Business plan financial projections usually start with a projection of revenue based on the number of units sold multiplied by the selling price per unit. In order to produce the revenue projection the business first needs to establish its product selling price using a pricing model. Three examples of pricing models are discussed below.
The 3 Pricing Models
- Cost based pricing model
- Competitor based pricing model
- Value based pricing model
Cost Based Pricing Model
The cost based pricing model uses the cost of a product and calculates the selling price needed to achieve a required gross margin percentage.
The formula used in the cost based pricing model is as follows:
For example, suppose a business estimates that its cost of producing a unit is 4.80, and wants to achieve a gross margin percentage of 60%, then the required selling price using the cost based pricing model is calculated as follows:
Selling price = Cost price / (1 - Gross margin %) Selling price = 4.80 / (1 - 60%) Selling price = 12.00
At a selling price of 12.00 and a cost price of 4.80, the business will make a profit of 7.20 on each unit sold. This profit equates to the required gross profit percentage of 7.20/12.00 = 60%.
While simple to calculate, the cost based pricing model is only useful for estimating what the selling price needs to be. If takes no account of the market in which the business operates, and for this reason, while it can be used in a market where there are substantial cost advantages, it should not be used when the market is highly competitive.
If the price is substantially different from the market driven price, then the business needs to review its costings and required gross margin percentage to establish a new price.
Further details of the use of gross margin percentage and mark-up can be found in our mark-up on cost tutorial.
Competitor Based Pricing Model
The competitor based pricing model uses the competitors prices as the basis on which to set the selling price.
The model involves carrying out research on competitor products and prices, and then deciding whether to set a price below the competitors prices, to drive competitors out, or alternatively, if the competition is low, setting a higher price. In practice most start-up businesses will have to set their prices at a similar level to their competitors and attempt to distinguish their product using features other than price, such as quality or service delivery etc.
Value Based Pricing Model
Value based pricing, sometimes referred to as customer based pricing, uses the value the product has to customers in order to set the selling price. In this context, the term value refers to the amount the customer is willing to pay for the products.
In order to arrive at a value based selling price, the business needs to understand the market and its customers by carrying out research into how much a customer is prepared to pay.
One technique often employed is to change the selling price of the product for a period of time, monitor how it affects demand, and then compare the total revenue for each price point to find the optimum selling price.
For example, if a business increases the price of a product from 10 to 12, and over the period of a month unit sales drop from 1,500 to 1,400, then the total revenue comparison is as follows:
Revenue = Selling price x Units sold Revenue at price 1 = 10 x 1,500 = 15,000 Revenue at price 2 = 12 x 1,400 = 16,800 Change in revenue = 16,800 - 15,000 = 1,800
Setting the price at 12 has resulted in an increased revenue of 1,800.
Suppose the business now attempts to set the price at 13 and finds that the demand falls to 1,250. Again the total revenue calculation is as follows:
Revenue = Selling price x Units sold Revenue at price 3 = 13 x 1,250 = 16,250
While setting the price at 12 results in more revenue, increasing the price further to 13 has resulted in a fall off in demand and a lower total revenue. This indicates that in this particular example, the value based price should be set at around 12 to achieve maximum revenue.
Using the Three Pricing Models Together
In practice a combination of all three pricing models should be used to establish the best selling price for the product. For example, the following steps could be taken:
- Use the cost based pricing model to establish the selling price needed to achieve the required margin.
- Use the competitor based pricing model to decide whether the price in step 1 is achievable in the current market place. If not, adjust the costings or the required gross margin percentage to bring the selling price in line with competitors.
- Use the value based pricing model to adjust the price in line with the amount research shows the customer is willing to pay.
Use in the Financial Projections Template
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.