I wrote a post on another blog I run, that talked about selling farm fresh eggs. It was the first post on that blog to provoke an e-mail from a reader, and it was interesting as the e-mail was to tell me I was dead wrong on how to price eggs, and walked me through “the right way”.
I appreciated the e-mail and understand that the sender was trying to be helpful. But she was the one who is dead wrong. I’m one of the most open-minded people you’re likely to meet, and I can usually see the merits in any position people might like to hold. The small number of times when I’m sure someone is mistaken is about something that I’ve spent a ton of time thinking about or when they hold a position that I used to hold – and I discovered I was wrong about. This was one of the second situations.
The 100% Wrong Way to Think About Pricing
The e-mail sent to me had all sorts of information, multiple articles attached, and different arguments on the issue. The woman sending it teaches small farm business courses and was quite convinced that her view is correct. One part of her e-mail, which summarizes this view, is the following formula:
Here’s a way to think about determining price:
On its face, this seems to make perfect sense. You add up what it costs you to produce the item (Labor, expenses, materials, and overhead), add to this the profit you want to make and the sum is what your sale price should be.
It’s also a nice mathematical formula. For the naive, this seems like a savvy and tractable way to think about selling something.
Years ago I talked to an older academic who had been involved with a number of tech companies and I asked him what he thought his biggest mistake in business had been. He cited using a variant of the above formula. He told me that for years he clung to the idea that the proper way to set a price was to use your costs, increase them by a set factor, and sell for that. His experience was that customers couldn’t care less what something cost you and that this was an arbitrary and ridiculous way that would just about guarantee you the wrong price.
The correct way, which he eventually started using, is detailed below.
I used the same, wrong, approach when I used to do software development. I would figure out a time estimate for the job, multiply this by my hourly rate and quote that to customers. This is similar to the above, except it was principally made up of labor. Again, this was a foolish way to price.
This seems like a fair way to price things. Who could criticize you with your price based on your costs? Does that make this the right way to do it?
no, No, NO. NO! NOOOO!!!!
The Correct Price to Sell Something For is the Highest Amount the Customer Will Pay
This is the entirety of the formula. It gets a little more nuanced when you are trying to sell multiples of an item – basically, you want to sell at the highest price that will sell all the items you have. The thinking behind this is that you will offer your good or service in the marketplace. There are different values different customers will attach to it. The customers who attach a higher value than your price will buy. Those who do not won’t. You want to set your price so that there are as many customers who will buy as you have items to sell. If you sell out and there are customers still wanting to buy, then you’ve set your price too low. If you still have items at the end of the day (or whatever your sales period is), then you set your price too high.
If I go to the farmer’s market with 20 dozen farm fresh eggs and the market runs until 3 pm, I want to sell my last egg at 2:59 pm. Obviously, there will be randomness in the process, and I can’t always guarantee that result, but that’s my goal.
We can use this value, combined with the “foolish price” above to determine if we should even bother doing something. If the smart price (what customers will pay) is less than the foolish price, don’t bother trying to operate the business. It’s a waste of your time. If the smart price exactly equals the foolish price (what luck!), I’d suggest not bothering with the business. If you’ve been overly optimistic on any of your projections or have some bad luck you’ll be able to easily lose money. If your smart price is 50%, 100%, or more, higher than your foolish price, then this is something worth doing!
What The Foolish Price Actually Is
I was talking to a friend who is an economist and he felt that what is being calculated with the foolish price is your opportunity cost. This can be interpreted as the absolute lowest price where it even makes sense to sell. Below this you should just do something else.
Obviously this isn’t what we want to use as our price!
Smart Price < Foolish Price: Move on to something else.
Smart Price = Foolish Price: Move on to something else.
Smart Price > Foolish Price: Give it a try and see if your estimates were right.
Smart Price >>> Foolish Price: Lean into this! You might be onto something.
Talk to some business owners you know. I can guarantee they will use something closer to the smart price than the foolish price. How can I be so confident? Because business owners who use the foolish pricing scheme will have gone out of business and will no longer run a business!
What is the last thing you had to set a price for? How did you determine that price? Do you think you priced it appropriately?