As you read the title to this article, you may have scoffed thinking that reducing your prices to increase profits is a ridiculous concept. However, in certain situations, it’s absolutely true.
The technique is called incremental pricing and if your supply chain business is in a cyclical industry or otherwise has times when operations are at less than normal capacity, it may help you increase your profits.
Normally, many businesses calculate their selling prices as markups on the costs that go into their products. Materials, labor, and overhead are usually the costs included. If the company is operating at or near normal capacity, then the costing should include all of the costs going into the product plus an allocation of enough overhead to ensure that all of those costs have been absorbed by the end of the year. However, when the company has unused capacity, this same approach could result in lost opportunities, especially if competitors also need work and are aggressively pricing. In this situation, incremental pricing can provide you with a significant advantage.
Here is how incremental pricing works
When you have an opportunity for new business at a time when there is capacity and you suspect there will be tough competition for the work, start by identifying all of the costs that will go directly into the product. Exclude any overhead or other costs that aren’t direct costs. Once you have arrived at all of the direct costs, you have now determined what your minimum selling price is. Anything less than that would cause you to actually lose money on the product. Note the amount you can sell the product for (or incrementally price) in excess of the minimum is contributing to covering your overhead. It may seem to be a confusing concept at first, but if you were to not incrementally price, you may not have gotten the sale at all. In that situation, you would not have gotten contribution toward overhead.
Here are a couple things to keep in mind
- Only use incremental pricing when you have excess capacity. You don’t want to have to pass up higher margin work due to using up your capacity on incrementally priced work.
- It’s critical to understand the costs that go into your product. If you miss some direct costs, you may underprice your product resulting in lower than expected profits.
If you have questions or would like to learn more about incremental pricing, contact Mike Steinl.