This first part of a publication on maximising prices and profits is about setting your prices. The whole publication is available free just by sending an email to firstname.lastname@example.org. Include your name and address please, and what you do, so we can see what else we have you might benefit from.
Economists claim that prices are set by markets. But they are wrong.
Prices are set by people running businesses. People like you. And they are among the most important decisions you will ever make. Get them right and you could be on the road to fame and fortune. But get them wrong and your business will be doomed to failure.
Why so many businesses get it wrong
To prove that setting your prices is one of the most important things you will ever do, let’s start by looking at an example.
Last month WidgetCo made £500 profit selling 1,000 Widgets.
|Sales||(1,000 Widgets at £10 each)|
|Deduct: cost of sales||(1,000 Widget at £7 each)|
|Deduct: fixed overheads|
WidgetCo has commissioned some market research, which suggests that they have two options:
Option A – They could increase their sales volume by 20 per cent if they reduced prices by 10 per cent to £9, or
Option B – They could put up their prices by 10 per cent to £11, but then would lose 20 per cent of their sales volume.
When we ask them what WidgetCo should do, most entrepreneurs have no hesitation in saying something like: “Go for option A. It is always worth selling more, and anyway, WidgetCo gains more in volume than it loses in price, so it must be profitable“.
Are they right? Unfortunately not. And it’s precisely because so many people get this question wrong that their businesses get into very real trouble.
So let’s continue with our example by seeing what WidgetCo’s profits will be next month under each of the two options.
Next Month’s Profit and Loss Account – Option A reduce price
|Sales||(1,200 Widgets at £9 each)||£10,800|
|Deduct: cost of sales||(1,200 Widget at £7 each)||(£8,400)|
|Deduct: fixed overheads||(£2,500)|
Next Month’s Profit and Loss Account – Option B increase price
|Sales||(800 Widgets at £11 each)||£8,800|
|Deduct: cost of sales||(800 Widget at £7 each)||(£5,600)|
|Deduct: fixed overheads||(£2,500)|
As you can see, under option A (i.e. the price cut) WidgetCo makes a loss and is heading for disaster. It is actually worse off than it was before the price cut. And it is much worse off than it would have been if it had increased its prices.
There is nothing very special or unusual about this example. It simply illustrates a fundamental point that is all too often overlooked: stimulating sales by cutting prices may boost your top line turnover, but it can just as easily devastate your bottom line profits.
Like many other companies, WidgetCo will not only be able to generate bigger profits by increasing its prices. But by reducing its sales it will also need less cash to finance debtors and stocks, and by eliminating customers at the cheaper end of the spectrum, it will probably reduce the amount of money it loses as bad debts.
As a result, when it increases it prices WidgetCo becomes a leaner, fitter business, providing a higher rate of return using less working capital. In contrast, when it cuts prices under Option A it becomes a lame duck. Choosing the right pricing strategy can be the difference between success and failure. Is your business an Option A or an Option B company?
There may, of course, be times when you can prove that lower prices will lead to higher profits. For example, in the case of WidgetCo, Option A’s 10 per cent price cut could have been more profitable than Option B’s 10 per cent price rise, but only if it leads to at least an 80 per cent increase in the number of Widgets sold! Ask yourself, is that likely?
All of this illustrates the general rule very nicely: if you can prove that the demand for your products is very sensitive to changes in price, then cutting your prices may increase your profits.
But never, never, never simply accept the naïve equation much loved by salesmen that:
Lower prices = Higher sales = Higher profits.
The truth is that convenience, habit, concerns over quality, and the “better the devil you know than the one you don’t know” syndrome all make many customers reluctant to switch allegiances for the sake of a few pence or per cent in price. If you don’t believe it, ask yourself a few questions. How often do you switch your allegiances from a favourite supermarket, garden centre, pub or restaurant just because a new one has opened up offering slightly lower prices? How often do you even realise that they do offer lower prices? How often are you prepared to pay just that little bit more for a product or service that you know, understand and are happy with?
So if you want simple equations, try these two instead:
Lower prices = Lower profits (until proven otherwise)
Higher prices = Higher profits (until proven otherwise)
Next – Pricing for maximum profit