Pricing – the Holy Grail of Maximising Profits

Great Pricing = Knowing Markets and Costs = Maximising Profits

Setting the perfect price may seem like a dark art, but with a bit of research, and the know-how outlined below, you will soon be setting your prices like a pricing expert.
Starting with what is your most profitable point, it is the point where you maximise both your number of sales AND the price you are charging… Think of this example – A shopping bag costs $10 to produce…

  • When it is priced at $100 ($90 profit per sale) it will only sell 5 units a month, and therefore make a total of $450 profit
  • When it is priced at $20 ($10 profit per sale) it will sell 200 units a month, and therefore make a total of $2,000
  • BUT when it is priced at $30 ($20 profit per sale) it still will sell 200 units a month, and therefore make a total of$4,000 profit

The right price point is pivotal to ensuring the most sales AND the most profits. To make sure your pricing perfect follow these 5 steps.

Step 1: Do your Market Research

Starting where most people start, the competitor’ prices. If your prices are set to match your competitors’, your profit will most likely turn out to be more or less than theirs, because although your customers and clients will come from basically the same pool of people, your costs are never going to be exactly the same as anyone else (even if you are part of a franchise). By setting prices exactly the same as their competitors these business owners never make an informed decision about the pricing strategy they intend to use, and consequently many end up in financial trouble that can easily be avoided.
How much profit your competitor is making is actually pretty irrelevant to your business – but what is relevant is you making ENOUGH profit for your situation (a very personal requirement). However, what your competitors are up to is a good indication of what customers and clients are looking for, and what is profitable in this kind of business long term and what doesn’t.
Market research enables you to understand exactly who and where your competitors are and what your customers and clients are currently paying. Look at national, regional, and local competitors to determine pricing averages for your products and services. When looking at all your competitors, it is a good idea to both find out the ceiling price – the highest price that people are willing to pay for these kind of goods and services, and the basement price – the lowest price your competitors are selling for. An honest assessment of what the market is currently doing will help you decide where your ultimate prices should fall. Take care to also look at the historical trend of your market, is it stable from year to year, and season to season or does it have peaks and troughs to be considered – heaters are generally priced quite differently in summer than in winter, where are lounges and beds and plumbers’ prices tend to be much the same throughout the year.
You don’t have to hire a team of researchers or subscribe to costly trade publications to access small business data and statistics – Most governments provide free access to numerous facts and figures. Start your search online, looking for industry standards and publications:

The next step, so you can make this decision properly, is to really understand your costs, so you are clear on the implications and what upsides, and downsides you are facing BEFORE you finalise your prices.

Step 2: Calculate ALL Your Costs

Quick Definition – Costs are the things sacrificed to achieve a specific objective, such as manufacturing a particular product, or providing a client a particular service and may include expenses from multiple reporting periods spanning up to several years.
The timeframe for when money is spent is not important to the pricing process, what is important is capturing and allocating ALL the cost incurred to make sales irrespective of when they occur, or even if they are still to happen. Consider how large mining companies must now also factor in the costs of repairing the environment once the mine is closed – up to 50 years after the mining started.

Anything sold has two sorts of costs:
Direct – costs that have a direct correlation with the number of products/services sold e.g. each piece of stock has an attributable purchase cost; every sale has a set amount of Commission; every item sold has a package/box
Indirect – costs that have no direct correlation to the number of sales e.g. rent, electricity, stationery
When setting your prices direct costs are easy to understand – it is like cooking for every cake you make you need 2 eggs, 1 cup of flour, ½ cup of sugar etc. You can easily work out the price of each ingredient as you know the cost of one packet of eggs, one packet of flour and one packet of sugar you can apportion a part of that cost to what you have used in the cake. Indirect Costs are harder to assess – as they are not used and paid for in any kind of proportion to the number of items sold. In the cake example above, how do you include an amount for the wear-and-tear on the equipment you used?
There are many many methods and systems for costing these indirect costs (often also known as Overheads), the method you will need to use in your business tends to vary according to the type of goods/service being sold – which

makes sense as different production processes have different ways of recording information.
Normal costing is widely used by most companies to improve the accuracy of the standard costing method.

Overhead Rate for next period =

Budgeted Overhead Cost for next period

Budgeted Units to be sold for next period

This method calculates and applies their overhead rate using expected overhead costs and quantity to be sold – instead of relying only on what happened in the past. Because it is about expectations you can incorporate known information such as an electricity rate rise scheduled for this quarter, or a price rise in eggs as winter approaches.
Back to the cake example above, you think the electricity bill for next quarter will be about $350 due to the price rise and you intend to bake 150 Cakes, and you decide that you this will be slightly more electricity for cake baking say 7%. Then you will attribute $24.50 of your forecast electricity bill to the 150 cakes you plan to bake – ie add 16.5c to each cake cost to include the electricity costs for all the cakes you will sell in the next quarter.
However indirect costs do not necessarily arise equally for all products. For example, one product might take more time in one expensive machine than another product so additional cost for use of the machine need to be recognized proportionally. So thinking again about cakes, if we are making 50 carrot cakes and 50 sponges, the carrot cakes take longer to cook and therefore have a greater proportion of electricity in their actual production cost.
Activity Based Costing looks at through-put and so tries to identify cause and effect relationships between inputs and outputs to objectively assign costs. This method enables apportionment according to process and product differences.
Firstly list all of your outputs, products or services you will sell – can you price for ‘cake production’ because you only produce sponge cupcakes, or do you need to price for cake type by size because you have an entire range of cakes from ‘chocolate mini-bites’ to ‘wedding fruitcakes’?
Once you have sorted your list of outputs for each one work out your inputs:

  1. who carries out the work and how much time they devote to it
  2. what materials are required for the activity
  3. what equipment is used in the activity

Then the per unit cost for each of these inputs needs to be calculated and assigned to each activity so that the total cost of the activity can be determined – you can do this by fine tuning the formula for Normal Costing, and instead of using a blanket ‘Budgeted Overhead Cost’ narrow it down to ‘Budgeted Time Cost’, ‘Budgeted Materials Cost’ ‘Budgeted Equipment Cost’ etc. and add them all together to get your total Indirect Costs.
Activity Based Costing, and other similar allocation methods are significantly more complicated to calculate – in Micro and Small SMEs with very little product differentiation not always necessary. However as a business grows in size and complexity improvements in costing accuracy that drive price adjustments will always deliver improvements in profit.
No matter how you decide to work out your indirect costs, to complete this step add them to your direct costs to get your Total Costs. If you set your price at this amount you will make zero profit, but can still pay all your bills. Any amount you charge above this point will lead you to make a profit – so the question becomes to how much profit do you want to make?

Step 3: Consider your Sales Strengths

When making this final pricing decision also keep in mind that your selling price is a function of your ability to sell – this may seem oversimplified, until you consider this:

“What’s the difference between an $8,000 Rolex and a $40 Seiko watch?
The Seiko is a better time piece, it’s far more accurate.
The price difference is related to each brand’s capacity to sell watches.”

If you are extremely capable at closing sales and bring in the money, then you are able to price higher than someone with weaker sales skills. This isn’t about your personal sales strengths; does the business have a good sales person, a premium brand, a hot product?
Once you understand your markets and costs, now you can set your final prices.

Step 4: Add your Mark-up

Mark-up is the amount added on top of Direct and Indirect Costs to create your selling price, this will tie directly back to how much profit you plan to make. This is where the Dark Art of price setting really comes into its own. But remember nothing is locked in stone, you can change your prices as often as you like or need (especially if you are decreasing them), but price increases are also relatively easy to orchestrate if you know how – see last week’s post Charge More
e.g. If you are a start-up it may serve you well to begin lower, establish your brand then follow through with several rapid price rises.

Mark-up v Profit Margin - What's the Difference?

It is also important to understand the difference between your mark-up and your margin – click here – make sure you really do make profits, instead of ripping yourself off.

Step 5: Monitor and Adjust Your Pricing

Finally, continuously monitor your prices and your underlying profitability on a monthly basis – you may even want to do this weekly if you are a start-up or are launching a new product. It’s not enough to look at overall profitability of your company every month, instead focus on the profitability of each product and service you sell so you can make absolutely sure every product is contributing to your profit goal (ensure your gangbusters are not carrying the poor performers).
Here are some other practices to help you price right:

  • Listen to your customers – customer surveys even casual chats can reveal allot about why people keep coming back or prefer one business over another – regularly get feedback and if possible amend your pricing to optimise your position – even raising them a little where possible (see back to the first example of shopping bags). Customers and clients love to know you care about what they think, and will respond to their input.
  • Keep an eye on your competitors – spend 1/2 hour each month or quarter to check google to see if anything has changed. It can also be useful (and cost effective) to hire college students once a year to do a secret shopper on you and your competitors – this can shed light on the different buyer experiences from business to business
  • Have a budget in place – this will act as a profit guide, helping you plan for your future pricing, price rises, sales and discounts.

How you set your prices can be the difference between the success, or failure, of your business – so take care to do it right!

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