Solving the Price PuzzleBy David Dodd on March 14th, 2010
Decisions about increasing or reducing prices are inevitably complex and difficult to make unless, of course, your prices are very low or very high relative to others in your market. It’s tough to pull the trigger on a price change because of the inherent uncertainty about what the financial impact of the change will be. If I lower prices, will I generate enough new sales to increase my profits? If I raise prices, will I lose so much business that my profits will be harmed rather than helped?
These questions are extremely difficult to answer. In fact, to answer them accurately, you have to know what the “elasticity of demand” is for your company’s products and services. And unfortunately, your company’s elasticity of demand isn’t something you can find in your local library or look up on the Internet.
The good news is that there is a simple calculation that can help owners and managers make more rational decisions about price changes. The calculation is simple because it doesn’t try to predict what will happen if you raise or lower prices. Instead, this calculation describes what must happen for a price change to be profitable.
Specifically, this calculation can answer two questions:
- How much would I need to increase sales volume in order to profit from a specified price reduction?
- How much could my sales volume go down before a specified price increase becomes unprofitable?
The calculation uses the actual contribution margin (expressed as a percentage of sales) generated during a base period (usually a year). When you reduce selling prices, the contribution margin goes down, and new sales volume must make up for that decline before profits will be improved. On the flip side, your contribution margin goes up when you increase prices, and you can afford to lose some sales volume before profits are impaired. This calculation will tell you where those “breakeven points” are.
The formula is: -(Price Change) / (Contribution Margin + Price Change)
To give a simple example, suppose that your contribution margin during the base period was 80% and that you are considering a 10% price reduction. How much will your sales volume need to increase for the price reduction to be profitable? The answer is 14.3%, calculated as follows:
Breakeven Sales Volume Increase = -(-10%) / (80% + (-10%))
Breakeven Sales Volume Increase = 10% / 70%
Breakeven Sales Volume Increase = 14.3%
If your company had sales of $5 million during the base period, you would need to increase sales by more than $714,286 for the 10% price reduction to be profitable.
I’ve created a simple Excel worksheet to calculate these breakeven points. If you’d like a copy, e-mail me directly at firstname.lastname@example.org