Every business, no matter whether they are big or small, is often faced with product pricing decisions. Every business person knows that a product priced too high may not attract as many buyers as a lower price product assuming equal quality. Similarly a product priced too low will leave potential profits on the table. Improper pricing often leads to financial problems or bankruptcy.
A business person faced with competitive pressures is often tempted to cut prices to attract more customers and sell more products. This can lead to undesirable results. Unless you are selling off a discontinued product line or end of season products you would probably be better off focusing on the positive features of your product or service and actually increasing prices.
Your current contribution margin percentage, (sales minus variable costs) will have a significant impact on how much extra volume you will have to sell in order to offset a price reduction. The following table indicates the increase in volume that is required to compensate for a price discounting policy. For example if your contribution margin or gross margin is 25% and you reduce your prices by 12% you will need a sales volume increase of 92% to maintain the profit you would have made if you had not reduced your prices. (Volume refers to the number of units sold.)
| 1. If your present margin is-> | 20% | 25% | 30% | 35% | 40% | 45% | 50% |
| 2. And you reduce your price by | 3. To produce the same profit, you must increase your sales volume by | ||||||
| 2% | 11% | 9% | 7% | 6% | 5% | 5% | 4% |
| 4% | 25% | 19% | 15% | 13% | 11% | 10% | 9% |
| 6% | 43% | 32% | 25% | 21% | 18% | 15% | 14% |
| 8% | 67% | 47% | 36% | 30% | 25% | 22% | 19% |
| 10% | 100% | 67% | 50% | 40% | 33% | 29% | 25% |
| 12% | 150% | 92% | 67% | 52% | 43% | 36% | 32% |
| 14% | 233% | 127% | 88% | 67% | 54% | 45% | 39% |
| 16% | 400% | 178% | 114% | 84% | 67% | 55% | 47% |
| 18% | 900% | 257% | 150% | 106% | 82% | 67% | 56% |
| 20% | 400% | 200% | 133% | 100% | 80% | 67% | |
| 25% | 500% | 250% | 167% | 125% | 100% | ||
| 30% | 600% | 300% | 200% | 150% | |||
The above table dramatically demonstrates that if you reduce your prices expecting greater profits you may be disappointed.
Similarly management may be reluctant to raise prices as they fear a price increase will cause a loss in business. A grocery store I was working with had sales of approximately $7 million and was breaking even. After much soul searching management raised prices by 2% i.e. .02 cents on every dollar of selling price. Since the price increase was spread over many products sales losses were negligible and an extra $140,000 in profits was realized.
The following table indicates the reduction in volume that can be given up and not lose profits when evaluating a price increase. For example if your contribution margin or gross margin is 25% and you increase your prices by 12% you would have to incur a 32% reduction in volume before your profit is reduced to the previous level. In other words you would have to lose over 30% of your customers.
| 1. If your present margin is-> | 20% | 25% | 30% | 35% | 40% | 45% | 50% |
| 2. And you increase your price by -> | 3. To produce the same profit, you could decrease your sales volume by | ||||||
| 2% | 9% | 7% | 6% | 5% | 5% | 4% | 3% |
| 4% | 17% | 14% | 12% | 10% | 9% | 8% | 7% |
| 6% | 23% | 19% | 17% | 15% | 13% | 12% | 9% |
| 8% | 29% | 24% | 21% | 19% | 17% | 15% | 12% |
| 10% | 33% | 29% | 25% | 22% | 20% | 18% | 14% |
| 12% | 38% | 32% | 29% | 26% | 23% | 21% | 17% |
| 14% | 41% | 36% | 32% | 29% | 26% | 24% | 19% |
| 16% | 44% | 39% | 35% | 31% | 29% | 26% | 21% |
| 18% | 47% | 42% | 38% | 34% | 31% | 29% | 23% |
| 20% | 50% | 44% | 40% | 36% | 33% | 31% | 25% |
| 25% | 56% | 50% | 45% | 42% | 38% | 36% | 29% |
| 30% | 60% | 55% | 50% | 46% | 43% | 40% | 33% |
A business that maintains appropriate margins will be in a much better position to provide quality products, quality service, maintain their equipment, keep key employees and provide greater customer satisfaction than a business that is struggling to be profitable and working harder to make a profit with less than adequate margins. Price cutting can make you poor, but price increases can make you rich if they are handled appropriately.
A manufacturing company might also consider higher prices for smaller orders as there are often inefficiencies in producing a small order compared to a large order that allows a one time machine set-up that can produce without interruption.
In any business for each dollar of sales there is only a small percentage of the dollar that ends up as profit; however, if a business can reduce expenses and not affect quality or customer service the full amount of the reduced cost ends up as profit. In any organization costs must also be watched and monitored very closely.
Visit osborne-group.com for other ideas and opinions from our Principals on a range of topics. Their views are their own and do not necessarily represent The Osborne Group’s perspective. The Osborne Group provides interim executive management, consulting and project support across all sectors and over a broad scope of service areas.
