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Pricing a product or a service is a common challenge for many people. There are a number of things that need to be taken into account when setting the price and this document gives you a simple model that you can apply to pricing in a variety of contexts.
Pricing Model
The following model will help you identify a practical price range using a ‘bottom-up’, i.e. ‘cost approach’ and ‘top-down’, i.e. ‘market approach’.
It is based on the assumption that there is a maximum price that customers will pay and a minimum price that is required by the organization to cover costs.
Price Range
The price range is the difference between the maximum and the minimum price established.
The actual price decided upon within this range will depend on several factors including the planned marketing strategy and any limiting factors, such as budget, that surround the customer.
Maximum Price
The maximum price for your product is based upon the perceived value of the benefits of the product or service to the customer and the level of supply and demand that exists.
In terms of the perceived value of the benefits this may depend on how clearly the customer understands the benefits and can place a value on them. Market research and testing can help you understand this more clearly.
The level of supply and demand for the product or service will also affect the price. The more people want the product or service and the lower the supply, the higher the price that can be charged. Alternatively, if there are too many products or people supplying a service than there is a demand for then this will force the price down.
Minimum Price
The minimum price is the price required to profitably produce the goods or service, i.e. ‘what can we afford to sell this product for?’
The calculation of a minimum price for your product or service will depend on the market your organization is in. However, the following model can be readily adapted to suit most needs:
- First estimate the total volume of sales you expect to make.
- Second, establish the variable cost of production. If the production of your goods or service increases costs for every unit produced then it has what is known as a variable cost.
- Third, calculate the fixed cost of the product/service. Organizations seldom have just variable costs and each product/service sold will be expected to contribute towards the remaining fixed costs of the business. Divide the total fixed costs by the expected volume of sales to calculate the product/service’s share of the fixed cost of production.
- Fourth, add the variable costs of production and the share of fixed costs to produce your minimum price.
Calculation
Variable costs of production (total variable costs such as labor and materials)
+
Share of fixed costs of production (total fixed costs / expected sales volume)
= minimum price
If the minimum price calculated exceeds the maximum price you can charge, or if the price range is very narrow, then product or service may not be viable.
You may find it useful to use the Microsoft Excel template in ‘Calculating the Minimum Price’ to help you do your pricing calculations.
Worked Example
Imagine, for example, Dial-a-com are looking to identify a price range for a new model of mobile phone which has unique technological features and a competitive tariff rate. Market research has established that the perceived customer value for the product is £85.
- The variable costs of production are for each phone are: labor - £15, materials - £10, phone tariff - £25
- The total fixed costs of production are £50m.
- The estimated total sales are 1,000,000.
- The fixed costs of production do not include the cost of research and development for this phone model, which is £10m.
- It is also useful to do a sensitivity analysis to see what happens if sales are at 50% of the projected volume and the result if sales do better than expected.
Original
Sensitivity Sales -50%
Sensitivity Sales +50%
£
£
£
Perceived Customer Value
85
85
85
Estimated Total Sales
1,000,000
500,000
1,500,000
Variable Costs
Labor
15
15
15
Materials
10
10
10
Phone Tariff
20
20
20
Total Variable Costs
45
45
45
Fixed Costs
Fixed Costs of Production
5,000,000
5,000,000
5,000,000
Total Research and Development Costs
10,000,000
10,000,000
10,000,000
Total Fixed Costs
15,000,000
15,000,000
15,000,000
Product Share of Fixed Costs
15
30
10
Minimum Price = Total Variable Costs + Product Share of Fixed Costs
60
75
55
Based on the expected sales and the planned marketing strategy this establishes that the price range for the new phone is between £60 and £85. If sales are down by 50% then Dial-a-com will need a minimum price of £75 to break-even.
