How do you decide what price to sell your products at on the net? Well
there are no fixed and fast rules, the only rule that really applies is
that if you give it no real thought then you are depending on luck to get
your price is right. Not the most scientific way to run a business.
There is one (usually correct) guideline, which is that if your price is
lower than the oppositions', then all other things being equal, you should
sell more.
Of course, there are many things that will not normally be equal,
reputation, quality, age of company, even the marketing budget. All of
these can change the level of sales that you can expect at a given price,
but for the sake of clarity - for now let's concentrate on the basics of
pricing.
Fixed and variable costs
The first and probably most important factor to most people is the cost
of the product - but what is the true cost? The obvious answer is the
cost of the product to you especially if you buy in a product for resale
rather than manufacturing it yourself. But is that the cost? You also
need to include distribution costs - how much it costs you to get the
product to the customer. But then what about warehousing costs? What
about the wages you pay to your admin staff?
When you look into this in detail you find that you have two types of
cost - fixed costs and variable costs. Fixed costs remains the same whether
you sell one item or one hundred items. Variable costs increase as a
direct result of each item you sell. (Of course, even fixed costs will
increase if you enjoy a huge increase in sales - but the increases tend
to occur in stepped increments - not per item.)
What are the implications of this? Well the first implication is that
if you are to have any chance of making a profit at all then you must
sell at a price that exceeds your variable cost for an item. This is
normally the cost to you of the product, plus delivery cost, and often
should also include a credit card processing cost. If you don't at
least cover these costs then the more you sell the bigger your loss!
Ok, so you are selling at a price that is higher than your variable
cost. Next question, HOW MUCH HIGHER? This is the critical question to
answer, and the answer you come to will depend very much on the volume
you can sell, but will be adjusted by your market strategy.
Let's look at an example:
You are selling widgets. Your variable (also known as direct) cost per
widget is $10. Your weekly admin and warehousing expenses total to
$2000 (your fixed costs). You are currently selling 500 widgets per week
at a sale price of $15. Your Sales are therefore $7500. Your direct
costs total to $5000, leaving you $2500. After you deduct your fixed
costs you have a $500 profit.
Your competitor is selling widgets at $15 as well. You decide to try and
win some of his market to increase your sales and therefore profit. You
decide to drop your price to $14. How many widgets extra do you need to
sell to increase your profit? Well your basic sales are now 500 x $14 so
are now worth $7000. Your costs remain the same, so on sales of 500
widgets you are now breaking even. However, your fixed costs are already
covered within that $7000, so each additional widget you sell will add
$4 (14 minus 10) to your profit. To exceed $500 profit, you need to sell
500/4+1 widgets = 126. So if your price drop to $14 brings in more than
125 new sales you will make more money!
This example illustrates the most basic consideration when looking at
fixed and variable costs - you must consider the equation -
(volume x price) - (volume x variable cost) - (fixed costs) = profit
With the critical relationship between price and volume in effect
forcing your hand. This relationship is known as the 'Price elasticity
of demand'! In other words how much does the demand for something
change with price?
The most common model on the Internet takes advantage of the lower
fixed costs involved in running an online company (automation of many
tasks, lower selling costs) to reduce price (in comparison with
conventional companies) and hence increase volume. Many well funded
companies reduce price even below this level (and sometimes below
variable cost level) in order to rapidly grow volume, but marketing
considerations of this sort can be left for another article!
Dave Broadway
June 2000
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