Understanding the true cost of a product

By Rene Botha, Area Manager, Business Partners Limited.

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Determining the right price point is a delicate balancing act that requires entrepreneurs to take both their short-term and long-term goals into account. Ultimately, what underlies all successful pricing strategies is a broad understanding of the true cost of a product or service.

Pricing is one of the most fundamental determinants of profitability for a small business. And when what should be a complex formula is oversimplified, pricing can become an Achilles’ heel, especially for small and medium-sized enterprises (SMEs) in their fledgling years.

Surface-level costs and hidden costs

There are several factors to be considered when determining how much a product or service should cost. At the most basic level, the universal formula that can be used to determine the cost of manufacturing is raw materials plus labour costs plus overheads. While this formula may appear to be quite straightforward, there exists, within each of them, a number of hidden costs that can be easily overlooked.

When calculating the cost of labour, for example, you must consider the total cost to company of salaries and wages, which includes pension, medical aid and other contributions. Other potential hidden costs include the cost of providing safe and sterile sanitation, office supplies, stationery, and equipment. And while overheads like rent, electricity and water may be accounted for, there are also less, “obvious” costs like the depreciation of equipment, insurance, software subscription fees, banking fees, connectivity and telephone costs, as well as printing expenses. If you as an entrepreneur use entertainment as a marketing or lead generation tool, this cost also needs to be factored in.

What about the cost of not selling a product or service?

One of the most notorious hidden costs that SME owners neglect to consider is the cost of not selling a product or service. Frozen goods providers, for example, will need to account for the cost of keeping those goods frozen, should they not be sold within a specific time frame. Aspects like rental and utilities are of particular relevance here too.

Another example can be found in the tourism industry, where getting ‘bums on beds,’ is the ultimate business objective. Establishments that do not manage to optimise their capacity still have to pay staff wages, maintenance costs, rental, bond costs and other expenses. Entrepreneurs in this position need to establish what these expenses are and adapt their pricing accordingly.

Pricing strategies like discounts, specials and bundles may become particularly useful in mitigating some of these hidden costs. Here, small businesses have their size as an advantage. Typically, they are more agile than larger corporations and can adapt more easily to changing economic circumstances.

Looking beyond the financial cost to determine future value

Apart from the costs that can be accounted for in rands and cents, there are also non-monetary factors that need to be considered. Here, two crucial components come into play: time and effort. The first few years of starting and running a small business are associated with a high level of unpaid labour, in the form of late-night planning, high levels of stress and physical labour.

As an entrepreneur, you may want to consider adding a percentage onto the cost of your product or service to account for this. That percentage could make it possible for you to reward your employees for going the extra mile, through bonuses, morale-boosting team building events, prizes and other incentives. Thinking in terms of the non-monetary component that comes with manufacturing a product or offering a service is a good departure point for planning for the long term.

Getting to know your customers

Determining the correct pricing also involves considering that there is a degree of psychology involved in how people choose which brands to support and how to spend their money. The target market is therefore a key determinant of price. If an entrepreneur is hoping to gain traction in the mass market, they might need to consider that their audience is price-sensitive, many of whom may be bargain hunters.

On the other end of the spectrum, suppliers of luxury goods may need to consider that their target audience is particularly brand-sensitive and image-conscious. To price a product or service too low could damage the perception that the target market has about the product’s value or ability to represent a specific kind of lifestyle.

This is where market research can play a “make or break” role in a small business. Beyond conducting costly market surveys, there are a few things that SMEs can do to get to know their market. Tools like Google Analytics and Facebook Insights can prove invaluable insights into understanding niche markets. Building a test group that is representative of the market in terms of demographics and asking that group for product or service reviews, is another way of conducting marketing research cost-effectively.

When in doubt and on a budget, you could turn to competitor business models. Look at how their business model developed over time, identify any pain points and how they addressed them, examine their customer service and review onboarding strategies. Sometimes the best way to learn as an entrepreneur is from the mistakes and learnings of others.

Social media polls and surveys are also a great way of capturing information, as well as one-question surveys that can be sent via email. As a fledgling small business that does not have the funds to spend on acquiring the advice and assistance of expensive market research companies, the biggest investment to be made is time. No time spent on understanding your target market: their buying behaviour, their lifestyles and their daily routines, is ever time wasted.

The competition factor

Looking to competitors as determinants of what your pricing should be can also be an effective strategy.

It is however, not without its pitfalls. Entering the market with a price that undercuts competitors can lead to the perception that your product or service is inferior. Price your product too high and your target audience may be reluctant to choose you instead of competitors when they know very little about your brand or your value proposition.

While competitors’ pricing models can be used as a factor to inform your pricing, it should never be the only factor. Pricing must be considered holistically, because as a cornerstone of your business model, it can determine whether your business will endure for the long haul.

One of the most common pitfalls for emerging small businesses occurs when entrepreneurs set their ambitions on taking on large businesses or corporates in a way that leverages on the pricing of a product or service. Entering into a price war with a larger company is never a good way to launch an SME, because larger companies will be able to cut their prices on certain products and absorb the loss in a way that doesn’t have a big impact on their bottom-line.

As an SME, when the sale of every product or service counts, being undercut by a larger company could mean the end of business. Choose your market carefully and strategically. Know who the big players in the space are and go into business cognisant of the existing and emerging competition.

How to address price increases

For small businesses, size is both an advantage and a disadvantage, but there are ways to optimise this strength by pricing products strategically. You could, for example, come in at a lower price than originally expected and then increase your prices gradually. This is where customer service becomes indispensable. In a business environment in which good service is rare, you could differentiate yourself by providing a superior level of service.

You could also introduce bundled pricing, where deals on multiple bundled products serve as an indicator that customers are getting more value. Loyalty programmes and membership schemes are also effective ways of adding value, which could serve as a buffer against the effects of increasing your prices. Your price increases should be communicated to your target market openly and with a degree of transparency that will instil trust in your brand. Often, a well-written rationale that lets your customers know what you are doing to ensure that your pricing remains justifiable, will help you to avoid any potential backlash.

As a small business, once the pricing of your product or service has been determined, it will become part of your role to defend that price by leveraging your unique selling proposition. Offering value in a world with a “quantity over quality” mindset and taking a human-centric approach to business, could provide you with the competitive edge you need to go from starting a business to building a brand.

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