Price, the neglected lever

No for-profit business, as suggested by the term, can survive in the long run without making a certain amount of profit. Hence, every manager needs to fully understand the actions that underpin a firm’s operations and allow it to make profit. These actions are called profit levers because like mechanical levers when they are pulled they can change profitability. There are four levers a manager can pull in order to increase profits:

  • Sales i.e. sell more units or increase market share
  • Variable costs i.e. decrease material and/or labour costs related to production output
  • Fixed costs i.e. reduce overheads such as rent or loan repayments
  • Price i.e. change prices

Not all of these levers are treated equally though. Price tends to be the last lever a manager will pull, despite the fact that study after study show it’s the most effective one. Take for example a manufacturing firm with average profitability or 15%. Suppose that it can cut its fixed costs by an average of 1% without affecting any of its other operations then its profitability would increase on average by 3.3%. The effect of lowering its variable costs by 1% would be a 2.3% increase in profits. If it were to increase its volume sales by 1%, without changing any of its costs structures or pricing, then it would see its profits increase by 4.3%. However, the effect of increasing its prices by only 1%, without altering anything else and providing sales remain stable, would result to an increase of 6.7% in profits.

Impact of levers on profit
Impact of levers on profit

Why do managers rarely use it then? The main reason is the fear of the negative impact on lost sales a miscalculated pricing strategy can have. Pricing is perceived as complex , often requiring advanced maths and analysis, which tends to scare most people off. A poorly thought through strategy can backfire and result to lost customers and market share or a price war with your competitors damaging a whole industry. Furthermore, a successful pricing strategy requires the interaction and target alignment of several departments such as sales, manufacturing, marketing, finance and the supply chain. However, managers are usually aware that this could be very challenging as generally many departments within organisations tend to work in silos.

The fear of a negative impact on sales is understandable but not always justifiable, once one realises how much of their sales can be lost before gross margin starts to erode. The table below illustrates this point; if your current gross margin is 40% and you intend to increase your prices by 5%, gross margin will increase to 45% providing you don’t lose any sales. If the price increase had a negative effect on your sales, you could afford to lose 11% of your current sales before the gross margin fell below the 40% mark.

Table 1. The amount (%) that sales can fall before total gross margin reduces from its current level
The amount (%) that sales can fall before total gross margin reduces from its current level

Pulling the price lever is challenging but it’s an action worth taking. Done properly, considering and mitigating risks and with proper planning, analysis, and communication, the gains realised from pulling the pricing lever will outstrip those of any other initiative.

PMSI-8026

Maria Kordeli (Consultant, Price Align)

 

 

 

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