Maximising Selling Price = Maximising Profits
Margin can be complicated but by understanding and maximising selling price you can make better pricing decisions enabling you to make more PROFIT.
Pricing products and services has two components – one component requires some sleight of hand and the other is a calculated fact.
A. The Mark-up – it is how much ON TOP OF your costs you added to arrive at the selling price
B. The Cost – everything you sell will have associated costs and there are many ways of increasing how accurately you allocate all of your costs to each item you sell. – for more on costing see last weeks post Pricing Products and Services starts with knowing Costs
Mark-up and Margin
Margin and markup are rooted in the same concept – what you get to take home at the end of the day; their difference is the basis used for calculations:
Markup – the amount you add to cost to get the selling price.
Profit Margin – the percentage of the selling price that is profit.
Following on from last week, let’s return to cakes…. We calculated it costs you $4.50 to bake a cake. If you want to sell these cakes at $5 each then:
* there is a 50c mark-up
* a 10% profit margin (50c divided by $5 = 10%)
Profit Margin IS NOT calculated as 10% x cost price = selling price
in this example that will give a selling price of only $4.95 instead of the $5
REMEMBER: Doubling the original cost to establish your selling price gives you a 100% markup, but only a 50% profit margin.[/box]
Both Profit Margins and markups can be positive and negative: when the profit margin is negative the selling price is insufficient to cover the costs of production. This can be caused by an informed decision (usually involving a mark-down or discount to move older stock) or unintentionally which always rapidly leads to a business crisis.
Setting a profit margin is a matter of researching conventions and industry standards, and then tailoring these numbers to your company’s specific circumstances.
But the process of setting a profit margin is also ongoing – it is important to regularly re-evaluate whether the profit margins are sufficient to cover all the business expenses (they will be negative profit margins if your costs are not covered), PLUS give you a good return for the risk you are taking AND provide sufficient additional money to ensure you are compensated for all the time and effort you contribute as a business owner.
There are three Factors for Maximising Selling Price
Apart from knowing what your costs are some extra research, and calculations are needed before finalising your best price:
A. Understand your Competitors
The simplest and easiest, and therefore generally the least accurate method involves working out what your competitors are doing and then setting your price to reflect theirs. This is a DANGEROUS APPROACH when used on its own as it assumes your costs, and the return you need for your risks, are exactly the same as your competitors – That is really, really unlikely….
Your business; your investment; your needs; therefore YOUR PRICE!
An example of why price matching or discounting is risky is shown in the price/service war happening with Hardware shops across Australia – the big US brands have come in with massive buying power and huge logistical operations that enable them to offer their goods very cheaply. The locally based companies are unable to offer these same low prices and those that tried to compete only on price quickly went into liquidation and are no longer in business.
B. Understand the Demand from Customers
The next method of establishing the mark-up is to work out how much your customers will pay for your product or service. I could go on for hours about the economics of supply and demand curves and how lower price = higher demand, but I don’t necessarily always subscribe to this ‘old school’ approach – especially in relation to high end services and luxury items. Suffice to say Customers will try to get the lowest priced product that meets all their needs, but remember ALL their wants and needs may not be completely obvious so spend some time digging about to really understand.
Both of the above methods are based on reflecting what other’s think your product will do for them….This will help you set a “basic price” and keep your business ticking along However to maximising selling price there is an extra step.
C. Understand Your Value Proposition
Instead of using a market driven approach to pricing use a value approach by leveraging perception of value and you can price accordingly.
This method enables pricing of process and product differences, rather than simply fulfilling a single delivery need this pricing method takes a more holistic approach to customers needs and wants – it takes into consideration their feelings.
A great example of how this method can work is fair trade coffee – it is consistently more expensive in a bag and in a cup. Initially the market for coffee was very clear, there were lots of competitors and customers so the price was very stable and the profit margins pretty consistent. But, by raising market awareness as to the conditions the coffee was grown and picked in and offering a more expensive alternative that drove to prevent the bad conditions the market was opened up to a more costly product. The benefit to a customer of fair trade coffee is exactly the same as that of regular coffee – they are equally as tasty and satisfying except that the fair trade coffee has an extra value proposition – it also enables the customer to directly support poorly paid communities there is an added value of ‘feeling good’ that enables a higher price to be charged.
In addition to the perceived customer value for products there is also a “respect” element to pricing when dealing with services. This approach is really well summarised by Dr Greg Chapman’s Circle of Price:
- The more you charge, the more you are respected
- The more you are respected, the more your clients comply with your recommendations
- The more they comply, the better the results they get
- The more results they get, the more clients you get
- The more clients you get, the more you charge
- The more you charge, the more you are respected
Recognise that if you are a start-up building a value perception can take a while, especially given ‘value’ for services is usually built on trust and testimonials. Having a go-to-market strategy that incorporates a ‘trust building’ and ‘value demonstration’ component will be necessary to implementation of this kind of pricing.
So to summarise – there are 6 steps to maximising selling price:
- Calculate the amount of product/services (volume) that you expect your business to produce and sell each month based on your production capacity and the demand you have observed through your marketing research.
- Understand and include all of the direct and indirect costs your business will incur when operating at the volume you established above.
- Research and understand the percentage profit margins specific to your industry, your customers’ demands and your value proposition.
- Set a price for your products based on your costs plus mark-up.
- Using the price and volume you have determined above, and calculate your monthly profit. Divide this projected net profit by your projected gross monthly revenue from slaes to calculate your projected profit margin. Ensure this calculated profit margin is at a minimum your industry average
- Evaluate your profit margin over time to confirm whether your projections are realistic because a profit margin goal that you rarely attain is most likely unrealistic, and will send you backwards. Further make sure your profit margin provides you enough income and return for the risk and time you put into your business – if you don’t calculate to pay yourself well the business will be unsustainable.
About the Author
Often described as the small business answer to The Supernanny, our principal Eve Blackall also owned a Tax Accounting Practice for 15 years and also has worked as Financial Controller and advisor for various ASX listed companies.
Working with Smart Accounting you get to work one-to-one with Eve and not many consultants have her experience and expertise. She has been advising on how businesses can be more profitable, and how business owners can sell for the highest price, for over 25 years.
To start increasing the value of your prices right now download this Free Benchmarking Tool by clicking here and compare your ratios to the industry averages published by the ATO.[/box]