Inflationary pressure: pricing strategy

Introduction

Following three decades or so of price stability in most developed economies, inflation is now back with a vengeance. Veterinary practices, as with all businesses, have to deal with this unusual situation, and most of them struggle to understand what should (or should not) be done. In order to consider how a practice should adjust its fees to allow for inflation, let’s focus on a case study using some simple data and questions.

PremiumVet price review

PremiumVet* is a first opinion companion animal veterinary practice that trades as a partnership. It has what is regarded as an adequate pricing policy – i.e., consistent with its market positioning – and a satisfactory level of profitability from the perspective of the two partners, Jane and Kevin.

* The name “PremiumVet” is hypothetical and has no relation to any actual practice or business of the same name.

The two partners meet in late December each year to decide on their annual price adjustments for the upcoming 12 months (Figure 1). For the meeting in December 2022, Jane prepares as usual by collecting relevant data. This includes a simplified projected forecast of PremiumVet’s final Profit & Loss (P&L) account for 2022 (Table 1) and details on the inflation rate.

Table 1. Simplified projected forecast of PremiumVet’s final Profit & Loss (P&L) account for 2022.

Nationally, the final overall inflation rate for 2022 is expected to reach 10%, fueled mainly by rises in energy and food prices. As of late December 2022, the majority of forecasts roughly anticipate the same level of inflation for 2023, although uncertainty remains very high (most economists anticipate between 5 and 12%). Of course, not every cost rose by 10% in 2022, so Jane reviewed the data for all their expenditure, as summarized in Table 2.

Table 2. PremiumVet’s inflation rates over 2022/2023. Note that simply using the average or national inflation rate will mask the varying increases in different expenditure categories, and it is better to identify the specific inflation rate for each sector wherever possible.

Now Jane and Kevin have to make some major decisions:

1. At their annual meeting at the end of 2021, Jane had proposed to increase prices for all veterinary services by 2.5%, (i.e., roughly the 2021 inflation rate), with staff salaries increased by 2% from 1^st January 2022, and Kevin had agreed immediately. However, March-April 2022 saw energy prices take off, and then in late spring many other prices also significantly increased, such that pressure on salaries within the business became a concern. At this point Jane proposed to add an extra 4% to fees, but Kevin was reluctant to do so; eventually, in late September, he agreed to a 2.5% increase from October 1^st, with a further 4.5% increase in staff wages at the same time. They now face the question; what price adjustment should be implemented on services for 2023? Should it be an adjustment across the board at a set percentage, or would it be preferable to make different adjustments according to service categories? They also feel that they need to give their staff a 5% increase in wages from January 2023.
2. For products sold at the clinic, the 2021 adjustment was almost automatic: the partners applied their usual mark-up rates to the updated purchase prices. For this year, it is even more difficult to make sound decisions for products than for services, as there have been huge variations in purchase price increases (between 2 and 38%!). The conundrum is best illustrated by considering two products stocked by the practice (with all prices excluding VAT for simplicity):

• For Product A the purchase price in 2022 was 30€, and it was sold to clients at 54€ (a mark-up of 1.8). The 2023 purchase price is expected to be 31€. Furthermore, product A benefits from having little competition from other channels – i.e., clients will usually purchase it from the practice (Figure 2).
• For Product B the purchase price in 2022 was 60€, and it was sold at 84€ (a mark-up of 1.4). The 2023 purchase price is expected to be 75€, probably because of the increased cost of specific raw materials and/or high energy costs. In addition, product B suffers from major competition, i.e., clients can also source it from non-veterinary competitors, mostly on-line stores (hence the historic choice of a lower mark-up than for Product A).

The partners face three important questions

1. What is the increased gross margin PremiumVet needs to maintain its profit (in constant currency) in 2023?

Using the information collected by Jane, the two partners were able to calculate their internal inflation rate, as shown in Table 3. Total costs for 2023 were estimated to be €43K more than the 2022 costs; if inflation is assumed to be 10%, this would mean that a comparable profit for Jane and Kevin in 2023 would be €165K, (i.e., 10% higher than 2022). To achieve this their gross margin would have to go up from €770K to €828K.

Table 3. The calculation required to maintain the profit level for PremiumVet’s owners by applying the appropriate inflation rate to each expenditure category.

* To be absolutely accurate, two consecutive rises in wages of 2% and 4.5% result in a 6.59% rise (1.02 x 1.045) and if the first one is applied from January 1st and the second one from October 1st, the average rise is 3.15% (2% x 3/4 + 6.59% x 1/4).

It’s important to note they used the national inflation rate only to calculate their maintained profit in constant currency; for all other items they used specific data. The required gross margin – €828 K – means that PremiumVet needed a gross margin that is 7.5% higher than in 2022 to maintain an equivalent net profit for the partners.

In front of that, the practice increased prices by only 3.1% on a full year basis (2.5% on January 1^st and 2.5% on October 1^st) although the level at December 31^st will be 5% higher than a year before*.

*To be absolutely accurate, two consecutive 2.5% rises in prices result in a 5.0625% rise (1.025 x 1.025) and if the first one is applied from January 1^st and the second one from October 1^st, the average rise is 3.14% (2.5% x 3/4 + 5.0625% x 1/4).

2. What is an appropriate level for their service prices in 2023?

Considering PremiumVet prices are adequate – i.e., consistent with its market positioning – the simplest method to update service prices is to increase each of them by 7.5%. Nevertheless, the partners may decide to increase some of them by more than this if they think it’s needed and/or possible, and others by slightly less only if it’s absolutely necessary (for instance if the fees charged by other local veterinary practices are competitive), provided that, on a weighted average – taking into account the volume of each service – the increase reaches at least 7.5%.

Of course, the two partners agreed to keep an eye on the situation throughout the coming year, and to be ready to move again as the situation required. After all, their decisions for January’s price adjustment are only able to offset the last part of 2022’s actual internal inflation and barely include the minimum anticipated for 2023.

3. How should the issue of product pricing be addressed?

When it comes to setting product prices, the two examples given show two opposing situations. The purchasing price of Product A is to rise by only 3.3% in a category which is not affected by any major competition, whilst the price of Product B is expected to rise by 25% in a category heavily exposed to alternative channels.

If PremiumVet sticks to its previous strategy and applies its usual mark-up rates (1.8 for Product A and 1.4 for Product B), the practice will only increase its gross profit by an additional 80 cents, or 3.3%, for Product A. For Product B the increase in gross profit would be an extra 6€, which is a 25% uplift. In the first example, the price increase is below the required 7.5% rise in gross margin to maintain an acceptable level of profit (as calculated in Table 3) and will not optimize the opportunities offered by low competition. In the second example, the price adjustment will exceed the gross margin objective but exposes the practice to the risk of losing sales to competitors.

A better alternative would be to increase the gross margin made on each product by 7.5% – so for product A, take the 2022 gross margin of 24€ and increase it by 7.5%, which gives a new gross margin of 25.80€ and therefore a selling price of 56.80€ (31 + 25.80); for product B, the same 7.5% increase would give a selling price of 100.80€ (75 + 25.80).

However, an even better option would be to then adjust the final pricing from this basis considering the specific competitive context. Table 4 sums up the pricing options using the practice’s “standard” mark-up rates and by using a 7.5% increase on gross margin, and presents the final decisions Jane eventually proposed to Kevin.

Table 4. PremiumVet’s pricing options using the practice’s “standard” mark-up rates and with a 7.5% increase on gross margin. The table shows how a flexible and considered approach to different products can preserve or increase the profit.

Kevin agreed in principle, but asked for a general policy easily implementable to all products sold by PremiumVet. In return, Jane proposed the price adjustment policy (summarized in Table 5) which takes into account both the requirement for an increase in gross margin and the need to consider product placement in a competitive context.

Table 5. A summary of the price strategy implemented by PremiumVet where price increases vary according to the level of competition.

Take home messages

The above exercise illustrates some basic points to bear in mind when reviewing fees and product prices in a veterinary practice. There are at least three important messages here:

• It is useful to depart from the standard annual price adjustment of services and usual mark-up rates applied to products when inflation rate exceeds 5% per year, and it is absolutely essential to do this when it reaches 8%.
• In addition to the national statistics, it is very interesting to survey the "internal inflation rate" of a veterinary practice. Moreover, it is important to ensure that annual profits increase annually, at least in line with the national inflation rate, otherwise practice profitability will drop in constant currency. Using the appropriate data, it is possible to set a target for a gross margin evolution of X%.
• Service prices should be raised each year by at least X% using a weighted average. If inflation is established in the national economy, it is preferable to adjust service prices two or three times a year, rather than in one sharp rise. When it comes to products, the authors recommend the guidelines set out in Table 5.

Conclusion 

After several years of near-zero inflation, veterinarians need to adapt in the way they increase the price of their services and products. There is no simple solution, but this article highlights the different parameters to be taken into account in order to optimize your pricing strategy.