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Does reducing your price increase your profit

Bridget Holmstrom - Monday, May 25, 2015

Does reducing your price increase your profit

A common business response to competition or to a downturn in the economy is to reduce prices.  But before responding by reducing our own prices small businesses should have a careful look at a few things.  Firstly, why is your competition reducing their own prices, secondly, what will be the impact of reducing prices.  Will we at least be able to hold our margins or will we not only reduce price but also reduce profit.  Certainly, reducing price, may be expected to increase revenues.  That is a fairly fundamental economic assumption, may not always be true though.  But does increasing revenues automatically result in improving profits.

Why is your competition reducing prices

Perhaps they are new to the marketing and trying to build themselves a market.  Perhaps they are introducing a new value range because this is what the market is asking for or perhaps they are desperately cutting prices in order to keep hold of customers that would otherwise choose to go elsewhere.  Understanding why your competition is reducing the price is important because your response may well be guided by those reasons.  It may not make sense to reduce prices when your competition is desperate as it is probable that rather than just your competitor going out of business you will too.

What will happen to profit when you reduce your prices

There are some questions to ask before reducing your price:
  • How price sensitive are your customers?  What difference to your customers will a 5% price reduction make to their profit or do they value quality of service over price.  Perhaps, to be brutal, the impact of 5% reduction in your price makes little or no difference to their own bottom line and the cost of finding a new supplier is more expensive than the benefit of lower prices.  Basically you are not big enough to matter.
  • What level of costs do you have cover before you start making a profit.  If you have high fixed costs or high variable costs.  If you have high fixed costs, say you have significant labour that you must cover and premises costs, that are always expensive to run.  Reducing prices where there are high direct costs makes it much more likely that you experience a loss even though it is possible that you increase your revenues.
  • What is the marginal profit on your goods or service.  A high margin gives you much more flexibility in pricing and makes it much more likely that you can withstand a fall in prices, at least for a while.
Lets have a look at this.

Breakeven Point

-5% Selling Price

+20% Sales Volume

+5% Selling Price

-20% Sales

Volume

Volume

1,000

1,200

800

Selling Price

£100

£95

£105

Unit Cost

£90

£90

£90

Sales

£100,000

£114,000

£84,000

Direct Cost

(£90,000)

(£108,000)

(£72,000)

Contribution

£10,000

£6,000

£12,000

10%

5.3%

14.3%

Fixed Costs

(£10,000)

(£10,000)

(£10,000)

Fixed Cost %

10%

8.8%

11.9%

Operating Profit

£0

(£4,000)

£2,000


As you can see in the example given here.  A 5% reduction in price gives an increase in revenues but a consequent loss of £4,000.  Conversely a 5% increase in price results in a 20% reduction in revenue but an increase in profit of £2,000.  This is not what is expected.  Those businesses with a low profit margin need to have very substantial increases in sales after a price reduction in order to maintain profitability, or have any chance of increasing it.

A table showing the increase in revenue required to offset a price reducing at different profit margins can be found here.  As you will be able to see there are some occasions when an increase in profitability is not easy to achieve. 

For more information about upcoming training contact Bridget here or phone 07795 463202.