IntroductionSetting the right price for a new product or service can be one of the hardest tasks faced by small business owners. Costing a product or service is relatively straightforward, but pricing is essentially set by the marketplace. The price of a product or service needs to cover all the costs and allow for a profit, but it must also take account of what competitors are charging and how much customers will be prepared to pay.
Setting too high a price can lead to lost sales. Setting too low a price will reduce profits and possibly result in the business failing. It is important to understand the impact of pricing on profitability and be able to choose the best pricing strategy for a business.
This factsheet outlines some of the costing and pricing issues that should be considered and looks at alternative pricing strategies that can be used.
Glossary of common terms and definitionsThis section outlines some of the most common terminology used when considering costs and pricing.
The direct cost of a product or service is the cost incurred in producing and supplying the product or service. These costs are also known as 'variable costs', because they vary in direct proportion to the number of units produced. Direct costs include, for example, the cost of raw materials, bought-in components or goods and direct wages (that is the wages of staff employed specifically to produce the product or service).
Every business has costs that are incurred regardless of whether any products are produced or sold. These fixed costs are also known as 'overhead costs' and include items such as the owner's salary or drawings, employee salaries, rent, rates, insurance and depreciation in the value of any fixed assets such as machinery and equipment
- Cost plus pricing. This is a traditional method of calculating the price to charge and is often used in pricing products rather than services. It is based on applying a percentage markup on top of the direct costs of a product in order to cover fixed costs and make a profit.
- Value-based pricing. This involves setting a price based on what the market will bear. The impact of factors such as fashion, convenience and market share affect the price level that can be achieved.
- Breakeven point. The breakeven point is the point at which revenue from sales exactly equals all the costs incurred by a business. A higher level of sales will result in a profit; fewer sales will result in a loss.
- Gross profit. Gross profit is the selling price less the direct costs involved in making a product or delivering a service.
- Operating profit. A business' operating profit is the gross profit minus the fixed costs.
- Contribution. As long as a business sells a product for a higher price than the direct cost, the income received from the sale of the product will make a contribution to the fixed costs of the business and then to the operating profit. If a business sells a range of products, it should look at the gross profit generated by each product to compare their contribution. The product that has the highest volume of sales may not have the highest level of contribution, but could still be a useful product for the business to offer in order to attract and retain customers.
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