As a truck shop owner, your ability to succeed in your enterprise depends on a number of factors. One of the most important factors to consider is how to price your products and services. We all know that a business will fail if it is consistently taking a loss, but what you may not know is how to ensure your profitability for the long term.
In this two-part series, we will explore some important principles and concepts which you need to understand if you are going to achieve real, stable, on-going profits. The concepts are simple, but you may be surprised about some of the misconceptions you have been working with, when it comes to pricing your goods and services.
In part 1 of this series, we’ll build on our previous article series, The Real Cost of Doing Business, and take a deeper dive into pricing your parts and inventory. In the second part, we’ll take a harder look at how you price your services, and learn how to accurately account for the costs and income involved in providing those services to your customers.
Markup or Margin to Set List Prices?
One of the most common mistakes business owners and managers make when it comes to pricing their products is that they don’t understand the difference between marking up a product, and setting a price to achieve a specific profit margin. It’s an easy mistake to make, since it’s common these days to hear “margin” and “markup” used interchangeably in a business setting. But there is absolutely a difference, and misunderstanding this difference could mean the destruction of your bottom line.
To begin to understand the difference, we should first define the terms:
Markup: The markup of an item is the percentage difference between the actual cost and the selling price. Markup should never be used to determine the list price of an item.
Margin: The margin of an item is the percentage difference between the selling price and the profit. When setting a list price, you want to determine your ideal profit margin and work from there.
Where You Can Go Wrong: Commonly, business owners will mark-up the cost of their inventory by what they believe is the correct profit margin, thinking the concepts of markup and margin are interchangeable.
For example: To mark up a $1.00 item by 50%, many business owners will simply multiply $1.00 by 150% to arrive at a list price of $1.50. This is NOT a 50% profit margin; it is only a 33% profit margin! Later, when they discount this item by 30% (thinking they have ample profit to work with) they multiply $1.50 by 70% to arrive at a 30% discount. The discounted price they offer is now $1.05, or a measly 5% profit margin.
So, what happened to the math, and why did the profit margin come out so different than what you would expect? The problem is, the math was wrong. Now we’ll talk about why that happens, and how to prevent it.
Other Common Pitfalls
When determining an appropriate list price for a product, you must first know the actual cost of that item. If you’ve been following this article series, you know that the actual cost of an item is not simply the price you paid to the distributor; it includes a variety of other associated costs, as well, which need to be accounted for. These added burdens can easily increase the cost of an item by 20% or more. To learn more about determining the actual cost of a product and calculating your cost burdens, read our article about calculating cost burdens and carrying costs.
Pricing mistakes are easy to make. For example, say you buy a part for $1.00 from the distributor. You may have only paid $1.00 to purchase that part, but that part could easily end up costing you $1.20, once all of the burdened costs have been added up. If you fail to account for that extra $.20 cost burden, and mistakenly figure your markup based only on the $1.00 purchase price, you’re not going to be able to accurately price the item for profitability.
To continue with this example, let’s say you want to markup that $1.00 part by 50%. It would be easy to set the price at $1.50 and feel good about the 50% markup you think you’re getting when you sell that part. But, you’ve made two mistakes: You forgot to calculate the fully burdened cost of the part, so that part has actually cost your company $1.20, not $1.00; and you have made the math mistake outlined earlier, confusing your markup with your profit margin.
Now, what happens if a customer comes in and asks for bulk pricing on the item? You incorrectly assume that you have a 50% margin on your item, so you decide you can cut this guy a great deal and give him a 30% discount on his bulk order. You think this will allow your company to keep a 20% markup on the item, while giving the customer a great deal. A win/win, right? Not quite! Because you forgot to accurately figure the cost of the item in the first place, (by neglecting to add the burdened costs), and you used the wrong math to achieve your original list price.
Suddenly, that 30% customer discount is creating a financial loss for your company of $.15 for each item sold. You are now literally paying your customer to take the part off your hands at a loss to your company, while mistakenly believing you are keeping a 20% markup on the deal. See how you can quickly get in trouble, if you don’t markup an item with full knowledge of the burdened costs? This is why it’s vital for the success of your company that you always make sure you understand the principles of burdened costs, and the proper math to achieve a profit margin, before you start setting list prices and offering discounts.
How to Create Real Margins for Profitability
Your profit margin is different than your markup, and the two concepts are not interchangeable. To accurately calculate a profit margin:
Fully Burdened Part Cost / (1 – Desired % Profit Margin) = List Price
Let’s go back to the $1.00 part example we used above. Since the profit margin on an item is the percentage difference between the selling price and the profit, your $1.50 part sale would yield a profit margin of 33% if the actual cost of the part was really only $1.00.
Because we now know that the $1.00 part really cost your company $1.20 once we factor in the burdened costs, this brings your profit margin down to 20% when you sell that part for $1.50. Not terrible, but not great. Now, consider that 30% discount you’ve offered your customer, when you thought you had a nice 50% markup. That discount would bring your actual profit margin down into the negative; -14%, to be exact. Can your business survive a consistent -14% loss on every part you sell? Of course not.
So, how do we calculate an accurate price point for a healthy profit margin?
Let’s say you want to set a real 50% profit margin on that $1.00 part. Using our formula above, this is what that would look like:
- Plug your desired profit margin into the formula, in this case, 50%: (1 – 50%)
- Use your actual, fully burdened, cost for the item: $1.20
- Run the calculation
- Find your list price
Fully Burdened Cost of $1.20 / ( 1 – Desired 50% margin ) = $2.40 List Price
Your actual sale price for this part should be $2.40 to achieve a 50% profit margin and a 100% markup. This is considerably higher than the $1.50 you would have settled on, if you didn’t understand how to accurately determine the cost of a part, and calculate a proper profit margin. Now when you discount the item by 30%, your shop will have 20% of real margin to keep for profit, and you truly have created a win/win for yourself and the customer receiving the discount.
More Strategies For Profitability – Cost/Margin Matrix Pricing
Another way to get the most of your parts inventory is to take advantage of the purchasing psychology of lower cost items. Most people become less sensitive to price when approaching a lower cost item. For instance, a nut or bolt you pay a dime for can easily be sold for $.50 without causing much concern from your customers. Because customers don’t have a way to gauge what a small item should cost (nor do they particularly care!), you can set much higher margins on these small items.
|Burdened Parts Cost||Desired Margin||List Price|
More Strategies For Profitability – Volume Pricing
Volume based pricing is designed to get you a high return for high volume parts. Typically, fast moving parts are also the most price competitive parts in your shop. In this case, it’s best to set your prices on what your local market can bear, while ensuring a level of profitability for your business.
High volume inventory generates more profit than slow moving inventory. For instance, a part priced at $2.00, with a 40% margin, sold daily will generate $24 of profit for the month. The same part sold once a week will only generate $3.20 of profit for the month.
Volume based pricing takes frequency into consideration when determining an ideal profit margin for an item.
|Burdened Cost||Frequency Sold||Margin||Quarterly Profit|
|$10.00||Twice a Month||35%||$21.00|
|$10.00||Twice a Quarter||50%||$10.00|
This method emphasizes turnover of your inventory, and getting rid of slow-moving parts.
More Strategies For Profitability – Customer Matrix Pricing
Another effective strategy for a business that does a large volume of parts with specific returning customers is to provide a discount on revolving orders. If you are using volume-based pricing, it’s really important to pay attention to how much discount you provide, and on which types of products. For example, if you provide a volume customer with an across-the-board 20% discount on the model above, it would cause you to break even on your best profit generating products. It is much more effective, and profitable, to offer specific discounts based upon the category of a product, offering your best sellers at a lower discount than your slower moving inventory items.
Moving Forward With This Knowledge
Once you have run some calculations and have a better idea about how to price your parts and products, you’re in a strong position to control the profitability of your business. As you work through some of the calculations we covered above, and begin to understand the nuanced difference between margins and markups, you will become better equipped to guide your company toward an ever-improving bottom line and better management of your evolving inventory. These are essential ingredients in the recipe for your shop’s ongoing growth and success.
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