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Pricing for Profit: How to Set Realistic Profit Margins

Pricing for Profit: How to Set Realistic Profit Margins
Granville Y. Brady, AuD Jr, FAAA
October 25, 2010
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Introduction: How to make a profit

One of the most confusing concepts for the beginning practitioner, and often for experienced audiologists as well, is how to price goods and services for maximum profit. Laws regarding price fixing are strict, so it is not easy for an audiologist to call around and find out what prices are being charged for hearing aids and audiological services. The Medicare fee schedule gives a general idea of what Medicare reimburses for specific procedures. It is important to know that Medicare rates reflect a budgetary constraint and may not reflect prevailing rates. Discussing fees with other local practices may be construed as price-fixing (ASHA, 2010). Setting prices in collusion with colleagues is illegal. Fees set by Medicare are far too modest for the practitioner to survive, and they do not include CPT codes and fees for hearing instruments.

Let's review how pricing is established by some audiologists. One method is to follow the prices set by the audiologist's employer. Some hospitals take the cost of goods sold (COGS) for a particular time period and double it, giving a 100% markup, while others use a factor of 2.5 or 3 times COGS to set the price that the public pays. Audiologists may also look at community standards. By some unscientific process, most practitioners know where the top and bottom ends of pricing are and believe that it is economic suicide to "price oneself out of the market." While this might be an understandable strategy, it does not help to establish a consistent pricing policy.

Another traditional way to look at prices is to take the manufacturer's retail price schedule and work down. A hearing aid company may too often develop the MSRP without looking at the real facts. Thus, a "40% off MSRP" provides the consumer and practitioner with little evidence to determine if the price is reasonable or if it allows for adequate profit.

Profits defined

Profit is simply the amount left after total expenses are subtracted from total revenues. There are actually two types of profit that are considered for accounting purposes: gross profit and net income or earnings. Gross profit is defined as revenues minus the cost of sales. Gross profit is what is left over to pay operating expenses. Net income, often referred to as earnings, is the amount left when all expenses are paid. This is usually considered the "bottom line." When setting a profit margin, we are looking at gross profit.

To understand gross profit, it is important to know the difference between fixed and variable costs to an audiology practice. Variable costs are expenses that change based upon the activity of the practice related to sales and services. Examples of variable costs are cost of goods (hearing aids) and materials used, direct labor, depreciation, sales and advertising costs, packaging, and commissions or bonuses paid.

Fixed costs are more stable expenses that are usually reoccurring and are not affected by business cycles. Examples of fixed costs are rent, salaries and wages (but not commissions), payroll taxes, insurance, professional fees and employee benefits. These costs must be paid regardless of the flow of cases into the practice.

Reasons to set a profit margin

Profit margins are set for an obvious reason: to allow the owner to make money above his costs. The resulting net profit, after all expenses are paid, is what the owner brings home at the end of a year. The primary reason someone goes into business is to make a profit. Without the profit incentive, the owner just has a job, albeit one that allows for some time flexibility, but little else.

Another reason to set a profit margin is to calculate break-even. At some point in every practice, the audiologist must cover all fixed costs and begin to make a profit. If a profit is not forthcoming in at least two out of five years, the IRS considers the activity to be a hobby and disallows all deductions taken as a business.

The third reason to establish a profit margin is to prepare a business for sale. A practice that shows too little profit, no matter how successful, is not worth very much to the buyer. It is difficult for a new owner to raise prices if the practice has been operating at a marginal profit for many years.

The fourth reason to set a profit margin is to give the owner capital for expansion. Profits are not always taken as income and practice owners who reinvest in their practice keep ahead of the curve.

A fifth reason is to stay competitive. When the practice owner is able to obtain hearing aids at a discount, he/she can price the instruments to allow for a maximum profit margin while giving the patient the benefit of the discounted wholesale cost of goods. By pricing instruments using the acquisition cost, rather than an inflated MSRP, the audiologist is able to compete with other offices that artificially price their hearing aids too high and give an unrealistic discounted price that is often unsustainable. The author knows of several instances where hearing aid dispensers tried to undercut prices only to fail later when patients came back for follow-up services.

A final reason to set an adequate profit margin is to allow the profits to be invested in a pension plan and other benefits for the owner and employees. Unlike public and many private sector jobs, a private practice has no guaranteed pension plan. Unless profits are plowed into a pension, retirees would have to rely on their social security alone— a grim prospect in the 21st century.

For some practice owners, profits translate into money for vacations, college payments for children or grandchildren, a vacation home and other luxuries that would be beyond their reach as an employee.

Profit margins and markups

When we think about a profit margin, most of us think about the difference between what a car dealer pays and what he charges you. The MSRP is usually the benchmark. For some car dealers, they make only a few percent above what they paid the manufacturer. Most of the profit is made in add-ons like undercoating, GPS systems, additional warranty, etc.

The gross profit margin is the acquisition cost of the goods subtracted from the selling price and then divided by the selling price. For example, an item costs you $5.00 and you sell it for $10. $10-$5= $5/$10. The profit margin is .5 or 50%.

People who are not involved in retail sales erroneously think that doubling the price gives you a 100% profit margin. That is not true. Doubling the price gives you a 100% markup, but only a 50% profit margin.

What is a markup? Simply stated, it is the increase in the price using the COGS as a baseline. Markup is the proportion of total cost represented by profit, whereas gross profit margin is the percent of the selling price that is profit. Although the two are often used interchangeably, they are defined and calculated differently.

An example of how a markup differs from a profit margin is seen when the audiologist pays the manufacturer $600 for a hearing aid. If the hearing aid is sold for $1200, we show a markup of 100% but have a profit margin of only 50%. ($1200-$600= $600/$1200= .50 or 50%.) In this example, the markup of 100% was much higher than the profit margin of 50%. Doubling the cost results in a 100% markup but only a 50% gross profit margin.

Profit margin on the other hand takes the COGS and is used by the audiologist as a reference point to set prices that will allow for maximum profit. Unlike setting a markup, a profit percentage is first determined, and then a formula applied to meet the percentage goal. The profit margin is a percentage that gives the audiologist the maximum amount of profit independent of the COGS. This is achieved when the audiologist sets an arbitrary profit margin percentage and than "backs in" to the amount charged by dividing the difference between 100% and the percentage of profit margin desired.

Another way to look at the difference between profit margin and markup is to analyze how each is set. In setting a markup, the retailer looks at the COGS and decides what the selling price will be based on product total cost. When establishing profit margins, the audiologist looks at what the desired profit will be and then chooses goods and services that can fit into the format to achieve the desired profitability. In the case of hearing aids, if the profit margin desired is 65% (.65), the audiologist must be sure that the wholesale cost of the hearing aid cannot exceed 35% (.35) of the selling price. This gives the audiologist flexibility on how much a hearing aid can be purchased for, as well as what the selling price can be.

Let's look at how we achieve a price using a profit margin formula. We need two bits of information: the COGS and the desired profit margin percentage. For example, if we want to make a 65% profit margin, we take the COGS and divide it by the difference between 100% and the 65% desired margin. For example, if a hearing aid costs (COGS) $725, divide it by .35 (100%-65%=35% or .35). The amount charged to obtain a 65% profit margin in this case would be $2071 ($725/.35), which would be rounded up to $2075.00. To check our figures, take the selling price of $2075, subtract the COGS and divide that by the selling price ($2075-725= $1350/$2075= 65%).

Profit margin, fixed costs and break-even

Break-even occurs when the practice is able to meet all fixed costs but doesn't show a profit. Fixed costs are those expenses that are recurring, contractual or mandated and include rent, telephone, insurance, salaries, etc. They are fixed whether or not the practice makes any sales. Variable costs are tied into sales. Examples include sales commissions, some non-contractual advertising, travel, entertainment, etc. These are discretionary expenses that can be eliminated if the practice is not making sales or if sales are off.

To calculate the break-even point, the audiologist must know two things: fixed costs for the practice and the markup. In order to cover fixed costs, a practice must sell enough to meet these expenses, plus cover the COGS (cost of goods sold). By dividing the fixed costs by the profit margin, the dividend is the amount needed in dollars to break even.

Look at this example:

Dr. Amy Jones' Audiology Services has the following monthly fixed costs:

Salary $ 8300
Rent 2100
Telephone 500
Utilities 300
Contracted advertising 400
Taxes 2075
Insurance 375
Worker's Comp 250
Accounting 200
Total Monthly Fixed $14,500
If her profit margin were 65%, the amount needed to reach the break-even point would be:

$14,500/. 65=$22,307.70
Using the same fixed costs, another audiologist who shows only a 50% profit margin needs $29,000 to break even:

$14,500/.50=$29,000
Both practices have the same fixed costs but the more profitable one shows an earlier break-even point than the one with a lower profit margin. In both cases, the break-even takes into account the fixed costs and the costs for hearing aids. A mistake often made by students new to business is that when the fixed costs are met, break even is achieved, but we see that break even must account for cost of goods sold (COGS) as well as fixed costs.

Brady's Rule of Thirds

Because most audiologists do not sell a large volume of hearing aids, and because they must be professionally fitted and adjusted, the profit margin has to be higher than that of other types of retail sales such as a food store. Hearing aids cannot be made in advance, in most cases. Also, the cost for R&D is high since our field does not get a great deal of research funding or venture capital. The wholesale cost of hearing aids is affected by the declining dollar when compared to the currency that most foreign-based hearing aid manufacturers use in their country of origin. These factors all play into the cost of hearing instruments.

The development of a rule of thirds takes into account the factors that make up the practice's expenses. There are four types of costs that most practices endure: (1) hearing aids and COGS; (2) fixed costs such as salaries, rent, insurance, telephone, calibration, etc.; (3) variable costs of advertising, commissions, educational expenses, automobile expenses, etc.; (4) finally, the profit to the shareholder(s). So the rule of thirds is simply this:

1/3 to pay the suppliers for the product (COGS)
1/3 to pay for testing, dispensing, and all the expenses associated with the practice (Fixed costs & variable costs)
1/3 to pay shareholder(s) or the practice owner(s)
Based upon that rule, we should not buy a hearing aid for more than 35% of the selling price. In other words, if we pay $300 for a hearing aid, we must sell it for at least $857 ($300/.35=$857). To look at it another way, you sell the aid for $857 and it costs you $300 leaving a gross profit of $557. Your $857 sale gave you a 65% profit margin. Of course, the selling price depends on other variables such as the number and expense of follow-up visits, comparable pricing in the region and the need to achieve an overall gross margin on all sales for the month or year. Thus, the same hearing aid, when sold for $1000 yields a gross profit margin of 70% ($1000-$300=$700/$1000=70%).

Keeping a flexible gross profit margin is wise for a couple of reasons. First, the cost of some of the advanced technology instruments is high. If the audiologist pays $1500 for a hearing aid, the market may not allow it to sell for $5000. Different geographic regions and overall economic conditions influence prices. Competition also has an effect on the asking price. Another factor is dictated by volume that allows for greater wholesale discounts. However, profit margin is only one factor in staying afloat. The business must achieve both a comfortable profit and enough volume to sustain itself. If the number of sales declines below fixed costs, the practice will run a deficit, no matter how high a profit margin is established.

Bending the rule

A greater profit margin can be achieved in two ways: decreased acquisition costs or increased selling price. To decrease acquisition cost, join a good buying group that gives exceptional price breaks and not just better marketing tools that are paid by the members. Some buying groups give great ideas for developing the business, which can be valuable, but the cost for those great ideas is coming from the breakage or difference between what the buying group pays the manufacturer and what the group member pays to the buying group.

Another way to lower acquisition cost is to buy less costly products. That is risky in a field that demands quality. The American consumer is much more aware of quality hearing instrument technology since the accessibility of the Internet became so global.

Raising prices is a good way to keep the profit margin stable. By increasing the prices for hearing aids every year by a 3%-5% factor, the audiologist can keep up with suppliers' price increases and preserve the profit margin. Selling post-fitting services through service contracts and extended warranties is another way to improve the profit margin.

Keeping a good product mix with appropriate profit margins is another way to stay in the game. If prices cannot be raised to yield the highest profit margin on superior-technology items, the profit margin can be increased on lower-end instruments and decreased for higher-end products. For example, an audiologist may not be able to charge $5000 for a top-end digital that costs $1500. Even if the audiologist gets a volume discount so the acquisition cost is $1275, she may not be able to get $4250 per instrument ($8500 binaural). By pricing each hearing aid at $3200 ($6400 for 2) gives a 60% profit margin. If this were done for every hearing aid, the audiologist would see more dollars but less profitability over time. The break-even point would take longer to achieve, and the audiologist would be working harder for less profit. That is not a good way to operate a practice since it leaves less money, over time, to re-invest back into the business. Instead, the audiologist could price lower-technology instruments to obtain a higher-than-average profit margin. An instrument acquired for $250 and sold for $1250 yields an 80% profit margin. The technique is similar to dollar-cost averaging when investing. As long as there is a good mix of high, medium and low-end instruments, the audiologist can plan for a greater profit margin for the aids costing less and a lower profit margin for higher-cost products. The objective is to preserve a stable 65-70% profit margin over the life of the practice.

Keep in mind the pricing. Profit margins, cost factors and financial planning are based upon long-term objectives. When setting up a system, keep a separate sales ledger that is your private barometer of how you are doing. List all hearing aids sold by the following:

Date of Sale

Referral/advertising source

Name and address of patient

Type of aid, e.g., BTE, ITE, CIC, etc.

Acquisition cost

Selling Price

Gross profit

Profit margin percentage
Do this for each sale. At the end of the month, tally it all up, and you will see how much revenue you generated, your gross profit and the profit margin percentage. This can be compared to the previous month or previous year. For those who like graphs and charts, you can keep this as a running snapshot of what you are doing.

Summary

Abide by the rule of thirds to pay the suppliers of the product, for testing and diagnostic evaluation, and to pay the shareholders of the company. Always consider your profit margin and calculate accordingly. A good product mix will help stabilize profit margin. To get a better profit margin, lower costs by comparing and offering better discounts, as well as joining buying groups. The bottom line is to get a better profit margin, raise prices and add non-cost items like service contracts and warranties. Lastly, keep a daily log or sales book and review it often. This is the best way to track your own trends and find areas of personal improvement.

References

American Speech-Language Hearing Association (ASHA) (2010). Coding for Reimbursement FAQs: Audiology. Retrieved August 18, 2010, from www.asha.org/practice/reimbursement/coding/
Signia Xperience - July 2024

granville y brady

Granville Y. Brady, AuD Jr, FAAA

licensed audiologist and speech-language pathologist with offices in Clifton and East Brunswick, NJ

Granville Y. Brady, Jr., Au.D., F.A.A.A. earned his Au.D. from Arizona School of Health Sciences. He is a licensed audiologist and speech-language pathologist with offices in Clifton and East Brunswick, NJ. Dr. Brady teaches business development and accounting at A.T. Still University. In addition to his clinical experience, Dr. Brady has served as councilman and finance chairman for the Borough of Somerville, NJ and was responsible for the budget, insurance and retirement operations of the municipality. He serves as treasurer of the Audiology Foundation of America.



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