You have a product that sells and generates profits for your business, but you want to make more profit. There are lots of ways you can approach this issue, including changing your pricing strategy. In other words, you can increase your prices to make more per sale or decrease your prices to get a higher sales volume. Which will make you the most profit?
Increasing or decreasing your prices is likely to impact your business in a number of ways. For example, decreasing your prices means you will make a smaller margin on each sale but you may also increase sales volume.
Increasing prices could have the opposite effect, i.e. increasing the margin per sale with a reduction in sales volume.
The question remains – which is the best option? Let’s look at an example.
Which Pricing Strategy to Choose?
In this example, we have a business that sells 5,000 products at €50 each producing sales of 5,000 x €50 = €250,000. The cost of each product is €35 so the total cost is 5,000 x €35 = €175,000.
The gross profit is, therefore, €250,000 – €175,000 = €75,000. The overheads in the business are €35,000 giving a profit of €75,000 – €35,000 = €40,000.
What happens when you either increase or decrease the price of each product?
To keep the calculations simple, we’ll assume the cost of each product and the business overheads remain the same. We’ll also assume that an increase in price will reduce sales with the opposite effect happening if the price is decreased:
- Decreasing prices by 10% results in a 20% increase in sales quantity
- Increasing prices by 10% results in a 20% drop in sales quantity
As a side note, the above assumptions are not exact and will depend on your business. For example, increasing prices by 10% may not reduce sales quantities by anything like 20%.
Back to the example, let’s look first at what happens when you drop prices. The price per unit of the product becomes €45 and sales increase to 6,000 units:
- Total sales are 6,000 x €45 = €270,000
- Total cost is 6,000 x €35 = €210,000
- Overheads are €35,000
- Profit is, therefore, €270,000 – €210,000 – €35,000 = €25,000
Let’s now look at what happens if you increase prices to €55. If sales volumes reduce by 20% as a result, you will sell 4,000 units. Here are the figures:
- Total sales are 4,000 x €55 = €220,000
- Total cost is 4,000 x €35 = €140,000
- Overheads are €35,000
- Profit is, therefore, €220,000 – €140,000 – €35,000 = €45,000
So, here’s the summary:
- Keep prices the same – profit of €40,000
- Reduces prices to get more sales – profit of €25,000
- Increase prices which reduces sales volumes – profit of €45,000
So, Is Pricing Low Never a Good Idea?
The obvious answer to the question asked at the start of this article is you should increase your prices, accept the reduction in sales volume, and you will make more money. In the real world it is not as simple.
Firstly, you must look at the numbers in your business – that is obvious. There is another crucial point, however – you must always consider costs when looking at your pricing strategy.
Therefore, looking at pricing alone to increase sales volumes is rarely a good idea. If you look at pricing in relation to costs, however, pricing low can work. Here are two situations where this might happen:
- The reduction in sales volumes as a result of a price increase puts up the cost of each product to you, reducing your margin
- Achieving higher sales volumes reduces the cost of the product to you, improving your margin when you decrease prices
If costs remain relatively fixed, however, as in the example above, pricing low is likely to mean you will make less profit. It is important to understand this when setting your pricing strategy.
For more help and advice with your business, including creating a pricing strategy, please contact a member of the Gilroy Gannon team today.