Commentary & Analysis
Solving (One Part of) the Price Puzzle
By David Dodd
Published: March 14, 2010
Recently, a client asked me whether it would be a good idea to lower prices in order to generate more sales. I suspect that many printers have thought about the same question more than once.
Decisions about increasing or reducing prices are inevitably complex and difficult to make unless, of course, your prices are very low or very high relative to others in your market. It's tough to pull the trigger on a price change because of the inherent uncertainty about what the financial impact of the change will be. If I lower prices, will I generate enough new sales to increase my profits? If I raise prices, will I lose so much business that my profits will be harmed rather than helped?
These questions are extremely difficult to answer. In fact, to answer them accurately, you have to know what the "elasticity of demand" is for your company's products and services. And unfortunately, your company's elasticity of demand isn't something you can find in your local library or look up on the Internet.
The good news is that there is a simple calculation that can help owners and managers make more rational decisions about price changes. The calculation is simple because it doesn't try to predict what will happen if you raise or lower prices. Instead, this calculation describes what must happen for a price change to be profitable.
Specifically, this calculation can answer two questions:
- How much would I need to increase sales volume in order to profit from a specified price reduction?
- How much could my 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). This calculation can be used to evaluate across-the-board price changes and price changes that apply to major segments of your business. It cannot be used for individual jobs.
The calculation uses the actual contribution margin (expressed as a percentage of sales) generated during a base period (usually a year). When you reduce 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, your contribution margin goes up when you increase prices, and you can afford to lose some sales volume before profits are impaired. This calculation will tell you where those "breakeven points" are.
The formula 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 $5 million during the base period, you would need to increase sales by more than $714,286 for the 10% price reduction to be profitable.
I've created a simple Excel worksheet to calculate these breakeven points. If you'd like a copy, e-mail me directly at ddodd(at)pointbalance(dot)com.
G. David Dodd is available for speaking engagements and consulting projects. To get more information contact us here.
G. David Dodd is a principal of Point Balance, LLC ( www.pointbalance.com ), an executive education and management consulting firm. Point Balance provides cutting-edge management education programs designed for printing and publishing executives. The firm also provides management consulting services involving business strategy development, strategic marketing, cost management (including activity-based costing), business process management, and balanced scorecard performance management systems. Dodd is a co-author of Activity-Based Costing for Printers: An Implementation Guide, the authoritative resource relating to the use of activity-based costing by printing and publishing firms. Dodd also co-authored Making Value Added Services Work, a comprehensive reference tool for printing company managers who are just beginning to consider diversification or who have already added new services and are not receiving the benefits they expected.
David Dodd can be reached at ddodd@pointbalance.com,931-707-5105.
Printers certainly don't need much encouragement to drop their prices, but I haven't seen any printer declare an across-the-board price reduction. They’re making decisions on a job-by-job basis.
And while the calculations in the blog posting are correct, they're not addressing the narrower question at hand. If a printer has unused capacity, and has the choice of taking a job at a lower price or not getting it, the more immediate question at hand is the contribution made by that job, or NOT made if the job is lost.
Putting it more precisely: what amount extra would the printer spend in-house to produce that single job (after allowing for paper, ink and supplies)? Or putting it the other way: what would that printer NOT spend in-house in order NOT to produce that job.
The answer to both questions is the same: not very much.
Yes, there's an unstated problem: cutting prices becomes infectious, inducing printers to resort to price-cutting as a primary means of competing for business. So the real-world challenge is to avoid confronting this decision on every job, cutting prices across the board and foregoing profit opportunities on some work that doesn't demand price-cutting.
Printers must find ways to compete more effectively for business, and must examine why they're being forced to compete largely on price.
Yet at the moment a single job comes into view, the economics of that single job are undeniable: how much extra would be spent to produce it, and how much less would be spent in order NOT to produce it.
As in most important issues, the challenge lies in choosing the right questions to answer.
David,
I would like to republish this article on my linked in group, DIG Write In. I suspect that many are not members of WhatTheyThink.com but this is so powerful I don't want them to miss it. Is this possible?
Kate,
No problem. I'd be honored. Drop me an e-mail at ddodd(at)pointbalance(dot)com, and we'll figure out the best way to make it happen.
I would suggest you reading the book named: "PRICING, Making Profitable Decisions" By Kent B Monroe. You will figure out that it is mostly impossible to increase sales volume to that extent that it will cover the lost of money given by the price reduction.
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