Product Pricing & Margin

$19.95 vs. $20? COGS vs. Gross Margin? How much am I really making? 

The Story

As a young college student in 1997 I took a job selling water softeners door-to-door in Utah. I came from a family of limited means and was required to find a different kind of college job. I had to make a little more money than most of my friends to cover the cost of my tuition, housing, transportation and still have a little left over to go on a date or two on the weekends. 

I worked for an entrepreneur named Albert that had built a successful water treatment business and, in his 60's, he loved training young kids like me that he believed had some potential. "Paul", he'd say me, "Business is simple. Find a good product and just make sure you always have more money going into your pocket than money going out of your pocket." Seems simple enough, right? 

What I enjoyed about working for Albert was his pricing system. It was simple. I would buy the water softeners from him for C (Cost), and then I would try and sell them for R (Retail price) My profit formula was simple R - C = P (Profit).  So when I was in a home trying to sell a water system, I knew exactly how much profit I had and how much I could discount to make a few bucks of my own and still give the customer a great deal. 

As I sold more systems, new variables were introduced. Some customers liked to take advantage of financing options that came with additional fees that I had to pay for. Sometimes a customer would change their mind, and I would have to send a plumber back to remove the system from the customer's home, that also came at a cost. The math became more complicated than R-C=P.  

I remember the first week that I lost money. For whatever reason, everyone was turning me down one week. To close any sale, I had to discount my products a lot. It felt like I was working twice as hard for 80% less profit. Towards the end of the week, I deeply discounted an order to a very nice family and, two days later, they changed their mind. The same thing happened with another family the very next day. After paying the plumber to remove the 2 systems from those customer's homes, I realized that I personally lost $200 that week and, in 1999 as a college student, $200 was a LOT of money. It hurt. 

In my enthusiasm to win every battle of the day, I lost the war of the week. By offering overly aggressive discounted pricing to really great people, I overreached. I discounted pricing too much and when the customers changed their minds later, I learned an important lesson.

The Lesson

My R-C = P pricing model had to evolve and account for much more, or I would be out of business. As my volumes increased my formula for success became much more complicated. I had to consider factors that I wasn't aware of yet, such as future returns, the cost of managing returns, fuel and travel costs, the cost of my time coordinating returns vs. being in homes selling.

Looking back now I realize that I would have been much more successful if I would have asked the more experienced sales people that I was working with for advice. But I think in my exuberance to show that I could sell as much as the older, more experienced guys -- my pride -- got the best of me and I continued to make similar mistakes longer than I needed to. I learned you should ask for help often and as early as possible. And be ready to be proven wrong sometimes. Nobody has all the answers. Nobody is right all the time. 

Pricing is an art form as much as it is a scientific experiment. Your first goal when creating a new business is to stay in business. You can't help anyone or yourself if you close your doors. So you have to make sure that your product is priced in a way that will give great value to your customers and sustainable, fair profit to you. 

The following outlines an important methodology to setting your product's retail price. 

The 7 Steps to Establishing Price:

1. Market research. What are you competitors selling the same (or similar) products for? How is your product better or worse than your competitors and, based on those differences, what should your retail price be? 
2. Cost evaluation. Make a list of all the factors that make up the cost of your finished product. Your list should include the following:
   1. The cost of the ingredients in your product. (Your COGS - Cost of Goods Sold)
   2. The cost of ingredients that are lost in the making of your product. (Account for spills, items dropping on the floor that can no longer be used, etc. This is typically a % of COGS. 
   3. The labor cost of making and packaging your product. 
   4. The cost of the product packaging. 
   5. The cost of product labeling. 
   6. If you accept credit cards - the cost of the merchant fees. 
   7. If you are an e-commerce company - the cost of picking, packing and shipping your product. 
   8. Inventory holding costs.
   9. The cost of shipping envelopes, boxes, etc. 
   10. The cost of shipping via USPS, UPS, FedEx, etc. 
   11. The cost of inventory that is damaged. 
   12. The cost of potential returns. 
3. Now, compare your retail price in step 1 and subtract the costs in step 2. Does R-C = P that is exciting to you? If your P (your profit) is a lot less than you anticipated after adding in all the costs, don't panic. 
4. Review all your costs. Have you over-estimated any of them? Are there costs that can be eliminated permanently? 
5. Review your market research that established the retail price. Can you increase the retail price? And, if so, what reason will you tell your customers that justifies your price being higher? (Now it's becoming a marketing question.) 
6. List your "Fixed Overhead" costs of selling your products. This will include:
   1. Cost of gas/travel to/from the farmer's market or your retail store. 
   2. Retail store rent or any farmer's market fees that must be paid. 
   3. Cost of 1 or more employees if you need them. 
   4. Any utility costs. 
7. Lastly, take look at your final margin per product and ask yourself how many products you would have to sell to pay your fixed overhead and allow some profit to pay yourself at the end of the day that is worth while. And the golden question: Can you sell the amount of product you need to sell to make it worth your while? If so, let's dive in! If not, don't despair. We just need to dive deeper into your pricing strategy and develop cost-saving strategies like bundling to increase average order value and lower average order costs. 

If you aren't proficient in Microsoft Excel or Google Sheets, you should certainly begin to consider taking some basic online lessons. Most entrepreneurs live inside their Excel spreadsheets to make sure their efforts remain profitable. (We offer a 1 hour business crash course on Excel/Google Sheets to teach the fundamental basics of using Excel/Sheets in product pricing.) If you are not yet proficient in either of those programs, here is a basic chart that you can use to help you begin. We can also build a detailed custom pricing model for you in Excel if you need a comprehensive starting point. 

For simplicity, I'm going to say that I want to start a cake business. I will buy a pre-made cake mix, my own eggs, my own oil and pre-made frosting. I want to make and sell my finished cakes at a farmer's market. Here is what my spreadsheet would look like: (Note: To get my oil cost, I take the cost of a full 750ml bottle of oil and I divide it by 50, which is the total number of tablespoons in 750ml after a quick google search) 

In our simplified example, we have started asking more complicated cost questions to get a better estimate of what our real profit per sale looks like. Most people would stop at the 64% margin and begin operating their business as if they are making $6.40 on every cake they sale and then, at the end of the month, they are surprised at the final outcome when the cash in their bank account is lower than expected. 

What we are trying to demonstrate here is a methodology - a way of thinking - that is a little more critical as you begin your business. You want to try and poke holes in your logic to find where you might be wrong - not to convince yourself to stop chasing your new business dreams, but to introduce important pitfalls that will help you ask and address the more difficult questions now. 

A more robust spreadsheet might also include the cost of marketing, yield loss of ingredients during baking, ware and tare of kitchen appliances, baking pans that drop and need replaced, oven mitts, utility costs of running the oven all day, cleaning supplies for cleaning the kitchen and tools before/after, etc. etc. etc. 

In summary, you should build a mental habit of critical thinking as you begin. Try to prove yourself wrong, before you begin spending your valuable time and money on your efforts. This type of thinking must begin at the product pricing strategy level to ensure that your efforts don't lose money. 

In their book, Mistakes Were Made, But Not by Me, Tavris and Aronson brilliantly explain confirmation bias - a tendency we all have to make a decision first and then only search for data that reaffirms why our decision is correct. I witnessed an example of confirmation bias in business just recently. A very good friend of mine opened a new business 2 years ago. At a lunch I had with him, he told me that he didn't want to tell me about his business idea before he opened (even though I had over 15 years of experience in that field) because he was afraid that I might talk him out of it. I told him that the most valuable feedback a person could receive at a time that they intend to invest their life saving's in a new business, is experienced feedback that shines a light on potential challenges to be aware of.

Critical feedback from friends and advisors is given with the same love and respect as positive feedback. Critical feedback is a gift. But confirmation bias, inherent in us all, is one of the reasons that 95% of new businesses fail. We don't want to know the negative after we've decided to proceed. We only want to hear why our decision is right. Fight that instinct and embrace the contrarians that love you enough to challenge your decisions. And it's OK if you're proven wrong because, at this point, it hasn't affected your bank account or your life in a significant way. 

Question your conclusions - especially when it comes to pricing. It is always easy to lower prices when you find that you have more margin than you anticipated. It's very difficult to raise prices when you discover "surprise" expenses that were not anticipated when pricing was created. And if you are getting advice from experienced friends and advisors, you should be able to mitigate the occurrence of major, negative surprises. Ask for critical feedback. It will benefit you much more than shallow affirmations from those not wanting to offend you. 

Of course, our team can assist with creating a comprehensive pricing model that you can use for your business as you begin. When we are finished, we will send you an Excel Spreadsheet that you can build on in the future, as the backbone to your pricing strategy. If you would like to manage the steps above yourself and simply need a quick consultation about your pricing strategy, we can help you there as well. You can also take a class from us to learn how to build the pricing model yourself. 

Most importantly - enjoy the journey!

Paul Fulton