Identify Profit Leaks
As I stated in the last article, understanding and setting a value based price can be a bit complicated as it involves both objective and subjective measures. But one way to find out if your pricing does not reflect the true value of the product/services you are providing is by doing a pricing audit of your business.
Depending on the size of your business, this could be a daunting task but after you do this, it will return dividends for sure. Especially if you’ve never done this before.
I’m going to show you a before and after financial snapshot of an actual, yet typical, case taken from a past client.
I had asked my client to provide me with the last 12 months profit and loss statement and here is what was given.
After reviewing the above financial statement, I asked the following questions.
- Where are all your cost of goods? All businesses, even service based, needs to capture their direct and indirect (contractor) labor in cost of goods (service). If it’s buried in fixed expenses, you won’t get an accurate picture of your gross profit.
- Product based businesses need to make sure to capture all their supplies, materials, production costs, direct and indirect labor in cost of goods.
- Can you categorize your sales by product or service type? (i.e. Service A, Service B, Service C, etc.) If you have a lot of categories, work on the 20% of sales categories that drive 80% of your business. Then lump the other categories under misc. for the purpose of this audit.
Here is what their revised profit and loss statement looked like after the changes.
This new P&L statement gave me a little better look into the financial picture of the business and quickly identified some glaring discrepancies. I highlighted in yellow the “low hanging fruit.” It all had to do around Product B.
- Product B net sales were almost half of what it is for Product A
- However, direct labor cost for Product B is almost the same as that of Product A
- Product B’s gross profit weighting and margins are significantly less than Product A
So my question was, if you’re spending as much in labor for one product as the other, why are sales and profit margins significantly lower?
After more digging, we found that the business had not made any price increases in almost 5 years. Also, I saw that based on their expertise and value they bring to their customers, they were significantly underpriced anyway.
They were spending just as much time with their Service B client as their Service A client but charging almost half the rate of what they should be charging. In my observation and research, Service B provided a more valuable service than Service A.
We set new prices for Service B that were at least double what they were charging for all new clients moving forward. Then we came up with a schedule to increase prices to their existing clients over time to not give sticker shock and acknowledge their loyalty over the years.
The new prices would amount to +300% increase in gross profit just for that sales category alone. And that was just the beginning.
Since concentrating on this facet of marketing in 2016 (yes pricing is one of the 4P’s of marketing) this scenario has not been that unusual and neither has the outcome.
If you follow this exercise for your own business you will most likely find one or more of these profit leaks.
- Profit margins are not what you thought (will be lower)
- Some sales categories are under-priced relative to the value you’re giving your customer
- Understanding your true profit margins, you may find that you don’t have room to discount or sell wholesale unless you make adjustments
- You’re spending too much time working/selling low margin items that take away time from marketing items that drives the business
Take the time and effort to go through this pricing exercise and you won’t be sorry! You will most likely find areas to increase profits without adding a single new customer.