Setting Up Shop - Chapter 3: Setting the Price Right (PART I)
Original article published on LinkedIn on Apr 18th 2022.
Pricing, and more importantly, the right pricing is at the heart of every business. Today we will look at the different constituents of a P&L and how setting the price right can have a strong influence on your business' financial performance - positive or negative.
In a second article (Part II) we will look at the different pricing approaches that a business might take.
Bear in mind, the purpose of this article is to highlight what the different elements to be taken into account are, but it is in no way meant to give you advice on how to price your product or services.
In the first part of today's article we will look at all the elements of a P&L from Turnover all the way to NOPAT, and in the second section we will take a look at an example of the effect of price increase on GPNet in a fantasy craft beer business.
Section I: The different constituents of your P&L (top to bottom)
Let's get started down the rabbit hole!
Turnover
This is the amount that is payable according to the invoices you are issuing. The number on the invoice should cover all the expenses and profit margins achievable or desired. Even though this is the first item we are discussing, this is the end result of your P&L and pricing strategy. Turnover is also what comes into your bank account and represents inbound cash flow. Managing cash flow is a whole different topic and headache. Just to make things simple, your operational profit result and your cash flow aren't usually aligned.
Customer facing taxes and duties
The majority of countries have a VAT rate that varies according to the country or the business segment you are in. A good resource for VAT checking online is Avalara. You likely know all the impacting VAT for your business and your accountant should know them too.
Other consumer / customer facing taxes can be excise duty such as can be found in luxury products, alcoholic or tobacco products or other. From the government's point of view this is tax levied on your product to attenuate the effect of your business activity on certain important parameters to the greater public such as health or the environment. For example the consumer facing tax for cars in Croatia is two-fold: one is for luxury and the other is based on the impact the car has on the environment, which is usually linked to CO2 emissions.
Make sure you are well informed on the calculation of taxes as they are, usually, non-negotiable. They have to be part of your price, and if you miscalculated, you will still have to pay them out of your revenues. The government or its institutions won't feel sorry for you for miscalculating. In the Croatian example Excise Duty is taken as a basis for VAT calculation - these are important facts to know in order to calculate your final price correctly.
Gross Revenue
Ah! If there is a gross there must be a net? There is. But more on that later.
Gross Revenue represents the amount of money remaining in your bank account after you have accounted for the taxes discussed above. This is the line where you can start to have more influence on your P&L, because as discussed earlier, taxes are usually not negotiable, you have to account for them, however everything that sits below your Gross Revenue line is where you start to have influence.
Gross Revenue is also used as a benchmark to measure what proportion of your P&L is used to finance which activity. It is all fine to spend 100.000 EUR on marketing investments at the customer's stores and to pay a transaction fee of 12.000 EUR on a Gross Revenue of 3.000.000 EUR, however when you express these as a percentage of Gross Revenue, the discussions start to become more meaningful and allows you to compare your different products like for like.
Discounts to Customers / Cost to Sell
Next up in our line of terms to be familiar with is Discounts to Customers or Cost to Sell, depending on the industry you are working in. If you are selling via major retailers, all kinds of discounts you are giving them, investments in marketing on their side for your brand or service, etc... sit here.
If you aren't in the FMCG business any type of referral fees you might be paying your distributor or sales channel are booked here as well. If you are running a restaurant and you are also selling via delivery service providers, their fees should be booked into the Cost to Sell line.
If you are selling via popular e-commerce portals, their fees are also to be booked here. Same goes for payment service providers.
These are all costs that you are paying as a business to have your product sold. You could also include logistics expenses here if you want to, however this could make things more difficult to measure later on.
Net Revenue
This is how much is left to you after you've sold your product. This is also how much is left to you to pay for everything else. And there is a lot left to finance still!
COGS (Cost of Goods Sold) / Cost to Produce
Everything that you sell needs to be created. If you are selling a physical product you will include here the cost of all raw materials used to make it, the cost of time of the people (or you) making it, any directly linked utilities costs.
In principle depreciation costs of all machinery used to create a product should be booked here, however approaches differ and sometimes they won't be booked here but will be in the depreciation line (there may be many reasons why it is so, but this could be a topic for another day - ultimately you will still spend the money for the depreciation, so in terms of how much cash is available to you it doesn't matter!)
If you are selling a service or a media product, again all costs that you incur should be booked here. In case you are selling an online course and have had to use different services to have it produced that are directly linked to its production, you will book them here. These don't include software licences! (those are a fixed cost).
LOGS (Logistics of Goods Sold) / Cost to Ship
Producing a great product is fantastic, but unless it is placed where the buyer can see it, it doesn't matter. Here you will book any costs directly linked to shipping the product to its ultimate place of sale or costs linked to shipping the product directly to the customer in case you are selling directly to the customer.
Gross Profit
By the time we've arrived here it's a good time to take a breather and see how we are doing. Not just from an article length point of view, but also as a business.
Gross Profit represents how much income is left over to fund your business after you have produced your product, shipped it and sold it. Now hopefully there is money left. If here you get into negative numbers it is time to really look hard into every single cost line above Gross Profit to see if there is anywhere that you are leaking income. As mentioned earlier, everything under the Gross Revenue line is under your influence and can be changed either by renegotiating terms, finding a less expensive sales channel or shipment method, or other component.
The amount of Gross Profit or Gross Profit Margin (GP as %GRev) you are making depends on your industry, and should be healthy for your segment of your industry.
Marketing Expenses (ATL, BTL, whichever... it's all marketing!)
Ah... An old favourite of mine. In times of crisis in big companies usually the first one to go into savings, but when asked why we aren't growing again "people" tend to forget that the marketing budget was cut to make the results last quarter.
In the marketing expenses you will book all costs related to telling people about your great product or service (SEO, SEM, Social media, TV, OOH, Print, Sponsorships, Communication and Creative Agencies expenses). Every single cost that you incur to let people know about your product, anywhere, is booked here.
Gross Profit Net
This one is simpler, it is just Gross Profit reduced by your Marketing Expenses. For those who have been following, you will notice that we still haven't discussed getting paid ourselves! And we still aren't there.
Gross Profit Net is the best place in the P&L (in my view) to measure the financial health of your product. By the time you come to Gross Profit Net you have accounted for all the variable costs in your P&L that are linked to the sale of your product. This is important due to the fact that if you are running a business with multiple products or services (and we all are), this is where they all equal out (if that is a verb?) and at the Gross Profit Net line we measure how much each of those products or services is contributing to financing the fixed costs of your operation.
Overhead costs / Fixed expenses
This part here is quite a bucket that fits all types of costs.
HR costs such as salaries, trainings, compensations and benefits will be booked here. IT costs such as software licences will be booked here too. The monthly rent costs for your office or production location will also be here. The costs of your shops rental, and the list goes on.
This is where you get paid your regular salary, so you better make sure that there are some resources left by the time you come to this line.
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation)
EBITDA is one of the key measure of financial success of a company and can be used a valuation line by investors or banks to grant you an investment or loan. This is also a very good measure to compare companies on an international level as every country has different tax levels.
Depreciation and Amortisation
To make things simple accounting principles provide for the fact that some expenses are not expenses, but rather investments into assets that allow us to create future value, which aren't written off at the time of purchase, but lose value over time as they are being used to create new value. (I made this as simple as possible. Also please have in mind I am not a finance person, looking forward to any corrections!)
This is also where operational profit and cash flow start going their own way big times. What do I mean by this? Last year when I started my company I bought myself a laptop. At the store I paid the full invoice (turnover value of the store) and the cash left the account of my company that day. Since I've had the laptop for 16 months now approximately only 30% of its value has been depreciated by now (booked as a cost).
Personal rant: The net effect of this to my entrepreneurial pocket is that I have had to pay corporate income tax that had only 25% of the laptop costs accounted for in Year 1 and ate away at my cash flow. What a nightmare for Year 1! However when Year 4 comes around and the laptop is fully depreciated the cash part will net itself out, however as a business you have to make it until Year 4!
EBIT (Earnings Before Interest and Taxes)
This one is quite simple: EBITDA - DA = EBIT.
When looking at companies this line is quite important too as it will show you how much earning potential there is. Sometimes some companies will show EBITDA because they are heavy in DA and will show a better result.
As a budding entrepreneur, the differences won't matter much to you initially, however when you go to the bank for the loan we mentioned or when you will be meeting investors it is good to understand the differences so that you are more ready for the investment negotiations.
If you will be paying yourself out dividends (which are in principle cheaper personal earnings than paying yourself a salary) this is the amount that you can pay yourself out. And you can pay it out whenever you want in later years, it just depends how much cash you have in the bank.
Interest and Taxes
As the name says, this is where the business pays interests on loans and taxes.
NOPAT (Net Operating Profit After Taxes)
This is the financial result that is left in the business after everything (almost!) has been paid and accounted for. As you can see we are quite deep in the rabbit hole by now, and not a lot is left from the initial Turnover line. NOPAT is often looked at by investors as a key line that tells them how much is really left in the business and is the best measure of their return on investment.
Another cost element that hasn't been covered are one-off costs. EBITDA, EBIT, NOPAT are all parameters in the P&L that represent a "usual" business year. One-offs can be expenses that are accrued for but aren't viewed by the business as regular business. They impact cash, but not the direct health of the day to day business. These are litigation costs, restructuring costs or any other cost that aren't the day to day business. Also cash can be recouped via loans and impact the Balance Sheet of an organisation, but not its P&L (apart from Interests).
Section II: Setting the right price
There is an old game show "The Price is Right" which some readers may know of (just goes to show my own age...). The premise of the show was that people had to guess what the price of a specific item was in order to gain points.
The idea of the show actually points to a very relevant dimension in pricing strategy and that is setting the price at what the user / consumer / buyer is willing to pay for it. Pricing strategies aren't the topic of this article, however it does draw the point that we have to know what people would be willing to pay for our offer. Price it too high and it won't move, price it too low and you are leaving revenues on the table.
More importantly, pricing too low can drive your business into negative profit territory very fast.
Imagine a scenario where you are running a craft beer brewery and you have just finalised your first study of consumer willingness to pay for beer in your segment. Currently your beer is priced at 8,99 HRK per 50cl returnable bottle, because you had no idea what people would be willing to pay and the price seemed like the right psychological price point. Below we can see an example of your bottle's P&L until Gross Profit Net.
You are making an OK-ish GPNet margin of 32% vs Gross Revenue. You know however that you need to finance two more lagering tanks and the final amount your are making per year is cutting it just. You either have the choice to drive more volume (which means more investment into the market) to increase your absolute profitability, or you could increase price.
Thankfully you have just finalised the piece of market research discussed above and one of the key takeouts is that people are willing to pay up 9,64 HRK for a beer in your category and given the appreciation of your brand it seems like you could push the price up a little.
The scenarios for GPNet increase would look like so:
According to the analysis and the piece of market research you could increase your price by 6,7% from 8,99 HRK to 9,59 HRK and increase your GPNet by a tremendous 11,2% without too much volume impact. This would put you well in the clear to finance the two lagering tanks.
In practice, it is easier to increase the price on the shelf than to try to drive your volume or market share up by the equivalent amount. It is of course not as simple as stated here, it is a fine balancing act, but it goes to show that managing your price and volume sold well and controlling your costs can steer you in the right direction.
This also goes the other way: lose control of your costs and watch your profitability disintegrate.
Looking forward to reading your thoughts and comments on the topic. In Part II we will cover the different pricing approaches and strategies.
Until then - Price it Right!