How can you price competitively and still make a profit?
Last year, I sold my product at $1,000 USD, but the average market price was $1,600 USD!
If you're developing a physical product, you might have faced the same frustration. How are you supposed to price your product competitively, cover the costs of production and still make a return?
Well, mistakes happen when we attempt a blind jump into the competition with a price drop to capture the market.
I spent an entire year mastering pricing strategy, and I'm going to share the most effective and practical strategies to set the price of your product.
So, let’s jump right into it.
Why do you need to have a sound pricing strategy?
If you set your product's price by just taking a shot in the dark, you won't hit any target. But we're going to help you learn the right pricing strategy.
First, let's take a look at the difference between selling a physical product versus a digital product or service.
Pros of selling digital product or services
The setup cost of a digital product or service is lower compared to a physical product. You have no shipping cost and a theoretically infinite inventory. Nothing to go “out of stock”!
Best yet, there's zero marginal cost. In other words, selling one more unit of a digital product doesn't increase the cost of production.
Pros of selling physical products
Physical products have higher perceived value due to their tangibility.
Most clients will understand the straightforward benefits of physical products.
How do you calculate the right price to charge for your product?
Learn market dynamics
The market will give you a good idea of a competitive price.
Now, don't automatically opt for a price match as it will not make you stand out. Just see the price which clients are willing to pay and what the market can allow you to set.
This means you need to have a look at supply and demand. Look at long-term demand trends in your business vertical, and look at how the market is supplied.
Here's a bit of micro-economics for you: A demand curve plots how many units of a particular item consumers would buy at a particular price. A supply curve plots how many units of a particular item companies would produce if they can sell them at a particular price.
In general, the lower the price, the more units consumers will demand. The higher the price, the more units companies will produce. The sweet spot in the market is where supply and demand meet. This is called the equilibrium price. And that's where you want your product to reside.
Spy on competitors
But, unless you're an economist, it might be a bit difficult to plot supply and demand curves for your product. Don't worry. You can get a decent idea of the equilibrium price by looking into the pricing strategy of your competitors.
Look at several different competitors and make sure that their products are fairly analogous to yours in terms of form, function and quality. Then look at their pricing history. This should give you a decent insight into the history of demand. And an average of their prices should give you a fair idea of the equilibrium price for the product you're selling.
Your own unit economics
Every business has some organizational goal. While setting the price of your physical product, you shouldn't ignore your own revenue goals, or the costs associated with producing your product and bringing it to market.
Here are some tips which will help you:
Write key points of your business' financial model and keep on reviewing the pricing strategy from time to time.
Set reasonable margins at the start and then make decisions according to market feedback.
Don't compromise on a reasonable return on investment, and always calculate opportunity cost.
Your cost of production
Sit with all the stakeholders and calculate the total cost to produce your product. This should be broken down into a per-unit cost.
To do this, you're going to look at your fixed and variable costs.
Total fixed cost of production
Any cost that remains unchanged regardless of output is a fixed cost. This could include costs like building rent, insurance and property taxes. These costs are also known as overheads.
The income statement of your business will show a wide range of costs which include direct, indirect and capital costs. They are either short-term or long-term liabilities according to the balance sheet data.
See, you need to pay fixed liabilities either you get revenue from your business or not. So, include this cost while setting the price of your product.
The total variable cost of production
On the other hand, variable costs are those costs that change when the output fluctuates. The things that are included in variable costs are your labor costs, cost of raw materials and energy resources.
Average total cost of production
Now let me make things a bit complicated.
Your average total cost of production involves adding your total fixed cost to your total variable cost and then dividing by the quantity produced.
Let's say you pay $1,000 per month in overheads (lucky you), and you manufacture a widget which costs $2 per unit to produce. You produce 2,000 of these widgets, for a variable cost of $4,000. Add your fixed cost of $1,000 and you get $5,000. Divide by the 2,000 widgets you produced and you get an average total cost of $2.50.
Now, you have some data to base your pricing decisions on. You know that producing 2,000 widgets costs you $2.50, so you obviously have to sell them for more than $2.50 to get a return.
Diminishing marginal returns
OK, this might not impact your pricing initially, but it's a concept to consider in the future.
Diminishing marginal returns is the concept that, at some point, the cost of producing one more unit begins to outweigh the benefits.
For most of your business' production, manufacturing additional units will bring down the total average cost. In other words, the more widgets you make, the cheaper it gets.
For instance, in our example above, say we went nuts and produced 5,000 units instead of 2,000. At $2 per unit, that's $10,000. Add in the $1,000 fixed cost and we get $11,000. Divide by 5,000 units, and it's an average total cost of $2.20.
See what happened there?
But, let's say we decide to produce 20,000 units, but to do so we have to rent several more factory spaces for a total of $10,000. All of a sudden, our fixed cost jumps to $11,000 (including the $1,000 from before). We produce our 20,000 units for $40,000, add in our fixed cost for a total of $51,000 and divide by our 20,000 units. Our total cost has now risen to $2.55.
While it's not likely to be a problem early on in your business, as demand for your product rises, you'll have to take diminishing marginal returns into account in your pricing.
Getting a return
After you've figured out your total cost of production, it's time to decide what sort of return you want on your product.
The return you're looking for will depend on whether you're selling to a retailer or selling direct-to-consumer.
If you're selling to a retailer, remember that your product will be marked up again by the retailer. Typically, retailers will look for a markup of around 50%. So, in order to competitively price your product, you'll need to make sure it's still competitive after that 50% markup. And, you need to make sure the price you offer to retailers is competitive with similar products from other manufacturers.
A reasonable markup to retailers is about 20–30%. So, in our $2.50 widget example, you'd be selling to a retailer for $3.25, and they'd be selling to the consumer for around $4.88. That leaves you with a profit of $0.75 per widget.
Now, if you're selling direct-to-consumer, the average markup is 55–65%. So, let's say you mark your $2.50 widget up by 65% for a total price of $4.13. This means a profit of $1.63 per widget. Not only is it a bigger margin than selling to the distributor, but you also don't have to worry about competing for shelf space, and you can undercut the retailer on price.
Now, you should have a clear idea of how to price your physical product. Don't forget to keep on reviewing your pricing strategy to respond to supply and demand.