Once you know how you're going to be charging your customers, the next question is, how much? Despite the reality that setting a reasonable price for your product or service can be pivotal to the success of your business, doing so is frequently done haphazardly. Moreover, too often, we see startups price their products too low to appeal to customers early on and then struggle to survive as a business because they're bleeding money. Pricing is a combination of economics, psychology, and art. We'll discuss how to think about pricing your product both in the short run and as a long-term strategy. Alongside evolving your product and business model, you'll also want to evolve your pricing strategy as part of your competitive advantage.
Before we even delve into the more sophisticated strategy, a couple of fundamental components are essential to consider when thinking about pricing. They are summarized here and explained in depth below.
1. Costs
As we discussed in Basic Startup Finance, knowing what it costs to deliver your product is essential. After all, you can't afford to lose money indefinitely.
One way to calculate cost-based pricing is to divide the total costs (variable and fixed) by the quantity of the goods or services that you're delivering. This gives you your unit cost.
c=v+(F/Q)
unit costs = unit variable cost+ (total fixed costs / quantity)
v = V/Q
unit variable costs = Total Variable Costs / Quantity
Given the likelihood that you'll only have a few customers in the beginning, this unit cost will probably be extremely high. Let’s look at an example: a blender manufacturer has the following costs: unit variable costs: $20, total Fixed costs: $200,000. The expected unit sales are 50.
v=$20
F=$200,000
Q=50
c = $20 + $200,000/50 units
c = $4,020 per unit
That means the company needs to sell 50 units at $4,020 to break even. No one is going to buy your blender at $4,020! But that number is important in the long run for understanding the price at which you break even (cover your total Fixed and Variable costs), which we'll address below.
The most important thing to remember is never to price your product below your unit variable cost (how much it costs to make one additional product) because regardless of how much you sell, you will never make a profit. So in the above example, you would never price your product below $20.
The reason we use unit variable cost is that it doesn't include Fixed fees, which decrease over time due to economies of scale - the more units you sell, the less it will cost per unit.
Let’s look back at our example to demonstrate economies of scale and what the financials would look like once the business is up and running: a blender manufacturer has the following costs: unit variable costs: $20, total Fixed costs: $200,000. The expected unit sales are 5,000.