How Will Right Pricing Make Your Business More Profitable? Post 2 of the series

Another reason why businesses don’t Right Price is they look at their opposition and believe that their prices MUST be lower than their opposition. The trouble with this approach is several fold. For instance:

• Is your opposition pricing their products so that they actually make a profit anyway?
• Are you targeting the exact same customers as your opposition?
• Will you provide better services and products than your opposition? and
• Are you going to be the same as your opposition or are you going to be outstanding?

We’ll just touch on one of them today.

Is your opposition pricing their products so that they actually make a profit anyway?

You buy a product for $10 and sell it for $20 – you’ve made a profit haven’t you? Many business owners would tell me, “Yes”.

Trick question! The real answer is “yes” and “no”. Yes, they have made a profit on that one sale. But they may not have made a profit in their business. Confused? Let me explain.

Every business has what are called “fixed expenses”. These are the expenses directly related to keeping the business open and do not relate to, or are affected by, the number of products and services sold during the year. This includes things like rent, wages, advertising, insurance etc. etc..

Let’s say that it costs you $365,000 a year just to keep the doors of your business open. If you sell no products you still have to pay out this $365,000 (at this rate it won’t be for long mind you). If you sell a million of your products you will still pay out $365,000 in fixed expenses.

The cost of actually selling a product or service is called a “variable” expense. These only occur when we actually sell a product or service and are in addition to our fixed expenses. Sell no products or services, no variable expenses. Sell a million products or services, well that’s a million times the cost of that product or service in additional expenses to the business.

Here is an example of the difference between the two expenses. Let’s say you pay a salary and a bonus on all sales to your staff. The salary would be a fixed expense (paid no matter how much they sell) and the bonus would be a variable expense (only paid when a sale is made).

Another example would be petrol and the cost of running a car. I allocate a certain amount of budget every year to the general running of the car – for things like visiting clients for relationship building purposes, attending meetings etc.. This is a fixed expense. A variable expense for me is the additional petrol it costs whenever I am paid to deliver a workshop for one of my clients. This is a variable cost because the only time I need this additional petrol is when I sell a training workshop and I have to travel to that paid workshop.

You probably get it by now.

The difference between what I buy a product or the cost of delivering a service and what I sell it for is called Margin. The amount of margin left over from each sale is what you use to pay your fixed expenses.

Take the expenses and prices above.

It costs $365,000 a year in fixed expenses. I buy my products for $10 and sell them for $15. Let’s say I sell 70,000 of these products each year. That gives me total sales of $1,050,000. Not bad turnover for the year. I must be profitable with that amount of turnover – mustn’t I?

Sales = $1,050,000

Cost of those sales (variable expenses) = $700,000

Margin = $350,000

Fixed expenses = $365,000

End of year result = $15,000 loss.

What if this is your opposition’s position and they aren’t aware of what’s happening in their business and simply believe in putting a simple margin on their products? In this case they’d be going broke – only slowly. So, if I see the price my opposition are charging, say the $15 and I decide to undercut them by just 50 cents, I would be a further $35,000 worse off than them if all else was the same. They’d probably think they were successful as they watched me disappear from the scene.

Who’d think 50 cents would make such a big difference?

To solve this problem I can do several things. I could reduce my fixed expenses or variable or both. I could increase the number of sales or customers. I could increase prices. I could Right Price. Or I could do nothing and slowly go broke.

I will address some of these in later posts. But right now, how many extra sales would I need to make to break even in this example of selling at $15?

No, not 1,000 sales, even though my turnover has increased by $15,000. I’d still be $10,000 in the red (because of an extra $10,000 in variable costs).

I would actually need to sell another 3,000 items just to break even.

Total sales: 73,000 items at $15 = $1,095,000

Total cost of sales = $730,000

Margin = $365,000

Fixed expenses = $365,000

Net Profit = $0

In this case, you would have to sell 73,001 items in a year to make a profit of $5 for that whole year! At least your tax bill wouldn’t be that big.

Now, of course, this is all put in very simple terms. There may be additional cost involved in getting those extra sales through the door or savings because of increased stock purchases etc.. But enough for now.

We’ll go even further in future posts.

For now, all success.

Colin.

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