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The price is right

Many small businesses keep their prices low for fear of losing customers but end up losing money as a result. Laurence Harrould discusses how to move your business from a non-profit organization to a cash cow.

In business we often hear the adage ‘cash is king’, yet many small business owners put in long hours for little or no money and may even fund the business from a mortgage on the family home. This is not how it’s supposed to work!

When I talk to small business owners, they often tell me their biggest challenge is setting prices and managing costs in a way that makes the business profitable.

Increasing profitability can only be done in two ways: increasing revenue or reducing costs. We will look at both these options and explore which works best.

We’ll start with a business, such as a coffee shop, which sells items (see Table 1).

Customers3000
Number of purchases24
Average sale price$15
Sales1,080,000
Cost of sales(540,000)
Margin50%
Gross profit540,000
Overheads(400,000)
Nett profit140,000

Table 1: Item-based business

Our example shop has 3000 customers. The average customer visits twice a month and spends $15. Total income is $1,080,000. So far this is looking like a nice little business. However, we have to take out our costs. What’s leftover is usually what the owner gets to call his or her income.

Cost of sales is the expenses associated with the delivery of the actual product, such as the cost of ingredients, containers used to serve the food, and electricity used to do the cooking. Setting prices is always something of a dark art. In our example we have simply doubled our cost of sales to get our item price, hence the margin is 50%.

So far we have a gross profit of $540,000 – still not too bad. Then there are overheads. These are the expenses that occur irrespective of how many sales you make or whether there are any sales at all. Examples include rent, staff (you still need to pay them even if there are no customers – we’ll talk about this a bit later), telephone line rental, electricity, and insurance. I’m sure if you think about it for two seconds you’ll be able to come up with a whole list for your own business.

In our example, we have set the overheads at $400,000. Take this away from the gross profit and you are left with the net profit. In an ideal world, this might be what the business owner takes home. The taxman blows away that idea, but for the purposes of this article, we won’t look at that and just stop at the nett profit.

When prices go up, so do profits

As I mentioned, there are only two ways to affect the bottom line. The first option is to increase revenue. The easiest place to start is by putting up your prices.

“No way!” I can hear you scream. “I’ll lose all my customers! I’ll price myself out of the market!” Yada, yada, yada.
Many business owners have substantially increased their prices and increased their profits as a result.

A 10% increase in the price (see Table 2) has increased sales income.

Customers3000 
Number of purchases24 
Average sale price$16.50+10%
Sales1,188,000+10%
Cost of sales(540,000) 
Margin54.6%+4.5%
Gross profit648,000+20%
Overheads(400,000) 
Nett profit248,000+77.1%

Table 2: The effect of raising prices by 10%

As it has not cost any more to produce and deliver the item, there is no effect on the cost of sales or overheads, so the additional income goes straight to the bottom line.

By adding $1.50 to the average sale, we’ve increased net profit by $108,000 or 77.1%. Take home is now $248,000 as compared to $140,000. Would that make a difference to your lifestyle?

One of the big arguments against price rises is the fear of losing customers. How many customers would you lose if you added $1.50 to the price of the average meal? How many could you lose and still be ahead financially? As Table 3 shows, you could lose 16% (480) of your customers and still be a little ahead of your starting point.

Customers2520-16%
Number of purchases24 
Average sale price$16.50+10%
Sales997,920-7.6%
Cost of sales(453,600)-16%
Margin54.6%+4.5%
Gross profit544,320+0.8%
Overheads(400,000) 
Nett profit144,320+3.1%

Table 3: Losing 16% of customers as a result of rising prices by 10%

Also, consider which customers you would lose. It’s generally going to be people who are harder to deal with, complain more, and are more demanding.

By losing a number of these, you’ll have more time to support the customers you enjoy working with, resulting in better customer service leading to more loyal customers who are happy to do more business with you.

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