Small Business

Price-Cutting Peril: Do You Know What You're Doing -- Really?

By Mark Henricks

Updated on: November 19, 2010 / 4:10 PM EST / MoneyWatch

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

What happens when you cut prices? Say you drop it by $1 or 10 percent. At $9, you sell 25 percent more washes. But revenues climb less than 9 percent, to $150. Costs per wash stay the same, so total costs increase 25 percent. You make less money for working harder. Details:

Price	Washes	Revenues	Costs	Profits
$10.00	16	$160	$120	$40
$9.00	20	$180	$150	$30

When does cutting prices increase profits? The answer may surprise you. If you cut prices 10 percent, you have to wash nearly 69 percent more cars to make more money. At $9, you'd have to do 27 washes to beat the $40 profit you got washing 16 at $10 each. Your extra profit comes to 50 cents. Details:

Price	Washes	Revenues	Costs	Profits
$10.00	16	$160	$120	$40
$9.00	27	$243	$202.50	$40.50

On the other hand, if you raise prices 25 percent you'd have to lose more than half your customers before it hurt profits at all. Details:

Price	Washes	Revenues	Costs	Profits
$10.00	16	$160	$120	$40
$12.50	8	$100	$60	$40

This is a paper exercise, not a real business. A real business has fixed costs like rent. And employees want to get paid whether they are washing cars or popping each other with Sham-Wows. A real business may have to compete with the car wash across the street. A real business may find ways to reduce costs, even while increasing volume.

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

Mark Henricks

Mark Henricks' reporting on business and other topics has appeared in The Wall Street Journal, The New York Times, The Washington Post, Inc., Entrepreneur, and many other leading publications. He lives in Austin, Texas, where myth looms as large as it does anywhere.

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