Pricing Mistake Number 1 – Giving Away Productivity Improvements
Pricing mistakes and errors unfortunately are all too common in job shops. But, before we dig too far into the subject, let’s make sure we’re on the same page with regard to what, exactly we’re talking about.
What are the issues in pricing?
The issues in pricing are many, which reach far across the entire organization. In order to do pricing properly, one must take into account the customer, the sales situation, the market, the productivity of the business. The issues in pricing also include pricing mistakes – which unfortunately happen too often.
What are pricing mistakes and errors?
A pricing mistake or error is any assumption or input into pricing that prevents the company from maximizing the margin it is able to earn on the job, product, or service.
Some are obvious: omitting certain materials, time from departments, using the wrong order quantity, etc. Some, are not so obvious, such as using the fastest time possible, given the workers, machines, and resources in your shop. How can this be?
Let’s look at an example to see how this happens.
Many shop owners desire to buy newer, better machines for their shop to increase their productivity. And when the day finally comes, after months or years of saving your hard-earned dollars, the machine arrives and is installed. There it is, in all its glory.
However, despite how new, pristine, and capable the machine may be, it may also be a major source of lost profitability for your business, if cost accounting is involved in your estimating and quoting process.
Suppose you had an existing job, let’s say it’s Job 100 that needed to be re-quoted. Let’s say in looking at the job’s performance history, you see that the last time the job ran, it ran on the new machine and as a result, you the company was able to save $1,000 in job costs.
Now, as you examine the quote, you say to yourself, “This new machine is great. It’s saving us a ton of money on this job! In fact, I can offer the customer a discount (and they’ll love me!) – all the while I’m making more money!”
Here’s what Job 100 would look like, comparing the “old pricing”, before you had the new machine, versus the pricing you can offer to your customer as a result of the new machine:
The job originally earned $3,000 of margin and had a 30% margin percentage when ran on the old machine. On the new machine, because it’s newer, easier to setup, and can hold tighter tolerances (so there’s fewer roughing passes), the time involved is less, thus the job’s cost are $1,000 less.
And, even after considering a $500 discount to your customer, the net result equates to more margin when Job 100 is run on the new machine. Instead of earning only $3,000 margin the job now earns $3,500 and its margin percentage went from 30.0% to 36.8% – and that’s after a discount! What’s not to like?!
Well, unfortunately, there’s a lot not to like. And, if you’re attempting to run a profitable job shop, then you have a problem on your hands here. The way you’re estimating and quoting the new machine is causing lost profitability in your shop.
Odd, right? The new machine should be faster, hold tighter tolerances, reduce machine and labor time on jobs, be easier to setup, etc. etc. It seems like only good things can come from the new machine.
So why do we claim it’s a source of lost profitability?
Well, the reason is that many times shop owners give away their new-found productivity improvements (in this case, in the form of a new machine) in the form of lower prices. This is a HUGE pricing mistake.
Why do companies fail at price?
This pricing mistake occurs because there’s a nasty cost accounting trap too many job shop owners fall prey to.
That trap is this: When you quote parts using the time from the machine, your quote will invariably have less time – because the machine is so much more efficient. When quoting these lower times, you find that you can sell at the same (or even a higher) margin at a lower price. From there, the person doing the quoting says something along these lines to themselves:
“Hey, I can lower the price a little bit and increase our margins at the same time. Win-win. The customer gets a lower price, and we get higher margins on the job. Beautiful!”
Look again at the example job, Job 100:
You can see that the revenue went down $500, reflecting the discount you gave to your customer.
The problem here is that, while your cost accounting based pricing system is leading you to believe the job is now more profitable, you have just in fact negatively affected the profitability of your shop by giving a discount. That’s because cost accounting contains misleading metrics.
You see, you’re already earning a certain margin today, given your current pricing. And, when you update your estimates to account for the new machine, any lowering of the price lowers the margin dollars that come into your business.
However, this does not change the number of employees in your shop, the wages they are paid, nor any of the overheads (and in fact, the new machine has likely increased your costs in the form of depreciation and maintenance).
The net effect is that you MUST take on more work and know how to increase sales to fill the void caused by these lower prices. A second alternative is to reduce manufacturing overhead costs, which is very difficult to do. Other wise, you’re back to square one, needing to increase productivity.
Cost accounting simply does not work.
So, while the machine is brand new and more capable, many shops find themselves in the exact same position they were in prior to buying the machine a few months earlier: Working extremely hard to hardly make any money – all because they are making this pricing mistake and giving away their productivity improvements in the form of lower prices.
If you’re interested to learn more about this problem and how you can prevent it from hurting your bottom-line, check out our new 5-minute video on the subject below:
Pricing Mistake Number 2 – Negotiating with Yourself
Negotiating with yourself means you are conflicted about what price to charge and lack confidence in your quoted prices. Thus, no matter what method is used to determine a quoted priced, there is always uncertainty and anxiety related to the pricing.
How do you negotiate with yourself, effectively?
The most effective way to negotiate with yourself is to avoid the negotiation altogether. Simply having confidence in your pricing allows you to stop the negotiating process in your mind.
How do I stop negotiating with myself?
To stop negotiating with yourself, you need to develop a pricing system that you have confidence in. Notice we said PRICING system – it’s anything BUT a system built on cost accounting. A pricing system is a system that tells you the price you need in order to be profitable and it also will show you where and how you can improve the profitability of your jobs, products, and/or services – in addition to the profitability of the entire company.
Watch the video below to see how we think about negotiating with yourself:
How do you communicate with customers pricing?
How you communicate with customers on pricing depends on the situation you’re faced with. If you are in a very technical environment, it may be best to document technical details in an email that you send to the customer and follow the email up with a call. Alternatively, if you’re processing a routine order, a simple confirmation email might suffice.
Additionally, don’t be reluctant to pick up the phone and call the customer. This can be one of the best pricing communication methods as it allows for a very rich communication that you can draw a lot of information from. If there’s confusion, lack of clarity, or multiple email chains in everyone’s inbox, it’s often best to simply pick the phone and have a conversation with your customer.
What do you want to communicate with your pricing strategy?
There are several items you need to communicate with your pricing strategy:
- Your market position.
- The service level you provide.
- The value of service(s) you are providing.
- The terms and conditions under which you’re willing to accept work.
- The mix of business you prefer.
Oftentimes pricing is simply viewed a the result of a mathematical formula and is devoid of strategic thinking. This approach is inadequate with regard to pricing communications.
Pricing should be viewed as a tool, not a formula. Yes formulas are involved, but there’s more to pricing than just the formulas. For example, if there is a type of customer or job that you do not like to work with, if you strategically raise prices on these customers and/or jobs, you can limit you exposure to these customers and/or jobs – unless they’re willing to pay prices which are acceptable to you.
Watch the video below to see how we think pricing communications should really work:
How do I know if my estimators are correct?
The quotes prepared by estimators are subject to numerous inputs, assumptions, beliefs, tools, rules of thumb, and other just plain guesses. Odds are your estimators, despite doing what they feel is best, are likely incorrect in their estimates.
A common mistake that many estimators have are incorrect or broken formulas in the Excel sheet they’re using. Thus, before even getting into the details of any particular quote, it’s not uncommon due to Excel errors to have an estimate be completely incorrect.
Furthermore, many estimators quote in such a way as to increase material yield. While that’s nice, when it is appropriate to do so, optimizing on material yield is not the same as optimizing on profitability. Many times we find in working with clients that the estimators’ assumptions are totally incorrect, are optimizing on a ‘local optima’ (e.g. material utilization vs profitability) and have left thousands of dollars on the table for our clients.
How can I ensure the estimators are correct?
The best way to ensure that your estimators are correct is to compare their estimates to the actual results on a job or project. Now, if you’re using cost accounting, this can be an exercise in frustration because the measures of cost accounting are ineffective and unreliable. They simply don’t work and lead to conflict, confusion, and frustration.
That’s why we use a totally new measure in the Velocity Pricing System. It’s a measure that allows you to clearly see if your estimators, your operations, or another element of the process was the cause of lost profitability. This measure is simple, easy to use, and creates alignment across your entire organization, top to bottom. It’s called The Number…but more on it later.
Until there, here’s our video on Pricing Mistake #4: Trusting the Estimators:
What is considered an abusive customer?
Many times customers may become challenging, but occasionally they can cross the line and become abusive.
An abusive customer is one that does any of the following:
- Dictates onerous requirements to you.
- Is extremely demanding and unrelenting.
- Does not appreciate your hard work (Hint: appreciate = pays for).
- Believes they can set their own prices, terms, and conditions with you.
- May force you to expose your books, records, and other private information.
- Exert undue influence/control over your company and its operations.
How do you handle an abusive customer?
There are many tactics you can employ to help handle an abusive customer. The first tactic is simply to say, “No”. Saying “No” is a powerful tactic that can help you stop or prevent most abusive behaviors. Do not agree to their onerous requirements. Do not allow them to be demanding and unrelenting. Do not let them stretch terms and conditions. Simply saying “No” can prevent abusive practices from the outset of a relationship.
Another tactic to handle an abusive customer is to stand by your word by enforcing terms, conditions, and your expectations of how your customers should interact with you and your business. If a customer becomes abusive, then they’re acting in an unprofessional manner and it’s your responsibility to call them on their bad behavior, in a polite, professional, and appropriate manner.
Finally, you can watch out short video which gives you many insights into how you can deal with an abusive customer:
Do you have to honor a price mistake?
Now, what if you’ve already sent the quote out, and you realize you’ve just made this or other pricing mistakes? What options do you have? Well, there are several:
- Do nothing. Now, this isn’t the preferred choice, but nonetheless is a choice.
- Wait, and revise the pricing at a later date. The situation and needs may change, which could open the door to revisiting pricing.
- Admit your mistake, and revise the pricing now. You’re likely going to raise eyebrows and you might even cause a bit of stir, but at least you’ll have the pricing you want in front of the customer.
- Wait until more details about the order are known, such as the actual order quantity. Things may change and allow you the opportunity to revisit pricing.
What can be the impact of incorrect pricing of a product on the company?
The impact of incorrect pricing of a job, product, or service on a company is huge and cannot be understated. Pricing, is the one, single level, that when adjusted (either for good or for bad) will directly affect the net profit of a company.
That’s why we stress so much in the Velocity Pricing System how important it is to understand the real costs of jobs and your business, so that you can make informed decisions about pricing. Pricing is the single largest lever you can pull in your business to quickly generate more money and higher net profits.
How does pricing affect the business?
Pricing affects all aspects of the business. Pricing controls what jobs, products, and/or services you offer, the customers you work with, which market segments you cater to, and it also drives the strategy of how to best manage your operations. It affects everything. Pricing is the single largest lever in your business – one that can create tremendous wealth when done properly or one that can undermine all the effort in every other part of the business.