There is no better time to increase price than now!
If you really think about it, a company’s operating profits come from only three variables: The total cost to produce the product or service, the overall sales volume, and the overall price. So: (total unit sales x price) — total cost = profit.
Using this simple math, renowned consultancy firm McKinsey and Company made a study of what-if scenarios for the average American public company. The what-if scenario was also straightforward. They modeled this scenario; what if we change one of these three variables just one percent, what would happen to the profitability of the average company?
What they found was the following:
1. If the sales level increases by 1%, profits increase by 3.5%
2. If the cost is reduced by 1%, profits increase by 5.5%
3. If the price increases by 1%, profits increase by 11.3%
From this simple analysis, it is evident that pricing has the highest lever on profits in any company. But why is this? Well, think about it for a second. If sales volume is increased, both the revenue and cost of goods sold increase, and the profit margin remains the same. If the cost is reduced, the profit margin is improved, but since it is a percentage of a lower absolute number than the price number, it means a smaller amount in real dollars. Therefore, increasing the price with 1% (or reducing discounting with 1%) adds solely to the company top line, and because the price in absolute dollars is higher than the absolute dollars for the cost of goods sold, a one percent change makes it affect profits the most.
We have now established that price affects profit more than the other two variables that affect profits. Why then is now the best time to increase your price?
Let’s start by examining an increase in sales. Most companies already sell as much as they can, and an increase in sales volume may only happen after adding more salespeople, training salespeople, increase marketing spend or other changes that are costly and take a long time to implement.
When it comes to cost, most companies are already very good at keeping control over their cost. Only with organizational change (to become more efficient), with a renegotiation of vendor and service contracts, maybe even by reducing staff, will cost go down. Just like with sales increases, these are all long term and expensive ways to increase profits.
What about pricing then? Well, the fact is: you can change your price today. Or reduce discounting. Today! It requires zero infrastructure change. No training for salespeople. No costly new marketing campaigns. No renegotiation with vendors. All it needs is the will to do it.
Yet, many companies are reluctant to use price as the profit lever. Company executives worry about what will happen if we increase the price? Will my sales level drop dramatically? Will my customers flee to competition? Will it tarnish my brand and reputation? And then it becomes more personal as executives worry what will happen to them personally if a price increase goes wrong. Or if they decide to reduce discounting. Will they lose out on that promotion? Some even worry they might lose their job
The reason for this worry is that the relationship between sales volume and price is poorly understood and executives worry that price increases will have a dramatic adverse effect on sales volume. That’s because for most companies, the price was set using a suboptimal method, like “cost plus a fixed margin,” or by guess or gut feel. Or by “market price” (which in most cases is a euphemism for guessing). Or the price was just pegged to a competitor’s price.
So, instead of focusing on price increases or a reduction discounting to increase profit — activities that have an immediate effect on margins — many companies embark on long-term and costly marketing programs, on organizational change and on long-term and many times ineffective cost reduction exercises to increase profits. Because these are “safe,” no-risk, activities. They may, or may not, yield higher profits, but they are activities companies do every day. If they fail, nobody is hurt. (Well, to a point…)
In a study by Atenga Insight, American CEOs were asked the question “what is the most effective way to increase profits for your company?” A whopping 82% say the best way is to increase sales. Obviously the wrong answer and a missed opportunity to better their company.
If you have read my prior articles, you will know that the relationship between price and sales volume can be measured and modeled, and an accurate prediction of sales volume at different prices can be generated. You will also know that there is not a fixed relationship between price and sales volume, and that at certain price intervals, changing the price has zero impact on sales volume while at other prices, a change of price will have a significant impact on sales volume. The trick, of course, is to know ahead of time what will happen with sales volume at different prices when a price change is implemented,.
Thus, any worry that a company executive may have about the result of a price increase can be put to rest with an accurate prediction of sales volume at different prices. They will know what opportunity exists for a price increase, they will know how much the sales volume will be affected, and if it will increase, decrease or stay the same. They will know what price will yield the highest revenue. They can model how much profits will rise. And when they know, we are not talking about a 1% increase, as in the McKinsey what-if scenario above, but often much more.
So, knowledge is power. Power to control your price and profit!
Per Sjöfors
The Price Whisperer™
Founder
Sjöfors & Partners Inc
www.sjofors.com
Pricing has always been an interest area for Per. As a serial entrepreneur, running companies in Europe and the US, he did pricing experiences. Some of these worked spectacularly well, some did not work at all. As a result, Per founded Atenga (now Sjöfors & Partners) out of his frustration that what business schools teach about pricing is too abstract, too academic for a business executive to act on. Likewise with books about pricing. Consequently, he set out to make pricing practical and actionable. Pricing for business people. Since then, he has been at the forefront as thought leader in everything pricing and he is a sought-after speaker for a variety of conferences and business circuits.
Per appear regularly on business radio shows and gets quoted regularly in the financial press, including Forbes, Fortune Magazine, Inc., IndustryWeek, Business Insider and the Financial Times.
About Us: Sjöfors & Partners has developed a unique method for data-driven pricing based on price-specific market research, that generate precise measurements of customers’ willingness to pay or buy for a product or service. Armed with this knowledge, companies can focus their sales, marketing and product development efforts towards the market segment with the highest willingness to buy at the highest prices. The measurement also allows Sjöfors & Partners’ clients to accurately predict the results of different prices, taking the uncertainty out of pricing decisions.
