Last Updated Apr 26, 2011 2:30 PM EDT
We'll let you in on a secret: Once you pay for your overhead, every change you make affects your bottom line -- all price increases and expense reductions go directly to your net profit.
Therefore, with a 1% price increase, a 1% decrease in cost of goods sold, and a 1% decrease in your administrative expenses, you can boost net profits by 19% or more!
Let's look at a typical company's margin profile:
- Cost of goods: 50%
- Administrative costs: 40%
- Net profit: 10%
- A 1% reduction in cost of goods translates to 5% net profit.
- A 1% reduction in administrative costs translates to 4% net profit.
- A 1% price increase translates to 10% net profit.
Results will vary depending on margins, but nonetheless this shows the power of how small changes have a big impact on increasing your net profits.
Keep in mind, the revenue increase comes from a small price change -- not going out and making new sales. (The other two areas are also in your control by looking deeply at your cost structure and processes to determine where you can shave off 1%, and we'll address those in upcoming posts.)
So how do you increase your prices by 1% without adversely impacting sales?
Strategy #1: Don't let your customers notice
The easiest way to increase prices without cannibalizing sales is to make it virtually invisible or inconsequential to your customers. For example, a law firm billing over 300,000 hours per year increased its rate by $2 per hour. The increase was almost imperceptible to each individual client, yet the impact to the firm's bottom line was greater than their entire net profit had been previously. A furniture company raised the price of its best-selling bar stool by $1. They sold 250,000 barstools -- the same as the year before. The only difference was the quarter of a million dollars they added to bottom line profit.
Strategy #2: Offer several price options
Another option instead of simply raising prices is to offer customers a variety of pricing options. This strategy is win-win: Higher profits for your business and more choices for consumers.
In April of 2009, Apple's iTunes shifted from its one-size-fits-all 99 cents pricing strategy to a three tier pricing strategy ($0.69, $0.99, and $1.29) per song. Glenn Peoples, a reporter for Billboard, did a great analysis on the effects on sales right after the changes went into effect. At that time, the prices of 40 out of Apple's top 100 songs (which represent roughly $4.6 million or 20% of Apple's $23.5 million of monthly U.S. sales) went up to $1.29 while the others remained at 99 cents. Now, nearly all of the top 100 songs cost $1.29. Assuming the same percentages, 20% of the 250 million downloads per month adds almost $15 million each month in added revenue!
Strategy #3: Increase prices... without increasing prices
Baggage fees, anyone? US airlines added $2.6 billion dollars to their bottom line in these fees alone. This can be an effective approach for companies that are unable to raise prices due to regulatory or competitive constraints.
Regardless of which path you choose, there are a few things to keep in mind.
- Financial transparency is key: You need to know where you are making money and where you are not. It sounds simple but can be quite complicated in practice and especially as you grow. Think about the computer on your desk. It's really easy to see the power cable if it's the only cable. But add the wires to your keyboard, monitor, printer, speakers, and other peripherals and what do you have? Businesses (especially when they're in high growth) add profit centers rapidly and pretty soon the financial transparency is about as neat and tidy as the spaghetti behind your computer -- or at least ours.
- Limit your variables: To monitor price elasticity -- the effect prices have on sales volume -- it's important to make only one change at a time. Start small, measure, and monitor. Let the power of small changes work for you.
- Don't just set a price strategy; follow it. Whatever your strategy is, make sure your people to stick to it. Do your salespeople find it easier to negotiate prices with your customers or with you? Structure commissions around gross profit not gross revenue, or at least have margin qualifiers. Sales audits, training, and re-training will also help to ensure that you have pricing compliance.
After all, it's only 1%.
Have a small business finance question for The Money Dept.? Hit the comments or email us using the contact form under our photo.
Read more Money Dept.:
- How to Create a Culture of Profitability
- Anatomy of a Business Failure
- 10 Questions to Find the Right Bank for Your Business
Flickr photo courtesy of Marcin Wichary, CC 2.0