Pricing is one of the most critical decisions an organization makes. A 1% difference on top-line price is worth a 10% profit increase on a business with a 10% gross margin. That’s huge! All too often we don’t think of pulling the pricing lever because it seems small. “Heck, it’s only 1% or 0.5%. Why bother?”
Why bother? I’ll tell you why to bother!
Pricing and Profits
By way of example, if you’re selling your product for $100, and you make $10 per unit, that’s a 10% margin. If you raise your price by 1%, and go from $100 to $101. That incremental dollar drops straight to the bottom line! Now you go from making $10 to $11. That’s a 10% improvement on the bottom for a 1% improvement on the top! Even with a 0.5% price increase you’re still increasing your profitability by 5%. Better yet – if you’re a publicly traded company, your stock price is based on a multiple of your earnings so that 5-10% profit improvement gets multiplied by your P/E ratio which boosts your stock price. Pricing just got compelling, didn’t it?
Pricing has a huge impact on your overall profitability. You need to understand how your product or service is priced. Is it a one-time fee? Is it a subscription model? Do you have a razor and blade model where you sell something really cheap, but the replacement parts are an ongoing stream of revenue? Do you sell accessories or extras with your core product? Do you offer additional services or warranties? Different prices for different customers and different markets and features are typical for most businesses. The better you understand your pricing model, the easier it is for you to increase prices without undercutting the volume of product you sell.
Cost-Plus versus Value-Based Pricing
Two common pricing approaches are cost-plus or value-based pricing. Depending on your industry, your product/service, and customer behavior, one of these models may be more appropriate than another. That said, just because you currently have one pricing model, that doesn’t mean you can’t change to another.
Let me explain the difference between a cost-plus pricing model and a value-based pricing model. My firm is a leadership training firm. We teach people in a classroom environment and we deliver our service with an instructor on the podium. If we had a cost-plus pricing model, the way that would work would be we’d look at the cost of putting an instructor in the room, and then we would mark it up and put a profit margin on top of it (that’s the “plus” in cost-plus).
Now, no matter how many people are in the classroom, to the customer it’s a fixed fee under a cost-plus model. We would make just that margin above how much our instructor costs us for that day. We get no incremental upside for a larger class but we are also guaranteed a minimum fee for a smaller class. Let’s say our cost for an instructor is $5,000 for a day. We might charge the client $6,000 for the session. That cost-plus model puts $1,000 in our pocket. Not bad!
If we went with a value-based pricing model, it’s very different. We calculate the value that we’re delivering to each participant in the class and we capture a portion of that value as our fee for the session. Every person in that classroom is getting value from the instruction we’re delivering. By having a participant fee tied to everyone in the room, we’re capturing a portion of the value that we’re generating.
For example, if a participant was going to get $1,000 of value from being in our class and learning a new skill, we may say we want $400 of that value. If we had 10 people in the room, we would get $4,000 as our fee. If we had 30 people in the room, we would get $12,000 as our fee.
Let’s compare the profitability of the cost-plus and value-based models. Under the cost-plus scenario, we make $1,000 regardless of having 10 or 30 participants in the room. We pay our instructor their $5,000 and walk away with a tidy $1,000 profit. No risk but no upside.
Under the value-based approach, if we only have 10 participants in the room, we lose $1,000 because our fee to the client is $4,000 but we have to pay our instructor $5,000. Not cool. That said, if we have 30 participants in class, our profit is $7,000 which is the $12,000 fee minus the $5,000 instructor cost. Super cool! The value-based approach has more downside risk but also significantly more upside reward.
To be clear – selling a value-based program is harder to do than selling a cost-plus program. The total cost is higher and it requires us to pitch our product very differently. We have to demonstrate the $1,000 in value each person gets from the course. That said, if it’s easy for us to prove that value (which it is), then the value-based approach works.
Mitigating Downside Risk
“Gee Mike, I don’t like the thought of losing money though. That’s not cool. How do you deal with that?”
I’m glad you asked. You can mix and match these pricing approaches to achieve your profit objectives. We place a “floor” on our sessions and say no matter how many people attend, we’re going to charge for a minimum of 15 participants at $400 apiece. That approach gives us a “floor” of $6,000 of revenue resulting in a minimum profit of $1,000. This approach also preserves the upside profit if we have more than those 15 people in class. Another approach is to simply not conduct a class unless there’s a minimum of 15 people registered. We don’t lose money but we don’t make money either. Either way, we’re eliminating the risk of loss but maintaining the profit upside.
Having a value-based pricing model versus a cost-plus model results in a tremendously different set of economics. It’s definitely worth investing the time in coming up with the right pricing approach for your business.
When’s the last time you discussed pricing? If you don’t know the answer to that question, I think you have a meaningful discussion topic for your next team meeting…
To learn more about core business topics like pricing, you can watch my course Business Acumen on lynda.com, which includes a free chapter on knowing the basics of your business and setting priorities. Watch the course introduction here:
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