Common SMB Mistake: If you are using a Cost+ pricing strategy, then you are doing it wrong
Jeff Bezos would love it if you had a cost + price structure
When we take over a file from a private equity lender or a bank, our role as Chief Restructuring Officer (CRO) is to very quickly assess how can we stabilize the balance sheet by increasing liquidity. We’ll often renegotiate payment terms with suppliers, go on a receivables collecting spree or take quick actions with business operations to improve cash flow.
Any CRO worth their salt will first look to pricing. Why?
Every $1 increase in price flows directly to bottom line
MOST of the time, SMB’s haven’t made any pricing actions in years because they are scared that an increase will chase customers away
No major capital expenditures is needed to adjust pricing so it CAN BE all upside (as long as you understand price elasticity)
Major actions can start to be taken within weeks - we can show equity/debt stakeholders the progress that is being made
Virtually every SMB that my firm comes across (which is a lot) either…
a) never thinks about pricing —> I’ve seen management more worried about the cost of pens/staplers
b) has poor pricing architecture, built in on a shaky foundation that’s called COST +
What is COST + and why is it fundamentally flawed?
Some combination of variable cost per unit (VC) + fixed cost per unit (FC) and add a required mark up in order to meet a gross margin target needed to be profitable
Some companies ignore FC and others have all FC baked in —> are you starting to see the problem??
The fundamental flaws are as follows…
There is no consensus if it’s just (VC + markup) or (VC + FC + markup)
What do you with FC per unit as quantity changes? Are you always changing your price so that margin stays the same? Your customers are going to get a headache if they see this!!! They have a budget too you know
If your quantity increases meaning your FC/unit decreases, resulting in your gross margin/unit is higher, you only invite more competitors to enter the market to steal your share —> “Your margin is my opportunity” said Jeff Bezos
COST + is like selling one size of a t-shirt to every person that shops at your business; it’s an unwieldy method to segment the 5ft 2 inch person from the 6ft 5 inch person
Your competition may have a very different cost structure; Amazon vs. Walmart would have a very different split of VC from FC based on their business models but sell many of the same things
How does your sales people create estimates for new prospective customers? Often you don’t give sales staff access to your financials - that’s just bad internal controls & you open your business to huge financial risks
COST + will always misprice your product/ service when macro economic dynamics are changing. You will be overpriced in weak markets and underpriced in strong markets since you are using accounting data which is backwards looking
A quick math example to drive the point home…
In my very simplistic example here, see what is happening? Because you are using accounting data to apply to the market, this company would have been underpriced in a good market ($3.33 less) and overpriced in a weak market ($3.33 too high).
What would a sales person use the next time they sell to a new customer? What would you tell your longer term customers?
If you are underpriced in a good market, you might pick up some more volume as price sensitive customers move to you but your competitors will follow & that gain will be short lived. The opposite will be true in a weak market, forcing you to follow with a price cut
In conclusion, using COST + is a poor foundation to setup a pricing architecture & will allow stronger competitors to take advantage of you when markets are not in a steady state. This is what I see most (de) stressed companies do and a major factor to why they are there in the first place. Don’t make that mistake too!!
What’s a better model in your opinion?
I know for service based industries we use value anchors or performance based incentives to personalize + increase margin.
What’s a better way for products?