How to Set Prices that Maximize Profit
Pricing can be one of the most elusive strategies for a business to nail down, especially for B2B companies. But getting your pricing right can make or break your business – it’s not only a driving factor in your profits, it also impacts how your brand is perceived by your customers and market.
Every business is different, so I can’t give you a single golden rule to set the perfect price (even “never lose money” doesn’t work, as you’ll see). But I can give you a trusted framework and warn you of the most common mistakes I see people make.
There are three main phases in developing your pricing strategy: identifying cost, determining value, and setting your price.
1. Know Your True Cost
This first step is more important and a lot trickier than you think. Knowing your true cost isn’t as easy as getting a quote from your suppliers and totaling it up. To make smart business decisions you need to know the true cost of servicing your customers.
For a service business, the primary cost driver is labor hours. The bulk of costs are directly tied to the number of hours your team works on a specific project or account.
But the costs don’t stop there. You may also invest in marketing strategies for each of your services. These costs would not otherwise exist if you didn’t offer that service, so those must be included in the true cost of service.
The same can be said for businesses that sell physical goods. Your supplies, marketing efforts, and direct management expenses all need to be applied to calculate the true cost.
Be careful not to include business-wide expenses. If the expense is incurred independent of the sale of your product or service, it should be ignored in this decision. For example, my salary doesn’t impact the cost of any particular product we offer. Yours probably won’t either, unless you are responsible for a single product offering.
A good way to figure this out is to simply ask yourself: “If we stopped selling this product tomorrow, would this expense still need to be incurred?”
Once you know this number, you can use it to make sure that you are achieving your target ROI and making profitable decisions. Not knowing the true cost causes many businesses to run a loss without even realizing it!
But unless you are truly selling a nondifferentiable commodity, like copper or gold, you should not put too much weight on costs when setting your price.
Sure, it’s important to know so that you can evaluate a product’s success, but what is much more important is understanding your product’s value.
2. Determine Your Value
The most profitable businesses measure value against cost when devising their profit strategy.
For example, at my digital marketing agency, we consider how much our work will increase the profits of our clients, not how many hours we will have to bill to get them. Any price below that is reasonable. As long as you are providing more value to your clients than you are charging for, they will happily continue to employ your service.
Of course, you don’t want to take advantage of your customers and overcharge them simply because you can. That bloated margin will leave room for competition to come in and undercut you.
To determine the value of your product or service, you need to figure out what the business impact is on your client and how essential it is to their operations. You will know how to do this better for your business than I, but here are a few ideas:
- Ask them. Interview customers and potential customers to find out where your business fits into their bigger picture. Learn about the positive changes they experience when they switched from a competitor to you.
- Track results. In digital marketing, we know about the importance of tracking our success metrics. If the client’s average lead is worth $20 and you bring them 500 qualified leads a month, your services are easily worth $10,000.
- Ask yourself: “What would happen if I stopped serving them?” If you decided to stop serving that client, what would happen to their business? Would they have to use a more expensive competitor? Would they lose many customers? Or discontinue a product of their own?
When you set your prices with value in mind (and it lines up with the costs you need to cover), you should be on the path to healthy profits. The last step of this framework is to use effective strategies to set the perfect final price.
3. Use Psychological Pricing
Once you have a ballpark figure for your pricing, you need to finalize it using psychological pricing strategies. This is where you tweak your price based on different psychological triggers and guide both their emotion and logic to make the decision that you want.
One of the most well-known examples is adjusting your price in a way that reduces the first digit in your price. For example: $49.99 instead of $50.00. Although logically we know these prices are essentially equivalent, our subconscious mind has been shown to greatly favor the former.
But a recent study has actually questioned the universal nature of that effect. They found that when a purchase was driven by more emotional status drivers, round pricing actually performed better.
The theory is that uneven numbers require more energy to process and promote more thought. This results in the customer relying more heavily upon reason when making their decision. The round numbers are easier to process, allow customers to make the decision emotionally, and give them a greater feeling of being right.
However, it’s worth noting that many business purchases are made on rational, and not emotional, grounds, so these latest findings may not be as important in B2B pricing.
Another psychological strategy doesn’t actually involve changing the price, but rather how you present it. It’s called price anchoring.
To convince customers that your price seems reasonable (or even a steal!) you need to give them larger numbers with which to compare. The oldest example of this is the “perpetual sale” like you find on Amazon.
Of course $17.39 seems reasonable for a product that’s worth $25!
There are ways you can leverage this in your business transactions. For example, add a screen question early on asking clients if their budget is above or below $2,000 a month. They will then find your proposal for $1,200 very agreeable since their minds have been thinking about $2,000.
None of these tricks are magic and they can’t automatically triple the value you offer or cut down your costs, but they will increase your sales volume and profits if used in conjunction with the proper value-based pricing.
Consider Long-Term Business Objectives
Since your business doesn’t exist in a vacuum or in a single moment of time, it’s important to optimize your price for higher profits. But it’s also important to keep your eye on the bigger picture. Maximizing your price for profits should be a long-term goal, not a temporary fix.
There are four main outside considerations I keep in mind when setting my prices:
1. Market Share
Sometimes to maximize your long-term profits, you need to sacrifice your short-term income in exchange for more market share. The increased name recognition, customer loyalty, and publicity you gain from cutting prices can be worth it in the long run if managed well. Sometimes it may even be profitable to run at a short-term loss. This strategy is especially viable for new market entries.
2. Lifetime Value
Make sure you know your average customer’s lifetime value. If you sell repeat services (like SaaS) or have a strong upselling or cross-selling strategy in place, it may be worth it to sell loss leaders. These are introductory products sold at a loss in order to form a relationship with a customer who is expected to spend much more in the future.
Another reason not to raise your price too high, especially in more mature industries, is the threat of competition undercutting you. If you charge prices in excess of three times your cost, competitors will find it easy to underprice you and steal your business.
If you are a market leader for a particular product or manage a strong differentiation, you might be able to set your prices high at first, but you should keep an eye on the competition’s prices to make sure that you remain competitive as their offerings catch up.
4. Brand Image
This can go both ways. As a consumer example, Apple tends to keep their prices extremely high despite massive margins. This hasn’t shown much sign of decreasing their sales rate and certainly hasn’t dampened their profits or brand image. The high price point actually gives their customers a feeling of superiority and helps Apple position their products as top-tier luxury goods.
On the other hand, if you raise prices too frequently or fail to deliver on your quality, the market may view you as greedy or overpriced which will leave a bad impression and make it very difficult for you to earn back their trust, even after your prices have been lowered.
There is no single pricing strategy that works for all businesses, but if you test out these tips, you should be able to improve your price point. Try different psychological pricing techniques and interview more customers about the value you bring them. Track your results and record what you learn so you can improve each time and you’ll soon be on a constant train of price optimization and increased profits.
Zapier has come a long way since its founding in 2011. Learn how some of their earliest decisions as founders still hold up, even after years of growth and evolution.
Why is transparency such a core component of GitLab’s DNA? Co-founder & CEO, Sid Sijbrandij, breaks it down and explains how they’re able to provide so much more value to users because of their community.
Hired’s Head of Global Revenue, John Kelly, explains how the company successfully transitioned from a transactional to a subscription model – and lessons learned along the way.