Gross profit margin (GP%) has been a key accounting figure widely employed across many organizations for various purposes, including in pricing. Originally often employed in cost-based pricing, GP% can be rather misleading in Value-Pricing. This is particularly the case when innovation and value are associated with any GP% requirements. Other key figures such as value/price ratio are more appropriate to use. GP% should be reserved for its original purpose as an accounting figure when it comes to assessing the minimum profitability of business ventures.
GP% as a key measure of profitability
Gross profit margin or GP% is one of the most relevant figures in accounting. GP% as the realized gross profit share of revenues has been closely monitored and often used as a benchmark across organizations for various purposes, be it at company, business unit, geographic market area or at product category level. It finds use in monitoring the profitability of a deal, a customer, a product hierarchy or sometimes even at the single line-item level.
GP% calculation is mostly based on the manufacturing costs as well as any transfer costs that occur prior to a product reaching the selling organization of a company. As such, GP% is not the ultimate truth of profitability as more costs will need to be deducted for selling and shipping the product to the customer, for administration and handling associated with the selling organization, etc. – costs usually known under the term “Selling and General Administration Costs.” Hence, the net profit would be a more precise number. However, for benchmarking purposes net profit is of less use as the SGA can vary significantly across markets and product categories, thereby somewhat diluting the purpose of comparing. Plus, SGAs are much more difficult to assess than standard costs, and they usually require some re-allocations on the basis of headcount, revenue, etc. In short, accountants and managers are very fond of GP% as a reliable number and benchmark in controlling activities. They often operate and manage along this figure. Nothing bad about that: GP% is a useful accounting number! However, when it comes to pricing, the figure can be highly misleading and even provide the wrong basis for decisions.
Customers don’t care about your profitability
Everybody would agree that a customer sees and considers mainly two aspects of a transaction: the value that is in it for him, and the price he has to pay in return for that value. What a customer does not see is your profit (which is good!), and he even does not need to care about it. Hence, profitability is an entirely internal view that you need to take on your business, and especially at the GP% level. If you are able to reduce your manufacturing costs, that could give you a better profitability or put you at some advantage and give you more flexibility in pricing, especially if you are in a tight, commoditized market. This is important for you and your organization, but it will not bother the customer or anyhow change his decision to buy or not to buy with you. Value and price, however, will make a difference!
Another benchmark for the customer might be the existing market prices, where performance of products and services, possibly also outcomes on the customer`s own business, will be evaluated across the potential suppliers. Here again, it`s value and price that drive decisions. While value can be assessed and benchmarked by the customer, the price will undergo a competition between different sets of values and prices. For example, low but acceptable value combines with a cheap price, more value with a higher price, etc. Customers will usually have a choice and make a trade off and go for the best combination from their unique perspective and specific situation. Sellers would usually try to convince the customers that their offered combination is the best. At no point in this interaction would your GP% make any difference for the customer, and it shouldn’t. Should it make a difference for you to pursue or not pursue a deal? The answer is yes. Your deal needs to be profitable! Should it make a difference in how you price your products? No, it shouldn’t! Look at the following example:
GP% is completely disassociated from value
Imagine you are operating in an established market with a standard product A. Call it an industry standard product with a value index of 100%. Your product A sells competitively at $1 and you sell on an annual basis 100 units of this product. Your revenues will be $100. The COGS for this product amount to $0.5 per unit, after full optimization of operational efficiencies. Your GP$ will be accordingly at $50 or, in this simple case, the GP% will be equal to 50%. So far, so good.
Now, you are fond of innovation and you develop product B, a much more improved version of A, for which you establish that the value index of B would be 200% as it saves time, creates efficiencies and provides better outcomes for your customers. You established this perceived value professionally by diligent pricing research, applying conjoint analyses, fair-value line, van Westendorp, etc. With all the evidence available, you will have a sound case to convert your customers from A to B.
To reflect the value of B, you need to translate the value index into price, and hence, B could be priced in equilibrium at $2. After converting all your customers, you will still be selling 100 units, but your revenues will be now $200. The customers would be at even value with a double price and their total cost of ownership for B as they see savings in efficiencies, etc.
Table 1: Standard and superior product selling at same GP%
Now, there is a small problem. Your cost for product B stands at $1 per item, and so is twice as high as for A. This is because you added features and attributes to B, invested in manufacturing capabilities, etc. Thus, your GP% will be again at 50%. Looking at the GP% alone, it would not make sense to go ahead with product B as there is no improvement in that key number. But would you not go for it just because of the GP%? Of course, you would! You get twice the revenues, and maybe even more importantly, you get also twice the GP$, $100 vs $50! Besides that, you will have a good case for converting customers to a better product. Potentially, you may also be the first and only company to introduce an innovative product to the market that addresses and improves certain efficiencies, thereby setting new industry standards? And who knows? Maybe you will even grab some market share from your competitors! Well, if you base your pricing entirely on the GP% profitability of A and B, eventually and unfortunately you may miss out on this great opportunity and decide not to go for B as it shows no better gross profit margin.
GP% in pricing decisions will be misleading
Even if the above case demonstrates it, and some may think, yes, it is just common sense, be aware that the GP% trap is lurking out there! Yes, indeed, intuitively, one may think that a superior and much better product would also deserve better profitability because in the end, a company made investments and came up with something superior. So, why not ask for a better profitability at the GP% level? And then, how will you be sure about the conversion rate? Will you in the end achieve these revenues and GP$? Or maybe not? The “old” benchmark GP% could suddenly prevail over common sense as intuitively more reliable. But that is an entirely internal view. It disregards the market realities. If you think that a decision based on GP% in the above case would be wrong, be prepared, because things can get even worse.
Imagine that your organization’s finance team establishes a GP% requirement of 70% for B as it is a superior product. This would lead to a selling price of $3.40 for B which would be disproportionately high in relation to the perceived value of the product. In the best case, just a few customers may start buying B, and thus the overall revenue and profit growth might be significantly reduced (as shown in table 2). Even more importantly, your first-mover advantage might be gone, as you lose time with the product uptake of B, while competitors might be working on a similar innovation.
Table 2: Superior product with higher GP% requirement
But it could go even worse. Think that your customers perceive A and B in parity of value and price which is the case with $1 and $2, respectively. Hence, in sum, switching from A to B would not make them better off. In other words, what they gain on higher value in $ terms, they would have to give to you on price. Marketers would usually incentivize conversions of this kind and go for a win-win situation with the customer, by this significantly accelerating the uptake of the new product B.
Let’s say that at a value/price parity of 1, only 10% of the existing business would lead to a conversion to B. Your total revenues would still go up to $110 and your GP$ will be $55. That’s better than before with A alone. But if you want to hit the road fast, you may decide to actually increase the price of A, while at the same time reducing the price of B a little. Let’s say you price A now at $1.2 and B at $1.9. With this you will shift the value/price ratio for B to $1.26, by making A less attractive and B more attractive from a value/price perspective. That means the customer will now gain significantly more from B than from A, and eventually at this value/price ratio you may rapidly convert 50% of your business to product B. Your revenues will increase to $155 and your GP$ will be $80. You would be better off than just with A and also with A+B at value/price parity. But what is that doing to your GP% profitability? A will improve from 50% to 60%, and B will go down from 50% to 45%! If you request that a superior product needs to extract a higher GP% than a standard product, you will never accept such a move. But it would be wrong not do so!
Table 3: Value/Price ratio as driver of pricing and product uptake versus GP%
The examples above demonstrate that focusing on GP% as a single guide for price setting or any other initiatives that affect value and pricing can be highly misleading. Value and profitability perspectives are indeed completely detached from each other. Still, both measures GP% and value/price have their validity, but in very different contexts.
GP% as a threshold
As a key figure in accounting, GP% will still have some justified uses in business decisions. It should not be employed in price setting or any pricing decisions, as seen above, but it is an important figure when it comes in setting, for example, barriers. Such can be towards deals, customers or decisions to introduce products.
In the example above, imagine that product B would have a projected cost of $1.9, with the same value of 200%. The profitability of this product would be reduced to a GP of 5%. With a value/price ratio of 1, product B at full conversion will still yield $200 of revenues, but it would lead to only $5 of profit, which is much less than if you stick with A which delivers $50 of profit. Hence, from a profitability perspective it would not make sense to introduce B and cannibalize a more profitable product A.
From a top line perspective, and if only incentivized on that, sales will clearly be in favor of launching B. Even from a value and customer perspective, marketing may still find it appealing to go for B. But from a profitability perspective, finance should have here a veto to stop the launch, unless the costs can be decreased over time.
In order to set a threshold for the launch of B that makes sense from a profitability perspective, finance may request a minimum GP%. And this is exactly where GP% becomes a relevant figure, as it indeed is in accounting. To make sure that product B does not erode profits, a GP% of 25% is required to maintain the same flow of GP$ as with product A. In the above case, this could only be achieved if the cost for producing B will not exceed $1.5. If that is not possible, B should not be launched. If possible, B might indeed be launched as it significantly improves the top line and benefits customers through value while at the same time does not diminish the profitability of the business. Thus, GP% becomes an important figure for a “go” or “no go” decision for a product, deal, customer, business, etc.
Table 4: Cost impact on GP% and setting minimum profit requirements for a launch
Ideally, new product introductions should also support an improved profitability, and the 25% in the above example needs to be seen as the lowest requested. Besides that, the Sales and General Administration Costs as well as further costs down the waterfall cascade would need to be taken into account with a full P&L calculation. It is also possible that the launch of B might then not be seen as profitable in some markets, where in others it may be. In that aspect, finance has an important contribution in “policing” the bottom line by also employing GP% and asking for a healthy threshold.
Employing GP% in value pricing is just one of many examples where an overly simplistic compromise is often made, sometimes putting a business into bedlam. GP% is indeed used broadly for pricing decisions across many organizations, namely those which transition from a legacy in cost-based pricing towards a more value-based pricing approach.
As demonstrated in the cases above, GP% is not an appropriate measure for price setting. What applies for price setting applies indeed also for any other aspect of pricing as well, such as price guidance, price governance, price performance, price incentive plans, etc. Structuring pricing around GP% would in any aspect of pricing and in most cases deliver an inadequate outcome, and lead to wrong decisions.
The different functions of an organization such as Sales, Marketing, and Finance each have a different focus, objectives and background when it comes to pricing. Sales would usually be keen to sell a product and look at market and competition, revenue flows and growth. Marketing will be dedicated to value: to protect it and focus on product uptake. Finance will put their attention on profitability. All of these very different perspectives have their validity. In an effort to simplify collaboration in pricing, organizations might be tempted to compromise for a simple measure which in the end might be incorrect and misleading, and as a result lose on both sides through missed opportunities such as revenue and profit growth and/or depletion of value.
Pricing as a discipline should be mandated to mediate and balance between the different interests and views of sales, marketing and finance functions, and educate the organization about best principles of pricing.