By now, we’ve all heard the phrase “unprecedented times” too many times to count. And while this phrase often carries a negative connotation, there are some silver linings to the unprecedented times we live in. According to the U.S. Census Bureau, there were 5.4 million applications to start companies in 2021—a 53% jump from pre-pandemic levels. This is great news for the economy.
Whether your company is relatively new or you’ve been in business for a long time, how much to charge for products or services is one of the most important decisions you’ll make as a business owner. Because of recent inflation trends and fluctuating costs of goods and labor, pricing is one of the most intimidating aspects of growing a business in 2022.
If you’re thinking about starting a business or launching a new product or service, you’re probably asking yourself two questions:
- How much can I charge for this?
- How much should I charge for this?
Pricing is tricky; there is no one-size-fits-all solution. But don’t let that stop you from expanding your business. In this article, we’ll explain the pros and cons of some popular pricing strategies so that you can feel confident when you bring a new product or service to market.
How to calculate product cost
When deciding how to price a new product or service, the first step is to figure out the product cost. Here is a helpful equation to remember:
Cost of goods sold + packaging costs = product cost
The equation itself is simple, but various factors play into it. Let’s break those factors down together.
What is cost of goods sold?
The cost of goods sold includes all product-related costs to your business, such as materials, labor costs, overhead costs, shipping costs, and production time.
What are packaging costs?
Product packaging can affect the perceived value of your product and even increase customer retention. Because of this, you may want to consider investing in branding materials such as stickers, hand-written notes, or custom packaging. These materials make up your packaging costs.
With all of this in mind, you’re ready to tally your product cost. Here’s an example of what your calculations might look like:
- Cost of materials: $10
- Labor costs: $15
- Packaging and branding costs: $5
- Overhead costs: $10
Cost of materials + labor costs + overhead costs = $35. This is your cost of goods sold.
Packaging and branding costs = 5$. This is your packaging cost.
Now, plug those numbers into the product cost equation we mentioned earlier:
$35 + $5 = $40
So, in this example, your product cost is $40.
Now that you know your product cost, you’re ready to think about pricing strategy. Let’s dive into three common methods businesses use to determine pricing.
Three common pricing methods
Cost-plus pricing is a strategy where you take the product cost and add a percentage on top of that cost (a markup fee) to determine the price a customer will pay for a product or service. Various factors can impact your markup fee, including:
- Product cost
- Competitor pricing
- Customer-perceived value of the product
- Promotional discounts or coupons you might offer in the future
Once you’ve decided what your markup fee will be, this cost-plus formula will help you calculate the retail price of your product:
Retail price = [cost of the product ➗ (100 – markup percentage)] x 100
Let’s walk through an example together. In this example, we’ll say you’ve decided on a 50% markup fee, and we’ll use the product cost we determined earlier ($40).
[$40 ➗ (100 – 50)] x 100 = $80
So, in this example, your retail price is $80.
Using the cost-plus pricing method is one of the easiest ways to pick a price for your product, but it isn’t a magic solution that will work best for every business. While cost-plus pricing does ensure that you’ll come out on top after accounting for all costs associated with the product or service, it may not place enough emphasis on competitor pricing or perceived value.
Competitive-based pricing is a strategy that prices products or services based on data from competitors. You can use this method to break into the market with lower prices than your competition.
Here’s an example. Say there are two different gas stations on the same street—gas station A and gas station B. Gas station A uses the cost-plus pricing model to calculate a baseline price—the price they need to charge to remain profitable.
Once gas station A establishes baseline pricing, they do some investigating and figure out what gas station B charges their customers. Knowing what gas station B is charging will help gas station A make data-driven pricing decisions. They might choose a lower markup fee (maybe 45% instead of the original 50%) to keep their prices slightly lower than what the competition is charging.
Offering the lowest prices will likely result in a higher percentage of new and repeat customers for gas station A.
The problem with competitive-based pricing is that it can lead to price wars. While customers might love that your prices keep decreasing, your business won’t survive long without a healthy profit margin.
Finally, let’s talk about value-based pricing. This strategy uses the customer-perceived value of a product or service to determine pricing. The higher the perceived value of a product or service, the higher the markup fee you can charge. The idea is to charge your customers as much as they are willing to pay.
To get started with value-based pricing, you need to define your value proposition. What makes you stand out among your competitors? Some variables that may lead consumers to perceive a higher value for a product or service include:
- Positive reviews of the product or service
- Innovative marketing strategies
- Cohesive branding
- 5-star customer service
It’s important not to make blind assumptions if you decide to use this pricing method. Overcharging your customers could result in the loss of their trust. For value-based pricing to work, you need concrete evidence that shows exactly how much your customers are willing to pay. Research is your friend—gather data and use it to your advantage.
Don’t be afraid to adjust your strategy
In 2022, the costs of goods and labor are shifting in unprecedented ways, which makes pricing a top-of-mind issue for many business owners. While these fluctuating costs make pricing especially intimidating, the good news is that you don’t have to get it perfect on the first go. If you launch a product or service and find that one pricing method doesn’t work well, experiment with other pricing strategies.
By experimenting, researching, and adjusting pricing when necessary, you’ll figure out your ideal profit margin, become an expert on market trends, and feel more confident each time you launch a new product or service.