In every business I've ever seen, there's always some manager who wants to cut prices. If business is good, the reasoning goes, a lower price will help to capture an even greater share of the market. And if business is bad, cutting prices will help avoid disaster.
Well, that's nonsense. In my experience, at least, most companies don't charge enough for their products. When business is good, you need cash to fuel growth, cash that could be generated by high margins. When business is bad, cutting prices often makes matters worse. You have to increase sales significantly to recover the dollars lost by the cuts.
Let me try to convince you of the folly of charging too little. Suppose that you sell 100 fishing lures a month at $1 each. They cost 55? each, giving you a gross profit of $45 and a gross profit margin of 45%. If you cut your prices by 15% and your unit volume stayed the same, your sales would drop to $85 and your gross profits to $30. But if you want to maintain your original $45 gross profit after the price cut, you'll have to increase your monthly sales by 50%. Here's the formula I used to come up with that figure, with GPM representing gross profit margin:
GPM % / GPM% +/- price change % - 1 = unit vol. % change
In the example, for ease of calculation, I changed the percentages to decimals.
.45 / (.45-.15) - 1 = .50
In other words, with the cut in price, you'd need to sell 150 units instead of the 100 per month you are currently selling.
A price hike might make more sense. If, instead of lowering the price of the fishing lures, you raised it by 15%, and your unit volume stayed the same, your sales would go up to $115 and your gross profits to $60. To figure out how much your sales would have to fall off before your gross profit in dollars would drop below the original $45, use the same formula, but this time add, rather than subtract, the price-change percentage:
.45 / (.45 + .15) - 1 = -.25
The price increase would improve your gross profit in dollars from the original $45, even with a sales drop, so long as gross sales don't fall below 75 units a month.
By using the graph below, you can quickly calculate the changes you'd need in sales volume to maintain gross profits after a price increase or decrease. You'll see that price cuts must generate large -- often impossibly large -- increases in unit volume to regain lost gross-profit dollars. And price increases can sustain large decreases in unit volume and still improve gross profits.
Despite what seems to me to be the obvious benefits of price increases, I've seen many companies continue to underprice their products -- particularly companies in financial trouble. Here are some of the reasons why:
* Laziness. When prices are low, salespeople don't have to sell; they need only take orders. And marketers find nearly any marketing campaign is a satisfactory one. You sacrifice margins, of course, along with many potential opportunities. By selling Cadillacs at Chevrolet prices, General Motors Corp. surely would have missed the opportunity for the Cadillac market, and probably the Chevrolet market as well.
* Fear. Managers experience many fears when they think about raising prices -- that higher prices won't stick, that customers won't like them anymore, that salespeople will leave. But the fact is, you won't know the effect of a price increase until you try it. If higher prices don't stick -- if unit sales fall below the stay-even level in the graph -- you'll probably have to lower prices again.
I've talked with many managers who hate cutting prices right after they've raised them, but I must admit I've never understood that reaction. The idea is to charge what the market will bear. The most effective way to do this is to bump prices up a little, then bump them again and again, until you meet true sales resistance. Then back off. And what is wrong with backing off?
If you're loath to admit that your recent price increase didn't stick, there are ways to disguise a price cut. You could offer larger discounts for early payment; add value to your product by adding new features, for example, while leaving the price the same; change your schedule for quantity discounts, offering lower prices for larger orders; or sell two or more complementary products as a package, at a lower price than the two would cost if bought separately.
When you evaluate the success of your price increase, measure "success" by what your customers do, not by what they say. As one successful manager of a family-owned hotel told me recently, "My customers complain all the time about our prices. They complain and they pay."
* Markup pricing. Many businesses set prices as a markup of costs, a practice that virtually guarantees trouble. If your costs are higher than the competition's, you price yourself out of the marketplace. If your costs are lower, you leave money on the table.
The story of what happened in a major oil company when it introduced a windshield-washer fluid is a good example. The product, mostly water with a little detergent and antifreeze added, cost pennies to manufacture and sell. Originally priced using a markup of costs, it was a minor product with average margins. But then someone realized that people tend to buy windshield-washer fluid infrequently and are never quite sure what they should be paying for it.
Seeing an opportunity, the company raised the price, then raised it repeatedly. Finally, with the price several times greater than it had been originally, the windshield-washer fluid became a very successful and profitable product.
* Incorrect cost information. While product costs shouldn't limit what you charge for your product, they do limit the least you can charge, and they influence the urgency with which you should probe for the larger amount. Incorrect costs can make pricing analysis worthless.
Larry, the owner of a small company that manufactured etched-aluminum pictures, once asked me for help. "I don't have any cash," he said, "but my certified public accountant tells me I'm profitable. Would you look at my books and tell me what's happening?"
It turned out that by ignoring significant waste and spoilage, Larry had underestimated the cost of his products. He was paying close to $10 for materials to make his pictures, but he was selling them for only $8.99 because he thought they cost around $6. He appeared to be making a profit because the extra $4 of cost stayed on his books as inventory. He would have discovered the problem if had counted and valued his inventory. But he never took the time to do this because he was always scrambling for cash. (His accountant hadn't found the problem either, since he'd only been asked to do what's called a compilation, not a complete audit.)
* Inattention. With so much else going on, managers often ignore pricing. The most careful attention that I've ever seen given to pricing was by the president of a fast-growing chain of restaurants. During the late 1970s, when inflation was high, his staff checked prices and costs every week. If margins dropped to a certain level, the president immediately repriced and reprinted his menus. At times he reprinted menus every six weeks or so.
"What about your competitors?" I once asked this restaurant owner. "Don't they concern you?"
"No," he said, "for three reasons. First, no one controls costs better than we do. So when we see our margins slipping, we know that inflation is driving our costs up, not our own inefficiencies. Second, we have so much competition that someone is always raising prices. They've got to. Their costs are probably higher than ours. Third, we raise prices by small amounts frequently. This way, our customers don't seem to mind as much, and we maintain every little bit of margin we can."
My own experience in manufacturing and years of research by marketing theorists support the wisdom of the restaurateur's third point. Evidently, customers prefer price increases that are frequent but small to those that are infrequent but large. And certainly a policy of frequent price increases allows a company to maintain every last bit of margin it can.
* Full product lines. Many small manufacturing companies are convinced they must offer customers a full product line. Their marketing managers, often coming from large companies, condemn a partial line with all the fervor of an environmentalist in sludge. But the financial reality is that you may lack the resources and the sales volume to develop, price, and sell the additional products profitably.
I once worked with a company that made very good potting soil for house-plants. But to fill out the product line, the company also sold dehydrated cow manure, decorative stones, plant food, and so on -- all at a loss. The quality of the oddball products was below that of the potting soil, but the cost of sales was significantly higher. That was because the company knew nothing about the technology of the other products; it didn't have the special equipment needed to produce them efficiently; and it couldn't generate enough sales volume to justify acquiring the necessary knowledge and equipment. The company sold its secondary products for all the market would bear, but the losses on those goods nearly sank it.
If you need a full product line, there are other approaches. One, recently popularized by marketing consultant Regis McKenna, is to form a strategic alliance with other firms also looking to fill out their lines. Aldus Corp. has done this very successfully. The three-year-old company produces PageMaker, one of the best-known software packages for desktop publishing on microcomputers. Aldus has formed an alliance to sell a complete system for desktop publishing, which includes a computer and laser printer from Hewlett-Packard Co., a word processor and system software from Microsoft Corp., and the page-layout software from Aldus. The company has other strategic alliances in the works.
* Inappropriate objectives. Marketing theorists talk a lot about pricing objectives. Is your objective to maximize current profits? To penetrate new markets? To capture market share? To discourage entrants? To build traffic in a retail store? Or something else? Your pricing policies, they tell us, can be a very effective device to achieve these and other objectives.
Unfortunately, if your company is like most I've seen, you have a hard enough time generating current profits. Trying to achieve the other objectives through general price cuts usually requires more cash, more market knowledge, and more ability to forecast the future than you can muster. This is not to say, however, that if you have a Cadillac product you must ignore the Chevrolet marketplace. It does say that you should protect your Cadillac margins by selling Chevys in the Chevrolet marketplace.
When sales are slower than you would like, it takes knowledge and creativity to turn the situation around without sacrificing margins. Perhaps the positioning of the product needs to be changed or new segments found. Perhaps the product needs to be changed or redefined.
Sometimes, of course, when nothing else seems to work, a price cut may be the only way to increase sales. But sharp entrepreneurs will look to price cuts as a last resort, not as the first point of attack.