If you’re pouring your heart and soul into your business but not walking away with a good profit, there may be something wrong with your pricing strategy. We come across a lot of businesses that undervalue their services, thinking it’s a privilege to simply be in business. You need to make sure you’ve got your pricing right and being rewarded with cash hitting your bank account. Otherwise, you might as well be working for someone else and not have half the stress of running your own business! So what are the major financial drivers of profit?
It’s commonly believed that reducing costs has the most impact on profits, but did you know that out of all the profit drivers, the one that has the most impact is Price? Here’s why, and how you can leverage price changes to increase your business profitability.
Why price increases have the most impact
Higher sales volumes directly impact your bottom line, but they also increase variable costs 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.
So, although variable costs, fixed assets, overheads and sales volume are important drivers of profit, price increases have the highest impact on profit because every dollar of the increase goes to the bottom line.
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 and get 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 in evaluating your customers’ price sensitivity and the impact that price changes may have on demand for your product.
Price elasticity and profitability
‘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 decrease or increase 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.
Factors to consider
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 convenience and ease of use via an online app, customers continue to switch from traditional taxi services despite surge pricing during peak times and recent price increases thanks to additional taxes and service charges.
- 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 helps maintain loyal customers and can encourage potential customers to switch to your brand – and 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 goods are to a customer, the more inelastic the customer response. This includes utilities like energy and water.
- Someone else paying – For example an insurance provider can result in greater inelasticity as customers are not directly affected by the price.
Getting your pricing strategy right
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. Analysis of market trends in your industry, customer demographics, your competitors, web-based analytics and financial data is critical to for sound 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.