When you quote a potential customer for your product or service, either verbally or in writing, you’ll lose some business on price. You may not always know whether price was the issue. But suppose you could find that out, what proportion do you WANT to lose?
Your first thought is probably “Zero of course!” but wait a minute – that could mean that you’re too cheap! Maybe ALL of your customers would have paid more than you are quoting them!
In fact even if a few wouldn’t have paid any more, you’re still too cheap if you aren’t losing any business on price, and I’ll explain why in a moment.
But let’s get back to that question, “What proportion do you WANT to lose on price?” Salespeople never want to lose any, but let’s suppose you decided that losing none was too cheap, and you’d like to lose ten percent. How about that?
Well that means that the other 90% would have paid more. You are losing out on all that margin, all that profit, that you could be having from 90% of your customers. And if you’re making 5% net profit, getting another 5% from 90% of your customers would pretty much double your profit. So I think 10% lost on price is not enough!
Especially as those 10% are often the ones who are the biggest pain – you ABSOLUTELY want to get rid of them, you’re probably making a LOSS from them if you apportioned all the management time to them correctly. But what about going beyond the 10%? Where do we want to be?
So if you do some maths….
I have worked this out, both graphically and with algebra. The way to do it graphically is to either draw a demand curve (price vs quantity sold) or to imagine all your customers lined up in price order where the vertical axis is how much they pay – and you then look at areas under the graph, the gap between the price and the cost which equals the profit, the area of profit that you lose when you lose some customers on price, and work out the best place to put the price line.
The other way is to produce an equation for profit, based on the fact that profit = (price – cost) x quantity sold, and if you know the formula that connects quantity sold with price you can substitute that in. The cost is partly a fixed cost and partly a variable cost (which goes up with quantity sold). So you get a formula for profit purely as a function of price charge. Finally you work out the maximum profit point by differentiating the formula and putting that equal to zero.
Both of my methods come out with the same answer –that you should be losing 50% of your business on price.
50% is quite a lot isn’t it! If you were a sales person you’d feel quite unhappy, especially if you were incentivized on number of orders obtained, or, nearly as bad, turnover.
But 50% IS correct. If you are only losing say 25% then you are missing out on the extra income from the other 75%, and this income is important if your net profit margin is between 5 and 10% which it normally is.
Finally, don’t forget that by being better at selling, and by producing a higher quality product and offering better customer service, the price at which you lose 50% of your business will be higher – you can charge more and still get half of the customer to pay it. So don’t neglect these vital areas and then lose orders and blame it on price!
The aim is to be brilliant, and THEN turn away half of the potential customers because they can’t afford you. That’s your point of maximum profit, and also you have more time to think about new products, better marketing, better systems, improving quality, developing your people, and maybe even having a bit of time off!
But even if you’re not (yet) brilliant, your optimum point, right now, is still to turn away half of your customers because they can’t afford you.
Do some maths, set up a spreadsheet with columns for price, quantity sold, fixed and variable cost, and profit – based on your real numbers. Make some guesses about elasticity of demand (how much you lose when you put your prices up) and TEST those on some new customers and monitor carefully what happens. Then: what does your model say?
Send it to me too – I’d love to see it!
Onwards and upwards….