Gregory R. Passewitz
In business it is possible to have the very best product or service and have excellent sales volume, but if the wrong price has been set on the product or the service the business will eventually fail. In any business, the ultimate reason for a pricing system is to make a profit from your work. The amount of profit depends on your costs, both variable and fixed, selling price, and the number of items sold or services rendered. Some components to consider when setting a price include:
In determining a price for your product, it is important to use your costs of production as base. Therefore, you must know your cost of production so that a break-even point can be established.
The first step in pricing is to determine your product cost. All costs can be divided into variable and fixed (overhead) costs. Variable costs, sometimes called out-of-pocket costs, are the costs of doing business. These are production-related and include materials, labor, advertising and packaging. The fixed costs are the costs of being in business. They include all items that you pay for regardless of whether or not you are producing or selling a product. Examples are tools, equipment, depreciation, utilities and taxes. Remember, the reason for establishing your product cost is to form the base for your pricing formula.
No single pricing formula will work for all businesses, nor is there a formula that will assure maximum profits in all situations. Every business must approach the problem individually. What follows are several formulas to help you determine a price. Each formula adds an additional item to consider in determining a selling price. By making conscious decisions based on facts, you can determine your price. If, after using the formulas, you find that your selling price is noticeably higher than that of your competitors, you may need to look for ways to lessen your production costs, reduce overhead costs or accept less profit, and become more efficient without affecting the quality of your product.
In helping to compare the pricing formulas, assume a firm has determined that a market exists for guinea pig cages. The cost of materials per cage is $4. It takes one hour of labor to construct the cage and the labor rate is $5 per hour. Overhead costs are $2 per cage.
Materials + labor (production time x hourly wage) divided by number of units = selling price per unit.
Example: $4.00 + $2.00 + $5.00 divided by 1 cage = $9.00 selling price
This approach is often used by beginners because it provides a reasonable wage. You must determine material cost and give yourself a labor rate. There should be a value placed on your time. There is no allowance for overhead costs, inflation or profit.
Materials + overhead + labor (production time x hourly wage) divided by number of units = selling price per unit.
Example: $4.00 + $2.00 + $5.00 + $2.50 divided by 1 cage = $11.00 per cage
Overhead costs have been added in this formula.
Example: $4.00 + $2.00 + $5.00 + $2.50 divided by 1 cage = $13.50
This is the most individualized approach because a conscious decision is made about the profit you want from your business. You decide on a satisfactory wage and the amount of time you spend earning it. Profit and your labor rate are not the same.
Wholesale price (Formula C) X 2 = retail selling price per unit.
Example: $13.50 x 2 = $27.00
This is a general distributor or retail pricing formula.
It assumes efficiency in production and a steady demand. When you decide to wholesale you must understand that the buyer will mark up your item a certain percentage. If you sell directly anywhere in the vicinity of the retailer, you must not under-cut the shop that is handling your work.
A service-oriented business needs to figure the operating or fixed costs and the variable costs simply to keep the business going. These costs are the same as for the product-oriented business. In a service-oriented business the price should include:
Labor is usually the major portion of the service-oriented business expense. You must figure out what your time per hour is worth for each service job you do and include it in your price.
You may decide to change the hourly minimum wage for yourself. If the service you provide is complicated and/or requires special expertise not readily available, you may want to charge a higher amount for your labor. Keep in mind this will create a higher price and some customers will either be unwilling or unable to buy your service. Some entrepreneurs are willing to charge less than minimum wage for their labor until they have established their business reputation.
Profit should also be included in the price. A business cannot continue to operate if it does not make a profit. You will want to find out the profit percentage made by other similar service- oriented businesses and include a comparable amount in your price. Use the following formula to determine a price to charge for your services.
Formula A-Price Per Hour of Service
Labor expenses per hour + overhead and variable expenses + profit = price per hour charged.
Formula B-Price Per Job
In lieu of charging an hourly rate for your service, you may wish to have a per job charge. To figure out this price, determine the total hours to do the job, then add this figure to this formula.
Labor expenses per hour x hours needed to do job + overhead and variable expenses + profit = price charged per job.
Remember, the key to setting prices for your product or service is to set them high enough to cover all your costs and low enough to encourage people to buy. Learning to set prices takes some business experience. The information in this fact sheet is presented as a helpful guide; some degree of flexibility is needed.
Whether they know it or not, most consumers develop mental attitudes about the price they are willing to pay for a product or service. There is considerable evidence that the importance of price in the decision to purchase varies from product to product and person to person.
There are numerous price strategies used by businesses to take advantage of customer pricing psychology. Three of the more common are listed below.
Simply put, this is a strategy where the customer perceives quantity buying as involving greater savings. An example is an item that normally sells for 49 cents. Multiple pricing would change this situation to a two for 89 cents or perhaps three for $1.39 price. In general, multiple unit pricing is usually effective in increasing immediate sales. However, this pricing technique may not increase the rate of consumption of the product. People will buy extra units of the product and use them as needed.
Several factors ought to be considered when using multiple unit pricing. First, the multiple-unit price has to be easy to understand. Eight for 79 cents is usually less effective than simple multiples of two for 19 cents. Second, the bargain concept of multiple pricing is not usually effective over the $10 range. It is, however, very effective for items within the $1 range.
Odd number pricing refers to setting a price just below the psychological breaks in the dollar, such as a price is set at 49 cents or 99 cents rather than 50 cents or $1. Prices may be set at 19 cents or 49 cents or $19.95. This gives the psychological impression to the customer that the price is not 20 cents or 50 cents or $20, but less. Odd number pricing is often avoided in prestige stores or with higher priced items. An expensive dress could be priced at $150, not $149.95.
Prestige pricing refers to high markups and/or pricing above the market. Many consumers are willing to pay more for a product or service because it is felt the product or service is of higher quality or possesses brand or manufacturer prestige. Usually above-market pricing can be done only when the product is unique or distinctive, or when the seller or manufacturer has acquired prestige in the field.
All educational programs conducted by Ohio State University Extension are available to clientele on a nondiscriminatory basis without regard to race, color, creed, religion, sexual orientation, national origin, gender, age, disability or Vietnam-era veteran status.
Keith L. Smith, Associate Vice President for Ag. Adm. and Director, OSU Extension.
TDD No. 800-589-8292 (Ohio only) or 614-292-1868