It is the Customer, Competition and Value You Produce, Not Your Costs, That Determine the Price You Can Charge

Pricing is complex but there are three factors that determine price — competition, customers and value. When entrepreneurs set price, they usually concentrate on costs, not value. They look inward, not outward.

Let’s look at an example from 2012. You, the entrepreneur, have created a new fitness band that you hope will become the new standard. It is designed to track not only activities but vital health statistics such as blood pressure, temperature, and heart rate. It also tracks your hydration, food intake and estimates the net calories you consume relative to your food intake.

Your product has been expensive to create. Through venture funding you have invested over $8 million. The initial cost of producing each unit is also high because of the new sensors required.

The CFO of your firm estimates that unit incremental costs will be around $125 and estimates the product sales in the first year will be close to 50,000 units, half direct to consumers and half through retailers. Overhead per year is $1 million; the $8 million cost to create the product is amortized over 3 year or $2.67 million per year.

The CFO’s initial price recommendation, either direct or through retailers is $300 to the end-user. This will generate a profit of approximately $ 100 per unit after overhead and amortization of the development costs but before marketing costs and retailer’s margins. If the product is sold directly to consumers, the marketing cost per unit is estimated to be $15, generating an approximate profit of $85 per unit. If it is sold through retailers their markup is $60 leading to an approximate profit of $40 for your start-up.

Under the scenario just described, the company would have sales of $15,000,000 in the first year and profits of $3.2 million. This would make investors very happy because they would begin to see a return in the first year.

Is the above scenario likely to happen or is it simply the CFO’s overzealous forecast? Let’s analyze the market and assumptions in more depth. Which assumptions are highly likely to be accurate and which have a great deal of uncertainty surrounding them? The production cost data and retailer markups are likely to be accurate. The assumptions relating to expected units sold and the cost of acquiring a customer have the greatest uncertainty.

Some additional data can help us assess the accuracy of the forecasts. First, from an industry source estimated total sales of fitness devices in 2012 is expected to be 500,000 units. Second, there are a number of competitors in the market and most are priced between $75 and $150. Third, an independent research firm assessed the quality of competitive products and your product.

The chart below shows the price and a quality rating for some of the leading fitness devices already in the market and the proposed product.

The line shows the “fair market value” of the product given its price. For example, Vivoactive is priced around $125 and its quality level is just below 4. It is very close to the “fair market value. As the quality of the product improves, the line shows the fair market value increases. Products above the line are good value, products below the line are poor value.

The same third-party reviewed your product and indicated that the product’s quality level is 4. The price quality chart shows that at a quality level of 4, the product should be priced around $175, not $300. At $300 its quality level should be over 4.5. In its current configuration and at a price of $300 it is grossly over priced.

One more useful fact. What prices are consumers willing to pay holding fixed quality? The chart below shows the distribution of prices consumers are willing to pay. Of course as the quality is increased, they may be willing to pay more. However, it shows as the price goes above $200 there are very few consumers willing to buy a fitness band.

What does this tell us? The customer, competition and value set the price. Costs influence profits but do not directly determine price.

Reviewing the information above, we see that charging $300 is very unlikely to generate 50,000 units. Very few consumers are willing to pay $300. Also, the new product would generate a market share of 10% (50,000 units divided by a total market of 500,000). Not a very likely scenario for a new product.

One final comment on how costs impact price. The lowest price the firm can charge is $140 if it goes direct and $125 if it sells through retailers because below these prices the firm does not cover its manufacturing costs and marketing costs if it goes direct. Therefore, costs do have some influence on price. It provides the lowest price the firm can set and still generate a profit. However, It does not determine the ultimate price the firm can set. As stated above, the firm’s value, customers’ willingness to pay and competition are the drivers of price.

If you want to learn more about How to Price Your Product, you can download our free two-page worksheet here.

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