How to choose a pricing model

The economic landscape continues to change and present new challenges to small business owners, and considerations around these rising costs can prompt owners to reconsider the pricing model for their products or services.

Choosing an appropriate pricing strategy can be critical to get the most value out of your products or services, boost sales and earn your desired profit, compete with rival businesses, and avoid overcharging your customers and suppliers.

We’ve compiled helpful information about different pricing models for small business owners to choose from and tips for deciding on the model that might suit your business.

Identify your business priorities

Finding the right pricing model first means identifying your objectives in setting a pricing strategy. Begin formulating a pricing strategy with a market analysis by asking the following questions:

• How much do your competitors charge?
• Where do you want to position yourself in the market?
• What flexibility exists in the market?

For instance, it could help to identify if you are looking to establish your products or services in the market, competitively position your products or services, or increase demand for your products or services, or if you have another goal entirely.

Then break down your product or service, and consider what profit margin will provide the operating capital, fuel for growth and profit you need.

Select a pricing model

After determining your business priorities and customer preferences, it’s time to consider which method of pricing your products or services might best suit those priorities. Pricing models for small businesses include:

• Cost-based pricing. This approach adds an additional margin to the cost of a product or service. Make sure to cover all additional costs such as GST and tax.
• Competition-based pricing. Using this model, you price your products or services at a similar rate to how your competitors price their products or services.
• Value-based pricing. This strategy enables you to set prices based on your customers’ expectations for how much a product or service is worth.
• Product-based pricing. There are multiple product-based pricing models to choose from, including penetration pricing and skimming pricing, which raises or lowers the price of a product or service after a certain period of time.

Let’s take a look at one of those methods, the cost-based pricing method, which uses the following simple formula:

Manufacturing cost + Profit margin = Selling price

As an example, if the cost of manufacturing a product – including any relevant fixed overheads – is $125, and your designated profit margin is 20%, then the cost-based price you would set for the product is:

$125 + 20% = $150

The model you choose will depend on your business’s unique circumstances, so do your research and consider the particular composition of your customer base before deciding on a pricing strategy.

Consider your customers

The Ministry of Business, Innovation and Employment’s business.govt.nz website outlines several tips for setting the right price for your business. One of these is considering price sensitivity.

Customers who are price-sensitive typically buy more when prices drop and less when prices rise. Paying attention to the buying habits of your customers, therefore, is important.

According to business.govt.nz, businesses that sell “products with easy alternatives or luxury goods [customers] don’t really need” can mean those customers are quite price-sensitive, as the range of shopping options available to them is broad and a price increase from one business can easily push them to buy from another.

In such industries, it might be worth considering a value-based approach to pricing to accommodate for those purchasing trends.

And if you’re starting out as a business or introducing a new product or service, it might make sense to consider a cost-based or competition-based pricing model to ensure your business maintains its bottom line in the early days.

But if, across the course of your business’s growth, you’d identified your customer base as being very price-sensitive, consider the repercussions of significantly or abruptly raising prices. Your customers might buy less of your product or service, or even head to a competitor, if you do so.

A unique product range or serving offering – in other words, a strong business brand – can mean that customers are less price-sensitive. Consider ways to develop your business’s brand and, as a result, build trust and rapport with customers.

Whichever method you choose, remember your bottom line. It makes sense to set a price that covers all costs – otherwise, you’ll lose money regardless of the price point.