I think about prices a lot – wholesale, retail, on sale, organic vs. conventional, wild vs. farmed salmon, you-name-it. My clients (almost all of them) ask me (almost all the time) about discounting their prices, competing with amazon, competing with other discounters, etc. And my answer is (almost always) the same: ‘Hold the line or raise your prices!”. This isn’t based upon some blind allegiance to IMHO marketing, but rather upon some pretty solid math that you can do any day of the week.
Caveat: Clearly there many business models where you are not in the driver seat and do not have the option of raising prices. You may actually find after doing the math that your best option is to stop selling your products through the avenue that you have chosen. Some retailers are fine paying 15% to sell their wares on amazon.com – others find this idea abhorrent.
Our scenario:
Let us take our ‘typical retailers’, Janice and Skippy. They will purchase a widget from their wholesaler for, say, $50. Their initial markup for goods is 100%, giving them a 50% initial margin. Let us say that they sell 1,000 of these widgets a year, but 10% of them are sold at 10% off each year.
(900 x 100) + (100 x 90) = 99,000 total revenue
Since cost of goods (COGS) was $50,000, their maintained margin is now 49.49% ((49,000/99,000)*100)).
OK. So Janice and Skippy have a physical store, computers, employees, a marketing budget, extra strength Tylenol and all the other expenses that come along with being an entrepreneur. They are good business people so they know that their expenses must not out-strip their revenue. And they have worked it out so that their costs of running their shop, including their own salary, amount to 46% of total sales.
So at the end of the year they have 3.49% (49.49 – 46) of sales to distribute to themselves as an owner draw. Three percent might seem like very little, but you can trust that most mom and pop shops in the US don’t even manage that. Their 3.49% amounts to $3460 cash in their pocket at the end of the year.
What happens when Janice and Skippy raise their price by 5%?
Janice says to Skippy, “Let’s add 5% to the retail price of our widget.” Skippy says, “Are you crazy? Our sales will plummet. The market can’t handle it. It will ruin our business. Yada. Yada. Yadnauseum .” So let us do the math for them.
1. Their fixed costs, like rent, stay the same. Most of their business costs, like payroll, fluctuate, since their are running their business correctly, in accordance with the number of transactions that occur. Their COGS is the same on a per item basis. At any rate, the big picture is that their costs as a percentage of their sales are about the same.
2. Whatever they add to their retail price goes straight in to their pocket!
Here is what happens when they do raise their product price by just five percent.
(900 x 105) + (100 x 94.5) = 103,950 total revenue
Their maintained margin is now 51.90%.
Their percent profit went from 3.49% to 5.90% (51.90 – 46).
To put this into perspective:
This is NOT a 2.41% (5.90 – 3.49) increase in profit
This is a 69% increase in profit percentage
AND a 77.25% increase is their cash in pocket!
So let us address Skippy’s concern about a drop in sales. First what kind of drop in sales would be expected, if any? One percent? Three Percent? Five or ten percent? What is reasonable?
How is this for perspective?
In order for Janice and Skippy to lose even just $4.39 in profit after raising their price by just 5%, their sales would have to drop by an incredible…
Wait for it…
43.6%
Here is the math:
They sell 564 products sold (507 at full retail, 57 on sale)
Their COGS is $28,200
Their total sales are $58.621.5
At a 5.89 percent profit their cash in pocket is $3455.61, just $4.39 less than they put in their pocket at the original retail price.
The summary and more caveats:
Clearly there is a lot more math involved here. And this calculation can be argued on the basis of fixed costs like rent. But the conclusion to take away from this is that there isn’t a bean sprout’s chance in the Atacama Desert that you would experience losses on the order of 46% just by raising your prices by 5%. The lesson to take away from this is that discounting doesn’t make you money – it actually takes money directly out of your pocket. DIRECTLY!
