Welcome to Part II of a three-part blog about pricing. To read the fascinating Part I, please refer to our June 20, 2011 blog post. The scenario: Meet Janice and Skippy, our ‘typical retailers.’ 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 entrepreneurs. 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 the shop, including their own salaries which amount to 46% of total sales. 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’s do the math for them. 1. Their fixed costs, like rent, stay the same. Most of their business costs, like payroll, fluctuate, since they’re running their business correctly, in accordance with the number of transactions that occur. Their COGS (Cost of Goods Sold) 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 actually 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! 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. Tune in for our final thoughts – Part III of this dramatic blog discussion – tomorrow!
Trackback from your site.