Setting the Right Sales Prices in a Business - dummies

Setting the Right Sales Prices in a Business

The secret to making profit in a business is making sales and earning an adequate margin on them. Setting the right sales prices for products is a critical factor. (Remember, margin equals sales price less all variable costs of the sale.) Internal P&L reports to managers should clearly separate variable and fixed costs so the manager can focus on margin.

In real estate, the three most important profit factors are location, location, and location. In the business of selling products and services, the three most important factors are margin, margin, and margin. Of course a business manager should control expenses — that goes without saying.

As an example, say your sales prices earn 25 percent margin on sales. In other words, $100 of sales revenue generates $25 margin (after deducting the cost of goods sold and variable costs of the sale). So, $16 million in sales revenue generates $4 million margin. The $4 million margin covers your $2.5 million in fixed costs and provides $1.5 million of profit (before interest and income tax).

An alternative scenario illustrates the importance of setting sales prices high enough to earn an adequate margin. Instead of the sales prices in the previous example, suppose you had set sales prices 5 percent lower. Therefore, your margin would be $5 lower per $100 of sales. Instead of 25 percent margin on sales, you would earn only 20 percent margin on sales. How badly would the lower margin ratio hurt profit?

On $16 million annual sales, your margin would be $3.2 million ($16 million sales × 20 percent margin ratio = $3.2 million margin). Deducting $2.5 million fixed costs for the year leaves only $700,000 profit. Compared with your $1.5 million profit at the 25 percent margin ratio, the $700,000 profit at the lower sales prices is less than half. The moral of this story is that a 5 percent lower sales price causes 53 percent lower profit!