Increasing your percentage gross margin won’t necessarily improve your annual profits. Higher prices often lead to fewer sales, and profits depend on both. We therefore need to understand the ‘price elasticity of demand’ as well as our ‘economics of scale’. This week we discuss how both these relationships affect our profits.
Balancing sales and profits
Sales quantities usually vary with prices as some customers will accept a higher price, and other sales will be lost. For B2B products this ‘Price Elasticity’ is often harder to gauge than in consumer mass markets. Price sensitivity may also vary between market sectors depending on industry and geography, due to the structure and trends of each market. Similar customers in different markets may have very different price expectations for the same product. See the previous article on ‘What price will your customers pay?’ for more on this.
Can discounts deliver profits?
In mature markets, discounting is a common strategy to improve sales. Consumer markets often rely on regular price discounts to keep revenues flowing. B2B vendors tend to be more cautious but often use special offers to boost revenues, especially at financial year end. Even younger companies with disruptive products can be tempted to discount their pricing as they attempt to break into new markets. In all cases, it pays to consider the dynamics of your market. Will your customers ‘stock up’ on your special offers, leading to a ‘sales drought’ soon afterwards? Will discounts make it harder to raise prices in future? While many businesses are driven by short-term targets, their long-term usually profitability matters more to shareholders.
Hardware pricing sensitivity
Physical products will have lower percentage gross margins than software or services. So, you will see stronger variation of profits with revenues. A typical 50% manufacturing margin means that a 10% price increase delivers 20% more value in gross margin per sale. Even if sales then decline by 10%, you could still be left with 10% more revenue on your bottom line. This effect can be dramatic if your current profits are small. But price rises should always be carefully considered as it may take time for their effect on the market to become apparent.
Tiered pricing on a common product platform
Hardware economies of scale mean your ‘Costs Of Goods Sold’ (COGS) can vary strongly with sales quantities. This tempts manufacturers to make as much product as possible to drive down their costs. Designing different branding and product benefits for tiered ‘premium’ and ‘commodity’ markets helps us achieve economic volumes on a common platform without sacrificing margins. Many manufacturers use this technique to maximise their margins from premium sales while offering competitive pricing in tougher markets.
Initial and recurring revenues
Pricing which combines one-off and recurring elements can deliver better profits. Sometimes the ‘after-market’ value of a customer’s purchase is worth much more than the initial sale.
For instance, professional software was often sold as locally hosted per-user licenses with annual maintenance fees. Now it is increasingly provided through cloud-based subscriptions.
Hardware products can generate revenues from the sales of equipment, installation, logistics and training as well as consumables and services. By packaging these as ‘hardware as a service’, manufacturers can increase their recurring revenues. But beware the increased cost and risks of financing your customers’ purchases!
Whether you’re selling software, hardware or services you will need to estimate the Lifetime Value (LTV) of each customer. Maximising this value with a carefully designed price structure will drive growth in revenues and profits. This means you need to balance your up-front fees against your longer-term but higher risk recurring revenues.
Finding your pricing ‘sweet spots’
Profits are the often the small difference between much larger revenues and costs. Understanding how your costs will vary with revenues is key to maximising profits. The ‘price elasticity’ of each market sector needs to be considered carefully. Premium markets may be less sensitive but limited in size. Commodity markets can be larger but more elastic. Building products for different markets on a common platform combines the benefits of tiered pricing with economic scaling.