How to manage price for optimum profit.

How to manage price for optimum profit.

Oct 8, 2021 | Analytics, Management, Operations

 

We are all wary, in fact, usually very reluctant to put prices up, in case we lose customers. We ignore the sage advice of Warren Buffett who knows something about making a bob when he said: ‘If you have to go to a prayer meeting before raising your prices, you have a lousy business’

Increasing prices is a valid concern if two conditions are not met.

  1. You are undifferentiated in a way customers value
  2. You are in a commodity market.

There are five strategic drivers of price, the items that should be considered in your strategic thinking that delivers your pricing architecture:

  • Your business model
  • Price packaging
  • Strategic priorities
  • Market power
  • Behavioural drivers.

Before you consider the actual price you will be charging, you need to have built the pricing architecture that best accommodates the dynamics at play in your market, and the price elasticity of demand.. Any pricing decision has two dimensions:

Strategic: The pricing architecture that is consistent over time, which provides the structure of your price list.

Tactical. Price can be moved around as necessary, while always remaining inside the pricing architecture.

Many just leave price decisions to the end, a grave mistake, as finding the Optimum Price, the one that leaves a minimum ‘on the table’ will have a profound impact on your profitability.

If you produce a simple spreadsheet, such as the one below, you will be able to model how the profit changes at various price assumptions. It is almost always the case, that to a point it is better to put your prices up and take a modest volume loss, than to drop prices hoping that the added volumes will deliver greater profit.

The assumptions in the chart:

  • The Price we charge is entirely our decision.
  • The volumes we forecast at any price point are the combination of experience, assumptions, and gut feel. They can be very tactical, varying time to time, and customer to customer in some circumstances.
  • Cost of goods sold/unit and fixed costs are unchanged at any volume or price.

 

Developing a simple model is just maths and a range of assumptions, but we use it too infrequently. Our instinct is usually to drop prices in a crisis to preserve market share, rather than thinking about the impact on profit.  If you have a gross margin of 40%, for every $1 you drop your price, you have to gather in $2.50 in added revenue to break even.

Option 1 Option 2 Option 3 Option 4
Price/unit $15 $18 $21 $25
Quantity/period 100 85 80 55
GOGS/unit $6.0 $6.0 $6.0 $6.0
Fixed costs/period $400 $400 $400 $400
The profit outcome of the various options can be seen below
        Revenue Price X Quantity
Minus Total cost = ((COGS X Quantity) + fixed costs))
     Equals Net profit
Option 1 Option 2 Option 3 Option 4
Revenue $1,500 $1,530 $1,680 $1,375
COGS $600 $510 $480 $330
Total cost $1,000 $910 $880 $730
Net Profit $500 $620 $800 $645
Breakeven point.
Fixed costs/Unit Gross margin 44 33 27 21

 

The break-even point also changes. This is one of the most under-rated but simple calculations available to businesses to gauge their financial health.

Whatever you do, there will be some for whom the price is too high and will not therefore buy.

There will be others for whom you are pricing below what they would have been prepared to pay.

Either way, you leave profitability on the table when you pick a single ‘Optimum price’ point.

This is represented by the left-hand graph in the header.

When you can have two price points, you tend to increase the profitability.

I.e., You drop one price below the ‘optimum’ single price, and pick up those ‘cheapskates’.

You have a second option with prices higher to capture those who are willing to pay the higher prices.

The challenge is, how do you effectively fence off the two, so you are not just delivering an extra reward to those prepared to pay the higher price, just to capture the cheapskates?

It is in the ‘Fencing’ that the creative strategic thinking must take place.

This is represented by the right-hand graph in the header.

The obvious example is economy airline seats. Every economy seat is almost identical, yet there are price fences based on time, and ticket flexibility. Book early, cheaper than in peak booking time. Book very late, you might get a very cheap price, or you might miss out altogether. This is in addition to loadings on location: aisle and window, forward and aft. This is also in addition to the fences that exist between economy, business and first class, which has similar demarcation, for time, as well as the premium to be there instead of cattle class.

A final thought. Many SME’s are not selling time, or input costs & materials, they are selling the results of knowledge and experience and the value they can deliver to their clients.

How do you put a price on experience?

We all have trouble with that, at least I do, and most people I have come across do also. There are three basic rules to follow as you consider how to price for a job.

  • Price the client rather than the service. This means if you make them a million, shoot for a share of the outcome. This involves a ‘value conversation‘ early on. E.g., If I was able to deliver you added profit of 100k, how much would that be worth to you? This sets a benchmark, from which you can come to an arrangement. Remember, that a client asking you to do something for them is all about removing risk. You cannot offer guarantees with certainty, as there is always risk involved, but a bit of creativity can expose some useful ways to share the risk and reward.  To quote Peter Drucker: ‘In business all profit comes from risk‘. Therefore, the answer to how much they are willing to pay would be tempered by the risk and reward to both parties.

A further example: A friend of mine is a hypnotherapist, and often helps smokers become non-smokers. The value conversation around her services should not be about the price/session, but by how many packets of cigarettes it was worth, in which case, success would mean an ROI in a couple of sessions. E.g., How much does a packet of ciggies cost? How many packets a week do you smoke? Quick mental arithmetic… that means that success here will save you $250/ month on cigarettes, and that is before you factor in the health benefits. What a great deal!!!

  • Offer options. Where possible, offer more than one option at differing price points. A premium version, and one or more cheaper versions that have had some features removed. Think about the SAAS software options offered on the web. There are differing features listed for various price points, and it is always three.
  • Anchor high. Three price options, start with the highest first, it acts as an ‘anchor’. This is opposite to what we do automatically, we tend to price low as it seems that will be more effective at closing, but the opposite is true. Price high, usually they will go in the middle. In addition, it is far easier to price high and give a discount than it is to price low and try to add features at an increased price.

None of this is easy, if it was, everyone would be doing it. However, it can be done with some creative thought, experience, domain knowledge, and good feedback mechanisms to enable ‘fine-tuning’

 

 Note: Please excuse the dodgy graphs in the header. I am a strategic thinker, not a graphic artist! However, despite their dodgy state, I hope they convey the message.

 

 

 

 

Set objectives by deciding what not to do.

Set objectives by deciding what not to do.

Oct 5, 2021 | Customers, Marketing, Small business

 

We usually look at objectives and goals as the things we want to achieve. We then set about figuring out the path towards achievement.

There are always hundreds of ways to achieve a goal. Often we find ourselves bewildered by the options, and procrastinating or picking a fuzzy path as a result.

Try drawing a line through the things you will not do to achieve the goal, rather than struggling to pick what you will do.

This will help focus on a path quickly that removes ambiguity and the many opportunities to be distracted.

Over the years I have worked with a number of SME’s in the food industry. In almost every case, the seductive promise of the volumes delivering profitability to be extracted from the two supermarket gorillas is there somewhere. This always confuses the focus on delivering value and building brands for those who care about quality and differentiation before price. In addition, the resources for mass marketing and promotion that are necessary for success beyond an initial flurry in supermarket chains are usually absent in SME’s.

Failing to Recognise the mechanics of the supermarket business model, and the resultant infrastructure necessary to service this model, is a major source of financial and strategic failure of many SME’s in this space.

In those cases, I encourage people to set their goals, by excluding the option of supermarket distribution. Instead, focus their minds on the many opportunities outside supermarkets that better suit the capabilities and resources available.

 

 

 

What do Einstein’s theories have to do with your job?

What do Einstein’s theories have to do with your job?

Oct 1, 2021 | Change, Leadership

Most manufacturers seek to cut costs, a reasonable response to the increasingly tight margins available in all but very few manufacturing enterprises.

There is an alternative, hard to see and act on, but viable.

It involves thinking about the paradox that exists in manufacturing.

As automation has increased, and costs driven down by the reliability of machines doing repetitive work, jobs have not disappeared, but they have changed shape and location. The value added previously by people doing manual manufacturing tasks have moved somewhere else.

Value is a parallel to Einstein’s theories of relativity.

Matter does not disappear, it changes form under some sort of pressure, and moves somewhere else.

Value, similarly, does not disappear, it moves somewhere else. It cannot be destroyed, but when it moves, there are winners and losers. Think about all the value supposedly destroyed by mergers and acquisitions in the last 30 years, very few have lived up to the hype used to justify the change. Shareholders have lost, but those buying assets at less than replacement cost, and those benefiting from the exit of larger businesses have picked up value in many ways.

Again, value has not been destroyed, it has just moved.

If this is true, the task of manufacturing management is not to cut costs, but to extend capabilities.

It seems to me there is a progression happening.

Machines take on repetitive tasks, increasingly more complex over the last 50 years. They are now moving towards cognitive tasks, with the development of AI. It is in its early stages, but the shift appears to be real as I see the evolution. Again, the jobs of people in cognitive tasks will move somewhere else, they will not disappear.

The somewhere else seems to me to be towards social skills, untouched by automation. However, I suspect in 30 years that will no longer be true, but by then I will be gone, and someone else can worry about it.

Unlike the sci-fi of Netflix, this is not an inevitable dystopian outcome, it is a tool that is there to be understood and managed for the greater good.

Business leaders that see the differences and can manage the shape of them will win in the marketplace of the future, others will, well, move somewhere else.

Pity our political leaders seem unable to grasp the idea that change, and commercial evolution is a value adding outcome, that in the long term will be beneficial, while sticking to the status quo, betting the house on it remaining so, is the way to oblivion.

Header cartoon courtesy Tom Gauld in New Scientist. 

Is your website the digital equivalent of a camel?

Is your website the digital equivalent of a camel?

Sep 29, 2021 | Communication, Marketing, Social Media

 

As we all know, a camel is a horse designed by a committee.

So it is with many websites.

Digital camels.

Every page on a website should have only two objectives:

  1. Provide the catalyst to ‘convert’ to the next step.
  2. Make the conversion easy.

Not every page is a sales convertor, but each page should play a role in the progressive process towards a transaction, whether it be the first, or the twenty first, only the number matters.

The most common response I get when I make these sorts of observations are: ‘we need to educate‘ and ‘the objective of the site is brand building‘.

Both are valid drivers of the content of a website, but unless they ultimately lead to sales, they are little more than platitudes and good intentions.

Is your website just an elegantly coiffured  camel?

 

 

 

The three inevitable stages of successful entrepreneurial activity

The three inevitable stages of successful entrepreneurial activity

Sep 27, 2021 | Customers, Innovation, Small business

Every business starts small. The biggest on the planet all started somewhere, in a garage, dorm room, lab, somewhere between the ears of the entrepreneur.

Most fail, or at best deliver a return that would have been dwarfed by the interest on the same investment in a bank account.

Some however, do succeed, occasionally in spectacular fashion.

We all see the ones that do, they are shoved down our throats all the time as the heroes, the ones who made it, and we are asked the question, if they can, why can’t you?

There seems to me to be a pretty consistent sequence of growth, a sequence that holds true across all sorts of products and services, geographies, technologies, and circumstances.

Cheering.

This is the first stage, it is all enthusiasm, cheering from the sidelines, jumping up and down, wishing for stuff to happen. What it is about when you are in the midst of it all is hard grind, chaos, and cash.

At the beginning, you work your arse off, seemingly 24/7, with no letup. Everything that gets done depends on you doing it, you do not do it, it does not get done. Simple. It is messy, usually chaotic, as pressures come from every direction, your attention is demanded by each, which is why the 24/7, and still there is little forward progress.

Then there is cash. As you start, nothing is more important than cash. More start-ups go broke for lack of cash than every other reason combined. Managing your cash is simply the most important thing you must do.

Planning & doing.

Assuming you survive the cheering stage, you will have come to the point where you have a little more head time to be used considering ‘what next’. You probably have a small number of employees, and perhaps some outsourced services, like accounting and IT.

Answering the ‘what next’ question will be eating at your guts, as for sure you do not want to continue as you have been. Your kids are growing up without you, your family seem to be strangers, you have not had a weekend with your mates for ages.

So, you look forward to a different future and stumble into some planning. It is never as easy as filling in some generic template, of which there are plenty making alluring promises. It is more about the graft of figuring out how to accumulate and allocate the resources necessary to grow. While the game is still about cash, it has also become about profit, what is left for reinvestment at the end of the month, quarter, and year.

You plan your products and services, the foundation stuff you need to get right, like the legal and regulatory things that must be done, understand the financial and strategic pressures that are present, and settle for the moment on a business model that guides how you will turn your chaos into sustainable profitability.

However, a plan, no matter how good it may be at telling the future, envisioning new products, markets, and customers, needs one further ingredient.

It needs to be implemented.

Plans that do not get implemented are usually called dreams. You will also recognise the realty of the muttering of generals throughput the ages that while planning is essential, nothing ever goes exactly to plan, so you must be ready to be agile tactically, while consistent strategically.

Building & growing.

The essential ingredients to building and growing an enterprise, on top of the financial resources that enable that growth are threefold:

  • People to do the work,
  • Processes for people to follow, and over time, optimise,
  • Retention of the hunger and freedom that enables innovation.

The great paradox, and downfall of many if not most successful businesses is that they get the last one wrong, as they optimise risk out of their processes in favour of certainty and continuity of the status quo.

The task of being the entrepreneur has changed from one of management, to one of leadership. You are no longer engaged in tactical activity, which is being done by others in a manner that is transparent to overview, and with KPI’s based on outcomes. The tasks now are about the people doing the work, from the daily tactical stuff to the functional management. Your role is to lead all these people and ensure that the processes being deployed deliver on the plan. It is all about the productivity of resources deployed, people and financial, that is delivered via the processes that evolve.

Anyone who thinks this is easy has never done it.

Anyone who stands on the sidelines and cheers for you might be a cheerleader, supporter, and beneficiary, but they are not a coach. A coach delivers the models and means by which the success is generated, which is much more than cheering, as it involves getting dirty from time to time, being always challenging, and ensuring you are looking beyond the tactical that threatens to always consume you.

At each point in this growth pattern, there is a single question that you can ask that will give you an answer to the question of growth potential contained in any tactical decision:

‘Does this scale?’

Many small business owners do not ask this question, so end up selling their time for money, and there is only a limited time in any day. Therefore, if you are about to invest in tactical activity of any type, ask that simple question. If the answer is yes, fine. If it is no, think again.

When you are looking for a coach with the scars to prove experience, browse through the posts on this StrategyAudit site, and then you might want to give me a call.