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The price is right

PricingMany small businesses keep their prices low for fear of losing customers, but end up losing money as a result. Laurence Harrould discusses how to move your business from a non-profit organisation to a cash cow.

In business we often hear the adage ‘cash is king’, yet many small business owners put in long hours for little or no money and may even fund the business from a mortgage on the family home. This is not how it’s supposed to work!

When I talk to small business owners, they often tell me their biggest challenge is setting prices and managing costs in a way that makes the business profitable.

Increasing profitability can only be done in two ways: increasing revenue or reducing costs. We will look at both these options and explore which works best.

We’ll start with a business, such as a coffee shop, which sells items (see Table 1).

Customers 3000
Number of purchases 24
Average sale price $15
Sales 1,080,000
Cost of sales (540,000)
Margin 50%
Gross profit 540,000
Overheads (400,000)
Nett profit 140,000

Table 1: Item-based business

Our example shop has 3000 customers. The average customer visits twice a month and spends $15. Total income is $1,080,000. So far this is looking like a nice little business. However, we have to take out our costs. What’s left over is usually what the owner gets to call his or her income.

Cost of sales is the expenses associated with the delivery of the actual product, such as cost of ingredients, containers used to serve the food and electricity used to do the cooking. Setting prices is always something of a dark art. In our example we have simply doubled our cost of sales to get our item price, hence the margin is 50%.

So far we have a gross profit of $540,000 – still not too bad. Then there are overheads. These are the expenses that occur irrespective of how many sales you make or whether there are any sales at all. Examples include rent, staff (you still need to pay them even if there are no customers – we’ll talk about this a bit later), telephone line rental, electricity and insurance. I’m sure if you think about it for two seconds you’ll be able to come up with a whole list for your own business.

In our example we have set the overheads at $400,000. Take this away from the gross profit and you are left with the nett profit. In an ideal world this might be what the business owner takes home. The taxman blows away that idea, but for the purposes of this article we won’t look at that and just stop at the nett profit.

When prices go up, so do profits

As I mentioned, there are only two ways to affect the bottom line. The first option is to increase revenue. The easiest place to start is putting up your prices.

“No way!” I can hear you scream. “I’ll lose all my customers! I’ll price myself out of the market!” Yada, yada, yada.

Many business owners have substantially increased their prices and increased their profits as a result.

A 10% increase in the price (see Table 2) has increased sales income.

Customers 3000  
Number of purchases 24  
Average sale price $16.50 +10%
Sales 1,188,000 +10%
Cost of sales (540,000)  
Margin 54.6% +4.5%
Gross profit 648,000 +20%
Overheads (400,000)  
Nett profit 248,000 +77.1%

Table 2: The effect of raising prices by 10%

As it has not cost any more to produce and deliver the item, there is no effect on cost of sales or overheads, so the additional income goes straight to the bottom line.

By adding $1.50 to the average sale, we’ve increased nett profit by $108,000 or 77.1%. Take home is now $248,000 as compared to $140,000. Would that make a difference to your lifestyle?

One of the big arguments against price rises is the fear of losing customers. How many customers would you lose if you added $1.50 to the price of the average meal? How many could you lose and still be ahead financially? As Table 3 shows, you could lose 16% (480) of your customers and still be a little ahead of your starting point.

Customers 2520 -16%
Number of purchases 24  
Average sale price $16.50 +10%
Sales 997,920 -7.6%
Cost of sales (453,600) -16%
Margin 54.6% +4.5%
Gross profit 544,320 +0.8%
Overheads (400,000)  
Nett profit 144,320 +3.1%

Table 3: Losing 16% of customers as a result of raising prices by 10%

Also, consider which customers you would lose. It’s generally going to be people who are harder to deal with, complain more and are more demanding.

By losing a number of these, you’ll have more time to support the customers you enjoy working with, resulting in better customer service leading to more loyal customers who are happy to do more business with you.

Clearly, raising your prices can be enormously profitable.

Something else to consider is the effect of inflation. If your costs increase 3% every year (and inflation is currently closer to 4% in Australia), a profit of $100 is reduced to $63 by the end of four years – a loss of 37%. If you’re not increasing your prices, you’re going backwards rapidly.

The other ways to increase revenue are grow your customer base or increase the number of sales per customer. Let’s have a look at the numbers.

To increase our customer base by 10% we have to do some serious marketing – getting another 300 people to buy from us is no small task This would increase our cost of sales, which means nett profit grows but only by $54,000 or 38.6% (Table 4).

Customers 3000 +10%
Number of purchases 24  
Average sale price $15  
Sales 1,188,000 +10%
Cost of sales (594,000) +10%
Margin 50%  
Gross profit 594,000 +10%
Overheads (400,000)  
Nett profit 194,000 +38.6%

Table 4: The effect of gaining 10% more customers

Another option is increase the number of purchases, also called upselling or the ‘Do you want fries with that?’ approach. This can return significant benefits, as you can see in Table 5.

Customers 3000  
Number of purchases 26 +8.3%
Average sale price $15  
Sales 1,170,000 +8.3%
Cost of sales (585,000) +8.3%
Margin 50%  
Gross profit 585,000 +8.3%
Overheads (400,000  
Nett profit 185,000 +32.1%

Table 5: The effect of increasing the number of purchases per customer

However, adding around 10% to the number of purchases doesn’t deliver the significant improvements achieved by an equivalent increase in price.

Keep in mind this would require customers to frequent our coffee shop an extra couple of times per year. We need to change their behaviour, which can be the hardest task of all. Loyalty programs attempt this but give away part of the added profit as the incentive to come again.

When costs go down, profits go up

Often our response to financially challenging times is to look for ways to reduce expenses. If handled correctly this can make for a more efficient organisation. However, more often than not, it results in a downward spiral.

Back at our coffee shop, areas available for cost cutting are cost of sales and overheads. If our business is big enough, we might be able to cut a better deal from suppliers. But in most cases, the only way to reduce the cost of sales is to cut back on the quality of the ingredients or the quantity we provide.

Either way there’s a good chance it’ll cost us customers.

The other option is to reduce overheads. There are probably many small things we could do, such as using low-wattage globes for lighting. But there is not much scope to make significant changes.

This is usually where the business owner starts looking at the number of staff and wondering who to cut.

The immediate consequence of this is that person’s job still needs to be done, so someone else has to do it – most likely adding stress and additional hours to what they are already doing. Work is done less effectively and less productively. So be very wary of using staff cuts for cost saving.

A 10% reduction in overheads (how realistic is that?) returns $40,000 to the bottom-line – an increase of 28.6% (Table 6). This makes decreasing overheads the least effective approach.

Customers 3000  
Number of purchases 24  
Average sale price $15  
Sales 1,080,000  
Cost of sales (540,000)  
Margin % 50%  
Gross profit 540,000  
Overheads (360,000) -10%
Nett profit 180,000 +28.6%

Table 6: The effect of reducing overheads by 10%

This example has used an item-based business. However, the same situation holds true for someone providing a service and charging for time. [Unfortunately, we don’t have space to demonstrate this.–Ed]

A final point: the idea you need to be charging the same as everyone else. If you do, you are simply following the herd. You need something that will make you stand out from the crowd. What is your unique selling proposition?

Why would people buy from you rather than your competitors? If the answer is ‘because I’m the cheapest’, it’s time to review what you’re doing because someone selling the same thing cheaper is not far away. This is especially so when the internet means you are competing against the whole world.

Increasing your pricing by a small increment can have a massive effect on your bottom line. While there are other ways to increase revenue and reduce costs, nothing else has the same direct impact.

When was the last time you reviewed your costs and prices?

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