In the Basics of Supply & Demand, I explained why value, price and costs are so important.
Because demand is normally a downward sloping line, as price decreases then demand increases.
That happens at the market level and it happens at the individual product level.
If the price of cans of cola is cut in half, then:
- people who drink cola will drink more
- some of the people who drink other things like lemonade will switch
If the price of Pepsi is reduced but Coke stays the same, then some of the Coke drinkers will switch to Pepsi.
This idea of extra sales makes a price cut look very attractive but it probably doesn’t make much sense financially or strategically.
The Financial Impact Of Cutting Prices
Financially the extra volume needed to compensate for the price reduction is often bigger than you think.
Imagine you sell a product for $100 and you make 40% contribution margin after covering your variable costs.
And you sell 100 units per day.
That’s $10,000 of sales and $4,000 margin.
Your sales person comes to you and says that your prices are too high. You could sell much more if you discount your prices by 15%.
That would mean selling for $85 and making $25 margin (or 29.4% margin).
To break even on this price reduction – i.e. to still earn a daily margin of $4,000, you need to sell 160 units – a 60% increase in volume.
That’s right – a 15% price reduction needs a 60% volume increase to stand still and a much bigger increase to make it worth all the extra work.
(100 units *$40 margin = $4,000
160 units * $25 margin = $4,000)
Sure sales value has shot up
100 units * $100 = $10,000 sales
160 units * $85 = $13,600 sales
but just looking at sales value is deceptive when your real income is determined by margins.
The Strategic Problem Of Low Prices
If you cut prices to attract more volume, then how do you think your competitors will react?
Will they stand back and let you take away their customers or will they fight back and cut prices too?
The right answer depends on a careful assessment of the situation.
But the gut response is to fight fire with fire.
If the competition is cutting prices and you’re losing business, there is an almost irresistible response to cut your prices too.
And that creates a price war where no supplier wins – only the customers by capturing an extra share of the surplus value (the difference between what they would pay and have to pay).
Even if you don’t trigger a price war – because you only have capacity to take a tiny share of the market or because you genuinely have the lowest costs in your industry and no one dare take you on, you still have a problem.
A low selling price means you must have an intense focus on taking costs out of your business and keeping costs down to the lowest level possible.
Your focus is based on scrimping and saving.
A business ruled by the accountant’s mentality of saying NO to any unnecessary expenditure.
A business focused on the efficiency and productivity of internal operations rather than externally on what customers want and need other than a low price.
By definition someone has to be the lowest cost operator in an industry but there are two problems:
- Cost competitiveness may be achieved at a small market share which means that no one has a big enough cost advantage to create superior returns from a low price strategy. Instead you get a low profit stalemate.
- There’s always the danger that a new low cost operator will appear. That can happen if there are technological innovations which change the way your product or service is created or through lower input costs (low wage economies, new sources of raw materials).
It is tough to manage down to a low price.
It’s Not Good For Customers Either
I admit that every customer would prefer to pay less than more for the same product or service.
Buy this Mars bar for 50 cents or a dollar?
50 cents please.
But most customers want something special.
Different from what their friends buy.
Tailored to their special needs and circumstances.
Something which says something about their individuality and values.
Paul Simister is a business coach who helps small business owners to profit from differentiating their businesses, being distinctive in the eyes of their customers and standing out in a crowded marketplace.
You too can move past your profit tipping point by answering the seven big questions of business success.