by Steven J. Owens (unless otherwise attributed)
In general, pricing is a "black art". Nobody knows how to get it right. Everybody just figures out what works for them, or looks at what people in the industry around them are doing, etc. Anybody that says otherwise is lying either to themselves or to you.
There are two dominant -- or at least very widespread -- approaches, time & materials versus market rate.
Time & materials is pretty self-explanatory: you set a price on your time and then charge for that, plus the materials cost.
Market rate is: "What is everybody else selling this sort of thing for?"
Neither approach is "right", although it's a very, very good idea to run your pricing through both approaches. If you can't make enough to cover time and materials, you don't have a business. If market rates end up being lower than what you need to charge, then you may not have a business -- certainly you'll have an uphill battle making the case for why your products are worth the higher price.
In both extremes, small businessmen -- and especially craftsmen -- tend to forget to factor in a lot of details, like the time you spend sourcing the materials, the overhead of your shop, etc, the overhead of your sales pipeline, and so forth.
By the way, I highly recommend "Priceless: The Myth of Fair Value" as a general read, but it won't directly help you answer this question for yourself.
Market rate is easiest to explain but not necessarily easy to do -- what is everyone else charging for/paying for this product? Use that as a starting point, adjust from there. Price a little lower to get more sales, a little higher if you think you can convince the customers it's worth it (by having a better product, or better brand, or just being better at sales, etc).
Note, part of why market rate can be hard to do is that it's hard to know what other people are charging, and it's often hard to make an apples to apples comparison. Often the pricing strategy is a competitive issue, so your competitors won't be keen to tell you about theirs... and if they were, then you start to potentially run afoul of laws against price-fixing. I don't know much about price-fixing laws, I've just seen conversations (online) where somebody brought up that issue and opted out of the conversation.
Time & Materials
Time & materials seems to be what people new to business always default to, i.e. what do your materials cost you and what is your time worth to you?
In particular, I've seen this approach come up repeatedly among various craftsmen. This should definitely be part of your pricing process (see below) but don't limit yourself to this.
Of course, with time & materials it gets more complicated because you get into overhead costs like tools, workshop space and utilities, etc, which amateurs often forget or never get around to factoring in.
Obviously you need to figure out the materials and overhead cost at least to establish a lower bound to your price. If you can't go below $X without losing money, and nobody wants to buy at $X or more, then you don't have a business.
Similarly, market rate is useful to know because it's something of an upper bound -- if everyone else is selling this widget for $Y, then you're going to find it harder to sell for significantly more than $Y. You'll face an uphill battle, you'll need to differentiate (have a product that's better in some way that you can articulate to the customers), or be better at marketing and sales, etc.
Sometimes people -- especially craftsmen -- start with materials cost and then do a multiplier of the materials cost to cover time. I've never understood the reasoning behind this. I think it just goes back to "nobody knows how to do it right" and they look around at what other people in the industry do.
One possible origin of this "materials times multiplier" approach is that craftsmen may be imitating the price markups/margins in more conventional buy-and-sell businesses, like electronics, jewelry, etc. It's been literally a couple decades since I've learned the following, but I was told that consumer electronics retail operations typically have a 10% to 20% markup, and jewelry retail can have a 300% to 400% markup.
The key difference in these businesses is that the business's main value contribution is not manufacturing the product, only selecting the products, buying and stocking them, and fulfillment.
The Risks of Underpricing
Interestingly, underpricing yourself can actually be counterproductive -- there's a perception that goes along with price. This can be as simple as people assuming that higher priced goods must be better, or the opposite, "he's charging a lot less than the other guy, why does he have such a low opinion of himself and could that reason be a problem for me?"
Additionally, if you're more of a hobbyist than somebody making a living at it, obviously you can underprice yourself far more. Sometimes people do this through ignorance; they don't realize they're doing it, as in the case of amateurs forgetting to factor in overhead costs.
One of the consulting rules of thumb is that you need to figure out how much net income you need, and then charge 3 times that. Part of that is because of taxes and other overhead (and note that this rule of thumb is from software consulting where equipment & material overhead just isn't that much) and part of it is the "pipeline" overhead. In other words, you need to make enough money to cover your downtime, your time spent finding your next project and negotiating and closing that deal.
Obviously this is less of an issue if this is not your main job, but it's still something you need to think about. How much net income do you need to make, to make this worth while to you?
Sometimes people do this through insecurity. One thing I often point out to inexperienced software developers is that if they accept a low-balled salary offer, they're not just hurting themselves, they're hurting their colleagues who have to compete with that offer, or with the expectations set by that offer.
I wish I had a clear cut answer to end this comment with, but as I said, nobody really understands pricing.
Addendum: A Few More Details
There's a traditional approach of starting out near market rate and then adjusting your pricing until you find your sweet spot.
I.e. lower it bit by bit until you get enough sales, or raise it bit by bit until it starts to cut down on your sales.
In some contexts, it may actually be worth your time to raise the price enough to reduce your sales a LOT, but as long as each sale is making you enough profit.
This was discussed on a consulting mailing list I was on, at one point. More than a few people mentioned that they lost some customers when they raised their rates, but the customers they lost were the pain in the ass customers. The customers they kept were the ones that really appreciated them and were willing to pay the higher rate. Probably because they recognized that they'd been getting a great deal all along.
Also -- and this is something I've said to people I've bought services from (plumbers, mechanics, etc) on occasion -- that I'm happy to pay a little more for GOOD service, because it helps to make sure they'll still be in business for the next time I need them.
Finally, sometimes there ISN'T a "market rate" for something. This happens more often in software startups, obviously (because by definition most startups are doing something new...). At one startup our CEO spent our first dozen customers fiddling with the pricing approach, until he found an approach that that industry seemed comfortable with. Fortunately that particular product had a lot of knobs that could be fiddled with to tweak the pricing (a fee for importing accounts, a recurring fee for maintaining the data, a fee for each service provided, a fee for orders generated for the customer, etc).