Business owners are challenged with setting a profitable price for their goods and services. In today’s story, Paula struggles with the common psychology of pricing. You’ll see how she overcame her struggle to achieve success and how you can do the same.
Paula was frantic! How did she get here? She'd worked so hard to build what she thought was a successful business only to watch it crash. What went wrong? She had more orders than she knew what to do with, and yet she was ready to close her doors. She thought, 'maybe one more call to the bank.' Maybe her banker, Jonathan, could bail her out by giving her another short-term loan.
She called Jonathan and he wasn't very friendly.
Jonathan said, "Paula, I'd like to help you out, but you still haven't paid back the last loan we gave you."
Paula reacted, "But, Jonathan, I have a large order. If I can fill it, I can get your cash back within a few weeks."
"That's what you said last time."
"I know, but this time is different."
"I'll tell you what. I've been working with a few other business owners who got help from a business coach they call 'Coach Russ'. I think he may be able to help you. Interested?"
Paula was heartbroken, "If I can't afford to produce 1,000 units for a large client, how can I afford to hire a business coach?"
"I'm not sure what Coach Russ charges. I don’t think he charges anything for his first meeting.”
"What do I have to lose? Do you have his number?"
Paula started a name-tag business out of her house. At first, she made crafty tags that were a hit for social events; and then she started making professional name tags for large conventions. Her name tags were quite popular, but Paula was always lacking cash.
Russ agreed to visit with Paula over the phone about her situation. Paula felt this was her last chance. Although, she had no idea how this Coach Russ could get her the $3,000 in cash to fill her new order. Or how he could help her come up with the additional $10,000 she owed the bank.
Russ asked, "What's your latest opportunity?"
At first, Paula thought Russ was being sarcastic, and said, "I'm not sure what you mean by OPPORTUNITY? My business is dying here, and all you can do is poke fun?"
Russ responded, "Sorry, I wasn't making fun. It's a habit of us coaches to look for OPPORTUNITIES. I suppose it’s a way of looking at the bright side. Let me rephrase my question. What seems to be the problem?"
Paula knew that she had overreacted, and explained to Russ how she was out of cash, had debt she couldn't pay back, and ten employees she’d have to let go, if she couldn't figure out how to fill her latest order.
Russ asked, "What's happened to put you in the situation you're in now?"
Paula reacted again, "Look, Coach Russ, I'm in financial trouble right NOW, and I thought that you could help me find a way out. I really don't have time to dwell on how I got here!"
"I realize that you're in trouble right now; and you need to find a way out. However, unless I know how you got here, it's doubtful, you will find a way out."
"I don't get it. What will looking at my past do for my present situation?"
"What would happen in your situation, if the bank agreed to loan you an additional $10,000?"
Paula shrugged, "I just spoke with my banker and he said no dice!"
"The reason he won't loan you money is that you have a tendency of not repaying your loans with no apparent change in how you're doing business. If we can show him that you’ve altered how you do business in a way that will ensure the bank get its money back, he may reconsider the loan."
Paula realized that she wouldn’t be able to dodge Russ's question. So, she thought about how she got to this ugly place of constantly borrowing money.
After a long pause, Paula responded, "If I knew how I got here, I wouldn't be here."
"Fair enough. Let's start with another question. You're obviously strapped for cash. And, you don't seem to be generating enough cash to pay the bank back for previous loans. There are only a few things that cause poor cash flow. You're either not charging enough for your name tags, your expenses are too high, or you’re paying your suppliers too much. Let's start with your suppliers. What do you pay per name tag for raw materials?"
"I pay about $0.50 for a blank name tag."
"Is this the best price you can pay? What do other suppliers charge for the same blank tag?"
"I think this is the best I can do."
"Okay. How much are you paying your employees to make the name tags?"
"I know where you're going with this, and the answer is NO, I'm not getting these name tags made in China!"
Russ didn't see this one coming, "I'm not thinking of exporting manufacturing to China. I'm simply interested in what you pay your workers to make a single tag."
Paula calmed down, "Sorry. My workers average about $10.50 per hour."
"Thanks, but I'm not interested in their hourly pay. How much does labor cost you per tag?"
Paula didn't know the answer to this question. She’d never calculated it before. There were a few more questions she couldn't find the answers to right away; and committed to Russ that she would find the answers and get back to him the next day.
After a long night, Paula was ready with the answers when Russ called back the next day. She shared with Russ, that it was costing her $0.50 per blank tag; and $1.00 per tag for labor, and an additional $1.00 per tag for general expenses.
Paula already knew the question that was coming next... and then Russ asked, "What do you charge per tag to your customers?"
With tears forming in her eyes, Paula responded, "I charge $2.25 per name tag to my clients."
Russ said, "What do you think the problem is?"
"I charge only $2.25 per name tag; and it's costing me $2.50. But there's no way my customers will pay more for my name tags. They buy from me because I offer a low price."
"There's one of three things you can do. You can reduce your costs; You can charge more; or you can do both."
"But, what do I do with my current 1,000 name tag order?"
"It doesn't sound like you can make this order without a loan from the bank; and you won't get a loan from the bank until you fix your pricing and cost problem for good. Even if the bank were foolish enough to give you a loan, you’d be losing $0.25 per name tag on your 1,000-name tag order. This means that, if you fulfill this order, you will be $250 further in debt."
Paula was convinced that her prices were as high as they could go. Russ was convinced that, like many of his business owner clients, she was charging way too little for her quality name tags. Paula saw no way out of her situation and so she decided to hire Russ by paying with her credit card, hoping that her company would turn the corner before the credit card payment was due.
In their first session, Russ asked Paula to research prices for name tags that were like hers. Paula realized that, although there were a lot of factory-made name tags, none were quite like hers. The factory name tags were selling for $1.50 per name tag, and there was no way she could drop her price that low if she was already losing money at $2.25.
Russ asked, "How would you feel, if you charged $7.50 per name tag?"
Paula laughed, "You're kidding. How on earth would my clients pay more than three times for the same name tag I was selling them for $2.25? And how can I compete with the $1.50 name tags people can buy from large factories?"
Russ persisted, "I didn't ask if you’d be successful. I asked, how you'd feel?"
"I'd feel foolish!"
"Okay. How would you feel, if you charged $7.50 per name tag, and you got the same number of clients you have now?"
Paul played along, "I would feel amazing! But I'd also feel like I was cheating my customers by charging too much."
Russ changed the conversation, "Do you think that you pay your employees too much?"
"No. In fact, I think I pay them too little. I can't afford health coverage or any other benefits. I won't be able to provide benefits at this rate."
Russ ignored Paula's doubt and asked, "What can you do to reduce your expenses?"
"I don't think I can reduce my expenses. We're running pretty lean as it is."
"Here's the thing, Paula. Most products sell for double what it costs you to make them. This means that your name tags should sell for at least $5.00 at your current costs. If you want to give your employees a raise, pay off debt and start making a profit, you need to charge $7.50 per name tag."
It was as if Paula could feel her heart breaking. How could this be? There was no way her dream name tag business could exist at such outrageous prices. The answer seemed obvious to her. She would have to close and file for bankruptcy.
Russ could see that Paula was going in the wrong direction and offered some advice, "Paula, pricing is a sensitive topic. But it doesn't have to be such a sticking point."
"How can I charge so much?"
"First of all, you have to understand that prices are established by two forces: 1) your cost; and 2) the market. You’ve told me that you can’t lower your expenses, and you acknowledge you’re not paying your people enough; so the only alternative is to raise your prices. If you've been honest with me, the market will respond positively."
"What do you mean, POSITIVELY?"
"If you’re selling your product at double your costs so that your business can survive, no one can sell your quality of name tags for less; and the market, your customers, will have no option but to purchase your name tags."
Paula was starting to understand, "But, what can I do right away to turn things around?"
"You don't have to turn things around right away, you merely need to have a workable plan that gives the bank confidence to loan you money. If you can prove that you can charge a much higher price for your name-tags, I can help you get the loan."
Within the week, Paula and Russ worked on a plan. If her customers would pay the higher price, she could get out of debt, give her employees raises and become profitable for the first time ever. After a few more coaching sessions, Paula was convinced that her new price was the RIGHT price. After all, no other company could do what she did for the same amount.
The bank insisted that Paula do a second mortgage on her house, but was willing to give her a $10,000 loan to fulfill the near-term order and a few follow up orders that were starting to come in at the higher price.
The price change was not easy, but Paula was amazed at what happened. She initially lost 10% of her typical monthly orders. With her triple price increase, the 10% drop wasn't even noticeable. With the added revenue, Paula invested into some marketing that illustrated the creativity of her name tags and soon orders increased. Just as Paula hoped, she was now able to give her folks raises and pay for the benefits they so desperately needed.
In a year, Paula was making plans to build a larger building and was growing by two employees per month. Jonathan, the banker, was amazed when Paula told him she would provide a 50% down payment for the new building.
Our fictional story of Paula and her pricing seems unreal to most small business owners. I've made pricing out to be a much simpler task that it truly is. However, I’ve coached several small business owners who are experiencing so much grief in their business and personal life because they don’t understand the mindset and mechanics of pricing.
There are five foundations of pricing that all business owners should consider: 1) Result or Quantifiable Benefits; 2) Costs; 3) Competition; 4) Quality; and 5) Strategic Discounts.
Results / Benefits
A result or benefit is something that your customer experiences because of purchasing your product or service. As a business coach, the result that I give my clients depends on their size of business and many other factors. However, it’s often the case that my clients experience benefits more than $1M because of actions that I influence. There are less tangible results I provide as a business coach, but I rarely talk about those because my clients can clearly see the financial return on investing in business coaching.
If you’re challenged with charging enough for your product or service, I urge you to focus on the result your client will gain by working with you. If you’re a marriage counselor, what’s the value of a healthy marriage? If you provide custom name-tags like Paula in our story, what is it worth to have a unique keepsake for a special event? If you own a restaurant, what is it worth to have an enjoyable night out with your spouse?
When I talk about “cost”, I mean your cost. In our story, Paula was paying more to make her nametags than she was selling them. This is a failing business model. It’s standard practice to pay about 50% of your price in direct costs and about 30% of your price in overhead. Direct costs are also called variable costs because they tend to vary with the amount of sales. Overhead costs are also called fixed costs because they don’t vary with sales. If you have a business like Paula’s, you’ll have a breakeven point. You’ll have to sell enough product to pay for your overhead before your business starts making a profit.
The best way to know your costs is to create a business plan that demonstrates how much product or service you’ll need to sell at your current price to make a reasonable profit.
It’s important to be diligent about negotiating the best prices with your suppliers and ensuring you’re paying your employees market rates for their skill.
And… like it or not, if you’re a manufacturer, you may have to investigate foreign manufacturing to be competitive.
One of the first things you should do when you start a business is shop your competition. If your industry is like mine, you’ll see prices all over the place. The key is for you to understand how your company compares with others in the marketplace. I recommend that you try to quantify as much as you can how your competitors compare with quality, reliability, timeliness, convenience, appeal, or whatever other measurable factors make sense in your industry. This way you can understand a good price target for your business. This competitive analysis will help you tweak your business plan so that your price is comparable with your competition given the level of quality you hope to provide your customers.
In our story, Paula discovered that her competition was charging $1.50 per nametag and it cost her $2.50 to make a nametag. If Paula offered no other benefit than a commodity nametag, her business wouldn’t survive. As it turned out, her customers valued the unique nametags she made and paid her accordingly.
We have a ritzy hotel here in Colorado called The Broadmoor. It’s an old historic hotel that charges $900 per night. The average cost of a hotel in Colorado Springs is a little over $100 per night. The person staying at the Broadmoor expects and gets an entirely different level of service, ambience, food quality and experience at the Broadmoor. That’s why they continue to book out their hotel to capacity… especially during the holidays.
The fact is that the higher you can drive the quality of your product or service, the more rare and precious your product or service is to a customer. One point of caution with quality is that this added quality and expense must be genuinely valuable to your customer, or it’s a waste of your investment. Each customer segment has a price point and value perception that you must understand to build genuine quality in your product or service.
As I mentioned in our cost section, there are variable and fixed costs. Many business owners will either provide bundled discounts to buyers based on volume buying. To offer discounts of this nature, you must understand your cost structure and how it’s related to the quantity of sales.
As a business coach, I sell numbers of individual or group coaching sessions. If I coach a group, the price is much less per client because the time I spend is less. I also charge less for package of sessions because I can overcome the overhead cost of onboarding a new client. Each industry has a different cost structure. However, in most cases, you will recover your overhead with a sale of one item, so it’s natural to discount larger purchases.
I urge you to understand how you can bundle and give reasonable discounts on your product or service. This is a benefit to you in more sales and a benefit to your customer in greater value.
That’s it for our story and lesson today. I hope you’ve learned a few things from Paula’s story and our brief discussion on pricing. If you’d like to learn more about me or my business coaching practice, I invite you to check us out at www.mmbizcoach.com .