Pricing decisions present a challenge for all business owners. In the search for greater profitability, should you raise or lower your prices - or just keep them the same? What would be the effect on profits of a significant price increase or reduction?
I can't offer a "one size fits all" answer within the scope of this blog, but what I would like to do is highlight one or two important points about how the pricing decisions you make can have surprising consequences for the profitability of your business.
Example 1 - selling at £20/ unit
Let's imagine a simple example. Let's say you sell a product for £20/ unit; it costs £10/ unit to make; and your overheads are £10,000. In year 1 you sell 1,100 units, so your profit & loss account looks like this:
£22,000 sales (1,100 units x £20/ unit)
£11,000 costs of sale (1,100 units x £10/ unit)
£1,000 net profit
Example 2 - selling at £22/ unit
Now, let's say that in year 2, you decide to raise prices by 10% to £22/ unit. By raising prices, however, you'll probably sell less units (some customers will buy from alternative suppliers, buy substitute products or perhaps just make do without). So let's say you sell only 950 units in year 2:
£20,900 sales (950 units x £22/ unit)
£9,500 costs of sale (950 units x £10/ unit)
£1,400 net profit
Despite a reduction in sales volumes of 150 units in year 2, the business has still increased profits by 40% to £1,400.
Example 3 - selling at £18/ unit
Alternatively, let's imagine that in year 2, you decide instead to reduce prices by 10% to £18/ unit. By reducing prices, you'll be hoping to sell more units. But how many more units would you need to sell to achieve the same net profit, £1,000, as in year 1? The answer is 1,375 units, a 25% increase on the amount sold in year 1:
£24,750 sales (1,375 x £18/ unit)
£13,750 costs of sale (1,375 x £10/ unit)
£1,000 net profit.
How many units would you need to sell at £18/ unit to make the same amount of profit, £1,400, as if you'd raised the price to £22/ unit? The answer is 1,425 units, a huge 30% increase on the 1,100 units sold in year 1!
And here's the issue: will dropping the price to £18 result in a 30% increase in sales volumes? That could be really hard to achieve.
On the question of whether to raise or lower prices, each case needs to be decided on its own merits. Customer behaviour will vary depending on the product or service you're selling, and the markets in which you operate.
However, the powerful mathematical effects of pricing decisions as illustrated in the simple examples above do need to be borne in mind. Effective pricing requires a sound understanding of profit margins and the relationship between profit margins, sales volumes, and profitability. If you'd like to know more, please feel welcome to get in touch with us.