Yes, it’s normal to make a margin on a sale.
It’s in the “ABC” of making money and yet many of us are uncomfortable with that reality. Given that your company lives through making a profit, how do you make yours more profitable and ensure that it values itself and its customers?
There are a number of ways to set prices but the two most common approaches are either through a “Cost-Plus” or a “Value Based” approach. The Cost-Plus Pricing Model is commonly applied in a couple of different ways either using a coefficient such as 2x, 2,25x, 3x the cost of production, or a “best-for-me” approach adding an appropriate margin to the production cost that suits the business’s need to generate profit. This approach is simple and easy to apply and is widely used for goods as diverse as beer to construction projects and can often be a quick way to get started. But it has its limits. It doesn’t consider nor reflect the true cost of production (fixed costs, salaries etc.), it ignores segmentation and in doing so it kills market orientation and most importantly for a business, it can leave money on the table.
The Cost-Plus approach is inward looking, focusing on your company, not on your clients (the market). It doesn’t, therefore, consider their thoughts and perceptions of value when determining the price. If your prices don’t match your customer’s expectations, you risk losing them, so business owners have to consider these expectations when setting their prices.
People don’t buy what something costs, they buy what it’s worth (to them).
An alternative way to set prices is to use a Value Based approach. Here, the final price has little relation to the actual COGS and instead factors in the perceived value your customer is getting from buying your product or service. When a business sets its prices, it is key to understand the value your customer attaches to what you are offering and identify how you can increase that value. How does this work?
Let’s look at a couple of examples. Take a bottle of wine, its price isn’t set relative to its cost of production, but instead takes into consideration its taste, independent rating, the Vineyard’s reputation and many more factors besides.
When you buy a smartphone, what makes someone choose Apple’s iPhone over Samsung’s Galaxy when one can be up to 3 times more expensive for a similar spec? Looking at the latest versions (iPhone 11 and Galaxy S10), both smartphones cost around $300 to produce, but they have vastly different RRP’s (iPhone $749-$1,149 vs Samsung $669-$899). However, when you factor in the various discounts on offer the average selling price for the iPhone 11 is up to 3 x more than the Galaxy S10.
So why is that?
People don’t buy what something costs, they buy what it’s worth. Warren Buffett says that “if you have the power to raise prices without losing business to a competitor, you have a very good business”. Apple currently benefits from roughly 94% share of profits vs Samsung’s 11%, so effective pricing coupled with a strong understanding of what motivates a customer to buy from you is clearly profitable. Consequently, if your product or service is worth nothing to your clients, it’s maybe time to think about adapting your business model or finding a new fresh market space. Because what is important is the value you bring to your customers, not the cost of production.
Set your prices based on how much your customers are willing to pay.
This doesn’t mean you should immediately increase your prices, nor does it mean you should start discounting (more about that another time). It’s about knowing what your customers value and understanding how you fit into that equation.
McKinsey suggest that 80-90% of all wrongly priced goods or services were set too low and a big part of that is underestimating your customers and the value you bring to them, and then developing a marketing strategy that delivers the value promise consistently.
If you would like advice on how to create the value difference that will get your business to the next level, get in touch.