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Costs, Competitors, and Customers: Three Strategies For Setting Prices

(March 2001) posted on Fri Sep 14, 2001

Goodridge offers three pricing techniques that can keep your company competitive, products profitables, and customers coming back.

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By Mark Goodridge

In the Internet chat rooms, newsgroups, and message boards frequented by screen printers, the question posted most often with the fewest good answers is "How much should I charge for...." The people who post this question are usually new to screen printing. Experienced screen printers are also puzzled by this problem, but these old-timers know better than to ask the question. They understand that if they don't know how much to charge for a job, no one does. My uncle Murphy Goodridge once told me that inside every small, simple problem is a much larger and more complicated problem trying to escape and ruin your day. The pricing question illustrates this concept beautifully. Even if the questioner, by some miracle, gets a correct answer, that won't solve his or her problem. The problem the screen printer faces is not how much to charge for a job, but how to set prices. So to all of you who ever scratched your head and asked yourself "How much should I charge for...," this one's for you. There are many ways to set prices, but they all boil down to three basic pricing strategies: cost-based pricing, customer-based pricing, and competition-based pricing. In the following section, I'll explain each of these strategies, list their advantages and disadvantages, and give you a few simple formulas. When you reach the end of the article, you still won't know what to charge for 5000, 3 x 12-in., two-color bumper stickers, but you should have a better idea of how to plan a pricing strategy that is profitable for you and popular with your customers. Cost-based pricing--the accountant's friend This strategy comes from the computer-spreadsheet school of pricing. At its simplest, it consists of computing the cost of raw material, manufacturing expenses, and overhead, then calculating a percent increase to allow for a profit. Cost-based pricing is easy to understand and relatively easy to calculate. It covers all types of costs and is popular with accountants, bookkeepers, and business managers who use a spreadsheet to sort their socks. When you use cost-based pricing, you make several assumptions that may or may not be true. The formulas used to calculate prices in a cost-based pricing scheme assume that your fixed costs (rent, utilities, etc.) do not increase as your production increases. The formulas also assume that variable costs (substrate, ink, etc.) remain a constant percentage of sales as production increases. And they assume that total costs as a percent of sales decreases as production increases. For ideal businesses (found only in accounting textbooks) this is true. Real businesses are a lot messier, though. In the real world, business managers have to set prices with an eye on the competition, plant capacity, market demand for the product, and even the customer's ability to pay. Cost-based pricing assumes that if a company has more than one product line (T-shirts and baseball caps, for example), overhead can be accurately divided between the two. This is rarely the case in the screen-printing shops I'm familiar with. The worst disadvantage of cost-based pricing is that it gives the business manager little incentive to control expenses and improve efficiency. Cost increases are simply passed on to the customer. Still, you shouldn't reject cost-based pricing out of hand. Even with its drawbacks, it works. It's simple, and it virtually guarantees a profit on every sale. Many profitable businesses use some variation of cost-based pricing. You can implement cost-based pricing in several ways, but I'm only going to mention two. The first is cost-plus pricing and uses the formula selling price = (total fixed costs total variable costs projected profits) ÷ units produced. If you're running a business with one product and one production line, selling to customers who are relatively price insensitive, then this strategy will work for you. An example of this would be if you are a subcontractor whose screen printing adds a relatively small amount to the final cost of the finished product. A second variation of cost-based pricing is called markup pricing, which uses this formula selling price = merchandise costs ÷ [(100 - Markup %) ÷ 100]. Some of you will recognize this formula as the one used by many wholesalers, distributors, and retailers. It's easy to figure and guarantees profits if sales are sufficient. As you can see, there are good reasons for considering cost-based pricing, but this strategy alone is usually not a good choice for the average screen-printing business. Let's move on to strategy number two. Demand-based pricing--If it works for e-Bay, why not for you? Demand-based pricing operates on the auction principle. If the supply is fixed and the number of people who want a product increases, the more the product will cost. For several years, my price-setting strategy was strictly cost based. But here in Maine, the demand for T-shirts fluctuates seasonally by about 300%, from a low in February to a high in June. Eventually I wound up raising prices in June (when I had more customers requesting product then I could service) and lowering prices in February (when a job with a very low profit margin was better than no work at all). The typical demand-based pricing plan works something like this: The screen printer estimates the maximum price that the customer will pay, subtracts out a markup to provide for selling expenses and profits, then from that number calculates the maximum he or she can spend to produce the product. If that sounds a little complicated, let me give you an example. Suppose you are printing T-shirts for a souvenir shop. The buyer informs you that the most their shop can sell a T-shirt for is $12.00 and that they expect to be able to mark up the T-shirts you sell to them by 100%. This means your selling price to them cannot exceed $6.00/shirt. If you know that your selling expenses and profit margin require a 50% markup, then you know that you have to be able to produce the T-shirts for $4.00 each. The $4.00 has to cover the cost of the shirt, printing expenses, and overhead. If you use a demand-based pricing strategy, you have to be exquisitely aware of how sensitive your customers are to price changes. The prices you set will be strongly influenced by the image of your product (generic products go cheap, premium products command a premium price). The price you can get for your products will also be determined by your customer's budget. Demand-based pricing has some disadvantages. A pure demand-based pricing strategy does not emphasize a thorough evaluation of your costs. Since price calculations are subjective, you may lose money because you don't cover all your costs. In a highly competitive market or one where demand is low, you will have to make do with very small profits. The market research necessary to determine the final selling price may be time consuming, expensive, or inaccurate. Also, it can be extremely difficult to determine the final selling price of a new product. One of the commonest forms of demand-based pricing is called demand-minus pricing, which uses the formula merchandise production cost = selling price x [(100 - markup %) ÷ 100]. Notice that in the demand-minus formula, the answer is not the final price of the product. You know that going in. The answer is how much you can afford to spend to produce the product. One of the dirty little secrets of demand-based pricing is that screen printers usually practice discrimination. Not politically correct, but not actually illegal, or in this case, even unethical. Price discrimination occurs whenever you set two or more prices for what is essentially the same product. Do you have one price sheet for your retail customers, another for stores, and yet a third for the advertising-specialty reps you do business with? Then you are practicing customer-based price discrimination. You can also do product-based price discrimination if your prices vary according to minor differences in style and other features. Despite it's disadvantages, demand-based pricing has two inarguable advantages over other pricing strategies. If you can find a market niche where there is little competition, profits are virtually assured. Also, if you use a demand-based pricing scheme, you are compelled to strictly control expenses in order to keep prices in line and profits continuing. Competition-based pricing--steal, steal, steal, never reinvent the wheel If there is any pricing scheme in our industry that has a bad name, this is it. Boy do we hate competition-based pricing. The only reason we don't have battles over the topic is because everyone is ostensibly against it. We all virtuously state that we never shop the competition or surreptitiously acquire their price lists. No, not us. Ahem. It is my distasteful duty to tell all of you who condemn the practices listed in the paragraph above that you're either being dishonest or overlooking the realities of your markets. Competitors and their prices are as much a factor in your success as are customers or government regulations, and you ignore any of them at your peril. There's nothing inherently wrong in basing your prices on the prices prevailing in your market, as long as you make a profit and you're not engaged in price fixing. Competition-based pricing strategies are easy to devise, and they don't disrupt the market. They're also much more common than you may suspect. If you look around, you will find many examples--products where a respected manufacturer has set a price, no matter how, and everyone else has fallen into line. In fact, this is one of the standard variations of competition-based pricing called price leadership. You must have noticed that music CD's, movie video tapes, real-estate agencies, and (to get a little closer to home) ad-specialty companies all have very similar pricing. This is competition-based pricing, and there's nothing wrong with it. It's a basic principle of marketing that you should know what your competitors are charging. In fact, the more you know the better because that knowledge will affect the way you set your prices. The advantages of competition-based pricing include simplicity and market stability. The disadvantages include the possibility that you may not make a profit from a competition-derived price. Even if you do, it's easy to become complacent, ignoring market trends, rising expenses, or other opportunities and problems until too late. The price is right In summary, cost-plus pricing virtually assures a profit, but it is most effective when the manufacturer can control the price. This strategy can work if you screen print dial faces for a subassembly in a control panel, for example. Demand-based pricing has the advantage of requiring you to focus on the customer and control costs, but there's no guarantee of profits. This strategy is appropriate for most garment printers. Competition-based pricing is the simplest, but this strategy won't guarantee profits and makes it easy to lose track of costs. If you routinely sell on competitive bids or print advertising-specialty products, you're already using a competition-based pricing scheme. No matter which pricing strategy you select for your business, you must keep the other two in mind. When you set prices you must always be aware of your costs to produce the product, your customer's expectations about the price of your product, and your competitor's pricing schemes for similar products.


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