Understanding Five Foundational Pricing Methods
How do you arrive at a price for the products and services you sell? While it depends on what industry your business is in, a handful of foundational pricing methods will be useful regardless of your business model. We outline five: time and materials pricing, cost-plus pricing, market pricing, target pricing, and value pricing. Let’s dive into each one.
Time and Materials Pricing
Time and Materials (or T&M) pricing is a method used by many service-based organizations. As you might have guessed, T&M pricing is based on the time spent performing the service. A few great examples of Time and Materials pricing include the hourly rate an attorney charges, the rate a massage therapist charges for a 50- or 80-minute service, or the minimum fee a plumber charges, plus a different rate for subsequent hours. It’s also a method typically used in construction and product development.
In some cases, time-based pricing may be loosely tied to the salary level of the person performing the service. Still, there must be a substantial markup to cover payroll taxes, health insurance, overhead, training, and any materials or tools that are included. While costs like hourly rates, materials, equipment use, and independent contractors are typically agreed upon by the provider and customer ahead of time, the customer won’t usually receive an estimate in advance.
Cost-Plus pricing (also referred to as Markup pricing) is typically used in the retail industry. Retailers select inventory from a manufacturer or wholesaler and then make those products available to the public for purchase. This method is based on unit cost plus a markup. A typical example is keystone pricing, when an item is marked up to twice the purchase price plus one dollar.
Other industries that use cost-plus include groceries and auto dealers, but the pricing approach would also be relevant to businesses like a bakery, which purchases inventory in the form of ingredients and transforms them into a new product, like a pie.
Market pricing is the act of establishing the price for your goods or services based on the rates your competitors are currently offering. It is dependent on fluctuating market conditions and allows the seller to stay competitive with other providers. Commodities are the best example of Market pricing: Crops, oil and gas, and metals are all priced by the market.
Target pricing is the process of beginning with a price that you feel customers will be willing to pay, and then designing a service or product around it. It’s commonly used in the SaaS, or Software as a Service, industry.
For example, let’s say you develop a concept for a subscription-based application that you believe consumers will pay a competitive rate of $29/month for–note that this price will be based on market research, not a ‘gut feeling.’ You would then build your application (and the resources required to support it) around a budget driven by the target price. If an organization can’t create the application build within the budget, it scraps the project.
When an organization takes the Target pricing approach, it can be more confident of a reasonable profit because the price is already consistent with market demand.
Value pricing is based on the price a customer is willing to pay and what they value, rather than the direct cost of the product. For example, a customer with more to gain from employing your services is likely willing to pay more than a customer of smaller means with less to gain. This is because, while both customers may receive the same services, their perceived value of your services is different. Thus, they’re willing to pay different prices. For project-based work, Value pricing can be based on the customer’s expected return on investment (ROI) and is used in digital marketing and for some professional services.
Pricing in Action
In business, determining a product or service’s price is part math and part art. It may even be a combination of two or more methods listed above. There are many factors and considerations that will inevitably go into your pricing decisions. New Business Directions can help you determine if your prices are adequate for the profit margins you want, competitive with your industry’s standards, and more. We can also help with if-then scenarios. For example, if you raised your rates by $100 an hour, but demand went down five percent, what would your profit margins look like? Please reach out to us to schedule a paid consultation if you would like us to help you with your pricing process.