Price cutting. What you need to know to keep your business healthy. Distributor Economics Series

Transcription

1 Price cutting What you need to know to keep your business healthy. 3 Distributor Economics Series

2 Pricing versus smart pricing Pricing to make a profit is the most important way to build a strong, healthy business. You must control costs and operate efficiently, too. But as important as they are, cost control and efficiency seldom replace profit lost because of price cutting! The effect of price cutting on margins can be minimized by setting realistic, market level prices prices which generate the gross profit needed to maintain a healthy, profitable operation. Also, remember, you can t spend margin only profit dollars. The same margin on a lower priced sale will not generate as much profit as selling a high priced item. Smart pricing means getting the best gross profit on every sale. Suggested resale price sheets help define what the market price level for the product is. Knowing your cost lets you calculate if the price you are setting generates enough gross profit both margin and dollars. It s the only way to avoid the trap waiting for anyone who cuts away at selling price while ignoring the consequences. 2

3 To begin, let s review the two basic ways most distributors look at pricing mark-up and gross profit margin. Both depend on determining the dollars of gross profit. That is done by subtracting cost from the selling price: Selling price $ Cost of product $ = Gross profit $ $50.00 Figure 1 Mark-up is expressed as a percentage determined by dividing the gross profit dollars by the net cost: Gross profit $ net cost = 50% $50.00 = 50% $ Figure 2 3

4 Gross profit margin Mark-up is not the same measurement as gross profit margin. In fact, thinking of it as a measure of profit can be misleading. Figure 3 shows the gross profit margin calculated on the same price as in the mark-up example in Figure 2 on the previous page. Gross profit margin is more accurate measure of the real profit on a sale. Gross profit margin is expressed as a percentage and is arrived at by dividing the gross profit dollars by the gross sales dollars: Gross profit gross sales = gross profit margin % $50.00 = 33.3% $ Figure 3 The last formula is used to check how much profit you will make if you sell at a given price. Use it to make sure the selling price provides enough profit margin to keep the company healthy and profitable. 4 The economic reality is that without sufficient profit, the business will eventually fall victim to the lack of return on the money invested in people, facilities and inventory.

5 If you know the cost and know what gross profit percentage you want to make, use the following formula: divide the cost by the percentage left over after subtracting the target gross profit percentage from 100%. In this case, the target gross profit margin is 40%, so we re dividing the cost by 60% (.60). Cost 100% the gross margin % = sell price $ = $166.67%.60 Figure 4 What is a good gross margin to shoot for? Typical distributors find the going tough if margins range lower than 30% to 40% on average. Profit margin target 40% 60% Figure 5 5

6 Cutting prices Cutting prices is one of the fastest ways to ruin a good business. The key to having a healthy business is to set prices that generate fair profit margins which provide the kind return that keeps a company healthy. Insufficient margins are a sure way to bring trouble. Cutting prices is a guaranteed way to make margins and profit dollars erode in a hurry. The percentage you give away will slash or eliminate profits in a big hurry. The effect of what might seem like a small discount can be devastating. Making up for cuts through greater volume may seem like a solution but may, in reality, be difficult or impossible. -20% -10% No cut When the gross margin is 25%, you have to move 66.6% more merchandise if you cut prices by 10%. Cut prices 20% and it s 400% more! Figure 6-20% The dollar volume also increases. Cut 10% and you have to do 50% more dollars cut 20% and the added volume jumps to 300%! -10% No cut Figure 7 6

7 Even comparatively small discounts can wreak havoc on margins. Making it up on volume is the usual rationalization for cutting prices to get the business. But as the chart below shows, the effect of even modest cuts can easily overwhelm your ability to compensate through more sales. The effect of cutting prices If you cut prices by and the gross profit margin is 25% 5% 10% 15% 20% 25% Figure 8 You must move 25% more merchandise and do 19% more dollar volume to make up for what you gave away You must move 66.6% more merchandise and do 50% more dollar volume to make up for what you gave away You must move 150% more merchandise and 112% more dollar volume to make up for what you gave away You must move 400% more merchandise and do 300% more dollar volume to make up for what you gave away You must move % more merchandise and do % more dollar volume to make up for what you gave away* *See if you can fill in the merchandise and dollar volume spaces for a 25% discount. The answer is on page 12. 7

8 Can you make it up in volume? For any group of products you sell, gross margins will vary. The effect of discounting on products with higher gross profit margins is less than on those with lower margins. But the loss Staying close to your customers, anticipating their needs and delivering exceptional customer service takes the pressure off price as the determining factor. in actual profit dollars may be larger because products with high margins often sell for higher prices. Price cutting always hurts because it s so hard to make it up in volume. For example: if ten seals, selling at 25% gross margin, are discounted 20%, it requires that you sell 40 more seals just to make up the profit dollars you gave away! In dollars and cents, those same ten seals normally selling at $10 each at 25% gross margin would give you a total of $25 in profit or $2.50 per seal. When you cut the selling price by 20%, you are left with only $5 profit on the sale just $0.50 per seal. In order to recapture the $20 you gave away, you must sell 40 more seals (40 x $0.50 = $20). That s a lot of work to get back to the original profit level and shows why price cutting is not a good idea (see Figure 8 on page 7). 8

9 Carrying costs Even if it s possible to sell more merchandise to offset price cuts, there can still be problems. Like high costs. Increasing volume means more inventory. The plain fact is that carrying inventory costs money. Combined with low gross margins, the cost of inventory can weaken an apparently healthy operation. With costs like these already eating up profits, it s easy to see why healthy gross profit margins are so important. Inventory carrying costs:* Obsolescence % $.25 Physical depreciation % $.25 Handling % $.13 Property taxes % $.03 Insurance % $.01 Storage % $.04 Sub-total % $.71 Interest.... % $.20 Total.... % $.91 Figure 9 * The example above shows a typical distributor s cost to carry inventory. Put your actual costs in the blank space as a comparison. The column on the far right shows what a $5.00 seal costs to carry as part of the inventory. 9

10 Earn and turn index How healthy is your business, today? There are several ways to tell. One is the so-called earn & turn number. The average gross profit percentage you ve made is the earn part. Position yourself as a problem solver with quality products. That goes a long way toward making the choice between you and a competitor hinge on value instead of solely on price. The turn number is calculated by dividing the total value of the inventory into the cost of goods sold for the year. The answer you get is the number of times the dollars invested in the inventory have turned over during the year commonly referred to as turns. If you multiply the earn percentage times the turns of inventory dollars, you get a number for comparison to industry averages and to past and future numbers in your own business. Opinions differ on what an acceptable number is. Some say that 100 is a minimum. Certainly the further below 100 your earn & turn number falls, the less healthy the company would seem to be. Gross profit 30% x Inventory turns x 2.9 = Earn & Turn index 87 E&T Figure 10 10

11 GMROI Another benchmark number is the gross margin return on inventory (GMROI). It s calculated by dividing the gross profit dollars by the total inventory dollars. The number that you get provides an index of the gross profit you generate in a year for each dollar of inventory investment. While there is no right number, a GMROI of less than 120% does not represent a particularly healthy return on inventory investment. Gross profit $ inventory $ = GMROI $35,000 = GMROI 1.25 $28,000 Figure 11 What can protecting margins do to help both the earn & turn and GMROI index? Assume a 40% gross margin due to elimination of price cutting and the numbers would look like this: 40% x 2.9 E&T 116 $46,667 = GMROI 1.67 $28,000 Figure 12 These numbers would indicate a profitable distributor operation. 11

12 Sample problems 1) If the selling price is $150 and the cost is $100, what is the gross profit in dollars? 2) If the selling price is $9.50 and the cost is 43.60, what is the gross profit in dollars? 3) If the gross profit is $50 and the cost is $100, what is the mark-up? 4) If the gross profit is $3 and the cost is $6.25, what is the mark-up? 5) If the cost is $100 and the selling price is $150, what is the gross profit margin? 6) If the cost is $6 and the selling price is $10, what is the gross profit margin? 7) If the cost is $100 and you want a 40% gross profit margin, what should the selling price be? 8) If the cost is $5 and you want a 45% gross profit margin, what should the selling price be? Answers: (1)$50 (2)$5.90 (3).50 (4).48 or 48% (5).333 or 33.3% (6).40 or 40% (7) $ (8) $9.09 From page 7 Cutting the price by the same percentage as the gross profit margin leaves no margin at all. You can t make up the loss no matter how much extra you sell. SKF is a registered trademark of the SKF Group. SKF Group The contents of this publication are the copyright of the publisher and may not be reproduced (even extracts) unless permission is granted. Every care has been taken to ensure the accuracy of the information contained in this publication but no liability can be accepted for any loss or damage whether direct, indirect or consequential arising out of the use of the information contained herein. Publication (rev. 03/10) Printed in U.S.A. SKF VSM NA 890 N. State Street Suite 200 Elgin, IL