Optimal price – definition and meaning
The optimal price is the price at which a seller can make the most profit. In other words, the price point at which the seller’s total profit is maximized. We can refer to the optimal price as the profit maximizing price. The optimal price refers to both products and services. There are various ways to determine this price.
If a product’s price is too low, the manufacturer is moving lots of it. However, the company is not earning the maximum possible profit from that product.
However, when a product’s price is too high, the manufacturer moves too few units. Even though it earns a high margin per unit, its profit is not the highest possible.
Most companies find their optimal price through trial and error. When they find the price point that gives them the ideal sales volume, they have reached the optimal price.
The word ‘price‘ refers to how much the seller will accept for the sale of something.
According to BusinessDictionary.com, the optimal price is:
“A typically profit-maximizing price where marginal revenue is equal to marginal price.”
How to set your optimal price
Getting the price right for a good or service is crucial. It is one of the most important decisions business people make for their company.
However, getting the optimal price is not easy. Below are some tips for setting your optimum price:
The product’s perceived value
You need to find out what your customers and potential customers perceive to be the value of your product.
Then, you will know what your maximum price is.
Perceived value matters much more than ‘actual’ value. Ideally, your product should have a greater perceived value than actual value.
What are your competitors charging?
What your competitors charge is important. You need to find a way of differentiating your product from your rivals’ if you want to charge a premium.
Sellers of commodities have little flexibility with price. For example, one gas station (UK: petrol station) cannot raise its price higher than another station’s price across the road.
Cost structure
In an Entrepreneur article, Doug and Polly White say that we should first focus on variable costs. Variable costs are those that increase as revenue grows.
For example, labor and material costs are variable. Variable costs determine what your lowest-possible price is.
We cannot set a price below variable prices because we will lose money if we do.
Price minus variable costs equals the amount of money you can make on each unit you sell. We call this the ‘variable contribution.’
We should then focus on fixed costs. These are costs that never change, regardless of how much we sell. For example, the rent of the premises is a fixed cost.
By dividing the fixed costs by the variable contribution, we get how many units we must sell to break even.
If you believe you can reasonably sell that many units, that’s great. However, if you can’t, it means that your price is too low. Therefore, you will need to raise the price.
Profit target
Now we add our profit target to fixed costs. We then divide the total by the variable contribution. We will then have how many units we must sell to reach our profit objective.
Regarding getting the price, right, Doug and Polly White write:
“If it is reasonable to believe that you can achieve this number of units at the price you are planning to charge, great. If not, you may need to adjust your price either up or down.”
According to economic theory, as prices rise volume will decline. You might need to make price adjustments over time to determine how they affect profits.
For example, does a slight reduction in price result in enough of a volume increase to raise profits? Conversely, does a price rise result in higher profits, even if volumes decline a bit?
You will need to continue adjusting your price until you reach the optimal price.
Monitor your competitors’ responses
It is very unlikely that your business is a monopoly. There are others in the market trying to sell similar products to your target customers. In other words, competitors react to their rivals’ behaviors and actions.
Whenever you make a decision, try to factor in what your rivals will do. And above all, monitor their responses carefully.