For those of you contemplating beginning the new year with a cut in prices in order to remain “competitive,” consider first how costly such a move may actually be to your bottom line. In fact, the following discussion and formula just may force you to reconsider.
Assume that your company has a 40 percent gross profit margin. Now, if prices are decreased 15 percent, a 36 percent increase in sales dollar volume is necessary to maintain the same gross profit. In terms of product sold, there has to be a 60 percent increase in the unit traffic in order to maintain the same gross profit dollar amount.
The formula: For the sake of simplicity, assume that an item or service sells for $100, and that 10 units are normally sold. That gives a $1000 gross sales volume. The gross profit is $40 per unit, or $400. If the price dropped 15 percent to $85 per item, the new gross profit per unit is $25.
Dividing the original gross profit ($400) by $25, we see that 16 units have to be sold to still earn a $400 gross profit. Sixteen units at $85 is $1360. Thus 60 percent increase in units and 36 percent increase in dollar volume are arrived at.
Consider now if prices are raised by 15 percent, then a 17 percent drop in sales dollars can be tolerated along with a 28 percent decrease in units. If the price is increased 15 percent, the gross profit becomes $55 per unit (instead of $40). At 55 percent gross profit, only 7.2 units (instead of 10) have to be sold to maintain the same $400 gross profit.
The moral of this story: Always consider if sales in units can be increased as much as they have to be to yield a gross profit dollar amount.
By dropping your prices without serious consideration, you may just end up giving away the competitive edge you were striving to achieve.
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