April 2020

Page 36

Pricing for a Profit Lee Rust, Owner, Florida Corporate Finance Years ago, my business economics professor asked our class how we would set the sales price for a new product. We immediately started discussing a calculation based on the cost to manufacture plus a reasonable gross profit. “Wrong,” the professor interrupted, “first do a market study to determine the maximum price you can charge and still sell appropriate quantities of the product. Then calculate the cost of manufacture only to determine if production of the product is attractive.” Setting sales prices is an art, not a science, and is based less on product or service cost than you might imagine. Markets do, and should, determine prices. Therefore, market analysis is an extremely important part of any pricing decision. In general, product or service prices should be examined and adjusted on a regular basis depending upon the volatility of the market. Of course, for a job shop bidding individual production projects, prices are set for each bid and the competitive price environment is known with every win or loss. In a commodity market, such as the production of landscape mulch or windshield washer fluids, market prices should be analyzed every few months as well as seasonally when demand peaks. For a proprietary branded product such as scuba diving equipment, prices might be set once or twice a year.



In setting prices, the tendency is usually to set them too low rather than too high. There is too often a fear of losing market share, suffering a sales decline or not winning the project award. Those fears depress prices, often well below what the market (or customer) would accept. Continual analysis is required. Raise prices and quickly judge any effect on sales. If a product is not selling at the levels you believe are feasible, lower prices and see if revenues increase. At higher levels of production, costs might even decrease to more than make up for the lower prices. All of this analysis should be based on a combination of financial and market data that must be current. As I’ve said before, financial statements that are generated more than fifteen days after the close of the previous month are historical curiosities, not control tools. Statements that don’t include appropriate profit center accounting for each product line or company division are also useless as pricing guides. In addition, beware of excessive pricing pressure from customers. Several years ago, I knew of a company that produced a component for a major manufacturer which represented a significant part of its revenues. The customer kept demanding price reductions and the supplier’s principals continually acquiesced. After the