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Margin vs. revenues: how price affects profits

Too many small-business owners work too hard yet do not bill their customers for the full value of the products or services provided. Often, they use discounting to entice customers with the mindset that if they could attract more customers then they would see more profit.

If you are in this camp, reconsider your position. Discounts may lower the perceived value of your product and cause you to work harder.1,2

Pricing can be confusing and daunting, but it does not have to be. Remember that your customers look to you to solve a problem for them, and they are willing to pay for that solution. Your job as the manager/owner or CEO is to understand your value in the marketplace and position yourself and your product accordingly. But these are not the only price-determining factors.

PUT THOUGHT INTO COST

First and foremost, consider what it costs to make your product. Account for the direct cost of the good. Do not simply add an amount to your pricing above your cost for the good. Also, account for the other costs necessary to sell that product, such as your company’s labor and expenses.

HAVE A TARGET PROFIT

This will help you price your product. Your target profit will be above and beyond the amount that you paid toward the direct and indirect costs of your product.

Business owners often survey what their competitors charge and then price their goods similarly. But, businesses often do not know what separates them from their competitors. This is worth finding out: you can become a “secret shopper,” look online at reviews, even just pick up the phone and call.2 Do they disclose the price over the phone? Does the price include pre- and postop exams? Are medications included? Does the surgeon personally see the patient before and after surgery? Comparing price without comparing what’s included can lead to the wrong conclusion. These calls can help discover areas where your service is superior. Be sure your call center points these out when they receive inquiries.

It is critical to understand how pricing affects profits — at the end of the day, profits count, not revenue. Revenue is the money obtained through sales. Subtract the direct costs of the products and labor (also known as “cost of goods sold” or COGS) to calculate gross profits. The ratio of gross profits to revenues is the gross margin.

You should understand the gross margin — and COGS — for each of your products and services before even considering setting prices. The monies left from gross profits go into overhead. In accounting lingo, this is known as the “contribution margin” for each product or service. Take the practice’s aggregate gross profits, pay overhead, and you have operating profits, sometimes called earnings before interest and taxes (EBIT).

To stay alive, a business must price its services high enough to cover COGS and overhead, and still leave enough money to pay taxes and interest on loans. Any money left over is called “net profit.” All businesses must generate profits. A business without profits is called a charity.

THE IMPACT OF PRICE ON PROFITS

The simple mathematics described above can be used to illustrate how prices affect profits. Prices determine revenues. If volume is kept the same, any adjustment in price goes to the bottom line.

Consider the following example. LASIK at $2,000 per eye may have COGS of about $800, leaving a profit margin of $1,200 and a gross margin of 60%. If practice overhead runs 50% (before any price changes), the EBIT is $600. Ignore taxes and interest and consider the EBIT equal to the net profit, yielding a profit margin of $600/$2,000 or 30%.

Now, drop the price to $1,750. COGS and general overhead stay the same, so net profit goes down to $350, and net margin reduces to 20%. Reducing the net margin from 30% to 20% represents a 1/3 reduction in profitability! So, while the price only reduced 13%, profits declined by 33%.

PRICING FOR CASH-PAY PROCEDURES

Pricing is a complex topic that fills many textbooks and journal articles. There are three basic approaches: market pricing, cost-plus pricing and value-add pricing. This topic extends beyond the scope of this article, but here are some basics to keep in mind before adjusting your prices.

Market pricing sets prices to match or beat the competition. Discounting is often used as a market pricing strategy to entice customers, but, as described above, it is a high-risk strategy. Rather than rely on price to drive sales, put effort into understanding how your product fits into your market and plays into the value niche that you have in your market. What makes your practice special? Are there changes you can make to further distinguish your practice from others?

Cost-plus pricing is the most basic — and generally the least effective — way to set prices. This approach often undervalues services and fails to maximize profits.

Value-add pricing strategies consider the value that the product or service delivers to the customer and prices the product accordingly. It actually costs less to produce an Apple computer than a similar PC, but Apple has created value around its brand that allows it to charge more. Value-add pricing requires insight into your patients and constant focus on product. Done well, it leads to better products and higher profits.

In summary, don’t discount — differentiate! You will end up working less and making more. OM

REFERENCES

  1. Heda S, Mewborn S, Caine S. How Customers Perceive a Price Is as Important as the Price Itself. 2017; Harvard Business Review. 1-3. https://hbr.org/2017/01/how-customers-perceive-a-price-is-as-important-as-the-price-itself . Accessed Nov. 29, 2017.
  2. Wasserman E. How to price your products. Inc. https://www.inc.com/guides/price-your-products.html . Accessed Nov. 29, 2017.

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