Last Updated on Thursday, 14 April, 2022 at 2:29 pm by Andre Camilleri
Silvan Mifsud is director of Advisory at EMCS Tax & Advisory
As we today have to face an ever evolving inflationary period, the focus on pricing strategy needs to sharpen. Business leaders need to base prices on true, current costs and each customer’s true, current profitability. Traditional across-the-board price increases, which treat all costs and customers the same, are likely to have a single result – loss of business and clients. Moreover, business leaders need to look at the pricing strategy as an increasingly important business strategy tool.
Today’s inflation is caused by a unique mixture of shock waves stemming from Covid-related surges in consumer demand and supply shortages fuelled by the same pandemic and the Ukrainian conflict. These events are disrupting the traditional supply-demand matches that underlie stable pricing. Hence, in such an environment the importance of focusing on your pricing strategy, while making sure that your pricing is data driven and precise, becomes of pivotal importance.
What should you be focusing upon?
Know your actual costs and profits
I meet many business leaders and managers, who in this period of unstable, ever-changing input costs feel at a great loss. The main reason for this is that they do not have an agile reporting system that constantly updates them with the actual costs of each product they are selling. Many business leaders also have access to revenue, costs, margins and profits in an aggregate way, without knowing how these are sub-divided and relate to each customer. There are various software packages that can make this possible for business leaders.
View margins and profitability per client
Linking customer analysis software to an accounting system is one way of doing this. When input costs are sourced directly from a company’s general ledger, they’re precise, timely and accurate. This enables managers to replace traditional standard costs, which were created before today’s digital era, with actual costs that reflect a company’s true cost picture and are updated periodically. These changing input costs would then feed into knowing the profitability per client, so that you are then able to determine:
- Profit peaks: Their high-revenue, high-profit customers (typically about 20% of the customers that generate 150% of their profits)
- Profit drains: Their high-revenue, low-profit/loss customers (typically about 30% of the customers that erode about 50% of these profits)
- Profit deserts: Their low-revenue, low-profit customers that produce minimal profit
Focus on profit peak and profit drain customers
Let us assume that your shipping costs have suddenly doubled. A system as outlined above would enable you to understand the magnitude of the profit declines caused by the increase in shipping costs. This would enable you to understand the importance of the cost increases on product cost and the actual impact of this increase in shipping cost on each customer’s profitability due to their product mix.
(i) You then need to focus on the profit peak customers whose profitability will be significantly affected by the shipping cost increase. Even, if you determine that a profit peak customer’s profitability will not be strongly diminished by the shipping cost increase, you should still underline and communicate to the customer that you are absorbing the increase in shipping costs and are foregoing a general price increase.
(ii) On the other hand, profit drain customers that will be significantly affected by the increase in shipping costs, also require particular attention. This is because the shipping cost increase may push the account into a loss territory. In this case, you would literally have no option but to be straightforward with the customer and explain why the price needs to be increased. However, things are not always straightforward. You also need to assess if profit drain customers are so if because this is a small/new/developing client, like a large company you just started business with and so only getting a small share of business from or else just a small client in itself. With regards a developing prospect you may opt to forego any price increase in return for profitable sales growth (unless the cost increase makes this prospect untenable). Then for other small, marginal customers, you can create price-increase bands that reflect the impact of the shipping cost increases on the profitability of serving such small customers.
Hopefully you have by now got the message. As various input costs are changing almost on a daily basis, you need to make sure that you have precise and updated data in hand at all times and to laser-target the customers who are appropriate candidates for price increases and to communicate to them precise cost information to justify specific price increases, so that price increases can be communicated as a matter-of-fact discussion that’s grounded in actual data.
Similarly, you can engage new accounts with the prospect of significant growth with an offer to forego price increases in return for substantial profitable growth. Moreover, you could also decide not to pass every cost increase on the so-called profit-peak clients, in order to defend their custom, while informing them that you are absorbing a cost increase as you value their custom.
Compare this process to the traditional practice of across-the-board price increases that set up a zero-sum relationship for all customers, regardless of a customer’s profitability and product cost profile, and eliminates the important opportunity to use the prospect of foregoing a price increase as a lever to increase turnover and customer profitability.
By taking up the advice outlined in this article, you would be able to turn a cost increase into a valuable and winning business strategy.