Setting and Changing Product Prices
There are three important considerations when making pricing decisions: costs, customers’ perception of value and competition. These three factors are also referred to as the legs of the pricing tripod. Product costs are internal to the organization, while customers’ perceived value and competitors’ prices are external to the organization.
The product cost is the floor price or the lowest price you can charge your customers. Unless you are in business for altruistic reasons, your product price must recover all your costs of doing business. Your product cost must include all relevant costs such as direct materials and direct labor (or variable costs) which are directly traceable to production. The variable costs increase with the number of units produced. There are other costs of doing business (fixed cost) which are not directly related to production such as the cost of electricity in running your administrative office, the salary of office staff, etc. The fixed costs are normally allocated by the company.
Secondly, the customers’ perception of the value of your product is also important. The ideal situation is when price is the same as how the customers perceive the value of your product. When you are charging a very high price compared to the perceived value, customers will simply not buy your product. However, if you are charging a lower price compared to the perceived value then you are foregoing revenue and profit opportunities. The challenge is how to identify the customers’ perceived value and this takes knowing your customers really well.
Finally, the prices your competitors charged for their products is the third consideration. Depending on your target customers, your product image and product features, you now situate your pricing relative to your competitors. A useful method is to use price indexing relative to the market leader in your category. You can charge a premium, say 20 percent above the category leader, if you have a superior product. Else, you can have a parity price or a lower price if your product is of lower quality. If your product costs serve as your floor price, competitive prices set the price ceiling.