Pricing for perfection

• Stephen Craft, Executive Manager Commonwealth Bank Local Business Banking
• 26 June 2008
• Page 1 of 2 : single page

I’ve never met you, and I don’t know your business. But I suspect your prices are too low. How can I be so sure? Because almost every small business undervalues its products.

I did it myself. When I ran my own business, I set my rates by looking at similar small businesses. I had lower overheads, so I figured that I could undercut them and still come out ahead.

Later, I went to work in-house for one of my largest clients. Then I discovered what they were really willing to pay for what I did. A lot more than I’d been charging, as you’ve probably guessed!

It turned out that my competitors were not who I thought they were. My client had been comparing me to big companies with high overheads and heavy workloads. For my client, the big attraction of my business was speed and responsiveness. Not price.

Know what you’re really selling

It turns out that I hadn’t paid enough attention to the first principle of pricing: understand what you’re really selling. What is it that sets you apart from the competition — the unique selling proposition that keeps customers coming back?

Here’s an example. One of my colleagues from the Commonwealth Bank used to run his own food services business. A major petrol company asked him to help improve sales at the convenience stores attached to its service stations. He found that the stores regularly discounted bread and milk — their biggest sellers — despite the fact that these fast-selling products were usually bought by men on their way home from work. But how many of those men could tell you what bread and milk normally cost?

Clearly the convenience stores were really selling — you guessed it — convenience. And we all know that people will readily pay for convenience. In reality, the convenience stores can afford to charge a premium for staples, instead of discounting them.

How much does price matter?

Once you understand your unique selling proposition, you can charge accordingly. That doesn’t mean you shouldn’t offer good value, but value might mean improving your service, rather than charging lower prices.

Recent research from Investment Trends and Commonwealth Bank Local Business Banking identified three key strengths in businesses with profit growth of 40% or more a year:

1. Quality of products and services
2. Marketing
3. Customer service

Notice that low prices aren’t on the list. While good value was a factor, it was very much in the second tier. Clearly these businesses were successful because they offered superior service at a reasonable price, rather than because they were cheap.

Pricing for profit

It is possible that charging higher prices might mean turning some customers away — but that isn’t always a bad thing. Remember, you’re pricing for profit, not turnover. (That’s the second principle of pricing.) Your aim is to maximise profits, not sales.

Sometimes they’re the same thing. If you’re running a low margin, high turnover business in a very competitive market, you’ll be looking to drive sales volumes as hard as you can. But many small businesses can do better by focusing on their most profitable customers and offering a value-added service with a higher margin. If you have to discount to win a customer, then perhaps you can’t afford to keep them in the long run.

Add up your costs

If you want to maximise profits, you need to develop a pricing strategy of your own, rather than just shadowing your competitors. After all, if you follow their pricing, you’re assuming they have their strategy right, and that you should adopt it. Can you really be sure of that? Your business has its own unique cost structure and customer base, so you need to build your own pricing strategy. That’s where the final principle of pricing comes in: factor in all of your costs.

It’s not enough just to take the cost price of a product (or an hour’s salary, if you run a service business), and then add some mark-up to it. Your prices have to cover all your costs — everything from interest payments and utility bills to payroll tax — plus you need to add a margin for profit. In other words, you have to look below the waterline of the pricing iceberg.

Setting a strategy

As a starting point, here are five essential questions about your business you need to answer:

1. What is your unique selling proposition? Are you selling on price, quality, service or convenience?
2. What are your real costs of doing business? If your prices don’t cover your costs, you won’t stay in business for long. Don’t forget to include owner distributions.
3. How sensitive is your market to price changes? Can you increase prices without losing business? Or can you drive extra sales with a small reduction in prices?
4. Are you running a high turnover or a high margin business? The answer will determine whether you can produce the highest profits with a low price or a high price strategy.
5. What are your best customers willing to pay? As any house-buyer can tell you, the value of something in a free market is simply the amount that a buyer is willing to pay. As an entrepreneur, your aim is to charge whatever the market will bear — not to satisfy some abstract concept of fair value.

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Top five pricing mistakes

1. Forgetting to pay yourself

Too many business owners treat their own time as an inexhaustible, free resource. You need to include your own salary and owner’s distributions in the price you charge, and pay yourself accordingly.

2. Cutting prices to win business

If you have to cut prices to win a customer, are they a customer you want to have?

3. Confusing mark-up with margin

It might seem obvious, but a 50% mark-up on your cost of goods doesn’t translate to a 50% margin. If you buy a widget for a dollar then sell it for $1.50, you’re making a profit of 33%, not 50%. And that’s before taking your other costs into account.

4. Forgetting the full cost of labour

Labour costs aren’t just about salary. Don’t forget leave, public holidays and super — not to mention payroll tax.

5. Discounting without counting

Temporary discounts to turn over stock can be an effective tactic. But you need to do your sums and understand how many new sales you need to compensate for the cut in profits.

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Case study: Brighton Consulting

www.brightonconsulting.com.au

Anthony Voigt understands the benefits of getting pricing right — and the dangers of getting it wrong.