Answer: Pricing products is something every entrepreneur needs to think about. You don’t want to price too low or you will have worked for nothing, on the other hand pricing to high will limit the number of customers you can service. Therefore, in pricing your products you must find a balance between profit and market tolerance by measuring the value of your product to your most targeted audience.
When pricing a product the question that determines your success is: “What will my audience pay for this product and can I make make money selling at that price?” Let’s dig into that and see what factors equate to a modern successful product. Another question you should ask your self is does your product fulfill a unique need? This question determines how much market resistance you can expect, if you begin as the market leader in your particular niche your ability to command a higher price increases dramatically. Although, just because your price is unique doesn’t mean you’ll be able to sell at astronomical price that breaks the aesthetics of the perceived market value.
We also want to know if our product is difficult to knock off, is there some mechanism that prevents our current or future competitors from easily copying the unique elements of our product? If so how do we re-enforce the value and pick a price point that makes the business viable but doesn’t invite a multitude of competitors. If your product is not unique or you are following into a market with many competitors you must craft a value proposition on a plain above simple cost. There is certainly someone who has more means and ability to produce almost any product cheaper if the market appears substantially lucrative to them.
The old way of product pricing calculations do not account of the cost of marketing the product to an audience. If you’re not the only show in town factoring in the cost of marketing and choosing products that have dimensions of repeat-ability or share-ability will be key factors to reducing the overall cost bringing your product to market.
Lets take a look at a few different profit margin calculations that do not factor in the the cost of marketing.
The direct costs margin is the margin generated after paying for costs from the sale of a product. . The formulas for direct costs margin and direct costs margin percent are:
direct costs margin = sales price – total direct costs
direct costs margin % = direct costs margins / sales price x 100%
The rule of thumb is that you must at least cover direct costs to continue offering the product. This is true on a line item level when a product does not lead to additional product sales or does not entice repeat business. If you run a online massage chair business, your chance of finding repeat buyers in a 5 year span is incredibly slim. Also it is unlikely that people will go around telling all their friends that they bought a massage chair in the the first place. In this example your direct cost margin should be very high to offset the limiting marketing factors.
Anytime you introduce a new product you want to understand your break even cost. The break even cost gives you a bench mark to product viability. This factor is not as important in made on demand products, or drop shipped product but must be a factor when products are pre-orders or large quantities of stock must be purchased.
break-even price = direct costs / unit + fixed costs / volume
If your price is set at your break-even price then your ending profit will be 0. Your direct costs can incorporate things like marketing, packaging, shipping, sh space and elfso forth. It’s important to understand the cost surrounding your product to determine if the effort is even worth it. In one ideal situation a container of bobbles is ordered and the sale of 20 percent of the bobbles reaches the break even point, and if those bo bbles can be sold at a reasonable velocity you have a good product. The other factor to look at here is if this product sale leads to the sale of more profitable products. As our sale price approaches the break even cost we must gain a secondary benefit in the form of additional capital. This is what is generally referred to as a hook product or loss leader. A loss leader is simply a product that is sold below a point of profitable that a company deems acceptable in trade for contextual sales brought in by stocking that product.
All these are great equations but the modern business owner must have a bench mark to determine how much marketing must take place to sell a single product. By understanding the success of marketing you can track your companies growth and profit from the results generated with a measured and budgeted approach.
Lets assume the following…
Our sample bobble details:
(GM)Gross Margin = 60% (The percentage of profit remaining after all fixed costs not including marketing)
(RM)Referral Multiple = 3 (for every 1 person that buys a product they tell their friends and 2 of their friends also purchase the product)
(ARPCL)Average Revenue per Customer lifetime = $1000 (this is our number for how much a customer will spend purchasing this product, or other products we offer at the same margin)
Now we want to understand what our customer Lifetime Value is. We typically annotate this as LTV/CLV
Life Time Value = Gross Margin * Referral Multiple * Average Revenue Per Customer Life time
Lets plug those values in:
1800 = .6 * 3 * 1000
What Does this mean?
This means, for each customer we market and bring in the door, their life time value represents 1800 dollars to us. This is an important number to understand as we grow our business from a new business to an established business. This equation is the foundation for calculating how much we should spend to acquire a customer. Next we need to understand the Marketing Multiple.
The Marketing Multiple is the rate at which we are willing to expend capital acquire a customer. Long established business will typically expend 1/7 of their net to increase the customer base where as new businesses will expend as much as 1/3rd to gain new customers. We represent these as a marketing multiple of 7 for the established businesses and a marketing multiple of 3 for the start up businesses. This marketing multiple dictates all of the pre-sale costs of selling a product and is a key indicator if a business is correctly leveraging marketing to grow their business.
Target Cost of Acquiring a Customer = LTV / Marketing Multiple
450 = 1800 / 4
What this tells us is that we should spend 450 dollars to acquire a customer that meets these conditions. We’re not quite there yet, we need to break down the cost of selling a product between our marketing activities and our sales activities.
Lets say that we allocate 30% of the target CAC to the sales team. That means we allocate 70% to marketing related activities.
Marketing Budget Per custom = Target CAC * Marketing Related Activities%
315 = 450 * .7
We now know we can spend 315 dollars in marketing activities to acquire a customer. We need to leave the 30% sales allocation alone because there is a sales process that must take place to get a prospect converted to a customer. We generally align this as the cost of sales bonuses, and personnel costs associated with the sales team. You can break this down further by looking specifically at the time and activities a sales person must go through with a prospective customer to close a deal. Deals can vary in size and complexity so we’re looking specifically for the average.
We’ve now boiled it down to 315 dollars that we can spend in marketing to acquire a new customer. Lets say we want to acquire 1000 customers we understand that our marketing budget should be 315,000 dollars.
When we look at traffic to our website we see that the traffic we buy converts at 20%. For the acquisition of the 1000 customers we would want to allocate 70% of our 315 dollars in marketing allocation to traffic. Since we understand that the traffic we buy converts at 20% we can distill out how much we are willing to pay for a customer.
Target Cost Per Conversion = Marketing Allocation * Traffic Budget * Conversion Rate
$44=315 * .7 * .2
To get the Traffic Budget to acquire those 1000 customers we simply multiply that Cost Per Conversion by the amount of customer we would like to acquire.
Total cost to Acquire 1000 customers we see that we must spend 44,000 dollars.
So How do I figure out what to charge for my product?
If you understand and estimate what it will cost to sell and advertise your product you can determine what price you must sell it at to turn a profit. By using the set of equations above you can determine how you should position and price a product for any audience. Not all audiences are created equal so before setting the final market price of a product take some time to test different options and pursue the optimal ratio of growth.