Pricing Depends On Your Business Model And Cost Structure

When releasing a product, one thing you always have to decide is the price.

There’s a rough rule of thumb often repeated: “You’ll be fine if you set the price at three times the cost.” This turns out to be surprisingly apt, and it usually hits close to the mark.

The first things to consider when setting a price are the “business model” and the “form of business.”

Put simply, a business model is “how you make money.” There’s the simple model of selling a product and taking a profit on that sale. There’s also the model of making money by offering a subscription service to the people who buy the product. And there’s the long-standing model of taking no profit on the product itself but making money on accessories or optional services instead. Depending on the business model, you have to judge differently whether profit must be secured at this stage or whether it’s enough just to barely avoid a loss. Apple, incidentally, might look at first glance like a company that makes its money on services, but apparently it actually runs “a model that makes money on both.” No wonder it’s grown into such a large company.

The form of business concerns what kind of company it is, how many people it employs and in what way, and what kind of assets it has invested in and how much — these factors change how a company thinks about profit considerably. In management terms, this comes down to “fixed costs” and “depreciable assets.”

A large company that maintains a big, impressive office and a full lineup of departments — development, sales, even back-office functions — carries very large fixed costs. Simply holding factories, warehouses, and other facilities means costs keep accruing for management and maintenance. And once a product ships, development department expenses drop off, but ongoing customer service and support costs take their place. At a company like this, you can’t decide product pricing based on parts cost alone; you have to properly calculate the costs sitting in the background and add them on as cost. In many cases, companies calculate this using fixed values or coefficients that the company or department sets on a yearly or quarterly basis.

A business with a small organization, only the minimum necessary staff, and most work outsourced, on the other hand, can calculate cost more easily and more accurately. As a result, strict management of price and profit seems easier to pull off. That said, each outsourcing partner adds their own reasonable profit margin, so the overall cost may end up higher to begin with.

Assets, too, aren’t just equipment and the like — they include development costs. Development costs include not only easily identifiable expenditures like purchased goods, prototypes, and tooling, but typically also the personnel costs of development team members, allocated proportionally and accumulated.

So a project developed over many years accumulates a large amount of assets. Those assets begin depreciating over a set number of years starting from the product’s release. Since that depreciation counts as a loss in accounting terms, profit has to cover it from a management standpoint. How large this depreciation amount is depends on the asset value and the depreciation period, so no blanket statement is possible — but be careful, because intentionally underestimating the asset value or stretching the depreciation period beyond reality can lead to major pricing mistakes.

I’ve written some fairly complicated things here, but here’s the interesting part: if you use all this as a reference and run a rough calculation in a spreadsheet or similar tool, setting the price at roughly three times the parts cost is often enough to secure sufficient profit.

The content of this post is an excerpt (original text) from the following book. If you’re interested, please consider purchasing the book.

The Shape of a Happy IoT Startup

The Shape of a Happy IoT Startup

Originally published in Japanese at https://clazytech.com/2022/08/1119/. Translated with LLM assistance and reviewed before publication.