Pricing is a huge topic with a lot of variables to consider. A lot of businesses go about it the wrong way, this is particularly true in small businesses with an owner who is also a maker or designer. I have first hand experience from my own misunderstanding of profit margins in the past. It was probably the single biggest mistake I made in my first business and it's unfortunately all too common. I spent far, far too much money on development of my leather handbags and belts. Handbags in particular are a very expensive item to have manufactured in the US. There was a charge for the new pattern and initial sample, then there was charge to make samples in different colors (roughly double what it would cost in a production run, because I wasn't meeting minimums) Then there was the costs of all the materials (which I overbought, in order to get a better price). Each time I launched a new style I was spending hundreds to over a thousand dollars and often I launched a collection of 5-8 styles a few times a year.
When development costs are relatively high, you need take that money into account and figure it into your costs. There are different ways to tackle this, one would be to figure out how many units (bags for instance) you would need to sell to get to the "break even" point, after that amount you begin to make profit on each one. Unfortunately, even though I understood the concept in theory, I didn't do a good job of putting it into practice.
Based on my sales, I really needed to reign in my spending on development, but I just wasn't being realistic. I also made a huge mistake in assuming that simply doubling my costs on each bag was the correct margin for my business. The truth was, doubling my cost was a completely arbitrary decision, I thought that was just what you were supposed to do. The bags were a very expensive item and as such didn't sell nearly as fast as my belts. The belts actually had a healthier mark-up and the cost to design and develop new styles was much lower (although truth be told, I had a pretty fuzzy idea of those margins as well). Unfortunately, the monster expense I had created with my handbag production and development practices, wound up eating up any profits I might have seen from the belts. There's nothing like looking at $100,000 in sales and seeing literally no profit. I vividly remember the moment I realized that my overhead expenses weren't adding up to anywhere close to what I was paying just to have things made. I had been thinking that it was things like my studio or paying for PR or commissions that was eating up my money, when in reality I had created a totally unsustainable pricing model.
There was an instance during all of this that sort of haunts me to this day. I was invited to dinner at a friend of a friends house. It was the (gorgeous) home of a women who designed and manufactured cashmere shawls and scarves. We were talking about business a little and I'll never forget she said something to the effect of "This can be a great business, as long as you can get good margins" I nodded in agreement, thinking I knew what she meant, but really I couldn't appreciate or even understand how much truth was contained in this single comment.
My first business may very well have been able to weather the economy tank of 08' if it had been built on a strong foundation with real clarity about what things where really costing me. I could say that I stuck my head in the sand, but for a long time I just didn't know that I was doing anything wrong. I just kept thinking I just needed more sales, and I would start to see profits. At a certain level that may have been true, but wouldn't it have made a lot more sense to make space for that profit early on instead of waiting around until you were selling thousands of units?
I should point out that even if you aren't spending hundreds or thousands (or hundreds of thousands) on production and development or you are the sole maker of your goods, you are just as vulnerable to losing money through bad pricing practices. In fact, it's often makers who have the hardest time wrapping their heads around what it means to price for profit. Let's look at the other end of the spectrum and talk about brand new businesses, just starting to sell products they make. You might be surprised to find that you are employing some bad pricing practices like the ones below.
1. Using some one-size-fits-all formula that you found online.
This one kinda makes me bananas. There are definitely calculations that you want to use to accurately determine what your product costs to make, and to determine what your profit margin is currently. What I don't like is the one-size-fits-all advice that is rampant all over the internet regarding how much you should mark-up above your costs. I hear 2.2X a lot, which is a standard amount (actually anywhere from 2.2-3x) for retailers to mark-up something they bought wholesale from you. However, just slapping that 2.2 mark-up on your manufactured or handmade product, is completely arbitrary and may not be appropriate to your business at all. There are a lot of questions you need to ask yourself before you just decide on a mark-up. Many of these questions have to do with your own personal situation, things like your business or personal overhead,(i.e. cost of living) or what sort of plans you have for the growth of your business. Also, If wholesaling your line to retailers is part of that plan, then you need to create a wholesale price first, then add your mark-up to retail. A simple 2.2x mark-up from cost to find your retail price, will make it impossible to have any wholesale margin, if you should decide to go that route later on down the road. The wholesale price shouldn't be viewed as a discount, it should be viewed as a part of your price structure. You need to start there.
2. Pricing based on what the other brands are doing.
This seems to be an especially huge temptation in the world of Etsy and Craft Shows, but you also see it quite a bit in service businesses. Let's say you create a product that is in a highly competitive category (like jewelry, or coaching) and then base your own pricing off of other brands selling something similar to what you have. "Arbitrary" is the dirty word here, because you are essentially choosing a price based on no real information, much less anything relevant to your own business. Worse yet you may just be copying another person's potentially terrible decisions. I don't mean to sound harsh, I just want to help you understand that these are important decisions that you may be making blindly which is totally detrimental to your bottom line.
3. Limiting the value of your products.
If you are selling handmade or manufactured products you design, there is a concept that you should understand. The value of what you make is not the exact sum of each penny you paid for every scrap of material and every minute of the time it took to make. Yes, these things are PART of the equation, but there's so much more to it and not all of it is completely tangible . For my own designs, that "je ne sais quoi" comes from years of studying design and painting, and my experience as a freelance jewelry designer, and stylist. All of these things inform my designs and my aesthetic. A big part of what you are paying for is me. Part of your pricing structure should include you, your taste, your take on things, your vision. Yes these things are intangible but they are also valuable. (Screw the other ten thousand people on Etsy selling under-priced necklaces, they aren't you!)
4. Trying to undercut perceived competitors.
Again, many independent makers have Etsy to thank for this temptation, I said "perceived competitors" for good reason. You probably don't want to get into competing heavily on price unless your business model includes selling in retail outlets like Target or the Dollar Tree. Most brands that are super cheap or undercut everyone else are able to do it because of one thing - VOLUME. They also typically manufacture in countries with much lower minimum wages than the US or Europe. Often they have paper thin margins but they sell thousands and thousands of units. Don't think that this doesn't relate to you because you may be small and only sell online or on Etsy. Trying to compete on price is a pretty slippery slope. Also, recent changes to Etsy's business model means that even there you still may be competing with cheaper overseas manufacturing or at least with hobbyists and newbies who simply aren't making any money. Either way, these aren't the businesses you want to model yourself after or call your "competition".
One reason I've taken on the subject of pricing is the same reason I got interested in helping people with line-sheets. There was a black hole of missing information on online, (there's more out there now, but still not much). Information about pricing, can be found, but is usually incomplete and glossed over. The simplistic formulations that are available on the web, barely scratch the surface but often present themselves as the whole picture. When I started my first business, I did take a costing class, and I really thought I had the whole picture. The reality was that I needed to dive much deeper to get the answers for my unique business. Costing and pricing are now at the center of everything that I do. I constantly re-evaluate it to make sure it is still in line with my business goals. I'm also not afraid to look at it anymore, I would much rather know if a product has less than ideal margins. The knowledge truly is power.
As you may have read on the homepage, I'm currently putting together a strategic coaching package for costing and pricing. I'm also releasing a line-sheet tutorial in early March 2015. If you would like to receive $10 OFF one of these offerings, please leave a comment below. (just refer us to your comment at the time of purchase) I would love to hear what you have to say about pricing, costing and profit margins.
What are the challenges you are facing right now?