How to Calculate Retail Pricing

Dan Rentea/iStock/GettyImages

Arriving at a retail price for a product is a complex process. Before you can decide on the best pricing strategy, you have to understand the multitude of factors that influence the price a consumer is willing to pay for your product. For example, prices are affected by economic conditions, actions of competitors, labor wages, cost of materials, incomes of consumers and government regulations. For some of these factors, you can find reliable numbers from research data; for others, you have to rely on your instincts.

No single formula for a retail price exists that works for all small businesses. But you can use the following steps as a guideline to develop a pricing strategy for your business.

Study Your Target Customer

You must understand how your target buyers think. You have to get inside their heads and find their motivating factors. What are the features they're looking for, and how much are they willing to pay? How will you be able to promote your products so that customers will choose them rather than the competition?

Who are the target customers? Are they male or female? What is their income level, and what is the age range? Where do they live? The more details you understand about your customers, the better.

Buyers are looking to satisfy a need when they purchase a product. What are the needs of your potential consumers, and how do your products meet those needs? Your promotional and advertising campaigns must be in sync with meeting the wants of the customer.

Analyze the Price Structure of the Market

What are the price point levels in your market? Is it a low-priced market dominated by high-volume, low-price retailers such as Walmart and Costco? Or is it a market with premium prices with luxury or premium brands, such as Rolex watches or Coach leather goods?

Can you differentiate your products from the competition? In some markets, the products are the same and a retailer has to compete by offering and promoting additional services, such as a no-hassle return policy. Which market will your product fit in?

Calculate Your Costs

The first step to calculate a retail price with any pricing strategy is to determine the costs of the product. The selling price should be enough to cover all of your costs and leave a profit.

A product's costs include not only the variable costs of direct labor, materials and distribution but also an allocation of fixed manufacturing and overhead expenses. Examples of fixed overhead expenses are rent, utilities, administrative wages, supervisor salaries, marketing, insurance, accounting and licenses.

Define Your Pricing Objective

In spite of popular opinion, pricing methods are not always about maximizing profits. For instance, you might want to set a low price to maintain market share in reaction to competitors' aggressive marketing campaigns. Or you could choose to reduce prices to discourage other companies from entering your market.

Each of the following price strategies is designed for a specific purpose.

Let's follow an example of the Hasty Hare Corporation's introduction of a new sneaker for rabbits, Blazing Feet. This new style uses lighter-weight materials that are eco-friendly. The cost of production for each pair of sneakers is $75, and the company accountant is allocating fixed overhead charges of $265,000 per year to Blazing Feet.

Penetrate the Market

When introducing a new product, you can use a market penetration strategy to quickly get the public's attention and establish a market position.

If the price of an average pair of sneakers from all competitors is $129, Hasty Hare could decide to set the retail price for Blazing Feet at $99. This price is significantly below the average for the market and should generate sales immediately.

Costco and Kroger are examples of large retailers that use a penetration strategy to dominate the market for organic and natural foods. While other grocery stores try to maximize profits with higher prices on organic foods, these two large retailers earn high profits with more sales volume at lower prices.

Establish a Premium Value

At the other end of the pricing scale is the premium strategy. This pricing method requires you to establish your product as having unique, distinctive features that are worth a higher price. The consumer must perceive that your products have additional value above the competition and be willing to pay more.

In the example of Blazing Feet, these sneakers are lighter and have the additional appeal of using materials that are biodegradable and not as harmful to the environment when disposed of. Hasty Hare could use these special features to justify a premium price of $169 per pair since no other competitor is offering a similar product.

Creating the perception of premium value requires a significant investment in marketing and advertising campaigns to persuade consumers that the product is worth the price.

Skim to Maximize Profits

If you're able to establish a premium price for your products, it makes sense to keep these higher prices for as long as possible to earn the most profits. This process is known as "skimming".

Skimming works until competitors notice your high prices and start offering competing products. At that point, you will have to start lowering your prices to maintain market share and begin to attract more price-sensitive customers.

Keystone Your Prices

A common pricing method for retailers is keystoning. With this method, the retail price for a product is found by doubling its cost. For example, if a product costs $65 delivered to your warehouse, then the retail price would be twice that cost, or $130.

Keystone pricing allows a retailer to make a reasonable gross profit margin at the beginning of a season and still have room to mark prices down at the end to quickly move out unsold inventory.

Although keystoning is simple to use, it does not work in all markets. Increased price competition from e-commerce sites has made it difficult for traditional brick-and-mortar retailers to maintain the higher average retail markup on clothing that results from keystone pricing.

Calculate Your Break-Even Sales Volume

After you have decided on a pricing strategy and a retail price, calculate the break-even sales volume needed to cover all costs and produce a profit. This sales volume becomes the objective that is communicated to the sales personnel and supported by a marketing and advertising campaign designed to reach that level.

The formula to calculate the break-even point in number of units is:

Break-even number of units = Total Fixed Costs/(Retail sales price - Variable unit cost)

A further refinement to break-even calculations is to include the desired profit level with fixed costs. After all, the objective is not just to cover costs, but to produce a profit, so why not also treat profits as a fixed expense?

Calculate the Retail Price for Blazing Feet

The management of Hasty Hare believes that Blazing Feet is a unique sneaker that will appeal to a higher-income, environmentally-conscious consumer. They also feel that this target demographic is willing to pay a higher premium price of $169 because of these distinct features.

The break-even unit volume for Blazing Feet is as follows:

Break-even number of units = $265,000/($169 - $75) = 2,619 pairs of sneakers

The process to calculate a retail price involves an understanding of the needs and desires of consumers, the price structure of the marketplace and the strengths of the competition. However, the initial choice of a pricing strategy is not set in stone.

Continued monitoring of results could reveal that marketing and sales plans are not performing as expected, and changes must be made.

References

Resources

About the Author

James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.