Part 2: Pricing with Profit Margin

Purple Elephant Bookkeeping
Jan 21
3 min read

Welcome back to our series on setting the right price for your product. Last week, we dived into Cost-Plus Pricing, exploring how adding a markup to your costs can help cover expenses and achieve profitability. This week, we’ll focus on Profit Margin Pricing—a strategy that offers greater flexibility and can align more closely with your financial goals and market dynamics.

Understanding Profit Margin Pricing

Profit Margin Pricing goes beyond simply covering your costs. It focuses on achieving a specific profit margin, ensuring that every sale contributes meaningfully to your bottom line. Unlike Cost-Plus Pricing, which adds a fixed markup, Profit Margin Pricing considers both your costs and the percentage of profit you aim to retain from each sale.

Why Choose Profit Margin Pricing?

Flexibility in the Market: Profit Margin Pricing allows you to adjust your prices based on market conditions, competitor actions, and changes in consumer behavior. This adaptability helps you stay competitive without compromising your profitability.
Alignment with Business Goals: By setting a target profit margin, you ensure that your pricing strategy directly supports your financial objectives, whether that's reinvesting in the business, expanding your product line, or increasing your savings.
Better Financial Planning: Understanding your desired profit margins aids in more accurate financial forecasting and budgeting, providing a clearer picture of your business’s financial health.

How Profit Margin Pricing Works

Let’s revisit our candle store example to illustrate Profit Margin Pricing.

Retail Price = Total Cost per Candle / (1 - Desired Profit Margin)

Retail Price = $19.50 / (1 - 0.50) = $19.50 / 0.50 = $39.00

In this scenario, to achieve a 50% profit margin, the candle store should price each candle at $39.00.

This means half of the sale price is profit after covering all costs.

Comparing Cost-Plus and Profit Margin Pricing

While Cost-Plus Pricing is straightforward, Profit Margin Pricing offers a strategic advantage by directly tying your prices to your profit goals. Here’s a quick comparison:

Aspect	Cost-Plus Pricing	Profit Margin Pricing
Basis	Adds a fixed markup to costs	Sets price based on desired profit margin
Flexibility	Less adaptable to market changes	More adaptable and responsive
Profit Alignment	Indirectly aligns with profit goals	Directly aligns with profit goals
Complexity	Simpler to calculate	Requires understanding of margin targets

Practical Considerations

Market Research: Understand what your customers are willing to pay and how your prices compare to competitors. Profit Margin Pricing requires balancing your desired margins with market expectations.
Cost Accuracy: Make sure all direct and indirect costs are accurately calculated. Inaccurate cost assessments can lead to pricing that either erodes your margins or makes your products uncompetitive.
Scalability: As your business grows, revisit your pricing strategy to make sure it continues to meet your profit objectives in changing market conditions.

Example Scenario: Fluctuating Sales Volume

Let’s see how Profit Margin Pricing handles different sales volumes using our candle store:

Scenario 1: Selling 500 Candles

Total Cost per Candle: $19.50
Desired Profit Margin: 50%
Retail Price= $19.50 / (1 - 0.50) = $39.00

Scenario 2: Selling 250 Candles

Indirect Cost per Candle: Increases to $24
Total Cost per Candle: $5.50 (direct) + $24 (indirect) = $29.50
Desired Profit Margin: 50%
Retail Price= $29.50 / (1 - 0.50) = $59.00

With Profit Margin Pricing, when sales volume drops to 250 candles, the retail price should increase to $59.00 to maintain the 50% profit margin. While this ensures profitability, it highlights the challenge of maintaining customer satisfaction with significant price hikes.

Balancing Profit Margins and Customer Expectations

To mitigate drastic price changes, consider the following strategies:

Volume Discounts: Encourage larger purchases by offering discounts for bulk orders, balancing higher prices with increased sales volume.
Cost Management: Continuously seek ways to reduce both direct and indirect costs without compromising quality.
Value Addition: Enhance your product’s perceived value through superior quality, unique features, or exceptional customer service, justifying higher prices.