When inflation is low, as it has been for many years, pricing is pretty easy. Costs don't change much and neither do prices.
But in an escalating inflated environment, companies can get seriously hurt if they don't get it right. Price too high, you lose customers. Price too low and you lose margin (and consequently profits). So how do you know what's just right?
It can depend, in part, on the nature of your industry. If you sell a commodity, like my friends in the copper mines of Zambia or my friends in iron ore at BHP, the market price can be found in any old business publication like the Wall Street Journal. You can (and should) differentiate by service, delivery time, or quality. But like the price or not, you'll be selling close to it.
Maybe you sell to the same customers year after year, like David and Prue Pring do at their Australian-based custom countertop and cabinet business, Post Form Laminate. By speaking directly with customers about their purchasing criteria, they learned that on-time delivery was valued over price--so they differentiate on service and on-time delivery. The Prings still need to pay attention to pricing--materials are roughly 40% of their business, and material prices are rising fast. And while their team is strong on economic engagement, the market price for labor, energy, tools, plant space and almost everything else is headed in the same direction.
The fundamental pricing problem for most companies is the same. The key is that the market only gives you feedback when you price too high.
Let's say the market price for a job is $10,000. If you price too high, say $12,000, you get immediate market feedback: customers take their business elsewhere. If you price the job at even $10,300, chances are the customer will walk--unless you have a close relationship, in which case they might ask you to match the competition at $10,000.
What if you price too low, say $8,000? The customer accepts your bid, period. They don't tell you that you left $2,000 on the table. If your margins are 25%, you'll make only $500 instead of the $2,500 you would have, had you priced correctly. You can see how quickly this kills margins and profits. But if you don't know what that market price is, you might get the same market feedback either way--the customer accepting your bid--even if your price were just a couple bucks too low. The important question becomes: how far below the mark did you land?
There is one exception to this rule--one time where the market gives you feedback even though you priced too low. Say you bid $5,000 on a $10,000 job, which is to say way too low. A smart buyer might think, this company has no idea what they are doing. They're bound to go out of business.
One of the Prings' competitors made this mistake, pricing a job at roughly the material cost, or negative margin. The customer (a contractor) called David and told him his bid was roughly double that of one competitor. David said, "We know our costs and the margins we need to stay in business. If you go with the other guy, I'd keep an eye on product quality and job execution."
When the contractor reported back, he confirmed the competitor's quality and on-time delivery were a problem. But the nature of his work (government funded education) dictated that they always choose the cheapest tender. David wished them well, restating the fact that his business needed a positive margin on every job to provide quality sustainable service. The competitor's approach provides a short-term boost, but no lasting value to the business.
Now, when the major raw material supplier raises their price, David follows suit every time, protecting his margins. And every time, he checks to see if he lost any business. So far, not once. The only thing I know for sure is that the market never tells you how much more you can raise the price.
I grappled with this at One Week Bath, a company run by Matt Plaskoff where I'm 30% owner. Everyone at OWB understands that if a job runs a day too long, we just lost 1 crew day, or $2,000, which is our average-per-day. This is our key metric, and we all watch it like hawks. A couple years ago, we wanted to identify why our margins were deteriorating.
First, we sorted every job by margin-per-crew-day. We noticed several smaller jobs in the range of $900-$1,200 per day. We'd always assumed that these smaller jobs were purchased by price-sensitive customers, leading to low margins. We decided to test this by pushing the price. Fortunately, we had the room to risk some potential loss of business. (OWB often has a backlog of 20+ weeks--the one-stop, complete solution, fast field execution model, with flawless customer service, tends to be highly valued.)
Matt decided to implement a minimum margin per day of $1,750. He figured we couldn't lose. If customers accepted the price, margins would buoy. If they didn't, we could be rid of these low-margin jobs, replace them with higher-margin jobs, and reduce backlog at a time when we could stand to.
It turns out Matt is the kind of partner you want around. The market proved him right six short months later, when our win/loss ratio on the smaller jobs remained unchanged. Just as Matt thought, we'd been leaving a lot of money on the table. Now, that money means higher profits and more bonuses for the entire team. The idea is to slowly nudge prices on all jobs, including product price increases, then wait for feedback from the market that we may have gone a bit too far. Margin, profits, and bonuses keep rising in sync, as does repeat and referral business. With the right amount of risk, the right price can be a real reward.