In our blog of last week we considered a few vital things an entrepreneur should know about business or enterprise profitability. Closely connected to profitability is the aspect of product or service pricing. I know that the majority of enterprises adopt and follow the cost-plus pricing system, and this makes it critical to understand this principle, and of course other approaches to pricing. Don’t you think so? Remember the variables in the profit equation we saw last time; income less expenses equals profit or loss. In the income we have quantity and price as the variables. Do you get what I mean? Hope so. Now let’s move on.
While there are enterprises that price themselves smiling to the bank, there are those that price themselves into insolvency or bankruptcy and out of business. The latter is especially common with small enterprises, where the entrepreneur has very limited knowledge of costing and pricing, and more so is reluctant to consult the right people in order to get appropriate advice, not forgetting that the big players also sometimes get caught offsite on this with comical pricing blunders followed with quick U-turns. Candidly, in some of my casual discussions with various entrepreneurs, I occasionally discover some with hardly any clue about good costing and pricing principles. Let me say the following: –
- We know that the most common product and service pricing method is the cost-plus method. In this approach you are simply aggregating your costs to derive the unit cost and then adding something on top for profit to arrive at your price. Yes – I know I mentioned the word ‘aggregating’ and some entrepreneurs start by missing it right here. Others get it right in the ‘aggregating’ part and miss it in the secondary bit – that something, which is often referred to as the mark-up or margin. In aggregating, you have got to consider both your variable and fixed costs as may be relevant. Of course the fixed ones have to be apportioned or allocated somehow to the units of output – products or services – that you are considering. The variable and direct costs are easier to determine per unit of output or product. Remember that I made a brief description of variable and fixed costs in my last blog. Please Mr. Entrepreneur, I kindly advise you to consider all the cost elements because when you miss some you are technically deriving a wrong costing and pricing. Do I need to tell you the consequences of this? I don’t think so, because you may learn the hard way soon enough.
- The mark-up and margin. As mentioned above, you might get it largely correct in the first step above, but might miss it in the second step regarding the mark-up or margin. Before we proceed, let me just repeat that mark-up is the proportion or percentage of your gross profit on costs while margin is your percentage or proportion of gross profit on sales or revenue. Of course this definition can come in several other ways. Someone may just ask you this question – what gain do you want on your cost price or costs (meaning mark-up)? The gain on sales price is therefore the margin. Endless times I have heard people turning these two things upside down and down upside. Gross profit is the gain you get before considering or deducting overheads. Get what I mean? Your gross income (I mean gross profit – though these terms in practice are used interchangeably) is derived by subtracting your direct costs from your sales revenue, and equates to the mark-up or margin. Direct costs (which could be variable or semi-variable) are those cost elements that are incurred in, or are required to create and deliver your products or services, such as raw materials and direct labour. Your pricing has to take into account the mark-up or margin you desire to give you the gross profit you need to cover your overheads.
- Mr. Entrepreneur, you also need to know the impact of your overheads on your pricing. Overheads, also commonly referred to as operating expenses (OPEX), are those expenses that are not direct – hence indirect. In other words overheads are expenses not directly required to produce your goods and services. They are not directly involved in creating or generating revenues or income. Examples might include rent of premise, salaries of non-production staffs, telephones and postage, marketing costs, legal and statutory fees etc. The list might be long but is dependent on the type of enterprise you are operating. Being an entrepreneur, you must know that if your overheads exceed the gross profit mentioned above, then you are in a loss, and vice-versa. This means that your gross mark-up or margin that equates to your gross profit, should cover all the overheads of the enterprise, and leave you with some profit – called the net profit. Again as I mentioned before, you only omit some overheads at your own peril! Don’t say you never knew or nobody advised you. You have got to be a smart entrepreneur. Don’t you think so? So a good consideration of the above factors, costs (direct and indirect; variable, semi-variable and fixed) and gross profit requirements to cover overheads, can properly guide you in determining your pricing per unit. I leave the calculation details to you or your accountant.
- Beyond the above cost-plus approach, several other factors influence pricing decisions and you need to be on top of these. The stylish marketing guys, or some solid academic guys will list for you many approaches, but certainly you don’t need to try and cram all the terminologies used. Not very necessary I think. However, you need for example to know that occasionally you might price low (below the price derived by using the above approach) to enter a market. In other words you may plan to take some hits and make some losses while planning for big profits later. This is a market penetration pricing Alternatively, you might decide to price differently to people in different segments. Of course there is nothing wrong in making the more affluent pay more – and I hope no one will raise a hammer for me here. Yes – some select people could be charged a premium, or subjected to luxury pricing? Isn’t this a good idea? Additionally, some people buy based on perceived value or uniqueness of an item; hence you could use value-based pricing. How about the incremental approach, where you start low and gradually raise your prices? When promoting your products you could consider promotional pricing – giving away some discounts, or pay-what-you-can approach to introduce a test product? Couldn’t you? What about a temporary competitive pricing to give your competitors a run for the business? Lots of terms, isn’t it? The approaches can be many, but it’s vital that you understand and know why you are using a specific approach. Don’t be Mr. ‘Follow – Follow’ entrepreneur who just blindly follows what others are doing without understanding the rationale. Never be ‘opaque’.
Oh my, it’s time to run. Bye for now and best wishes.
The Wise Entrepreneur