This post originally appeared on Hackthings.com

So you have a hardware product in the works? Before you can launch it, one of the most important things you need to figure out is pricing. Unlike software, you can’t AB test your pricing and change it for different customers, which means your product has one price and everyone wants to know what it is.

I have found pricing matters for two reasons. First, it determines your profits, i.e. how long you can stay in business. Second, you are stuck with the initial price you set, which means you need to get it right.

Although you may want your product to be affordable, it likely isn’t cheap to make when you get started. You have a cart before the horse problem. Your pricing is determined by your volumes, which you have no understanding of until you launch your product, which you can’t do without a price. It doesn’t mean you can’t change your price on future models, but the rule of thumb is you can always lower the price, you can’t raise it.

The mistake most hardware startups make is they don’t charge enough because they don’t think of the problems they will encounter at scale. They don’t calculate the real cost to deliver their product to a customer’s door, they leave no margin to sell through retail down the road when opportunities arise, and they can’t easily raise the price after it has been set.

After some painful lessons, this is the process I would go through if I was bringing a new device to market.

Profits Matter
At the end of the day you are picking a price that enables you to stay in business. As @meganauman says “Profit is not something to add at the end, it is something to plan for in the beginning.”

Before you can calculate your price you need to understand how much money you need to make per unit, which in the hardware world is called gross margin. It’s the difference between how much cash you keep from the customer and the amount in cash you paid to deliver a final product to your front door. This spread stays in your bank account as your profit.

Because gross margin dollars between products can vary so widely, I prefer to use gross margin percentage. Unless your product includes ongoing service revenues, i.e. the Kindle that makes money on book sales, you want to make at least a 50% gross margin on the sale of your device. Especially when you start, your volumes will be low, your mistakes will be high, and you will wonder where all the money went after you fulfill the initial customer demand.

Know Your Costs
This seems obvious, but it’s not. You start by calculating the cost of the physical product, with packaging, shipped to your door. Don’t get fooled when the supplier gives you an initial price without packaging or a price with packaging you have never seen before. Assuming anything is a mistake, especially when the Apple like packaging you are thinking about is a far cry in cost from the packaging they initially quoted you.

Once you come to an agreement on the final price of the product, you can call on a handful of logistics companies to figure out the shipping costs. You are a long ways from shipping palettes or containers full of product, which means you will be airfreighting everything, the most expensive option available. Be sure to shop around for the best price.

Your cost analysis doesn’t end here. You also need add in the cost to support the customer and manage defective units.

Although it’s only you and your dog when you start, you should expect to hire 1-2 people at $10 per hour to help you with customer support, shipping, and managing random surprises. This is something you can scale up after you determine the success of your product, so for now use it as a rough guide.

Defective units on the other hand are very real. A 2% defective rate would be amazing, but don’t be surprised if it’s 15% when you start. Yes, 15%. If you haven’t already, you will need to have worked out in grave detail with your supplier, who is going to cover what, as well as the process to repair units. Regardless, expect to cover the customer’s shipping costs (both directions) to replace the the crappy product you sold them.

To demonstrate how you calculate your product cost, lets assume I am launching a new device that costs me $50 (with packaging), has a 15% defective rate and requires me to hire my first employee. You want to estimate a monthly sales volume for your product so as that grows over time you can see how your cost per unit changes. I picked a flat number of 1,000 units sold per month to be conservative, recognizing that with larger volume I can likely drive my costs down across the board. But until I am at that point, I’m not.

What you notice right away is the $50 per unit price I get from my supplier is a far cry from my final cost. If I had missed this $8.10, I would have been $8,100 short in the first month and almost $50,000 after six months.

Top Down Pricing
In school they teach you about top down pricing. It’s where you look at the market, compare similar products, and try to guess what the price should be. Regardless of your cost structure this exercise is an estimation of what you think people will pay. Largely irrelevant when you start, I recommend using top down pricing strictly to guide where you ultimately want your product to be priced in the market.

Early in your product development process you can ask people how much they would pay. This exercise can be helpful, but often misleading because they quality they are picturing for your product is a lot higher than will come off the production line when you start. And until they actually give you the money you can’t be certain how much they will pay.

Next you can look at your target customer and think about what else they buy. At Contour we recognized that our customer was an outdoor enthusiast, therefore spending significant money on gear, travel, and sport. We compared the prices of helmets, goggles, clothes, and select accessories to give us an idea of how much they were spending on their existing sport. Hoping to be an accessory to their gear, this gave us an idea of what price range our product needed to fit into.

Last, you can look at adjacent products. Again using the Contour example, we researched both digital cameras and video cameras. We found similar pricing for both categories, where $149-299 was for every day consumers, $299-1000 was a large enthusiast range, and $1,000 was the beginning of the professional market. These numbers helped us understand where our prices needed to be over time to reach different types of customers. Even though a Contour camera is now $199 we spent many years in the $299-399 price range.

Continuing my example I have created a top down analysis for my new device. Wanting the product to retail at $200, I calculate how much it will cost me to reach a customer and therefore my gross profit. Whether you go to retail or not, it’s important to build a model that shows you the impact on your margins either way. Pricing your product to sell direct when you aren’t yet sure on your distribution strategy can be a costly mistake, especially if you want to be in retail down the road.

 

Please keep in mind I used general retail channel percentages based on my experience at Contour. Although applicable to most consumer electronics, you will want to spend time understanding what margins retailers expect to make on your category.

If your gross margin is less than 50% your price is too low.

Bottom Up Pricing
As a start-up and first time maker of your new product, I highly recommend this method of pricing. Sure, you want your product to be affordable out of the gate, but picking a retail price (MSRP) that enables you to stay in businesses is even more important.

To calculate bottom up pricing, you start at the bottom (your costs) and work up to what the retail price would be. The number you arrive at will freak you out, thinking there is no way someone will pay that price. You’re right, millions of people probably won’t, but when you start you’re focused on hundreds to low thousands of first customers.

Again continuing my example I assumed I needed a 50% gross margin and that I wanted to understand the pricing impact both in and outside of retail.

 

In this model you can quickly see the price impact to the customer if you leave room for a healthy retail channel. It is why a lot of products, including FitBit, started online only, enabling the company to build cash flows, lower its costs, and ultimately it’s MSRP price.

Conclusion
Everyone wants to deliver a great price to their customers, but recognize that if you don’t make enough money per unit sold you won’t be in business very long. You are a start-up and it does take time to efficiently deliver a quality product to market. You can’t short-cut this learning curve and reducing your own margin is one of the fastest ways to become non existent.

I believe that bottom up pricing is the best way to go. And yes it will make the MSRP of your product more expensive than you first imagined, but that’s okay. Your initial customers will be early adopters and if they aren’t willing to pay your high price, you most likely didn’t create a product they can’t live without.

Don’t be afraid to charge more. Long term, your loyal customers will thank you for staying in business.

 

Image Credit: Savings by Enjoy The Fresh