Price-Cutting Peril: Do You Know What You're Doing -- Really?
Few business owners realize the powerful leverage that lower prices can have on their profits. To get a feel for it, consider this hypothetical example.
You own a hand car wash. A base wash and wax at your business normally costs $10. Costs for soap, wax, labor and supplies on each procedure come to $7.50. You get $2.50 profit per customer for a 25 percent gross margin. After keeping prices at this level for five years, you raise the price to $12.50. That's a 25 percent increase -- not small. But it's nothing compared to the effect on your profits. These double to $5 per wash, while your profit margin increases to 40 percent.
Some former customers now decide to go for a bucket and sponge in the driveway rather than pay you more. But a whole lot of them have to opt out in order to cut into profits. How many? Let's get out our pencils.
Say 16 people buy the $10 wash every weekday afternoon. At $12.50, just a dozen come in. But even washing 25 percent fewer cars, the business makes more money at a 25 percent higher price.
Price | Washes | Revenues | Costs | Profits |
$10.00 |
16 |
$160 |
$120 |
$40 |
$12.50 |
12 |
$150 |
$90 |
$60 |
Price | Washes | Revenues | Costs | Profits |
$10.00 |
16 |
$160 |
$120 |
$40 |
$9.00 |
20 |
$180 |
$150 |
$30 |
Price | Washes | Revenues | Costs | Profits |
$10.00 |
16 |
$160 |
$120 |
$40 |
$9.00 |
27 |
$243 |
$202.50 |
$40.50 |
Price | Washes | Revenues | Costs | Profits |
$10.00 |
16 |
$160 |
$120 |
$40 |
$12.50 |
8 |
$100 |
$60 |
$40 |
The point is that raising and lowering prices even a small amount can have an outsized effect on profits. If you're cutting prices without matching cost reductions, you're going to need a lot more new customers than you might have suspected to avoid losing money.
Mark Henricks has reported on business, technology and other topics for The New York Times, The Wall Street Journal, Entrepreneur, and other leading publications. Follow him on Twitter @bizmyths.
Image courtesy of Flickr user America: My Personal Observations, CC2.0