Lee Rust, Owner, Florida Corporate Finance
Years ago, my business economics professor asked our class how we would set the sales price for a new product. We immediately started discussing a calculation based on the cost to manufacture plus a reasonable gross profit. “Wrong,” the professor interrupted, “first do a market study to determine the maximum price you can charge and still sell appropriate quantities of the product. Then
calculate the cost of manufacture only to determine if production of the product is attractive.”
Setting sales prices is an art, not a science, and is based less on product or service cost than you might imagine. Markets do, and should, determine prices. Therefore, market analysis is an extremely important part of any pricing decision.
In general, product or service prices should be examined and adjusted on a regular basis depending upon the volatility of the market. Of course, for a job shop bidding individual production projects, prices are set for each bid and the competitive price environment is known with every win or loss. In a commodity market, such as the production of landscape mulch or windshield washer fluids, market prices should be analyzed every few months as well as seasonally when demand peaks. For a proprietary branded product such as scuba diving equipment, prices might be set once or twice a year.
In setting prices, the tendency is usually to set them too low rather than too high. There is too often a fear of losing market share, suffering a sales decline or not winning the project award. Those fears depress prices, often well below what the market (or customer) would accept. Continual analysis is required. Raise prices and quickly judge any effect on sales. If a product is not selling at the levels you believe are feasible, lower prices and see if revenues increase. At higher levels of production, costs might even decrease to more than make up for the lower prices.
All of this analysis should be based on a combination of financial and market data that must be current. As I’ve said before, financial statements that are generated more than fifteen days after the close of the previous month are historical curiosities, not control tools. Statements that don’t include appropriate profit center accounting for each product line or company division are also useless as pricing guides.
In addition, beware of excessive pricing pressure from customers. Several years ago, I knew of a company that produced a component for a major manufacturer which represented a significant part of its revenues. The customer kept demanding price reductions and the supplier’s principals continually acquiesced. After the liquidation of that company, a client of mine took over the production of that component. That client immediately met with the customer and explained that she would not produce any product with less than a reasonable gross margin. She raised prices substantially and told the customer to buy the part from another supplier if there was one with a lower price. Now two years later, my client is still producing that component and not only has a profitable operation overall, but is also generating attractive profits from that specific item and is producing other components for that customer.
Also, watch for competitors who continually depress prices. If prices get too low, either let them have that market segment or maintain a higher price with lower sales only to customers who value quality and service more than the lowest price.
As an integral part of your pricing strategy, train your salespeople not to sell on the basis of price. In conjunction with your sales group, list in the order of priority all of the factors which might control a buying decision by your customers. You may be surprised how low pricing is on that list. Then use that list to convince your salespeople that salesmanship is not offering the lowest price but is, for instance, convincing your customers that their total cost of use might be lower for a higher quality product than for one with a lower price.
In general, sales managers should not set prices without some oversight. In addition, incentives for individuals with some control over prices should rarely, if ever, be based on the level of sales. Only in the case of sales commissions where the salesperson has no control over prices should the commissions be a percent of revenues. Otherwise, sales incentives should be based on gross profits, which go up if the salespeople can sell at a higher price.
With most, if not all, of your pricing decisions, attempt to be the price leader rather than a follower. Years ago, my father ran an engineering/construction firm. One of its divisions built large industrial chimneys. That division, however, was a chronic loser. Although the decision was finally made to close the division, my father said that they should not simply exit the business. Chimneys, he explained, are connected to the factories that the company also designed and built and my father didn’t want to alienate the clients. Instead, he suggested that they just bid the chimneys at high prices. They would not be the successful bidder and the business would wind down with no ill effects. Five years later, the chimney division was one of the most profitable at the company. They became the price leader and their competitors followed.
You should also periodically test various pricing levels. Either raise or lower prices for specific products or services more than you normally would and measure the revenue and gross profit results. You might be pleasantly surprised. If not, you can always return to the earlier price points.
In regard to all pricing strategies, remember that markets are never static. Their extent and rate of change should be reflected in your pricing decisions. Base your prices on market factors, sell features other than price, periodically test your pricing, know how your competitors price their products and services and be a price leader wherever possible. The art of pricing is a significant part of the art of business. Do it well and your company will prosper.
Lee Rust, owner of Florida Corporate Finance, specializes in Mergers and Acquisitions, Corporate Sales, Strategic Planning, Financing and Operations Audits. He can be reached by phone at 407-841-5676 or by email at hleerust@att.net.
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