Pricing better is the most effective and fastest way to increase profits. Small improvements in pricing can result in significant improvements in operating profit. In fact, pricing has a stronger effect on the bottom line than any other major profit lever.
Let’s consider a company with the following cost structure:
- Price (total revenue) 1000
- Variable cost -700
- Fixed cost -200
- Operating profit 100
The following pictures illustrates the relative impact of improving different profit levers by 1%. Pricing improvements deliver a greater increase of operating profit that any other scenario.
It is equally important to remember that nothing destroys profitability as fast as letting prices erode a few percentage points. Pricing is always related to volume, too. This means that lowering prices will result in greater volumes sold (immediately or in a longer term), and vice versa.
Further to the earlier cost structure, the following picture illustrates the price vs. volume trade-off for the example company. This trade-off addresses the following questions:
- How much volume can you lose before a price increase becomes unprofitable? If a price increase is followed by a volume decrease which is smaller than this amount, the price increase is successful.
- How much additional volume should you gain to justify a price decrease? If a volume increase is greater than this amount, the price decrease is successful.
The above consideration applies to stable market conditions. Changes in the marketplace (e.g. new competitor) may force price changes that do not affect volumes.
In summary, we may agree that pricing is the strongest profit lever but a few questions remain:
- Is it easier or more difficult to affect pricing than, for example, variable costs?
- What exactly could I do to develop pricing in my company?