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HOW TO DEFINE YOUR PRICING STRATEGY: COST-BASED PRICING

This month’s article is the first of a series on pricing strategy. Why do we speak of a pricing strategy rather than price setting? Because there are several elements around pricing that fit into this reality - as we shall see in this article.

When looking at a pricing strategy, there are three main categories to take into consideration: price based on costs, the market price, and the price as a positioning tool.

In this article we will focus on cost-based pricing.  It is important to note that this article is intended for managers of small businesses, those who are self-employed and professionals aiming to figure out how to set their prices.

In its simplest form, cost-based pricing establishes prices based on cost and a predetermined profit margin. This is one of the most common techniques used, however, it does have some shortcomings - one of which is the fact that it uses elements over which we have little control, so it is prone to error. It can also underestimate the perceived value that the consumer places on the product or service.  This technique may result in your company "leaving money on the table", meaning that your target customers may have been interested in paying more for your product or service. On the other hand, this technique is particularly effective when your product or service is an innovation; you offer something that does not exist or for which there is little or no comparable offering on the market. This also holds true for companies that operate at a high volume.

What are the elements that must be included in calculating cost-based pricing? For a large company, here are some points to consider:

    - The cost of the raw materials;
  1. - The cost of production;
  2. - The corresponding administrative costs associated with production;
  3. - The corresponding financial costs associated with production;
  4. - The volume of anticipated sales for the product or service used to amortize costs over the number of units to be sold;
  5. - Acquisition costs by the client (Does the product or service need be financed? Are the payments deferred? etc.)
  6. - The cost of delivery (if it is included in the calculation of prices);
  7. - The desired profit margin.

 

For the self-employed or professional, how do all these translate into reality?

  1. It is necessary to define the cost of your raw material. What does that mean? For example, if you’re a travel agent, you sell your tour operator products, so this is your raw material cost. Do you use subcontractors? The amounts they charge you are your raw material cost. And so on.

  2. What is the cost of production? For many professionals, the cost of the transformation process is your time. It is therefore important to consider your salary in the calculation. To get there, we need to approximate the number of hours you spend on production and the rate you want to earn.

  3. For the administrative costs, it is important to consider all the aspects that go into your operations, even if you have not yet begun to pay them. What does that mean? One of the most often overlooked item here is the rent. You work from home, why then should you calculate rent? Because there will come a time where you have to include it. If you do not include it now, it is because you have made the decision to finance your business. But what happens when you find a place of business? How will this impact your pricing?

  4. The financial costs of your operations or financial expenses that are related to your business, such as bank account, line of credit, credit card payment, etc.

  5. Your business volume is perhaps the most difficult to quantify, but there are ways to find the number of units you need to sell: the breakeven. This is the point where your sales coincide with your expenses. So basing your calculation on the number of units you need to reach that point, you will be able to spread your expenses over a certain quantity of products or services. But beware, this is a circular argument; as you seek to determine your price, the quantity of units will vary accordingly. But another factor will limit this variable; the production process. In the world of services, we can determine the time a transaction takes. Thus, knowing the number of hours per week that you have, you will be able to identify an upper limit of the "quantity" variable.

  6. Often, we exclude delivery cost when we are in the "business to consumer" field; it's simple, the customer pays the delivery in addition to the sale price. So if he/she is far away, "delivery" charge will not be reflected in a higher selling price. That said, when we are in the "business to business" field, delivery costs are often included in the final proposal - so do not forget to include it.

  7. Financing cost is an important element of the pricing strategy. For items that are relatively easy to acquire, this aspect is simple: payments are made by cash, checks or credit cards. But when the transaction volume becomes more important, the financial dimension increases in importance. We will devote an entire article on this topic in the the coming months.

  8. The profit margin is calculated on top of your salary. Why? Because you have to have a profitable business and be able to cover all of the expenses that we have identified here as well as generate a profit. What is an acceptable profit margin? This largely depends on your field, the level your company has reached and your strategic positioning.

Do you feel a little lost in all the elements explained here? Remember that you can get help and your best resource is your accountant. But being aware of the different components that go into pricing, you will be able to assist him/her and have a more productive collaboration.  

Stéphane Elmaleh-Riel, B.Ed, MBA
Marketing consultant