If your gross margin isn’t enough to make your business profitable, it’s time to re-evaluate your pricing.
There are three red flags that your prices are too low every business should know. In this article, we’ll share what they are and what you can do about it.
What is gross margin?
Gross margin is the percentage of revenue left over after you subtract the direct costs of providing your product or service.
Direct costs include the materials and labor used in providing the product or service.
For example, let’s say you sell a cup of coffee for $2.00. The cost of the beans in a single cup is $0.25 and the cost of the paper cup is $0.15.
The gross margin for the cup of coffee is: $2.00 - $0.25 - $0.15 = $1.60
Direct costs include anything that can be only used once in the production of a product. For this coffee company, any equipment used or retail space aren’t included as COGS. This is because they are not used up in the production of a single cup of coffee.
Since gross margin has two components—price and costs—there are only two things that you can change to increase it. Let’s dig into pricing and how you can tell if your prices are too low.
3 ways to know if your prices are too low
1. You’re undercutting competitors
The first step in evaluating your prices is looking at your competitors. Having a price advantage over them can drive sales, but it won’t do you much good if your gross margins aren’t high enough.
It’s a good idea to have two or three competitors that you’re regularly checking up on. This includes their prices, any promotions they run, and how they position their products in marketing materials.
If you’re an online seller, don’t forget to look at your shipping costs. When offering flat rate or free shipping, you risk having your shipping costs eat away at your margins. A competitor with lower prices might be charging more for shipping to protect their bottom line.
2. You’re experiencing overwhelming demand
A quick lesson on supply and demand: demand is inversely proportional to price. This means that as prices go down, demand goes up.
If you’re experiencing a large volume of orders to the point that it’s tough to keep up, you can control this demand. Increasing prices will cut demand down until it’s manageable.
When experiencing overwhelming demand, you ideally want to increase prices to the point where you’re making the maximum amount of orders you can comfortably handle. You will reduce your sales volume but remember that you’ll be pocketing more off of each sale.
3. You can’t afford promotional pricing
Sales are a fantastic way to drum up attention and acquire new customers who otherwise wouldn’t have tried your product or service. But if your prices are already low, you don’t have as many promotional options available.
When setting your prices, consider what the margins would look like with different percentage discounts. This gives you the leeway to participate in seasonal promotions like Black Friday or Boxing Day.
Base your prices on a desired gross margin
A common pricing model is called “cost-plus.” It gets its name from the fact that you start with your direct costs and then add in a “plus”—your gross margin.
Let’s say after adding up manufacturing and fulfillment costs, you find it takes $30 to produce the product and send it to a customer. You also know you want a gross margin of 50%. Using this info, you can figure out you need to set prices at $60 ($30 direct costs + $30 gross margin).
Negotiate with suppliers
In some cases, suppliers are willing to provide discounts for buying in bulk, quicker payments, or other changes to the terms of exchange.
Depending on who your supplier is and what your relationship is like with them, you can approach them with a suggested deal or request a change of terms in writing. What’s important is that you come out of the agreement with clear terms that keep the engagement positive.
In your proposal, make sure the incentives for the supplier are clearly outlined. Any supplier is more likely to say yes to a proposal if it makes business sense for them.
Introduce upsell opportunities
A famous case of underpriced products is printers. Manufacturers often sell them at a loss in order to sell ink jets, the real money makers.
Upsell opportunities don’t need to be as much of a long-term play. But when done effectively, you can pair a high margin product as an upsell with a low margin product to maintain solid profitability on every order.
Do some brainstorming about products that pair well with what’s already sold. To level up your upselling tactics, consider running a discount for selling those two products together—so long as the margin is still satisfactory.
Expand your shipping options when selling online
While flat rate shipping keeps things simple, you risk losing a large chunk of the margin you earned on shipping alone.
Consider offering multiple shipping options on orders, like paying more for an expedited shipment. Or alternatively, change to a strictly variable shipping rate calculated based on the customer’s address (see how it can be set up in Shopify).
You can also save on shipping by changing your packaging to be shipping-ready. It’ll cut down on the additional bags or boxes typically needed to send a product to a customer.
Re-evaluate your packaging
If you’re set on your product and price, the next thing to look at to reduce costs is your packaging.
Loose fillers like user manuals are unnecessary in the age of hosting things online. You could switch to a QR code that users can simply point their camera at to take them to an online guide.
Sizing down on boxes or moving towards minimal packaging saves money on producing and shipping the product. Even a small change pays off on every sale you make. As an added bonus, it’s better for the environment.
Growing your gross margin and tracking results
When making any change to your pricing or operations, it’s essential you track the results. Measuring this impact tells you whether the change was successful or not.
You should always be staying on top of your sales revenue and COGS (cost of goods sold) to see how your gross margin is changing over time. This is made much easier when you have up-to-date reporting to help track your finances.
You can save time on generating reports and entering transactions by bringing on help, like Nill Tech & Finance. We maintain your financial reporting for you. That means less time generating reports and more time learning from them. Get started today.
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This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.