Small Business Strategy | Margin | Pricing

Updated: Aug 23

Small Business Strategy – Margin - Pricing

Perhaps one of the most striking deficits in many business owners minds, is the lack of awareness of margins being made, when negotiating or providing prices to potential customers.

If the business is achieving a profit before tax of say 10% on its sales. What if the price of the goods/services/projects charged were 5% less than they could be? Well, if they were priced 5% higher, then the profit of the business would be 50% Higher. If prices were lowered by 5%, then you would need to effectively DOUBLE the sales of the business to achieve the same previous profit.

So, it is clear as a profitability strategy, that generally the business prices its Goods/Services 1) As high as possible (Taking into consideration competitors prices) and 2) Does not compete solely on the basis of price (Commonly referred to as Non-Price Competition).

Optimal pricing

It is important to be aware of competitor pricing for similar/substitute items. This is achieved by surveying competitors and any financial incentives they offer (Volume rebates, Trade discounts and so forth).

Also, to be aware of the cost of provision. Unless you know the costs of providing a specific good or service, then you will not be able to understand whether the price it sells for, provides sufficient margin.

Furthermore, quite often within business, the Pareto principle holds up, effectively 20% of products provide 80% of profits, with 80% of products only generating 20% of profits.

If certain items sold are connected to the sale (or future sales of other items) then there is a case to initially sell at a favorable price, so long as the total lifetime or chain of connected purchases delivers the intended profits. Often this is seen with introductory offers.

With respect to understanding the cost of a product or service, then your time would be well spent, to logically calculate all the relevant costs attached to its provision. Direct costs such as purchase of any stock or materials are easy to attribute. There is a less objective relationship between many selling/distribution, administrative and overheads against individual products/services supplied. However, if you look at all these costs in your businesses’ previous income statement (Profit and Loss) and then divide them as a function of sales, then you should be able to calculate a rule of thumb for a general allocation of these costs to individual sales.

Hence, as an example let’s use the simple Income Statement shown earlier in this article.

As we can see, Operating and Overheads is 27,346 and sales is 134,583. So, we need to generally recover 20.3% of income, to cover overheads.

So, lets assume we’re a generic general building contractor and we have total direct costs to a piece of work totalling say 2,567. (Materials and Labor) (Shown below as Cost of Sales), then we’d need to add an extra amount, to cover the general overheads and the intended profit margin.

The mini profit and loss for the job would look like this:

Hence the net labor and material costs of 2,567.00 required an additional uplift of 1,012.84 to cover a contribution to overheads of 654.86 and enough to make a net profit of 357.98 (10% on sales).

Once you’ve done an initial example, it’s not very difficult to develop effectively a rate card of standard uplifts on any project, as in this case. Gross profit at 1,012.84 in relation to sales of 3,579.84 is 28.3%. So, if you know the costs of your materials and labour, if you total those up and divide by 0.283 then you know your total sales value. Obviously if you believe you can charge more, then do so, but this gives you the knowledge of what you should be recovering to cover your all your other costs and overheads plus a sufficient profit.

By ensuring you're adding a sufficient amount to each job/product/service to cover overheads and indirect costs, then at the end of the year, you hopefully won't be in the situation that you've worked hard but not made any profit!

As a very broad rule of thumb many businesses aim to achieve a 30% mark up from which 20% covers their overheads/Indirect costs, so they are left with a 10% profit on Sales.

If you have competitors, then any potential new customers will almost certainly assess you against them. Logically, if you’re fractionally cheaper (Or even often the same) and potentially offer some additional non price benefits, then they’ll almost certainly choose you each time all things being equal. If they’re likely to be repeat customers, then you can potentially improve the initial benefit. In the example previously, you could assume that so long as you get your basic cost of sales back, then you can offer the rest as an initial discount, I.e., 2,567.00 instead of 3,579.84. Such a discount could be pivotal in getting very loyal customers of a competitor to try your offering, at least once.... even loyal customers have a price.

Non price competition

Beyond simple price competition the other relevant areas are Product, Place and Promotion. In marketing the marketing mix is referred to as Price, Product, Place and Promotion (The 4 P’s). From these we look to create sustainable competitive advantage through differentiating against our competitors, effectively marketing the businesses brand and quality of offering, rather than simply lowering prices.

Product – Product differentiation, unique selling points, After sales service

How does your product/service fulfil a need/want of customers?

By understanding the customer, you will be in a far more knowledgeable position to assess this. Customer segments can be the general public or trade, experts or novices. Who are you targeting? How will this be comparable to current competition offerings? If you are supplying a generic standardized product then more emphasis will need to be placed on Place and Promotion.

Place – Subsidized delivery, Speed of delivery, Extensive distribution, Main/High Street? Industrial zone? Online internet based?

From knowing your customer, you should be able to gauge how important this is. If you are selling to other businesses then this has different distribution channel issues than selling direct to the public. Normal retail customers are increasingly impatient and numerous suppliers seek to fulfil as close to ‘immediately’ as possible, so it can play a deciding factor, when all else, things are similar to competitors. For basic wants in retail, then customer footfall and proximity to certain attractions plays a significant deciding factor.

Promotion – Loyalty programmes, Accumulation of positive reviews, Advertising, free gifts, coupons, sales staff.

When, where, how are your potential customers located, and at/in which time slots? Promotion is expensive, so it needs to be targeted to achieve maximum cost/benefit for its spend. Promotion differs according to what you are seeking to influence. A new customer is different to customer retention.

Finally, you can use a mix of these features to provide the best value to customers. Knowing your customer and knowing your competition is key to assessing how you can better serve customers relative to the competition, while retaining as much margin as possible (Price), because ultimately you are in business to make a profit, and ideally as much as possible for your efforts.

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