How to Navigate Our Complex World of Competitive Pricing

Competitive Pricing is Key to Financial Success

Welcome to part four of "Tuning Your Pricing Strategy: A 5-Part Guide." I'm here to guide you through the labyrinth of pricing to achieve optimal results. To gain a better understanding of the series, review the roadmap (image below). Newcomers can access previous installments at the bottom of this page.

Developing a Competitive Pricing Strategy: Essential Techniques for Success in Every Market

In the previous article (#3) on value-based pricing, the willingness to pay (WTP) of a customer was evaluated through the example of Darby's potential purchase of a robot vacuum. It was concluded that Darby has a high WTP for the product.

Darby is currently struggling with "analysis paralysis" due to the overwhelming amount of product options available. To illustrate this, take a look at the following data:

• Product price range: Approximately $150 to $1,500

• Number of brands: 30+

This becomes a challenge for Darby as the buyer and the sellers!

Assisting Darby in Overcoming "Analysis Paralysis" with Competitive Pricing

Darby has chosen to prioritize these features and evaluate how competitors compare before making a purchase:

• Run time

• Wi-Fi/cellular connectivity

• Noise level

• Ease of use

• Cleaning effectiveness

• Battery life

• Warranty

Competitive pricing strategy is crucial for attracting customers. It involves identifying competition, evaluating their offerings, and considering customer perception and willingness to pay.

Challenges of Pricing with Limited Customer or Cost Data

Our pricing strategy series has so far delved into two techniques: value-based pricing and cost-based pricing. However, these methods may not be practical when data is scarce. Here are some scenarios to consider:

• As a startup, you may not have a clear understanding of your variable and fixed cost structures yet, making cost-based pricing impractical.

• If you're introducing a new product or service that has been kept under wraps, you may not have enough insights on customer willingness to pay for value-based pricing to work.

Put simply, gathering competitive pricing data and conducting analysis can yield significant benefits.

Adopting Jeff Bezos' Approach to Competitor Analysis for Your Pricing Strategy

"We watch our competitors, learn from them, see the things that they are doing for customers and copy those things as much as we can."  -Jeff Bezos (Founder of Amazon)

To put these ideas into practice, we will focus on two important steps:

1. We’re going to focus on identifying competitors so we know who to monitor, evaluate, and copy! This includes two “mini examples.”

2. We’re going to focus on the evaluating, learning and copying! Throughout this step, we will use a couple techniques and examples to gain insight into the customer's point of view.

By mastering the art of competitive pricing, you'll have the power to charm customers with perfectly-priced products and services.

Introducing Myself as Your Guide to Competitive Pricing Strategy

Before we delve into the details, let me assure you that I have the necessary expertise to direct you towards the right path. I hold an MBA from Chicago Booth, where my concentrations were in Strategy, Entrepreneurship, Finance, and Organizational Behavior. Additionally, my enthusiasm for pricing strategy led me back to Booth, where I took a course on this subject taught by Jean-Pierre Dubé. In this article, I highlight some of the key concepts covered in the class.

BEFORE Analyzing Competitive Pricing Strategies, It’s Critical to Accurately Identify Competitors

To create a competitive pricing strategy, you must first identify your competitors and then analyze their prices. It's important to accurately identify your competition to ensure that the analysis is useful. Without this crucial step, the analysis won't provide any value. Let's focus on identifying competitors...

Identify Your Competitors (Even If You Think You Don't Have Any!)

This involves research, including identifying key players in your industry. No matter how unique you believe your product or service is, it's essential to recognize that you always have competition. Here are two mini examples to emphasize this point:

Customer Substitutes for the Robot Vacuum (Mini Example)

Envision this scenario: You're the brilliant inventor of the world's first robotic vacuum cleaner.

Even at the time of your invention, you had competitors popping up like whac-a-moles, offering alternatives to your customers, and they are still relevant today:

• Hire a cleaning service that provides all materials (eliminating the need to own a vacuum and do the work)

• Purchase a vacuum of a different type and explore second-hand options (to lower upfront costs)

• If the floor is not carpeted, use a mop instead (cheaper than a vacuum and doesn't require power)

Customer Options for Group Outings (Mini Example)

Picture this: You're the only place in town where you can play Whirlyball, and you specialize in hosting group events like office socials and birthday bashes.

However, your customers have several other options to choose from, including:

• Escape Rooms (can even be hosted remotely to accommodate virtual attendees)

• Golf/mini golf (offers more flexibility than Whirlyball, which has a limit of 10 players per court)

• Live Theater (a great way to support nonprofits)

Now that we better understand our competitors, we can proceed to analyzing their pricing strategies. By examining their pricing structures alongside other factors like service levels, we can make informed decisions. To help us with this analysis, we'll be utilizing frameworks with real-world examples. Let's dive in!

How to Conduct Competitive Pricing Analysis to Stay Ahead of Competition

A Quick & Simple Guide to Competitive Pricing: Method A (Explanation)

To begin, we'll explain a quick and easy-to-follow two step framework (with some fancy terminology). After that, we’ll offer an example that everyone can relate to – apartment prices.

Step 1: Establish the Reference Product & Its Reference Value

• Identify the "reference product", which is the best customer substitute for your product or service (which can vary across customer segments)

• Use the price of this "reference product" as the "reference value"

Step 2: Evaluate Differentiation Value & Apply it to the Reference Value

• Identify the product's distinguishing factors, as perceived through the customers' willingness to pay (as explained in the previous article)

• Then estimate the “differentiation value” based on how the customer perceives the value of the features that are different from the competitor

• Take the “reference value” identified in Step 1, and then adjust the price (it may increase or decrease) based on the “differentiation value” determined above

Pricing Apartment Listing with Method A (Example)

I’m listing a 4 bedroom apartment, which is a unique item in the city, and I don’t have lots of time to conduct market analysis to set the listing price.

Step 1: Identify Closest Competitor to Apartment Listing & Its Price (Example)

Before searching, I establish the key factors in the eyes of customers are:

Example of competitive pricing: listing a 4 bedroom apartment

• Location: The competitor's location should be within a one-mile radius of my listing.

• Bedrooms: The competitor should have four bedrooms, the same as my listing.

• Baths: The competitor should have two full bathrooms, the same as my listing.

• Outdoor space(s): The competitor should also have outdoor space(s), the same as my listing.

• Condition: The competitor's property should be in good condition, the same as my listing.

Then, I go online to identify the closest competitor to my listing. The unit that I identify meets all the key factors above and is listed for $4000, which becomes my “reference value.”

Step 2: Compare Features Between Listings to Set Price for My Listing (Example)

I identify some key distinguishing factors to consider:

• Closest competitor has better natural light

• Closest competitor is further from train line

• Closest competitor does not offer private parking option

• Closest competitor does not have new appliances (i.e. stainless)

Here are the steps to finding the price for the listing unit:

1. Begin with the closest competitor's listing price at $4000.

2. Add $100 to my listing price for more convenient public transit options (which is valued at a minimum of $25/week)

3. Add another $100 to my listing for updated appliances (better function and appearance), bringing the price to $4200.

4. However, to be fair, my unit has less natural lighting, so subtract $100 from my listing, which brings the price down to $4100.

5. Since there is a lot of time to rent the unit (the lease would begin in 3 months) and the landlords are A+ rated, we list at $4200. We can easily reduce the price if interest is lacking.

Since we've successfully tackled apartment pricing with a painless competitive pricing framework, let's shift to a more intricate framework, including a B2B scenario.

---

Comprehensive Competitive Analysis: Method B (Explanation)

Got some extra time to research competitive pricing strategies? Check out this plan: Rather than simply basing your prices on the closest competitor, scout out multiple contenders. Think of it as an approach that Darby would take to maximize the value of his robot vacuum investment.

Expanding Market Presence for Boutique Consulting Firm with a Website Launch: Method B (Example)

This time, let's examine the competitive options by looking at them through the buyer's lens. In this case, a boutique consulting firm is considering launching a website to expand their market presence, and the Founder is faced with lots of choices:

• Outsource all aspects of website design, content creation, SEO research, and maintenance.

• Outsource certain aspects of the website project.

• Forgo the website entirely and invest time and/or money towards social media, paid ads, or other marketing avenues.

Step 1: Identify Competitive Products/Services for Website Launch (Example)

When considering website building options, the founder initially thinks of WordPress, but believes it may be too complex for her needs. To identify other options that might be more suitable for her small business, she jumps on g2.com to identify “website builder” options. After some research, she adds Wix and Squarespace to her list of potential options.

Step 2: Compare Website Builder Features to Make a Decision (Example)

Identifying Important Features

To support the analysis process, the Founder brainstorms a list of key factors that she values (assuming she does most of the work herself):

• Ensuring website is simple to set up

• Ability for website to become more intricate over time (i.e. events)

• Simple maintenance (i.e. add new content)

• Selecting vendor with a stable history

• Strong mobile features for positive user experience

• Availability of customer support from vendor and third-party options

• Product direction/roadmap (plan to stick with the product for around 3 years)

• Availability of Canva plug-in (ideal but not necessary)

Identifying Unnecessary Features

In addition, she creates a list of features that numerous products or services may provide but are not important to her, including:

• Translation or additional languages beyond English

• E-commerce capabilities

Constructing a Comparison Table

In order to compare website builder platforms, she utilized the brainstorm lists above to create a table that highlights the key features of the identified purchase options. For each key feature, she notes quantitative and qualitative data that is readily available.

During her evaluation process, she has identified several more features worth considering:

• Availability of free trial

• Storage capacity

• Metrics and analytics

• Video hours

Here are few methods to make a decision:

Compare Options by Assigning Feature Weights and Scores

1. Assign weights to each feature, totaling 100%. (This may vary depending on the customer segment/use case.)

2. Then assign a score to each product/feature. (This approach might work well for Darby’s robot vacuum where he can reference Consumer Reports, customer reviews, and ask friends about their product experiences.)

3. To determine which product offers the best value, calculate a score for each item and then compare it to its price. (If you’re lucky, the one with the highest score will be the cheapest. If not, you have to consider if the higher scoring options are worth the premium price.)

List Features in a Customer Journey Decision Sequence

To better understand the customer's decision-making process, try listing the features in the order of the customer journey decision sequence. This method can help identify which options buyers may eliminate early in the purchase evaluation process.

Here's how this method played out in real life:

1. The Founder of this boutique consulting firm tried the "free" version of each seller, attempting to create basic elements, such as a landing page.

2. With WordPress, the buyer felt "stuck" due to certain features being exclusive to the paid subscription. Furthermore, WordPress was flooding her inbox with multiple marketing emails every day.

3. Wix was quite user-friendly for the buyer who started building the website with gusto. Since the "free" version did not have a time limit, she had infinite time to experiment and could switch to the paid version (minus the Wix branding) when she was ready to launch. Of course, this was all contingent on whether or not she decided to go ahead with the website launch.

4. The buyer had heard good things about Squarespace from other small professional service firms; however, she found that some of the more nuanced options in Wix were not available in Squarespace and her trial was limited to 14 days, offering her less time to experiment with the platform.

5. After narrowing her options to Wix or Squarespace, the Founder delved into pricing, knowing that each brand has multiple options available with varying features for each. This is where the features like storage and video hours got considered.

6. For the features the founder needs, the prices were not significantly different. However, with Wix, the storage space seemed far simpler to understand. Ultimately, the Founder decided to stick with Wix as it gave her a zero-cost option with zero expiration until she decided to actually launch a website.

Keeping Up with the Competition: Monitoring & Dynamic Pricing

A key takeaway from the B2B website example is that the product with the most generous free trial won over a potential customer. The competitors were quickly left behind.

In the wild world of business, keep your eyes on the competition, especially new competitors. This is especially if you're using dynamic pricing. Stay on your toes and don't get caught off guard!

What’s Next: Our Last Stop on the Pricing Strategy Roadmap

Homework

• For your organization’s pricing models, work through a competitive pricing analysis similar to the examples shared here.

• Compare your results from cost-based pricing, customer value (as measured by willingness to pay), and competitive pricing.

• If you have time, check around to ensure that you've gathered all relevant competitor data worth considering.

What's Next

• In the final article of this series, we assimilate the strategies covered in this series and share implementation tips. Think of it like making a soup where each person has a “special” recipe – it's all about finding what works best for you (and your target customers). With the knowledge you have gathered, you can then set your prices with greater confidence!

• Subscribe so you don’t miss the final article in this series.

Here's what we're covering in the final article (#5)

Other Suggested Resources -Link to article 1 in this series -Link to article 2 in this series -Link to article 3 in this series

Revolutionize Your Revenue: How to Use Customer Willingness-to-Pay for Value Based Pricing

Welcome to the third installment of our series, Tuning Your Pricing Strategy: A 5-Part Guide." This series provides you with a roadmap (image below) to evaluate key pricing strategies and examples to develop optimal pricing.

Most recently, in #2 we focused on an example of cost based pricing. If you’re just joining the series, you can reference the links at the end of this article to catch up on earlier content before diving into this article.

Lately, We've ALL Questioned Purchasing Decisions

You (and your customers evaluate):

• “Did I get what I expected?”

• “Did I just pay more for less?”

"Price is what you pay. Value is what you get." - Warren Buffet

To further illustrate these concepts, I’ll share a quick story:

While visiting a chain restaurant, my partner and I were dismayed to discover that the beloved side dish was not available. Furthermore, the business did not provide any explanation, yet we proceeded to order.

Months later, we returned to the same restaurant but a different location, and not only was the signature item still unavailable, it was still listed on the drive-in menu, providing a false sense of customer hope! We arrived home with our order and were unpleasantly surprised that both of our side dishes were half empty (image below).

Our "half" sides

Understanding the Importance of Value-Based Pricing

If you read the article on cost-based pricing, you may have identified products or services in your organization that aren't as profitable as they could be. But don't despair!

Although analyzing cost-based pricing is important, it's equally critical to evaluate pricing based on the customer's value. Here's why:

• A discrepancy often exists between customer's willingness to pay and cost plus some basic markup

• Conducting a value-based analysis will help your organization better articulate the value of your product/service to customers, making it easier to retain current customers and attract new ones

• This pricing strategy is often utilized in the technology industry and among high-end goods

Remember, understanding the value your product or service brings to the customer is key to pricing it effectively.

My Experiences with Value-Based Pricing Strategy

I've conducted hundreds of analyses to inform purchase decision making for companies, boards, and my personal life, utilizing my education and work experience in finance and strategy. Similar to cost-based pricing, we aim to quantify whenever possible (but on the other side of the transaction - in the mind of the buyer!) to estimate customer value (which is ultimately compared to purchase price). Value-based pricing, unlike cost-based pricing, relies heavily on quantitative and qualitative analysis, making it more complex. To me, this makes value-based pricing interesting!

Let's get started!

What is Value Based Pricing? What Does "WTP" Mean?

“Value based pricing” is a strategy that primarily relies on customers' perceived value of goods or services to determine what to charge customers. "Willingness to pay" (WTP) is a term to describe the maximum amount a customer is willing to pay for a good or service. A buyer's willingness to pay may vary significantly from customer to customer. Here are some of the factors that contribute to this variation:

a. Customer's perceived need for the product or service

b. Customer's perception of benefits that the product or service can offer, which you can evaluate by:

• Listing out every possible customer benefit. (You can always decide later it is not significant.)

• Quantifying customer benefits in $ where possible (i.e. cost or time savings, incremental sales/revenue/income).

• Categorizing/describing qualitative customer benefits (i.e. risk).

c. Customer's perception of product/service quality

d. Customer's actual ability to pay (i.e. income, cash on hand, access to credit)

Dynamic Pricing Strategies & Their Relation to Value-Based Pricing

Customer willingness to pay is not fixed over time and may change due to factors such as: the economy, competitor offerings, and brand reputation (i.e. word-of-mouth, news headlines). Consequently, value-based pricing may be closely related to dynamic pricing strategy.

Combining Value-Based Pricing & Cost Based Pricing

By combining the insights from our previous article on cost-based pricing with this article’s focus on value-based pricing, particularly customer's willingness to pay, we aim to address the following question (see visual below):

Obviously, an organization can talk to customers and conduct surveys and focus groups to help identify customer's willingness to pay for products/services. However, how do buyers (i.e. business leaders, smart consumers) determine their $ WTP from a logical point of view?

Demonstrating Value-Based Pricing through Customer Willingness to Pay (WTP): An Example

To illustrate value-based pricing and customer WTP, let's consider Darby's customer persona, as he navigates the process of considering a robot vacuum purchase. (Side note: a similar process can be applied to B2B purchase decisions.)

Current situation:

• Darby currently has a well-functioning vacuum, so he considers purchasing a robot vacuum as a "want" rather than a "need."

• Darby has a monthly cleaning service which spends 0.5hr vacuuming and charges $40/hour.

• On the alternating weeks, Darby drags himself out of bed on weekends to vacuum himself. (Darby's partner hates to vacuum so takes on other chores to balance things out.)

• If someone stops over unexpectedly between vacuuming, Darby often hides due to his anxiety. Unfortunately, it is usually his grandmother who is always trying to use a gift of Darby’s favorite Temptations treats as an excuse to stop over. If Darby ghosts on his grandmother, he ends up buying the treats himself for $5/bag/week (~$260 per year).

Potential benefits of purchase:

• By switching to the robot vacuum, Darby can reduce cleaning costs by 0.5/hr per visit x $40/hour x12 months per year, which equals $240 per year.

• In addition, Darby can also eliminate the need for "active vacuuming” that he does on weekends, when he’d rather sleep in or consider working an extra hour at his fun weekend gig which pays $30/hour.

• Furthermore, the robot can run often, thereby reducing Darby’s anxiety about unexpected guests popping over. So Darby would program it to run daily to make sure he doesn’t miss grandma’s weekly visit with his favorite treats.

Willingness to pay:

• Darby has done initial research and knows he can purchase a robot vacuum for $240 or less, so he would easily breakeven financially with reduced cleaning service costs within one year after purchase.

• Darby knows he could also get up to $260 in “grandma treats.”

• Darby could either schedule more work hours or sleep in since he would not need to perform vacuuming himself.

• Darby sees this purchase as an investment (remember, he already has a functioning vacuum) and loves cool technology. Therefore, he will explore higher end products to assess if they are worth the extra cost compared to their features.

Ability to pay:

• Darby has two-earners in his household and they manage their personal finances well with no major competing $ priorities currently.

Below is a recap of key factors related to Darby’s WTP:

What's Next: Exploring Our Final Pricing Strategy

Homework:

• Begin by working through a value-based pricing analysis for your organization's pricing models identified in #1 article in series. Start with the simpler pricing model if you have more than one.

• Compare the results of your value-based pricing analysis based on this article to your cost-based pricing analysis from #2 article in series.

• Consider how dynamic pricing may relate to both cost-based strategy and value-based pricing strategy for your organization.

• To avoid underestimating your customer's willingness to pay and thus understating your potential profitability, conduct research to ensure that you are considering all potential "values." Additionally, seek other perspectives on the values you have assigned to your customers to avoid inadvertently overstating customer willingness to pay.

• Looking ahead, in the next article in this series (#4), we'll delve into competitive pricing and explore how value-based pricing and competitive pricing strategies are interconnected, as both rely heavily on customer perception.

Subscribe so you don’t miss next article in series, which focuses on competitor based pricing

If you would like to get more help with pricing strategy, contact me.

Other suggested reading: Link to article 1 in this series Link to article 2 in this series

Boost Your Bottom Line: Expert Tips for Cost-Based Pricing

Welcome to part two of our series: "Tuning Your Pricing Strategy: A 5-Part Guide." This series aims to provide you with a roadmap of pricing strategies and examples to develop optimal pricing.

If you missed it, check out part 1, which includes:

• Top 10 reasons to tune your pricing strategy

• Parallels between pricing activities and arcade game, Whac-A-Mole

• Definitions of foundational pricing terms

• Recommended homework to identify what pricing models you should build

Currently, we're at #2 on roadmap of series, "How to Win the Pricing Strategy Game"

Managing Costs is Important (Although Customers Don’t Care)

While customers mainly focus on your value compared to other competitors, it's critical to keep your expenses in check. Why? Costs have a direct impact on your profitability, which in turn impacts your organization's ability to deliver value – both in the short and long term. Later this series, we'll drill into the many ways value can be delivered when we examine pricing strategies related to customer value and competitors.

You might wonder why the first pricing strategy that we're diving into during this series is cost based pricing. Well, here are a couple reasons:

1. It is a critical pricing strategy to evaluate, because if you are losing money while selling products/services, your organization's sustainability is probably uncertain.

2. Cost based pricing is one of the most straightforward pricing strategies.

3. Competitors with a cost structure that results in more profit have an advantage in making strategic investments.

A Guide to Analyzing Cost-Based Pricing

This article discusses how to analyze cost based pricing using examples throughout. While service-oriented companies (such as consulting firms) and businesses with narrow profit margins (like restaurants) rely heavily on this pricing approach, it is crucial for all organizations to gain a complete understanding of costs and profits by product/service.

Next, take a moment to review the image below, which depicts cost challenges in classic arcade game "Whac-A-Mole" format. Then, consider the following questions:

1. What moles has your organization faced recently that have challenged its cost structure?

2. Does your organization have a clear understanding of its current cost economics regarding products/services and customers compared to sales revenue?

My Cost-Based Pricing Credentials & Commitment to Making This Topic Graspable

As a CPA with dual majors in finance and accounting and over two decades of experience in company finance, I’m confident that I can contribute useful insights on a topic that many find daunting. While this topic is heavy on math, I strive to simplify complicated concepts so everyone can follow along. Even a brief look through these concepts can be helpful. (If you prefer to skip this article for now, don't worry, you can subscribe to our series so you don't miss out on anything.)

Subscribe to Series

Key Cost-Based Pricing Objectives & Metrics

The "cost-based pricing" strategy involves determining the cost of a product or service and then adding a markup to that cost to arrive at a sales price. While this may seem simple, the intricacies of this approach get tricky!

The main objective of cost-based pricing is to ensure that the selling price of a product or service covers all costs associated with it, both variable and fixed, while also generating a reasonable profit margin. Here are some further details:

• Cover all costs: This includes direct costs such as materials (i.e. coffee for cup of cold brew) and labor (i.e. barista ) as well as indirect costs such as marketing (i.e. paid social media campaigns) or back office technology.

• Achieve a reasonable profit margin: While covering all costs is important, an organization also needs to actually make a profit to sustain itself; cost-based pricing aims to mark up the total cost to achieve a reasonable profit margin.

The Power of Cost-Based Pricing: A Guide to Analysis

Costs can vary drastically, even if two companies sell the exact same product; this may be due to differences in automation levels, geographic location, etc. For example, one company may produce furniture using robotic automation, while another may rely on manual labor resulting in higher variable costs. The same concept relates to fixed costs where one company pays for office rent in Manhattan and the other doesn't have a corporate office. Let’s run through a simple example of cost-based pricing analysis and key metrics, starting with paragraph format and followed by spreadsheet format...

Gross Profit Metrics: Basic Example

If a company generates $1 million in revenue and incurs $700,000 in direct costs to produce and sell products (also referred to as “cost of goods sold”), it would result in $300,000 of gross profit; gross margin % would be: $300,000 Gross Profit/ $1,000,000 Revenue = 0.3 or 30%, meaning that for every $1 of revenue, the organization keeps $0.30 as gross profit after accounting for cost of goods sold.

Net Profit Metrics: Basic Example

If this company has $200,000 in indirect expenses, Net Profit is calculated as $300,000 Gross Profit minus $200,000 Indirect Expenses = $100,000 Net Profit; Net profit margin is $100,000 Net Profit / $1,000,000 Revenue = 10%, meaning for every $1 of revenue the organization generated, they keep $0.10 as net profit after all costs.

If these costs spiraled out of control (i.e. supply chain challenges) or sales volume was significantly reduced by 75% (i.e. harsh new competition), the organization may face negative margins.

Key Questions for Cost-based Pricing Analysis

Before we jump into a more nuanced example to develop a deeper understanding of how actual cost items drive the aforementioned key metrics, below are some key questions for us to consider:

Cost-Based Pricing Example: Selling Cheesecake at Pop-Up Market

Let's consider the following scenario. I make cheesecakes and stumble across an opportunity to market them at a pop up event. For simplicity, let’s assume: -location does not have sales tax -transportation is not needed (everything is walkable in the neighborhood)

Below are the main steps related to cost-based pricing analysis:

1. Calculate all costs associated with producing the product or service, including materials and overhead expenses. (This is extremely important and tedious, so we break it down into many steps.)

2. Determine desired profit & determine selling price profit decisions may be highly discretionary. Simply, add desired profit to the total cost per unit.

Guidance: When doing pricing analysis, it's important to document all assumptions. For example, eggs may be a critical ingredient and a dynamic cost (i.e. $4 this week and $5 the next week) which then requires frequent tracking.

Let's dive into calculating all the cheesecake example costs and corresponding pricing...

Step 1A: Identify cost drivers. First, list ALL cost drivers to help determine the cost basis for products/services.

Guidance: In this brainstorming exercise, you should lean towards including every item; you can always decide it is not significant later.

Cheese cake pop up cost drivers are listed below and illustrated in the image below:

• pop up booth

• cheesecake ingredients (i.e. cream cheese, eggs, sugar, vanilla, crust)

• packaging for cheesecakes

• energy to bake cheesecakes (i.e. oven)

• energy to cool ingredients and cheesecakes (i.e. refrigerator)

• labor (we're not sure what's required yet)

• other (anything else that we might have missed)

Step 1B: Determine if each cost is fixed, variable or TBD (to be determined).Take each cost driver from step 1A and determine if it is fixed or variable, so we can eventually perform cost-based pricing calculations.

Guidance: Reference the “cost drivers” visual below and drop each cost driver into the appropriate cost bucket: fixed cost, variable cost, OR TBD.

You'll note that the pop up booth is categorized as a fixed cost. It does not matter if we sell all the cheesecakes or none, it is still $250. We are uncertain about our human capital needs yet, so that is categorized as TBD.

Step 1C: Decide the specific product(s) or service(s) to allocate costs across.

Guidance: Are we selling a single product or multiple products/services? If more than one, then cost allocations will likely differ for each one and therefore costs (and price) should be calculated separately for each product/service.

Obviously, I am selling cheesecake, but we need to decide the size, shape, and flavors to figure out economics per unit sold. To start, we keep our product simple, it's a 9 inch diameter round plain cheesecake.

Step 1D: Lay out your cost pools for variable cost drivers and underlying actual or estimated costs. This is key to start understanding your variable cost structure.

The first obvious cost pool is “ingredients” for each cheesecake, which will be assigned to units produced (number of cheesecakes) as the cost driver. We need to determine actual or estimated amounts for each ingredient and find a source for quick cost data.

Guidance: Try to draft initial cost estimates quickly to see what “ballpark” you might be in; then, you can fine-tune underlying assumptions.

Next, we consider costs associated with running the oven. It takes 45 minutes to bake each cheesecake. Looking at our gas oven, we can bake at least 6 cheesecakes simultaneously. From google.com, we learn that running a gas oven at 350 degrees costs between $0.10 and $0.23/hour. This cost data results in the calculations below:

We think about other variable cost drivers:

• Let's ask customers to bring their own bags to mitigate costs (plus our area has a "bag tax").

• The cheapest and easiest way to build capacity for cooling ingredients and cheesecakes is to borrow coolers and using ice packs on hand, resulting in $0 costs.

To summarize, variable costs per unit total $9.95 (Calculated as $9.92 for ingredients and $0.03 to run the oven.)

Step 1E: Lay out cost pools for fixed cost drivers and corresponding actual or estimated costs to calculate unit cost economics.

Guidance: Although there is a lot of judgment in fixed cost allocation methods, it’s important to be thoughtful, fair and accurate to make informed decisions about pricing.

Thankfully, our only fixed cost is the $250 pop up booth. We start thinking about how many total units to produce so we can allocate this cost over the # of cheesecakes. To ensure the cheesecakes are fresh, we are only baking for one day for up to 8 hours. Based on this, below are a couple scenarios related to total cheesecake volumes and spreading the $250 of fixed costs:

If I only produce 32 units, the fixed cost allocations drive up total cost per unit to $17.86 However, with 64 units, we enjoy lower total costs per unit of $13.86. By allocating fixed costs across more units, we have more opportunity to make a decent profit per unit, so we decide to make 64 units.

I haven't factored in my labor yet; however, I estimate that I spend a total of 20 hours between planning and attending the pop up, shopping and baking/distributing. For this event, I will not need any additional labor.

Step 2: Determine desired profit & selling price

If we price the 64 cheesecakes at $25/unit and sell out, I get $713; at $20/unit, we only make $393 (reference table below).

I decide that I want $500 profit for my time and want to reduce the risk of leftover cheesecakes by offering a fair price. So, I figure out the selling price to hit that $500 profit target, which is $21.67 for the 64 units, calculated as follows:

1. Variable cost $9.95/unit times 64 units equals $636.80

2. Plus fixed costs of $250.00

3. Equals total costs of $886.80

4. Add $886.80 total costs plus $500 target profit to get $1,386.80 sales revenue needed

5. $1386.80 revenue divided by 64 units results in $21.67 price per unit

We can use a formula similar to what is above to calculate what price would result in breakeven (profit of $0) for 64 units.

Are There Opportunities to Reduce Cost Structure?

We can consider:

• Shifting from name brand to store brand for sugar, vanilla, and cream cheese

• Looking for other vendors for crust because even the store brand is pricey

Important Odds & Ends

Let's briefly touch on a couple items that we didn't cover yet:

• If you have staff, it is essential to calculate fully loaded costs (i.e. gross pay plus payroll taxes and benefits) to make sure you are not understating costs and overstating profitability.

• Regularly consult with a tax-specialized CPA to avoid unexpected surprises when it comes to tax matters. (Taxes are always changing!)

Where Do We Go From Here?

• For your organization’s pricing models (identified in series #1 homework), try to work through a cost analysis process similar to the cheesecake example and work through the checklist questions.

• Guidance: Start with the simpler pricing model first to gain momentum and hit the ground running. For example, with the recreational client referenced in the prior article, we started with the food pricing strategy and model, because it was simpler than lodging, which ranged from a tent to an elaborate lodge and involved more cost drivers and complex allocation calculations.

• If you have time, talk to your accounting/finance team or other coworkers to make sure you think of all costs; otherwise, you may underestimate your actual costs and therefore overstate your product's profitability.

• Look for the next article (#3) in this series, where we focus on value based pricing, which includes understanding customer’s willingness to pay, which will be entirely different than cost.

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If you need more assistance with tuning your pricing strategy, you can reach out to Katherine:

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