Product and Service Pricing: Get It Right to Maximize Profit

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Profit Enhancement Strategies,published by The Business Owner

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Is your business making a healthy profit? If not, do something about it now. Something drastic. There’s no sense owning and managing a business that’s not growing and generating a healthy profit. Why mess with it? Your time and talent are worth so much more.

Moreover, you won’t survive breaking even while your competitors earn a profit. They’ll have profits to invest toward enhancing their ability to reach and satisfy customers. You won’t. You’ll fall further and further behind in your ability to compete and earn a profit.

To accept break-even or near break-even performance for an extended period of time without doing something about it is like having cancer and not seeking treatment. It’s a death sentence.

If you’re in this situation, do what turnaround expert Gary Sutton says (paraphrasing):

Take drastic action. Change the way you do business. Find a new, cheaper source for purchased goods or services. Outsource to a contractor what you’re now paying employees to perform. Focus on what you do best and get rid of the rest. Raise prices. Double the sale quota for your salespersons and let go of anyone who can’t hit the new mark. Try new, radical things, without delay. Sure, some may not work, but you’re going to die anyway if you stay on your current course. If you can’t seem to bring yourself to make these kind of changes you need to get out of the business altogether.

No Margin, No Mission

If you provide a product or service that’s competitively sold, odds are there’s a price — or price range — you have to be within to be competitive. Do you know what your competitors charge? Do you know the quality of each of their offerings relative to the price they charge? If you’re not completely sure, find out.

How does your product or service compare to your competition? What is your strategy? Is it a “we do that too” offering that competes on price? Or do you charge more but deliver more? There’s nothing inherently right or wrong with either strategy; you just need to know which is yours and whether you can succeed at the one you select given your particular competencies (or that of your company) relative to those of your competitors.

If you’re not profitable, something is amiss. It might make sense to find out what customers think about your product or service. About how you rate compared to your competition. Then ponder your competencies, those of your competitors, and the strategy that gives you the greatest odds for high profit. A third-party consultant might be helpful.

Do you require a premium price but offer a “me too” product? Do you try to offer a premium product but not charge a premium price?

For example, if you try to compete on price, it does not make sense to offer a premium product. The only way to earn superior, profit-winning sales with a low price is by having the lowest cost structure. This requires you to wring cost out at every turn. The result, of course, will not be (and cannot be) a premium product or service. Similarly, the only way to earn high profit offering a superior product is by charging a markup that’s greater than the extra cost you incur when adding the extra value.

Only through skilled execution of a clear, appropriate strategy can you earn profits that exceed those of your competitors. Legendary business strategist Michael Porter refers to a lack of strategic clarity as being “stuck in the middle.”

Pricing as Product

Sometimes, innovations in pricing can be as important as innovations in product. Take Xerox. Despite the breakthrough technology, its newly introduced copy machines were not selling. The machines were very expensive and executives did not grasp how they could reduce cost. Amazingly, business managers seemed okay with the way they were making copies: secretaries typing with carbon paper. What turned the tide was an innovation in pricing as significant as the product. Xerox stopped requiring up-front purchase and began charging by the copy. It placed its machines in large offices for free and charged for copies. No executive approval was required and office personnel quickly grasped its utility and productivity. Usage grew and Xerox revenue exploded.

Another example is Gillette razors. Competitors sold “the handle” for $20 and then cartridge refills for a few bucks. Gillette began giving away “the handle.” Men obviously liked getting it free. All they needed were refills, so they bought them. Gillette razor usage exploded, as did revenue.

Pricing innovations can be as important as product innovations. Maybe your next breakthrough can be an innovation in price. Maybe your customers would rather pay for what they really want, such as a copy or a shave, instead of paying for “a copy machine” or “a razor.”

Opportunity and Peril in Average Cost Pricing

If you manufacture custom items, you bid jobs. If you bid these jobs on average cost, you have variances from actual. On some jobs, your average cost model builds in too little profit; on others, too much. The result is that you tend to win most of your underpriced bids (which yield lower profit) and lose most of your overpriced (higher profit) bids.

Obviously, this is a problem. You book a lot of low-profit jobs and fail to capture jobs that, had you not overpriced, you could have won at your target profit margin.

The solution? Find a way to gain the ability to more accurately estimate cost. To be able to bid on actual cost rather than average cost. You’ll earn a higher profit and put your competitors at a competitive disadvantage.

And here’s another problem. If you average cost and your competitors study your bidding history and figure out which types of jobs you underbid and overbid, they could exploit the error in your costing for their own gain (and your loss), for example, allowing you to win jobs you tend to underbid and scraping extra profit from jobs you tend to overbid. On the other hand, you could do this to your competitors (if you develop an ability to estimate cost more accurately than your competitors do).

Markup-on-Cost Pricing

This article is the final one of a series on cost reduction and profit enhancement strategies. We hope you’ve implemented the recommendations and wrung considerable cost from your operation. But be careful if you price by percentage markup-on-cost. Don’t give away all your savings! Take the following example:

Column 2 above illustrates what can happen if you strictly apply a percent markup-on-direct-cost following a cost reduction campaign that succeeded in wringing most of the cost savings out of direct costs (as opposed to SG&A). The third column illustrates an approach that would be much more logical and beneficial. The cost reduction campaign allowed this sample company to reduce the price from $17.33 to $16.00 and also increase the bottom line profit per unit from 5 percent to 24.4 percent.

Pricing your products and services is complex. It can also be confusing and frustrating, but it’s essential to your ability to complete effectively and earn a profit.

What and how you charge should match your overall strategy. If your strategy is to offer a low price, you should not add bells and whistles but rather lower your costs. Conversely, if you attempt to deliver superior value, you must charge a premium (to recover the extra cost you incur).

How you price and charge is as important as any other issue you deal with. An innovation in pricing can be as important as an innovation in product or service. So come on! Outsmart and outwit your competition through skilled pricing and earn superior profit. If you think about it, it’s not even really a choice. It’s a requirement for ensuring the long-term viability of your business.