Pricing

by Mr. Cheap

A big challenge for anyone running their own business is determining the right price to charge.

There are all sorts of ideas that claim to give you the right price (such as the idealized “supply and demand” curve from economics), and all sorts of wacky exceptions (such as loss leaders at the grocery store).

Many technical people fall into a trap when they get into business.  An elderly professor I know who had tried to run his own business found this was the core of what limited his success.  Even after he warned me about it, I went and did the same thing when I started my business.

Techies seem to gravitate to the idea that the right way to price products or services is to add up the cost, add a reasonable profit margin on this, then sell it for that price.  If, after labour, materials and everything, widgets cost you $30 to make, selling them for $42 (a 40% markup) is clearly the answer.

The joke is, a widget might not be worth $42 to the buyer.  It may be worth $20 (in which case you’re a fool to make them), or $400 (in which case you’re a fool to sell them for $42).  The right price to charge for something is the highest price customers are willing to pay.

Commodities are the exception to this, as they get driven down to the price to bring them to market plus a small markup.  There’s no real difference between brands of salt, so manufacturers will keep undercutting each other until the price gets to the “techie ideal” of cost + markup.

Kenny Kramer (the real life basis for Cosmo Kramer) sold electronic jewelry during the disco years.  He was able to get them manufactured dirt cheap, then sell them for a super-high markup.  This allowed him to not work for a years, long after disco was dead (will disco ever REALLY be dead though?).

Guiness416 recently pointed us towards a great article about gourmet chocolate.  The punch line is they buy chocolate that’s available to anyone and sell it in smaller chunks for a 1,300% markup. I was horrified reading it, and it just seemed so scummy to me.  It’s probably good business.  People with too much money want to find something they feel is extra-special, and are delighted to pay an outrageous price for it (given that the company is still in business years after the article was published).  They aren’t selling chocolate.  They’re selling gifts that say to the recipient “this cost a lot of money”.

Everyone has heard that the fountain drinks you buy at the movie theater for $4 costs them $0.10 to provide.  Is a 4000% markup reasonable?  Is it reasonable if it subsidizes other parts of the theater experience?

Long time readers know Mike and I would never say a bad word about real estate agents.  However, a case recently came up in Australia where a real estate agent bought a house worth $300k, from a man in a retirement home, for $150k (good thing they have a duty to their clients, eh?).  In this case I think its clearly wrong because the seller had a diminished capacity and the agent took advantage of that.  The same thing happened to my grandfather:  a real estate agent bought a parcel of land off of him for $5k, then resold it 6 months later for $10k.  This was 40 or 50 years ago, so it was a significant amount of money at the time.  Heck, it even landed the agent in the Cheap clan’s “Big Book of Grudges”.

I find it hard to shake the feeling that this isn’t right (I sure wouldn’t be comfortable taking advantage of someone like that), but all evidence seems to tell me that I’ve got the wrong outlook on this issue.  Or at least I don’t have the right outlook if I want to be successful in business.

Is it wrong to charge far, far more for something than it cost you?  What are the limits to “looking out for your own interests” and at what point does it become unethical gouging?

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{ 9 comments… read them below or add one }

1 Four Pillars

I think it is ok to charge whatever you want for a product as long as it is not an emergency situation. The chocolate example is pretty good business as far as I can tell – there is absolutely no reason for people to have to pay their prices but apparently they do.

2 Ron@TheWisdomJournal

I’ve told my store managers for years that “The market bears a certain price, not a certain margin.” We use gross margin rather than markup because we can control the price we charge but not necessarily the cost we pay.

I once owned a Hawaiian Shaved Ice business and could make those little cups of ice, sugar, and flavorings for less than 19 cents. I sold them for $2.00 – $4.50 depending on the size and people were happy to pay!

The key question is not “what did it cost YOU” but “what is the customer willing to pay?”

3 Mr. Cheap

Mike: That seems to be a good rule of thumb, but the downside is that it will deter people from going into business providing emergency products / services if they can’t earn as much money selling them.

Ron: It sounds like you’ve got the right outlook on it!

How do you guys feel about the Australian real estate agent? Do you think he should have been able to buy the house at a bargain? The guy in the nursing homes daughter WAS involved (so he didn’t do the transaction on his own), does that make any difference?

4 Four Pillars

Well, the Aussie RE agent definitely committed fraud by getting another agent to quote a low estimated value for the house.

The fact that he is a RE agent isn’t all that relevant – this situation could probably happen with anyone.

I don’t know where you draw the line between fraud and mis-use of trust. For example if my neighbour knows that I know a lot about used riding lawn mowers and asks me to value his – and then if I give him a below market quote and offer to buy it from him, is this fraud? Am I taking advantage of the neighbour’s trust? Is the neighbour an idiot?? 🙂

I’d say one REALLY great rule of thumb to handle this sort of situation is don’t trust the valuation from anyone who wants to do more than the valuation (ie they want to buy the thing). In other words – get independant valuation.

5 Mr. Cheap

Mike: Definitely good advice, but what’s the obligation if you’re doing business with someone who doesn’t follow it? The people buying chocolate could have gone through the process in the article to determine its value, but they didn’t (they probably wouldn’t have time for so much research before purchase).

I honestly don’t know when it crosses the border between taking advantage of an uninformed buyer/seller and when it’s good business.

6 Four Pillars

I don’t think the chocolate example is really an issue – there is no duty or trust or anything in that case. The chocolate makers built a great marketing campaign and some people bought into it. It’s the same thing as $200 sunglasses or $500 ladies’ handbags, $5,000 diamond rings, $1000 baby buggies etc. People are buying a name/status symbol and in a lot cases they know that.

As for your last question – yes, I also don’t know where you draw the line. What would you have done if the guy you bought your condo from had dropped the price by 20% because he thought you could use a break? Would you say yes or would you rather pay what you consider to be a fair price?

7 Mrs. Micah

I have this trouble in selling my design/consulting services. Some of my tech friends think I’m crazy to charge so little, but I’m not sure what my market will bear. Their hours are billed (by the company) at something like $100/hour, but then their clients are businesses, not bloggers…

8 Mr. Cheap

Mrs. Micah: Yeah, I suspect selling to businesses would be a better way to get closer to $100 / hour than selling to bloggers. I think with most design/consulting services, selling by the JOB is typically better than selling by the hour (people can’t estimate how long it’ll take you and they’ll be afraid the job might run up more time than they want).

9 Four Pillars

Mrs. Micah – given that your business is relatively new and it’s not a full-time job for you – I think you are taking the right approach with just offering reasonable rates – you can always raise them if you think the demand is there.

As Cheap mentioned – if your target customer is other bloggers then it’s tough to charge high rates! 🙂

Mike

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