By Ed Avis

I once suggested to my boss at a publishing company that we try reducing our shipping prices -- which were way higher than our competition -- to see if that increased sales. She refused, saying that since customers weren't complaining and we were actually profiting on shipping, our shipping prices must be ideal. Our relationship was strained, so it's possible she was rejecting my idea simply out of spite, but many people are surprisingly ignorant to the effect of pricing on profit.

I'm going to show you one way to somewhat accurately estimate the effect of price changes on your profit.

First, you probably already understand the basic concept of pricing: The ideal price of a product or service is that price at which you earn the largest overall profit from your aggregate sales. The elements that play into the equation are price (which directly affects margin) and volume. Profit = margin x volume, right?

For example, if my cost (from my distributor) of a roll of inkjet media is $50, and I sell that roll for $75, my margin is $25. And if I sell 100 rolls in a month, I earn $2,500 profit.

Setting the right price is the tricky part. You have competitors who are selling similar products, either online or somewhere else in your community. Don't kid yourself -- 100 percent of your customers care about the price, no matter how loyal they are or how amazing your service is. Some customers care more about price than others, but none of your customers are going to pay substantially more than your competition is charging.

This makes sense, right? If you raise your prices, you will probably lose some sales. If you lower prices, you will probably gain some sales. Economists call this "elasticity." The more elastic a price is, the more your sales will change when you manipulate the price.

So the magic price number is the price at which you make the most money -- at which you have the most sales at the highest possible price.

But how do you determine that magic number? Knowing the elasticity of your prices is one great way to do that. Since elasticity varies greatly among stores and markets, you will have to test your market to arrive at an elasticity. If you have a regular marketing piece -- such as an email newsletter or a direct-mail piece -- that you can divide into chunks, you have an excellent test vehicle. You can even use your website as a test vehicle if you can set it up so that different customers see different prices.

Create a marketing piece in four versions, each with a slightly different price on it and with a different order code. Direct customers to your website, and tell them to enter the code when they order. Or, if they order by phone or in your store, ask them the code.

Assuming the marketing piece worked, after a few weeks you should have enough data to determine your price elasticity for that product.

Continuing the example above about inkjet media, let's say I sent each of my customers an email promoting the media, but with one of four different prices -- $65, $75, $85, and $90. Now let's say I sell 33 rolls at $65, 25 rolls at $75, 19 rolls at $85, and 15 rolls at $90.

Since my cost from the distributor is $50 per roll, my margin at each price is $15, $25, $35, and $40, respectively. My profit = margin x volume, so my profit at each price is $495, $625, $665, and $600.

So what did I learn? I made the most money at a price of $85. Furthermore, I learned that the price elasticity of inkjet paper is approximately -1.7, which means for each percentage point I increased price, my volume dropped 1.7 percent. (Naturally, I manipulated my numbers in this example to make the -1.7 elasticity work at each level, and your own test might not come out that nicely; if so, determine the apparent elasticity between each level and take an average.)

Now that I know my price elasticity is -1.7, I can play around with the numbers. If I drop prices by 5 percent, I should expect an 8.5 percent increase in volume. If I raise prices by 10 percent, I should expect a 17 percent drop in volume.

Cool, huh?

This will not be 100 percent accurate, and the number will change as conditions in your market change, but using elasticities can be a handy pricing tool.

I'd love to hear from others how you set prices in your shop. Please share!