An old joke reads: A store owner procures pencils for $0.10 apiece, then turns around and sells them for a dollar a dozen. Trying to understand this bizarre offer, a curious store clerk asks, “How do you expect us to stay in business that way?” The owner replies, “Volume!”
Surprisingly, some entrepreneurs choose a similar strategy. They think they can succeed merely by pricing goods and services cheaper than the competition or making an incredibly rock-bottom introductory offer to new clients to get them in the door or roped into a contract. Low prices, they assume, will generate sufficient sales to more than make up for smaller profits. Like the store owner of the joke, these entrepreneurs rationalize, “What I lose in margins, I’ll make up in volume.” It is the single dumbest thing any business can do, yet, as consumers, we see it every day.
Competing on price is risky. Yes, some big businesses seem to thrive on low prices. But low prices mean narrow gross profit margins, and narrow profit margins mean less cash flowing into coffers. With a small financial cushion, a business is vulnerable with every cost increase. The landlord raises the rent five percent? There may go an entire year’s profit. Want to avoid making these pricey mistakes? Read on, friends!
A classic example
Let’s suppose you are a sign shop that typically offers real estate agents a set of roadside “Open House” signs for $150. Your cost-of-goods-sold for producing the signs is $50—a gross profit margin of 67 percent. You’ve been approached by an online coupon service to consider offering a “good deal” to new customers in hopes of stimulating sales. You agree to have the online coupon company sell vouchers worth $150 in goods for $90—a 40 percent savings for the coupon shopper. But, by agreement with the online coupon service, you only get half of the gross revenues collected. Hopefully, you see the problem here. For every set of signs sold, the business loses $5.
You may rationalize, “Well, at least I’m kinda breaking even and I’m introducing my shop to new clients that will surely order again, right?” Not so fast.
Here’s the rub: those new clients will not reorder unless the price is close to $90. In the meantime, your new customer tells others about the online voucher and where they can get their roadside signs for $90. For every person that buys a voucher, you lose another $5.
What if one of the real estate agents, who bought their signs last year from your shop for $150, finds out about the “good deal” now being offered? Do you think that’s going to make them want to place another order with you? Not for $150—no matter how great your signs are. They’ll want the bargain-basement price of $90, or they’ll find someone else from which to buy. In fact, they may not ever give you a chance to earn their business back because you treated someone else better than you treated them—a loyal, longtime buyer.
So, look at what’s happened to your profitability. If the new going rate for a set of signs is now $90 and the production cost remains at $50, your gross margin dropped from 67 to 44.4 percent.
Consequently, you begin to think you’ll have to find ways to reduce costs to bolster your deteriorating gross margin. The first thing you may be tempted to do is reduce wages and benefits, or cut your employees’ hours. Watch out! This means you won’t be able to attract good employees. They’re less likely to be productive or loyal. You’ll be busy keeping an eye on them, and they’ll be keeping an eye on the clock.
The next thing you’ll do is cut marketing. And businesses that compete on the basis of price almost always depend on high levels of advertising and promotions to keep customers coming in the door.
Low-price shoppers are loyal to price, not to you. So if the competition decides to squeeze you out with even lower prices, a lot of your hard-won customers will be gone in an instant.
And, it all began when you thought you could win new business with a low price. Silly rabbit!
What’s one to do?
While price should never be the cornerstone of your strategy, it also can’t be ignored. So how can a small company still maintain competitive pricing? Here are some ways:
- Carve out a niche. If you have the lion’s share of a particular market, you have more room to set prices. If there are 20 or more sign and digital graphics shops in your city, you’ll face constant price competition. But if you’re the only shop specializing in brilliantly colored, one-of-a-kind, custom-designed banners and signs with fast turnaround, you’ll face much less price pressure.
- Work smarter, not cheaper. Improve profits through innovative practices. Find ways to de-bottleneck production and reduce the time it takes to finish an order, without sacrificing quality. Look into equipment that speeds up and/or streamlines operations.
- Focus on value, not price. Value is a term used to represent the combination of quality, service and delivery for a price. When you shop for a winter coat, you may be willing to pay higher prices to get long-lasting quality. Likewise, a client may be willing to pay a higher price for your goods and services if you can deliver the job faster with fewer hassles than the competition. Excellence, innovation and service are competitive advantages that let you justify your slightly higher prices.
- Target the right customers. Not all customers are willing to pay more, even for better quality. Make certain to aim marketing efforts at customers who are predisposed to buy from you, will respond positively to the differences offered, and can pay a slightly higher price for that value.
- Build loyalty to you, not your price. Even if you use special pricing—volume discounts, “something extra for free” with an order—to initially attract customers, immediately go to work developing a relationship that keeps customers coming back when the price goes up.
People are competitive. Companies are competitive. It is quite natural in humans to want to beat each other. We all want to “win.” That’s why otherwise smart people often start or join price wars. Understand that price wars transfer money and control from sellers to buyers. This is not a good thing if you’re the pricing person, or a business owner.
Companies start price wars to “win market share.” Sometimes, this is based on a careful analysis of lifetime customer value to support aggressive pricing to certain market segments. More often, it’s just a matter of competitive instinct coming ahead of profit.
Either a price cut will cause a shift in market share or it won’t. If it doesn’t, you’ve just given your customers a big discount and hurt your bottom line. If it does, your competitor is likely to respond, negating any advantage. Don’t let yourself get caught in a continual battle to be the “low-price leader.” You may win that battle but lose the war—or worse, your business. Good luck!
Article Origin: Vince DiCecco