I have often heard “A fair margin is 25%”, or “That’s a fair price at a 30% margin.” Those things are usually said when trying to set a price for a new customer or product, or in arguing for a lower price. My reaction is always the same. A fair price is determined by the value to the customer or customers, not your margin. When prices are set by simply adding a margin, one of three things can happen:
- Your price can match the amount customers would be willing to pay based on the value they perceive
- Your price can be higher than the amount customers would be willing to pay, and you would lose sales
- Your price can be less than the customer value amount, and you would make less money than you should, leaving money on the table
When setting prices, do the work to figure out customer value first. After you determine the price according to customer value, it is appropriate to consider whether that price is profitable for you. If the answer is the value-based price is highly profitable and the margin is higher than normal, great for you. Invest that profit in your business, rather than simply giving it away. On the other hand if the value-based price would not be profitable, raising the price would significantly increase the likelihood of not selling the product at all. You would be better off finding a way to cut your costs so you can be profitable selling your product or service at a price customers will pay.
It is easy to understand why people think in terms of margins and have a concept of a “fair margin”. Most companies provide monthly reporting that includes margins by business unit, location, product, and sometimes by customer. The average margins are easy to remember, however they are just that – averages. There is nearly always significant variability in the margins earned on specific customers and products within a company. But typically it is not the higher margins that are referenced as fair. There is a natural tendency to think that something average or a little above average is fair. Although it would be easy to apply that average margin when setting a price for a new customer or new product, as we saw above, it would likely not be the best answer.
Consider another implication of simply applying average margins to come up with prices. If that type of cost-plus pricing worked, companies would have perverse incentives. An average margin applied to higher costs would result in higher total dollars of profit, so a company would have an incentive to increase their costs. Most employees recognize that their company can’t double every employee’s salary and then raise their prices by that amount plus their current average margin. Unless they have grossly misunderstood the value of their product or service, sales would likely decrease. So, why would it make sense to use that average margin for a new product or customer?
If you and others in your company talk about fair margins or appropriate margins, you can improve your profitability by changing your focus. First, do the work to determine customer value. Value is not the same for all customer segments and customers, so spend the time to figure out which customer segments are meaningful in your business and how value changes from segment to segment. Next, consistently communicate how your products and services add value. When someone wants to have a conversation about fair margins, change the discussion to the benefits your product or service brings to customers. Finally, rather than just reporting sales and margins, start reporting on price effectiveness. Communicate which prices reflect the appropriate value level and which do not. Also communicate the circumstances under which prices are expected to be higher or allowed to be lower.