03: Creating Your Product
Pricing and Margins
Pricing affects not only your company’s profitability but also its market positioning and customer perception. A well-thought-out pricing strategy can drive sales, improve market share, and build brand loyalty. Conversely, poor pricing decisions can lead to lost revenue, excess inventory, and a damaged brand reputation.
When TeaSquares first launched at Whole Foods, our multi-serving pouch retailed for $6.99. Why this price? Honestly, we kinda just made it up at the time and had no real strategy. After a few months, our sales were just OK. While doing demos, we heard from customers that the price was too high. So we redesigned our pack, made it smaller, and lowered the price point to $3.99. Sales increased! But not to the same total dollar sales from our larger size. After 6 more months, we actually made less money.
Understanding Market Dynamics
Before you set your price, you’ve got to know the landscape. What’s everyone else charging? Where do you fit in?
- Highest Price Point: What’s the premium product going for? What makes it premium?
- Lowest Price Point: What’s the bargain basement price? What’s sacrificed to get there?
- Most Common Price: What’s the middle ground where most products sit?
This gives you the range. Now, where does your product fit?
When consumers shop in a category, they use price anchoring to determine how much they’re willing to pay for a product. Decide where you want to be. Are you the premium option, the budget-friendly choice, or somewhere in between? It’s all about the value you bring and the problem you solve for your customers.
Pricing Methods
Here are three methodologies to use to figure out your pricing:
- Cost+ Pricing
- Value-Based Pricing
- Competitive Pricing
Cost+ Pricing Method
Cost+ pricing is simple but can be a trap. Here’s the basic formula:
- Calculate Your Costs: Add up your COGS – ingredients, packaging, labor, overhead.
- Example: Your COGS per unit is $0.96 (From our example in the COGS chapter).
- Add a Profit Margin: Decide on your margin.
- Example: With a 3x COGS, your price would be $2.88
It’s straightforward but doesn’t account for what customers are willing to pay or what competitors are doing.
Value-Based Pricing
Value-based pricing means setting your price based on what customers think your product is worth.
- Understand Customer Value: Talk to your customers. Find out what they value. Find out how much they’re currently paying for similar products and how much more they’re willing to pay with your additional features.
- Set Prices Based on Value: Price your product according to the value it provides.
- Example: If your customers care about organic certification, they might pay up to $1 more than the non-organic version.
Competitive Pricing
Competitive pricing is about knowing your rivals and positioning yourself accordingly.
- Analyze Competitor Prices: Check out what similar products cost.
- Set Your Price: Position your product competitively.
- Example: If the average price is $2.00, but the top priced product is $4.00, you might price your “premium” granola bar at $3.80.
The Value Chain and Its Impact on Pricing
Your product goes through several stages before it reaches the customer. Each stage adds cost and markup that you need to account for when choosing pricing.
Here’s how pricing works along the value chain for a product that retails at $1:
- Ingredient Supplier: Sells raw materials.
- Example: Ingredients cost $0.05.
- Manufacturer: Turns materials into products.
- Example: Sells to brand owner at $0.13.
- Brand Owner: Adds branding and marketing.
- Example: Sells to distributor at $0.25.
- Distributor: Moves products to retailers.
- Example: Sells to retailer at $0.53.
- Broker: Facilitates sales to retailers.
- Example: Adds commission, sells to retailer at $0.66.
- Retailer: Sells to the end customer.
- Example: Final price is $1.00.
As a brand, you may decide to also do the manufacturing, distribution, and broker steps during the beginning, but make sure you incorporate those costs into your price to leave room for outsourcing those in the future.
Brand Pricing
As a brand owner, you’ll typically set 3 pricing levels:
- Distributor Pricing
- The price charged to the distributor. Distributors buy products in bulk and are responsible for getting the product to retailers or directly to the market.
- Distributors look for a 7-20% margin.
- In the above example, you would sell at $0.25
- Wholesale Pricing
- The price charged when you sell directly to the retailer, who’s responsible for making the product available to customers.
- Retailers look for a 25-50% margin.
- In the above example, you would sell at $0.53
- Customer Pricing
- The final retail price charged to the end consumer.
- In the above example, you would sell at $1.00
Volume Pricing
Set discounts based on volume to encourage customers to buy more products. You’ll likely offer discounts across each of the pricing levels above.
Understanding Markup vs. Margin
You’ll often hear partners talking about Markup and Margin, and it’s important to understand the difference.
Markup
Definition: Markup is the amount added to the cost price of goods and is expressed as a percentage of the cost price.
Formula: Markup =((Selling Price – Cost) / Cost) x 100
Example: If a product costs $10 to produce and it is sold for $15, the markup is calculated as follows:
Markup =(15 – 10) 10 x 100 = 50%
Margin
Definition: Margin is the difference between the selling price and the cost of the product, expressed as a percentage of the selling price.
Formula: Margin =(Selling Price – Cost) / Selling Price x 100
Example: Using the same example where the product costs $10 and is sold for $15, the margin is:
Margin =((15 – 10)/ 15) x 100 = 33%
Key Differences
- Basis of Calculation:
- Markup is calculated on the cost price.
- Margin is calculated on the selling price.
- Perspective:
- Markup reflects how much more than the cost price a product is sold for.
- Margin indicates the portion of the selling price that is profit.
- Usage in the Value Chain:
- Manufacturers might use markup to determine the price at which they sell to distributors.
- Distributors and retailers often focus on margin to understand their profitability on each sale.
Margins
Now that we have our costs and an idea on pricing, you need to understand what your product margins are to make sure they can support a healthy business. Your gross margin is the difference between your selling price and your cost of goods sold.
Without a healthy margin, you can’t build a business. Expected gross margins vary from category to category, but should be 30-50% at a minimum.
Gross margin needs to cover every other expense within your business including:
- Discounts
- Salaries
- Marketing
- General Operating Expenses
And most importantly profit.
Always start with a high gross margin.
I advised a company selling a really great soup product. It was labor intensive to assemble and they had a low (20% gross margin). Their hope was that once they proved the concept they’d be able to improve their gross margin with scale. While they achieved some good initial traction, ultimately they didn’t realize any significant margin improvements, causing them to quickly run out of money.
Having strong margins for your business is a foundation for what comes next.