Does business pricing strategy play a major role in your profit goals?
Profit is the goal for every business. In its simplest form, net profit is determined by subtracting expenses from revenues. A profitable business is well-poised for future growth, securing loans from a bank, and attracting investors.
There are a couple of different actions that you can take to increase profit: Increase prices or cut costs. Before exploring pricing strategy, let’s look at analyzing costs.
Some useful metrics include:
- Customer acquisition cost
- Customer lifetime value
- Cost of goods sold
Customer acquisition cost (CAC)
The way that a service business generates profit is through their clients. When taking on new clients, it’s important to calculate customer acquisition cost. CAC tells you the average cost of acquiring a new customer. Usually, this includes sales and marketing costs. These can be anything from advertising expenses to staff costs, such as employee salaries.
To arrive at your customer acquisition cost, simply divide sales and marketing costs by the number of customers acquired.
Customer lifetime value (CLV)
Customer lifetime value measures how much money a client is expected to spend on your services over the length of their business relationship with you. This will tell you how much a client is worth, and it is calculated by multiplying:
- Average value of purchase
- Average purchase frequency
- Average length of customer relationship
Using CAC and CLV
Now that you’ve calculated these numbers, you may be wondering what to do with this information. Customer acquisition cost can tell you how effective your marketing and sales campaigns are, and customer lifetime value can help you determine which clients and services are most profitable to the company. These metrics can work together to provide valuable insights into the profitability of your business. For a business to be successful, customer lifetime value needs to be higher than customer acquisition cost, usually a minimum of three times higher. If your customer acquisition cost is too high, you will need to make some adjustments. These could include making changes to your marketing and sales efforts, or increasing revenue by charging higher prices for your services.
Cost of goods sold (COGS)
If your business sells products, cost of goods sold is a necessary metric to use. COGS consists of the direct costs that go into producing your goods, such as direct materials and direct labor. It doesn’t include indirect costs like sales and marketing. COGS is helpful to visualize your production costs and see if they are too high. If you aren’t earning enough revenue to offset costs, you will need to make changes, such as increasing prices.
You may be asking how to go about raising your prices. Fortunately, there are many established pricing methods that can help you!
Business Pricing Strategy Methods
Now that you know the costs involved in offering your services, it is time to use strategic pricing to up your profits.
Here are some common methods:
- Cost-plus pricing
- Competitive pricing
- Penetration pricing
Start by looking at the costs involved in offering your products/services and then calculate how much more you need to charge to achieve your desired profit margin. This is the thought process behind cost-plus pricing. The good thing about cost-plus pricing is that it’s predictable and easy to see what changes you need to make. However, it doesn’t take into account external conditions, such as competitors and customer demand.
When using this strategy, first assess what your competitors are charging for similar products/services. If your prices are lower than your competitors, increase your prices to be more on-par with the competition. This will help you bring in more revenue. This may seem like a quick fix for your profitability and cash flow issues. While the logic behind it is fairly simple, competitive pricing requires you to keep a close eye on your competitors’ actions and price fluctuations, which can be time-consuming.
Price skimming is an effective strategy when you have a new product/service that you are bringing to market. The product/service starts out at a high price, and you gradually lower the price over time as more competitors enter the market. Skimming really only works when your new product/service is unique and has little to no competition when it is coming to market. It is a great way to generate a lot of revenue quickly to make up for costs and produce a profit.
Penetration pricing is essentially the opposite of skimming. This method is used when you enter a market that has a lot of competition. In a competitive environment, it can be difficult to attract customers. One way to do this is to set prices that are lower than your competitors. This may seem counterintuitive at first, because isn’t the goal to raise profits? Keep in mind that penetration pricing is only for the short-term. The volume of customers you gain from penetration pricing will help to offset costs.
Developing your business pricing strategy
Pricing strategy is not a one-size-fits-all situation. Each pricing strategy is distinct. You will need to look at the particulars of each product/service, as well as the competitive landscape, to determine what will work best. Ultimately, any decisions you make about pricing require consistent tracking, reporting, and analysis to ensure that your business is maintaining its financial health. If you notice issues with your finances, you can always make adjustments and pursue other strategies.
Increasing profits through pricing strategy can seem like an impossible task at first. However, if you look at each product/service individually and make sure to use the metrics discussed in making strategic decisions, your business can thrive. Momentum Accounting provides innovative advisory services that will set your business up for success.