Price: A practical approach
Although pricing theories are abundant, small businesses often find them hard to apply; this section introduces a simple, practical starting point.
Beyond Cost-Plus: Embracing Value-Based Pricing
A common pitfall in pricing is relying on the cost-plus method. This means adding a fixed margin to the cost of goods sold (COGS). For example, if a product costs $100 to make, a 5% markup would set the price at $105. The method is simple and widely used. However, it can limit profit potential or set prices out of sync with customer willingness to pay. A better option is value-based pricing. It focuses on the value customers perceive in the product or service.
Pricing Between Value and Cost
At its core, value-based pricing dictates that your price should be set strategically between two critical points: the perceived value of your product to the customer and your cost of goods sold (COGS). The difference between your price and COGS represents your potential profit margin. Conversely, the gap between the perceived value and your price signifies the customer’s surplus or the perceived benefit they gain from purchasing your product.
COGS < Price < Perceived Value (Willingness to Pay)
Estimating Willingness to Pay (WTP)
A major challenge in value-based pricing is estimating the customer’s willingness to pay (WTP).
One direct method is to conduct surveys asking, “How much would you be willing to pay for this product?” While this may seem simplistic, it can be surprisingly effective and is widely used in practice.
However, for small businesses, conducting formal surveys can be resource-intensive. As a practical alternative, a simplified two-step approach can offer valuable insights without the heavy burden of survey implementation:
- Estimate the highest WTP for your product.
- Set your price below this WTP but above your COGS.
One effective way to estimate the highest WTP is to consider the price of the next best alternative available to the customer and then add the value of your product’s differentiation. This involves identifying a slightly inferior competitor product, noting its price, and then estimating how much more your product is worth due to its superior features or benefits. While quantifying this differentiation value can be challenging, even a rough estimate based on your deep understanding of your product and market can serve as a valuable starting point. For example, if a competitor’s similar product is priced at $90 and you believe your product offers an additional $30 in value, then your estimated highest WTP is $120.
Although this method won’t yield an exact price, it offers a realistic and actionable price range.
The Role of Marketing in Influencing WTP
Finally, it’s crucial to recognize that marketing plays a significant role in increasing customers’ Willingness to Pay (WTP). Through effective branding, communication, and positioning, you can enhance the perceived value of your product. This leads to a strategic choice:
- Keep marketing costs low and offer a more competitive, lower price.
- Invest more in marketing to justify a higher price point.
The optimal choice between these two strategies depends heavily on your product’s positioning, target market, and overall business goals.