Pricing by Margin: The Pitfall of Pricing by Markup

The Problem with Markup Pricing

Many business owners fall into the trap of pricing by markup instead of pricing by margin, which can inadvertently erode profits. As a small business owner, setting the right price for your products or services is crucial for profitability and long-term success. Understanding the difference between these two pricing strategies—pricing by margin and pricing by markup—and their impact on your bottom line can make the difference between the small business that slowly goes out of business and the small business that grows and prospers.?

Understanding the Problem?

Markup is the amount added to the cost price of goods to cover overhead and profit. It is usually expressed as a percentage of the cost price. For example, if a product costs $50 and you apply a 50% markup, the selling price would be $75. On the other hand, margin is the percentage of the selling price that is profit. Using the same example, a $25 profit on a $75 selling price results in a 33.3% margin.?

The problem arises when business owners use markup to set prices without considering the actual margin. This can lead to prices that seem profitable but fail to cover all costs, especially as overheads and other expenses fluctuate. Over time, this can significantly impact profitability and sustainability.?

Step-by-Step Process for Pricing by Margin?

1. Calculate Your True Costs:?Start by identifying all costs associated with your product or service. This includes direct costs (materials, labor) and indirect costs (overhead, marketing, utilities).

2. Determine Your Desired Margin: Decide on the profit margin you need to achieve to cover all costs and generate a profit. This should be based on your vision, your long-term business goals, and industry standards.

3. Set Prices Based on Margin: Use the following formula to set your prices based on the desired margin:

For example, if your product costs $50 and you want a 40% margin, the selling price would be:

4. Regularly Review and Adjust Prices: Costs and market conditions change over time. It’s a good idea to regularly review your costs and adjust your prices to ensure you maintain the margin you want.

5. Educate Your Team: Sit down with your employees and do a quick walkthrough of pricing by margin. Understanding the importance of pricing based on margin and how it works will help them make informed decisions and contribute to maintaining profitability.

Benefits of Pricing by Margin to the Business Owner, Employees, and Customers?

For the Business Owner: Pricing by margin ensures that all costs are covered and you have? consistent profit. That means better financial stability and the ability to reinvest in the business for growth and improvement.?

For Employees: A profitable business can mean better job security, competitive salaries, and opportunities for career advancement. Employees who understand the pricing strategy are also more likely to contribute to the business’s success.?

For Customers: While prices may be slightly higher, customers benefit from the improved quality of products and services that come from a financially healthy business. Additionally, transparent pricing builds trust and loyalty.?

Conclusion?

Switching from pricing by markup to pricing by margin can seem daunting, but it’s a critical step for ensuring long-term profitability and sustainability. By understanding your true costs, setting prices based on desired margins, and regularly reviewing your pricing strategy, you can avoid the pitfalls of markup pricing and build a stronger, more resilient business.?