Since it determines the level of profit that you can earn, pricing is an important element in your business strategy. Your pricing strategies can affect not only the volume of your sales but also the margins that you need to pay for your operating expenses. Of course, pricing can be simple when you are selling just a few products or service, but most of the time, many entrepreneurs find making pricing decisions complicated.
This is especially true for those who are in the retailing business, where there could be thousands of items that need to be priced individually. In any case, however, a good pricing strategy can help you achieve your long-term financial and marketing goals. You therefore need to carefully consider all relevant factors before setting a final price for the goods or services you are selling.
METHODS IN SETTING PRICES
There are two distinct methods in setting a price. One is the cost-oriented method, where pricing is determined by adding a fixed percentage to the cost of the merchandise. The other method is the demand-oriented method, where pricing is based on what the market is willing to pay for the item.
The cost-oriented method is commonly used in retailing, where a markup is simply added to the cost of the merchandise to come up with a retail price. This markup can be expressed either as a percentage of cost or as a percentage of the retail price. Take, for example, a trader who imports shoes from China at a cost of P200 per pair and distributes it to the department stores at a selling price of P500 per pair. The markup can then be computed as P500 – P200 = P300. As a markup on cost, this can be expressed as P300/P200 = 150 percent; as a markup on retail price, it will be P300/P500 = 60 percent.
Many retailers choose to set their prices using the markup-on-cost approach, but for purposes of analysis—such as product comparisons with competitors—the markup on retail price is the one most commonly used. Pricing decisions rely heavily on markups because they are the ones that determine the ultimate profitability of the business.
So how do you figure your markup? Your total markup should, of course, be sufficient at any time to cover your overhead expenses plus your minimum desired profit. For example, assume that you are a restaurant owner and have budgeted your monthly overhead expense for rental, electricity, and salaries at about P25,000, and that you think you need to earn a profit of P10,000 as a fair return on your investment.
To compute for your minimum margin, you simply add P25,000 and P10,000 to come up with P35,000. To determine the minimum target sales needed to cover this margin, you add this amount to your budgeted cost of sales, which would include the cost of your purchases of vegetables, meat, chicken, and drinks. If we assume that your cost of sales is P20,000, then your target sales would amount to P55,000 (P20,000+ P35,000).
This means that your restaurant must generate a minimum total sales of P55,000 to achieve the profit of P10,000. Also, when you compute for the average markup on retail price, you will find that it is 64 percent (that is, P35,000/P55,000), while your average markup on cost is 175 percent (that is, P35,000/P20,000).
To some retailers, particularly those who run department stores, the initial markup should also take into account anticipated markdowns and commissions. This is done to protect their margins in case of downward price adjustments (for example, during a “mega sale” event). For merchandise items that are newly delivered to the stores for sale, this initial pricing is sometimes called the Standard Retail Price. Most of the time, though, this initial price is not always the price at which the item is ultimately sold. This is because of price markdowns that are designed to increase sales or get rid of slow-moving inventories. In fact, some markdowns can result in a very small profit or just breakeven; others, in losses.
ADAPT IT TO YOUR BUSINESS
One reason why many retailers resort to markdowns is that pricing may not be market-driven, in which case prices have to be adjusted downwards to align them with market demand. The demand-oriented method of pricing seeks to determine the price that maximizes profits. This, of course, will depend on the product that you are selling.
For instance, if you are in the retail business such as a grocery, department store, or restaurant, your customers may be so sensitive to price that a price cut can substantially increase your sales. On the other hand, if you are in the gasoline or jewelry or power distribution business, your customers may be insensitive to your price, in which case you can increase your price gradually without affecting the volume demand.
It is best to combine the demand-oriented method and the cost-oriented method to arrive at an effective pricing strategy. In general, you can use the cost-oriented method as the basis of your pricing strategy, since it is mechanical in nature and is relatively simple to use in determining your target profit levels. For marketing purposes, on the other hand, you can use the demand-oriented method, for it is useful for fine-tuning your pricing until you arrive at your final pricing.
You can start with a price that is based on your profit goal. Your initial price point could then be high as result of your desired profit target, which is fine for as long as you can experiment with it to find out if the market will accept it or not. After conducting your tests, you can adjust your price according to what the market will be willing to pay you for your product. The experiment can be done through an actual sale, or perhaps through a simple survey that involves getting the opinion of your friends and customers about your pricing.
When it comes to pricing, though, it is important to remember that you need to consider that customers are not simply looking at price per se, but at the value of your product or services. Perhaps, then, before building your pricing strategy, you should consider first asking your customers how they define value with respect to your product or service you are selling.
Henry Ong, CMA, RFP, is president and COO of Business Sense Inc., a financial advisory and consulting firm that helps small and medium businesses. Business Sense is affiliated with INPACT International Network of Certified Public Accountants. You may reach him at hong@businesssense.com.ph or www.businesssense.com.ph.
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