Much of my time at work the last few months has been taken up with a profitability project.
Up until recently, we suffered from a problem a surprising number of mid-size companies have: we knew overall how profitable we were, and how profitably various product lines or manufacturing plants were, but we didn't have good data on what individual items cost, and thus on which items and customers were more and less profitable.
Over the last six months, we did a major project to get that item level cost data, and so now for the first time we have good, detailed information on which items and customers are profitable and which are not.
You might think that this would make it easy to increase our profitability: just take the stuff you're losing money on and increase the price or (if the customer won't accept the higher price) stop selling it. Ta da! Higher margins.
But everyone can come up with all sorts of excuses for why this just isn't possible: This is a strategic loss leader! If we don't match (money losing) competitive pricing on this product, customers won't buy our other profitable products. If we win this business (at a loss) it will lead to winning other (profitable) business, or maybe we'll build up enough sales volume that our cost of producing it will drop.
On and on it goes.
Those of us in the finance department decided it was necessary to put together a clear and short summary of what rules we needed to follow around pricing and profits.
"We need a ten commandments of pricing," I joked.
"Yes, that's exactly what we need," the CFO replied. "Can you write one?"
I cheerfully signed up to write a pricing decalogue. After all, I write all the time, often about religion, and I'm a pricer, so why not?
Then I found myself staring at a blank page and feeling like everything I wrote was just variations of "don't lose money".
In the end, my solution was to think about how the actual ten commandments are structured.
The first three commandments are a basic statement of what is true: There is one God. We should worship him and no others. Then the following seven commandments explain how we should live in relation to others due to those truths.
I tried to structure my pricing commandments the same way. The first three attempt to sum up what is true about pricing and profitability. The following seven then describe how we should conduct business based on that truth.
And here they are:
- A good price is lower than the value of the product to the customer (better than the price of the next best alternative plus the difference in quality/service) but higher than our cost to produce the product and run our business
- Price is the way we discover whether we are delivering enough value to the customer to sustain our business
- We as a business exist to turn a profit: if we are selling below cost, we are not paying for our people and our owners
- A market segment where we command strong margins is a segment the market is telling us to be in. A market segment with low margins is one where we are not currently delivering value.
- Customers who offer us high margins want us. Customers offering low margins do not. Believe them.
- New business that starts at low margins must come with a business plan for how it become higher margin and checkpoints at which we see if we followed the business plan
- Never sell below product cost (cost of material + manufacturing before fixed overhead): sales at negative product margin do not help with absorption or overhead, they are a deadweight loss
- We should seldom sell at a product margin below our SG&A rate
- Acquiring business by pricing at low or negative margins buys us bad business: we want new business at accretive margin rates
- Retaining business by matching a competitive price which brings us to low or negative margins retains bad business: sometimes we need to let go
3 comments:
Well written.
While most of this makes perfect sense within its purview, there is a significant philosophical problem with "3. We as a business exist to turn a profit".
No, business exists to provide goods and services (probably synonymous with "value" in this context) to people, in support of the common good of the whole society. Turning a profit is a way of ensuring the sustenance of a business and those who work at it, and profit is probably the most significant measure of the sustainability of a business; but it is not the purpose of a business, not the reason it exists.
Indeed, a business that provides profit for itself at the expense of the common good is a drain on the economy, a parasite feeding on the society from which it draws its excess wealth.
Robert,
It's a reasonable point to bring up.
I think I'd at least see the two as closely intertwined:
Obviously, a business could be in perfect equilibrium (neither losing money nor making a profit) and succeed in serving the good of both customers and employees, but assuming that over the long run we have to think of a business as either making money or losing money, if it's losing money then it will eventually have trouble paying its employees maintaining its infrastructure, etc.
So it seems to me that in order to provide social value, a business needs to make at least some degree of profit, and if it's going to invest in growing, it needs more substantial profit.
If a company is making profits but is not providing value to its customers or employees, I would tend to expect that to come back to bite it eventually and reduce its profits.
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