When Will Price Changes Be Profitable?

Price is one of the traditional 4P's of the marketing mix, and pricing is or should be a core component of every company's business and marketing strategy. Unfortunately, many marketers today focus almost exclusively on marketing communications (the promotion component of the 4P's), and they have largely ceded the remaining components of competitive strategy to other business functions. As a result, marketers often have little influence over several factors that drive business success.

In my view, marketing should play a leading role in formulating competitive strategy, and this necessarily means that marketers must get more involved in pricing decisions.

The reality is, no marketing strategy is complete unless it addresses pricing issues and includes a strategic approach to price setting. That's because pricing can be the single most powerful tool that company leaders can use to impact profits. To illustrate the power of price, consultants with McKinsey & Company analyzed the average income statement of the Global 1200, an aggregation of 1,200 large, publicly held companies from around the world. The objective of the analysis was to quantify the profit impact of various types of financial improvements.

The McKinsey researchers found that a 1% improvement in pricing would yield an 11.0% increase in operating profits at the average Global 1200 company. By comparison:

• A 1% decrease in variable costs would produce a 7.3% increase in profits
• A 1% increase in sales volume would yield a 3.7% increase in profits
• A 1% decrease in fixed costs would produce a 2.7% profit improvement

Pricing decisions are typically based on input from several business functions, but marketing should play a leading role in these decisions because marketing is (or should be) particularly well-attuned to the company's external market and competitive environment.

One issue that arises fairly often is whether a change in prices will result in more profit. Decisions about increasing or reducing prices are inevitably challenging because of the inherent uncertainty about what the financial impact of the changes will be. Company leaders must ask themselves:  If we lower prices, will we generate enough new sales to increase our profits? If we raise prices, will we lose so much business that our profits will be harmed rather than helped.

These questions are extremely difficult to answer. In fact, to answer them accurately, company leaders must know what the "elasticity of demand" is for their products or services. And unfortunately, your company's elasticity of demand isn't something you can find via a Google search or at your local library.

The good news is that there is a simple calculation that can help company leaders make more rational decisions about price changes. The calculation is simple because it doesn't try to predict what will happen if prices are increased or decreased. Instead, this calculation describes what must happen for a price change to be profitable.

Specifically, this calculation can help company leaders answer two questions:

• How much would we need to increase sales volume in order to profit from a specified price reduction?
• How much could our sales volume go down before a specified price increase becomes unprofitable?

The measure of "profit" used in this calculation is contribution margin (sales minus variable costs), and the calculation uses the actual contribution margin (expressed as a percentage of sales) generated during a base period (usually a year). When a company reduces selling prices, the contribution margin goes down, and new sales volume must make up for that decline before profits will be improved. On the flip side, contribution margin goes up when a company raises prices, and the company can afford to lose some sales volume before profits are impaired. This calculation will tell you where those "breakeven points" are.

The formula for this calculation is:  -(Price Change) / (Contribution Margin + Price Change)

To give a simple example, suppose that your contribution margin during the base period was 80% and that you are considering a 10% price reduction. How much will your sales volume need to increase for the price reduction to be profitable. The answer is 14.3%, calculated as follows:

Breakeven Sales Volume Increase = -(-10%) / ((80% + (-10%))

Breakeven Sales Volume Increase = 10% / 70%

Breakeven Sales Volume Increase = 14.3%

If your company had sales of $20 million during the base period, you would need to increase sales by more than $2,860,000 for the 10% price reduction to be profitable.

This approach can be used to evaluate across-the-board price changes and price changes that apply to individual products or product lines. It cannot be used for individual deals.

I've created a simple Excel worksheet to calculate these breakeven points. If you'd like a copy of this worksheet, send an e-mail to ddodd(at)pointbalance(dot)com.