Pricing is an art form, and is very dependent on market conditions and your ability to service that market. When costs go up the natural reaction is to say “I need to increase prices” but is this right or even possible sometimes? It’s definitely not “one-size-fits-all”, you don’t price the same way for everything. It is important to look at prices across different services, different products, different customer groups and different markets. Along with dependent factors such as volumes, how you allocate, and if you understand what the direct costs and overheads are and how they should be allocated to which part of your price breakdown.
Does your pricing strategy allow you to make money whilst still generating, converting and retaining customers?
Understanding the normal way to price
One common way to price is to add a set percentage markup to your estimated direct costs; this should cover your overheads and give you a profit. At some stage, you can compare this to the market rate which can mean changing that markup percentage. Obviously, market price fluctuates depending on supply and demand and we’ve been in an interesting period, where demand and supply have fluctuated greatly. Best practice is to regularly review market rates and look at where you’re pricing, because you could be pricing too high or you could be pricing too low.
If you are pricing too high then you lose the work, if you’re pricing too low, you’re leaving money on the table. Furthermore, you should be reviewing how your pricing compares to your accounts. You should be checking to see that you’ve priced correctly.
You start with your direct costs and you build up your price. The direct cost is the cost to make the product or provide the service. Direct costs include electricity, machinists, materials used to make a product, etc. Indirect costs are the salesperson, bookkeeper, etc. With your direct costs, make sure you add all the associated costs. The associated costs are: employers National Insurance, pension, benefits and holiday. Once you know the direct cost of your product or service, then look at your overheads (the ongoing expense of operating you business). Once you’ve calculated your direct costs and overheads, look at anticipated volumes. What are the volumes needed to produce the product or supply the service, along with your capacity. Often, businesses look at the previous year’s volume and adjust for market conditions.
Things to consider when you are reviewing pricing
Type of customers you supply:
Are they price orientated or value added based? There’s a massive difference in those type of customers in different markets. Supply and demand in various marketplaces were unprecedented over the last 18 months. It’s settled down a little bit now but, sometime in 2023, prices may come down. If your customers are price-orientated, it is likely you can cut down on some of the ‘value’ and, in doing so, cut your costs and prices. However, if your customers are more focused on the value that they’re purchasing, it will be easier for you to justify increasing your prices.
Regularly compare your competitors pricing:
Do this to understand and compare your pricing to your competitors. If you are pricing too high in comparison, you will lose custom and vice versa. You will also have to understand your customers’ requirements; are you delivering what they want? Are your competitors offering better value for money?
Understanding size of order:
Selling a product / service in bulk (large quantities to one customer) can have an influence on your pricing. If you’re selling a product for £100, and have received an order for 10,000 units, you may be able to look at decreasing your price for example. But be careful, as you need to know how low you can go to ensure you are still making money.
The size of order makes an impact on your pricing, as well as time pressures. Can you fulfill those orders? What is your capacity? What about currency fluctuations? Are there any guarantees, financing cost, payment terms? Then you look at what profit you want, what sort of level, and what’s in the market. In challenging times, you might actually have to go below cost to keep your employees, and then you have to look at whether you cut back etc.
Final thoughts
It is vital that business owners understand their numbers and this includes how to price properly and how this reflects in your profit and loss account. If you don’t know, work with someone who can help you because it is key to your business success and survival.
This is especially important with recent volatility; you know where prices have risen too fast, and you know there’s going to be a time when it is going to fall the other way, and you can have over supply. That will happen with recession, so try and be ahead of the game. You need to look at things that can go wrong such as price increases with your suppliers and currency movements. If you’re very dependent on the dollar, euro etc. be informed as to their predicted rates, and can you forward cover? Look at your supply chain and make sure that you’ve got a solid contract you can negotiate decent terms with suppliers.
You need to look at your accounting system – review your current system. Is it fit for purpose and providing the information you need? We use and recommend Xero, and with the right support you can have meaningful regular management accounts broken down into chunks for your direct costs to understand where you’re making money and where you’re not.
