Does It Pay to Cut Prices?

With everybody from Starbucks to Apple cutting prices during the recession, it's little wonder that small businesses are feeling pricing pressure, too.

But, if your business needs a pick-me-up, does it really make sense to cut prices or offer discounts at a time when your customers may not be in the mood to buy? Before you pull the trigger on your pricing gun, step back and ask yourself these questions:

• Do you know how much money you make on every sale?

Most businesses focus on two metrics--sales and bottom-line profits--to gauge their financial success. By contrast, gross margin--the ratio of gross profit to revenue--measures your company's efficiency in turning raw materials into sales. Think of it like this: For every $1 of sales that your company rings up, how much money do you have left over after buying the materials and other supplies necessary to make your product or provide your service? If the answer is 50 cents, your gross margin is 50 percent. If your prices aren't high enough to allow you to maintain at least a 20 percent gross margin on every sale, it's unlikely that your business is going to be able to clear much of a profit after you subtract rent, payroll, insurance and other fixed expenses.

• Do you have "people costs" you need to cover?

Just because you've got a gross margin of 50 percent doesn't necessarily mean that you're making a healthy profit. That's why your pricing needs to reflect your total cost of doing business (not just your cost of goods sold), which, in many cases, can be much higher. Don't forget to factor in the "people" costs--the admins, sales reps, production staff, contractors, etc. who do the work that makes your company tick. Before you cut your prices, remember that you need to pay these people, too!

• Do you need to pay to bring business in the door?

If you run a restaurant or retail store, customers walk in the door and you don't have to worry about paying for sales leads and referrals. But that isn't true of a manufacturing or service business in which small businesses without their own sales force rely on the Internet or on independent reps or agents to bring them customers and orders. Depending on the industry, these reps can charge commissions as high as 20 percent on every sale. Web traffic isn't cheap, either. That's why, if you need to rely on third parties to help sell your product or service, it's important to build in enough margin to maintain a distribution network and still make a profit.

The bottom line: If you've got a good relationship with your customers and sell a specialized product or service that the market wants and needs, you should try to find a way to hold the line on prices without losing business--and build a solid foundation for your company's future. If not, it may be time to go back to Starbucks for a $2 cup of Joe.

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