How do businesses come up with prices?

This is a concept that can leave consumers scratching their heads and wondering what these guys have been smoking. I’ll admit there are probably a lot of randomly priced products out there, but the best run businesses will often have a strategy when it comes to pricing.

To start with it helps to look at the 2 main methods a business might use to set a price for a product or service.

The first method would be to have a look at the costs associated with the product, for example the materials, staff, utilities and advertising and then add a mark-up to it. This is a great idea if a business wants to maintain margins, however it can often lead to premium pricing compared to the competitors and not for the right reasons. Customers will then end up walking away and the businesses reputation will lay in tatters.

The second method is to research the market and identify what customers are willing to pay based on prices other businesses are charging, they would then work out everything needed to supply the product and be left with their margin. This can be a better way as at least the price is acceptable to the customer, however if the margins are lower, then they would need to sell a lot more of the products to make the same amount of money.

The methods above look simple enough, a good accountant could probably work it all out pretty quickly and if a business wants to be average then that’s great they should pick one and go for it. But what do the market leaders do?

The best businesses mix the two, they identify what the customer is willing to pay, work hard to streamline their costs (yes I’ve noticed the Big Mac getting smaller over the years) and then they add value to it by offering additional services. If they work hard to convince the customer that the additional services are over and beyond anything the competition offers then the customer might pay the extra.

Let’s look at an example, what is the most profitable product ever created? The humble bag of popcorn at the cinema, it’s no secret that the bag costs more than the corn inside although there are popping and seasoning costs. It came about because the cinema’s identified that customers often only took the ticket price into account when looking at which one they wanted to go to but ignored everything else. That’s why they all competed on ticket price and then created an added value product to enhance their margins, which consumers were willing to pay for.

Over time a business’s competitors will catch up and offer a similar added value product at a similar price so that first business will once again need to think of a way of innovating ahead of the competition.

So as a customer how can you tell if you are being charged a fair price or being bent over? Well if you’re comparing products or services from different businesses then it makes sense to understand what you are really getting extra or sacrificing for the price difference. Is a “free” one year warranty really worth anything when you are already covered by the sale of goods act and how much are they adding to the price to give you that?

As accountants we help our clients when it comes to investing in their businesses, it’s a similar thought process to the one’s we’ve discussed in this blog and it looks at how much value they are getting for the money they spend. We also help them with pricing strategy and making sure they are getting the best return for the product and service they supply.

Please contact us with any questions you may have.

Nishi Patel

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