No one likes to increase prices. It requires difficult discussions with customers and the risk of losing a few of them. But if you’ve been avoiding price increases, you’re hurting the value of your business. You need to be strategic about your pricing, especially if you’re considering selling your company within the next couple of years.
Here’s why. The value of your business to a buyer is based on the cash flow of the business. The M&A industry uses substitutes for cash flow such as adjusted EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization), or for smaller businesses, SDE (Seller’s Discretionary Earnings.) While these aren’t perfect substitutes for cash flow, they provide a relatively quick and easy figure to compare one business against another. It’s the bottom line that a new owner can expect to make each year after he takes over your business. And it’s a zero-sum game, especially for manufacturers or other brick and mortar businesses. You have to purchase materials, ship products, operate a facility, and purchase and maintain equipment. When the cost of all of that goes up, your profit margins go down.
Inflation has increased costs by at least 8 – 9% over the past two years. If your customers are not paying more to offset your costs, your margins may have been cut in half. You may be able to get by on that for a while, but investors and buyers will be looking at year-over-year financial trends, and yours will not look healthy.
How to decide how much to raise your pricing.
The best way to manage price increases is to do what you do best: put a system in place that’s analytical and updated at regular intervals. You have the information you need to understand the cost of everything for your business and how it’s changed over the past couple of years. Materials, labor, shipping, maintenance, rent and utilities – put them all together in one file so you can see the total impact on your business. You might be surprised when you see them side by side, year by year. You can probably also predict what you’ll be paying next year, if your vendors are systematic about their price increases. All of this data will help you forecast what you should be charging to stay profitable.
But here’s the step many owners skip: you should increase prices not just enough to cover costs, but enough to cover your costs plus margin. That’s the way to keep your profitability stable. So if the cost of producing your product has gone up by $6.00 and your profit margin target is 15%, you should raise your pricing $6.00 plus 15% ($6.90). If not, your profit margins will be declining year over year which is not great for you or for your future Buyer.
If you’re playing catch up with pricing, you’ll probably need to ask for a significant increase. That’s all the more reason to do an annual review and forecast. It’s easier to ask for a small percentage each year than to ask for a large increase every three years. Your customers will appreciate the predictability and experience less sticker shock with an annual price increase.
Don’t forget that you may be able to offset some of your costs with efficiency. Take a look at your operation at the same time you look at your costs. If you can cut the cost of production by improving your processes, you’ll be able to save your customers some money. Improving efficiency will also increase the value of your business in the long run, so the investment will pay off in more ways than one.
It’s natural to worry about losing customers.
Many owners worry about losing customers. Here’s the reality: if you’ve been producing a quality product and treating your customers well, you’ll lose only those who can’t – or won’t – pay more. That is one way of figuring out who your best customers are and which you can afford to let go. If you have a good marketing system in place, you’ll have the option of replacing those customers with others who are financially stronger. (If you don’t have a good marketing system, you should develop one. Then you won’t have to worry that losing a couple of customers will put your company in jeopardy.)
There are several other factors you’ll need to consider in addition to your own costs, of course. You’ll need to understand your market and industry standards. If you’re already at the top of your market in pricing, you won’t have as much room to go up. But any way you look at it, this is the right time to do it; your customers are all experiencing the same cost increases, so they’ll understand why you have to take this step.
How to do it right
Good customer communication is crucial to customer retention. Write a letter or email that lays out the case for your price increase. First, thank them for their business – let them know you value and appreciate them. Then, explain the factors that have gone into the difficult decision to increase prices. Explain how and where costs have increased significantly. Give them a date when the prices will increase and time to adjust their budgets. Invite them to ask for more information if they need it.
This is also a good time to offer something that will make the customer’s experience better. Faster shipping, an improved ordering process, expanded customer service – if you’ve been planning to improve something, announcing the good news with the bad news will help your customers decide to stay with you.
Your bottom line is the bottom line.
I realize this may sound overly simplistic in theory and is a much bigger decision in reality. However, proper pricing is extremely important to the health of any business, and we run into many owners that have been very passive with their pricing strategy for years. As a consumer, I hate paying higher prices just like everyone else, but I understand costs do go up and business transactions have to be a win-win for both parties. You may lose a few customers, and you may have to listen to some unpleasant feedback. But in the end, you’re in business to make a profit. If you’ve done your homework and know what it will take to stay in business and stay profitable, you’ll be doing the right thing for your employees, your company, and your future.
If you’re unsure where to begin, start with getting involved in joining an association relevant to your industry.
