The process in determining how to price your products or service can often make or break your company.
Managing a startup’s financial health is a science. You have to learn to let data guide the finer points of your business, even when it goes against what your instincts might tell you. It takes time and experience to build that skill. But when you’re running a startup, some issues can’t wait.
One question that every business owner must answer (quickly) is how much to charge for their core offering. Whether you’re selling products or services, your financial health and the metrics you track on your financial dashboard are the key to getting it right.
This article covers everything that goes into that number on your price tag.
Let’s get started.
Initial Considerations in How to Price Products and Services
Before diving into the details, take the time to understand the bigger picture.
Market research and competitor analysis are important first steps in effectively positioning your business. Start by studying your customers and competitors:
Who are your target customers?
- Demographics: Define the key demographics that are hyper-relevant to your business and use them to create a simple customer persona. For example, if you’re selling men’s hair care products, then age, gender and annual disposable income will probably be the most relevant.
- Psychographics: Demographics define who you’re selling to, but it’s just as important to understand why people would want to buy from you. Are customers buying your product because they think they need it to live or do they consider it a luxury?
What strategies are your competitors using?
- Identify your competitors: Who are your closest competitors at the moment? Who would you like to be competing with down the line? Are you attempting to stand out in a sea of similar companies or are there only a handful of powerful market leaders?
- Study their tactics: How are your competitors pricing their offering? Is there a big discrepancy in price between them or do they prefer to differentiate with value? What’s making the best sellers successful? What’s holding the others back?
Answering these questions will help you get a feel for the higher-level patterns of your market. Once you’ve done that, it’s time to dive into the numbers.
Find Your Break-Even Point
In the early days of a start-up, prices can have some flexibility. You might test various rates on different customers, offer discounts to build loyalty or wait to charge more until you’ve acquired a full list of customers.
But that can’t last forever. Businesses need to focus on maximizing profits as soon as possible.
And whether you’re in those early stages or already well-established, setting your optimal price requires an understanding of your break-even point: the point at which your costs and revenues are equalized.
If you can’t sell your product or service for more than you pay to prepare it for sale, then your business will be doomed to failure.
Therefore, a simple and effective way to price your product or services is to:
- Tally up the costs to bring your offering to market
- Add an appropriate profit margin
Your target profit margins will depend on what you’re selling and what stage of growth your business is in. But the cost to prepare your offering can easily be tracked via your software or accounting solution.
Now, let’s take a look at what you’ll need to account for as a seller of physical products.
Pricing Physical Products with Cost of Goods Sold
Payments made to acquire or manufacture physical products for sale are collectively known as the Cost of Goods Sold (COGS).
If you’re purchasing your product ready-made from another vendor, calculating this number will be pretty straightforward. Just add the purchase price, the fees to ship the product to you and any additional labor costs needed to make the product ready.
If you pay for facilities to build your product from scratch, your COGS will look a little different. It will include:
- Direct Materials: The costs of the materials that go into the product.
- Direct Labor: Payments made to employees or contractors who work directly on the product.
- Manufacturing Overhead: The costs to maintain the space only for product creation.
Some industries only allow for very thin profit margins, which is why it’s so important to understand the costs that go into preparing your product.
For example, car dealers only make about a 2.2% return on a new car. The materials, cost of construction and facility overhead erode most of their profits. As a result, their pricing must be very specific to stay afloat.
Other Metrics to Track
Make sure to pay attention to the other financial metrics that will help you strategically price your products.
Here are a few that will provide some useful insight:
- Sales Volume: Even if you aren’t constantly updating your product, your prices are going to fluctuate. Savvy business owners often perform experiments with their pricing to find the ideal rate for a given market. Your financial dashboard software can track the resulting changes in sales volume, which will help you understand the elasticity of your product and price accordingly.
- Fixed and Variable Costs: Understanding the different types of costs that go into creating your product can help you gauge the perceived value for customers. Customers will likely be willing to pay more for a product that requires lots of fixed overhead (like a large factory) to create. Alternatively, if they purchase your product solely as a matter of convenience, your prices will be driven downwards.
- Repeat vs. New Business: Pay attention to whether most of your revenue comes from repeat business or from acquiring new clients. Studies consistently show that selling to existing customers is cheaper than acquiring new ones. Focusing on client retention will help you cut costs and avoid needlessly eroding your profit margins or inflating your prices.
Now, let’s take a look at how you can use similar tactics to price your services.
Pricing Your Services
As a service provider, you probably won’t have much in the way of inventory costs, but you will have to pay employees or independent contractors.
Wages and contractor fees are equivalent to production costs for service providers, which means that they’ll serve as the baseline for pricing your offering.
Just like product sellers, you can simply add those costs to your desired profit margin. However, you do have an extra choice to make as a service provider.
How do you package your service? In general, there are two ways:
- Time-based: Services are most commonly sold on a price/hour basis. Lawyers are an easy example of this model: law firms regularly pay their employees $50 for an hour of work and then bill clients $100 for that hour, leaving them with a healthy profit margin.
- Deliverable-based: The other option is to charge a fixed amount for the result of a service instead of the hours spent performing it. To continue with the lawyer example: a law firm might charge $500 flat for the creation of an operating agreement instead of billing for the 8 hours of work it takes to write one. This model incentivizes efficiency on part of the service providers and prevents customers from being surprised by an unexpectedly high price tag.
However, most deliverable-based packages are just a lump sum based on the estimated time to completion. So, whichever price method you choose, your rates will still largely correlate with the number of hours spent on a task.
That’s why the key to pricing for any service provider is to meticulously track employee hours.
Note: Again, a solid financial dashboard can help you aggregate this data and decide which method and price point are most profitable for your business.
The Unique Aspects of Software as a Service (SaaS)
Many start-ups these days opt for the SaaS business model, which falls somewhere between the traditional product and service offerings. The research and development process is similar to that of creating a physical product, but additional services are required after the initial sale.
That means pricing isn’t as simple as tracking the costs to bring your software to market. You also have to account for:
- Onboarding costs and customer education
- Consistent customer service and technical support
- Regular software updates and ongoing development
Expense considerations in a Saas business
Saas businesses have to account differently for their pricing, as typically users is the ultimate KPI to track. Unlike many businesses, your COGS doesn’t dramatically rise with each new user, but your headcount will.
One component to watch, however is your transaction fees. If you have a lot of users on a subscription model, they are probably paying by credit card. In your accounting it’s important you note the top line revenue, and then include your transaction fees (usually around 3%) as an expense.
If you’re not careful, your accounting system may count your revenue as what hits the bank after the 3% fee. This is not only incorrect for your revenue, but it also gives an inaccurate picture of your expenses.
Because of these types of nuances, pricing a Saas company is not as simple as it seems.
Fortunately, there’s precedent for a wide range of pricing models:
- Flat Rate: If you have a singular and straightforward software, this may be the best option. Its simplicity allows for a streamlined development and sales process. If you can set up a largely passive client support system (FAQs, recorded guides) and don’t require much ongoing software development, this might be the perfect pricing strategy.
- Tiered: For more complicated offerings, it’s helpful to use multiple product tiers. This allows you to sell to a wider range of customers by splitting your offerings, usually by feature. Your business can then charge higher fees to cover additional costs without excluding lower-maintenance customers.
- Usage-Based: Charging more as the usage or number of users increases is especially helpful for SaaS models that are heavily transactional. This allows clients to pay a rate that’s highly correlated with their perceived value. A customer that relies heavily on your offering will be happy to pay more, while a customer who uses less will be comfortable being charged accordingly.
The best option for your business will depend on the segments of your customer base. You can maximize profits by correlating your prices with your client’s needs, expectations and various usage.
But whichever price model you use, make sure your proceeds cover all the various costs unique to the SaaS model.
The Bottom Line
Whether you’re selling products, services or some combination of the two, setting an effective price will always come down to understanding your costs.
The best way to do this is detailed tracking and sound financial management. When you can easily visualize and study the costs of creating your product or service, pricing becomes simple.
If you’d like to take your business decision making to the next level, Pasquesi Partners can help. Feel free to contact us here to learn more about all the ways we can make your life easier.