July 22

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Why price cuts are seldom the answer

According to the June 2022 GFK survey, consumer confidence has dropped to a record low. And the UK Consumer Price Inflation is at its highest level since records began in 1997.

Margins are being squeezed - supplier prices are going up and up. Interest rates are expected to rise, making debt more expensive, and new borrowings harder to find than the Lough Ness monster.

It’s a tough time to be in business - how do you respond?

Let’s start with the not-to-do…

What not do to?

Don’t implement a knee-jerk price cut to be more competitive and win more sales. This foolishness will hit profits as hard as a Mike Tyson right-hander, and, worse, put pressure on your cash just when you need it most.

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Why?

Let’s work through an example from a ‘mythical’ business that sells widgets:

  • Each widget sells for £250
  • Material costs are £75 per unit
  • Manufacturing team costs are £15 per unit
  • Carriage to the customer costs £10 per unit

So, each unit sold contributes £150 to marketing costs and overheads.

In a typical month, the business sells 1,000 units for £250k, giving a contribution of £150k to marketing and overheads.

The owner decides to cut their prices by 10% to £225 per unit in an attempt to grow sales and ward off a price-cutting competitor.

After the price cut, each unit contributes £125 to marketing costs and overheads. (The costs, sadly, don’t magically change just because you’ve dropped your price).

To keep their contribution at £150k, they now need to sell 1,200 units. That’s a 20% increase. (Btw: if sales don’t grow, they’ve just cut their profits by £25k).

Assuming they hit the 1,200 target, raw material purchases go up by £15k, the monthly wage bill increases by £3k (assuming no spare capacity) and carriage increases by £2k. That’s an extra £20k of cash to find (assuming customers pay within 30 days - it’s £40k if customers pay in 60 days).

Sometimes price cuts are sensible, but they need to be carefully considered as they’re often irreversible once implemented.

How to think it through…

Before rushing headlong into a price cut, here’s the questions you should consider:

  1. How much would sales need to grow by to keep the contribution the same?
  2. What proof is there that the price cut will grow sales by that amount?
  3. How much extra working capital will you need to support the extra purchases for the increase in sales?
  4. How will we fund the increase in working capital needs?
  5. Is there enough capacity in manufacturing to produce the extra units?
  6. Are there enough people to manufacture the additional units?
  7. If there aren’t enough people, can you recruit extra people easily, or will costs go up because the team will have to work overtime?
  8. Can your suppliers cope with that increase in orders? (And is your credit rating strong enough to overcome that?)
  9. Will the current marketing budget be enough to drive a 20% increase in sales?
  10. By how much can you reduce costs to offset the decrease in contribution? (Btw: You’ll need to cut your costs by much more than the 10% price cut)

Once you've thought that through, then maybe a price cut is a good idea. If it doesn't make sense for your main products, there's an exception to the rule…

When you can sensibly cut prices

The exception is when you have finished goods sitting on your shelves that are unlikely to sell because it’s an old design or is a slow-mover. Basically, that’s a bundle of cash sitting there doing nothing. In that case, it’s worth cutting your prices for those goods to move them. It puts money in the war-chest to protect the business.

What can you do to deal with tough business conditions?

There’s a host of things to consider to address a tightening market. Too many for this post. But one thing that’s easy to do and makes everything else easier is to increase your prices.

If the business in the example above increases prices by 10%, they need only sell 868 units to get the same contribution as before (even with the same production staff costs). That’s 13.2% fewer sales. It reduces purchases by £10k a month and reduces carriage costs by £1.3k. That’s £11.3k extra cash in the bank.

Time to put your thinking cap on.

Your next steps

Take time out now and reflect on three questions:

  1. What happens if I cut my prices? use the ten questions above)
  2. How much business (if any) you would lose by increasing your prices. What would that do to your profits and your working capital?How do we position ourselves so that our ideal customers believe we’re the only people who can solve their problem in the way they want it solved?
  3. Find the answer to question 3 and you have what I call Monopoly Control. It is difficult to do and takes longer to implement, but when you have Monopoly Control, you have no real competition and you can charge what you like.

Give me a shout if you want help doing it - it’s a keystone of my Value Builder work. Not only does it make your business more profitable and easier to run, but it also becomes more valuable and easier to sell (f the urge should take you).

Take time out now and reflect on how much business, if any, you would lose if you increased your prices. What would that do to your profits and your working capital?

A better questions to ask though is “how do we position ourselves so that our ideal customers believe we’re the only people who can solve their problem in the way they want it solved?”

Find the answer to that and you have what I call Monopoly Control.  It's difficult to do, and takes longer to implement, but when you have Monopoly Control, you have no real competition and you can charge what you like!

Give me a shout if you want help doing it - it’s a keystone of the work I do with clients. Not only does it make your business more profitable and easier to run, it makes it more valuable and much more sellable.

Anyhow, until next time.

Warmly,

Richard

PS: Building a valuable and sellable business should be one of your most important goals, but if you don’t or can’t measure how you’re doing, you’re setting yourself up to fail.Get your value builder score now (it’s free and confidential) to see how valuable and sellable your business is today: Get Your Value Builder Score Now

PPS: Can I ask a tiny favour, please? If you found this email useful and/or enjoyable, please share it with a fellow business owner


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Financial management


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