Pricing is Key to Your Profits 1
Dave Cranmer, Phase 3 Consulting LLC
Pricing is a strategic as well as a tactical asset. Where you set your price sends a strong message to the market about what you think it's worth. That's why price is the key to your profitability. Too low a price and you don't make money. Too high a price and nobody buys.
How do you price your products and services? If you're like most small firms, and even lots of larger ones, the answer is "cost plus my margin," "meet competitive prices," or "whatever the customer will pay." Very rarely do companies say they "price to value." These answers raise two additional questions. One, do you know your costs well enough to know that "cost plus my margin" will yield a profit? Two, what is the value of your product or service to the customer and the customer's customer? Since most small companies price to cost plus margin, I'll discuss that in this article. In a later article, I'll discuss pricing to value and how you can learn to do it.
Let's start with costs. For this article, I'll use management (or cost) accounting, rather than financial accounting. The latter is what your CPA does typically. It's based on history, and isn't terribly good at helping you figure out the future. The management accounting view (a preferable view to my mind) looks at your variable and fixed costs.
Variable costs are the ones that go up and down as production goes up and down. That includes materials, labor, sales commissions, and anything else that changes with production level. Fixed costs are the ones that don't change with the level of production.
To establish a price with this information, you first determine your contribution margin (price minus variable costs). If your contribution margin is greater than zero, that amount "contributes" to covering some portion of your fixed costs. If it's less than zero, you might want to think about some changes to reduce costs or raise prices because you're inherently unprofitable. With contribution margin, at the very least, you've now established a "floor" price below which you know you lose money just making what you make.
Next, look at your fixed costs and determine a break-even sales volume or production level. You do this by dividing your total fixed costs by your contribution margin expressed as a percentage of price. That will tell you how much you need to sell to cover all your fixed costs. For any volume you sell above that figure, your contribution margin contributes to profit. If you think you'll sell more than that amount, you now can be flexible in your pricing to meet specific opportunities.
You can also use contribution margin to determine how sensitive your profits are to sales volume. The higher your contribution margin, the less sensitive your profits are to sales volume. The lower your contribution margin, the more sensitive you are.
Let's look at the consequences of some specific pricing decisions. If the contribution margin (price less variable costs) is 60%, and you reduce your price by 10%, you'll need to increase your sales volume by 20% just to break even and cover all your fixed costs. If your contribution margin isn't that good, the situation gets worse. With a 30% contribution margin and 15% price decrease, you need to increase volume by 100% to break even. Are you ready and able to ramp up the sales effort and production to meet the new volume requirements if you agree to these price cuts?
At the other end, for the same 60% contribution margin, and a 10% price increase, you can achieve break-even with 14% fewer sales. Are there some "pain-in-the-ankle" customers you'd like to get rid of? Consider raising your price to them.
Think about the following: Do you know your costs well enough to know that pricing to "cost plus my margin" will yield a profit? Use contribution margin to help you understand your cost structure. It's a good first step to improving your pricing and being able to recognize when you can afford to be flexible about it without sacrificing long-term profitability.