Some pricing propaganda

The pricing of the products in a company ranks among the tasks with the strongest influence on profitability. If you are operating on a 10% margin, increasing your prices by 5% leads to a profit increase of 50%! While this is not a very deep finding, it is sometimes good to remind yourself of this when you have to make a pricing decision.

Let's have a look at a less drastic, but for that matter maybe even more convincing example. Disregarding fixed costs, assume a business that is operating on a 40% operating margin. So, if the price of the product is 100, the unit cost would be 60 and the unit margin 40. Indexing the volume sold also to 100, the graph on the left shows what the overall profit situation looks like. Now, in this simplified example, you are faced with three options to increase your overall profit:

• Increase volume
• Decrease costs
• Increase price

Which of these measures would have the strongest effect on the overall profit?

If you manage to increase volume by, say, 10%, all the time managing to keep your costs and your prices constant, you just sell 10% more at the same price and level of profitability, so your overall profit also increases by 10%.

Next, assume you are able to decrease your costs also by 10%. Assume also that your prices and volumes sold do not change in the process. So unit costs have gone down from 60 to 54, unit profit goes up from 40 to 46. Since the volume remains the same, this means that we increased our overall profit by 15%!

Now, what about the price? Let's assume you manage to increase the price again by 10%. Unit costs remain unchanged. In that case the new unit price becomes 110, thus the new unit profit would be 50. Of course, you can always do this, the main assumption that we are making here, is that the volumes sold of the product in question are also stable. In that case, our overall profit goes up from 40*100 to 50*100, that is by 25%! Now, why is this propaganda? Clearly, the "ceteris paribus" assumptions that we are making, are pretty strong. If you knew about a situation, where you could increase prices by 10% without losing any volume, you would already have done it!

Still, we learn two things. 1) Pricing has a very strong leverage on your profit. It is often one of the most important neglected topics in a company. 2) Having a good idea about customer reactions to price changes is essential.

Turning the above examples around, it is just as easy to see that a decrease in price as compared to a decrease in volume or an increase in costs is also the most damaging to the overall profit. Again, while this should impress the importance of the price to you, it does not mean, that prices should all go up! The price reaction of the customers is clearly essential and this is where the analysis comes in. Read on in The basics of pricing