How To Decide What To Charge

In the 1990s, Porsche was in trouble. The company was small, its sales had fallen, and it was carrying a lot of debt. It needed a new car that would sell, and it decided to try something it had never done before: build an SUV.

That was a risky bet. Porsche was known for sports cars, not family vehicles. So before its engineers designed anything, Porsche worked with the pricing firm Simon-Kucher to answer two questions: would people even want an SUV from Porsche, and how much would they be willing to pay for one compared with an SUV from BMW or Mercedes?

The company told its product team to find out exactly what customers wanted in a Porsche SUV and what they would pay for it. If customers weren't willing to pay a price that would make the car a success, Porsche would walk away from the project.

Every feature had to prove itself. Features that most customers valued and would pay for became standard. Features only some customers wanted became paid options. Customers even convinced Porsche's engineers to include large cup holders.

Porsche built the car around the price, instead of building the car first and figuring out the price at the end.

The Cayenne launched in the early 2000s. It went on to help Porsche pay down its debt, earn the highest profit per car in the auto industry, and eventually account for about half of the company's sales.

Most people who start something do it the other way around. They build the product or plan the service, and then, at the very end, they stare at a blank space where the price should go. They look at what competitors charge, add up their costs, guess, and usually pick a number that feels safe, which often means low. Then they wonder why they're working so hard and making so little.

In Vol. 1, we covered where the money in a business comes from: people pay when they get something they value more than what they give up. In Vol. 2, we covered how to find out whether people will pay at all, and in Vol. 3, how to build the smallest version of your idea.

This issue covers the question that sits between all of them: how much should you charge? We'll follow Marcus, the real estate agent from Vols. 2 and 3, as he works out what to charge for the community he built for new agents.

First, a few terms. Your price is what a customer pays. Your cost is what it takes you to deliver the product or service. The difference between the two, for each sale, is your margin. And profit is what's left after all your costs for the whole business, like rent, tools, and your own time, are paid.

Small changes in price have a much bigger effect on profit than most people expect. In 1992, Michael Marn and Robert Rosiello of the consulting firm McKinsey published an analysis in the Harvard Business Review looking at the average finances of nearly 2,500 companies.

For the average company, a 1 percent increase in price, with no loss in sales, increased operating profit by 11.1 percent. By comparison, a 1 percent increase in sales volume raised operating profit by only 3.3 percent, a 1 percent cut in variable costs raised it by 7.8 percent, and a 1 percent cut in fixed costs raised it by 2.3 percent.

The reason is simple once you see it. When you raise your price, the extra money goes straight to profit, because it doesn't cost you anything more to deliver the same product. When you sell more, you also take on the costs of delivering more. That's why price is often the most powerful lever a business has.

It works the other way too. A price that's a little too low takes a big bite out of your profit, even if you're busy. Plenty of small business owners work long hours with full schedules and still barely get by, because every sale brings in a little less than it should.

When Marcus launched his community in Vol. 3, he picked $40 a month because it seemed reasonable and wouldn't scare anyone off. With 18 members, he was bringing in $720 a month for the calls, the group chat, and the time he spent answering questions. He liked running it, but at that price, it would never be more than a side project.

There are three basic ways businesses set prices. Many people use one of the first two without realizing there's a third.

You add up what it costs you to make or deliver something, then add a markup on top. If a candle costs you $6 to make and you want a 50 percent markup, you charge $9. It's simple, and it guarantees you cover your costs.

But it ignores the customer completely. The price has nothing to do with what the candle is worth to the person buying it, so you might be charging far less than they'd happily pay, or more than they ever would.

You look at what others charge for something similar and price close to them, often a little lower to win customers. This at least connects your price to the market. But it assumes your product is the same as theirs, and that their price is right. Often neither is true. Many competitors picked their prices the same way, by looking at someone else.

You set your price based on what your product is worth to the customer. This goes back to Vol. 1: people pay when they get something they value more than what they give up. The most a customer will pay for something is called their willingness to pay. Value-based pricing starts there.

The best way to think about it is as a range. Your costs set the floor, since you can't charge less than it costs you and stay in business. The customer's willingness to pay sets the ceiling, since nobody will pay more than it's worth to them. Competitors' prices show you what customers can compare you to, which affects how much they'll pay. Your price belongs somewhere in that range, and value-based pricing means aiming closer to the ceiling.

Marcus had priced off his costs and his nerves. When he thought about value instead, the picture changed. For a new real estate agent, closing one extra deal can mean several thousand dollars in commission. His members said the community had helped them get their first deals. Next to that, $40 a month was a tiny fraction of what the help was worth to them.

Customers don't judge a price on its own. They compare it to something. Researchers call that something a reference price: a number in the customer's head that makes your price look high, low, or fair. It might be what they paid last time, what a competitor charges, or simply the other prices on the same page. Several well-studied effects come from this.

The first number someone sees pulls their judgment toward it. In a classic 1974 study, the psychologists Amos Tversky and Daniel Kahneman spun a wheel of fortune in front of people, which landed on a number that had nothing to do with the question, and then asked them to estimate the percentage of African countries in the United Nations. People who saw a higher number on the wheel gave higher estimates.

If a meaningless number can do that, the first price a customer sees from you does too. Some businesses show their most expensive option first for this reason.

In 2003, Eric Anderson and Duncan Simester published the results of three field experiments with a women's clothing catalog, where different customers received catalogs with different prices for the same items. In one test, raising the price of a dress from $34 to $39 increased sales by about a third. Raising it to $44 instead made no difference in sales compared with $34.

Across their experiments, prices ending in 9 increased demand, and the effect was strongest for new items, where customers had less to compare the price to.

When people can't easily judge quality, they often use price as a clue. In a 2008 study, researchers at Caltech and Stanford, led by Hilke Plassmann, had 20 people taste wines while their brains were scanned. The people were told the price of each wine, but some of the wines were actually the same wine labeled at two different prices.

People said the same wine tasted better when they were told it cost $90 than when they were told it cost $10, and activity in a part of the brain linked to the experience of pleasure was higher too. A price that's too low can make people wonder what's wrong with your product.

How you lay out your options changes what people choose. In 1982, Joel Huber, John Payne, and Christopher Puto showed that adding a third option that's clearly worse than one of the other two makes the better one more attractive. They called it the decoy effect.

A few years later, Itamar Simonson found that when people see three options, many of them choose the one in the middle, because it feels like a safe compromise between paying too much and getting too little.

None of these should be used to trick people into paying for something that isn't worth it. A customer who feels misled won't come back, and Vol. 1 already covered why value built on deception doesn't last. But they're worth knowing, because customers react to them whether you plan for them or not. If you only offer one cheap option, you're still setting the anchor, and it's a low one.

Many people starting out charge too little. A few reasons come up again and again.

They price from their costs. If something costs them $10 to make, $20 feels generous, even if it's worth $60 to the customer. Their own costs feel real to them, and the customer's value doesn't.

They're afraid of hearing no. A low price feels safer, because it seems less likely to be rejected. But a price nobody ever objects to can be a sign that it's too low. If every single person says yes without thinking, you're probably leaving money behind.

They compare themselves to the biggest players. A new coach looks at a famous coach charging $500 an hour and thinks they should charge $30. A new bakery looks at a grocery store's prices. But a small business usually can't win on being the cheapest, and it doesn't need to. It can win by being better for a specific group of customers, which is worth charging for.

They don't count their own time. Many beginners leave out the hours they spend making, delivering, answering messages, and doing everything else. When you count your time, a price that looked profitable can turn out to pay very little per hour.

Marcus recognized all four. He had priced off what it cost him to run the community, which was almost nothing. He had worried that a higher price would make people leave. He had compared himself to free Facebook groups for agents. And he had never counted the six or seven hours a week he spent running calls and answering questions.

In Monetizing Innovation, Madhavan Ramanujam and Georg Tacke argue that the most important step is simply talking to customers about price, and doing it early. Start by talking about the problem and the value of what you offer.

Then move to price, with questions like "What would you consider an acceptable price for this?" This connects directly to the customer conversations in Vol. 2.

They also warn against averaging the answers. If some customers would pay $20 and others would pay $100, a price of $60 is too high for the first group and leaves money behind with the second.

When you see answers clustering into groups like that, it usually means you have different kinds of customers who need different options, which is where the next part comes in.

A widely used method for this, developed by the Dutch economist Peter van Westendorp in the 1970s, asks customers four questions:

• At what price would this be so cheap that you'd doubt its quality?
• At what price would it be a bargain?
• At what price would it start to feel expensive, though you'd still consider it?
• At what price would it be too expensive to consider?

Ask these to 10 or 20 people who fit your customer, and you'll start to see a range: the price below which people get suspicious, and the price above which most of them walk away. Your price should land somewhere inside that range.

What people say they'll pay isn't the same as what they'll actually pay, as Vol. 2 covered. So once you have a range, test a real price. Offer it to new customers and watch what happens.

If you can, try two different prices with two different groups of new customers and compare. Pay attention to how people react: if almost nobody pushes back, you can probably go higher. If most people hesitate or say no, look closely at whether the price or the offer is the problem.

Marcus asked his 18 members the four questions. Most said $40 felt like a bargain. Many said $100 a month would feel expensive but worth considering if it came with more direct help, like having him review their deals. A few said they'd pay several hundred a month for one-on-one coaching. Almost no one said $40 was too much.

One of the most useful things you can do with your pricing is offer more than one option. A common version is three levels, often called good, better, best: a basic option, a fuller option, and a premium option.

This does a few things at once. It lets customers with different needs and budgets each find something that fits, instead of forcing everyone into one price that's too high for some and too low for others, the averaging problem from section 06.

It sets an anchor: the premium option makes the middle one look more reasonable. And because of the middle-option effect Simonson found, many people will choose the middle level, so it's worth making that your main offer.

Monetizing Innovation recommends building these options around what different groups of customers actually value. Features that almost everyone wants and will pay for belong in every level. Features that only some customers value go into the higher levels.

And features that would make a customer refuse to buy if they were forced to pay for them should be left out of the basic option entirely. That's the same approach Porsche used with the Cayenne's standard features and options.

Based on what his members told him, Marcus built three options. The basic membership, at $49 a month, included the group chat, the recorded answers, and the twice-monthly group calls. The middle option, at $129 a month, added a monthly small-group session where he reviewed members' actual deals and listings. The top option, at $399 a month, added a one-on-one coaching call with him every two weeks, limited to five members, since his time was limited.

If you've been undercharging, at some point you'll need to raise your prices. Many people put this off for a long time, because they're afraid of losing customers. Some customers may leave. But as section 02 showed, a higher price brings in more profit from every customer who stays, so you can often lose a few customers and still come out ahead.

A few things make a price increase go better:

• Give notice. Tell existing customers ahead of time, so they aren't surprised.
• Explain what they're getting. If you've added value since they joined, say so. If the price simply hasn't kept up with what you deliver, say that plainly.
• Consider keeping your earliest customers at their current price for a while. It rewards the people who took a chance on you early, and keeps them on your side.
• Raise prices for new customers first. That lets you test the new price without asking anyone to pay more than they agreed to.

Marcus gave his 18 original members three months' notice that the basic membership would go from $40 to $49 for new members, and told them their rate would stay at $40 for the rest of the year as a thank-you for being first. Over the next four months, two original members left.

Six moved up to the $129 option, one took a spot in the $399 option, and new members kept joining at the new prices. By the end of that stretch, he had 26 members and was bringing in nearly three times what he had at $40 a month. He was spending a few more hours a week, mostly on the deal reviews and coaching calls, but each of those hours was now paid for.