The major financial drivers of profit for any business are price, variable costs, fixed assets and overheads, and sales volume. Do you know which has the most impact?
It’s commonly believed that reducing costs has the most impact on profits, but the answer is in fact Price. Here’s why, and how you can give your profit a boost.
Price vs costs and sales
Price increases have the highest impact on profit as every dollar of the increase goes to the bottom line. Higher sales volumes directly impact your bottom line too, but they also increase variablecosts so are not as effective as increasing price. Reducing variable costs will increase profit margins, but not to the same dollar effect as increasing prices. Cutting fixed costs has the least impact on profits as it has no impact on revenue. In spite of all this, one of the most feared commercial tactics in today’s economic environment is increasing prices. Given the range of potential market reactions, it’s no wonder that entrepreneurs steer away from price increases and focus on maximising sales instead.
How can you raise prices with positive results?
Having an in-depth knowledge of your products’ value proposition, your customers’ psychology, buying processes and trends, plus a well-communicated competitive position are all important. This will assist you to evaluate your customers’ price sensitivity and the impact that price changes may have on demand for your product.
Determining price elasticity
‘Elasticity of demand’ may be a familiar term from your economics studies. It’s a useful theory for testing whether a price increase will be accepted by your customers. Credited to English economist Alfred Marshall, price elasticity (or responsiveness) is the measure of how much the quantity of a product demanded will change for a given fall or rise in price.
Marshall used differential calculus to determine elasticities for products and services to find the optimal price point, however today there are easier ways to predict how your customers will respond to fluctuations in price. Accounting data, especially that captured through point of sales systems, provides a wealth of information from which you can predict customers’ responses to any particular product increase. In that process, there is a range of factors to take into account:
- The availability and ease of buying a similar product – If it’s easy to buy similar products nearby, customers will quickly switch, even if the price rise is small. Uber taxi is a topical example. Due to its ease of use via an online app, customers continue to switch from traditional taxi services despite recent surge pricing.
- Brand image – Loyalty to a brand can keep customers sticky even with price rises. Luxury designer goods are a good example of this concept. Building your brand and product quality to target the best customers can allow you to increase prices.
- Price relative to income – The lower the price relative to the purchaser’s income, the less likely customers
will be to shop elsewhere as the income effect will be insignificant. For example, price rises at a convenience store in an upscale neighbourhood are unlikely to have a big impact on demand.
- Necessity of the product or service – The more necessary the goods are to a customer, like energy and water, the more inelastic the customer response.
- Someone else paying – For example an insurance provider, can mean inelasticity as customers are not directly touched by the price.
Analysis is critical
Pricing and profitability management can be complex and risky. You’ll reap the rewards if you get it right, but the bottom could fall out if you get it wrong. Market trends in your industry, customer demographics, your competitors, web-based analytics and financial data will all help with your forecasting and pricing decisions. With the right analysis, it’s possible to determine how and where opportunities exist to increase prices and when discretion is advised. And of course pricing isn’t the only way to improve your profitability. Once the issue is addressed, a whole range of strategies may emerge. Most Accru offices specialise in profit improvement.
Please contact your local Accru adviser if you would like information on how we can assist.