How to Get Your Pricing Right – Part 1
What’s the right price for your service or your product? This is probably one of the hardest business decisions you’ll have to make and it should be, because pricing impacts everything you do.
Pricing impacts the profit in your business, can impact the cash flow, impact the growth of your business or your ability to grow as well as impacting the amount of capital you need to grow your business. Pricing can even effect the type of people you attract to your business, because if your business isn’t profitable enough it limits the type of people it can attract.
So how do most small business owners price?
When it comes to pricing, most small business owners that we’ve spoken to base their price on the industry average because they feel that if they don’t charge that price, they won’t get any business. They look at the last job their competitor lost based on price and assume the buyer will go for a lower or similar price.
Sometimes that’s right and sometimes that’s wrong. If the competitor doesn’t know how to price and you’ve copied their pricing, it’s like the blind leading the blind. When it comes to pricing, we need to spend a fair amount of effort in making the right decision. It’s important to protect your pricing decisions because sooner or later if you don’t, you could be out of business.
When it comes to our trade based clients we find they usually have three prices that they go by. There’s the price they come up when they have no work, there’s the price they come up with for their regular customers and then there’s the price they come up with when they’ve got too much work. This also tends to happen in a lot of other industries.
Before you can make a pricing decision, you’ve got to know your numbers
The first thing you need to know before you can make a pricing decision is you’ve got to know your numbers. What are your costs? The cost of labor, cost of materials. What are the variable costs? The costs that go up or down depending on how much we produce or the amount we manufacture. You also need to take into account overhead cost. These are the costs that stay fixed, regardless of whether you sell a thousand things or whether you sell nothing, you’ve still got to cover overhead costs.
Once you’ve identified your costs you can set your desired margin. When it comes to your desired margin, you generally consider your costs and then up the price of that product by a desired margin. And there are two types of margin. You can have what you call the gross margin and then you can have what I call your markup.
There are two types of margin
There is your gross margin and there’s your markup. They’re vastly different and can produce different results.
For over a year, we were advising a client of ours that their margins were too low. A target gross margin of 35 to 40 percent was set and being entered into their pricing system, but when it came to their end of year financials we were finding gross margins as low as 12 percent. We figured there was something wrong with their pricing. When we had a closer look at their pricing model, it became apparent that they were putting a 35 to 40 percent markup in to their system rather than a 35 to 40 percent gross margin. They had basically reduced their desired profit by nearly two-thirds.
This is why it is so important to understand the two types of margin.
What is something really worth?
When it comes to pricing, the cost alone including the margin isn’t all that matters. You need to look at what something is worth in your business and the value to your end user. Generally speaking, we find 15 percent of people buy based on price and 85 percent of people buy based on value, so the key is look at differentiating your value in the marketplace.
As a simple example, you can buy a Louis Vuitton handbag worth $2,000 or more or you can buy a handbag at K-mart for $20. Is the Louis Vuitton handbag worth one hundred times more than the K-mart handbag? Perhaps Louis Vuitton use materials that are one hundred times better or their manufacturing processes are one hundred times better than K-marts. It could be that they spend one hundred times more on marketing but don’t necessarily spend a hundred times more on the other things mentioned. Value is in the eye of the beholder and we need to understand this when it comes to business.
At the end of the day, when it comes to price, there are two types of pricing models that we will cover in Part 2 of How to Get Your Pricing Right.