Thinking Entrepreneur

An owner’s dispatches from the front lines.

My fellow blogger Paul Downs recently wrote an interesting post that described his ongoing struggle with developing a pricing strategy. He is hardly alone.

Figuring out how much to charge is part art and part science. We start our businesses, focus on delivering a better product or service, and price it in a way that we believe will win us some customers. Inevitably, we underestimate how long it will take to make or do something. No problem! In the beginning, when you do everything yourself, there is more room for error since you can make it up with your own labor and chalk it up to experience. As you grow, you might pay someone overtime to compensate for a bad estimate. Maybe you will even lose some money.

But it gets more complicated when the company gets bigger and has some success. Eventually, you have to develop a pricing strategy that will allow the company to grow profitably while you are paying people to do everything from sales to production to accounting to purchasing. It may require you to increase prices. For an entrepreneur, this introduces a new element: fear. Fear that you are going to ruin the magic formula that has made you successful. Fear that your customers will flee. And fear that new competition is going to move in on you the way you moved in others when you started the business.

Eventually, your head splits in two. A little accountant stands on one shoulder and says, “Your costs have gone up because you have had to hire more people. You need to charge more to cover the costs of your good people. Being busier does not necessarily mean you are making more money. Get control. You can’t fight the math!” On your other shoulder is the hungry, customer-driven, take-no-prisoners and lose-no-customers salesperson who says, “You have been successful because you are providing a great value. There is an old saying, ‘Quality, service, and price — pick two.’ But anyone can do that. You can provide all three! You are SUPER ENTREPRENEUR! Don’t raise prices, just work harder and smarter!”

Ahhhhhh! What to do?

As usual, doing nothing is a bad option. A good pricing formula is a critical component of a successful business. For some businesses, it is not that complicated. If you own a bike shop, for instance, there is a list price for the bikes, but you have some flexibility in how much to charge for accessories and repairs. If you make custom products like Paul Downs, and you are bidding to get business, it is far more tricky. My custom-framing business falls somewhere in between.

The process starts with cost accounting. When you buy a finished product that you resell, you know what your cost of goods sold is. Kind of. You still have to factor in whether the items will have to be discounted, whether any will be stolen (shrinkage), and whether a percentage of the products will end up in the trash (bananas, for example). Estimates of how long it should take to make something can vary greatly from how long it does take. Every year at the national picture-frame trade show — yes, there is such a thing — I do a pricing class. I always ask the group how long it takes to do the average frame job, and I give specific criteria in “framer language.” I always get answers that range from 15 minutes to an hour and a half. You simply can’t do intelligent pricing if you don’t understand your costs. And that’s true even if you are making money. You may have profitable products or services that are subsidizing unprofitable products or services.

Business owners attempt to compensate for this problem in various ways. You might keep telling yourself that because you are covering your fixed costs, any gross profit you make on incremental sales will fall right to the bottom line. And maybe it will — but only if you are not operating at capacity, and it’s not always easy to tell. Will you need more salespeople? Another delivery truck? More space for storage? I have learned that there are few costs that are truly fixed. When you increase sales volume, there is the opportunity for increased profits, but there is also the danger of unexpected expenses. Seller beware.

Some owners simply price to competition. If you have the exact same expense structure as your competitor and if your competitor is profitable, this may work. But in the real world, many low-price competitors are pricing themselves out of business. We recently had a customer tell us that our prices are higher than those offered by the framing shop she used to use — a shop, she went on to say, that went out of business. My sales consultant helped the customer connect the dots between those two facts.

At my frame shop, we provide great value, great service (my average framer has been here over nine years), and a one-week turnaround. We import frames from all over the world, and we have a rigorous quality-control process. Most of the companies that have tried to go after us by being 10-percent cheaper have gone broke trying because the 10-percent has to come from somewhere — some from profit, some from loss. If we dropped our prices 10 percent, we would get a little busier — and then we would go broke.

Do you sell a product or service that is especially sensitive price changes? This is at the heart of the fear factor. Doing some math can help you make an intelligent decision. Let’s say you sell a product for $1,000 that costs $600, including the cost of goods sold, packaging, sales commission, and charge-card expenses. Let’s also say that your company does $1 million in sales and only has a 1-percent net profit, or $10,000. You consider increasing prices 5 percent. If you do — and this surprises a lot of owners who don’t do the math — you could lose 11 percent of your business and still make more money with the price hike.

Here’s the math. Before the hike, you sold 1,000 units and had $400 on each one left to cover all of the other fixed costs and whatever profit is left. That produces $400,000 ($400 x 1,000) that we can call the contribution margin. Now — taking into account the 5-percent price hike and an 11-percent decline in sales — you sell 890 units with a $450 contribution margin on each one. That produces a total contribution margin of $400,500 ($890 x 450). That extra $500 will add to your net profit, taking it from $10,000 to $10,500. Still not good.

But suppose that, instead of falling 11 percent, your sales were to fall only 4 percent. That would mean you would sell 960 units at $450, which produces $432,000 in total contribution margin (960 x 450). This increases your net profit by $32,000, which means that it will go from $10,000 to $42,000, or 4.2 percent. Much better than 1 percent.

It is, of course, impossible to know exactly what will happen when you increase prices, but doing the math can help you can make an intelligent decision instead of a fearful guess.

There is at least one more factor in pricing, one I call market reality. Suppose, for example, your company makes jackets out of beautiful leather. Very expensive leather. You use good cost accounting. The extra large jackets take far more leather to make than the small jackets, especially because you have to use larger pieces that are perfect. These are luxurious jackets. But, as you probably know, the standard in the industry is to charge the same amount for both large jackets and small ones — even though one costs considerably more. When it comes to clothes, the larger sizes are effectively subsidized by the smaller ones. Go figure.

A business owner has to wear a lot of hats. For many, analyzing pricing is at the bottom of a long list of things to do, but I can’t think of anything that is more critical. Just do it.

Jay Goltz owns five small businesses in Chicago.

Article source: http://feeds.nytimes.com/click.phdo?i=0b7433d7f2c56762c59bc5d8780f79ad