The Science and Psychology of Successful Pricing
One of the most important factors affecting your business revenue is your pricing strategy. No matter how wonderful your product or service is, if it isn’t priced right, you won’t be able to sell it. A good strategy helps you find the best price point that will help you maximize your sales and resulting profits. Successful pricing is not just about putting a numerical price on an item or service based on a set multiple of your costs. Nor is it about seat-of-the pants instinct modified by what the competition is doing. Instead, for pricing to bring the most profit, it is helpful to employ a set of strategies that involve emotional and psychological considerations as well as the more scientific. When taken into account with your pricing strategy, psychology and emotion can have an amazing effect on your bottom line because you can increase your price over and above your cost-based price. No matter what method you use to price, however, ultimately your price must cover all of your business costs while, at the same time, maintaining a price at which your customers will still purchase your product or service.
Cost-based pricing refers to a pricing method that adds the costs associated with a product to an additional margin that will ensure the re-purchase of that product as well as a profit. Full-cost pricing and marginal pricing are two methods within this pricing category. Full-cost pricing includes a share of all the business costs in determining the final price of an item. For example, if you have 20 items to sell, a portion of your overhead, sales, administrative and other costs would be divided evenly between all 20 items in order to determine your cost and eventual price. In contrast, for marginal pricing, the only costs that are used to figure your price are those that are specific to the 20 items and then a margin is added to that. No overhead or other costs are used to calculate the price. It is hoped that enough items are sold to cover the overhead and leave a profit.
The advantage of full-cost pricing is that it ensures that all of your overhead costs and profit are covered with the sale of each item. It is fairly easy to calculate, will likely turn a profit, and is easily justified since the profits are based on actual costs. The disadvantage is that it may boost your eventual price so much that your sales of that product slow down. You also have much less flexibility in your eventual price.
The advantage of marginal pricing is that since it doesn’t add a share of the overhead and other costs on an item, it doesn’t drive the price up so much that sales suffer. You also have more flexibility to price with other market considerations in mind. The disadvantage of marginal-cost pricing is that you need to be sure that your other costs and profit are eventually covered by what you sell.
Using the full-cost pricing method, first add together all of your material, labor, selling, administrative, and other overhead costs with enough of a markup percentage to allow for a profit margin. Then divide by the number of units you expect to sell. To illustrate; you may decide that you want to make a profit margin of 50 percent on 1,000 items that you have to sell. Your total purchasing and overhead costs allocated to that item are $1,500.00, which means that your 50 percent profit margin would be $750. When the $750 is added to the $1,500 cost, the total comes out to $2,250. Dividing $2250.00 by the 1,000 items you want to sell, the resulting total cost of the product per unit comes to $2.25. In other words, if you sell the 1,000 items for at least $2.25, you will have a 50 percent profit of $750.
Since it is highly unlikely that each of the 1,000 items that you want to sell cost the same to purchase, you can break this down by item rather than average the cost of all your items. In other words, if the purchase price is $.75 for half of the items and $1.25 for the other half for a total purchase price of $1,000, to those prices you allocate $.50 to cover the $500 remaining overhead for the 1,000 item total for a cost of $1.25 for half the items and $1.75 for the other half. Then you add you 50 percent profit margin of $.75 to each of the 1,000 items, which, in turn, determines your final price of $2.00 for 500 of the items and $2.50 for the other 500 items. If you sell all 1,000 items at these two prices, it will still result in sales of $2,250 with a profit of $750.
Keep an Eye on Your Competition
When using a cost-plus formulaic pricing strategy, it is important to research what your competition is charging as well. If you find that your competition is charging much less than the price you set based on cost-plus pricing, you may need to reduce your costs or lower your profit margin. If they are charging more, you may be able to raise your price for more profit. When adjusting prices based on competitive prices, however, be careful that you don’t lower your price so much that you aren’t profitable, or that your products are then perceived as cheap or worth less than your competition. Likewise, if you price too much higher than your competition without enhancing a sense of your product’s value, your sales may drop.
Emotional, Psychological, and other Pricing Strategies
Cost-plus and margin pricing are not only some of the most widely used pricing strategies, but they can also establish a baseline price upon which you may add other pricing techniques that may greatly expand your profitability. These useful strategies include premium pricing, price anchoring, price skimming, and penetration pricing, among others.
Premium Pricing And Price Skimming
Premium pricing, a value-based and positioning pricing strategy, is when you use price to communicate that your product has features that make it worth more than what your competition offers. When you use a value-based or premium pricing strategy, not only are you appealing to your customer’s logic, but also to their emotions. Premium pricing involves setting a higher price than would be warranted by cost-based pricing alone. Whether it is a unique product, one with superior workmanship or quality, or a service that no one else provides, your job as a businessperson is to create a sense of perceived value so that your customer is willing to pay the higher price tag. You can create a sense of value through marketing and publicity, your store’s décor, packaging, by featuring products with point-of-purchase information, or linking them with respected leaders in your field through endorsements or positive reviews. Usually, premium pricing is only effective for a limited length of time. Once competitors start carrying the same product and it becomes more widely distributed, you will be forced to drop your price to be more in line with your competition.
Price skimming, related to premium pricing, is designed to help you maximize the sales on new products by setting your prices high during the introductory phase of a new product, then lowering it later in the product’s lifecycle. Rather than having to create a sense of value, the fact that your product is brand new is enough to warrant the higher price.
This is an effective pricing strategy to increase sales for your products. Anchoring refers to the human tendency to rely on the first piece of information, the “anchor,” when making subsequent decisions. Once an anchor is set, the brain interprets new information according to a bias formed by the anchor. With respect to sales, if you place a higher priced item next to a lower priced item, you will create more of a demand for the lower priced item. In other words, if you place a several smaller crystal balls next to a larger, $1,000 crystal ball, people will tend to buy more of the smaller crystal balls at $100 than if they were priced at $65 while shown separately. If you arrange your store’s products with this in mind, you will be able to charge more and will increase profit.
Penetration pricing is used to attract buyers by offering a lower initial price for either product or services to draw the customer’s attention toward you and away from your competitors. With such pricing, you are trying to penetrate a new market or a market that already exists, but one in which you don’t have enough market share. With penetration pricing, you encourage customers to try your new products or services and to familiarize themselves with what you offer. It is great for introducing new product, a new store or service. The disadvantage of this strategy is that you risk not covering your expenses, especially if you don’t get the sales that you anticipated by offering an inexpensive price. When you set your price low initially, it may be hard to raise it later.
There is no doubt that people like to get a bargain. Sales, discounts and giving something for free are some of the ways to do this without seeming to lower your price and suggesting that your product or service lacks value. Bargains have the ability to drive customers to buy now, or to buy more than they normally would, thus boosting sales.
Emphasizing free offers works wonders. Customers will buy more books when they get a free bookmark, for example. Free samples lead to more sales of what is sampled. Offering a free small crystal when a customer buys a larger stone will work wonders. Bundling products also works well. You will tend to sell more candles if you offer a third candle for half price if they buy the first two, for example. No matter what the bargain is, it is important to adjust your sales copy or have prominent signage to point your customers toward these offers. Also important is to have included extra profit margins in initial pricing so that you can afford to discount.
Odd Numbers, Simple Prices and Good Experiences
There are other considerations when setting your price that are quite psychological in nature: The first is to keep your prices simple. Prices that are more complicated look and sound higher. For example, $100 is more effective than $100.00. The second way to increase your price and profitability is by adding an odd number to your price’s ending. Because the eye moves from left to right, subconsciously customers will view the price as closer to the number on the left and round down on the right. We probably have all seen this in action. $4.99 is psychologically perceived as $4.00 rather than $5.00 even if our rational mind says differently.
All in all, to profitably price, it is best to be scientific as well as creative in your pricing while, at the same time, keeping a close eye on your results. This is true no matter what pricing strategy you are using.