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Pricing your business’ products represents one of the biggest challenges most startups face. This is especially true when you’re bringing something new to the market that can’t be benchmarked against similar products — although even new entrants into established marketplaces may find it difficult to determine where their offerings should fit, price-wise.
Getting this crucial business element right from the beginning should be one of your top priorities as a startup owner. It can be incredibly tempting to set your prices low from the start in order to undercut your competitors, but this is actually a terrible idea for growing businesses. Here’s why:
- Pricing low makes future growth less sustainable. If you do so, incoming revenues may not be enough to keep the business afloat. When you price your products low, you’ve got to sell a heck of a lot more of them to make enough money to continue reinvesting in your business. In some cases, there may not be enough customers in your target audience to ever generate sustainable revenue if you’ve set your prices too low.
- Pricing low devalues your product offerings. Consumers understand that premium products command a higher fee — which is why wines from prestigious labels routinely command higher prices than discount brands, even though blind taste tests fail to uncover significant differences in flavor. When customers see low prices, they often assume that there’s a reason for the discounted rates — and that the tradeoff in price comes at the expense of quality.
- Pricing low is hard to recover from. Even in the best of economic times, increasing your prices can be difficult. Whether or not the increase is justified, it can be difficult to convince consumers to pay higher rates for the same product they received before without losing customers in the process.
Instead, it’s a much better idea to price your products appropriately from the start. To do this, you’ll need to start with some background research. Put some time into understanding the following three variables before you set your prices:
1. Materials costs: the amount of money you spend on the raw materials needed to create your products.
If you manufacture products, these costs will be fairly straightforward (though you should be aware of various price breaks that may occur for bulk component purchases). Even if you only release digital products (as in the case of software and mobile apps), your materials costs may still include things like stock photography, licensing fees, and other expenses.
2. Labor costs: the number of hours required to make your product and the hourly rate associated with those hours.
It’s also essential that you know exactly how much time goes into creating each of your products and how you value that time. If you’re making each of your products by hand, understanding exactly how long it takes to create each piece — as well as the hourly rate you need to earn a living wage — will prevent you from setting your prices so low that you can’t afford to live. In addition, if you use outsourced workers at all in the creation of your products, be sure to account for their time and rates in your calculations.
3. Overhead costs: any further expenses required for the operation of your business.
The final cost category to be aware of when calculating prices is your overhead expenses. Depending on the scale of your business, this could include anything from web hosting and cell phone service to office space rental, electricity, and furniture purchases.
Once you have a good estimate for these expenses, use the following formulas to estimate your prices:
Base Cost = Materials Cost + Labor Cost
Wholesale Cost = (Materials Cost + Labor Cost) * Wholesale Markup
Retail Cost = Wholesale Cost * Retail Markup
Profit = (Retail Markup * Items Sold) – Overhead Cost
Now, there are a few things you’ll want to keep in mind as you complete these calculations.
- Research your potential markups. The specific markups you’ll be able to charge will vary significantly by industry, so it’s worth doing some research into what your niche’s standards are. Some fields — like grocery goods and mobile apps — operate on tight margins due to the potential for high volume sales. Others — primarily luxury goods and electronics — can sustain higher markup rates without diminishing sales.
- Respect industry ranges. If your calculations put your estimated prices significantly above or below your competitors, you need to either alter your profit expectations or find a way to make your products more efficiently. Alternatively, you may be able to find a way to market your product differently in order to command higher prices.
- Use these calculations to work backwards to your desired profit. If you know that you want your business to earn a certain amount of money each year, try starting with your desired profit instead of your set costs. Doing so will help you to determine whether your business ideas are sustainable or not.
By paying careful attention to both your costs and trends within in your industry, it is possible to set your prices in a way that both attracts potential customers and ensures your startup’s financial stability from the start.
AJ Kumar is the co-founder of Single Grain, a digital marketing agency based in San Francisco. Single Grain specializes in helping startups and larger companies with search engine optimization, pay-per-click, social media, and various other marketing strategies.
The Young Entrepreneur Council (YEC) is an invite-only nonprofit organization comprised of the world’s most promising young entrepreneurs. In partnership with Citi, the YEC recently launched #StartupLab, a free virtual mentorship program that helps millions of entrepreneurs start and grow businesses via live video chats, an expert content library and email lessons.
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