Pricing Policy and Pricing Index

In its most basic form, a good pricing policy is simply about maintaining your gross profit margin. Every business needs to operate at a particular gross profit margin. This covers costs of goods sold and operating expenses and leaves a net income that supports increasing sustainable cash flow.

Maintaining that specific margin is part of your brand identity, whether you know it or not. If your gross profit margin cannot be maintained, what is happening to the business’s brand value? The more your gross profit margin declines the more the service or product is becoming a commodity, priced accordingly.

How Does a Pricing Policy Work?

Your pricing policy starts with a number called the pricing index. This index is calculated by dividing revenue by the combination of your cost of goods sold (COGS) or costs of revenues. When this index increases, so does the gross profit margin, and vice versa. In other words, a higher pricing index means a higher gross profit margin and a higher gross profit margin means better cash flow.

The direct effect this index has on pricing can be found by multiplying the percentage change in the index by the percentage proportion COGS are to total annual revenues. This final figure is the overall pricing change in revenues.

For many companies it would be impossible to add up all widgets produced, compare that to the prior year, and know how much additional volume was produced. This task can be daunting for even well organized firms, so this pricing method is used to ferret out implied price increases or decreases in revenues due to changes in the COGS year by year.

The point here is to show that good performance at a given gross profit margin does not mean that this margin is ideal. We need to look at how strong the real revenue growth is and how strong the revenues are compared to seasonally adjusted revenues (all businesses have seasonality in their revenue change).

Monthly revenue seasonality should be calculated and updated every year when management does the budget planning for the year. If real revenues are growing strong and monthly revenues are outperforming the budget, increasing prices is a logical move to make because the brand is now in demand.

At this stage, management may say, “Why change prices at all when everything is going just fine?” Here’s why:

• The required gross profit margin may have been set lower than what would be acceptable to the overall client or customer base, meaning money left on the table.
• When the company under-prices its product or allows the required gross profit margin slide, the company is attracting a different type of customer than the company’s brand originally attracted or wants to attract now or in the future.

Preserving and adjusting your gross profit margin through your pricing policy keeps your brand strong and your cash flow healthy.

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