The Price of Bad Pricing

July 6, 2011, 12:00 pm  By JAY GOLTZ

If there is an aspect of running a small business that doesn’t get enough attention, I think it’s pricing. Unfortunately, there’s a good reason for that: pricing is hard to do and easy to ignore. But that’s especially dangerous right now when there’s a good chance your own expenses are changing.

With most management decisions, your goals are pretty straight forward. Most of the time, you simply want to be the best at whatever you do. You want to have the best staff, the best service, the best marketing. But pricing is more complicated. You may say you want to offer the best price. But what does that mean? The lowest price for the customer? The price that will provide the best value for the customer? The price that will result in the highest profit for your company? The price that will result in the most sales for your company?

It can get even more complicated. To figure out the relationship between the price you charge and the profitability that results, you have to do some cost accounting. For instance, if you are manufacturing a product, you have to take into consideration reject rates, machine maintenance, insurance, rent, utilities and inventory carrying costs, just to name a few expenses. Maybe you own an auto parts store that specializes in carrying parts for older cars. You pride yourself on having the alternator for almost every car built since 1960. Surely that would suggest that you could charge a premium. But how much? What is the carrying cost of your huge inventory?

Even figuring out that inventory cost is not simple. If you finance the inventory with borrowed funds, is the carrying cost the interest you are charged? Or do you have to consider the other things you might have done with that money? What if you are at your borrowing limit and you could have spent the borrowed funds on something more profitable? What about the fact that some of those parts are never going to sell? That is called obsolete inventory, which will probably be calculated when you — or your descendants — sell your inventory during a liquidation sale, for pennies on the dollar.

Every business has costs that are related to making a sale, whether those costs are charge card transaction fees or packaging costs. They all need to be figured in, as well. There are also fixed costs that can be connected to the activity of selling a particular product. Maybe you could reduce overhead by getting rid of a particular product or service. But business does not operate in a vacuum. Your competition is vying for the same customers. Winning market share is a common goal, but at what cost? This is where an understanding of price elasticity becomes important. The higher the price, the less you will sell. Usually! I have seen and heard numerous examples of sales going up when the price of a product — a bottle of wine, say — is increased. Some products and services are clearly more elastic than others, meaning that price changes have a greater impact on sales. (Here is a small-business guide with some examples of how other business owners have handled their pricing.)

From my experience, many business owners do not do an analysis to calculate the effect a price increase might have on their bottom lines — again, for good reason. It is very difficult if not impossible to do. It’s more like guessing, perhaps an educated guess. I cannot tell you how to do it, but I can tell you what not to do. Do not rely on just your salespeople! Most will tell you that the sky will fall if you raise prices. They will tell you that customers are already complaining.

Salespeople mean well, but their job is to sell more product. It is the boss’s job to make sure the company makes money. That requires doing a break-even analysis on any potential price increases. If the company is not making money anyway, you may not have a lot to lose. Suppose you have a 35 percent gross margin, but that margin does not leave enough money to cover the overhead and provide a profit. If you increase prices 2 percent, you would have to lose more than 5 percent of your sales to lose money on the change. If you lose only 2 percent of sales, you will have about the same revenue but your cost of goods sold will fall 2 percent, as well. That might allow you to start making money. It will also mean that you will have less work to do because you will have fewer transactions. Obviously some industries are more price-sensitive than others, but it is worth doing the math, especially if you are in a low margin business.

Here’s the math: if you sell 100 widgets a week at $100 apiece and they cost you $65 apiece, you have a gross profit of $35 a widget or $3,500 a week. But because your fixed expenses have been rising and these are really good widgets, you decide you can charge $102 and still provide a good value to your customer. If you now sell only 95 widgets a week, you will have a gross profit of 95 x $37, or $3,515. But if you manage to sell 98, you will make $3,626. The point is that sales have to fall quite a bit for you not to come out ahead.

There is one other factor to consider. Price can be a very effective way to control volume. How are some lawyers and house painters able to charge double what other people charge? They have more customers than they can personally handle, so it is profitable for them to charge more and lose some business — rather than lose business by being overwhelmed.

Pricing is as important as any business decision, but frequently it is treated as if it were no decision at all. Business owners just keep doing whatever they have always done, for better or worse. They do this because they fear they will — as they’ve been told a thousand times — price themselves out of the market.

No one ever warns them not to underprice themselves out of business. But I think that happens far more often.

Jay Goltz owns five small businesses in Chicago.