Many, many people in business make a big mistake when it comes to pricing.
It is this – they look to their costs first, add a markup and that becomes their price.
The problem is that, no one cares what your costs are!
People care about two things – value and price.
When you shop, do you care what a product cost to make?
Imagine that a product costs more to make than you paid for. Does that increase the value for you?
I hope not, because it might just mean they are super sloppy in their production.
Perhaps you’re worried they won’t last in business and a warranty will be useless.
Habit #1 – Look to the Marketplace First
Find out what people value and how much they will pay for your product. Your product is not a commodity like a Taco Bell taco. It is not. And, if it is, you are in trouble.
You cannot compete on volume with Amazon, Apple, Costco, or Taco Bell. You see, price and volume are like a teeter totter. Price goes up, volume goes down. Price goes down, volume goes up.
On the other hand, when you drop your price, don’t count on volume increasing!
Have you heard of Techno, Oppo, or Infinix? No? I didn’t think so…
These Chinese brands looked to Africa to sell cheap cell phones. (Where, by the way, I have not, at least in Kenya, seen one iPhone).
Over 1.2 billion people live in Africa. And everyone wants a cell phone! An 85 year old grandmother, living in a tiny shack, has a cell phone.
These Chinese brands sell pretty decent phones in Africa at thin margins. See here how price and volume are related. By selling at a low price with a thin margin means you need a lot of volume and Africa has the desire and the population.
As a small business leader forget about the game of low price- high volume.
You must look to adding value in a niche. That is habit number one.
Find out what people value? Do these 3 things:
- Ask your customers;
- Find out what people hate in your industry. Fix that problem;
- Do market surveys and research.
Habit # 2 – Know ALL Your Costs
Find out what it will cost you to make your product or service.
To do this, you need to know ALL your costs.
What Goes into Making a Product In-House?
If you make your own product here are the costs that go into creating your product:
- Raw materials
- Direct labour
- Indirect production costs.
For indirect production costs these must be added to each item produced.
Indirect production costs include:
- Building rent (if used in production)
- A portion of utilities
- Supervisor salaries
- Depreciation of equipment
To allocate all your indirect costs to each item do this:
- Divide the total indirect costs by total direct labour hours, or,
- Total machine hours
Bravo! You have your total product costs per item.
What goes into your service cost?
Your costs in a service business are:
- Direct labour and any other variable costs
Know Your Gross Margin Percentage
First, determine all your variable costs. These would include:
- Product costs;
- Direct labour for a service business
- Sales commissions.
A variable cost is something that only occurs when you make a sale. No sale, no variable cost.
Finally, add up all your fixed costs.
Work out Your Breakeven Volumes
Ok, you have your per product costs. You know how much you want to charge per item sold. You know your variable and fixed costs.
Let’s put it all together…
As an example, let’s say you own a furniture making business.
You did market research and decided that you can sell a desk for $500. Your product costs are $200 per desk. Other variable costs are $100 per item. Fixed costs are $15,000 per month.
How many units do you need to sell to make a profit of $10,000 per month?
It goes like this:
First, figure out your gross margin percentage. To do that, we will see what our gross profit is on each desk sold. We take the sales price less all variable costs.
Sales price – $500
Product cost – (200)
Variable costs – (100)
Gross margin $200
Next, add your fixed costs to your desired profit. In this case, that would be $15,000 plus $10,000, or $25,000.
Finally divide 40% into $25,000 to get your sales volume.
The answer is $62,500
When you divide $62,500 into your price per desk of $500 you get 125 desks.
You need to sell 125 desks at $500 each to earn $10,000.
Prove Your Numbers
125 desks x $500 price equals $62,500
125 desks x $200 product costs (25,000)
125 desks x $100 other variable (12,500)
Gross margin $25,000 (40%)
Less fixed costs (15,000)
Net profit $10,000
Habit #3 – Sharpen Your Pencil
There are three things to master.
Number one – play a bit with your pricing to see the effect on volume. Be careful – an increase in price can decrease volume! As well, a decrease in price does not always lead to higher volume. Why not?
People are funny – some like to brag about how much they pay for a thing!
Number two – sharpen your pencil with costs. Can you reduce your production costs by putting in systems? Have you considered outsourcing? Other suppliers? Less expensive production facilities?
Start with pricing and then work backwards to costs. Then determine your breakeven sales volume. Play a bit – carefully – with the price-volume relationship.
Keep your eye on adding value to your customer. Do not play the volume game when you are small!
Thanks for reading…