Your Margins are Sending You a Message

Customers who are willing to pay the most above your cost value you most

Say you’re looking across all the different types of products or services that your company sells, and you’re trying to figure out which ones are the most valuable to customers. Or you’re looking at all the different types of customers you serve and trying to decide what niche you are best at serving. Do you need to conduct a major study? No, they’re already telling you.

Just look to see which products or customers are the most profitable.

Think about what a product gross margin is: the price your customer pays for that product minus what it costs you to produce the product.

This means that the products you sell with the highest margins are the products where customers see you as adding the most value when you produce that product.

Let’s think through some examples.

There’s a maker of automobile brake pads, Great Lakes Brakes. Their manufacturing is still in the US, and their materials are high quality, but they make a variety of product lines. Some are basic and are sold through mid-tier brands in stores like AutoZone. Others are performance oriented and are sold to car hobbyists.

The basic products and performance products are not the same. They use different materials and are built to different levels of precision. But even so, their gross margins are 10% on the private label products and 30% on the performance products.

What does this tell our brake pad company?

They are valued as a maker of performance products, but they are not as much valued as the maker of basic products.

If one of their sales managers suggested that they should price their basic products lower, so that they could sell more of them against the lower priced imported basic products, I would tell him this was not a smart move. This company is not the best at making basic products. Their margins are telling them this. Pricing the product lower would only decrease their margins. It would be very hard for the company to make the same amount of total profit dollars that they are now, even if sales increased significantly.

The only true way they could significantly improve their position with the basic product lines would be if they found a way to become much more efficient at making those basic products, producing similar quality at significantly lower cost. If they did this, they could either lower their prices to capture more share of the basic market (while still making higher margins) or they could keep the business they have now but make higher margin on it.

But right now, their margins are telling them that they are valued as a premium maker but not valued much as a basic brand.

Isn’t this always the case? Am I just saying that premium products are always better?

Not necessarily.

Picture the mirror image of Great Lakes Brakes: Pacific Brakes located in Thailand is very successful with their basic brake pads. They’re good at making low cost products, and make 25% margins on their basic brake pads. They’ve tried to launch a premium line too, but here they struggle. With their tools and their staff, producing truly high performance products takes a lot of time, and even so they produce too many mistakes and have to scrap 10% of the products due to not passing quality inspection. And even so, their premium products do not command as high a price as the Great Lakes Brakes premium products, because they aren’t perceived by customers to be as good.

As a result, Pacific Brakes only early 15% gross margins on their premium products.

What is this telling them? The market values them as a producer of basic, value products. But they are not as valued as a premium brand. The margins tell the story.

Often I see people suggest in order to compete for some coveted sector of the market, it’s necessary to lower the company’s pricing and accept lower margins to compete.

However, often low margins are a sign that your company is not very good at satisfying the market segment you’re going after. If customers are not buying from you at healthy margins, and the only way to win business is to significantly lower your margin expectations, it may be that you do not have an efficient enough business to capture that segment. What you may need to work on, if you truly want that group of customers, is lowering your costs.

On the other hand, if there’s a market segment where you routinely command very high margins, this tells you that customers really value what you are doing in that area.

Of course, all of this assumes that you are already at the highest reasonable price you could charge. If you’ve been cautious with pricing, it might be you have some very happy customers who value what you’re doing a great deal and would be willing to pay significantly more for what you are doing, but you haven’t yet found that out by asking them for a higher price.

The indicator that this might be the case is if you have a moderate or low margin line or business or custom segment, where you have no problem winning sales and your customers seem happy. This is a sign you have unrealized pricing power: your customers value you more than your pricing currently reflects.

If this is the case, you are in a very good position to raise your prices. Your customers might like getting your product for much less than they value it, but they will still be willing to buy your product even at a higher price.

So, to review… If you command significantly higher gross margins in some product categories or with some customer segments than others, this indicates that you are providing more value on those products or to those customers. Believe them! When you assess your business, you should always first lean in to the areas where you have the higher margins.

Then you should look for the areas where you have very satisfied customers and very high win rates for your quotes, and you should consider raising your prices in those areas, because you may well be underpriced for the amount of value you are providing.

Lastly, in the areas where you have low margins and you at still struggling to win customers, you need to look at your efficiency and the products you are offering. These are the areas where the market is telling you that you are not providing much value compared to your competition. You can’t solve this by lowering your prices! If you make a change here, it must be to make your products more efficiently.