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Make Sure The Price Is Right

November 22, 2009

Pricing is the neglected orphan of business. There is no more important decision a business will make than the pricing of its products.

Revenues minus expenditures yields a remainder commonly referred to as profit. Revenue is the product of price and volume. These simple formulas highlight the prominence and impact of pricing. Product quality, marketing strategies, customer service, and cost control all get considerable attention. Perhaps the weight of competition and market forces make pricing decisions appear inevitable rather than discretionary.

Cost information will establish a floor for prices. Three generally accepted cost based pricing approaches are cost plus, target rate of return, and a break even analysis. Each approach requires a knowledge of the actual cost of the products being sold. Determining cost is easier in some business, like retail, than in others, like manufacturing. The more difficult it is to determine cost in your business, the more important it becomes to do it.

Market information will establish a ceiling for prices. Market oriented pricing methods include competitive and demand approaches. A common error for small businesses is pricing products too low. The “I can do it cheaper” theory is flawed because if you can do it cheaper, chances are that somebody else can do it also.

Undercharging in the early stages of a new venture is also common. “Timid undercharging” is the result of an entrepreneur being overly optimistic concerning their costs and overly cautious concerning the value of their product. Price conveys image, give your company a positive image. Remember it is always easier to lower prices than it is to raise them.

Lowering prices for higher volume is a pricing strategy that always looks good on paper but rarely translates well into reality. Few businesses have the marketing and financial strength to profit from this strategy. Innovative pricing strategies that improve profit margins are the most productive.

One manufacturing business sold between five and six million products per year priced between seventy-five cents and five dollars apiece. After implementing an exhaustive pricing review process that involved the controller, sales manager and manufacturing manager, the C.E.O. suggested that they add a “penny a piece” to each of their prices.

The “penny a piece” strategy directly impacted the company’s revenue. The increased profit was dedicated to the funding of a profit sharing program and remained a fixture of this company’s pricing strategy. Not a sophisticated approach some might say, but it was successful in focusing attention on the importance of pricing and in generating additional revenue.

Across the board price increases can do more harm than good. They are often justified as expeditious or because accurate detail information is not available. Completely accurate information is never available, but there is always some information available that will allow you to make a more enlightened decision than “five percent across the board”.

In addition to the fact that “five percent across the board” rarely ever generates a full five percent, across the board price judgments cause the subject of individual product pricing and profitability to be swept aside. There is no element in the formula of business success more important than pricing, it should receive constant and detailed attention.

Shortly after acquiring their business, the new owners saw profits began to decline and within a year the business was losing money. The reasons for the decline were unclear but certainly the management transition and the change in ownership were factors.

They were not confident with the cost information available for a detailed price analysis. They felt that a five percent revenue increase would restore the profit margins that the business had historically achieved.

The only problem was that their “five percent across the board” price hike didn’t generate a five percent revenue increase. The unit sales of some of the products remained the same and the price increase did generate a five percent increase in revenue. But the sales of other products actually declined, resulting in a revenue increase of less than five percent.

A brief analysis uncovered the following information. Nearly ten percent of the company’s products were generating a negative gross profit. In this particular business a gross profit of twenty percent translates to about break even, so this small group of products was generating a loss of $108,000.

The experience of the previous owners could accommodate this inefficiency, but clearly this was a problem that the new owners could not live with for long. They learned their lesson and soon a healthy bottom line returned.

Because its your business, price your products for a profit.

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