective popularity of each one. With this knowledge, you can further hone your list and evaluations of direct competitors.
Additionally, you can follow the social media accounts of your future rivals. You’ll learn about their target demographic, their marketing strategies, and whether they’ve found a niche. Do they have a large online audience? If so, you’ll want to pay close attention to their tactics—especially when they involve price. Watch what type of promotions they offer and when, and consider whether you can match or exceed their discount pricing strategies.
If your internet efforts don’t yield the results you need, you might also investigate the old-fashioned way. You can call or visit possible competitors. You can also ask your current or potential future customers about the competition, as we discussed above.
At this point, you’ve performed all of the research and calculations you need to determine how to price a product. With the information you have, you’ll be able to look at some of the most popular pricing strategies and decide which ones you’ll want to use to set your own prices.
Of course, these pricing strategies are simply frameworks to help guide your decision-making process, not definitive blueprints. Therefore, it’s very likely that you’ll want to incorporate several methodologies in order to calculate the selling price of your product, as well as adopt these tactics to your unique business needs.
First, you might consider cost-plus pricing. In short, this is the textbook model of how to price a product that we referred to above: calculate your costs, add your desired level of profit, and then you have your price. Some sellers calculate the price of their product simply by doubling their costs, which is a simplified version of cost-plus pricing.
As an example, let’s say you’re trying to determine how to price a product for your retail business. You sell sweatshirts with the following costs:
You decide you want to make a profit of 50% of the cost of your expenses. Therefore, you’d multiply $30 by 1.5 to get a price of $45. For each sweatshirt you make, it costs you $30, but with a price of $45, you make $15 on each sale.
Although this methodology is common, as we’ve seen, it fails to account for factors like customer preference, brand image, and competition. It also largely ignores the laws of supply and demand.
This being said, even if you adopt this model, cost-plus pricing might not be a realistic option out of the gate; it might be impossible to cover all your costs right away, especially if you’ve just started out and have accrued significant one-time expenses.
Moreover, if you use this approach, you’ll want to be certain to include all your costs in these calculations. If you overlook hidden costs like inventory markdowns or holiday pay, you may undercharge your customers and neglect to produce the profit you require to stay afloat.
The goal of many pricing models is to maximize profit. However, it might be just as (if not more) important to maximize market share—which measures the percentage of an industry that your business controls—particularly if you’re new to that market.
To gain market share means that you gain customers, which should eventually produce a net increase in revenue, even if you must first lower prices to grow that market share. (Think volume over price.)
A boost in market share may also result in what is called a network effect, where the value of your product rises as more people use it, which might allow you to raise the price later down the road.
The Windows operating system created by Microsoft is an excellent example of the network effect. As Windows became an industry standard, more developers created applications that ran on Windows, which increased its inherent value to the consumer, and thus customers tolerated a surge in price.
If you have a low market share in a fast-growing industry, the goal should be to increase market share or to penetrate the market, as they say. You might consider a lower price than your competitors to encourage customers to try your product or service, and perhaps to switch for good.
You can raise your price slowly once you establish brand loyalty with your new client base, although that might not always occur. A consumer who changed companies once because of the price is more likely to do so again, so this strategy might only take you so far.
Dynamic pricing is also called demand pricing, which means that the cost of a product or service varies based on when and where it’s offered or sold, and to what extent the demand for the item is on the rise.
For instance, you might find your favorite fashion at various prices, depending on where it’s sold. The apparel industry consists of retailers, discount chains, wholesalers, ecommerce sites, and more. Each of these vendors will pay a different price for the same item, and will likely pass that cost on to the customer.
If the style you seek is not popular, i.e. demand is low, the production house may pass the clothing to a wholesaler, who buys inventory in larger quantities and for less than a retailer. The wholesaler may then unload that inventory to a discount chain or an ecommerce site, where the customer can acquire the piece at a reduced price. Conversely, if the item is on-trend and market demand is high, you’ll need to pay full-price at a primary retailer to obtain the same style.
This being said, surge pricing is a type of dynamic pricing most commonly observed with rideshare services like Uber and Lyft. When demand rises during inclement weather or during rush hour, for example, the price of a ride increases significantly.
Ultimately, using a dynamic pricing model to calculate the selling price of a product requires you to keep tabs on the demands for your time and the popularity of your product, and to raise prices commensurately.
Next, in some markets where it’s difficult to distinguish between products, like in the airline industry, businesses use a competitive pricing model. There’s often a market leader who sets the standard, and competitors follow suit. If one company raises or lowers prices, other companies feel compelled to follow.
In a competitive pricing model, if you wish to charge more than your rivals, you must convince the consumer that you provide a superior product or service—which is where investing in the right marketing tactics comes into play.
Finally, as discussed above, if your target market is not budget-conscious, they might accept a higher price when they perceive added value in your product or service. This is called the value-added pricing model.
If you think this model might help you as you determine how to price a product, you might use the following tactics to boost customer benefit and justify a higher price:
With all of this preparation, you should have all of the information you need to calculate the prices for your products and start selling. As we mentioned above, you might choose to incorporate multiple pricing strategies or adopt certain strategies for your individual product, business, and industry.
This being said, it’s important to remember that after you’ve successfully learned how to price a product, it doesn’t mean your pricing process is over. In fact, it’s highly unlikely that you’ll only set prices once.
Instead, you’ll want to monitor your prices and sales, and adjust as necessary. You’ll want to watch for changes in the market, as well as keep an eye on your competition. Additionally, you should track your costs to ensure they don’t rise significantly without your knowledge and mind your operating revenue as well.
Moreover, you should note whether the public perception of your product changes for any reason, either positive or negative. Any of these issues might signal a need to reevaluate your prices.
At the end of the day, much of the process involved with learning how to price a product is fluid. Nevertheless, the best thing you can do is get started and take the process one step at a time.
This being said, as you perform research, evaluate your costs, and consider possible profits, you’ll want to carefully weigh all the factors we’ve laid out here. When it comes down to it, however, it’s likely that you’ll want to err on the side of higher prices (but also keep pricing transparency in mind). Many entrepreneurs tend to charge too little for their products, especially when they’re just starting out.
Plus, it’s always easier to lower prices than to raise them, and the market will provide a quick correction if you overshoot the mark with your strategy. Therefore, whether you’re brand-new to business or a seasoned veteran, your effort and your ingenuity are probably worth more than you realize—don’t be afraid to trust your instincts and set your prices accordingly.
Elizabeth is a marketing and communications consultant who specializes in expansion, strategy, and branding. With a background in ecommerce, tech, and lifestyle, she’s written and managed digital media campaigns for websites and corporations including Glamour and Amazon. You can follow her on LinkedIn.