What Is a Price Margin?: Definition, How to Calculate & Benefits
For a businessperson considering the introduction of a new product, setting the price is a vital consideration. You will always face choices in determining an appropriate price for a product or service. The price margin is a pricing strategy that involves the creation of models based on costs and projected sales to set prices that allow for adequate profit.
The price margin gives a more precise picture of a product's costs and how profitable it is to your business.
A price margin is similar to the idea of markup. Both refer to the amount (usually expressed as a percentage) that is added to the cost of a product to arrive at a selling price. However, the price margin takes this a step further by taking into account not only the cost of the particular product (for a retailer this is the wholesale price) but all other costs that must be covered for a given volume of business, including profit margin.
When you calculate markup it’s relatively simple. If a product costs $10 and you set the price at $15, the markup is 50%. To convert markup to margin, you need to have an estimate of the number of units that will be sold during a stated period, typically a month or year. For that period you determine the amount of all other costs (store rent, utilities, labor and so on) that must be allocated per unit.
After adding in an allowance for profit, the total will be the amount you need to add to the cost of the product to arrive at a selling price. For example, if your per-unit cost is $10 and you need to allocate $4 per unit to cover all added expenditures at your projected unit volume, plus an additional $1 for profit, you’ll arrive at a price of $15.
Many new business owners make the mistake of arbitrarily choosing a markup for a product or simply imitating competitors’ prices or attempt to grab a share of the market by pricing the product below market. The use of a price margin analysis can help you avoid either underpricing your product, and thus losing money, or overpricing and losing customers. To use price margins effectively you have to start with an accurate estimate of all costs and a realistic estimate of projected volume, which requires at least a minimum of market research.
One of the major benefits of the price margin concept is that it can help you determine in advance if a product even can be profitable. If your analysis shows you can’t generate enough volume at an adequate price to at least break even, you can avoid investing capital in the product.
Another benefit of the price margin concept is its flexibility. You can use it to calculate break-even points at various prices, or to estimate the impact on profits of offering coupons and other discounts to draw customers in.
Keep in mind that simply having a sale is not enough. The goal of a sale or coupon is to generate enough additional business to offset the price reduction. Knowing how much that added volume needs to be and if it’s a realistic goal is critical to using sales and other pricing strategies effectively.
A "good" profit margin depends on your industry as well as other factors. Avoid the trap of trying to sell at the lowest possible price, especially if you are putting a new product on the market ahead of other competitors. This may prove to be a wise move, but it may not. If an item is priced high and marketed properly, the perception by consumers that it is of high quality will often generate more volume than a lower price. Furthermore, it’s very difficult to start with a low price and then raise it without losing your customers.
In some industries (the perfume industry, for example) this is a common strategy. Marketers of high-end brands often refuse to place their product in discount stores because the “exclusive” image they’ve established is more valuable than the added volume they might generate. You can always use sales or coupons to generate more traffic and still maintain a high base price if you can effectively market your product on the basis of high quality or service.