There are many ways to price the product or service you sell. Many of them involve some sort of markup. You can calculate a markup based on the cost of the product or a markup based on the selling price of the product.
Factors to Consider when Setting a Product Price
There are many factors a business owner should consider when pricing a product using markup and breakeven analysis. These three may be the most important:
- The cost of production
- The market demand for the product
- The desired markup by the business owner
The Cost of Production
Fixed and variable costs determine both the markup and the selling price of a business firm's product. Fixed costs include items such as your overhead including rent for your office or manufacturing space. Variable costs include items that change with your sales volume like labor and materials. In pricing your product, you have to first determine how much of your fixed and variable costs go into producing each unit of your product.
You can also analyze your costs in terms of direct and indirect costs. You think about the classification of your costs differently but the end result is the same. Using direct and indirect costing may make it a little easier to allocate overhead.
Making the determination of how much of your costs go into producing each unit of your product may be the most difficult calculation you make. There is a simple calculation you can make to estimate your operating costs per unit of product or service you sell.
- Estimate your total fixed costs
- Estimate your total variable costs
- Take the sum of your fixed and variable costs and divide by your estimated total sales.
That is your cost of production per unit of your product or service. Now you have a base price for your product to work with. You know you have to sell the product for at least this amount in order to cover the costs of production. You have to be careful when making this estimation, particularly with your fixed costs. Allocating overhead is tricky and you do not want to allocate too little to each unit of your product or you will lose money on the product.
Market Demand for a Product or Service
Market demand for a product or a service is the second factor that a business owner should consider when pricing a product. The law of demand is that there is an inverse relationship between demand and price. As prices fall, demand rises and as prices rise, demand falls. Demand for your product is just as important to consider when setting a price as the costs of production.
A number of factors besides price affect the demand that a company will experience for a product. There is usually a positive, or direct, relationship between consumer income and demand. As a consumer's income goes up, so does demand for a product.
The price of related goods has an effect on demand for a product. If your firm manufactures a product that is usually used with another product, the price of the two will usually go up or down together. If two products are substitutes for each other, like Pepsi and Coke, if the price of one goes up, the demand for the other will usually go up.
The tastes and preferences of consumers, as well as their expectations, should also be considered when determining the price of your product. If a new study is released saying that a particular product is bad for your health, demand may fall for your product whether that study has been verified or not.
Regarding consumer expectations, if there are rumors that an improved version of a product or service is going to be released, then consumers may stop buying the older version of the product, even if the news is only a rumor.
Determining how much to add to the price of your product based on market demand is more difficult than making that determination based on the costs of production. It's a subjective determination though it is based on market research.
Determining the Markup on your Product
There are many factors that go into calculating the markup on your product or service. Two of the most important are the costs of production and the market demand for your product. After taking those factors into account, look at your industry. Is there a standard industry markup? Dun and Bradstreet is a service where you can get industry reports that will help determine how prices are set in your particular industry.
Prices are set differently depending on your type of small business. Pricing strategy differs for the following types of firms:
- Service firms
- Building Contractors
Regardless of the type of small business, the markup is the amount you add to the cost of your product to determine the selling price. The markup percentage is determined by the amount of your planned profit, the type of the product or service you are selling, how rapidly the product sells, and the amount of service performed by the seller.
Based on the factors discussed, determine the markup percentage that you wish to use for your product. If you wish to use 30%, for example, add the 30% markup percentage to 100%. Multiply the 130% by the cost of your product. That will give you the selling price for your product.