percentage of revenue

Pricing Basics: Value Positioning and Margin

by Tom Gray | on Mar 16, 2012 |  Comments

The price you choose for your products is one of the strongest messages you can send. To use it well, you must decide both your value positioning and the minimum margin you need to meet your goals, before deciding your price.

Value Positioning

Positioning means “how the customer thinks of your company” – a mental image or identity that expresses your competitive edge, the benefit you offer. Your company offers some unique benefit which your target customers appreciate, one they prefer to get from you rather than other sources. Otherwise, you should not be in business! See Competitive Analysis and Differentiation: Be Different or Be Gone!

This benefit has value, which should be reflected in your price. If you offer more value, your price should be higher. For example, if your device seldom fails and you have the fastest repair turnaround time, you can charge more than a competitor whose unit fails more often, or who takes weeks to repair/replace a failed unit.

People do not always buy the lowest price alternative. People buy value—the best combination of features/functions and price.

  • They buy luxury cars, not just Chevys.
  • They buy bottled water even though tap water is free.
  • They buy cable TV even though national networks are free.
  • They buy their favorite brand even though it costs more.

Why? Because that brand meets their needs best within their price range. Their needs include more than raw functionality. The brand they choose will also meet their needs for style, social acceptance, their need to be sure the product will work as advertised, and others.

When setting a price, know what your customers value, and how you deliver that value better than competitors. Then set your price higher than those who deliver less value. If your offering has value, your pricing should communicate that. Having the lowest price merely communicates adequacy, not value.

Calculating Minimum Margin

Margin is the difference between the price you charge and your variable cost of production. Your price must provide enough margin to cover

  • variable costs (e.g. labor, materials),
  • fixed costs (e.g. rent, insurance), and
  • target profit.

The important point is to set the price high enough to recover more than the variable costs to make and deliver the product. You must collect enough to pay for overhead (fixed costs) and provide the target profit as well.

So you must know what your costs are before setting your price, and you must select a target profit, expressed as a percentage of revenue.

For example, if you want a 15% profit before tax, and your fixed costs are 30% of revenue, then your variable costs can be as much as 55% of revenue (100% – 15% – 30% = 55%). If variable costs are only 45% of revenue, then your profit is 25%, given fixed costs of 30% (100% – 45% – 30% = 25%).

The basic formula is target revenue  = variable costs / (fixed costs % of revenue + target profit % of revenue), or variable costs /.45 in the above example. This formula applies for one product, or for the company as a whole.

 

Value Positioning and Margin are the two basic considerations for pricing. In the next few articles Business Techniques in Troubled Times will explain a number of pricing techniques based on these two concepts, such as margin analysis, shop rate, good/better/best, value-in-use, various price structures, differential pricing, types of promotions, and  distributor margins.

Acknowledgement: this article draws on some material presented by Dennis Sester, Phil Grisolia, and the author in the SCORE Fox Valley Pricing Seminar.

Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. See www.tom-gray.com.

Owning Your Own Business Means Owning Your Own Books

by Tom Gray | on Jan 05, 2012 |  Comments

Most small business owners don’t understand bookkeeping, Quickbooks, contribution margin, or cash planning, so they shy away from learning how to use their results to improve the business.

Yet when small businesses fail, it’s because they run out of cash. Why does this happen, and why do owners allow cash shortages to develop in the first place? Too often, it’s because they don’t try to understand their numbers.

They assign someone else to “keep track” of the numbers.  Unfortunately, bookkeepers are not planners. Bookkeepers look backward, not forward. Owners are the only ones whose job includes using past performance to improve future results, but they usually do not know how.

The owner is the expert on what the business does, spending up to 80 hours per week to make sure the business has effective operations, and maybe even spending some time on getting new customers. Small business owners typically do not make it a priority to understand their numbers well enough to predict their future. Short term demands make future planning seem like a low priority. Then they run out of cash!

Fortunately, it is not difficult for small business owners to understand their numbers well enough to plan, even without learning software (e.g., Quickbooks) or bookkeeping. Three techniques are all they need.

  • First, require the bookkeeper to export the monthly Quickbooks Profit and Loss Report to an Excel spreadsheet with one column for each month of the year.
  • Second, have the bookkeeper reformat the data in Excel into an Income Statement with a reasonable number of revenue and expense categories (see below), and for each category heading show the “% of Revenue” in that line.
  • Third, study where the money goes and create ideas to change those percentages.

Let’s look a little deeper at each of these techniques. First, the Internet has dozens of entries telling the bookkeeper how to export data from Quickbooks to Excel.

Making Quickbooks Reports Manageable

In the second task, you are making the Quickbooks data more useful by reducing the number of entries to a manageable number. For revenue, you should have a summary line for each product type. Even in a job shop, you can categorize your jobs into types.

The next main category is variable expenses, or Cost of Goods Sold (COGS). Your lines for variable costs will be labor (and associated payroll tax and possibly benefit costs), materials, subcontractors, shipping, and sales commissions. The labor line will include labor costs devoted to production, with nonproductive labor hours shown elsewhere as overhead costs.

The last major category is fixed or overhead expenses, those that stay the same regardless of production volume. Here is where you will invent headings and summary lines to group costs by type, so the number of lines is manageable. Ten categories should be sufficient. For example,

  • Nonproductive labor/tax/benefits
  • Salary/tax/benefits
  • Facility costs (rent, maintenance, utilities)
  • Computer costs (hardware, software, maintenance)
  • Vehicle costs
  • Office expenses (include phone and bank charges)
  • Professional services (accountant, legal, consultants)
  • Marketing costs (include travel and entertainment)
  • Dues and Licenses (professional licenses, conferences, dues and subscriptions)
  • Miscellaneous – but try to keep this minimal!

This is a lot easier to work with than 30 or 40 accounts, most of which say 0 for the month! If it is easier to work with, there is a better chance you actually will work on it!

Analyzing the Results

The third technique is analyzing the results. This is the owner’s job, and no one else’s. Up to this point you have simply been telling the bookkeeper to present the data in a more useful way

Analysis starts by looking at % of revenue for each line. The key line is “contribution” (to cover overhead and provide profit), also called gross margin. This is revenue minus variable costs, or revenue minus COGS to some accountants.

Hopefully this margin is at least 50% of revenue. Why? This margin is what you have left after building the product, and its job is to pay for overhead and leave a profit. If your margin is 50%, and your overhead is 30% of revenue, then your pre-tax profit is 20% — a good number.

Numbers are the way we keep score. Without them, you can’t know if you are winning the game or losing, until it is too late! Small business owners can avoid a cash shortage without expertise in bookkeeping. The secret is to present their results in a way that enables planning, using percentage of revenue and contribution margin. In the next article, we will discuss how you can use this data to improve your business.

Does this seem do-able so far? Does it seem worth doing?

Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. See www.tom-gray.com