31 Jul 2023

Pricing methods to ensure long-term business profitability


7 min

How your clients charge determines how much they make!

The method your clients use to charge for their products or services is critical to how much income they generate and the extent of profit margin that’s created.

What we are seeing:

  • fixed fees that don’t cover the service delivery costs

  • adopting competitor pricing that doesn’t reflect the real price

  • hourly rates don’t work when you don’t record the time spent on the client/customer

  • fixed-price long-term contracts becoming unviable with inflation wiping out the profits

  • cutting pricing to gain market share and making losses

  • not counting Big Tech’s slice of the pie when setting prices

  • reluctance to change prices causing declining profits.

These issues are not isolated to any one industry and cover the full spectrum from construction, manufacturing, retail, to even professional firms.

While no method is either correct or incorrect, each method has its advantages and disadvantages and some as a method of pricing should just be ignored. Understanding these pitfalls helps you to help your clients.

Fixed fees

Standard charges and fixed fees make life easier. There’s no need to overinvest in timesheets and more time on the job earning income is good, in theory, and can be practical provided they are managed correctly.

The issues:

  1. The fixed fee not aligned with the underlying cost of the service or not being increased each year in line with business costs.

  2. The fixed fee hasn’t been fully costed.

  3. The fixed fee is not reflective of all the items covered. Often the same fee is applied to a range of services that vary in time and cost.

  4. The fixed fee leads to scope creep when the customer thinks it’s covered and the provider finds it difficult to charge separately for the additional work.

These issues tend to lead to busy staff but poor productivity and declining profitability. When clients use fixed charges, it must be clear what is covered and what is not. They also need to be properly costed and maintained to ensure they will provide profitability. When costs rise, it’s critical that fixed fees are increased. It may be necessary to have a wider range of fixed prices that better reflect the services the client provides.

Adopting competitor pricing

While possibly the easiest way for clients to set prices, the risks include:

  1. The competitor may not have costed correctly and could be making a loss.

  2. The competitor may not be providing the same service or product, i.e. one might be standard while the other is premium.

  3. The competitor may have a larger business customer base who are less price sensitive; while your client may have a smaller customer base who are more price sensitive.

We come across clients who set their prices by reference to their competitors pricing only to find out this led them to making significant losses. As they hadn’t costed their services, they didn’t understand their business costs and what they needed to generate a profit. After changing how they set their pricing, they had a rapid turnaround in profit.

For your clients, while ensuring they’re not too far outside of their market’s price point is part of the process, it must be as a check to properly undertake price setting methods.

Hourly rates

Hourly rates are fundamental to many businesses including professional services and trades. The key issues with hourly rates are:

  1. Ensuring they are correctly calculated, including, labour, overheads, and most importantly profit.

  2. Ensuring your assessment of your clients’ productivity is accurate.

  3. Ensuring all time is recorded to reflect what’s been incurred or written off.

  4. Monitoring staff productivity.

When assisting business with financial difficulties, we regularly see hourly rates being calculated without factoring all business costs and a profit margin.

Finally, we are seeing many clients not monitoring their staff productivity that leads to significant lost time and poor financial performance.

Hourly rates require regular review and costs and productivity monitored to ensure the profitability is achieved.

Fixed-price, long-term contracts

When inflation was low and stable, properly costed long-term, fixed-price contracts worked well, especially for the construction industry. However, when COVID hit and prices skyrocketed, profits plummeted and many businesses closed.

The longer the contract term: the greater the risk. Contracts must reflect the greater risk with higher profit margins or the ability to pass on price increases in materials used in delivering the contract. While the latter goes against the nature of a fixed-price contract, if your client has gone broke due to price increases they can’t pass on, they can’t deliver the contract.

An alternative is to effectively hedge the contract by buying all materials at the contract outset, which then creates cash-flow issues.

Market share at all costs

Undercutting competitors by underquoting is a tactic used by newcomers to the market or those chasing a greater market share to ensure a positive result in the short-term. However, it rarely leads to long-term success. This tactic can create the following issues:

  1. It’s hard to be financially viable when undercutting.

  2. It can become a race to the bottom with competitors undercutting each other to retain market share.

  3. Quality suffers when prices are reduced, and customers move on.

  4. When your client repositions their price to market levels, the customers generally go back to their previous supplier.

Leveraging technology is a proven way to lower the price and gain market share. But, building the relationship and better service is a better way to develop a long-term profitable customer base.

Big Tech’s income splitting arrangements

Over recent years Big Tech has taken a slice of your client’s pie through ecommerce and delivery services. The slice can be quite large and creates these issues:

  1. Many businesses latch onto Big Tech’s services due to fear of missing out on a sale.

  2. Comprising the transaction’s profitability after Big Tech's share is factored.

It’s important that Big Tech’s cost is included in pricing otherwise the profit goes to Big Tech. Many charge 30% plus for an order and delivery. If Big Tech merely replaces existing services, the impact may not be great; however, if it’s being added and net profit margin is below Big Tech’s fees—then these transactions will create a loss.

I can’t put up my price…my customers will leave!

One of the first things we get told by business clients who are making a loss or a limited profit is that they can’t put up their prices because their customers will leave. We recommend regular annual price reviews and increases. By not putting up prices for several years, the client gets left in the position of having to increase their price significantly, and potentially creating tension with their customers.

In the case of a business not making money this point is moot as going out of business or becoming insolvent is likely.

In conclusion, knowing these pricing method weaknesses is key to implementing systems to ensure the method works best for your client.

We can assist both you and your clients to review their pricing and profitability to ensure their long-term viability. Please contact your local Worrells contact to discuss how we can assist.

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