One of the most important questions to ask when starting venture is really a difficult one to answer for new entrepreneurs:
“What should I charge?”
There are a few different (and great ways) to set prices, but I want to show my favorite–vision based price setting. Before we get into that, let’s talk about a couple of the common pricing pitfalls new entrepreneurs make:
THE RACE TO THE BOTTOM
When multiple businesses try to be the cheapest in the area its off to the races! Unless when you originally created your business to be the price competitor (like WalMart)–don’t even try to be it. Because unless you can be sure to be the absolute lowest price, there is no reason to be second cheapest. In the end you, your staff, and most importantly, your clients, will have to suffer from the cost of using cheap price setting techniques in your business. If they want nice restrooms, you cant afford them. Good staff members? Won’t stay once they get offered better. Fancy branding? Nope.
“Won’t my competitors take me out if they are less expensive?” Great question, and the answer would be an astounding “YES!”…. If customers cared only about price. The truth is, people want value not cheap.
- Cheap is that crappy cup of coffee that the overworked waitress burnt.
- Value is the smooth and great experience of a well crafted cup that used the finest beans Columbia had to offer for a fair price.
- Cheap is the cockroach infested apartment with the noisy neighbor.
- Value is the gated complex with the swimming pool that was within a reasonable budget.
When value outweighs the financial cost of something a person buys it. That means it’s important to focus on value and not on cost, as the cost is dependent on how much value is being provided to the customer. Providing value is such an important topic that it deserves multiple dedicated blog posts on it’s own, but the point is that racing to the bottom leaves everyone broke, and the customer without the great business that they used to look forward to going to. With that being said, some might think a great way to set prices is to base them off an already well set price…
THE COMMON MISTAKE — Competitor Based Pricing
“It’s easy” you tell yourself.
“I’ll just set my prices based off my competitors!”
That is, until you set your prices to mirror of those around you and discover that they weren’t making any money and now you aren’t either. The biggest problem with this is that you are praying that your competitor knows what they are doing in their business–and one thing I can tell you is that there are a LOT of startup entrepreneurs that don’t yet have the basics (such as price setting) figured out. I know this intimately because in my first business I did this. I researched every competitor within my city and I set my price to what they were charging. The results came in pretty fast–it wasn’t possible for me to make any money and I was paying thousands of dollars a month to be in business. This was a head scratcher for me because I couldn’t understand how they were making money with those prices and I wasn’t. I even had more customers than them!
Well my confusion was short lived as about a year later six of those businesses that were similar to mine closed–and I was on the brink of business failure myself. In a means of survival I called what has since become my mentor and he taught me the importance of vision based pricing.
VISION BASED PRICING–Money Made Right
One of my favorite things about business is that it doesn’t take a PhD to be great at it. However, a little algebra won’t hurt–especially when setting prices.
Algebra teaches that if you know enough variables in an equation, you can solve for missing ones. In our equation, there are some unknowns, but what we are looking for is the price we want to set that will keep our operations in motion. We will call this “Vision Pricing” as it based off three main parts of a business:
- Overhead Costs – Static reoccurring cost to the business. (i.e.: Rent, Internet, Maintenance, Monthly Bills, etc.)
- Staff Pay – Cost associated with staff.
- Ownership Share – How much the owners or shareholders make.
Vision Pricing = Overhead Costs + Staff Pay + Ownership Share
The reason we call this vision pricing is because our goal is to set prices based off of what our vision is for our business, employees and ourselves–which means WE control our outcome, and our environment and competitors don’t. But first, we set what % of our business we want to allocate and to where. These numbers are malleable, but a good starting place is to set 20% for overhead costs, 45% to staff pay and 35% to ownership or shareholders:
Now, 20% (Overhead) + 35% (Owner) + 45% (Staff) = 100% (Gross)
So, now all that one needs to do is define what the terms are, and vision can lead to the answer for Owner and Staff. As an example we will build a fake pizza parlor:
All we need is one of the numbers to fill everything in, so we will start with staff. The aspiring pizza parlor owner wants to pay his staff $55,000/yr and he has two staff members (so $110,000 total).
- 45% (Staff) = $110,000
We can figure out the total that his business needs to gross, which in this case is about $245,000. ($245,000 x 45% = ~$110,000)
Our equation, with numbers filled is starting to look like something understandable:
20% (Overhead) + 35% (Owner) + $110,000 (Staff) = $245,000 (Gross)
To figure out the dollar amount cost of overhead and ownership shares, we simply determine 20% x $245,000, and then 35% x $245,000:
- 20% (Overhead) x $245,000 (Gross) = $49,000 (Overhead)
- 35% (Ownership) x $245,000 (Gross) = $85,750 (Owner)
We now have all the data!
$49,000 (Overhead) + $85,750 (Owner) + $110,000 (Staff) = $245,000 (Gross)
- The aspiring pizza entrepreneur now knows he needs to look for a lease, internet capability, marketing, and supplies that total around $49,000/yr (or $4,085/mo).
- He knows that he will be able to pay himself $85,750/yr ($7,145/mo) if he makes his goal of $245,000 gross this year.
“I thought this was a post about prices? Not how much a building will cost me or how much personal pay I will receive,” You’re right, but it’s important to see WHY it’s considered vision based pricing, as you can see the vision is already starting to appear. However, let’s get into the details about pricing:
In this scenario, it’s best to use the customer base to create pricing. A good figure for a pizza business in a medium populated business would be around ~100 people a day, open an average of 5 days a week. The total customers per year would be:
100 (customers) x 5 (days) = 500 (customers per week)
500 (customers per week) x 4 (weeks in a month) = 2,000 (customers per month)
2000 (customers per month) x 12 (months in a year) = 24,000 (customers a year)
Now the pizza entrepreneur knows he needs 24,000 customers to make him $245,000–so he simply divides to determine how much each customer needs to spend on average:
$245,000 (gross/yr) / 24,000 (customers/yr = $10.20 (payment per each customer)
Pizza-preneur knows that he has to make at least $10.20 per pie (assuming each client buys their own) to make his goal!
Additionally, our pizza entrepreneur has no doubt that if he sells 100 pizzas a day he will hit his mark–as all the math has already been done. What’s great about this, is he can adjust his prices to reflect possible slow times, meaning he raises them in order to handle less customers. While this takes a second to calculate out and to get used to doing, this is the preferred method I use to set prices in my own businesses and in the businesses I help mentor. As a side note, this is also a great way to show investors how much return they will get on their investment–one that is VERY HARD to pick apart.