The parameters within which you set individual price points for your products and services (i.e., your price floors and ceiling) can be the difference between setting optimal prices to maximise revenue…

…or barely breaking even each month.

The strange thing is though many managers don’t even know that an item’s price floor is the foundation of a profitable price point. Instead, they go head first into price setting without validating clear price boundaries and lose hard earned margin in the process.

In this article, I’m going to show you how to determine an item’s price floor so that you avoid setting unprofitable prices.

What are price floors?

A price floor is the starting point for setting a price. Under many circumstances, businesses should be setting their prices within pre-ordained parameters – known as price floors and price ceilings.

A price floor is the lower end of your price range parameter. Typically, managers should be thinking of setting the price floor by considering their costs – but not so much so that they get lost in allocating fixed and variable costs. It is important to have this set if you have haggle price negotiations.

It is a challenging task to allocate fixed costs into per-unit values – and pretty much an analysis that is not worthwhile or even recommended for price setting.

Many managers, however, make the mistake of fully allocating costs before price setting. They feel they must translate the arbitrariness of overhead expenses into per-unit values. This kind of makes sense given that you usually express price as a per-unit quantity. However, our advice is to leave cost accounting to the experts (i.e., accountants) and don’t waste your time here (read the case study below to find out why).

Case study

Consider the following real-world case study of a building materials business based in Sydney. This business tried to enter the market for an extensive range of bracing products in the commercial properties segment. They developed a range of high-quality lining products and calculated a very modest markup over fully allocated costs.

By a detailed analysis of their costs (fixed and variable), they determined each item’s price floor. This came about because an accountant in the finance department decided to allocate all costs among the individual items sold. In his view, it was important to resolve all arbitrariness. He then felt it was acceptable to set price points for all their lining products by applying a simple percentage markup to each item. This was somewhere in between the price floor and price ceiling.

When the building materials distributor/manufacturer investigated why their lining range was not selling well, they discovered that their main competitor, who was also producing very similar, high-quality lining products, was underselling them by a considerable amount.

The business was flummoxed: ‘Why was this happening? Had they painstakingly allocated a portion of fixed costs to individual products?  Had they applied a markup as they had always done?

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A few months later they decided to hire a pricing manager to review their pricing. The new pricing manager solved the mystery on the first day on the job.

She was taken through the business price setting procedure after an introduction to the business’ pricing system. Instantly, she could see that the accountant was spending too much of his time translating fixed costs into-per-unit values.

She asked the accountant why he decided to determine the price floors for lining products like this. To which the accountant replied: ‘This is what we do here. How else can you minimise the arbitrary allocation of overhead costs?”

The pricing manager then asked: ‘What’s your rationale for allocating a more significant amount of the office staff costs to trimming than lining products?”

The accountant couldn’t remember exactly: “Erm, it seemed right at the time… I’ll have to review the numbers again.”

“Look at your competitor’s price points for instance,” the pricing manager continues to explain, “their prices are considerably lower than ours, yet they are selling pretty much the same lining products as us. You and I both know this competitor very well, and their fixed cost structure is pretty much the same as ours. What do you think they are doing differently to us to produce lower prices?

The accountant began to understand that they were overselling their lining products just because of an accounting convention.

‘It appears to me,” said the pricing manager, ‘that our competitors have likely applied a markup percentage to their variable costs whereas we are applying a mark up to the total of each item’s variable costs, as well as its share of the company’s fixed costs.”

Discussion

Experienced and skilled pricing managers simplify their cost analysis to derive more valuable price points and pricing strategies. They focus on variable costs to set price floors for their products and services (i.e., a cost which vary directly with the number of products units sold).

The problem with determining price floors based on an item’s share of the company’s fixed costs is that you are likely pricing yourself out of the market, i.e., your price floor for an article is more likely to be higher than a competitor who puts fixed costs aside.

Implications

  • Think about setting an item’s price floor using your variable costs, it is likely that your final sale price will be higher than your variable value and in turn result in profitability. Have a trial run at putting fixed costs (i.e., costs which do not change with the number of units sold) aside when determining a product’s floor price. Has it increased your price flexibility?
  • Think about how you are going to translate your customer’s needs into a single price. Determine accurate price ceilings for your products and services. Don’t stop until you find out the maximum amount your customer would pay, when fully informed.
  • An accountant may not be the best person to set prices. Yes, they understand costs. However, you don’t need to translate fixed cost into per-unit values. Instead, you need to be highly skilled at translating your customers’ needs into per unit values. The main role of a pricing manager.

Conclusion

Using variable costs to set a product’s floor price is a more natural way to consider a product’s per-unit costs. This ultimately enables you to establish more effective price points.

If you would like to know whether you are under or overpricing your products and services  – check out this guide.

Determining a suitable price floor will enable you to set more profitable prices. However, a strategic price setting strategy should always focus more on customer value rather than costs. Don’t find out too late in the game that your final selling prices are not covering your expenses. Worse still, driving customers to your competitors.

Don’t lose another dollar implementing the wrong pricing and team strategy – download your free guide here.

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