In everyday life, you probably don’t spend a ton of time questioning why items cost what they do—you simply choose whether or not to buy them depending on your needs, desires, and budget.
But it turns out, a huge amount of thought goes into each and every price tag you see. And if you’re not making incredibly strategic decisions about your own product’s price, well, you’re sabotaging your business.
Here’s what you should consider before putting a dollar value on your goods or services.
The Three Basic Pricing Models
There are three foundational approaches to calculating prices: cost-based, competition-based, and value-based.
Cost-Based Pricing
This method is the simplest. Start with how much you want to make on each product, then add how much it takes to make and distribute that product. The sum is your price.
Although cost-based pricing will give you the margins you’re looking for, most people agree it’s not effective because it’s not tied to customer demand, market conditions, or the product’s true value.
Competition-Based Pricing
Using this approach, you analyze how much other companies are charging for similar products and choose competitive prices. If you use this model, your product needs differentiating features to give customers a reason to buy it.
If you’re in a well-established industry where consumers are familiar with how much the traditional product costs, competition-based pricing may be the way to go.
Many apps rely on competition-based pricing. For example, productivity apps Fantastical 2 and Clear are both priced at $4.99.
Value-Based Pricing
Value-based pricing is the most popular and effective. Of course, it’s also the hardest to nail down. To determine your value-based price, you figure out how much money or value your product generates for the user in the long run, then take a fraction of that.
For a simplified example, let’s say that you’re selling an email replacement tool that helps companies recover $7,000 in productive hours each month. Ten percent is a reasonable cut, so you set your monthly price at $700.
Obviously, if you’re selling something that’s not directly functional, value-based pricing becomes even more nebulous.
Get around this by gathering a sample of potential customers (i.e., people in your target demographic) and asking them if they’d buy your product at X price, at Y price, at Z price, etc. You’ll be able to generate a rough bell curve of the percentage of consumers who will buy at each price point. In general, the “value” of your product is at the peak of the curve. (That doesn’t mean that’s what your price should be, however—more on that in a bit!)
Pricing Goals
Even after you’ve found the most suitable pricing model for your product, you need to factor in your company’s business plan.
Make Money Fast
There are a couple situations that may demand bringing in as much profit as you can as quickly as you can. First, if you’re bootstrapping it (which means running your company with no outside money), you’ll need to generate profit right away. Second, if you’re looking to attract funding, showing profitability is a great way to convince VCs or angels that your startup will be a good investment. (Note: You don’t always need to be in the black to get investors excited—Snapchat and Facebook were worth billions of dollars before they ever turned a profit!)
Drive Your Revenue Up
Another goal is to generate huge revenues—but not necessarily huge profits. In other words, you’ll be making and spending lots of money. This strategy can help you establish dominance in the market. It can also enable economy of scale, which will help you lower your costs down the line.
Online marketplace jet.com is using this strategy. Jet has earned a $600 million to $3 billion (depending on whom you ask) valuation by offering lower prices than Amazon. Despite the valuation, it’s not making any money yet—the Wall Street Journal picked out 12 items on Jet (selling for a total of $275.55), researched how much it cost Jet to buy and sell those items, and found that Jet was actually losing $242.91.
Get Customers
Acquiring as many customers as possible is yet another goal. Uber is the poster company for this technique; it frequently gave away rides (thus operating at a loss) because it knew that once people rode in an Uber, they were very likely to become repeat customers.
If, like Uber, your product is “sticky,” or if it’s available as freemium, than getting customers should be your primary objective.
Develop a Reputation
If you’re positioning your product as affordable and attainable, your prices should be on the lower side. Alternatively, if your product is a luxury good, price it high. Many people confer high prices with better quality, even if there’s no real evidence that’s the case.
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