What are the main methods used to decide the price of a product?

For a profit-oriented company, the correct price to sell products at is the price that maximizes its net profit. That is, the price that multiplied by the quantity sold gives the greater number. Typically the quantity sold decreases as the price increases and vice versa (it is called “elastic demand”). Sometimes it decreases to a lesser extent than the price increase, sometimes to a greater proportion and in some sectors, but it is much rarer, it even increases with the price increase. It is quite simple in theory but in reality it is almost impossible to guess the perfect number. So how to define the price of a product?

What methods do companies use to determine the price at which to sell their products?

MARK-UP METHOD

Most companies operating in the clothing, footwear and accessories sector, both formal and sports, still use the “mark-up” method to decide the prices of their products, which consists in determining the price starting from the cost of the product and applying a standard mark-up.

For example, if the cost of product A is $20 and the firm aims to achieve an average margin of 50%, the selling price of A will be $40. If it decides not to discount, it will achieve the desired percentage margin. But this is the only advantage (besides its simplicity) of this method which is now considered outdated in many other sectors and which does not allow to maximize corporate profit. By doing a simple mathematical calculation, for example by multiplying the cost x 2 (mark-up), it is practically impossible to find the exact point that maximizes the company’s profit because the final consumer is not being considered at all and therefore how much the price will affect the quantity that will be sold.

Also, this method is especially dangerous in those industries where:

• variable costs are difficult to calculate (and, for example, production generates many inventories of raw materials that are difficult to reuse);
• fixed costs are high and are not included in the cost of the product (which typically only includes the variable costs of raw materials and direct labour) and therefore even the target margin established at the table may not be sufficient to make the company profitable.

PERCEIVED VALUE METHOD

This method, which, unlike the previous one, considers the value assigned by its target consumer in order to assign the price to the product, is called the “perceived value” method. The cost becomes relevant information only as it constitutes the minimum limit under which it is not convenient to sell the product, but it does not determine the final price in any other way.

Products with different costs can thus be sold at equal prices and, for the same reason, products with equal costs can be sold at different prices. The only thing that matters is how much the consumer is willing to pay for a given product (also called the “utility function”), regardless of how much the firm cost to produce it.

In the example above, being able to sell the product for $49 instead of $40, in terms of company profits can mean the difference between a profitable business and a losing one.

If, on the contrary, in a highly competitive sector, lowering the price below the main competitors could lead to a sharp increase in the quantities sold. In this case the company could find it convenient to sell at a price which allows a margin of less than 50%, but thanks to which it is able to sell much more quantities and therefore can increase the overall profit of its company.

There is therefore no formula for calculating the right price at which to sell your products.

Assigning prices to each single product on the basis of the perceived value, through an in-depth study of the market and of the final consumer, his purchasing behavior and his psychological thresholds, is certainly one of the most effective systems for maximizing your company’s profit.