Christian Brim, CPA, is CEO of Core Group. Grow profitably.
My experience with some entrepreneurs is that they don’t pay enough attention to the financial health of their company. I get it. Many business owners aren’t comfortable with finance and accounting, and those of us in the industry have often done little to help. I like the analogy of accounting being a language that tells a story about your business. Used properly, this story can help you in a variety of ways.
Gross profit tells the story of “Are we charging enough?” and is one of the most important numbers you need to know and track. Simply put, your gross profit is the amount of money you have left after paying for the direct expenses of delivering the good or service you sell. If you sell $100,000 worth of service, and you spend $45,000 in direct labor to provide that service, your gross profit is $55,000. Gross margin converts that number to a percentage so it’s easier to use. In this example, your gross margin would be 55%.
Although you certainly should work on efficiencies to keep your direct costs down, there is much more leverage on the pricing side of the equation. In other words, it is easier to raise your prices by 10% than it is to reduce your direct costs by 10%. But I’ve found this is where entrepreneurs struggle. The idea of raising your prices may scare you. What if you lose customers or clients?
My experience is that most business owners have more room for price increases than they realize, but they are afraid to use that leverage. My question to entrepreneurs contemplating price increases is, “When was the last time you lost a customer or deal over pricing?” I’ve found this fear often puts a downward pressure on pricing in perpetuity. But if you monitor your gross margin to ensure you are making the right amount of gross profit, you are eventually going to have to raise your prices.
Which leads me to the current economic situation. Coming out of 2020, I’m sure you’ve noticed the labor market shortage and supply chain disruptions. We’ve seen housing prices jump by around 15% in one year, as an example. The reality is that there is severe pressure on the gross profit, and you may want to consider doing something about it now. If you haven’t yet experienced climbing costs or labor, it’s likely that you will.
Raising prices allows you to do a couple of other things in your business. The first is to focus on your value. If you are uber clear on the problem you are solving for people, and you deliver a solution to that problem, they want to pay you for it. Many small businesses struggle with pricing because they are trying to be too many things to too many people. Reviewing your pricing gives you the opportunity to find out what you are really good at and charge what the market will pay.
This leads to the second thing that pricing reviews give you — an opportunity to get rid of bad customers. You know the ones I’m talking about. They pay a lot of money, but they take up a lot of time and resources. At the end of the day, you don’t make as much money on them as you do with the other customers. But that money — you don’t want to give it up! In my experience, if you price your products and services correctly, those problem customers go away, and their gross profit is replaced by other customers. In other words, you make the same amount of gross profit with less work.
Start by determining what your direct costs are so that you can determine what your gross profit and gross margin are. Then list your clients in order of profitability top to bottom. This exercise alone will open your eyes if you have never done it. Now look at the bottom 20% of your clients (as determined by gross margin). Determine how much gross profit (total dollars) that represents for your company. Chances are, it is not as large as you thought.
How do you increase your value and pricing to replace that bottom 20%? Is there a premium service or product that you could add? Pareto’s law tells us that there are 20% or more of your clients on the top end that will gladly spend more money with you. You just have to find it.
Raising prices can feel scary, but in my experience, most of that is in your head. If you make a big deal out of it, it is a big deal. When we have communicated price increases, it has been with very little fanfare. I suggest not to announce the changes but to deal with customer inquiries quickly. Give your team a script to follow explaining the business need for the change in pricing. If you have a few customers that you need to make signficiant changes in the pricing (more than 10%), then you can talk to them proactively. Depending on your industry, you may be able to work in the changes into smaller increments over the next few months, but don’t let the fear keep you from making the change.
Determining the timing of when to make the change will depend on your business. Generally, there isn’t a good or bad time to to make the change, but remember, you are already behind the eight ball. If it makes sense to wait a couple of months to when new product years or models come out, then wait. The point is, just do it! Yes, you’re likely going to have some complaints. Be respectful, but firm. Remember, you are in business to make a profit.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.