A guide to increasing profits by pricing at the right level and how to find that level
Whether you are selling a service, a product or a combination of both - from the day you start your company and throughout its existence, you will need to make decisions on price.
So how do you do it?
In many SMEs you will hear: "Whatever I can get away with" or "I always match or go 10% lower than my competitor” or “Same as last year” or "I just apply the trade prices”… Does this sound familiar? Unfortunately, these methods rarely survive the test of time and usually result in low profits at best.Before we list some of the pointers which will help you to define “Your Right Price”, we need to define its major components:
Selling Price = Cost of Sales + Overhead Expenses + Operational Profit
Cost of Sales are all the resources you are directly employing in order to sell/deliver a specific product or service.
For example, technical/manufacturing staff remuneration & operational costs (vehicles, machinery, subsistence etc.) directly linked to sales in the period (month/year), materials and products bought to satisfy the sale, manufacturing costs associated with products sold, sourcing and shipping costs or stocks purchased to satisfy the sale, any ancillary costs like plant hire, specialised subcontractors, or packaging associated directly with the sale.
Overheads are typically all expenses which are not cost of sales.
The main components are Directors, admin and sales staff remuneration, cost of premises, motor expenses, IT/telephone services, professional services etc. These are costs that are spread across all sales, not directly linked to a specific sales transaction but needed in the period to support the full breadth of business activities.
Operational Profit is what allows the company to pay its taxes, dividends and re-invest – it’s the business’ reward or compensation for operating!
Where do I start? I recommend you start at the end!
Whatever the method you employ to calculate a selling price, Cost Plus, Gross Profit or Mark Up, you need to base your strategy on how much Operational Profit the company needs or wants to aim for. Once you have determined this percentage or value, your costs of Sales & Overheads will be clearer to estimate – and you can set your target price.
Forecast your profits: Don’t let your accountant reveal them at Year end!
Pricing is a strategic decision which involves thinking, planning, and monitoring. Understanding your costs will help define it.
Efficiency and productivity
Are my staff resources fully employed? Am I clear on the utilisation of my direct staff and their correct “charge-out” rate? Are my estimation methods up to date? Am I using the correct skills to perform a job?
Sourcing and manufacturing
Is my cost base adequate? When was the last time I sat down with my suppliers to negotiate a fair purchase price for products or subcontractors bought in? Do I need to review the range/mix of products we sell?
Systems and methods
Are my back-office costs efficient? Can we eliminate unnecessary tasks? Do we need to review how we operate or from where we operate?
How can I justify my Price?
Providing value to your customers and increasing your competitive advantage is still the base of any pricing strategy. It is when your customers stop perceiving value that you are faced with competition, price discounting and external stakeholders’ pressures which ultimately can jeopardise your pricing strategy and profit.
There are 4 main pricing strategies:
1. Premium pricing: High price, high-quality
This works where you have a Unique Selling Proposition, a strong competitive advantage or exclusive product. This can associate your company with premium/prestigious brands.
Benefit: Achieves higher profits and supports brand identity
Disadvantage: Can attract discount competitors
2. Penetration pricing: Temporary Low price, high-quality
Helps to penetrate a new market sector or large customer attracted by lower prices. If time limited, this can be used to launch a new product or service.
Benefit: Gains market share and increases turnover
Disadvantage: Win on price, lose on price”; Can price increase?
3. Economy Pricing: Low price, low-quality
Suitable for high volume “box shifting” operations where Gross Profit per unit is low, cost of sales and overheads involved are minimised. This strategy can be successful when complementary, or entering a new established market, or used as customer pull or ad-hoc e.g. de-stocking an end of life product.
Benefit: Gains market share and new customers
Disadvantage: Jeopardises profitability and customer loyalty.
4. Skimming strategy: High price for as long as possible
Used when launching a new unique offering and is sustainable until it attracts competitors forcing the market price to stabilise at a lower level. If you are innovating constantly, this might apply.
Benefit: Early high profits can cover initial high costs
Disadvantage: May antagonises early customers.
The Right Price is the one that follows your pricing strategy which should be regularly sense checked, monitored, reviewed, and adapted to achieve your goals.