A solid pricing strategy can do more for your business than cover costs and generate a profit. It can position you in the marketplace and affect your long-term success.
In manufacturing, a key financial calculation is gross margin: What is left after cost of production is subtracted from revenues.
Gross margin must cover operating overhead and desired profit. However, actual gross margin dollars fluctuate according to volume as well as price.
For example, assume each unit sold contributes $1 after manufacturing costs are subtracted. If your remaining costs and desired profit equal $100,000, you must sell 100,000 units or profits erode and you start to lose money.
If you increase price by $1 per unit, then gross margin dollars double and you need to sell only 50,000 to cover all costs and profit. Any adjustment in price will affect gross margin and therefore your break-even point and needed production and sales volumes.
Many companies set prices by forecasting expected sales, identifying manufacturing costs per unit, and then tagging on an amount sufficient to cover the other costs and profit goals. This is called cost-plus pricing.
Although simple, cost-plus pricing has some major limitations. It is vital to understand unit costs and maximize capacity, i.e., not have bloated overhead in comparison to output. Your CPA can compare your financial ratios to others in your industry to gauge your performance and room for growth.
Focusing solely on costs ignores two major factors in determining an optimal pricing strategy: customers and competition. Responding to both depends on your product and where it fits into the marketplace.
At the high end are premium products; at the low end, a commodity competing solely on price.
Premium pricing focuses on obtaining a high price per unit and works only if you have a significant competitive advantage. Examples might be a drug patent or a new electronic gadget. The next tier is value pricing, for products that have limited competition.
In contrast, the next tier, competitive pricing, comes into play when a lot of competition keeps the market in balanced status quo. Many food and consumer items fall into this category.
Finally, penetration pricing is used when a company wants to gain market share quickly by charging less than competitors. Once goals are reached, prices often increase.
Examining your present and potential market position could reveal opportunities for higher profits or a need to become more productive and shave costs.
Related to penetration pricing, small manufacturers often face a challenge when taking on huge orders from large retailers or wholesalers. The resulting ramp-up of manufacturing capacity increases economies of scale, but the lower price per unit erodes margin and profits. Many companies have lost money on the large order they thought would take them to the next level.
Pricing based on customer relationships is becoming more sophisticated, moving beyond order volume as the main determinant of price. Software that segments and analyzes customers is used during the order process to weigh factors such as location, loyalty, cost to serve and purchase history.
Product analysis software can also help sales reps make recommendations that build orders and meet customer needs, thereby improving customer service.
Automated systems also allow a company to continually update prices based on cost inputs, field intelligence and economic conditions. PROS, SAS, SignalDemand, Vendavo and Zilliant are examples of pricing optimization software.
Improving the ability to capture and analyze financial and customer information in light of your present competitive environment will help you maximize your pricing strategy.