Pricing Strategy: Pricing Inputs Theory

This is part 2 of our series on Pricing Strategy. Previous segments are available on our archives page.

Pricing Inputs (Theory)

Today we will focus on the inputs you need to inform your pricing decision. When you first sit down to try to determine how to price your product, there are a number of different inputs you can use to narrow in on the optimal price:

  • Cost of goods sold (COGS), plus a margin
  • Target revenue divided by the number of expected customers
  • Price of your competitors
  • Value of your product to your customers

Let’s consider the strengths and weaknesses of each of these to understand where they should fit into your pricing strategy.

Cost of Goods Sold (COGS), Plus a Margin

This is one of the most straight-forward and easy-to-calculate ways to think about pricing. You have fixed and variable costs of producing your product, so as long as you cover your variable costs in the short-run (and can find a way to cover your fixed costs in the long-run), you are in business! You’ll still need to test whether customers are willing to pay you enough to cover your variable costs, but knowing how much you need to make per unit helps you understand the price you need to charge to stay in business. But if customers are willing to pay more than your costs, you’ll be leaving lots of money on the table!

Target Revenue Divided By the Number of Expected Customers

Another relatively straight-forward input is to identify a target revenue goal and divide it by the number of anticipated customers, thereby yielding the amount you should charge per customer. This metric is easy to calculate as your revenue and customer targets are based on your company’s current strategic goals. Revenue and customer targets can help you aspire to a goal, but you won’t know if any / enough customers are willing to pay your calculated price or if you are underpriced relative to their willingness to pay.

Price of your Competitors

Knowing the price(s), and related product offering(s) associated with the offered price(s), of your competitors helps you understand your market, particularly how much customers are willing to pay for a similar product or service. This input can serve as a benchmark for your product and should be easy to measure as most pricing for SaaS and e-commerce companies is available on their websites.

However, your product is differentiated from your competitors’ in important ways that affect its price. Or, in some cases, you are developing something new and there are no direct competitors. Plus, you don’t know that your competitors have thoughtfully set their prices in a way to maximize their revenue. For all of these reasons, using your competitor’s price as the only input in your pricing strategy is a bad idea.

Value of your Product to your Customers

Keeping in mind how much value your product is providing to customers is key when developing a pricing strategy. This cost / benefit analysis is certainly what your customer is asking herself / himself consciously or subconsciously as she / he decides whether or not to buy your product! Thinking about pricing in this way gives you a realistic view of what people think of your product and how much they’re willing to pay to benefit from it. The input you get about the value of your product has the added benefit of helping you determine which features are the most valuable or new ones that need to be added.

Compared to the other pricing inputs, product value is the most difficult to measure accurately. One approach is to conduct a market survey or talk to customers; however, customers are biased in their response by their desire to minimize their costs. As a result, they have little incentive to truthfully tell you exactly how much they are willing to pay for your product. Another option is to estimate the direct benefit of your product by, for example, estimating the time your customer’s employees save by using your product.

So, What Do I Do?

The most important data to have available when determining the price of your product is the value you are going to add. The other pricing inputs help to complete the pricing narrative but are not sufficient alone. For example, knowing your competitors’ prices shows that you are knowledgeable in your industry and gives you the opportunity to showcase why your product is better in order to justify the price you are charging. And when you know that the price you are asking will also cover your variable costs and put you on the path towards achieving your targeted goals, you know you have a viable business!

Tomorrow, I’ll give you an example of assembling inputs to form a pricing strategy for Doug’s Desserts, my hypothetical company.

Recipe of the day: Cook’s Illustrated The Ultimate Flourless Chocolate Cake (free trial / subscription required; I do not receive any compensation for this link)