I don’t usually get into quantitative examples here, but this one is worth it to make a point. It’s surprising, but relatively few managers seem to appreciate just what a powerful profit-lever price is. Ask the following questions and see how many people involved with deciding your actual prices know the answers.
Q1: If you have a £100M turnover business, with a variable cost per unit of 70% and a fixed cost of 20% (so, you get an operating margin of 10% i.e. an actual profit of £10M), what is the effect of a 1% increase in price?
A1: Well, let’s assume your volume stays constant (customers won’t leave over a 1% increase), so you will have sales of £101M – an extra million, ALL of which will drop to the bottom line. In other words, a ONE percent increase in price gets you a TEN percent increase in operating profit! That’s quite some leverage. (Of course if you increased the turnover by increasing volume, you’d get less of a profit lift because you’d incur extra variable cost.)
Here’s another question (particularly important for all those people whose only tactic in response to competition is to cut prices).
Q2: If you discount your offering 20% – you know, to get volume/share – how much more volume will you need just to get back to the same level of profit?
A2: A remarkable number of people think the answer is 20%…Wrong!
Very wrong. In fact for a typical manufacturer, it’s more like 100%! That’s right – you may well have to double your volume. Remember, that’s simply to hold position at the profit level. Why? Because for a typical cost structure a 20% discount might halve your contribution margin, so you will have to double sales just to recover the discount. This is a world-class way to go out of business, and it’s how unimaginative competitors bleed the profitability out of whole industries (airlines, this means you).
If this is news, you ought to convince yourself of the arithmetic of these simple examples, and then run the numbers for a real example in your business.
Many companies have a basic strategy that amounts to trying to do what the competition does, but better (in reality so little better that the client or customer doesn’t notice), and whose only method of ‘differentiation’ beyond that is to cut prices/fees. But you can’t win a price war unless you are genuinely the lowest cost producer. As you are probably not, the point of this back-of-an-envelope sketch is to impress just how vital it is to find ways to protect and raise prices. In an upcoming post I’ll talk about factors which need to be in place to enable you to do that.