When launching a new product or service, one of the hardest decisions a business must make is the price of the product. Every other component of the product launch could be perfect, but if the price is too high, customers won’t buy. If the price is too low, the company may sell a lot of product but won’t be maximizing profit.
How does a company decide how to price its product? First, the company must take three things into consideration:
1. Is the company a price-maker or a price-taker?
A price-marker is a company that can set its prices. Typically, the product is more unique and there is less competition. One of the most famous price-makers is Apple. Apple does not fit the traditional definition of a price-maker. There is a lot of competition in the cell phone, tablet, and computer markets and there are lots of similar products on the market. What makes Apple unique is its brand loyalty. Many Apple fans would never consider purchasing a non-Apple product. The customer believes that Apple’s products are unique, and therefore, would not consider the alternatives that are on the market. That allows Apple to charge higher prices for its products. Price-makers typically use a cost-plus pricing approach. Cost-plus pricing is when the company calculates the cost of its product and adds a percentage mark-up to cover operating expenses and profit.
A price-taker is a company that has little control over its prices. Typically, the product is not unique and/or there is a lot of competition. Most commodities, like gasoline and milk, are price-takers. When searching for gasoline to fill up our cars, we typically look for the gas station with the lowest price. Most people are very sensitive about gasoline and will use apps on their phones to search out the lowest price in their area. Price-takers must use a target costing approach to pricing. Target costing forces a company to look at its desired profit, the price the market will bare, and attempt to cut costs to achieve the profit desired.
2. What is the desired company profit?
All businesses have profit pressures. Owners demand a return on their investment, whether the company is large or small. In small businesses, profit determines the owner’s salary. That salary is what the owner takes home to support his or her household. Most small business owners know how much they need to bring home, and therefore, how much profit their business needs to make. Publicly traded companies have target profit projections to keep share price up and to pay dividends (if applicable). If companies miss these target profit projections, it could affect the share price and shareholder willingness to purchase or hold stock in the company.
3. How much will customers pay?
Even if a company is a price-maker, there is a price point at which customers will start to question the value they are receiving, and sales will decline. Companies are looking for a sweet spot to maximize profits, where price and demand are at their highest points to generate the most revenue.
Cost-plus pricing is what most of us think of when we think of setting the price for a product. Price-makers compute total costs, add desired profit and calculate the amount of revenue needed to hit their projections.
Once total desired revenue is calculated, the company can divide total revenue by the number of units it projects it will sell to calculate price per unit.
While there may be some pricing pressures, price-makers have much more control over final pricing decisions.
Target costing is an approach where a price-taker must control costs. Therefore, the calculation looks a bit different than that you are familiar with. Typically, we say that revenue less expenses is profit. When doing target costing calculations, we have no control over price and little control over desired profit. Therefore, we must learn to control costs. That causes us to look at the calculation a bit differently. Rather than profit being the result of the calculation, cost is the result:
Notice that, in this case, we are using the two things we have little control over, revenue and desired profit, to calculate the item that we do have control over, cost. On paper, this looks a lot easier than it is. A company’s desire to cut costs could lead to lower quality and poor customer service which could lower revenue and create a vicious downward spiral. It is important to look at costs and quality when using the target costing approach to pricing.
Rather than cutting costs, the company could also decide other approaches. The company could try to differentiate itself from competitors. We see this time and time again from companies that sell bottled water. Water is water, right? Many companies have convinced us that it is not. A second approach would be to accept a lower profit. This approach might not work for the long term but could be a good short-term strategy while looking at other alternatives.
When setting price, it is important to understand where the company fits in the marketplace. If the company is a price-maker, it should use the cost-plus approach. If the company is a price-taker, the target costing approach should be used.