CVP

The Importance of Proper Pricing

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picture showing several bundles of money

Pricing is one of those things that can make or break a company. Doing it right takes an understanding of your business (cost structure and growth / profitability goals), the market, your competition, and more. Doing it wrong can mean the death of your business (fast or slow), the inability to attract and retain the best talent, as well as creating a situation where you will no longer have the opportunity to reach your full potential.

These problems apply to companies of all sizes – although large organizations are often in a better position to absorb the impact of bad pricing decisions or sustain an unprofitable business unit. Understanding all possible outcomes is an important aspect of pricing as it related to risk and risk tolerance.

When I started my consulting company in 1999 the plan was to win business by pricing our services 10%-15% lower than the competition. It was a bad plan that didn’t work. Unfortunately, this approach is something you see all too often in businesses today.

In our case we only began to grow once we increased our prices (about 10% more than the competition) and focused on justifying that with our expertise and the value provided. We were (correctly) perceived as being a premium alternative, and that positioning helped us grow.

Several years ago I had a management consulting engagement with a small software company. The business owner told me that they were, “an overnight success that was 10 years in the making.” His concern was that they might not be able to capitalize on recent success so he was looking for an outside opinion.

I analyzed his business, product, customers, and competition. His largest competitor is the industry leader in this space, and products from both companies were evenly matched from a feature perspective. My client’s product even had a few key features that better for management and compliance in Healthcare and Union environments that his larger and more popular competitor lacked. So, why weren’t they growing faster?

What I found is that competition was priced 400% higher for the base product. When I asked the owner, he told me their goal was to be priced 75% – 80% less than the competition. He could not explain why he did this, other than to state that he believed that his customers would be unwilling to pay any more than that. His lack of confidence with his own product became evident to companies interested in his solution.

In many cases he lost head-to-head competition against that competitor, but almost never on features. Areas of concern were generally on the size and profitability of the company, and the risk created by each for prospects considering his product.

I shared the graph (below) with this person, explaining how proper pricing would increase their profitability and annual revenue, and how both of those items would help provide customers and prospects with confidence. Moreover, this would allow the company to grow, eliminate single points of failure in key areas (Engineering and Customer Support), add features, and even spend money on marketing. Success breeds success!

Graph showing revenue relative to the life cycle stages of a successful business venture
Source: Entrepreneurial Finance by Leach and Melicher (3rd Ed.)

In another example I worked with the Product Manager of a large software company who was responsible for producing quarterly product package distributions. This work was outsourced and each build cost approximately $50K. I asked a simple question, “What is the break-even point for each distribution?” That person replied, “There really isn’t a good way to tell.”

Graph showing cost volume profit analysis
Sample cost-volume-profit (CVP) analysis

By the end of the day I provided a Cost-Volume-Profit (CVP) analysis spreadsheet that showed the break-even point. Even more important, it showed the contribution margin and demonstrated there was very little operating leverage provided these products (i.e., they weren’t very profitable even if you sold a lot of them).

My recommendations included increasing prices (which could negatively impact sales), invest in fewer releases per year, or find a more cost-effective way of releasing those products. Without this analysis their “business as usual” approach would have likely continued for several years.

Companies are in business to make money – pure and simple. Everything you do as a business owner or leader needs to be focused on growth. Growth is the result of a combination of factors, such as uniqueness of product or services provided, quality, reputation, efficiency and repeatability. Many of these are the same factors that also drive profitability. Proper pricing can help drive profitability, and having excess profits to invest can significantly impact growth.

Some customers and prospects will do everything possible to whittle your profit margins down to nothing. They are focused on their own short-term gain, and not on the long-term risk created for their suppliers. Those same “frugal” companies expect to make a profit on their own business, so it is unreasonable to expect anything less from own suppliers.

My feeling is that, “Not all business is good business” so it is better to walk away from bad business in order to focus on the business that helps your company grow and be successful.

One of the best books on pricing that I’ve ever found is, “The Strategy and Tactics of Pricing: A Guide to Profitable Decision Making” by Thomas T. Nagle and Reed K. Holden. This is an extremely comprehensive and practical book that I recommend to anyone responsible for pricing or who has P&L responsibility within an organization. It addresses the many complexities of pricing and is truly an invaluable reference.

In a future posts I will write about the metrics that I use to understand efficiency and profitability. Metrics can be your best friend when it comes to finding ways to optimize pricing and maximizing profitability. This can help you create a systematic approach to business that increases efficiency, consistency, and quality.

At my company we developed a system where we know how long common tasks would take to complete, and had efficiency factors for each consultant. This allowed us to create estimates based on the type of work and the people most likely to work on the task, and fix bid the work. Our bids were competitive, and even when we were the highest priced bid we often won because we would be the only (or one of the few) companies to guarantee prices and results. Our level of effort estimates were +/- 4%, and that helped us maintain a 40%+ minimum gross margin for every project. This analytical approach helped our business double in revenue without doubling in size.

There are many causes of poor pricing, including: Lack of understanding of cost structure; Lack of understanding of the value provided by a product or service; Lack of understanding of the level of effort to create, maintain, deliver, and improve a product or service; and Lack of concern for profitability (e.g., salespeople who are paid on the size of the deal, and not on margins or profitability).

But, with a little understanding and effort you can make small adjustments to your pricing approach and models that can have a huge impact to the bottom line of your business.