Setting prices for online retail stores, like setting prices in any context, is as much an art as a science. It’s not easy to know where to begin, and you’ve got to continually adjust in response to various factors like cost and demand. There are many strategies to setting prices, and I’m going to go through a few of the most popular.

Cost + Margin

Cost plus margin is a common strategy, especially in new businesses or new product launches. It’s popular because it’s so simple. You calculate your cost for a product, you select a target margin, add that to the cost, and that’s your price. Determining your cost is particularly important to this strategy, and costing is a topic that merits its own post. Briefly, your cost per product is going to be your overhead, i.e. costs that don’t vary based on the number of sales, plus your variable cost, or the cost you pay per sale.

Cost

For online stores, overhead will be things like your hosting fees and any fees you pay for software or services. In my case, running an online retail store focused on dropshipping, my overhead includes my Shopify subscription. You can get very detailed here and include things like the depreciated value of the computer you use, even the cost of the electricity used to run it. If you have staff that you pay on a regular basis or rent space for inventory, that will fit here, too. Once you know your overhead, you estimate your sales for a given period, divide your overhead by that number, and add that to the unit cost. Variable costs will be things like shipping and taxes. In some cases, labor can be a variable cost if, for instance, you pay someone royalties on each sale.

It’s worth making special note of marketing costs here. Where you pay a flat fee for marketing, that’s going to be overhead. If you pay for something like Cost-per-Click advertising, that, too, is overhead, despite the fact that it varies, because it doesn’t vary based on your sales. The latter is something I have certainly learned, somewhat painfully. On the other hand, affiliate marketing, for instance, would be a variable cost. In a sense, you’re paying the affiliate a commission on each sale.

Margin

Margin is simply the difference between your cost and your price. Essentially, margin is profit per sale. The key to setting a good target margin is finding an acceptable price that will cover your cost but also represent a price customers are willing to pay. The reason determining your cost accurately is so important to the cost-plus-margin strategy is that it’s very easy to forget, for example, that shipping prices vary, so if you’re including shipping in the price (and, in the age of ubiquitous free shipping, this is often a good idea) you have to set a price high enough to cover the most expensive shipping option you’re willing to provide for “free”.

Margins will vary between industries, products, and even over time. High margins are attractive, certainly, and in the right scenario can be profitable. Products that are very popular or where you enjoy little competition because of differentiation or the novelty of the product can often be priced at higher margins. In other cases, such as when you’re selling a product that is relatively common, similar to other products, or easily substituted, narrow, or lower, margins are more feasible. Higher-cost items tend to benefit from lower margins as well, since customers might be scared off by high prices, but a modest margin will still result in a healthy profit.

Benefits

• Simplicity: pick a margin, add it to your cost, adjust as needed
• Offers a good starting point for other pricing strategies
• A good “default” strategy

Drawbacks

• Doesn’t accommodate diverse product lines well, since margins can vary widely
• Requires a lot of tweaking to find the right margin
• Difficult to use in more sophisticated marketing strategies

Competitive Pricing

Competitive pricing is not a terribly sophisticated strategy, but it is a popular one and it does work, to an extent. Let’s say you’re selling tennis balls. You do some research, and you find that your closest competitors are selling tennis balls for $1 each. So, you price yours at $0.85. That’s it.

In competitive pricing, you’re basically opting to compete on price alone. You’re betting that most customers will gravitate towards the lowest priced item. It’s the opposite of cost-plus-margin, in a way; you’re starting at the price and working backwards, rather than starting at the cost and working forwards. The idea is to find a price where you can make sales and then figure out how to accommodate that price in your business structure. Instead of adjusting your price in order to reach an acceptable margin, you’re adjusting your cost.

Substitution

Although this strategy is sometimes criticized, and not without merit, it does have its place and it can be a profitable one. If you sell items that are easily substituted or are not particularly different from those of competitors, you can certainly benefit from being the lowest priced option. Most people will not pay a premium for a USB cable, for instance, no matter how well its marketed. If you’re in the market for some tennis balls to throw for your dog, you’ll probably just buy the cheapest you see and call it a day.

Where this strategy runs into problems is when you can’t compete on price, which, for an online retail business—and specifically an online retail businessperson looking for advice in a blog post—is common. Competitive pricing makes a lot of sense if you can take advantage of economies of scale to reduce your costs, but for small businesses that’s not the case, as a rule. While you can use this strategy in combination with other techniques—such as bundling, or loss-leading—to compensate for selling at a price below your cost, or below an acceptable margin, on its own this isn’t a winner. In situations where a small business can compete on cost for a given product, there are likely better strategies to use.

Another shortcoming here is that it fails to take the customer’s perceived value into account. Consider something like batteries. Companies like Energizer and Duracell charge considerably more money for comparable products sold at lower prices simply because of effective branding. Golf balls are largely indistinguishable without the labels, but golfers routinely pay premiums for particular brands because they believe they’re receiving some additional benefit. This strategy overlooks the power of branding, which is one of the few places where a small online retail business can compete with bigger companies.

Benefits

• Even simpler than cost-plus-margin
• Likely to result in sales
• Great for non-differentiated or easily-substituted products

Drawbacks

• Requires cost reductions that might not be possible for smaller businesses
• Ignores customer attitudes towards brand, perceived value

Value-based Pricing

Value-based pricing is the most involved of the three strategies. It involves setting a price based on what you think a likely customer would be willing to pay. Simple, right? Here’s where it becomes complex. First, you need to understand your customer base. You need to think the way a potential buyer would think. In the user experience world, people create personas, or model users, to try to understand motivations, interests, etc., and then consider how that person would use their product, what they’d value, and so forth. Apply that strategy to pricing. Are you targeting young mothers of small children? What do they value? What would they see in your product that would appeal to them, and how much would it be worth to them?

Next, think about your marketing. We’ll go back to the tennis ball example. Maybe you’re selling tennis balls to dog owners. What do they value in a tennis ball? It’s not going to be the same qualities that a tennis player might value. Maybe it’s brighter, so it’s easier to find in the grass. Maybe it’s stronger, to resist chewing, but bounces less.

Product Differentiation

Value-based pricing relies heavily on product differentiation. Remember the batteries? If you’re selling batteries to someone who needs to buy a lot at a time but doesn’t really care how long they last—maybe they’re being packaged with toys, for example—your marketing strategy will be different than if you’re selling high-quality batteries that will last a long time, e.g. to campers using them for lanterns. Or maybe you’re selling batteries that store well and maintain charge, for people who want them for flashlights they use in emergencies, where they aren’t used often but absolutely must work even after months of no use. That person will likely buy a more expensive battery if he or she thinks the price difference is a result of added value.

Here’s a more concrete example. On my site, https://americanmaderetailcompany.com, I sell dog beds made by a company called The Houndry. These beds start at $199, much higher than most beds you’ll find in PetSmart. The reason is that they’re made by hand to order out of Sunbrella fabric and filled with resilient plastic fill that lasts a long time. Each one comes with a year warranty from the manufacturer. My target market isn’t the guy buying a dog bed at Wal-Mart on the way to a campground because he forgot the good one at home. My target market is someone who really, really cares about his or her dog’s comfort and wants a long-lasting, durable bed that will look good and work well for years. I cannot compete with a $30 dog bed, but I can offer a value-added proposition at a higher price for people looking for something other than the cheapest thing they can find.

Benefits

• Targets potential customers directly
• Works with strong branding
• Can allow favorable margins

Drawbacks

• Requires strong knowledge of customer base
• Requires solid branding
• Much more work involved supporting price decisions

As you can see, there is a lot of variety in pricing strategies, and I’ve only just touched on three. It’s a complicated topic and there aren’t easy answers. An effective pricing strategy will likely involve a combination of these: starting off with cost-plus-margin as a base, using competitive pricing to inform decisions where differentiation is low, and moving towards value-based pricing as your understanding of your customers grows. It’s a journey, and you’ll probably change strategies often. The key is to focus on providing value while remaining competitive. One way to do that is to use techniques such as bundling—offering a discounted price for multiple products—or prestige-sale pricing, where you offer goods at high prices with appropriate marketing of value-add to drive interest and then periodically discount in order to encourage conversions while maintaining an acceptable margin.

In future posts, I’ll go into more detail about various methods of driving sales through discounting, bundling, and other strategies. Also, I’ll discuss dropshipping as a business model, it’s advantages and disadvantages, and whether it might be right for you. In the meantime, thanks for reading, and good luck!