This Profitability Thinking article is the first in a series of three that discuss how to make more money from your business.
The topics covered will be pricing, variable costs and breakeven point, and fixed costs.
Getting these three profit components correct will improve business profitability greatly.
That would seem obvious, but many businesses don't manage these components of profitability properly, if at all.
So here in part one of the three part series, we will cover some pricing basics.
In the financial markets, there is the concept of "price discovery.
" The idea is that the market "discovers" the price point at which someone who is willing to sell matches the price point at which there is a willing buyer.
That point, at least for that moment, is the price of the financial instrument.
And it makes total sense.
The price of the financial instrument is what a buyer is willing to pay for it when there is a willing seller offering it.
However, some businesses miss this point in making pricing decisions.
Although you have a right and an obligation to price in such a way that makes a profit for your business, ultimately the value of an item is the price customers are willing to pay for it.
So how should a business determine pricing for their products or services? The first thing to consider is that pricing should be part of an overall marketing strategy.
Remember the four P's of Marketing: Product, Price, Promotion and Place (channel)? There are three more P's which you might want to consider as well: Positioning, Profit and Production (costs).
Pricing strategy should be decided in the context of all the other P's.
Let's take a look at some considerations.
What are you trying to accomplish with your pricing? What is your position in the marketplace and will pricing play a role in that positioning? If your position is as a discounter, your pricing will need to be lower than your competitors.
If you have a high end product or service, maintaining a high price might actually improve the perceived value of your offering.
Your pricing has to be consistent with your position in the marketplace.
In economics, there is a concept known as elasticity of demand.
Briefly, elasticity means change in demand as a function of change in price.
The more elastic, the more demand changes when price changes.
The elasticity in demand for a product or service has implications for pricing decisions.
If your demand will fall off a cliff due to defections to competitors, substitution of other products or customers simply unwilling to buy if you raise prices, then you will need to find another way to raise revenue.
Conversely, great elasticity in demand when reducing prices might make your product or service one of the few where increase in demand will make up for lost margins.
If demand is inelastic, then you have to ask yourself if you're leaving money on the table by not charging enough.
Even in situations where demand is inelastic, there are other considerations such as what your customers think is fair and beyond which you start to generate ill will.
Then there are competitors who might be tempted to enter your market if they see high margins generated by overly high prices in an inelastic market.
Finally there are cost factors to consider.
If you're to stay in business you do need sell your products and services at a profit.
However, tying pricing to costs leaves one essential ingredient out of the equation: the customer.
Customers buy products and services based on perceived value, and don't care about your costs unless they can use that information as negotiating leverage to get you to reduce your price.
So pricing to cost plus a percentage markup or to a target margin runs the risk of reducing your possible profits in three ways.
The first is that you're under pricing and leaving money on the table because your target margin doesn't factor in the value your product or service has to the customer.
If the customer would have been willing to pay more but your pricing model aimed at a margin, you've left money on the table.
The second way pricing to a target margin or markup reduces profits is that you may be leaving sales on the table because your pricing methodology over prices your offering, again not taking into account the value customers place on your offering or the position of competitors in your market.
The third way these pricing schemes can reduce possible profits is if you miscalculate your costs causing mispricing of your product or service, leaving either sales or money on the table.
In any event, if customers aren't willing to pay a price for your product or service that gives you an adequate profit, it may not be the end of your business, but you may need to reconsider your business model.
You will need to either cut costs significantly or change your value proposition to your marketplace, and recreate and reposition your products and services to add margin.
There are any number of ways to add more value to the products and services you take to market.
More product training? Faster delivery? Bundling of several items in the same product? Perhaps a good/better/best product strategy to match products more closely with what customers want.
Perhaps in exchange for a price reduction, your client could enter into a long term supply contract with you that will smooth out your cash flow.
At the end of the day, just as in the market pricing of financial instruments, something is only worth what a customer is willing to pay for it.
Get close to your customers and find out what they value and what that price point is.