Business mentor: Be careful with reactive pricing

Q. We own a small business which specialises in selling commercial cleaning machinery and aids. Most of the sales we obtain are "off the floor", although we also submit several quotes to interested parties for our larger products. Unfortunately, this industry has become very competitive and we are having more difficulty aligning our charges to maintain a fair profit.

We could reduce our margins and increase turnover, but there must be a point where this business is no longer sustainable.

How do we combat these diminishing margins and where is the point when we should consider an exit strategy before it is too late?

A. Stewart Hobbs, managing director and editor of Financial and Business Advisor responds:

In the first part of your question, you raise an interesting issue not often understood by many businesses - that of price setting. Naturally, it is in our better interests to set our prices as high as possible in order to create a niche at the top end of the market, thereby commanding better margins.

However, this is not always practical for several reasons.

All too often we have products stocked by competitors and, for a premium line to be seen to be good value, we have to price competitively on lines where there is more competition.

This is called "reactive pricing", which is an important concept not well understood by many businesses in NZ, predominantly through a lack of understanding of how the simple formula works.

Profit levels are easily determined when we use use proactive pricing decisions where the business initiates price changes ahead of competition. But this is not always the case and sometimes businesses consider reactive price changes. The questions to ask here are:

1. What is my lowest acceptable price change in meeting a competitor's lower price?

2. What is the minimum sales gain required not to follow my competitors?

If ABC Company has goods which sell for $10 each and has direct costs (excluding overheads) of $5.50 each, the contribution margin is $4.50 per unit and the percentage contribution margin is $4.50/$10, being 45 per cent.

Now, if your main competitor reduced prices by 15 per cent, what is the minimum potential loss in sales volume that justifies meeting the opposition's price cut?

Basically, if ABC Company lost more than 33 per cent in sales then it would be better off matching the competition's price.

If customers are fairly loyal and turnover will decrease by less than 33 per cent, then ABC is better off making no price adjustments.

When a competitor raises its prices, the procedure is the same.

If the opposition raised its prices 15 per cent then ABC Company could match the price.

However, if ABC did not match its competitor's price, sales are likely to increase.

If ABC Company is confident that sales will increase by more than 33 per cent then it needs to take no action.

In contrast, if sales are likely to increase less than 33 per cent then ABC Company should also increase its price.

The second part of your question relates to an exit strategy.

We have the concept that everybody is in business to build a business for an eventual exit, thus creating substantially tax-free wealth for the business owners.

We have no specific advice in this regard except to state that it pays to exit any business before it is too mature, i.e. while profit levels are still increasing or at least stable.

We suggest that you implement pricing reviews before you consider any exit strategies.

* Financial and Business Advisor specialises in providing information and advice to small businesses in New Zealand. For more information on pricing strategies and business management issues you can contact Financial and Business Advisor on (09) 836-5060.

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