Understanding Your Business: Setting the Right Price

One of the more challenging things for small business owners to do is to set prices correctly. Figuring out what to charge for goods and services requires figuring out how to charge enough to cover expenses and make a profit while not charging so much that potential customers will refuse to pay. There are several theories about pricing. One theory that works with commodity type products says to charge a very low price and try to sell a lot. Another theory that works with specialty items or very high quality items is to charge a premium. Your approach will probably be somewhere in between those two approaches. Before you can do anything, however, you must know what it costs you to produce your product.

If you break your costs into parts, you will find that you have both fixed and variable costs. Fixed costs are the costs that you have before you begin selling anything. Variable costs are the costs of each product that you sell. If your business is a coffee shop, your fixed costs are rent, utilities, payroll, and the like. You will have those costs even if you sell no coffee or food. Your variable costs are what it costs you for coffee, food, and whatever else you sell. Fixed and variable costs behave differently as your sales increase. Variable costs per unit sold usually stay the same. If costs you a dollar to make a cup of coffee, put it in a cup, and then wash the cup when the customer is finished, then if you sell 100 cups of coffee your cost is $100. If you sell 500 cups, your cost will be $500. Fixed costs, on the other hand, get less expensive per unit as you sell more. If your monthly rent and utilities total $2,000 and you sell 1000 cups, your fixed cost per cup will be $2.00. Your cost per cup will drop to $1.00 if you double your sales. In this simplified example, if you 1000 cups of coffee in a month, you will have to charge $3.00 per cup to cover your variable cost of $1.00 plus your fixed cost per cup. If you sell 2000 cups, your price can drop to $2.00. Even though the variable cost remains the same, your fixed cost per cup is only $1.00.

The lesson is that your price must be high enough to cover your variable costs plus some portion of your fixed costs plus a reasonable profit.



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