Pricing Products Profitably

In setting prices, the objective is to maximize profit. Profit has just three ingredients: costs, selling price and sales volume. In this articlre we are concerned with selling price, which has about the same elements for all types of businesses. For example, in manufacturing, the elements of the selling price are direct costs, manufacturing overhead, nonmanufacturing overhead and planned profit. In a service business, the elements are materials and supplies, labor and operating expenses, planned profit and competition. In a retail business, the elements of price are costs of goods sold, overhead, sales volume, planned profit and, often, competition.

Types of Costs

In the retail business, there are two types of costs: the cost of acquiring the goods, called cost of goods, and the cost of operating the business, called operating expenses.

Cost of Goods (Variable Cost)

Cost of goods is known as a variable cost or expense because it varies depending upon the amount of goods purchased for resale and the price of the goods. Cost of goods includes the price paid for goods, freight charges, import duties, handling charges and any commissions.

Operating Expenses (Fixed Cost)

Operating expenses are a fixed cost because they usually do not vary with the volume of business. Operating expenses include wages, management salaries, rent, utilities, office supplies, insurance and any other costs attributed to the operation of the business.

Planned Profit

Planned profit is whatever the owner/manager calculates the business will generate. Usually, return on owner's investment, fruits of labor, plans for expansion or relocation, return to stockholders, demand for the product and competition are considered when calculating the amount of planned profit.

Competition

In setting prices, small businesses should consider prices charged by competitors for similar or comparable items. A small business should not try to compete pricewise with large stores, discount houses or supermarkets. This type of competitor can charge less because of buying power. Pricing should be based on the quality or type of service offered, as customers will pay higher prices for merchandise to obtain the services they want.

Pricing Below Competition

Beating the competitor's price is effective only if it greatly increases sales. This strategy reduces the profit margin. Consequently, cost of goods and/or operating expenses must be reduced and inventory must be closely controlled; the product line must be limited to fast moving items; and services must be limited or eliminated.

Pricing below competitors often backfires because every cost component must be constantly monitored and adjusted. Competitors can retaliate by matching the lower prices, at which point both businesses lose.

Pricing Above Competitors

This strategy depends on whether non-price considerations are important enough to customers to justify higher prices. These considerations include specialized services (such as delivery, product knowledge, exclusive location, brand or designer names), satisfaction in handling complaints, in-home demonstrations and so on.

Markdowns

A markdown is a reduction in the price of any item brought about by overbuying, overstocking seasonal merchandise, misjudging customer response, poor personal selling or competition. This technique is used to avoid being left with dated merchandise that will be difficult to sell. In setting a markdown price, the original cost of the merchandise should be recovered if at all possible. If the selling price originally was high enough, a small profit is possible.

Price Lining

This is a marketing strategy based strictly on price. A specific portion of the buying public is targeted by carrying products in a specific price range. For example, a retail store carries an exclusive line of women's undergarments or an expensive designer perfume line.

Price lining is only successful if there is little or no competition. It works to the benefit of the retailer because it limits the merchandise line and makes inventory and buying easier. It is also easier for the customer to select merchandise, so that fewer salespeople may be needed.

Markup

One technique of establishing price is to mark up goods sold by adding a percentage to the total cost of the goods. For example, a retailer purchases shoes at $25 per pair and marks them up 60 percent for resale.

The 60 percent markup must cover all operating expenses, including the owner's salary and profit.

A given markup is satisfactory depending on the sales volume. When beginning a business, it is difficult to determine how much goods must be marked up because the new business has no history of sales on which to base future sales projections. An experienced retailer usually can use markup successfully, particularly if he or she has historical information regarding
the movement of merchandise.

Suppliers often suggest a retail price, which makes it easy for the retailer. If there is a competitor selling the same or comparable merchandise, check the competitor's retail price. It may dictate your price.

Break-Even Analysis

A break-even analysis can be used by a new or old manufacturing or retail business. It indicates the amount of revenue at which a business will neither lose nor make money. For a retail business, the break-even point is when sales equal the cost of goods plus operating expenses, or

                S=FC+VC

where   S = sales in dollars
           FC = fixed costs or operating expenses
           VC = variable costs or cost of goods.

From a strict accounting standpoint, cost of goods cannot be determined until an inventory has been taken, because cost of goods is determined as follows:

         Inventory at beginning of a period + Purchases during the period - Inventory at end of period = Cost of goods sold

Thus, the break-even analysis involves a variation in the break-even formula because the total cost of goods is not known. First, gross profit (also known as the gross margin or contributing margin) on sales is determined as follows:

       Cost of sales - cost of goods = gross profit

The break-even point is then calculated as

       FC (operating expenses)
       -----------------------
          GM (gross margin)

Earlier, an example of a retailer buying shoes for $25 a pair and selling them for $40 a pair was used. The gross margin on each pair of shoes sold was

       Selling price = $40.00 or 100%
       Cost of shoes = $25.00 or 62.5%
       ----------------------
        Gross margin = $15.00 or 37.5%

Note that the gross margin and cost of goods (variable unit cost) are expressed as percentages of the sales price.

Let's assume the shoe retailer has operating expenses (fixed costs) of $75,000 per year. The break-even point is

       FC ($75,000)
       ------------
       GM (37.5%) = $200,000 in sales

Sales of $200,000 mean the retailer must sell 5,000 pairs of shoes at $40 per pair to break even. Assume the retailer cannot sell 5,000 pairs of shoes. To break even, he must raise his price, which will raise his gross margin. The question is how much the retailer will have to raise his price to break even.

Assume the retailer determines that he can sell the shoes for $50 a pair.

       Selling price = $50.00 or 100%
     - Cost (shoes)  = $25.00 or 50%
       -------------
       Gross margin  = $25.00 or 50%


With operating expenses of $75,000, the sales volume to break even is

       FC ($75,000)
       ------------
         GM (50%)   = $150,000 of sales

At a price of $50 per pair, the retailer now has to sell 3,000 pairs of shoes to break even. The retailer is confident he can sell this volume, but he will not make a profit selling at $50 a pair. He would like to realize a profit of 10 percent on his operating or fixed costs ($75,000 x 10% = $7,500). To calculate the volume of sales required to earn this profit, he adds the profit to the fixed costs. If he holds the price at $50 for a gross margin of 50 percent, the sales needed to realize this profit are

       FC + profit ($75,000 + $7,500)
       ------------------------------
                 GM (50%)             = $165,000 in sales

This level of sales will cover the variable expenses (cost of goods), the fixed expenses (operating expenses) and a profit of $7,500. To generate $165,000 in sales, he must sell 3,300 pairs of shoes at $50 per pair.

Because the retailer has no competition, he is confident he can sell this volume of merchandise and can also raise the unit price of the shoes. He decides to do a calculation using a gross margin of 55 percent.

       FC + profit ($75,000 + $7,500)
       ------------------------------
                  GM (55%)            = $150,000 in sales

The unit selling price or price per pair of shoes at 55 percent gross margin is determined by dividing the unit cost by the percent of variable costs.

       VC = 100% - GM%
          = 100% - 55%
          = 45%
 
       Unit cost of shoes ($25)
       ------------------------
               VC% (.45)        = $55.56 or $56 selling price

As a check

       Unit selling price = 100% = $56
     - Variable cost      = 45%  = $25
       -------------------------------
       Gross margin       = 55%  = $31

Let us determine if $150,000 of sales at a gross margin of 55 percent will provide a profit of $7,500.

       Today's sales  = $150,000 or 100%
     - Cost of sales  =   67,500 or 45%
       ---------------------------------
       Gross margin   =   82,500 or 55%
     - Fixed costs    =   75,000
       -------------------------
         Profit       =   $7,500

If a business manager calculates the gross margin for all merchandise sold, the price structure that will generate a level of revenue to purchase goods, pay operating expenses and make a profit can be determined.

The gross margin percentage can be used as a monitor of the sales/purchasing area of the business. The gross margin calculation allows the manager to buy goods that can be sold at or higher than the desired margin. Pricing policy should be based on gross margin.

If an item of merchandise has a low sales volume, it should have as high a gross margin as possible or else it will not be profitable. If a business does a high volume of sales, it may be possible to have a pricing policy based on a lower gross margin, subject to calculation.

In review, the break-even point is the level of sales that will just cover fixed plus variable expenses. By determining the gross margin for each item of goods sold, the level of sales needed to break even can be determined as follows:

           Fixed cost
          ------------
          gross margin = break-even sales

By adding planned profit to fixed costs, the level of sales to make the planned profit can be determined. To determine the unit sales price of an item at a desired gross margin the formula is

          Cost of goods per unit
          ----------------------
              (100% -  GM%)      = unit selling price

Examples: Shoes cost $25 per pair. What is the selling price at 60 percent and 70 percent GM?

          $25.00                     $25.00
      -------------              --------------
      (100%) - 60%) = $62.50      (100% - 70%)  = $83.33


Many businesses have gone astray by ignoring the need for break-even analysis. Remember that increased sales do not always mean increased profits. Goods must be priced properly.