Pricing and the P&L – Gross Margin, Variable Costs and Overheads
While shining a bright light on Pricing and its impact on the component parts of the income statement, Mark Stiving teaches a bushel full of lessons finance leaders will appreciate. Share these important concepts with your team and colleagues to help grow your business.
1. How Pricing Affects Gross Margin, and Vice Versa
What is the difference between a 75% gross margin, and 50% gross margin?
That’s easy, 25%.
So, you might be tempted to jump to the (incorrect) conclusion that if you currently have 50% gross margin, and want to grow that number to 75%, you simply raise your price by 25%.
However, to go from 50% to 75% gross margin, you actually have to double your price (assuming costs don’t change).
HOW TO UNDERSTAND GROSS MARGIN PERCENTAGES AND PRICING
Let’s go through an example.
Let’s remind ourselves of the formula for gross margin:
(Price-cost) / Price
Let’s say your product costs $1 to make. You sell it for 2 dollars. Using the above formula, your gross margin is (2-1)/2 =0.5 or 50%. If you double the price to $4, the new gross margin is (4-1)/4=0.75 or 75%.
The lesson here is to not be fooled into thinking that a particular percentage change in price results in the same change in gross margin percentage. When your gross margin is small, small changes in price make large changes in gross margin percentage. However, when your gross margin percentage is large, it takes significant price changes to move the gross margin percentage even a little.
At the end of the day, this is only important if you are thinking in terms of gross margin percentage. Ask yourself: do you need to think in terms of gross margin percentage and not gross margin dollars? Why/why not?
2. Variable Costs: Do They Matter in Pricing?
What exactly is the role of variable costs when it comes to pricing?
It depends on if you are able to set a different price for every customer or not.
DETERMINING THE ROLE OF VARIABLE COSTS
In most – if not all – B2C businesses, the company sets a price and people decide whether or not to purchase at that price. There may be sales or promotions, there may be segmentation (at least, I hope), and there may be versions – all leading to differences in prices among products. But even with these differences, the common theme is that many customers see one of these prices, and make a purchase decision. Presumably, the lower the price, the more people who purchase.
In this B2C setting, variable costs are important because you are maximizing your total gross profit. Remember, profit = Qty * (Price – variable cost). Changing the price impacts the quantity sold and the per-unit contribution margin in opposite directions. The price that maximizes profit is a tradeoff of these two effects. The key point here is that variable costs matter when determining the profit-maximizing price.
However, in many B2B situations, some deals are negotiated independently. The price one customer pays is not necessarily related to the price any other customer pays. This happens when your sales team is negotiating to get the customer to pay the most they are willing to pay, and the buyer is negotiating to get us to sell the item for the least we are willing to accept. Each customer negotiates a different price.
In this B2B setting, the only role our variable cost has is to inform the decision about the least we are willing to accept. We negotiate with a customer to see how much they are willing to pay, and then we make a decision on whether or not we want to accept their business.
This doesn’t mean, however, that we accept all business above variable costs. There may be reasons not to. Possibly our investors have margin expectations we want to hit. We may not want to devalue our product if the price does become public. We may not want our channel to see such a low price. Regardless, we certainly would not accept business below variable costs without extremely good and well-thought-out strategic reasons.
CONTRASTING VARIABLE COSTS TO FIXED COSTS IN PRICING
This is an interesting parallel to the role of fixed costs. The role of fixed costs is only for us to use to decide whether or not we want to be in business. The role of variable costs, at least when it comes to pricing, is to decide whether or not we want to accept a specific piece of business or deal.
To summarize: what are the roles of variable costs? When many customers buy at the same price, variable costs are a key component in determining the profit-maximizing price; this is common in a B2C context. However, when we negotiate independent deals with customers in a B2B context, variable costs only help determine whether or not to accept the business.
3. Fixed Costs Matter to Your Business – NOT Your Pricing
It’s true. Your fixed costs matter sometimes, but they are not relevant to your pricing decisions.
Your prices should be determined by your customer’s willingness to pay. Their willingness to pay, of course, is driven by the amount of value they get for your product. That value is determined by (among other things) what else they might do with their money, and the incremental benefit your product or service gives them. Notice what you didn’t see there? Their willingness to pay does not change if you have higher R&D costs. Your fixed costs don’t matter.
Variable costs, however, do matter. For example: what if a prospect’s willingness to pay is less than your variable costs? You shouldn’t sell to them. Sometimes, especially in a retail setting, you only get to set one price for many customers who have different price expectations. In this case, variable costs matter because you are trading off incremental gross profit per unit sold, against the gross profit of lost sales. You want the net result to be a positive overall.
HOW FIXED COSTS AND VARIABLE COSTS RELATE TO PRICING
Again – fixed costs DO matter, just not to pricing. Fixed costs matter when you decide whether or not to get into a business. The easiest way to understand may be by looking at a video game company. EA spends millions of dollars to develop a new video game. Those millions of dollars are fixed costs. Should they spend that money on developing a new video game? It all depends on how much profit they expect the game to generate. They estimate the price they can get, the expected demand, and their variable costs. Using simple math, they estimate how much profit they can generate, and compare that to the amount of the fixed costs. Then they decide whether or not to invest the dollars into fixed costs.
A common mistake many companies make, is to calculate a “standard cost” by allocating their total manufacturing overhead (fixed costs) to individual products. For example, if they have $2M overhead, and their forecast is to sell 1M units, then they allocate $2 of fixed costs to each unit. This might be alright for accounting purposes, but it can cause bad pricing/business decisions – especially for relatively low margin products.
For example, imagine this company with the $2 fixed costs allocated to each unit also has variable costs of only $0.10. Their standard costs are $2.10 ($2 fixed cost plus $0.10 variable cost). Now, a new piece of business comes in. They can sell 100,000 units if they are willing to sell them for $2.00. Do they want it? If they use their standard cost of $2.10 they would turn down this business. However, if we only look at the true variable cost of $0.10 (which is all we should look at when it comes to pricing), it could be a great deal. In this example we see that allocating fixed costs can lead us to poor business decisions.
This principle may seem complex, but it’s important.
Fixed costs should NOT be considered in pricing. Fixed costs should be used to determine whether or not you should be in business.
Variable costs SHOULD be considered in pricing. One place they are particularly important is in determining whether or not to accept a piece of additional business.
The logic (and the hidden math) may be challenging at first, but trust me – don’t use your fixed costs while making pricing decisions.
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