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Pricing - What are the Guidelines
Question: I am trying to understand how to price my product. All I know to do is look at the prices of the competition. Are there any guidelines?
Answer: The initial question, which I assume you have answered affirmatively, is whether the fixed costs of production make the marketing of the product feasible. Fixed costs are relevant when deciding whether to offer a product but are not relevant when deciding how much to charge for a given time period. Assuming there is a sufficient margin over fixed costs, the optimal selling price should depend on two factors – the variable cost per unit and how sensitive unit sales are to changes in price (elasticity). Instead of pricing based on marking up variable costs according to the price elasticity of demand, many managers mark up based on total cost and desired profits. This method will not result in maximum profit. Variable costs change with the level of output, increasing as more product is generated. Marginal cost and marginal revenue are defined as the change in cost or revenue as each additional unit is produced. For each unit sold, marginal profit equals marginal revenue minus marginal cost. If marginal revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less than marginal cost, marginal profit is negative. When marginal revenue equals marginal cost, marginal profit is zero. Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it reaches a maximum where marginal profit is zero (where marginal cost equals marginal revenue). If the market is perfectly competitive, the price is determined by supply and demand, and there is no pricing decision, only a production decision. In a purely competitive market, a firm maximizes profit with a quantity of production at the market price where marginal revenue equal marginal costs. Most markets are not purely competitive and the product can be marketed at a range of prices. The decision must be made about both the price and the quantity to produce and sell. Realistically, managers are unlikely to have complete information concerning the elasticity of the market demand, their marginal revenue function or their marginal costs. The profit maximization conditions can be expressed graphically or in a formula where Ep is elasticity of price (P) and MC is marginal cost: P = (Ep/(1 + Ep)) MC. However, the approach is not to begin with complicated formulas or graphs, but to understand the demand of the market and how elastic (competitive) or inelastic (non-competitive or branded) it may be. Most markets are somewhat competitive, so start with an assumption of a purely competitive market. Become more sophisticated by incorporating graphical analysis with historical information. Use an analysis which focuses on variable costs and profit maximization and utilizes more sophisticated information as you learn about your market.