Pricing a product or service correctly can be a problem. You can almost never know exactly what people are willing to pay at a given place or time. Some people will expect to pay exactly the same thing regardless of differences between products. Other people may be willing to pay different prices for exactly the same thing.

This is the short response: Expect to get pricing wrong. Almost everyone does.

Let’s get it less wrong then, together.

Here are five ways to set a price, in descending order of desirability...and difficulty.

Economic pricing

Using sales and marketing data, determine the mathematic formula for the demand function – the changing amount of a product the market will consume at a series of different prices. Then pick a price in that series in which your marginal cost – the cost to you to make one more unit of goods – equals the marginal revenue you receive for selling those goods. That point maximizes your profit. 

Why this is good: This is the mathematically, economically correct way to set a spot price, and maximizes your short-term profits. It doesn’t depend on your competitors to signal a correct price. It allows you to predict the effects of a price change and the profit impact of changes to your variable and fixed costs. It also allows you to gauge the effects of competitors and changing customer demand on your prices.

Why this is bad: First, demand function data useful enough to make these calculations is usually difficult and expensive to acquire. You’ll need months if not years of data from your own business, or access to serious marketing research. Second, the data itself is almost never perfectly accurate for anything less than global commodities, which means you may be more confident in your pricing decisions than you have any right to be. Third, if your product is really different from others in the market, it’s hard to use demand data from competitors to draw your own charts. And last, if you fully understand economic modeling enough to apply this successfully, you probably don’t need to be reading this.

Value-based pricing

Estimate the value your product or service gives to a client, then sell it for something less than that, based on your competitors’ prices and your costs. For some products, figuring out how much value you provide can be easy. If a new widget will save a $25-an-hour mechanic an hour a day for a year, your widget is worth $9,125 to him. If it costs you $5,000 to produce, you’ll be selling your gear somewhere between $5,000 and $9,125 a unit, depending on your competitors’ prices for similar products, among other factors. Most of the time, it’s not quite this cut and dried.

Why this is good: You’re doing more than just guessing at the right price based on competitors’ pricing – you’re assigning a value based on what you can do well and what customers want. That will help prevent you from trying to compete solely on price and driving your profits into the ground. If you can’t clearly articulate your product’s unique value, you probably shouldn’t be selling it. Using this method also means you’ll be trying to understand just what your customers want and your place in the market, which is how business is supposed to work.

Why this is bad: You’re still relying to some extent on your competitors to help set prices, which always stinks. This method breaks down when you’re offering something really, really difficult to value to the market, like some kinds of art and brand new technology, to which you may have no similar products to compare. Customers may not always be able to clearly articulate their value to you, or the value may be so different for so many customers that getting a read on this becomes really difficult.

Auction-based pricing

Put your product up on eBay (or its equivalent) and see what it sells for. This is pretty cut-and-dried. You might shove your gear on Craigslist with a “make me an offer” tag on it. Or perhaps there’s a formal auction market for your products and services.

Why this is good: You’ll sure know what someone is willing to pay for your stuff. Your competitors can affect your prices only by adding more material to the market at a lower fixed price. And if you gather enough of this data over time, you can start to build a demand function for economic pricing.

Why this is bad: If a perfectly liquid market exists for your stuff, then you’re selling a commodity. Small businesses making and selling commodities is usually a very bad thing. If your market isn’t really all that liquid – if there are wild changes in the prices, or a small number of buyers in the auction – then you’re not really getting an accurate picture of your customers’ needs. If you sell some stuff on eBay at a really low price because buyers are scarce, you may signal poor quality, or worse – urge them to wait for the next “sale” on eBay instead of buying your stuff through the usual channels.

Competition-based pricing

Use your competitors’ prices. Mark your stuff up or down, depending on how much better or worse you think your stuff is than the market leaders’ stuff, what kind of profit margin you can stand, and whether or not you want to take away market share based on your prices.

Why this is good: You don’t need to guess at what your competitors are charging. You can see that in the market. Your prices will be as competitive as you want them to be. This is dead simple. This is the most common method, is said to reflect the common wisdom, and it’s similar to value-based pricing.

Why this is bad: First, you’re assuming your competitors know what they’re doing. They may have the market priced all wrong.  Second, you’re not taking your customers into account at all – they may value your product much differently than they value your competitors’ stuff, or be more flexible in pricing than you’re giving them credit for. And the market leader may be sacrificing profitability for market share with a lower price than warranted.

Cost-plus pricing

Take your cost of production per unit, then add a set value to that. Companies use cost-plus pricing to make sure they’ve hit a desired return on investment. In some industries, like construction, cost-plus pricing is standard for making a bid. The expected mark-up percentage can be well known, depending on the product or service. Real estate agents use a six-percent sales commission as a standard price to sell a house, for example.

Why this is good: It’s simple. There’s no estimating value to a customer, and no dependence on competitors for pricing cues. Banks and investors can like the predictability of a profit-projection using cost-plus pricing.

Why this is bad: Those same bankers will want to know if anyone is willing to buy at those prices. If you have any sense of what the demand for a product will be, you can (and should) use another method. This is the worst pricing process around, but sometimes it’s what you’ve got.

Consider three more things when trying to figure out what to charge.

• It’s hard to raise prices once your customers get use to a price. Companies will do everything they can to keep from raising a price in a competitive marketplace, because customers can be very sensitive to price changes, especially in a bad economy or when there are close substitutes for your product.
• Your customers will infer a lot about your product – and your company – from its price. Pricing below your competition will tell some consumers that they can get a better value from your product. Others will infer that you’re offering an inferior product.
• So will your competitors. If you price lower than your competitors for a similar product – and you market your product as similar – then you’re asking for a price war. If you steal enough market share from a competitor this way, you’ll get one. Most of the time, you’re going to want to differentiate your product – by offering something better or more convenient or just plain different. You’re less likely to spark a price war like that.