Price calculation: How to find the right price for your product

Are you starting your own business? At some point you reach the moment when you have to think about your costs. How do you set the right price for your products? Which costs do you need to take into account? These and other questions related to starting a company can challenge you as a founder.

Many factors must be considered when setting up a business. The price of your products is not only supposed to cover incurred costs — you also want to generate profits and remain competitive. In the following, we will give you an overview of how to calculate your prices correctly.

Before you can offer your product to a third party for sale, you need to think about the offer or sale price you want to charge. In plain terms, this means performing a price calculation. When setting your sale price, there are several things to keep in mind. For example, the willingness to pay of your potential customers plays an important role. Just as important is the price charged by other providers offering a similar product on the market. A prerequisite for the pricing calculation is therefore that you, as the provider, know all the costs incurred by your business.

1. Price calculation – How do I calculate my sale price wisely?

Willingness to pay of my target customers

Your customers should come first, because they are your target group and the people who are supposed to buy your products. But customers only buy if they perceive the price as appropriate. You therefore have to think about your potential customers' willingness to pay at a very early stage. The moment a new product is being developed in your company, it must also be clear in parallel what the product is supposed to cost. That is why it is important to get to know your potential customers.

A target group analysis for your price calculation can help with this. Your target group is derived from your defined business objectives. You set these objectives when planning your self-employment. At the beginning of your target group analysis, you look at the obvious characteristics to find out who makes up your potential target group and who buys your products. These include:

• Demographic characteristics: place of residence, age, marital status, gender
• Socioeconomic characteristics: occupation, qualification/level of education, salary/income
• Psychographic characteristics: preferences, lifestyle, religion, interests, attitudes, loyalty, purchasing behavior, tastes, brand loyalty, needs, wishes, communication behavior

If your customers are business customers, other characteristics play an important role:

• Organizational characteristics: location, company size, company age
• Economic characteristics: profit, revenue, liquidity
• A company's purchasing behavior: time of purchase, company principles, supplier loyalty
• Personal characteristics of decision-makers in a company: attitudes, communication behavior, openness to innovation

Target group analysis – Price stability and purchasing behavior of my customers

You now have a first impression of your target group. In the next step, you analyze the price stability and purchasing behavior of your target group. You need these values for your price calculation as well. So you should think about the following questions:

• At what price can your target group afford the products? The income available to your target group is an important factor here.
• At what price is your target group willing to buy the product?

A high income in your target group does not necessarily mean that they are willing to pay a high amount for your products. The product you offer may not be very important to your target group, so they only want to pay a low price for it. The perceived quality of a product can play a role in whether your customers are willing to pay more or less.

To illustrate this, here is an example:

The founder Leo has developed a vegetable powder that consists solely of organically grown vegetables and was produced in an environmentally friendly way. He sells the product online. For Leo, the following target group results:

• People living alone, aged 25 – 60, living in the city
• An income slightly above average
• An environmentally conscious lifestyle
• Emphasis on healthy and organic nutrition
• Willingness to spend more money on healthy, organically produced food
• The target group values high quality

You are probably wondering how to get hold of this information. You can conduct your market research in two ways: qualitative and quantitative research. The two approaches can also be combined.

If you want to conduct qualitative market research, you can use the following sources:

• Web analytics
• Banks
• Auditors
• Market research institutes (e.g. GfK)
• Public studies/industry studies (e.g. Statista, Federal Statistical Office)

And for quantitative market research, the following options are available:

• Surveys or customer interviews
• Market studies (Sinus-Milieus)
• Ethnographic research (e.g. Google Analytics)
• Industry associations

Competitor analysis – What is my competition doing?

As described above, you want to be competitive. So you should also analyze your competitors, because your competition is important for your price calculation as well. You can find out who your indirect and direct competitors are, review their product range and monitor their prices. You also need to consider the so-called price-performance ratio. Specifically, this means checking whether and which additional services your competition offers. For example, this could be free shipping.

This results in questions such as:

• What does my competition do better than I do?
• What unique selling point does my competition have?
• Who is the potential target group of my competition?
• At what price does my competition sell its products?
• What plans does my competition have for the future?
• What are the strengths and weaknesses of my competition?

Demand is often estimated too optimistically in price calculation. People often assume a high sales volume and strong demand. As a result, more material is usually purchased and produced than is ultimately needed. However, if the quantities produced are not sold, the costs are not covered by the calculated price. This is because actual revenues then no longer match the calculated price. In an unfavorable case, your expenses will then probably not be covered. To assess actual demand for your price calculation, you can consult industry reports and figures. From these you can derive the real market potential.

How high are my actual costs?

In the next step of your price calculation, you need to determine the actual costs. After all, these are supposed to be covered by your sale price. To do this, you need to record the costs incurred through the marketing, manufacture or service delivery of your product. These are your company's total costs. As a rule, they consist of the following cost items:

• Material costs: operating supplies, auxiliary materials and raw materials
• Production costs: machinery, production facility (e.g. space costs), production (e.g. energy costs and production wages), development and design costs
• Development costs: research costs, fixed assets, personnel, operating resources for research, experimental development and product development
• Service costs: costs for leasing or transport, consulting costs, service and maintenance costs
• Sales and administrative costs: marketing, sales wages, accounting, customer service, human resources, depreciation, lease or rent, postage costs, travel costs

Even once you have calculated the price for your product, it is important to review the price regularly. This way you can determine whether the calculated price is still up to date or needs to be adjusted.

As a guide, you can ask yourself the following questions:

• Have your total costs changed?
• Were you able to reduce your costs, or have they risen?
• Have you hired new staff?
• Have you sold more or fewer products than planned?

2. The price floor – What does it mean?

The price floor is also important when starting your business. The price floor refers to the minimum sale value a company must reach in order not to make a loss.

The costs you take into account in your price calculation are divided into fixed and variable costs. Fixed costs arise for your company regardless of what happens in production, such as insurance, salaries or rent. Variable costs, on the other hand, depend on the produced quantity or the service offered.

The price floor can be divided into the short-term and long-term price floor, with specific characteristics applying to each.

The short-term price floor

In short: the short-term price floor is the price that just covers your variable unit costs – fixed costs are left out.

The short-term price floor (also called KPU) corresponds to the variable costs incurred in production. No fixed costs are taken into account here. This means that losses can occur if the price is at the level of the variable costs. This price floor only makes sense for a short period, e.g. to gain market share.

To calculate the short-term price floor, you take the average of your variable unit costs. What matters is whether the cost function is linear or polynomial.

The formula for a linear cost function for calculating the short-term price floor is:

Sum of your variable costs / number of units

The long-term price floor

The long-term price floor (LPU) corresponds to the total costs and represents the minimum of the average unit costs. Both variable and fixed costs are taken into account here. This limit prevents losses, but no profit is possible either, since the costs are merely covered.

To calculate the long-term price floor, you can either derive an average cost function or look directly at your total costs. The following formula helps you with this:

The liquidity-based price floor

Liquidity is not taken into account in either the short-term or the long-term price floor. This can lead to problems. Liquidity means that your company has enough funds to meet ongoing payment obligations. If your company is liquid, you can avoid financial bottlenecks.

The liquidity-based price floor, however, takes into account liquidity difficulties that may arise with the short-term price floor. It includes your revenues, variable costs and cash-effective fixed costs in the short term (for example salaries or rental expenses). To calculate the liquidity-based price floor, you add your variable costs and cash-effective fixed costs and divide them by the sales volume.

3. Maximize profit

As you can see, there are a number of points to consider in order to find the right price. You need to know how much your target group is willing to pay for your product and how high the price must be so that your costs are covered.

The next step is to find out which price allows you to maximize your profit. If you offer your product cheaper than the competition, you may:

• achieve more sales if your product is cheaper
• achieve fewer sales, but more revenue per product or service, if your product is more expensive.