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How to price a product is a complex decision and one that can make or break a business. While pricing considerations are unique to every small business, the prices you set for your products will generally influence the number of sales you make and the revenue you earn.
Production costs, demand for the product, competition and brand recognition all impact a pricing strategy. These six steps can help get you started in pricing your products.
Evaluate your costs
The first step in deciding how to price a product is to establish how much it costs to make your goods or provide your service. After all, to turn a profit, all your expenditures must be covered. Generally, your expenses fall into three categories: materials, labor and overhead:
Materials: Materials constitute the raw components of production. For example, if you make clothing, your materials might include cloth, buttons and thread. If you provide a service, such as a cleaning company, mops, buckets and other cleaning supplies are required. If you source products from another business, your materials are the items you acquire from the initial seller, plus anything required for repackaging.
Labor: Labor measures all physical and mental manpower necessary to create your product. Whether it’s a worker on the factory floor or the receptionist in your office, if you hire someone who adds value to your business, that person becomes part of your labor calculation. This includes salaries and wages paid to employees, related payroll taxes and employee benefits.
Overhead: Overhead refers to the costs that didn’t fall into the materials and labor categories. This includes rent, utilities, business licenses, marketing and advertising, insurance, office supplies and legal fees.
Adding these numbers together will give you the total cost of output for your product or service. Be sure to take into account whether each expense is a fixed amount each month, such as rent and insurance, or if it varies, such as marketing costs and certain utilities. To calculate variable expenses for the purpose of pricing, use an average monthly figure based on an estimate of the annual total.
Determine your desired profit
You can calculate your desired profit as the dollar amount above the cost of output that you wish to make per unit or per customer. Another option is to calculate the percentage of revenue that’s actually profit once you deduct all your expenses — a figure known as your profit margin.
Your profit goal might be somewhat arbitrary, although you can look to professional associations in your industry for guidance. If you’d like to compare your desired profit margin to others in your industry, Risk Management Associates is a nonprofit organization that creates reports on the financial health of small- and medium-sized businesses.
Understand your customers
Focusing on your target audience and understanding what motivates them will play a large role in how you price your products. Depending on your budget, you can work with a third-party research firm or collect data yourself through surveys, in-person conversations and other means.
Here are some topics and questions to cover in a target audience survey:
Demographics: What is their gender, age, general location and income level?
Competitive intelligence: What are their favorite products or services that are similar to yours? List some options for them to select.
Budget consciousness: How important is the price of an item when they make a purchase?
Motivation: Do they prioritize price or convenience when making a purchase?
Status: How important is the brand name of the product?
Psychological susceptibility: Are they more likely to buy a product that is priced at $9.89 than one priced at an even $10?
Answers to these questions can help you determine if your target audience’s primary focus is on cost, comfort, feature set or luxury. If their priority is cost, bundling products or services or tiered pricing may appeal to their preferences. If comfort is of utmost concern, you might decide to charge more and emphasize the features that set your product apart from the competition. And for customers who associate the cost of an item with its quality, you may want to consider marking up your price to match the customers’ expectations.
Research your competition
While you may not want to completely mirror the pricing of your competitors, looking at their strategy can help you develop your own. You can start with an online search of businesses that offer similar products and note their pricing.
You can use online tools such as Google Alerts, a free digital marketing tool that sends you email alerts for product, industry and competitor news on topics and brand names you choose, and Google Trends, which can provide information on popular search terms — such as the name of a competitor.
You can also follow your competitors’ social media accounts to learn about their target demographic and marketing strategies, such as the type of promotions they offer and when. This will give you the opportunity to consider whether you can match or exceed their discount pricing strategies.
» MORE: How to market a product
Choose a pricing strategy
Using the information you’ve gathered to this point, you’ll be ready to evaluate popular pricing strategies and decide which ones to use to set your own prices. Pricing strategies are simply frameworks to help guide your decision-making process, not definitive blueprints. You may want to incorporate several methodologies in order to calculate the selling price of your product, as well as adapt these tactics to your unique business needs.
What it is: Based on the sum of overhead plus desired profit. When to use it: Helps build trust because it’s easy to communicate and justify. Downside: Ignores brand image and competition.
Cost-plus pricing is the textbook model of how to price a product where you calculate your production costs and add your desired level of profit to determine the product price. However, it doesn’t account for factors such as customer preference, brand image or competition, and largely ignores the law of supply and demand. If you use this approach, be sure to account for hidden costs such as inventory markdowns or increased seasonal staffing.
Market share pricing
What it is: Lowering prices to increase the number of customers. When to use it: When you have a lot of competitors. Downside: May attract bargain hunters that aren’t loyal.
Market share pricing emphasizes volume over price with the objective of maximizing market share — the percentage of an industry that your business controls. The primary goal is to gain customers, which should eventually result in a net increase in revenue. With this model, you may offer a product at a lower price initially, but as more people use it and your market share grows, the value of the product increases, allowing you to raise prices. However, your ability to develop brand loyalty is important here because a consumer who changed companies once due to price may do it again if your product is no longer the cheapest.
What it is: Varying prices by area and need. When to use it: May be effective when offering a high-demand product. Downside: May alienate customers who miss out on deals.
Dynamic pricing is also known as demand pricing, surge pricing and time-based pricing. It’s a strategy where the price of a product varies based on demand. It takes into consideration when and where a product is offered or sold, and to what extent the demand for it is on the rise. Airlines, for example, use dynamic pricing. A ticket price may vary depending on seat type, availability of seats, flight time, destination and other factors.
What it is: Strategically adjusting prices based on the competition. When to use it: For businesses that may not otherwise stand out against competitors. Downside: Continuously monitoring the competition can be time-consuming.
A competitive pricing model is common in saturated markets where it’s difficult to distinguish between the businesses that sell a product, such as grocery stores and gas stations. There’s often a market leader who sets the standard, and competitors follow suit. If one company raises or lowers prices, other companies feel compelled to follow. If you wish to charge more than your rivals, you must convince the consumer that you provide a superior product or service.
What it is: Based on how much your customer believes your product is worth. When to use it: For businesses that stand out from the competition. Downside: Not effective for truly new products.
The value-added pricing model targets buyers that are likely to accept a higher price when they perceive added value in a product. The value your product or service provides could include convenience, status, first-of-its-kind technology, advanced features, uniqueness or unparalleled customer service.
Monitor your prices and adjust accordingly
Regardless of the pricing strategies you use, it’s highly unlikely that you’ll only set prices once. You can expect to regularly monitor your prices and adjust as necessary. Keep an eye on your competition’s pricing as well as changes in the market.
Additionally, tracking your labor, material and overhead costs will help ensure you’re continuing to turn a profit from your sales. If those production costs increase, you’ll want to adjust the price to match.
Elizabeth Kellogg, a freelance writer, contributed to this article.
A version of this article originally appeared on Fundera, a subsidiary of NerdWallet.