This post was written by John Teel and reposted with permission from the Predictable Designs blog
When developing a new hardware product, setting the price is one of the most important decisions you’ll make. You need to get your pricing right as early as possible. If you mess this up it will be difficult to fix later. Pricing is a complex decision with many variables. In fact, there are entire books written on the subject of pricing. This article will give an overview of the factors you should consider when setting a price point for a hardware product.
Software and online products can use A/B testing to determine the most profitable sales price. Unfortunately this isn’t really an option for physical products. Once you set a price for your hardware product it becomes significantly difficult to increase it. Decreasing the price is more easily accomplished. In most cases you’re better off pricing your product on the high side since you have the flexibility to lower it if necessary. However, if you start with a price too high then your early sales might be too low. If your product doesn’t sell well initially, it will be difficult to recover. Either way, it’s best if you can hit the ideal retail price as early as possible.
Positioning Your Product
Where in the market do you plan to position your product? Will your product be something that only appeals to luxury buyers, or will it be targeted at the broader consumer market?
For example, if you develop a wearable fitness tracker will it be targeted at the general consumer who desires only the basic features and a low price point?
Or will it be aimed at more serious exercisers willing to pay a bit extra for more features? Or finally, perhaps your device will be targeted to professional athletes willing to pay for a top of the line product?
The price needs to reflect the demographic that will be most likely to purchase your product. Gathering basic demographic data on your target market is a good first step.
What’s their gender, income level, age, family size, location, etc.? You may want to get more advanced and create behavioral profiles of your ideal customers. The goal is to understand not only who buys, but why they buy.
Your pricing strategy absolutely depends on your distribution strategy. If you sell your product on your own website your profit margins will be much higher than if you sell through retail outlets. However, you’re likely to achieve much higher sales volumes and better name recognition by selling through large retailers.
Most new hardware startups begin by selling their product on their own website, then later migrate to retail. But be careful. Even when selling your product on your website you need to price it for retail distribution.
You don’t want to undercut your retailers by offering the product for less on your website. One way around this is to have a slightly unique version of your product that is only sold on your website. This eliminates any direct competition with your retail outlets.
You’re likely to end up with various distribution channels, each with their own associated costs. For some large retailers, you may need to go through a distributor who takes a percentage.
For other retailers, you may have an independent sales representative that takes a commission on each sale. You need to incorporate all of your distribution channels into your pricing strategy.
Although there are three pricing strategies that we’ll discuss shortly, the first calculation you need to make is the Cost-of-Goods-Sold (COGS). This is ultimately how much you pay for your product. Without knowing the COGS for your product you have no way to know if your product can make a profit.
The COGS includes not only your product’s manufacturing cost, but also other costs such as packaging, shipping, warehousing, and import/export duties.
You can look at your product’s COGS as the pricing floor. If you sell your product for anything less than the COGS you will lose money with each sale. The COGS is your break-even sales price. As I discuss in detail later, your COGS will be significantly reduced as your manufacturing volume increases.
Definition note: I tend to use Cost of Goods Sold (COGS), manufacturing cost, production cost, and landed cost interchangeably; however, each really has a specific definition.
Manufacturing cost only includes the actual cost to manufacture the product.
COGS includes all direct costs associated with producing the product.
Production cost is technically defined as all business expenses for a company producing products.
Finally, landed cost is the total cost you pay for your product once it reaches your warehouse or distributor.
I’m an engineer and entrepreneur, not an accountant, so I frequently use them all synonymously. But, in most cases I technically mean COGS.
Calculating the COGS for your product as soon as possible is critical but by no means simple. Most entrepreneurs make the serious mistake of waiting until their product is fully developed and ready to manufacture before they calculate the manufacturing cost.
Don’t wait, you need to estimate your product’s cost well before you spend serious capital to develop it.
Here’s a quick summary of what makes up the Cost of Goods Sold (COGS):
- Electronic components (microchips, sensors, connectors, etc.)
- Printed Circuit Board (PCB) production
- Soldering all of the components on to the PCB
- Injection molded plastic parts (enclosure, etc.)
- Miscellaneous mechanical components
- Final product assembly
- Quality testing
- Manufacturing scrap (no manufacturing process is perfect)
- Customer returns
- Logistics and warehousing
- Import/export duties (taxes)
There are three strategies for pricing a new product: cost-based, market-based, and value-based. Instead of focusing on any one pricing strategy I believe it’s best to consider all three.
Pricing Strategy 1: Cost-Based Pricing (Bottom-Up)
To calculate your cost-based price you simply take your product’s COGS and add on the profit:
Cost-based Retail Price = COGS + Profit
Also, don’t make the mistake of ordering a huge quantity of your product just to get better pricing. Initially, you should always prioritize minimizing risk over maximizing profit.
You need to start small and ramp up gradually to be sure your product sells as expected and to work out any bugs. If you can only break even on your first run that’s okay – as long as your calculations show your profit margins increasing significantly at higher production volumes.
For your initial production runs, the volume will be so low that it’s likely impossible to make much profit.
Of course, you could charge more for your product during this stage but that’s unlikely to work. No matter how unique your product may be, you will have competitors that limit how much you can charge.
Your competitors are manufacturing at much higher volumes and their price reflects this fact. You can’t compete if you price your product based on low volume production pricing. Instead you must price it based on the COGS once you are running higher production volumes.
Using cost-based pricing alone to set the price of your product is a not a good idea. This is because it ignores two very important things: competition and the buyer. This is why you need to incorporate all three pricing strategies.
Pricing Strategy 2: Market-Based Pricing (Top-Down)
Whereas cost-based pricing is a bottom-up strategy, market-based pricing starts at the top by researching the prices of competing or similar products.
With market-based pricing you set your product’s sale price based on what your competitors are charging for their solution. Research all of the competing products on the market and determine where you want your product to fit in the mix. Typically, the sales price and the features determine the position it will occupy in the market.
The big concern with market-based pricing is to not price your product so low that you can’t make a sustainable profit. For example, if one of your competitors is a large company manufacturing massive quantities of product, then it will be difficult for you to compete.
Unlike a company such as Apple, you won’t be manufacturing millions of units so you won’t be able to compete on price alone. This is why you need to set your product’s market position based on more than just price. You’ll be much better off if you compete on innovation and not price alone.
With market-based pricing the manufacturing cost and buyer are the forgotten variables. Once again this is why you need to merge all three pricing strategies.
Pricing Strategy 3: Value-Based Pricing
Finally, we get to the end buyer. Value-based pricing incorporates buyer psychology into the price. A value-based price is primarily based on the value it provides to the buyer.
The easiest value-based example to consider is a product that saves the buyer money. For example, let’s say your product is an energy saving device which reduces the electric bill for the average household by $300 dollars a year. It’s an easy connection to say the product’s value is at least $300.
In reality, value-based pricing must also incorporate competitor pricing into the pricing equation. Although your energy saving device may save the user $300 per year, competing solutions may be on the market for only $100.
The key is to differentiate your product enough from the competition so the value to the buyer will be the dominant factor in their purchase decision.
As discussed in the excellent book The Hardware Startup, finance people typically prefer cost-based pricing, sales people prefer market-based pricing, and marketers prefer value-based pricing. Being an entrepreneur, you likely fill all of these roles so you’ll need to look at pricing from all three viewpoints.
I recommend that you first start by calculating your product’s COGS. From there, you can come up with your cost-based sales price.
Next, perform a market-based pricing analysis to see where it intersects with your cost-based price. Ideally, the market-based sales price falls within 3-4 times your COGS.
For comparison you should assume a manufacturing volume of around 10k pieces. That’s a high enough quantity to allow you to achieve much better volume pricing, but it’s still a low enough volume that it’s a realistic early target.
Finally, perform a value-based pricing analysis to see if the value your product provides to users is higher than the product cost or competing products. In the end, your cost-based price is likely to serve as the pricing floor, while the value-based price will be the ceiling price. Based on the competition your sales price will fall somewhere between these two limits.
Although pricing experts will tell you that value-based pricing is the way to go, I typically find that unless your product is truly revolutionary, competition will dictate that market-based and cost-based pricing are more important.
Of the three strategies cost-based and value-based pricing will be the most difficult to accurately estimate. Calculating your value-based pricing is challenging because determining how much “value” is provided to your customers isn’t easy to estimate.
As I explained previously, it takes a considerable amount of work to estimate the COGS for your product, and it requires a significant amount of engineering effort. But it’s time and money well spent.
Ultimately, performing the cost-based, pricing analysis is one of the most important first steps you can take. Any pricing analysis will be of limited use until you know your manufacturing cost.
Without knowing your manufacturing cost you have no way of estimating your profit. If you have no idea how much profit you can make then any pricing strategy will be limited.
Be sure to download your Ultimate Guide: How to Develop and Sell Your New Electronic Hardware Product.
This article was written by John Teel and was originally posted on Predictable Designs, a company which helps entrepreneurs bring new products to market.