Every business struggles with pricing to some degree, but small business owners often have fewer tools at their disposal to solve the pricing dilemma. This article explains one technique for logically pricing your products and provides two simple tools to help you do that.
For many small business owners, pricing is a shot in the dark. You mark stuff up, hope it sells, and pray your net income keeps you above the poverty level. Sometimes it works, and sometimes it doesn’t. You know that your sales need to be higher than your costs, but making sure the difference will pay your mortgage can be challenging.
There’s a better way.
A Simplified Pricing Strategy
The technique I’m going to describe works better for an established business than a startup because an established business has historical data to analyze. For a startup, you can use the financial projections from your business plan (you have one of those, right?) as a guideline, but you’ll obviously want to start using actual data as soon as it is available.
If you are just getting started with a true pricing strategy, you usually start at an aggregate level. In other words, you look at your total income and expense figures, and apply the same pricing scheme to all products. Over time, however, you can fine-tune your pricing for individual products as you learn more about how they sell. Every product has its own "sweet spot" where the price of the product and the demand for the product generate the highest possible level of income. Unfortunately, that sweet spot is often a moving target, so it literally pays to experiment with different pricing levels.
To get a very rough idea of how you need to price your products to meet your financial goals, start with your income statement, and calculate the following for an average month:
- Calculate your average operating expenses. Include your salary in this figure, but do not include cost of goods sold.
- Calculate your average cost of goods sold. This figure is essentially the amount you paid your suppliers for the items you actually sold.
- Decide on your desired gross profit from the business. Do not include your salary in this figure.
- Calculate your target gross sales by adding all three of the above figures together.
You just figured out how much money the business needs to earn each month for you to reach your financial goals. The next trick is to figure out how to price your products to reach the desired gross sales figure.
Markup Versus Margin
Converting Wholesale and Retail Prices
Warning: High nerd factor
The wholesale multiplier and the retail multiplier are reciprocals of each other.
For example, if multiply your wholesale price by 1.3 (130%) to get your retail price, then you multiply your retail price by 1 / 1.3 (= .77) to get your wholesale price.
Margin is the difference between your retail price and your wholesale price, so the margin percent is the complement of the retail price multiplier: 1 – .77 = .23 = 23%.
For most businesses, the easiest way to price items is to determine a markup percentage and multiply the wholesale price of the item by that amount. That sounds easy, but how much of a markup do you really need? If you come at the problem from the perspective of reaching your desired gross profit, you are really looking at how much of a gross margin you need to earn from your sales.
So what’s the difference between markup and gross margin? While researching other articles on the Internet related to this topic, it became clear that many people would like the answer to this question. And not all of the answers I found were accurate. In fact, one so-called expert claimed they were the same thing, which is completely false.
The distinction is subtle and confusing because the dollar amounts are the same. The percentages are what differ, and that difference is critical to you in terms of a pricing strategy. So, for the record:
- Wholesale markup is the percentage you multiply a wholesale price to calculate a retail price.
- Gross margin is the percentage you multiply a retail price to determine how much money you earn on the item.
An example will help clarify the distinction. Suppose you sell a product for which you pay $5.00 wholesale. Your markup is 50%, which means you multiply the wholesale price by 1.5 to get a retail price of $7.50. Now, what is your profit margin? Are you thinking 50%? Nope. It’s 33%. If you do the math, you see that making $2.50 on a $7.50 sale gives you a profit margin of 33%.
Now you can see how you could get into trouble if you calculate your target profit margin and then try to use the margin percentage as your wholesale markup. You would set your price too low to meet your goals.
At this point, a concrete example is in order. I put together a worksheet that illustrates the points I’ve made so far (you can download a zip file containing the worksheet if you want to play with it yourself). In the worksheet shown below, I’ve entered dollar amounts into the green cells for a mythical product business.
In the first section, I calculate the gross sales I need to achieve to reach my income goals. I entered the Expenses, Cost of Goods Sold (COGS), and Target Gross Profit figures. The worksheet added those figures up to calculate Target Gross Sales.
In the second section, I calculate wholesale markup. I did that by subtracting COGS from Target Gross Sales to determine the Target Margin dollar amount, which is also the Wholesale Markup dollar amount. To calculate the Wholesale Markup percentage, I divided the Target Gross Sales by COGS. To get the Target Margin percentage, I divided Target Margin by Target Gross Sales.
From the spreadsheet, I learned that I need to mark up my products by a little over 200% to reach my financial goals. In other words, I need to charge double the amount I pay for each item. This amount of markup is not unusual in the retail world, although it certainly varies by market. The more competitive the market, the lower the markup you can usually get away with.
The spreadsheet is useful as a "what if" tool, but it makes several assumptions that you’ll have to take into consideration. The spreadsheet assumes:
- Your average expenses are consistent.
- Your average sales are consistent.
- You’ll sell the same amount of stuff regardless of what you charge for it.
Even if the first two assumptions are historically accurate in your business, the last one is very unlikely to be true in practice. Any economist will tell you that as price goes up, demand goes down. A good marketer will argue the point, but with all other things being equal, the economic view is generally true.
My point here is that you can use the spreadsheet to find out if your financial goals are even reasonable. If you determine that you need to mark up your products by 500% in order to reach your financial goals with your current level of sales, you probably have to rethink your goals or figure out a way to sell a lot more widgets.
Retail Price Calculator
The worksheet is a nice strategy tool, but if you want to play with the pricing of a particular item, you can take advantage of this simple retail price calculator:
To use the tool, you enter the wholesale price of your item and one other value. Then you click the Calculate button next to the other value. The image above shows what happens if I enter a Wholesale Price of 20, a Markup Percent of 25, and then click the Calculate button next to the markup percent. Note that the Price and Amount fields are monetary and the Percent fields are percentages.
Take Time to Strategize
Unfortunately, there is no simple answer or quick fix for figuring out the optimal pricing strategy. However, if you set goals, monitor your sales, and adjust your pricing tactics periodically, you’ll gain valuable knowledge about your business that will help you identify trends and opportunities. Best of all, you’ll be far ahead of your competition, who are still operating by the seat of their pants.