Price calculation: how to calculate correctly

How to find a price that is competitive and attracts customers? Entrepreneurs and self-employed people often find it difficult to calculate prices – and make mistakes that cost them a lot of money.

Whoever launches a new product or offers a new service should think carefully about how much money they want to charge for it. Because pricing is more than just adding up all the costs and adding X amount of profit. If the price is poorly calculated, the entrepreneur may miss out on a lot of money because customers would also have been willing to pay more. Or the product becomes a slow seller because the calculated price is much too high.

But how do you find the right price – one that covers all costs, is competitive and attracts customers?? And what mistakes should you avoid at all costs when calculating the price??

Content: What to expect in this article

The first step: Determining the target customers’ willingness to pay a price

"It’s much too late to start thinking about price when the product is already ready," says Georg Tacke, pricing specialist and CEO of strategy and marketing consultancy Simon-Kucher& Partners.

Even when writing a business plan or developing a new product, Tacke says it’s important to consider how much the product will cost. "After all, this is when it is decided whether I am working on a useful new product that will allow me to earn money at some point in the future – or not."

He warns against relying on your gut feeling when calculating prices. "How much you yourself would be willing to pay doesn’t matter at all," Tacke says. It makes much more sense to ask potential customers about their willingness to pay a price.

Larger companies should invest in a market research for it. For example, the future purchasing situation is simulated by presenting potential customers with the new product and comparable competitor products with different price tags. Then the customers are asked which product they would choose – and why.

If founders don’t have the money for such market research, Tacke advises them to approach potential buyers and simply ask them themselves:

• Is this an interesting product for you?
• Why is it interesting? What do you find good and exciting? (How to find out which features of the product are most important.)
• Would you buy it if it cost X euros??
• Why? Or rather: Why not?

Even if you only talk to 10 to 20 potential customers, that’s still better than not taking any action at all. "You may not develop the perfect pricing strategy in the process, but at least you’ll get an 80 percent solution," Tacke says. He considers it grossly negligent not to do so. After all, this is the way to avoid gross errors right from the start. "For example, it’s hard to correct a price that’s way too low," he explains.

What factors do I need to consider when calculating the price??

The costs incurred

In addition to the customer’s willingness to pay, the second important factor in pricing is the costs involved. Founders must be able to break down exactly what costs will be incurred: How much are the material costs? What does manufacturing cost?? How much is spent on marketing and sales? All of these items must be broken down to the individual product to determine the cost price. The easiest way to get an overview is to use a spreadsheet program like Excel. You can find an example calculation here.

Basically, two types of costs can be distinguished in the calculation:

• Direct costs: They can be directly assigned to a product. If I need 50 grams of oatmeal for a muesli, for example, the cost of this falls under the direct material costs.
• Overhead: They cannot be easily attributed to a single product and must be prorated among products. Manufacturing overhead includes, for example, depreciation on machinery.

A typical beginner’s mistake: Some founders forget to include their own earnings in the costs. But if you work for free at first and can’t raise your prices later, you end up exploiting yourself.

Pricing expert Tacke also warns against including development costs in the calculation. Money spent on development is referred to as "sunk costs": it is gone. If you include it in the calculation, the costs are set too high – and the product ultimately becomes too expensive.

The profit margin or margin

Founders are often advised to base their price calculations on the margins customary in the industry. Depending on the business, profit margins can vary extremely: Some dealers mark up 250 percent. Supermarkets price groceries at up to 100 percent for dry goods but only 30 percent for fresh goods. In the restaurant business, the margin is often 30 to 50 percent; in snack bars, it’s more like 20 percent.

Tacke thinks this approach is wrong: "This is a typical inside-out approach. I take my costs and add something to them – but I have no idea how much, so I try to go by an industry standard markup. But that’s not how I exploit my price potential."

He does not see the markup as something to start working with. An example of this so-called outside-in approach: A founder has developed a new robot vacuum cleaner and knows how much it will cost to produce the product. He also knows the price willingness of his customers. From this he calculates the price: it is 100 euros, its cost is 50 euros. So he would get a margin of 50 percent. Now he has to ask himself if this is enough to cover his fixed costs and to achieve the desired profit.

"Imagine if the founder came up with a new production method that made his robot vacuum cleaner no longer cost 50 euros to make, but only 25," Tacke explains. "If he followed the logic of taking the industry standard markup rate, he would then have to lower the price – which would be stupid."

Discounts and rebates

When calculating the sales price, possible discounts must also be taken into account – otherwise entrepreneurs would reduce their profits every time they offer a discount.

The discount is deducted directly from the selling price. Volume discounts are common, for example, when a customer buys a large number of products, but loyalty or new customer discounts are also possible. Discount is granted to buyers who pay within a certain period of time. The discount is usually two to three percent.

Sample calculation: How founders can calculate prices

A real-life example: the founder of a cereal store calculated the price for a pack of cereal (190 grams) as follows:

The minimum turnover procedure

Many founders rely on the so-called minimum revenue model when calculating prices. Not only the costs are considered, also the demand is included in the calculations. For example, those looking to start their own granola business should observe comparable businesses in the neighborhood. In addition, founders should obtain industry figures and studies and derive the market potential from them. Why this is important? Someone who sells only 20 bags of cereal a month may have to charge higher prices to survive than someone who sells 100 bags a month.

In the case of the muesli store, for example, the market potential can be approached as follows: according to surveys, 6 percent of Germans eat muesli several times a week. Berlin-Friedrichshain counts nearly 280.000 inhabitants, which means 16.800 potential cereal buyers. Assuming that 1 percent of these consumers – and that would already be an enormously high average – would go to the store once a week, then the founder would have 168 customers, calculated on the day just under 28.

A real market potential analysis is even more complex, but in principle the following applies: From a figure estimated in this way, entrepreneurs can determine how much sales they need and which price calculation is realistic for them.

Typical errors in price calculation

Assessing demand too optimistically

Many founders assume the wrong number of customers. Anyone who compares himself as a cereal seller with catering businesses in the area and concludes that he too has a customer in the store every ten minutes can quickly be wrong. If instead of the estimated 60 buyers a day, only 15 show up, the revenues don’t even cover the expenses – because the founder bought cereal for 60 customers and adjusted the price calculation accordingly.

The "feature shock

The developer of the robot vacuum cleaner is proud of his new product, knows its costs, adds 20 percent – and is horrified to discover that it flops on the market. It is too expensive for the customers. "This often happens when a product can do too much. This makes it too expensive to produce, which in turn results in a price that is not enforceable on the market," says pricing expert Tacke. Technology- and innovation-driven companies fall into this trap particularly often. "Economically, it would often make more sense to launch a product that can do less. It is always a question of orienting oneself to what the target customer expects – and is willing to pay."

According to Tacke, if a product is "too good," there is also the option of removing additional features from the actual offering – and then offering them as an add-on option. This is especially interesting in the case of services.

An unclear revenue model

With products such as a vacuum cleaner robot or a muesli mix, the question of the revenue model is quickly answered: price per unit. But with software, things look different. Offer the customer a personal license? Is the program in the cloud? Or is there a pay-as-you-go model – so you only pay when you use it?

According to Tacke, many entrepreneurs give too little thought to the appropriate revenue model, especially in the initial phase. "Before I determine the price level, I have to consider whether I really want to sell the product – or whether a subscription wouldn’t make much more sense as a use," he says.

In the case of Internet and software products, the so-called "freemium" model – the combination of free and premium – is currently in vogue. The goal is to first gain as many customers as possible with a free version. To those who have higher demands on the product, you then sell premium offers, i.e. additional services and features.

It is often forgotten to consider what exactly the premium offer should look like. "Often we then hear: we’ll worry about that when the time comes," says Tacke. "That is, of course, much too late."

What do service providers and freelancers who sell only their labor have to pay attention to?

If you are not offering a product, but a service such as a seminar or coaching, you have to take some special considerations into account when calculating your prices. First, you look at the working time you have available and calculate how much you should charge per hour.

For this, all running costs for rent, wages and salaries and one’s own gross earnings including insurances are added up. This sum is divided by the available working days (not forgetting vacation and sick days!).

The result is the minimum turnover per day. However, this only applies if each employee works every day of the month – and can charge this time to a customer. Most of the time this is unrealistic, so founders should expect a 50 to 60 percent markup in pricing. That means: All those who buy have to pay for the idle time as well.

An example: a founder offers seminars for aspiring writers. She maintains her own course rooms in Berlin and rents in other cities as needed. A one-day seminar costs 125 to 225 euros – higher prices are not enforceable with their target customers.

Included in their calculation are the expenses for rent, seminar documents, the preparation and the fees for the founder and her lecturers. From seven participants a seminar is cost-covering. If there is less demand, the seminars will only take place if the lecturers come from the same city and no travel costs are incurred.

Her business becomes really worthwhile when the participants book individual coaching sessions afterwards – in this way, the entrepreneur absorbs fluctuations in demand for the courses.

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