Your pricing strategy will depend on numerous factors. Your prices will need to reflect the target market you select, the nature and extent of competition, the strength of your location, your cost structure, the types of goods and services you offer, and your target market’s price sensitivity. There may be as many approaches to pricing as there are factors that affect a business’s pricing strategy. Take for example, the Standard Markup Approach to pricing.
Quite a few businesses use the standard markup or cost-based approach for setting their prices. The this approach, a retailer will base its price for an item on what it paid for that item plus a percentage of that cost. The percentage of cost that is added to the cost is what is referred to as the “markup.”
The standard markup formula is: Retail price = cost + markup
The markup percentage may be suggested by your suppliers, or it could be based on other cost-related factors. Many retailers use a customary markup of 100 percent of cost. The 100 percent markup is easy to figure. If the owner of a shop buys an item for $6, then the item will be priced at $12 to customers.
Service businesses frequently use the standard markup approach. One CPA firm’s hourly rate is three times what it pays the accountants who will be doing the work. The logic behind this pricing strategy is that the price for the firm’s services has to cover three important components. The first component is what the CPA firm has to pay the accountants for the work they actually do. The second component is the fringe benefits, social security payments, training time, and the time the accountants are in their offices between clients. The second component also includes training, office rent, insurance, clerical assistance, and the depreciation of equipment. This component represents the “overhead” of the business. The third component is the salaries of the senior managers who coordinate the firm’s operations, along with a reasonable profit.
The standard markup approach is fairly common in certain types of businesses. If you are starting such a business and you want to have an idea of what the average markup is, you can check trade data or “Annual Statement Studies” published by RMA to get the average markup figure. Trade data frequently report the gross margin as a percentage of sales. The gross margin is the result of subtracting the cost of goods sold from sales. If trade data indicate that the gross margin is 40 percent of sales, then you know that the cost of goods sold must be 60 percent of sales. If an item sells for $10, then the business had to pay $6 for it. The gross margin represents the markup of $4 on a cost of $6 per unit. If the gross margin is 40 percent of sales, then the markup on cost is 66 percent of cost.
The standard markup method has two major shortcomings: It fails to take into consideration either the unique nature of the market or competition, or both. The standard markup approach is based on costs rather than market conditions. It also assumes that your competition uses the same approach and that your customers are willing to buy your products or services at those prices.
If you use the standard markup approach, makes sure you use the proper base. Some industries state markup as a percentage of cost; others state it as a percentage of selling price. There is a big difference between a 60 percent markup on cost and a 60 percent markup on selling price.
Stephen Harper, Ph.D. “The McGraw-Hill Guide to Starting Your Own Business: A Step-by-Step Blueprint for the First-Time Entrepreneur.” Publisher Info: 2nd Edition, 2003, McGraw-Hill.
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