How to Price an Invention for Retail

{Don Debelak’s new book, Turning Your Invention into Cash is now available on Amazon for $3.49. Go to Amazon.com and enter inventions Don Debelak to purchase. From the author of Entrepreneur Magazine’s Bringing Your Product to Market.}

Many inventors have a hard time pricing their product.  Why is this?  It is because pricing your product is a very difficult task—one that takes weighing multiple factors.  The two main aspects you need to weigh are cost and market factors.  We will deal with pricing in a three part series, with the first part dealing with market pricing, the second part dealing with cost pricing and then the third part dealing with how to balance the two.

Market Pricing

Market pricing is often favored by many companies, and although this can have disastrous consequences, which we will talk about in our third article, this is also a way to maximize your profits.

So what is market pricing?  Market pricing is a price based on market factors, for instance, what customers will pay or what is the minimum or maximum price based on the distribution channel’s image.  Most often, market pricing deals with what customers will pay for your product.

Different customers of course will have a different value for your product.  For instance, some people pay a large sum of money to buy a condominium or loft in a downtown district while other people prefer to have a large house in the suburbs.  This is because they value the housing differently.  Those who prefer downtown like the convenience, lifestyle and image of living downtown, while the people who prefer the suburbs might value privacy, having more space and not mind commuting.  These are different value judgments and the people who prefer to live downtown might look at the prices for houses in the suburbs and think that they are much too high for the location and the people who live in the suburbs will look at the prices downtown and say that they are much too high for the space.  It is important to understand how different customers will value your product if you want have the price that allows you to make the most money.

Before you can start determining your price, you need to find out who values your product the most, meaning, who will pay the most for your product.  You need to base your product price based on this group of people.  For instance, using the above examples, if you were building new condominiums downtown, you would want to find the price that the people who want to live downtown would pay, not the people who prefer living in the suburbs.

Once you have determined which group will pay the most money for your product, you will need to have focus groups with people from this customer population.  Never ask anyone how much they think your product is worth.  They will always list a price lower than they are actually willing to pay.  You need to take a variety of products that are similar to yours that have a range of prices.  Without listing the prices, have your focus group rank the products listed in order of value to them.  So they could rank the product they think has the most value first and so on down the line.  Then look at where your product falls in the list.  If your product falls below products that cost $50+ and above products that cost $40- then your price should be in the $45 range.  It probably won’t be so simple, but you need to use the prices as existing products as a guide.

Once you have a pretty good guess from the focus group about what your price should be, you need to have some limited test runs.  If your product lends itself to being sold at fairs or shows, you should try that.  Or you can try limited retail runs or anything that gives your product a test with real buyers.  Then you need to try different prices for your product.  The goal is to see how well your product sells at different prices.  At lower prices, of course, you will sell more products, but your goal isn’t to sell the most products, but rather to make the most money.

You will also find that after a certain price the number of people buying will sharply drop off, this is because your price is too high.

Let’s look at an example to see how this works.

You have a product that costs $5.00 to make.  You have arranged to sell at 3 trade shows for 2 days each.  Each day you will have a different price to see how each price sells.

Day 1 – Price: $20.00 – Products sold: 1,000 – Profit: $15,000

Day 2 – Price: $22.00 – Products sold: 975 – Profit: $16,575

Day 3 – Price: $24.00 – Products sold: 925 – Profit: $17,575

Day 4 – Price: $26.00 – Products sold: 850 – Profit: $17,850

Day 5 – Price: $28.00 – Products sold: 800 – Profit: $18,400

Day 6 – Price: $30.00 – Products sold: 400 – Profit: $10,000

So in the above example, we see that $28.00 is the best price for that product, even though you sell 200 fewer products than when the price was $20.00, you made $2,400 more. There may be factors that make your trials less clear, like attending different types of shows or fairs or having a busy or slow retail location.  You need to try to make your trials as equal as possible, but if this is not possible, you will need to adjust.  For instance if you go to a big show one weekend and then a small show next weekend, you will need to adjust your results based on the difference.  Again, this will help you determine what price best reflects the value of your product and what price will bring in the most money.  It is highly unlikely that your results will be so easy to interpret, but by using test runs, you will have a much better chance of choosing the right price based on the market.

Cost pricing

Cost Pricing refers to setting your price based on your product and distribution costs. These costs will be different for the same product in different distribution channels.

There are many costs that are involved in running a business.  You have administrative costs, marketing costs, space costs, taxes, insurance, product development, employee benefits, incidental expenses, travel expenses, and the list goes on.  So when you sell your product, your price needs to be enough to cover all of these expenses.

The standard cost pricing formula is simple: retail price is four times the manufacturing costs.  The manufacturing costs include labor, parts, distribution, packaging and overhead costs for manufacturing and administration.  Doubling your manufacturing costs would typically give you your wholesale price if you were selling to distributors or retailers.  This may seem high, but many companies make a total profit of only a few percentage points, so it is not too high at all.

So where does the rest of the money go?  It goes into those expenses mentioned above: product development, insurance, etc.  This is why financial personnel in many companies are so important – if your company only makes a profit by a few percentage points, an adjustment in costs, either higher or lower, can mean your company will not make a profit or will be increasing their profits considerably.

So is pricing your product just as simple as four times your manufacturing costs?  Maybe, but you should consider all of your costs before you set your price.

Is there something about your business that creates higher costs?  For instance, in technological companies, the cost of developing new products is very high.  If you are planning on developing new products, which you should do, you will need to charge more for your current product to cover the costs of developing new products.  Or if you have a product that needs a lot of insurance, again you will need to charge more for your product to ensure you can make money.

Another factor in pricing your product is your distribution.  If you sell directly to retailers, your wholesale cost will be half of the retail cost, so your retail price will be four times manufacturing costs.  If you have more complicated sales, like through sales agents or representatives, who then sell to distributors, there are more people who get paid, so your retail price will need to be higher.  Different industries have different standards of distribution.  Some always sell through distributors, others not.  You will need to look into how many people your product will need to go through before the product finally reaches the consumer.  Each group has a certain mark up, usually expressed as a percentage of the price.  Once you have your manufacturing price, double it for yourself (or more as discussed above) and then count the costs of the distribution mark ups and then the retailer will sell the product for twice what they pay for it, so add another 100%, and this will be your retail price.

If you sell directly to consumers, your retail or final price can be much lower, but again, you can’t set your price too low, because there are many costs involved in selling directly to customers.  For instance, if you manufacture your product yourself, possibly in your garage, and sell the product on the internet, you might think that everything you charge over the cost of parts in money in your pocket.  This will not be true.  You will have product insurance costs, website costs, marketing costs (which will probably be higher than you expect), office supplies, telephone bills, etc.  But because of the lack of distributors and retail discounts, you can probably make a profit if you sell your product for twice the manufacturing price, which would include paying yourself for labor and overhead costs. This is why products sold directly to consumers can be cheaper than in retail stores.

Balancing market pricing and cost pricing

So now you know what the market determines for your price and you know what your costs tell you about how much you need to charge to make a profit — now what?  Well, this will be easy if your market price is higher than your cost price, because then you can just go with your market price and you should make plenty of money.  This is because the market can bear a price higher than you need to make a profit.

The trouble comes when your market price is lower than your cost price.  This means the market can only bear a price that ensures you won’t make a profit.  Does this mean that your product can’t succeed?  No, because you can always change your product.

Your market price will be lower than your cost price when customers don’t value your product enough for what it costs to make.  So you have two options, make your product have more value for little extra cost, or have your product keep value with less cost.

For both options, you will need to go back to your focus groups.  If your product wasn’t ranked as the top value, what was lacking that was present in other products?  Can you add similar features for low cost?  Often, adding an abstract appeal is the best way to add value with little extra cost.  Can you make your product look fancier or more in-style?  If so, that adds value.  Another good way of adding value with little extra cost is to provide a more complete solution.  If your product needs to be used in conjunction with another product, can you combine the two products to create a high value?

Also look at what product features are not important to customers.  If you have a feature that customers aren’t interested in, eliminate it, that will save you money in manufacturing, hopefully bringing your market and cost prices in line.  Also, to lower your costs, you can look at sourcing your manufacturing overseas.  You will want to still have a way of monitoring quality, but this can be a good option for lowering prices.  Before you resort to that, you should find an engineer with experience in manufacturing to look at how you make your product.  He or she might be able to suggest some new methods or materials for manufacturing that could dramatically lower your costs.

Another option is changing distribution.  If you switch to a distribution system with fewer steps in between you and your end users, you may be able to make the market demands and cost demands line up.

One hidden cost in distribution is packaging.  For instance, if you sell to retail stores, you will need high quality, professionally designed packaging.  This is a big expense, but one that the distribution channel requires.  But if you sell through catalogs, or directly to customers either through the internet or direct marketing, you will only need a package that can get the product safely to the customer.  This can be a huge savings.

If you end up making changes to your product, either by adding value or cutting costs, go back to your focus group and see how they rate your product.  You will want the rating to stay the same if you cut costs and you will want the value to go up if you tried to add value. Hopefully your value added will be a bigger proportion than your costs to add that value, but if not you will need to employ some other tactics mentioned in this article to bring your market price and cost price in line.

Getting your product priced right is a big concern, because like I mentioned in Part 1, having the wrong price can have disastrous effects.  Usually this happens when someone prices their product too low.  This can only lead to bankruptcy.  I think the problems many airlines are going through reflect this very well.  Many airlines are trying to set prices at what the market can bear, unfortunately often it costs them more to run the flight than they make from it.  This is the danger of market pricing.  But some airlines are staying in business and even doing well, how are they doing it?  By using the tactics we talked about in this article.  They know that the market demands one price, so they bring their costs into line with this.  For instance, if a certain flight (or for products, a distribution channel) cannot be profitable, they drop that flight.  Also some airlines have secured fuel contracts that keep their fuel prices under control, thereby making the cost of flying cheaper (like with inventors, finding cheaper ways of manufacturing or by sourcing their manufacturing overseas).  Also these airlines evaluate what customers value, and what the customers don’t value they eliminate, along with the costs associated with it.  It takes a lot of creative thinking to lower your costs and still keep value, but if you can do this well you will have a much better chance of making a profit.

It is worth while to evaluate your costs no matter what, since it will help you earn a larger profit, but sometimes you will need to really spend a lot of time so that your product is profitable.  Some people think that they can get by with a lower percentage of profit, or margin, if they sell more products, but this never happens.  The more products you sell, the more costs you have to sell those products, so unless you are charging at least twice the manufacturing costs, you will not make a profit.  One of the main reasons Wal-Mart has succeeded is that they know this fact and put it into practice.  They do not have low margins on their products; they cut costs so they can have lower prices and still have high margins.

Remember, let the market dictate what your product’s price should be, then make sure that your costs are in line with that.  Be creative, think outside the box, but get those costs low enough to make a profit.

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