Top Down or Bottom Up? How Do You Price Your Products?
Most business owners know what they sell their products for. Far fewer know whether that price actually makes sense. Some businesses calculate their costs and add a margin. Others start with what the market is willing to pay and work backwards. The most commercially successful businesses do both. There are some businesses out there which do neither and simply hope for the best.
Understanding the difference between top-down and bottom-up costing can be the difference between building a profitable business and working incredibly hard for very little reward.
The Most Important Commercial Questions You May Not Be Asking
One of the quickest ways to get into trouble in business is to assume that if you can sell a product, you must be making money.
It sounds obvious, yet throughout my years as a turnaround consultant, I have seen businesses generating millions of pounds of revenue whilst losing money on almost every sale. They are busy. Customers are buying. Orders are flowing through the system. However, the commercial reality tells a very different story.
The reason is often surprisingly simple. They do not truly understand their costs. Or they do not understand the market they are selling into.
In reality, every product and service should be tested from two directions. The first is known as bottom-up costing. The second is top-down costing. The most successful businesses understand both.
What Is Bottom-Up Costing?
Bottom-up costing starts with reality. You begin with the direct cost of your product or service and then build upwards until you arrive at the true cost of delivering it to your customer.
Imagine you are importing products from overseas into the UK. The manufacturing cost is only the beginning.
You then need to consider freight costs, import duties, customs clearance charges, insurance, warehousing, stock losses, damaged goods, onward distribution, packaging and fulfilment costs.
You may also need to consider the cost of holding stock, working capital requirements, financing costs and the operational overhead required to support the business.
Before long, the £10 product you thought you were selling may actually be costing £18 or £20, or more, by the time it reaches the customer, and that is before you’ve included any markup.
The next question becomes whether your selling price provides enough margin to cover your fixed costs and generate a meaningful profit.
Many businesses stop their calculations too early and discover much later that they have been underpricing their products for years.
What Is Top-Down Costing?
Top-down costing approaches the problem from the opposite direction. Instead of asking what the product costs, it asks what the market is prepared to pay. This is particularly important when selling through retailers, distributors or other intermediary channels.
For example, a customer may only be willing to pay £49.99 for a particular product. That immediately creates a commercial reality. If the product is sold through a retailer, the retailer will require a margin. VAT may need to be deducted. Distribution costs may apply. Promotional support may be expected.
Once all of those elements have been removed, you are left with the price you can realistically charge. Only then can you ask whether your product can actually be manufactured, delivered and supported profitably.
This exercise can sometimes reveal very uncomfortable truths. The market may simply be unwilling to pay what you need to charge in order to make a profit, let alone a decent living from your business.
When that happens, you have several choices.
You can redesign the product. You can source more efficiently. You can reduce costs. You can reposition the product. You can target a different customer segment. Or you may conclude that the commercial opportunity is not viable in its current form.
Whilst that can feel disappointing, it is far better to discover this before investing heavily or getting into financial difficulty later.
Which Approach Is Better?
The answer is neither. You need both.
Bottom-up costing tells you what you need. Top-down costing tells you what the market will allow. Commercial success happens when those two numbers overlap.
If your required selling price is lower than the market price, you have an opportunity.
If your required selling price is higher than the market price, you have a problem that needs to be solved.
The gap between those two numbers is where some of the most important business decisions are made.
The Costing Exercise Most Businesses Never Do
One of the most common issues I encounter is that businesses perform one calculation but not the other, or in some cases, they do not carry out any meaningful costing exercise at all.
Some understand every penny of their costs but have never validated whether the market will support their desired pricing. Others focus entirely on market pricing without truly understanding what it costs them to deliver the product or service.
Many businesses rely on historical costings that have not been updated to reflect changing market conditions. Others apply a standard markup or multiplier and hope that it will be enough. Some include the obvious costs whilst overlooking less visible costs such as warehousing, working capital, financing, damages, theft, warranty claims, stock obsolescence or overhead recovery.
The problem is that every assumption carries risk.
Understanding your commercial reality means understanding both your true costs and your market reality. Only then can you make informed decisions about pricing, product design, sourcing, margins, growth and profitability.
The businesses that consistently make good commercial decisions are rarely guessing. They understand their numbers well enough to know where they are making money, where they are losing money and where opportunities exist to improve performance.
Is Your Product Actually Making Money?
Many business owners have been surprised when we work through their numbers in detail.
Sometimes products that appear highly successful are barely covering their costs.
Sometimes products with modest sales volumes generate most of the company's profit.
Sometimes a small change in pricing, sourcing or distribution transforms the economics of the entire business.
The challenge is that you cannot improve what you do not understand.
If you are unsure whether your products, services or pricing structure are delivering the profitability you need, it may be time to take a closer look.
Need A Commercial Reality Check?
Whether you manufacture, import, distribute or provide services, understanding your true costs and market pricing is fundamental to long-term success.
If you would like help reviewing your costing models, pricing strategy, product profitability or commercial performance, I would be delighted to help.
Book a call with Ogilvie Advisory and let's help you and your team understand the commercial reality behind your products, pricing and profitability, ensuring your products are working as hard for your business as you are.
