Gross Margin Is Almost Always Irrelevant in Pricing
If you’re a regular reader or a pricing aficionado (aren’t we all?) then you already know that costs are ALMOST always irrelevant to pricing. The single most important driver in pricing is what your buyers are willing to pay.
Your buyers don’t care what your product costs to make. They only decide if the value they receive is more than the price you charge. Many B2B companies use a direct sales force to negotiate individual deals. Hopefully these salespeople are determining the most a buyer is willing to pay. The only question for the company that is relevant to costs is: “Do we want to accept this piece of business?”
However, there are markets where costs do matter in pricing. These are called TIOLI markets, where TIOLI stands for Take It or Leave It. For example, potato chips at the grocery store is a TIOLI market. The vendor sets a single price and buyers choose to buy at that price or not. Buyers do not negotiate.
Costs matter in TIOLI markets. Imagine the cost to a vendor for a bag of chips is $2.88 and he sells them for $2.89. The vendor makes 1 cent per bag. Now if the vendor raises the price to $2.99, he will probably sell fewer bags but will make 11 cents per bag. The vendor could lose 91 percent of his volume and still make more profit. Obviously, this is an exaggeration, but it clearly demonstrates that costs matter in TIOLI markets.
But the costs that really matter are only variable costs. Fixed costs are completely irrelevant to pricing. Fixed costs only matter as to whether or not you want to be in that business. When you sell at the optimal price, will you make enough margin to cover your fixed costs plus a profit?
Finally, we can get to the title of this blog, gross margin is ALWAYS irrelevant to pricing. Gross margin is an accounting term that talks about total costs of sales, including allocated fixed costs. But fixed costs never matter to pricing, so gross margin is the wrong measure.
Instead, use contribution margin when calculating your optimal price. Contribution margin is defined as the price minus the variable costs only. The perfect measure.
There is one use for gross margin in pricing. I do not recommend sharing margin (or cost) information with salespeople, but if you must, share gross margin not contribution margin. Seeing a higher cost will prompt them to sell at higher prices.
To summarize, here are the rules on costs and pricing:
- Costs don’t drive pricing. Willingness to pay drives pricing.
- Fixed costs never matter to pricing.
- Gross margin never matters to pricing.
- Variable costs matter to pricing in TIOLI markets.
- If variable costs matter, use contribution margin.
These are all true. The challenge will be getting your CFO to adopt them. Good luck.
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