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When competitive pressures increase, it’s tempting to cut your prices. In fact, it’s the first reaction of many business owners and managers.
While this may be required for defensive reasons, it can often kill your bottom line in the short run. Worse yet, it can destroy the value of your business in the long run.
Working harder for the same money
Let’s look at a simple example so you see the true impact of a price cut. We’ll use a retailer since they have a simple business model – they buy merchandise for a set price and then resell it.
Let’s further assume that our retailer sells just one product, something you obviously wouldn’t want to do. This product costs $10 per unit. Our retail store sells it for $20 so the Gross Profit on each unit is $10. Here’s what that looks like visually:
To respond to a competitor, our retailer lowers the sales price by $2. Now it’s selling the product for $18, which only leaves an $8 Gross Profit:
So now, in order to make the same Gross Profit, our retailer has to sell 1.25 units ($10 ¸ $8). Put another way, to make the same money, they have to sell 5 units for every 4 they sold before.
Many people intuitively think a 10% decrease in price would require selling 10% more to break-even. In fact, given the assumptions here, this retailer will have to work 25% harder!
How it kills your bottom line
On the surface, that may not look like much of a difference. But let’s make it more personal. Let’s say this is your operation and talk about what it really means to you:
You will have to order 25% more products. Okay, that may not take long. But you also have to unload 25% more products off the truck. Then you have to stock 25% more products on the shelves. Finally, you have to check out 25% more products.
Just to make the same amount of money as you do now!
If you are operating efficiently (i.e. you and your staff are at full productivity), then you will need 25% more people or you will all have to work 25% more.
Oh oh! This price cut is starting to hurt your bottom line.
Not only that, you (and/or your managers) will have to manage 25% more people. This may require you to work longer hours. There goes the little free time you have!
OR you may have to hire people to manage the people you just hired! Yet another hit to your bottom line.
But it goes even further than that: You may need up to 25% more customers. So you will need to spend 25% more on advertising.
Whew – this price cut has killed your bottom line!
In fact, if we assume that you spend 20% of sales on payroll and 5% on advertising, you actually need to increase sales by 43% in order to make the same amount of money. Ouch!
It works much the same way in any business. You have to work a whole lot harder just to make the same money if you cut your prices.
So, before you cut prices, consider its full financial impact on your bottom line. Then consider your alternatives. In most cases, there’s a better strategy – one that leads to BIGG success!
What suggestions do you have for pricing profitably?