Charging too much for a product or service can be problematic for a startup business—and so is failing to charge enough. If prices are too high, customers may be scarce. If prices are too low, the enterprise might be scraping by right out of the gate.
How can a new entrepreneur know when the price is right?
Fortunately, there are proven concepts to follow in forming an effective pricing strategy. And it all starts with research, said Elisa Waldman, an award-winning consultant with the Kansas Small Business Development Center at Johnson County Community College.
Industry and Market Research
“The first thing you need to do is a tremendous amount of industry research and market research,” Waldman said. “You need to understand both the industry that you are entering and the best practices of how the industry works in regard to pricing. And you also need to understand the target market, who you are selling to.”
If that sounds like a lot of work, it is. But as Waldman has told her many small business clients, there’s a way to initiate the process that doesn’t cost anything and produces an abundance of helpful information.
“The public library is an excellent resource for business research,” Waldman said. The library is where anyone can access information organized by the U.S. government’s North American Industrial Classification System (NAICS), a numbering structure developed by the Occupational Safety and Health Administration (OSHA). It allows the government to collect data from different industries.
“Let’s say you want to be a residential home builder,” Waldman said. “So you look up the NAICS code for residential home building and meet with a business reference librarian. He or she will have a plethora of business databases that you can plug that number into, and it will spit out all kinds of industry information. You can see the profit-and-loss statement for the industry overall. You can understand the trends in the industry.”
Market research is a “little different,” Waldman said, because it helps you to determine and evaluate whether there are, in fact, people or businesses that will buy your product or service.
That plays into pricing, “because pricing is part of the overall marketing mix,” she said. “People might need your product or service, but are only willing to pay for it at a certain price. So you need to study your target market to understand their pricing parameters.”
Two Ways to Price
Two major pricing strategies are cost-based pricing and competition-based pricing. Cost-based pricing relies on the business owner understanding her operating costs and covering them to make the desired profit. Competition-based pricing requires the business owner to know what the competition is charging to see if his pricing is “even in the ballpark,” Waldman said.
What if your new business can’t afford to charge as little as the competition?
“You’ve probably missed something,” Waldman said. “Maybe you’re not really buying wholesale or something’s wrong or uncovered in your research.”
Another possibility, Waldman said, is that the competition isn’t actually making money. Take the restaurant industry.
“When you walk into a restaurant that’s jam-packed with folks, the assumption is that, ‘Wow, these people are bringing in money hand over fist,’” she said. “And then two months later, you drive by and that restaurant is no longer in operation. One reason might be because they weren’t charging enough for the food.”
Undermining Yourself by Undercutting
A common pricing mistake that Waldman sees new businesses make is attempting to undercut the competition at any cost.
“That typically backfires, unless the competition is overpriced,” she said. “If the competition has done its analysis and they were the first to market and got to name their price, then there might be some wiggle room there.
“But if the competition is running a tight ship and an efficient one, if you’re underpriced, you’re going to wind up with the phenomenon of possibly having a great deal of demand for your product or service. But you will work very, very hard in servicing people. And at the end of the day, you may not have any cash in the bank. It can even cost you money when you end up doing that.”
If a startup isn’t generating enough profit, the only sure way to tell if it’s because of the pricing strategy is to meet with a business adviser and review your financial statements, Waldman said.
“And that begets the question of whether there are financial statements,” she said. “So bookkeeping is essential. Having detailed records of all of your expenditures is critical in order to evaluate pricing.”
