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The Importance of Pricing for the Profitability of Your Business

Posted by Stephen King
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Importance of Pricing and Profitability GrowthForce

Knowing what to sell and how to sell it are two essential components of any successful business. After all, without a solid product or service and great sales people to move it along, there's really no way to grow your bottom line.

Pricing is the Key to Increasing Profits

When it comes to putting a price tag on the final product, it's not uncommon for leaders of small and medium-sized businesses to miss the importance of spending time to figure out the right pricing model. That is to say, pricing becomes more of a reflection of their costs, or competitors' price tags than a function of how to strategically increase a company's own profitability.

Unfortunately, many business owners simply don't realize that pricing is, in fact, THE most vital component when it comes to making money.

Price your items poorly, and you're leaving money on the table. Price your items well, and you'll beat out your competition without diminishing the perceived quality of your brand.

How much do you think a 10% increase can mean to your bottom line? Let's take a look at a quick example. When all else is equal if you have 10% profit and there's no change in expenses, a 10% bump on a $100 revenue stream that has $90 in expenses will double your profits, assuming you don’t lose any clients.

Sounds simple, right? Of course, if the profitability equation was truly that effortless, it wouldn't be a problem for any business. But, as we all know, breaking the barrier between the red and black is far from an uncomplicated feat.

Since you're here, we thought you might be among the many financial decision makers who are seeking a little guidance. If we've hit the nail on the head, start with the fundamentals.

Here's a rundown of three pricing strategies you should understand before you proceed further:

Value Pricing

Value pricing is as much of a science as it is a strategy. Basically, you're trying to determine what's the most someone will pay for your product or service. How much will the market bear?

You could use gut instinct, but really, is that enough in the business world? A Spidey Sense is critical, but your intuition can't provide you with data and analytics to support your instinctual decisions, and it certainly won't provide you with metrics to help you measure your success or opportunities. Gut instinct is valuable, but it really doesn't belong anywhere around your books.

On the other hand, you could seek tools that provide you with quantifiable data, which allow you to see the true cost of each customer or job, which helps you find hidden value, hidden costs and measure the true financial impact of your decisions.

There is a lot already written by value price experts on value pricing best practices. We suggest you also get a clearer picture of expenses and costs, you'll be better able to understand where your opportunities lie.

Focal Points for Value Pricing Strategy

  • Seek quantifiable data. Numbers matter -- a lot. By putting your data to work for you to see ALL the value you deliver to a client you'll be able to justify a small change in price and see how it can have a big effect on your bottom line.
  • Understand overall benefits versus costs. Expenses are only unaffordable if they don't pay for themselves. If you invest in tools that enhance your company's efficiency and propel productivity, the increases to the bottom line will more than makeup for the additional spending.

Target Gross Profit Margin

This strategy requires you to switch up your thinking a bit from a traditional approach. Rather than thinking in terms of dollars and cents, focus on percentages. Static numbers, such as salaries, don't mean much if you don't have a big-picture perspective to help you understand the percentage impact per business element.

This is when the power of true job costing becomes interesting. Do you know what your fully-loaded labor force (with full true fringe benefits) is costing you? Do you understand how that number relates to your organization's profits?

The amount of money you're spending on your staff greatly impacts your bottom line, and you need to realize how. Job costing allows you to track hidden costs as a result of time leakage and uncover other areas of potential added value.

Common ‘people costs’ include the following:

  • Training
  • PTO
  • Travel
  • Project managers & workflow management platforms

Focal Points for Target Gross Margin Profit Strategy

  • Set a *minimum* price of your items as a multiple of your costs. In doing so, you'll be able to make sure you get your target margin by piecing together the whole puzzle. If you know the minimum you can test the market and see what the market will bear. If you aren’t losing some percentage of bids, you aren’t charging enough.
  • Measure actual gross profit percent. It's important to perform this measurement on every job so you can begin to identify trends and outliers. Armed with this information, carefully study why you have differences so you can figure out where you add the most value, and get the highest gross profit percentage, or on the flip side get to the root of a problem or utilize a successful job as a baseline for future experiences.
  • Use your insights to improve your future. Once you understand your true costs, the true time it takes to do each job, then you’ll know what your target gross profit margin is, and you can price future jobs accordingly. You’ll also be able to better explain all the value in your work and increase profits.

Cost Plus Pricing

We don’t recommend cost plus pricing because it limits your potential upside. But if you must do cost plus pricing, you need to take everything into account -- including fully loaded labor cost, materials, and overhead -- when you price your items.

Using this cost-based method of accounting, you would price your items according to a certain standard percentage markup. In other words, you would determine your total price, then mark every single part of the process up by a predetermined percent.

But most service businesses don’t understand their true costs. They don’t know their labor cost “burden”; the real cost of each employee. They don’t have visibility into time leakage – time that slips away each day due to inefficient processes, unaccounted for travel, project management or client engagement.

That’s usually the difference between success and failure.

To be clear, unless your business is a commodity, this is the worst way to price. Using this structure, you can't make money if you gain efficiency.

Focal Points for Cost Plus Pricing Strategy

  • Truly understand your costs before you pick a pricing strategy. Cost plus pricing can work in the right situation, but it's important to understand that typical business scenarios don't lend themselves to success with this model. You're much better off gaining a solid understanding of the costs associated with various aspects of your workflow and processes so you can identify your most profitable clients, services and jobs. That’s likely where you’ll be able to add the most value and where you should focus your sales and marketing resources.
  • Evaluate value pricing versus cost pricing. As rudimentary as it may sound, think about this phrase at face value. Are you pricing based your goods or services based on the value you provide to your consumers, or are you pricing your items based on the cost of production? Your brand's value should always supersede superficial cost metrics (even though basic costs are a great starting point!)

So hopefully you can see that while optimal pricing is vital to the profitability of your company, it isn’t a simple process to get there. Tracking and accounting for the cost of doing business is much easier said than done, particularly if you aren't employing tools that can help you maximize your pricing model and leverage every aspect of your brand.

So how do you optimize your pricing model to increase your company's profitability? You turn to your management reports and look at the data.

Management reports help CEOs figure out if they are pricing their jobs right, and also to help business owners to really understand who their most profitable clients are, and what makes them profitable.

If you aren’t getting the right quantifiable data, then you should start by reading the 3 most common problems with your management reporting.

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