Pricing your product or service is one of the most important business decisions you make. There are many approaches, some scientific, some not. This article provides a framework for making pricing decisions that take into account both your cost and the customer’s perception of value.

Think of cost as the floor -- you must set prices above the floor to cover costs or you will quickly go out of business. If you decide to set prices below cost it should be for a specific purpose, such as to gain market entrance.

Think of customer perceived-value as the ceiling -- this is the maximum that the customer will pay for the perceived value of the product or service. This is sometimes described as “what the market will bear.”

Somewhere between the floor and the ceiling is probably the right price for your product or service – a price that will enable you to make a fair profit and feel fair to your customers.

To get a handle on the minimum price for your product or service, we use what is called a 'break even analysis'. This analysis shows how much revenue is needed to cover costs, and lets us look at different projections for prices and volumes. For a service business, we add up all the fixed costs (recurring expenses that have to be paid every month such as rent, insurance, and utilities), and then we add up the variable costs (the costs that vary directly with the amount of service provided such as the hourly pay for a contractor on a specific project). For a product business, the approach is very similar. It's important to understand the overhead (fixed costs) as well as the cost per unit, including direct labor and materials (variable costs).

As an example, let’s consider a business that provides training consultations in its facility and is trying to determine an appropriate hourly rate for consultations. First, we would add up all the fixed costs (e.g., rent, insurance, utilities). Once we determine that the business has fixed costs of $30K/year, and has a variable cost (instructor pay) of $15/hour, we can graph costs for different amounts of billable hours/year. We can also graph revenue projections at three different hourly rates ($30/hour, $35/hour and $50/hour).

To be profitable, we must generate revenues in excess of costs. From this graph, we can see that at an hourly rate of $30/hour, the business will need to generate $60K to cover expenses and break even (see note 1). At $30/hour, the number of sessions required to just cover costs is 2000 (see note 2). Assuming a 50-week work year, this means that 40 hourly sessions would have to be conducted per week in order to just cover costs. This does not look like a realistic pricing model unless it is realistic to schedule substantially more than 40 hourly sessions per week!

If we calculate break-even at an hourly rate of $35/hour, we find the number of sessions per week required to cover costs is 30. At $50/hour, the number of sessions required per week to cover costs is 17, a more realistically achievable number (see notes 3 and 4).

So the floor for setting prices for this business is in the range $35/hour just to cover the costs. From the cost perspective, the price will probably need to be set at a higher level, such as $50/hour or more to make a profit.

The next step is to assess the customer's perception of value for the services, and determine whether prices can be set at a higher level. To understand the customer’s perception of the value in your product or service, we look at more subjective criteria such as customer preferences, convenience, quality, image, benefit or cost saving to the customer.

How do your customers describe what they get for their money? Do they save a great deal of money or time? Do they gain a competitive advantage from using your product or service? Is it very convenient to use your service rather than try to do it themselves? What are the customer’s choices? What does the competition charge?

With this information, we can begin to understand the maximum price the customer will pay for the benefit received. In this case, it may be worth it to the customer to pay $75/hour for the convenience of dealing with a local business. If the customer is only willing to pay $30/hour, however, you have to recognize that it will be difficult to make any money on this business unless you have a high volume of billable hours.

Once you understand your cost floor and your value price ceiling, you can make an informed decision about how to price your product or service. Pricing will always be influenced by the competition. Competition will drive prices lower, and you need to figure out how you will sustain your business in the face of competitive pressures. What will be your sustainable competitive advantage?

Note 1. Break-even $ are calculated as equal to fixed costs/1-variable cost/unit price. In this case, break even is $60K at $30/hour ($30K/1-$15/$30).

Note 2. Break-even units can be calculated as follows: (fixed costs divided by unit price minus variable cost/unit) or 2000. Therefore, $30K/($30-$15) = 2000.

Note 3. We find that the break even cost level is $52.6K ($30K/1-$15/$35) and the number of sessions per week required to cover costs is 30 ($30K/$35-$15 = 1500 divided by 50 weeks = 30/week).

Note 4. Break even at $50/hour is $42.9K ($30K/1-15/50) and the number of sessions required per week to cover costs is 17 ($30K/$50-$15 = 857 divided by 50 weeks = 17/week).