The Basics of Pricing for a Small Business
By: David Arseneau
It sometimes appears that start-ups and even experienced entrepreneurs can overlook the importance of pricing. The start-up is worried about many items on their checklist including a lease agreement, opening inventory, needed employees, outside sign, and much more. The experienced entrepreneur gets caught up in decisions regarding an equipment purchase, an employee health plan, workers’ compensation, insurance issues, and much more. It is easy to overlook some of the most basics aspects of running a small business. One of the most basic concepts missed is one of the 4 P’s of marketing called pricing. (pricing, place, promotion, and product)
Pricing is most certainly not overlooked intentionally. Entrepreneurs and small business owners just seem to neglect its extreme importance. The area of importance centers on the aspect of profit, more specifically gross profit. It is this area on the income statement where a small business can become very successful or flounder miserably. This is why it is extremely important for all owners to have at least a basic understanding of their financial statements.
Essentially, gross profit is the difference between a business’s selling price and the cost of the product or service provided. A cost of goods sold section is more complicated than this but for the purposes of this price discussion a simplified approach will be taken. It should also be noted here that a service business usually does not have a cost of goods sold section but the concepts presented here do apply relative to product or service mark-up.
Selling Price – Cost of Product/Service = Gross Profit
Selling Price / Gross Profit = Gross Profit Margin (%)
This leads to an opening discussion on the basic mechanics of pricing to achieve a “wanted” gross profit margin. The reader may begin to wonder what is meant by a “wanted” gross profit margin. This concept could become the key to overall profitability for any small business. Most owners are aware of financial benchmarks in their industry. If not, this information needs to be secured from industry sources in order to manage a small business more efficiently. Ultimately, owners should be able to obtain an average (benchmark) gross profit margin for their industry. Once this benchmark is obtained and validated, this information provides key decision-making data for pricing a product or service.
Example: Assume an owner finds out the industry benchmark gross profit margin is 30%.
Assume: Cost of Product $10.00 “Wanted” Gross Profit Margin 30%
Example A Example B
Pricing Calculation: $10.00 X 30% = $3.00 $10.00 / .7 = $14.29
Pricing Decision: $13.00 Selling Price $14.29 Selling Price
$10.00 Cost $10.00 Cost
$ 3.00 Gross Profit $ 4.29 Gross Profit
23% Gross Profit Margin 30% Gross Profit Margin
The above Example B not only illustrates “how to price” but identifies a very common pricing error by the novice entrepreneur or small business owner in Example A. Please carefully analyze the flaw in the pricing decision in Example A. As noted, if the “wanted” gross profit margin is 30%, the owner takes cost and divides by .7 to get a selling price. As expected, if the owner wants a 50% gross profit (which is typical for clothing products), the pricing decision would be:
Pricing Calculation: $10.00 / .5 = $20.00
Pricing Decision: $20.00 Selling Price
$10.00 Gross Profit
50% Gross Profit Margin
This example demonstrates why a pair shoes that costs the business $50.00, priced at 50% gross profit margin $100.00, can be discounted 25% $25.00, and still yield a 33.33% gross profit margin to the retailer. (See Example D)
Pricing Calculation: $50.00 / .5 = $100.00
Pricing Decision: $100.00 Selling Price
Discounted Price: $ 75.00 ($100.00 X 25% = $25.00 discount)
$ 50.00 Cost
$ 25.00 Gross Profit
33.33% Gross Profit Margin
The above examples should clearly outline to the reader that pricing decisions are very important to overall profitability. If an owner cannot maintain the appropriate, benchmarked, or “wanted” gross profit margins to cover expenses, the business will generate bottom line numbers that may be negative, unacceptable, or exceedingly low. All businesses need to maintain or protect gross profit margins and reduce expenses at the same time if possible. This will yield solid net profits and an acceptable net profit margin on overall business sales.
The bottom line of this article is to illustrate the need for careful analysis when pricing any product or service, especially high-ticket items. An owner must also look at additional aspects of pricing including competitive pricing. The “wanted” gross profit margin may be 30% but the competitive market may not allow a price point to generate that % margin. The owner may then need to discount from retail or establish a gross profit margin at a lower percentage. That being said, can the owner then control expenses to maintain a proper net profit (margin)?
Other pricing aspects to think about here would be the consideration of packaging, shipping, and sales tax and their overall impact on the pricing decision. How should they be taken into account relative to the pricing calculation? This presents another analysis by the small business owner.