Most of my posts are a result of the conversations I have, or have had, with clients during the month. This month I spent much time discussing the importance of properly setting price with many of them. I refer to the overall process as The Price Equation. What is The Price Equation? Let me explain.
As a young boy, my mom and I had the pleasure of operating a family business with the sudden passing of my father. Neither of us were equipped at the time for such a task, but by asking the right questions, we figured it out. Long story short, one of the things we “figured out” was the direct correlation the variables of price had on the income statement. And we all know that the income statement is where we look for see if we are making any money. Here is what we learned:
First, the equation: Price = DPC + OH + Margin
DPC is the acronym for Direct Product Cost, or simply put, the costs that a directly related to the revenue an item produces. For example, a motherboard would be a DPC related to the manufacture of a computer. It just would not operate without it.
OH is the acronym for Overhead, which are the rest of the costs that are not directly related to the revenue an item produces, oftentimes referred to as Operating Costs or Expenses. In the same light as the first example, the marketing expenses to sell that computer, while important, are separate from the manufacture of the unit. In other words, these costs are independent of the manufacturing process, but related to the final sale of the item.
Margin refers to the amount of profit that will be made from the sale of the goods or services offered. Therefore, if we collect all our costs and add a margin for our services, we make money. If we do not, or have to sell the item for less that retail, we lose potential revenues.
So, how does this tie to the Income Statement?
The main elements of an income statement are Revenues, Cost of Goods Sold (COGS), Operating Expenses and Income (Profit). If you consider that Revenues are the summation of Price x volume for each product or service charged, then…
Revenue (aka “Price x Volume”) = COGS (aka DPC) + Operating Expenses (aka OH) + Income (aka Margin).
Once we understood this relationship, we soon realized when we made pricing mistakes, usually when we set it too low, we lost money (income/margin), since most often we forgot to include the total cost of the DPC and OH expenses. We also realized, much too late in the early days, that our vendors that were included in the items DPC and OH were not so quick to cut their costs to us for the mistakes we made. For example, if I forgot to include the cost of fuel for my vehicles in a proposal, I could not approach the gas station and explain I needed a price reduction to make up for my oversight. They would laugh at me and then tell me to “pay up”. Makes sense huh?
So, how much time do you spend setting price? Do you just match your competition without looking at the variables? If you do not know your variables, you will lose potential money and possibly price yourself right out of business. Now, you don’t want that, do you?