The most frequent mistake made when setting a selling price for the first time is to pitch it too low. This mistake can occur either through failing to understand all the costs associated with making and marketing your product, or through yielding to the temptation to undercut the competition at the outset. Both these errors usually lead to fatal results, so in preparing your business plan you should guard against them.
These are the important issues to consider when setting your selling price.
Make sure you have established all the costs you are likely to incur in making or marketing your product. Don’t just rely on a ‘guess’ or ‘common sense’ – get several firm quotations, preferably in writing, for every major bought-in item. Don’t fall into the trap of believing that if you will initially be working from home, you will have no additional costs. Your phone bill will rise (or you will fail!), the heating will be on all day and you’ll need somewhere to file all your paperwork.
One potential entrepreneur, when challenged as to why there were no motoring expenses budgeted for in his business plan, blandly replied that he already owned his car and paid its running expenses. It had not occurred to him that the average personal mileage per annum is 12,000, whereas for the self-employed businessperson that rises to nearly 30,000. Similarly, his insurance could nearly double as a business user, his service charges and petrol would increase directly with the increased mileage, and the expected useful life of his car would be reduced from six years to three. The net effect of this was to wipe out his projections for a modest profit in the first year and push his break-even out to the second year.
Also make sure you analyse the effect of changes in turnover on your costs. This can be done by breaking down your costs into direct and indirect (see Assignment 22 for an explanation of break-even analysis, as this area is sometimes referred to).
Another consideration when setting your prices is the perception of the value of your product or service to the customer. His or her opinion of value may have little or no relation to the cost, and he or she may be ignorant of the price charged by the competition, especially if the product or service is a new one. In fact, many consumers perceive price as a reliable guide to the quality they can expect to receive. The more you pay, the more you get. With this in mind, had Dyson launched his revolutionary vacuum cleaner, with its claims of superior performance, at a price below that of its peers, then some potential customers might have questioned those claims. In its literature Dyson cites as the inspiration for the new vacuum cleaner, the inferior performance of existing products in the same price band. A product at six times the Dyson price is the one whose performance Dyson seeks to emulate. The message conveyed is that, although the price is at the high end of general run-of-the-mill products, the performance is disproportionately greater. The runaway success of Dyson’s vacuum cleaner would tend to endorse this argument.
The misconception that new and small firms can undercut established competitors is usually based on ignorance of the true costs of a product or service, such as in the example given above; a misunderstanding of the meaning and characteristics of overheads; and a failure to appreciate that ‘unit’ costs fall in proportion to experience. This last point is easy to appreciate if you compare the time needed to perform a task for the first time with that when you are much more experienced (eg changing a fuse, replacing a Hoover bag, etc).
The overheads argument usually runs like this: ‘They (the competition) are big, have a plush office in Mayfair, and lots of overpaid marketing executives, spending the company’s money on expense account lunches, and I don’t. Ergo I must be able to undercut them.’ The errors with this type of argument are, first, that the Mayfair office, far from being an ‘overhead’ in the derogatory sense of the word, is actually a fast-appreciating asset, perhaps even generating more profit than the company’s main products (department stores, restaurants and hotels typically fit into this category), and second, the marketing executives may be paid more than the entrepreneur, but if they don’t deliver a constant stream of new products and new strategies they’ll be replaced with people who can.
Clearly, you have to take account of what your competitors charge, but remember price is the easiest element of the marketing mix for an established company to vary. They could follow you down the price curve, forcing you into bankruptcy, far more easily than you could capture their customers with a lower price.
Economic theory suggests that, all others things being equal, the lower the price, the greater the demand. Unfortunately (or perhaps not!), the demand for all goods and services is not uniformly elastic – that is, the rate of change of price versus demand is not similarly elastic. Some products are actually price inelastic. For example, Apple’s iPhone and Bentley Motors would be unlikely to increase sales if they knocked 5 per cent off the price – indeed, by losing ‘snob’ value they might even sell fewer. So, if they dropped their price they would simply lower profits. However, people will quite happily cross town to save 2p in the £1 on a litre of petrol.
So setting your price calls for some appreciation of the relative elasticity of the goods and services you are selling.
The overall image that you try to portray in the marketplace will also influence the prices you charge. However, within that policy there will be the option of high pricing to skim the market and lower pricing to penetrate. Skim pricing is often adopted with new products with little or no competition and is aimed at affluent ‘innovators’. These people will pay more to be the trend setters for a new product. Once the innovators have been creamed off the market, the price can be dropped to penetrate to ‘lower’ layers of demand.
The danger with this strategy is that high prices attract the interest of new competitors, who see a good profit waiting to be made.
Opening up with a low price can allow you to capture a high market share initially, and it may discourage competitors. This was the strategy adopted by Dragon Lock, Cranfield enterprise programme participants (the executive puzzle makers), when it launched its new product. Its product was easy to copy and impossible to patent, so it chose a low price as a strategy to discourage competitors and to swallow up the market quickly.
Obviously, the overall conditions in the marketplace will have a bearing on your pricing policy. In ‘boom’ conditions, where products are virtually being rationed, the overall level of prices for some products could be expected to rise disproportionately. From 2002 to 07, UK house prices, for example, rose sharply ahead of general price inflation. However, during the recession of 1990–92 house prices fell rapidly, in real terms, as they did again in the winter of 2007/08. From 2008 to 2011 prices virtually stood still, before starting to rise sharply again in 2013/14.
Seasonal factors can also contribute to changes in the general level of prices. A turkey, for example, costs a lot less on the afternoon of Christmas Eve than it does at the start of Christmas week.
Your selling price will have to accommodate the mark-ups prevailing in your industry. For example, in the furniture business a shop may expect to set a selling price of double that charged by its supplier. This margin is intended to cover its costs and hopefully make a profit. So if your market research indicates that customers will pay £/$/€100 for a product bought from a shop, you, as the manufacturer selling to a shop, would only be able to charge £/$/€50.
Your capacity to ‘produce’ your product or service, bearing in mind market conditions, will also influence the price you set. Typically, a new venture has limited capacity at the start. A valid entry strategy could be to price so high as to just fill your capacity, rather than so low as to swamp you. A housewife who started a home ironing service learnt this lesson on pricing policy to her cost. She priced her service at £5 per hour’s ironing, in line with competition, but as she only had 20 hours a week to sell she rapidly ran out of time. It took six months to get her price up to £10 an hour and her demand down to 20 hours a week. Then she was able to recruit some assistance and had a high enough margin to pay some outworkers and make a margin herself.
According to Management Today, nearly 80 per cent of UK companies price by reference to costs: either using a cost plus formula (eg materials plus 50 per cent) or a cost multiplier (eg three times material costs). Whatever formula you use, as accountant Brian Warnes has pointed out, you should endeavour to ensure that you achieve a gross profit margin of at least 40 per cent (sales price less the direct materials and labour used to make the article, the resulting margin expressed as a percentage of the sales price). If you do not achieve such margins, you will have little overhead resource available to you to promote and build an effective, differentiated image for your company.
Your competitive analysis will give you some idea as to what the market will bear. We suggest you complete a comparison with your competitors (Table 8.1) to give you confidence that you can match or improve upon your competitors’ prices. At the very least you will have arguments to justify your higher prices to your customers and, importantly, your future employees.
Table 8.1 Product comparison with competitors
(Score each product factor from −5 to +5 to justify your price versus the competition)
|
Rating score |
Much worse |
Worse |
Same or nearly so |
Better |
Much better |
|
|
Product attributes |
−5 |
−4 −3 −2 |
−1 0 +1 |
+2 +3 +4 |
+5 |
|
|
Design |
||||||
|
Performance |
||||||
|
Packaging |
||||||
|
Presentation |
||||||
|
Appearance |
||||||
|
After-sales service |
||||||
|
Availability/distribution |
||||||
|
Delivery methods/time |
||||||
|
Colour/flavour |
||||||
|
Odour/touch |
||||||
|
Image/street cred. |
||||||
|
Specification |
||||||
|
Payment terms |
||||||
|
Other |
||||||
|
Total |
Price is, after all, the element of the marketing mix that is likely to have the greatest impact on your profitability. It is often more profitable for a new company to sell fewer items at a higher price while you are getting your organization and product offerings sorted out (remember Henry Ford); the key is to concentrate on obtaining good margins, often with a range of prices and quality (eg Marks & Spencer has a tiered catalogue of three main price ranges: easy, medium and upper). And if you have to increase prices? Try to combine the increase with some new feature (eg new design, colour scheme) or service improvement (eg the Post Office reintroducing Sunday collections at the same time as a 1p increase in price).
The stock market works by gathering information on supply and demand. If more people want to buy a share than sell it, the price goes up until supply and demand are matched. If the information is perfect (that is, every buyer and seller knows what is going on), the price is optimized. For most businesses this is not a practical proposition. Their customers expect the same price every time for the same product or service – they have no accurate idea what the demand is at any given moment.
However, for the internet company, computer networks have made it possible to see how much consumer demand exists for a given product at any time. Anyone with a point-of-sale till could do the same, but the reports might come in weeks later. This means online companies could change their prices hundreds of times each day, tailoring them to certain circumstances or certain markets, and so improve profits dramatically. easyJet.com, a budget airline operating out of Luton, does just this. It prices to fill its planes, and you could pay anything from £30 to £200 for the same trip, depending on the demand for that flight. Ryanair (Stansted) and Eurotunnel (Waterloo) have similar price ranges based on the simplest rule of discounted low fares for early reservations and full fares for desperate late callers!
CASE STUDY Secret Escapes
Some business sectors, in particular double glazing, travel and hotels are famous, or perhaps it would be more accurate to say infamous, for misleading pricing. Endless sales on the high street have made consumers justifiably cynical about price-led promotion. Secret Escapes, founded in 2010 relies on selling discounted luxury hotel stays as the heart of its business model. The company’s skill lies in convincing customers that the 70 per cent discount touted is real. They achieve this by using television advertising, a believable media, to get across their message that ‘even the best hotels don’t want empty beds’. They hand pick the best hotels in their sector in the UK, Germany, Sweden, Poland and the USA, the markets in which they operate, and offer deals that are exclusive to Secret Escapes for the period they are on offer making sure their proposition is significantly cheaper than anyone else in the market.
Founders Alex Saint (42) and Tom Valentine (33) come from related industries. Saint, a Geography graduate of Nottingham University, began his career at Unilever, before launching Dealchecker.co.uk, an aggregator travel deals website. Valentine has always been in online market places, starting out with eBay before coming across from online fashion brand Koodos. Getting visibility on television isn’t cheap; their first month’s campaign cost £250,000. It was £14 million worth of fundraising from Octopus Ventures, Atlas Venture and Index Ventures, the private equity firm who backed online clothing retailer Asos and LoveFilm, the online movie rental business acquired by Amazon, that made heavy-hitting TV commercials a practical strategy.
Although the founders now only own 30 per cent of the shares of Secret Escape, they have a business that can confidently spend over £10m annually on promoting its pricing proposition. The company’s latest accounts (2016) show annual revenue of £30,888,000, up from £11,597,000 three years earlier. They have over 23 million people on their mailing list.