Pricing is important because it is the primary influencer of the gross profit margin.
The gross profit margin is the amount that is left over once the costs of what is sold are paid.
Businesses go broke because of declining gross profit margin – in other words, your sales price is too low relative to the costs of the product you are selling.
GROSS PROFIT MARGIN FORMULA:
The formula for calculating a gross profit margin is as follows:
GROSS PROFIT MARGIN = SALES REVENUE – COST OF GOODS SOLD
Tom Smith’s widget business has sales of $100 and cost of goods sold is $50.
Using the above formula, we can calculate that Tom Smith’s Gross Profit Margin is $50.
Or, expressed in terms of the formula:
Gross margin = Sales Revenue – Cost of Goods Sold
$50 = $100 – $50 or as a percentage: 50% = 100% – 50%
Squeezing the Gross Profit Margin
What happens when you:
- Reduce your price,
- Don’t increase price in line with cost increases or
- Partially increase your price in line with cost increases.
REDUCING YOUR PRICE AND COSTS STAY STATIC:
Let’s say Tom Smith reduces his price by $10 and his costs remain the same. See what happens to his gross profit margin.
(The easiest way to calculate a percentage is to divide the amount by the total amount. Then you need to multiply the answer by 100. This will give you the percentage of the amount relative to the total amount. In this example, this is $50/$90 x $100 = 55%)
PRICE STAYS THE SAME BUT COSTS RISE:
Let’s say Tom Smith holds his price but his costs have increased by $10. See what happens to his gross profit margin.
Now let’s say Tom Smith increases his price by the same amount as his costs have increased ($10). See what happens to his gross profit margin. If he doesn’t increase his prices by more than the cost increase, he is assuming a price cut in gross profit margin percentage terms.
What Tom Smith needs to do to is raise his price by $20 to maintain his 50% gross profit margin.
For more information about Gross Profit Margin visit Wikipedia.
The Argument about Volume
Many, many businesses drop their prices on the assumption that more sales will be generated by it.
Anyone who has ever been exposed to basic economic theory will have heard about supply and demand (http://en.wikipedia.org/wiki/Supply_and_demand). In essence, economists believe that price will equalize the quantity demanded by consumers (amongst other things). The theory goes that if you drop your prices, consumers will buy more.
This almost never happens in real life. At least, not in a way that is sustainable.
What happens in real life is that one business drops its prices. Because of it, it may increase its volume for a short time before competitors become aware that they are losing market share to the cheaper supplier.
So the competitors drop their prices too, even undercutting the original cheaper supplier, to take the business back.
Before long, only the strongest competitor will survive the price war that eventuates. Once there is no competition left, the prices shoot right back up again.
READ: More about pricing strategy, The Basics of Costs, Breakeven and How To Test for Price Sensitivity.
I also recommend an excellent book I read some years ago, How To Sell At Margins Higher Than Your Competitors by Lawrence L. Steinmetz, PhD and William T. Brooks.