If yours is like many of the small businesses I’ve studied, the price you quote for your products or services is determined by a simple formula, based on your estimated costs. Feed in your costs and your desired gross margin and presto, out comes the price. There’s just one problem: price has nothing to do with cost.
When I tell my clients their prices should have nothing to do with their costs, they usually look at me as if I have suddenly sprouted a third eye in my forehead. After all, they’ve been doing that for (fill in the blank) years and it has worked, for the most part.
That may be true, but in doing so they are probably missing opportunities to increase profits on some products or services, or to gain market share with others. Those two things are what pricing strategy is about.
When a business creates a budget, it estimates sales revenue, costs, and a desired gross margin that will cover overhead and produce a budgeted profit. Looking at the budgeted profit and loss statement, it is easy to fall into a trap of thinking, “If we can just get every sale for the estimated cost plus gross margin, we’ll be right on target.” It sounds simple and scientific, doesn’t it?
The problem is that what buyers are willing to pay has nothing to do with the sellers’ costs. You don’t believe that? I’ll give you two scenarios.
I wear a Timex Ironman watch that I can buy for about $35 from a number of retailers. It is a very accurate watch with a quartz movement and some very nice features. “Casual” quartz watches from Gucci made with similar materials sell for $275 to $350.
Trust me – I know manufacturing – there is no possible way to explain that price differential based on manufacturing costs. That’s why you can buy fake Gucci watches for less than my Timex on the street. The differential is totally due to the cachet of the Gucci brand. The price is what the market will bear, the value the buyer puts on the product.
Suppose you have two identical machines, except one is paid for and you took out a big loan for the second one. The person who runs it is a long-time employee, who makes a higher wage than the guy running the paid-off machine. The cost of the second machine is higher than the cost of the first. Do you believe you can get a different price for a product based on which machine you decide to use? Of course you can’t.
Pricing is both strategic and tactical. Working with companies to improve profitability, we have adopted a strategy of slowly raising prices above what we get with the magic formula until customers push back. We often end with prices at a higher, more profitable level for many, but not all customers. It’s the customer, not the formula that determines the best price.
We have experimented tactically with what the market will bear for change notices, usually much higher margins than for the original orders. In that case the customer is a captive audience. But sometimes we ease up on the change adjustment, and let the customer know it to build good will.
We have sometimes reduced prices below the magic formula to build market share or capture a new account. If the new business is incremental, it is all good on the bottom line.
The magic formula gives you a nice target, but don’t fall into the trap of thinking that is your best price.