ARE YOU UNDERPRICING?

Yesterday I added £25,000 to a client’s bottom line next year – guaranteed even if he makes no other changes to his business. That’s £25,000 a year in profits he's been losing because he’s not got one critical part of his business right. His pricing structure. Like many business owners I meet, my client had been underpricing his services. In this case for 4 years. That's at least £100,000. Ouch! Are You Underpricing?

How do I know my client was underpricing? I did some simple quick calculations. I worked out the direct cost of producing his product (that's cost of goods sold or COGS in a product based business), multiplied this by 45%, and added the direct cost to calculate the unit price. This told me the minimum price he should be charging his customers. When I compared the price my client was charging, and the figure I came up with, I realised my client was underpricing.When it comes to setting your prices, your starting point is to know the direct costs of producing your product or service.

Understanding Your Direct Costs

'Direct costs' are those expenses that are directly attributed to manufacturing your product or service; normally materials and labour costs.

Confusingly direct costs are sometimes referred to as unit costs or cost of goods sold (COGS) or cost of sales in the case of services. Bear in mind that your direct costs may fluctuate due to an increase in the cost of raw materials or of labour. If this is the case for your busines, you'll need to reflect this in your pricing strategy.

The Minimum Price You Should Charge

Once you’ve established the direct cost (or unit price), your next task is to work out the price.

If for example the direct cost (or COGS) is £10, the minimum selling price per unit should be £14.50. This is calculated as follows:

£10 direct cost

+ 45% of the direct cost (£4.50)

= Minimum Selling Price, or £14.50

You should never sell a product for less than COGS (or unit cost) plus 45% times COGS because you will struggle to pay the running costs of your business and make a profit. Charging 'COGS plus 45% times COGS' will give you a gross profit margin of 30%.

Gross profits are used to pay your overheads, sales and marketing costs, your salary and to generate a net profit. Given that you should be spending 10% of revenue on marketing (more if you're a start up or aiming to scale seriously) you can see already how tight this 'COGS (or unit cost) plus 45% times COGS' formula is.

Basically the less you charge, the greater the volume you have to sell to hit breakeven point and become profitable.

 

Your goal is to build a profitable business with the resources you need to invest in its growth and development. Not to maintain an expensive hobby that will leave you in the poorhouse! And the only way to do this is to make sure you get your pricing right.

[callout]CLICK HERE to start planning your 2017 budget and map out your financial plan for the year ahead.[/callout]

What Do You Do If You Discover You've Been Underpricing?

If you discover you've been underpricing, there are three ways you can restore profitability.

  1. Raise the Minimum Selling Price – but bear in mind you'll only be able to do this if customers are willing to pay for the increased price. (This is where brand perception comes in).
  2. Lower the unit cost – by re-engineering the costs of producing the product.
  3. Drop the product from your line if you can’t sell it at a price high enough to cover the direct cost plus a 45% markup.

If you can both raise the selling price and reduce the unit cost, you’ve hit the jackpot!

Although a small increase in the gross profit margin percentage may not sound a lot, compounded over the course of a year, it will soon add up.

Let’s go back to our example.

If we sell 10,000 items at a Minimum Selling Price of £14.50, the revenue (or total sales) will be £145,000. Our gross profit percentage is 30%  gross profit  and our gross  profit will be £45,000.

But if we could make a 10% saving on the unit cost, to reduce it to £9, and increase the price by 10% to £15.95, we would make £6.95 on every item sold instead of £4.50. That would give us an additional profit per unit is £1.55. This may not sound a lot. But compounded over the course of the year, this will make a big difference to the profitability of that product line. This could be the difference between breaking even, making a loss, or being profitable.

So if we sold the same volume (10,000 items) we would now generate total sales of £159,500 instead of £145,000. Our gross profit would now be £69,500 (£159,500 less £90,000).  This would put an extra £24,500 in the business coffers - just by reducing the direct cost and making a small price increase.

Now if we were to invest some of this £24,500 in marketing and increase volume ...

Are You Underpricing?

To make sure you're not underpricing:

  1. Calculate the unit (direct) cost of producing your product or service.
  2. Take this number, multiply it by 45% and add it to the unit cost .
  3. Compare your current price to this figure. Which is higher.
  4. If you discover that you're underpricing, look at whether you can (a) reduce direct costs and/ or (b) increase the price.
  5. If you can't charge the minimum viable price, drop it from your product range until you can.

The lesson here is that every product or service you offer must deliver at least a 45% markup on what it costs to make (or deliver if you're a service based business) if you are to to avoid underpricing your product or service.

[callout]CLICK HERE to start planning your 2017 budget and map out your financial plan for the year ahead.[/callout]

Remember COGS (or unit cost) plus 45% times COGS!

Join The Conversation

Question: I hope you’ve used this article to check whether you’ve been underpricing or not. Have you discovered that you’ve been underpricing? I love reading your feedback so please do reply using the comments box below.

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Work With Me

I’m Denyse Whillier, a Sussex and London based business coach and consultant. I work with responsible business leaders to build profitable and successful brands that do good, make money and help to change the world. I draw on Built To Succeed™, my proven success system, developed during my 8 years in the trenches as a CEO.

I’d love to start a conversation about whether we’re a good fit to work together. Simply use this link to arrange an informal Skype coffee chat. There’s no hard sell. Just solid advice and a straightforward, honest assessment of whether 1:1 business coaching (or business consultancy) would be right for you.