Pricing and profit

Understanding the basic concepts of costing and pricing is important in running a business. You need to know the optimum price you can charge for your product or service to:

• cover your overheads and make a profit, BUT
• not price yourself out of the market!

You therefore need to consider what the market will bear, and what your profit margin will be.

Assessing your market

What the market will bear will depend on how unique and/or needed your product or service is, or whether the market is artificially restricted (e.g. shops at airports and movie theatres which tend to charge high prices).

If there’s little competition you can probably charge more. However, if you price too high, sales can be low and you provide competitors with an incentive to copy your product or service and sell it cheaper.

If your product isn’t unique and you're not the only outlet, then setting prices is easy. Your prices simply can't be higher than that of your closest competitor.

The question you should then ask is: should I be selling this product or service? The answer may depend on your profit margin.

Your profit margin

There are three different profit margin calculations one should consider: direct costs margin, break-even pricing and profit pricing.

Direct costs margin

This is the amount that remains after paying the costs directly associated with the product or service being sold. Obviously you would want to at least cover your direct costs to continue selling the product or service.

Break-even pricing

Rather than just focusing on the direct cost of the product or service you’re selling, this calculation also takes into account your fixed costs. These are expenses that don’t fluctuate with sales, like rent, depreciation, any salaries, and so on. A break-even price would give you a profit of $0, so obviously you need to charge more than whatever that figure is. The break-even price is calculated as follows:

break-even price = direct costs/unit + fixed costs/volume

Profit pricing

This is, as you’d guess, the price at which you’ll finally make a profit. The calculation is as follows:

profit price = direct costs/unit + (fixed costs + desired profit)/volume

If you can sell your products and services at this price, and still be competitive, you’ve got a business. If you can’t, you can lower your direct costs, fixed costs or desired profit, or sell something else that offers better margins.

Price as a weapon

Price is commonly used as a strategic weapon between competitors, and there are many different pricing strategies, including:

• cost plus pricing – adding a mark-up unrelated to real cost
• perceived value pricing – based on buyers’ perception of value rather than sellers costs
• target profit pricing – based on achieving a target profit
• going rate pricing – when the price is influenced by what competitors are offering
• loss leaders – products or services priced below their true cost in order to attract customers to other items.