ON BUSINESS || How to set prices to optimize margins and test consumer demand and feasibility
You’re starting a new business. How do you set prices and margins to ensure you can generate enough consumer demand?
If you’re looking for a formula, you could do this from a bottom-up or top-down method. The bottom-up method is where you take the cost and add on the margin you want after you factor in the cost to make the product or service. The top-down method is where you would start with the price you want to sell the product or service for and work backwards to ensure all of your input costs are covered. In other words, all the cost required to produce the product fits within the price you want to sell the item for.
The bottom-up pricing method is more aligned with the business interest because you ensure your costs are covered and then add on the desired profit margin to set the retail price. Whatever price you arrive at using this formula, you will also need to test for market and consumer demand at this price to see whether the product you are building is feasible.
The top-down pricing method considers consumer demand and prices your product based on what people are willing to pay. This is because you are setting the price that you want to sell the product at first. Then you set the profit margin you want to earn from each of the units, and from that, you figure out your costing and logistics to ensure you can profitably produce the product.
In my opinion, the top-down method gives you a better chance of success in finding a product-market fit in terms of pricing. The rationale is that if you are starting with the retail price, you would first look for other substitutes being sold on the market to see what consumers are willing to pay for your company’s offering (or at least something similar). If there are no other similar offerings on the market, you can still create your prototype, take it to the target audience, and ask them how much they are willing to pay.
How will you test for product demand, pricing, and feasibility?
Startups would build a minimum viable product, put that out in the market and see what the consumer reaction is. Doing a small batch launch of your product or a soft launch of your service is a great way to unveil the full scale of the costs associated with producing your offerings. We often underestimate how much it takes to get our product from the company into the hands or homes of the customer. A minimum viable product allows you to test us on a small and time-boxed scale so you can see how much the market is willing to pay and how much it’s going to cost you to deliver that product.
Another benefit of taking your product or service to the market before you do a large-scale launch is sometimes the market reacts in a totally unexpected way—storytime. When I launched my first business, it was supposed to be tailor-made for students travelling around the world to help them save on currency exchange. What ended up happening was we saw a much greater demand coming from small businesses with regular currency exchange needs that wanted to use our service. We made tweaks to our website to cater to the recurring exchange rate needs of small businesses. What was great about this is that the businesses helped guarantee a stable revenue stream because we knew that they would have to use us each month, whereas students travelling the world may not need to exchange currency as frequently. What helps you survive? It’s repeat customers.
Knowing how much it’s going to cost for you to produce an item and how much the customer will pay for it will also tell you whether the margin you’ve set is feasible. This answers your feasibility question, which is of utmost importance because if you’re not making money, why are you in business?
In summary, bottom-up pricing is where you would take your cost, add on a margin and charge whatever that price is. Top-down pricing is where you go to the market first, see what they’re willing to pay and then make your numbers work to deliver that product at that price. Whichever method you choose, the ultimate goal is to ensure your costs are covered, you’re making a decent profit, and the market has sufficient demand to sustain your company for the long term.
