What is margin compression?
Margin compression occurs when the costs to provide a product or service rise faster than the sales price of that product or service, applying pressure to profit margins.
Every business needs to manage profit margin actively, understanding common contributors to margin compression.
5 common contributors to margin compression
- Increased competition — Profit margin, pricing strategy, income streams and costs all need to be reviewed as competition increases.
- Internal production issues — Internal issues can include rising raw material costs, skill shortages and supply chain issues.
- Macroeconomic factors — These can include rising fuel costs and rising interest rates. Global conflict and weather events can also impact macroeconomic factors
- Rising Selling, General and Administrative costs — Your pricing model needs to reflect changes in S,G&A costs.
- Lack of business agility to adjust to the above changes — Business agility requires the right focus and the right data.
4 steps to avoid margin compression
Avoiding margin compression involves creating pricing for profit strategies based on data relevant to current market circumstances. For example, after analysing your pricing, you may:
- Structure prices or contracts to adjust for increased or decreased costs or other market factors.
- Apply temporary surcharges to pricing in response to short-lived or dynamic scenarios.
- Set up data flows, processes and systems to allow for automated recalculation of pricing.
- The fourth and most important step is being proactive and paying attention to the data.
Helping SMEs make better pricing decisions
Record keeping is crucial when it comes to trading in crIn the SME market, entrepreneurs and owners may rely more on gut instinct than sophisticated data. However, while relying on gut instincts allows SMEs to make quicker business decisions than larger organisations, in today’s volatile market, depending on gut instinct alone may increase risk and contribute to margin compression.
Over the last two years, consumer choices have changed, as have supplier attitudes. The world has shifted, and gut feel, while valuable now more than ever, needs to be backed up with evidence.
Data analysis challenges your current pricing strategy and can determine if your current price point will get you what you want in the market.
Determining your pricing strategy
Your pricing strategy helps you manage margin compression and what is known as margin leakage (over discounting that erodes your profit margin).
In determining your pricing strategy, you may want to consider:
- Cost-based pricing — Adding a small margin to the costs of producing, distributing and marketing your product.
- Penetration pricing — Attracting new customers by offering lower prices allows you to enter a competitive market and raise the price later.
- Value-based pricing — Pricing your product or service on what the customer believes it’s worth; this is a common strategy for premium products.
- Competitive Pricing — Setting a price based on what your competition charges.
- Price skimming — Setting a high price and lowering it as the market evolves.
Determining the right pricing strategy for you will depend on several factors, including:
- Level of competition
- Variable costs
- Consumer demand
- Brand image
- Product quality
- Market conditions
- Manufacturing costs
Today’s market volatility requires business leaders to be far more responsive and not rely solely on lived experience. As a result, business owners will need new responses to business questions, including pricing. Awareness of personal biases and using the right data to back your instincts can help create these new responses.
To learn how data analysis can help reduce the risk of margin compression and guide pricing strategy, contact Beyond Advisors. We’re here to help build stronger businesses through better decision-making.