Category: Knowledge

 

When it comes to pricing your  products and services, there are many ways to go about it, two of the most common pricing methods used are cost-plus pricing and contribution margin-based pricing, but if you check the list below, there are many more options open to you. We will go through a long list of them in this article.

Pricing methods

• Cost-plus pricing
• Absorption pricing
• Contribution margin-based pricing
• Premium Pricing
• Competition-based pricing
• Marginal cost pricing
• Predatory pricing
• Odd value pricing or Psychological pricing
• Dynamic pricing
• Skimming (unique product/service and sell at high price),
• Penetration pricing
• Limit Pricing
• Loss Leader
• Economy pricing
• Promotional Pricing
• Captive product pricing
• Optional product pricing
• Psychological Pricing
• Product Line Pricing
• Geographical Pricing
• Price leadership
• Drip pricing
• Target pricing
• Value pricing

Cost-plus pricing

Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price. This method although simple has two flaws; it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price.

Price = Cost of Production + Margin of Profit.

Absorption pricing

Absorption pricing is a method of pricing in which all costs are recovered. The price of the product includes the variable cost of each item plus a proportionate amount of the fixed costs. It is a form of cost-plus pricing.

Contribution margin-based pricing

Contribution margin-based pricing maximizes the amount of profit derived from an individual product, and is based on the margin between the product’s price and its variable costs, otherwise known as the contribution margin per unit. To calculate the figure you have to assume how many units of the product you are likely to sell at that price. There is an assumption to be made regarding the relationship between the product’s price and the number of units that can be sold at that price. The product’s contribution to the firms total profit (i.e., to operating income) is maximized when a price is chosen that maximizes the following: (contribution margin per unit) X (number of units sold).

Premium Pricing

Premium Pricing is used where there exists a uniqueness regarding the product or service and where a substantial competitive advance exists. Premium pricing is used by such luxury brands as Savoy Hotels, Rolls Royce and Prada.

Competition-based pricing

Competition-based pricing comes about when setting the price based upon prices of the similar competitor products. Competitive pricing is based on three types of competitive product:

1. Products which have a lasting distinctiveness from competitor’s product. Here we can assume
   • The product has low price elasticity.
   • The product has low cross elasticity.
   • The demand of the product will rise.
2. Products have perishable distinctiveness from competitor’s product, assuming the product features are medium distinctiveness.
3. Products have little distinctiveness from competitor’s product. assuming that:
   • The product has high price elasticity.
   • The product has some cross elasticity.
   • No expectation that demand of the product will rise.

Marginal cost pricing

Marginal cost pricing is the practice of setting the price of a product equal to the extra cost of producing an extra unit of output. By this policy, a producer charges, for each product unit sold, only the addition to total cost resulting from materials and direct labour. This is often done by businesses during periods of poor sales. If, for example, an item has a marginal cost of £10 and a normal selling price is £20, the firm selling the item might wish to lower the price to £11 if demand is slow. The business would choose this approach because the incremental profit of £1 from the transaction is better than nothing at all.

Predatory pricing

Predatory pricing is an aggressive pricing strategy intended to drive competitors out of a market. It is illegal in some places.

Odd value or Psychological pricing

Psychological Pricing is used when the business wants consumers to respond on an emotional, rather than rational basis. For example selling for £9.99 instead of £10, this is evident in most supermarkets and retail outlets.

Dynamic pricing

Dynamic pricing is a flexible pricing mechanism made possible by advances in information technology, and employed mostly by Internet based companies. By responding to market fluctuations or large amounts of data gathered from customers – ranging from where they live to what they buy to how much they have spent on past purchases – dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a dynamic pricing success story. In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.

Dynamic Pricing has a number of variants such as:

• Negotiation (bargaining)
• Yield Management – depends on inventory and time of purchase. i.e. hotel rooms or airline seats.
• Real time Market – based on supply and demand.

Price Skimming

Skimming is selling a unique product or service at a high price, and sacrificing high sales in preference to high profits, therefore ‘skimming’ the market. Usually employed to reimburse the cost of investment of the original research into the product – commonly used in electronic markets when a new range, such as DVD players, are firstly dispatched into the market at a high price. This strategy is often used to target “early adopters” of a product or service. These early adopters are relatively less price-sensitive because either their need for the product is more than others or they understand the value of the product better than others. This strategy is employed only for a limited duration to recover most of investment made to build the product. To gain further market share, a seller must use other pricing tactics such as economy or penetration. This method can come with some setbacks as it could leave the product at a high price to competitors.

Penetration pricing

Penetration pricing is the opposite of skimming, where a product is sold with a low price to gain market share.

Limit Pricing

Limit Pricing is the price set by a monopolist to discourage economic entry into a market, and is illegal in many countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition. The problem with limit pricing as strategic behavior is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm’s best response. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labour for a long period of time.

Loss Leader Pricing

Loss Leader pricing is illegal under EU and US Competition rules. Larger players in a market may use loss leaders as part of an overall pricing strategy, such as using it to draw customers into their establishment and encourage them to buy other products once there. Loss leadership can be similar to predatory pricing or cross subsidization; both seen as anti-competitive practices.

Target pricing

Target pricing is a pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production. The target pricing method is used most often by public utilities, like electric and gas companies, and companies whose capital investment is high, like car manufacturers. Target pricing is not useful for companies whose capital investment is low because, according to this formula, the selling price will be understated. Also the target pricing method is not keyed to the demand for the product, and if the entire volume is not sold, a company might sustain an overall budgetary loss on the product.

Economy pricing

Economy pricing include things like the no frills lines found in supermarkets.

Promotional Pricing

Promotional Pricing is used to promote a product and is very commonly used. There are many examples of promotional pricing including approaches such as BOGOF (Buy One Get One Free).

Captive product pricing

Captive product pricing is seen in cinemas when you are forced to buy refreshments from the foyer, or blades for razors, or ink cartridges for ink jet printers, where the ink is often more expensive then the initial printer cost.

Optional product pricing

Optional product pricing is seen when you buy an airline ticket and are charged extra for seat next to window, extra baggage or speedier check-in.

Product Line Pricing

Product Line Pricing is where there is a range of products or services and the pricing reflects the benefits of parts of the range. For example car washes. Basic wash could be £2, wash and wax £4, and the whole package £6.

Geographical Pricing

Geographical Pricing is evident where there are variations in price in different parts of the world. For example rarity value, or where shipping costs increase price.

Drip pricing

Drip pricing is agreeing an initial price, with a customer only to add extra charges when the customer is about to buy. It works because once lured by the initial price and into a sense of ownership, a consumer attaches more value to the goods in question. This “endowment effect” makes them more likely to accept later charges as people hate the idea of losing £5 much more than they like the idea of gaining £5. Extra charges also only become apparent after the customer has invested time and effort, which they don’t want to waste, in the sales process. Anchoring helps here (“it doesn’t cost £200, it only costs £x” – £200 is the anchor). Make the pricing structure complex, create a sense of social approval – “everyone is buying” – then chuck in something free and its job done.

Price leadership

Price leadership is seen with regards to oligopic business behavior in which one company, usually the dominant competitor among several, leads the way in determining prices, that the others soon following.

Value pricing

Value pricing is generally used when external factors such as recession and competition pressure sales. This focuses on prices you believe customers are willing to pay, based on benefits your business offers them. Companies try to increase profits and get the maximum value out of their scarcity and are interested in who is willing to pay more, rather than who can afford to pay more.

Price Discrimination

Imagine that you dealt with every customer as an individual, and knew exactly how much they valued any possible version of your offering and that the price charged to any customer remained unknown to all the others. Develop a pricing scheme which gets as close as possible to this ideal. There are some attempts to make use of this pricing system:

1. First degree price discrimination – seen as unfair and unpopular
   • Tactic used by car salesmen and estate agents
   • Supermarkets use discount cards which are needed to take advantage of sales prices
   • Money on – Amazon used to tailor prices based on customer profile using “cookies” to display different selling prices to different customers.
2. Group discrimination – more accepted form of price discrimination
   • OAP and student discounts
   • Discounts for local customers who purchase regularly
3. Self discrimination – getting customers to confess they are sensitive to price, while still taking advantage of those willing to pay a premium price

Summary

So there you have it, there are lots of pricing options open to you. Use a method that best suites you and your business circumstances. Cost-plus pricing and contribution margin-based pricing are the most commonly used methods historically although some form of price discrimination is the ideal in most instances, although is very difficult to implement effectively for smaller, less technically endowed businesses.

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Having run a number of businesses over the years I have come accustomed to dealing with the day to day challenges that come along and the reactionary style owners often adopt in dealing with them. One of the key challenges I have found is to remove myself from a state of “fire fighting” and into working on the business and not in it.

Working on a business involves some strategic (eyes glaze over) thinking and planning. As a business owner I am constantly looking to increase profit and in doing so must look three areas:

• Increasing Prices (follow link to article)
• Increasing Sales
• Reducing Costs

In this article I’m going to cover what is often considered the most boring of the three topics “reducing costs“, But saving money within your business is probably easier to achieve then increasing sales, where you need to spend more on advertising or communication with existing customers all of which will involve some form of expenditure, and increasing prices which can be a scary proposition, with research showing it causes much anxiety amongst entrepreneurs and business owners alike. Taking costs out of your business will directly impact the bottom line and increase profits, if done correctly.

There are two ways to reduce costs:

• Reduce costs as percentage of sales. For example higher sales on  the same costs or costs rising less than sales are rising
• Simply cost cutting – However simply cutting costs is not always the answer as it may adversely impact sales and margins. If efficiency or output is reduced as a result of cutting costs than some analysis of the risks and rewards needs to be undertaken first.

5 step plan

Go through this 5 step plan in the sequence I have laid them out, this will prevent you feeling overwhelmed.

1. Eliminate waste and spare capacity. Use your time wisely, don’t waste hours and hours trying to save a few pounds.
2. Consider your position on a long term view versus a short term view. Set the level of investment spending where you want it to be.
3. Make sure your pricing is set correctly, failure to do this prevents you from knowing the potential of the business. (Check out my pricing strategy article here)
4. Understand your product offerings. what products haven’t been costed properly, what products aren’t valued by your customers but weigh heavily on costs. What parts of your business have moved away from your core activity and do these contribute sufficiently to profits
5. Strategic review. The business is the wrong shape. Going small and more niche or larger to cover cost base by pursuing better margin areas of your business.

Below is a list of other areas to consider:

Employees

One of the first things that businesses look to cut when making cost savings are with regards to employees, because generally employees are one of the biggest costs and biggest headaches (in an admin sense) for companies. This can be done a number of ways, by reducing staffing levels, introducing short time working, imposing salary freeze, and or reducing pension service costs. However taking this approach can cause an adverse effect on company morale, efficiency, staff absence and turnover levels and may cause issues with supplier relationships, where supplies reduce credit arrangements for fear of not getting paid by a company that is perceived to be struggling. Another way of dealing with such costs rather than simply cutting is to improve productivity.

Improving the productivity of employees is a more positive way of reducing costs per employee, and should involve the employees in the formulation of this process. If they are involved in the development process they will have ownership of it and will be more likely to follow through on initiatives. You don’t need to introduce productivity incentive bonuses to improve productivity, creating a happy working environment where employees are valued and feel they are contributing is beneficial for all.

Increasing Capacity

If you’re increasing capacity, employ an extra shift before adding more space to increase output. This will make it easier if capacity drops again so that you’re not stuck with the cost of a long lease and under capacity.

Outsource

Outsource all non-core tasks. If you do certain things infrequently look to get things off the books and done by a specialist on a freelance basis..

Supply chain management

Look for bulk purchase discounts, or source cheaper suppliers (but be wary of the risk of supplier failures or enforced single sourcing), reduce stock levels, cut excess production capacity in tougher times. Reduce inventory levels and move to a “just in time” supply or materials

Other options

• Cut capacity, such as closing business units (stores, website etc),
• Sale of business units, such as Clapham house selling Tootsies
• Oversees shifts – moving operations to cheaper lower cost locations (be wary of weakening of control over quality)
• Asset value write downs – (none cash write downs, cleanse the balance sheet and give clear picture of  the trading position, setting a new base to build on. This is more of an accountancy issue rather than something that physically impacts the business.

Debt Management

The general rule of debt management is to pay off your debts, such as your mortgage, loans and credit card bills, before you start to save money. This is because the amount of savings income you can get is almost always dwarfed by interest rates you pay on your debts. To check whether you are better off saving or repaying your debts, you should compare the interest rate on your credit facilities with your savings or investment rates.

Pay down debt levels to reduce debt service costs when surplus income cannot be utilized better through investment or purchase of assets.

If times are really desperate, consider a Company voluntary arrangement (CVA), which would release it from certain liabilities to its landlords.

14 Savings on Purchases

1. Don’t buy impulsively!
2. Do your research – do your research to find out when the industry is on the downside of the demand curve and buy, buy, buy.
3. Know about the secondary market – returns or refurbished
4. Understand that retailers are in business to make a profit on you – Retailers always have to move through product to make room for the next batch.
5. Don’t be an ‘early adopter’!
6. Don’t be afraid to ask for a discount
7. Buy during off-peak times
8. Don’t give in to the fashion trends
9. Always be ready to walk away.
10. Expose your purchase to competition – Squidbid.com is a Demand Driven marketplace which has developed a cool concept.
11. plan needs (no impulse buys)
12. shop for value
13. ask for discounts
14. examine receipts and bills

Summary

So there you have it, cutting costs doesn’t need to be boring. In fact saving costs is tax free, in many cases doesn’t require any capital and doesn’t rely on any marketing activities. It’s often the easiest way to put money back in your pocket so should be the first area of consideration when looking to increase profits. Check out the other two areas by clicking on the links below.

• Increasing Prices
• Increasing Sales (not completed yet)

Anyone that’s running a business wants to make more profit. There are only two ways to do this:

1. Sell more goods and services (volume).
2. Make more profit per £1 of sale (margin) either by increasing prices or reducing costs or increasing prices while reducing costs.

For the purposes of  this article we’re going to concentrate on the  “Increase Prices” part of the model (above) in our quest to increase profit margins.

Many business owners are afraid to charge “more” for fear of losing custom and putting people off buying from them, but the flip side of this is you may be leaving money on the table that could be in your bank account rather than in the customer’s pocket. I once heard this sentence and it changed the way I thought about pricing, it goes “Unless you are the most expensive in your field you can always afford to put up your prices”.

Well not everyone is comfortable about increasing prices, and as business owners we should be wary about the way we edge them up. There are a number of tactics we can employ to ease price increases into our business

1. Introduce a new pricing structure for new customers only, look after your loyal customers, but let them know that you will honour the old price structure for as long as they stay with you. Should they leave and come back at a later date they will have to go on the new pricing model. Let them know you value their loyalty and are rewarding it, make it a good PR exercise.
2. Begin to shift your overall product sales mix towards higher profit margin products and services, and start phasing out your lower margin items. Introduce higher margin new products that are perceived as higher value solutions for customers.
3. Decrease the level of discounts you’re currently offering customers.
4. Increase your minimum order volumes so that customers have to reach a higher threshold before they qualify for discounts.
5. Increase your delivery charge and start charging for any additional special services related to delivery.
6. Charge your customers for any engineering and installation services that you previously included as standard.
7. Increase prices to cover for overtime or additional time needed to deliver rushed or very short notice orders.
8. Start collecting and charging interest on overdue accounts from the last few months.
9. Begin to write stiffer penalty clauses into all of your contracts. Think about it – your suppliers will almost certainly be doing this to you, so there’s no reason why you can’t be commercially more hard-nosed as well.
10. Find ways to decrease some of the physical features or characteristics of your product, but continue to charge the same prices.

Times are tough, but we have to make sure we are getting a fair price in exchange for our services/products. Make sure you’re maximising profits so that you can continue to provide for your customers in the years ahead.

Check out my other articles on the subject:

• Reducing costs to increase profits
• Increasing sales

If you have any additional ways you have increased prices please put them in the comments. Hope you found this post interesting please subscribe to my newsletter so that you get to hear about my newest content as soon as it’s published.

 

When I first started off in business, I found cash flow one of the harder things to get my head around. I figured as long as I had my prices right and was making a profit, I would be fine.

However cash flow is one of the most important aspects to a business, the lifeblood of it, in fact. Without good cash flow, your business is dead in the water, unless you have access to enough cash reserves or funding.

Cash Flow doesn’t mean “Cash”, as in paper money

Just something to bare in mind here, when we are using the term ‘cash’ we are not literally talking about cash-in-hand, as in paper money, but referring to money actually entering or leaving your bank account in whatever form either through electronic payments, cheques, or cash.

How cash flow impacts business

Below is a simple example of how cash flow impacts a business, and why careful consideration needs to be given to it, particularly when you are starting off and in periods of growth.

Cash flow projections

Example 1	Month 1	Month 2	Month 3	Month 4
revenue	£10,000	£10,000	£10,000	£10,000
costs	£7,000	£7,000	£7,000	£7,000
profit	£3,000	£3,000	£3,000	£3,000
Accum reserves	£3,000	£6,000	£6,000	£6,000

Example 2	Month 1	Month 2	Month 3	Month 4
revenue	£0	£10,000	£10,000	£10,000
cost	£7,000	£7,000	£7,000	£7,000
profit	-£7,000	£3,000	£3,000	£3,000
Accum profit	-£7,000	-£4,000	-£1,000	£2,000

I have tried to keep the numbers very simple and constant for illustration purposes only, of course revenue and costs will vary from month to month in the real world especially for a business start up, usually building up over time. As we see in example 1, revenue of £10,000 is coming into the business each month, with costs for that period of £7000, this leaves the business trading at a profit of £3000 during each month. The business is profitable. If you want to imagine how this would work for a larger business, just add more zeros to the end of each of the figures in the table.

Now lets assume that the business is trading in exactly the same way in example 2 as it is in example 1 with just one big difference, revenue is not coming into the business during that particular month, but is being delayed a month. This wouldn’t be uncommon if you were a business dealing with other businesses where standard payment terms tend to be 30 days from date of invoice, and can even be as much as 90 days when dealing with some larger organisations.

The business is still trading at a profit technically from a profit and loss point of view. But from a cash flow basis, it doesn’t look as healthy as example 1. The revenue earned in month one is not actually coming into the business until sometime in month 2 which means that due to costs of £7000 in month one which had to be paid in month 1, there was a shortfall of £7000 in month 1. This would have to be paid otherwise you would have problems with your landlord, utility companies, suppliers etc.  So you have to find £7000 in financing to cover the shortfall, maybe from the bank, maybe an overdraft facility or your savings or from friends and family.

Now when it comes to month 2 you are trading with revenue from month 1 coming in, the trading pattern of revenue, costs and profit is the same for month 2 in example 2 as it was for example 1, but because you had a shortfall in month 1 of £7000 you are able to put £3000 of your profit into paying off some of this, but it still leaves you £4000 down overall (see the accumulated profit row above).  In fact it takes to month 4 to pay all of the initial £7000 deficit in full.

Now this doesn’t necessarily cause your business a problem as long as you have prepared for it, which is why as part of doing a business plan you should do a cash flow statement which tries to predict how money comes in and out of the business during each month. It is a great way of predicting where you will need to finance shortfalls in cashflow.

Understanding the Cash Cycle

There are various things we can do to reduce the ‘cash cycle’. The cash cycle is a great way of measuring the way relationship between incoming and outgoing payments.

• Cash cycle is:

Time that elapses between the delivery of inventory and its conversion into sales (1 week)

PLUS time that elapses between the sale of goods and services to customers and receipt of monies due from these accounts receivable (nil – payment terms are cash on delivery)

LESS time that elapses between the receipt of goods and services from suppliers and subsequent payment to these accounts payable (4 weeks)

= 1 week + 0 weeks – 4 weeks = -3 weeks

The -3 weeks above refers to the fact that in this example you would have delivered your goods or services to your customer and received payment for them 3 weeks before you would actually have had to pay your suppliers for them. This is good cash flow. It effectively means your customers are financing your business. They are paying you to pay your suppliers.

To improve the cash cycle look to get better terms from your suppliers (increase creditor days). There are a number of payment terms such as pre-paying for supplies, or paying cash on delivery, beyond that you may have 30/60/90 day terms. Try to get the best possible deal for you business. The rule of thumb is try to arrange to pay you bills as late as you possibly can. Don’t do this in a unethical way. Such as telling a supplier the cheque is in the post,  but negotiate with them a deal that satisfies you both. If you mislead supplies they may refuse to deal with you again, which can cause you damage to your business and reputation.

On the other side of the equation are “customer payment terms”, it is good practice to look at reducing debtor days wherever possible. Getting money up-front, or cash on delivery is the best you can aim for. Try to avoid giving your customers credit for 30/60/90 days unless you know you can deal with the lack of cash coming in. Generally it is difficult to dictate terms outside your industries norms, unless  you are particularly valuable to your supplier or customers, but try to get the best deal for your business that you can.

There are other things you can do within your business to help improve your cash flow position. I have myself used interest free credit periods on credit cards to get me over difficult periods. If your business holds stock you can look to reduce stock levels by improving inventory control and using warehousing to store inventory from suppliers to improve bulk buying margins

Increase stockturn (less stock levels moved quicker) on the basis of forward cover (reduced volume of stock order, order more frequently), or Improve IT ordering system to help control stock levels and avoid holding too much stock and running out of inventory.

Rationalize outlets by scaling down outlets by closing not profit making outlets or by move away from cyclical sectors into more non-cyclical sectors.

Summary

Cash flow isn’t an easy subject to master, mainly because when you start to talk about the subject most peoples eyes start to glaze over. But lets be clear, it is one of the most important aspect of running a business you should understand, other wise your business life could be short lived.