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Pricing Strategies in Marketing
Next to forecasting sales, setting pricing strategies in marketing a product or service is one of the toughest jobs facing small business owners and sales and marketing managers. Actually, pricing and forecasting are related efforts that need to be coordinated to help preserve and build profit margins.
Following are some of the most common pricing strategies.
Competitive Pricing Models
Matching what competitors are offering as prices is a strategy often pursued by larger organizations who can absorb some losses from offering less than profitable pricing, usually to gain higher market share. Products and services offered at these rock bottom prices are referred to as loss leaders. This strategy banks on the hope that customers will make additional purchases at retail or above OR make aftermarket purchases in the future. Example: Ink jet printers are offered at super low prices so that the manufacturer can make money on the printing cartridges in the future.
Businesses who use competitive pricing strategies may start out using MSRP. But then they carefully watch what their nearest competitors are offering for the identical (or very similar) offerings, adjusting pricing to either match or come close to that of others. If the business is a large enough retailer (such as Walmart or Target), continuous pricing adjustments of this type require significant technology and administrative investments which are usually out of the range of small businesses.
While it is important for businesses of all sizes and types to have knowledge of prices in their marketplace, competitive pricing can be one of the most financially dangerous pricing models. Totally basing prices on competitors can kill a business' profits even to the point of going out of business. So this strategy is usually pursued by large companies that have a large array of products and services to offer which can offset losses from discounting or price matching.
MSRP Pricing Models for Resale Businesses
Businesses who purchase goods for resale may choose to use the manufacturer's suggested retail pricing (MSRP) as their pricing structure. This makes it easy for the business to set prices, but evaluating whether the price meets the business' profit goals is a bit more difficult.
These businesses are usually given a discount off the MSRP as a wholesale price. The difference between the MSRP and the wholesale price is the gross profit margin. Overhead and a desired profit margin need to be deducted from the gross, as noted in the following example.
Example: A company receives a 40 percent discount off of MSRP to purchase goods from a manufacturer for resale. Therefore, 40 percent is the gross profit margin. The company has an overhead rate of 25 percent and desires to retain at least a 10 percent profit margin after costs. Working the numbers...
40% gross profit margin - 25% overhead - 10% minimum desired net profit margin = 5% net profit margin
So in this example, the company could discount the MSRP by 5 percent and still retain their minimum desired net profit. Alternatively, they could choose to stick with the MSRP as the price and boost their total net profit margin to 15 percent.
But say that the MSRP is 30 percent. Here's how it changes the scenario:
30% gross profit margin - 25% overhead - 10% minimum desired net profit margin = - 5% net profit margin
In this situation, the company can:
- Reduce the desired net profit margin that they want to 5 percent;
- They can increase the price they charge customers by 5 percent;
- They can reduce overhead;
- A combination of all three strategies.
The first option reduces the net profit the company earns. The second option preserves the net profit margin but may receive some market resistance if customers are used to paying a lower price for the product. The third option requires a critical review of expenses to identify possible cuts. However, if the cuts reduce the level of customer service, it could have an effect on sales. And while doing a combination of reducing expectations, increasing prices and reducing overhead may be beneficial, it may be difficult to figure which of the strategies is actually helping to preserve profits.
Markup Pricing and Cost Based Strategies
Developing prices based on cost is a little tricky to understand at first, but it is truly just a process of plugging in the numbers. Cost based pricing, also known as markup pricing, is usually done for products, but can be used for services in combination with other pricing models.
What causes confusion for most people is the fact that markup is NOT the same thing as gross profit. For example, to achieve a 50 percent gross profit margin, the markup is 100 percent. Markup is the amount that is ADDED to the net cost to create a retail price. Ugh!
Desired gross profit margin needs to be determined BEFORE determining a markup. Critical to finding a profitable retail price is determining an adequate gross profit margin. This is a combination of overhead costs plus a desired net profit margin. Remember gross profit margin is the amount of revenue left over after net cost of goods sold (COGS) is paid.
So a starting point for determining a gross profit margin would be finding the desired gross profit margin:
Overhead Percentage + Desired Net Profit Margin Percentage = Desired Gross Profit Margin Percentage
To figure a retail price that achieves the desired gross profit margin, this formula is used:
Formula #1: Net Cost of Goods Sold / (1 - Desired Gross Profit Margin) = Retail Price
While this formula works every time, it is unlikely to be one that can be easily used by sales and service staff when preparing quotes. Usually, the markup percentage (or multiplier) is given to them. The basic formula for arriving at a markup rate is:
Formula #2: Gross Profit Margin Percentage / (100% - Gross Profit Margin Percentage) = Markup Percentage
So to arrive at a retail price, the long formula is:
Formula #3: Net Cost of Goods Sold + (Net Cost of Goods Sold X Markup Percentage) = Retail Price
Applying a little algebra to the equation, another way to solve for retail price is:
Formula #4: Net Cost of Goods Sold X (1 + Markup Percentage) = Retail Price
In the equation, the term (1 + Markup Percentage) provides an easy multiplier that staff can use to quickly calculate a retail price from net cost.
Formula #5: 1 + Markup Percentage = Multiplier
The multiplier can also be expressed as a percentage. For example, a markup percentage of 25 percent would create a multiplier of 1.25 which is the same as 125 percent.
Example: A company has a 25 percent overhead rate and wants a 15 percent net profit margin. The net cost of an item that they resell is $6.00. Determine the retail price and what multiplier they would give to their sales team.
25% + 15% = 40% Desired Gross Profit Margin
Formula #1: $6.00 / (1 - 0.40) = $10.00 Retail Price
Using a markup pricing model, the retail price would be calculated as follows:
Formula #2: 40% / (100% - 40%) = 0.40 / (1.00 - 0.40) = 0.6667 OR 66.67% Markup Percentage
Formula #5: 1 + 0.6667 = 1.6667 Multiplier OR 166.67%
Plugging in the multiplier into Formula #4: $6.00 X 1.6667 = $10.0002 Rounded to $10.00 Retail Price
As shown above, both formulas result in the same retail price. The multiplier formula is just easier to use. So to make a 40 percent gross profit margin, this company would have to multiply their net costs of goods sold by 1.6667 or 166.67 percent.
Surprised at how much a product needs to be marked up? In the example, that's more than 1.5 times the net cost. This is a concept that most customers and, unfortunately, many small business owners have difficulty grasping. Being in business means more than just paying the net cost for a product.
Value-Based Pricing Models
How should prices be set for services, particularly unique services such as custom consulting projects? This is one of the toughest pricing scenarios because it is not usually based on costs, but on the value of knowledge, experience and expertise.
Using competitive pricing can be a slippery slope toward becoming unprofitable in custom service businesses. For example, good writers can be paid very handsomely for their skills. However, low cost content sites online can offer written content for only a few dollars per project. Competent writers who lower their prices to compete with these sites devalue their expertise and quickly become frustrated or financially strapped.
But the question remains as to how to price services based on value. The following are some strategies that consultants and other service providers may use as a starting point for setting service pricing:
- Employment Equivalent. Some professionals who make the leap from employment to offering their expertise on the open market use their employment salary as a basis for what to charge customers. An annual salary would be divided by an annual number of hours based on standard work week (50 weeks X 40 hours = 2,000 annual hours). This could work if services are sold to clients similar to the previous employer who may wish to outsource various functions. If not similar employment history is available, looking at industry reports for salaries in similar professions can also provide a baseline hourly rate. The caution is that it may not properly cover the expenses of offering these services as a business. So a thorough evaluation of expenses needs to be done prior to setting an hourly consulting rate.
- Need. How much is needed to maintain the business and the lifestyle of the owners? Some consultants figure what they'll need to survive both professionally and personally, set that as a goal and then set hourly rates to help meet those goals. A realistic forecast of the number of jobs that can be sold is critical to setting a rate that meets all needs.
- Custom Project Quoting. Many service and consultant business projects are custom quotes since each project is unique. A custom quote could be a combination of MSRP, markup and value based pricing.
What Pricing Strategy Do You Use for Your Business?
Is an 80 to 94% Markup Fair?
In an online forum, the question was asked, "Would you pay a contractor an 80 to 94% markup for supplies or equipment (for a contracting job)?" I answered that in businesses it is often necessary to charge 2 to 3 times the net cost of the item to maintain profitability. The response was, "Maybe this is why many small businesses fail due to excessive mark ups." Fair or fail?
First, let's clarify what 80 to 94 percent markup really means. Using the formulas and solving for markup, it would mean that the multiplier would be 180 to 194 percent. Sounds like a lot, eh? Heck, that's almost 2 times the net cost!
But let's look at the most important number: gross profit margin.
Algebraically solving Formula #2 to obtain the gross profit margin, we find that an 80 to 94 percent markup translates into roughly a 44 to 49 gross profit margin. That may even sound like a lot to some until overhead is factored in. In some businesses, overhead can be as high as 25 percent of revenues or more... sometimes way more. This can quickly obliterate any profit margin. And if taxes weren't included in the overhead, bam!, that profit margin can be almost wiped out.
The business in question in the forum was contracting. Contracting can be an overhead cost intensive business due to vehicles, administrative costs, phones, dispatch, insurance (huge bill!), tools... the list goes on and on.
So whether any markup percentage is fair truly depends on the business and the costs to run it.—Heidi Thorne
Disclaimer: Any examples used are for illustrative purposes only and do not suggest affiliation or endorsement. The author/publisher has used best efforts in preparation of this article. No representations or warranties for its contents, either expressed or implied, are offered or allowed and all parties disclaim any implied warranties of merchantability or fitness for your particular purpose. The advice, strategies and recommendations presented herein may not be suitable for you, your situation or business. Consult with a professional adviser where and when appropriate. The author/publisher shall not be liable for any loss of profit or any other damages, including but not limited to special, incidental, consequential, or other damages. So by reading and using this information, you accept this risk.
© 2013 Heidi Thorne