In business, it isn’t uncommon for executives, stakeholders, and investors to focus on top-line numbers, such as revenue and sales growth. While these are important numbers to monitor and understand, they tell you little about your company's profitability. After all, your company can bring in millions of dollars in revenue each year and still be unprofitable.
Profit margin, on the other hand, is a direct measure of how much profit your business has generated during a reporting period. As such, it’s a financial metric that many business leaders focus their efforts on improving.
Below is an overview of what profit margin is and how it’s calculated, along with a look at how you can use a value-based pricing strategy to improve your company’s profitability.
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What Is Profit Margin?
Profit margin is the level of profit that a company has captured or kept from the revenue it’s generated from business activities. It’s typically depicted as a percentage and, for that reason, is often referred to as a “profitability ratio.”
There are multiple profit margin types, each of which is calculated in slightly different ways to tell a different story. While this article is focused on strategies you can use to improve gross profit margin, it’s essential to be familiar with the other types:
- Gross profit margin is most often used as a profitability measure for a specific product or item line and doesn’t account for overhead, interest, or taxes. It’s typically calculated by subtracting the cost of sales from the total revenue generated by the product line, then dividing that figure by the revenue.
- Operating profit margin is used to measure how much profit is left after a company subtracts its operating costs (also called overhead) from its gross profits. It’s calculated by subtracting overhead from the company’s gross profit, then dividing it by the revenue. The resulting figure represents how much money the company made that can be leveraged for its ongoing operations.
- Pretax profit margin, as its name suggests, is a measure of a business’s profit level on a pretax basis. It’s calculated by subtracting the company’s interest expenses from its operating profit (and/or adding any interest profits), then dividing that number by the revenue. It doesn’t account for tax expenses.
- Net profit margin measures how much profit remains after taxes are accounted for. As such, it offers the most accurate insight into a company’s profitability.
Related: Cash Flow vs. Profit Margin: What’s the Difference?
What Is a Value-Based Pricing Strategy?
A value-based pricing strategy is a specific method companies use to price goods or services. It’s sometimes known as “customer-focused pricing.”
Companies that follow this strategy base their prices on customers’ perceived value of whatever is being sold. When the customer perceives that a product or service has a high value, the company can charge more for it without fear of potentially alienating the buyer. When a customer perceives that a product or service has a low value, however, the amount the company can charge is constrained.
Companies that pursue a value-based pricing strategy must, therefore, have a firm understanding of their customers’ willingness to pay for their product or service, as well as their suppliers’ willingness to sell (WTS) the goods or components required to make those products. These data points are often compiled in a graphic known as a value stick, which depicts the total value of a product or service as it’s split between a company, its suppliers, and its customers.
Related: 5 Economics Skills All Managers Need
How to Increase Profit Margins with a Value-Based Pricing Strategy
As explained, gross profit margin is calculated by taking the revenue generated by a product’s sales, subtracting the cost of goods sold, then dividing the resulting number by the revenue. This formula demonstrates that there are two ways to increase your level of profit: You can increase revenue or decrease costs (or pursue a combination of both).
1. Increase Revenue by Increasing Customers’ Willingness to Pay
Willingness to pay is the maximum amount a customer is willing to pay for a product or service. It’s typically tied to the perceived value of whatever is being purchased.
When a company sells a product or service to a customer, the value is effectively split between the company and the customer. The value that the customer receives can be measured as the difference between their willingness to pay and the price charged, while the value that the company receives can be measured as the difference between the price it charges and the cost of producing the product.
By increasing your customers’ willingness to pay for your products or services, you can raise your prices without reducing your customers’ excitement about purchasing. This enables you to boost revenue and enjoy a greater profit margin while driving customer satisfaction.
There are many tactics you can use to increase your customers’ willingness to pay. You might, for instance:
- Add features or functionality to your product that your competition doesn’t include
- Redesign your product to be more aesthetically pleasing and distinct
- Leverage luxury components that can establish the good as a status symbol
- Construct the product according to standards (such as environmental or fair-trade regulations) that customers are willing to pay a premium for
The goal is to increase your customers’ perceived value of whatever it is you’re selling to a level that allows you to increase your prices without diminishing their excitement for the purchase.
2. Decrease Costs by Lowering Suppliers’ Willingness to Sell
Willingness to sell, also known as “willingness to accept,” is the lowest price your suppliers are willing to accept in exchange for the product or service they’re providing.
When your suppliers agree to sell a product, component, or service, they’re motivated to charge as much as possible to maximize profits. Your company, on the other hand, is motivated to reduce expenses to preserve value and share more equitably with end customers while still making a profit.
By lowering your suppliers’ willingness to sell, you can decrease your costs, enabling you to improve your profit margins without raising your prices or closing more sales.
While it can be more difficult to lower your suppliers’ willingness to sell than increasing your customers’ willingness to pay, some strategies for doing so might include:
- Purchasing components or products in bulk: This enables a supplier to lower its price on a per-piece basis because it enjoys greater overall revenue from the increased volume.
- Committing to future contracts: A supplier may be willing to reduce its prices if you ensure you’ll be a reliable source of business in the future.
- Think of your employees as suppliers: Would your employees be willing to work for less money in the form of salary and wages if you provided them with other forms of compensation—for example, more vacation time, the ability to work remotely, or equity options?
Increasing Value for All Parties
The benefit of leveraging value-based pricing to increase your profit margin is potentially threefold.
While higher margins can benefit your business, you need to provide greater value to your customers to increase their willingness to pay (and, in turn, your prices). This value can go far in promoting customer loyalty and referrals.
Similarly, you need to offer your suppliers’ additional value to lower their willingness to sell. Doing so can establish your firm as a preferred account and lead to increased collaboration.
Ready to learn more about pricing strategy, innovation, and other key concepts that can drive your business to new heights? Explore our online Strategy courses and download the free flowchart to determine which is the best fit for you and your goals.
