Increasing your prices may seem to be an easy way to increase profitability and earn higher profits. In some cases this is true! Although increasing prices does give a higher profit margin for each item sold, it might not increase profits – a higher price may mean fewer products sold, and lower sales revenue.
There are numerous pricing strategies a business can follow, and the strategy you follow will impact on your profit margins. It will also affect the quantities of items you would need to sell to make the profits you would like. Since you need to always ensure that any price you charge will cover costs, when setting your prices, it’s a good idea to start with understanding your costs.
Remember that the cost is the amount you pay to produce a product or service (or buy it from a supplier, distributor, or manufacturer). The price is the amount you want your customers to pay for that product or service. The difference between the total cost of providing a product or service and its price is (hopefully) the profit you’ll make.
However, there are other things to think about, such as how much your competition is charging and how much customers are willing to pay. If you base your prices just on covering costs and earning a certain amount of profit, you might end up charging too much or too little. When your prices are high enough to cover costs and make you a reasonable profit, yet are attractive to customers, you’re on the right track.
There are many pricing strategies you can use in your business. The below list shows some of the options and includes notes regarding the impact on profitability.
Work out the cost to deliver the product / service, then add a margin to cover fixed costs and profits (a mark-up). This helps ensure you make a profit, but be careful to also check whether customers are willing to pay the resulting price.
Set the price based on what your competitors are charging. This could mean:
- Setting a higher price, which means you’ll need to differentiate your product, so it is seen as offering more value.
- Setting a similar price, which helps avoid price wars but still means you’ll need to differentiate your product so customers will choose you instead of competitors. This is also called ‘going-rate pricing’. Also check that you can make a profit from this price – your competitors may be able offer this price only because they have lower costs than you.
- Setting a lower price. This is risky – aiming to always have the lowest prices can lead to price wars and making losses instead of profits.
Recommended Retail Pricing:
Sell the product for the price set by the manufacturer or supplier. Using this strategy can be used to avoid price wars, but ensure your fixed costs are low enough for you to maintain a profit.
Change the price of a product depending on the location or point-of-sale. For example, offering a lower price on an online auction website than in store. Variable pricing can also be based on the day of the week. Depending on your rationale for the difference in prices, this could have a positive impact on profitability. For instance, a tradesperson could charge more for weekend work as customers who have emergencies after-hours are willing to pay extra.
New Product Pricing:
Set the price of new product high to take advantage of the lack of competition. Prices are then lowered over time once competitors begin offering similar products. The higher initial prices have a positive impact on profitability per sale – just be careful that it does not result in reduced profits through low sales quantities.
Choose prices based on how they are perceived by customers. Some examples of strategies which may increase profitability include:
- Setting a price just below a ‘round’ number (e.g. $29.95 instead of $30). This is because this is psychologically a lot less than $30 in the minds of customers. This can even work if you are increasing the price (e.g. $29.95 instead of $28.75) – many customers are unlikely to see any real difference in these two prices, even though one is $1.20 more than the other.
- Setting a high price for a product because it gives the impression that the product is of a high quality.
- Introducing a ‘premium’ version of a product for a higher price — this can work in two ways. If the ‘premium’ version is seen as being of higher quality, customers will compare this to the standard version and decide the premium version is worth paying more for. On the other hand, it is also possible to create a ‘premium’ version with additional features customers don’t care about – in this case, customers will probably see the standard version as being better value, and be more likely to buy that instead. If you follow this strategy you need to ensure the version you want to sell more of has a high enough profit margin to provide the profits you want.
- Splitting the price of an expensive product – that is, telling the customer something costs $3.33 per day rather than $100 per month.
Sell a basic product at a reasonably low price, but then make money off high priced ‘add-ons’ which customers are likely to want.
One way to increase profitability per sale is to simply increase prices. This can be risky – customers can react badly to price increases, and your sales volumes may significantly drop. However, the impact on sales may not be as bad as you would think, and a price increase may actually be necessary.
A common mistake is to not review and increase prices when the overall costs in the industry are increasing. If you have no control over increasing costs, passing these on to customers may be the best option. Keep an eye on what your competitors are doing. If they are also affected by the same costs, they may be increasing their prices too.
Example: Increasing Prices
Assume you’re selling a product for $100 which cost you $60 to produce. You’re making sales of 1,000 units per year, so with expenses of $25,000, your net profit is $15,000. Consider the impact of increasing prices by 10%. The new price would then be $110.
You can use the following formula to work out what quantity of goods you will need to sell in order to maintain a net profit of $15,000.
Increasing prices by 10% would mean you can afford to reduce sales quantities by up to 200 products (from 1,000 down to 800) before your profits are reduced. This is a decrease of 20% (calculated as the reduction of 200 products divided by the original quantity of 1,000).
In this case, you would then need to work out how likely it is you will still be able to make at least 800 sales with the higher price.
Before you decide to increase your prices, remember to do research on what your competitors are charging and what your customers will be willing to pay.
After deciding to raise your prices, the hard part is going to be telling your customers about the increase. You could just increase the price and not tell anyone – you’d be surprised how often a price increase goes unnoticed. But if you have regular customers, it is best to be upfront about price increases. The chances are your customers will understand, especially if your customers are businesses. After all, they are likely to have had to raise prices themselves!
Give customers warning in advance, rather than surprising them with an overnight increase. If you are worried about the impact on sales quantities, also consider combining an increase in prices with a way of offering extra value to customers (at little cost to you).