As a small business owner, you don’t have big pricing departments or teams of PhDs with fancy algorithms to set prices. Pricing is often the last thing you want to think about (we’ll talk about why this is a big problem in another post). You want to put a price on a quote, website, menu, etc, and get some sales. You’ve got 3 basic methods to set a price:
Cost-plus is the simplest. In theory, you have the numbers you need. You take your costs, and add a markup. There are a couple of problems with this, one fixable, and one intrinsic.
The fixable part is that you may miscalculate, mis-allocate, or simply miss some of your costs. Now your numbers are off, profit is below expectations, and you need to work more hours (for no extra pay).
The intrinsic issue is that you’re leaving money on the table. You can’t compete with larger vendors, outsourced labor and other advantages that larger players enjoy. If you have a hardware store, you don’t want to compete with The Home Depot on price. If you have a restaurant, you don’t want to compete with McDonalds on price. If you have a service business, you don’t want to compete with the cheapest off-shoring option available on price. There can be only one low-cost provider in any market, and for a small business owner, they only way you’re going to the low cost provider is if you don’t get paid. Not a good option.
So you might look at the competition and try to price against them. But wait, if they’re costs are lower than yours, trying to match prices with them could leave you even worse off than cost-plus, right? That depends on how they price, of course. There’s a saying in pricing that you’re only as smart as your dumbest competitor. But you also have the option of using the competitions’ prices as a guide and marking up from there. Notice that this is the opposite of the common small business philosophy of marking down from the competition because you’re “not as established”. When you mark up, you have a great chance to highlight the differences relative to the competition. “Sure, your main law firm charges a little bit less, but this is our area of expertise. We’ll do better with less risk and less headaches.” “The upfront cost is higher, but we’re faster and you’ll get the value from your new system in 1 month instead of 6.”
As we’re talking about how we’re different from the competition, and why that difference matters to the customer, we come to value-based pricing. This means pricing based on the perceived differential value of your offering. This is the way to maximize your profits. Note that value is perceived by the customer. It is not an objective number. But you can do a lot to help customers perceive your value.
The more differentiated your offering, the more you can price relative to the alternatives. Make sure you highlight the differentiators. A lot of small businesses don’t realize the value that their personal service provides. Notice that the less differentiated the offerings, the closer your value is to your competition. In a “perfect market”, suppliers prices get driven down to the marginal cost, and all 3 methods product the same price. As a small business owner, you want to avoid perfect markets. (Large businesses do, too, but they have the advantage of leveraging the regulatory apparatus, that in theory is supposed to protect competition, to achieve the opposite effect.)
Value-based pricing takes a bit more work, but the dividends can be huge. Some small business have raised prices 20-200%, without losing business. They just didn’t realize the value they provided.
We’ll get into more details on how to do value-based pricing, but for now, the idea is to avoid cost-plus and strict competitive-match pricing.