PRICING MANAGEMENT
Managing your company’s pricing process is vital to the success of your business. Declining gross margins generally indicate pricing problems and may lead to the ultimate failure of your company.
The success of any business depends on several key factors including achieving consistent gross margin targets. How gross margin is adversely impacted by pricing decisions is illustrated here by 3 simple examples below.
Let’s assume you have a business with net sales of $100,000; your COGS (cost of goods sold) is $60,000 and your gross profit is $40,000;
EXAMPLE 1
Illustrating the effect of cutting your price by 10% by offering your customer a discount. In this example your gross margin declines from 40% to 33%:
SALES $100,000 100% $90,000 100%
COST OF GOODS SOLD $60,000 60% $60,000 67%
GROSS MARGIN $40,000 40% $30,000 33%
EXAMPLE 2
Illustrating the effect of a 10% increase in the COGS, such as in the case of wage or material increases without any price increase adjustment. In this example your gross margin declines from 40% to 34%:
SALES $100,000 100% $100,000 100%
COST OF GOODS SOLD $60,000 60% $66,000 66%
GROSS MARGIN $40,000 40% $34,000 34%
EXAMPLE 3
Illustrating the effect of increasing the sales price by the amount of the cost increase. If the cost increased by $6,000 as in this example, and you increase your selling price by the same dollar amount, you have in effect implemented a price reduction. To retain the same margins, you must increase the selling price by the same percentage as the cost increase. In other words, you must increase the price to $110,000 (10%) to retain the 40% gross margin target.
SALES $100,000 100% $106,000 100%
COST OF GOODS SOLD $60,000 60% $66,000 62%
GROSS MARGIN $40,000 40% $40,000 38%
GROSS MARGIN EROSION
Declining gross margins generally signal trouble within a business. It is often an indication that a company is experiencing difficulty in selling products or services at a high enough price relative to costs. Some reasons may be: there are too many people on the payroll, material costs have increased and not reflected in the selling price, or overheads are too high. Managing every aspect of a company’s costs is therefore paramount to the success of the business. Good business management commands a regular review of key financial metrics to quickly allows you to focus on the key numbers that drive the profitability of the business and if necessary make operational adjustments.
FOCUSING ON VOLUME VS. MARGIN
Many company leaders including those of large companies believe volume is the key to business success. They believe you can cut prices and make it up by increasing volume. If that was true, large corporations like Nortel, Enron, Blockbuster and many others would not have filed for bankruptcy.
To illustrate the increase in sales revenue necessary to offset a selling price discount, let’s assume we generate a 40% gross margin on annual sales of $100,000. Our COGS is therefore $60,000 and our gross profit is $40,000. If we implement a 10% discount on sales, we would have to increase total sales by 33.33% to $133,330 to maintain our gross profit target of $40,000. Obviously if the business isn’t able to generate the volume increase the overall gross margin is reduced.
PRICING STRATEGY
Companies generally cut prices because of competitive pressure. The general assumption being that all buying decisions are made on price. Research has shown that this is not true. In today’s world of social media, on line reviews are much more influential in the buying decision. Spend the time to determine your company’s competitive edge. Find ways to differentiate your company from the competition. Focus on service, quality and operational efficiencies. Create great customer experiences and ask them for reviews. This is what great companies do, especially those in highly competitive businesses. There will always be “low price” competitors. When one disappears another one comes along. Don’t repeatedly cut your prices and play their game if you want your business to survive.
Hans Berger ASE