I guess Pricing Nugget number 54 is not too early to discuss why pricing is important 😀
You might have a gut feeling that pricing has a big impact on your profits. And you might be right.
Today, we look into the hard facts, the data, and the studies that confirm your instinct.
And second, I want to share with you a calculator to calculate the power of pricing for your business and your situation. I look forward to diving into this right now.
To figure out how important is pricing for your business, and for your profits, you need to compare it against something.
There are (only) four common profit levers:
- You can raise your prices.
- You can increase your sales volume, the number of units and services that you are selling.
- You can reduce the variable costs, the cost of producing an additional service or additional product.
- You can reduce your fixed costs, the cost that happens anyway.
A Harvard Business Review article from the early 90s featured a study from McKinsey consultants who analyzed the impact of a 1% improvement of these four profit levels on profitability. And they found out for 2,500 international companies that
- a 1% reduction in fixed costs only increases profits by 2%,
- an increase in sales volume only increases profit by 3%,
- a reduction in variable costs only improves profits by 8%, but
- a 1% increase in price increases profit by 11%.
The study was updated a few years later and the numbers did not change much.
Better pricing capabilities lead to better firm performance
So, you might conclude if companies are more capable and smarter with their pricing, they should enjoy greater financial performance. And you might be right. Researchers surveyed 1,800 professionals who were responsible for pricing and asked them about their pricing capabilities. Then they asked what is their perceived performance relative to key competitors, which is a measure to analyze the performance of the company. And the researchers found a statistically significant relationship.
What does it mean for us?
This means, looking into pricing is very important for your company's performance. And if you need more inspiration on pitching the idea of improving pricing for your company, you might check out this book.
It includes a couple of studies from various authors and institutions that confirm that better pricing leads to better financial performance. And with this book, you make the case for your CEO to dive a bit deeper or to stress the importance for your own business to double down on pricing.
Your "Power of Pricing Calculator"
"Your pricing" is the perfect keyword here. To evaluate the importance of pricing for your business, I created a calculator to calculate the power of pricing for your business. You find it here and I will show you what you find in this app as of today.
What do we have for you in this power of pricing calculator?
The idea is that you can easily estimate the impact of changes to the four profit levels to your profits. The tool is (hopefully) self-explanatory and intuitive.
- You can start by by either applying percentage changes to the profit drivers or absolute values. Let us stick with relative changes in this example.
- We have these four profit drivers: current price, current unit sales, current variable costs, and the current fixed cost. And now we can change them a bit.
- Let us say we want change the price by 5%. So, we click on the slider and increase it by 5%.
- We immediately see how the current profit increases to the new profit.
- We have the current contribution margin being calculated and the new contribution margin being calculated. All these outcome variables got calculated, and you see that a 5% change to your price increases your profit by 13.51%.
- As a neat sanity check, I also included the breakeven point in sales that still leads to the same profitability as before. So in this case, if we increase the price by +5%, sales can go down by -11%, and we still have a positive impact on our profits.
I invite you to plug in your numbers, play around with the profit drivers, see how these profit drivers change and how do they impact your bottom line.
What did we learn today?
- we learned that price has a tremendous impact to your bottom line, to your profits.
- We learned that companies that are smart and capable around their pricing, also enjoy greater performance.
- And we found a way to easily estimate the impact of price changes to our own financial situation in our company.
Baker, W. L., M. V. Marn, and Craig C. Zawada (2010). The Price Advantage. Wiley Finance. Hoboken, NJ: Wiley.
Kohli, C. & R. Suri (2011). The price is right? Guidelines for pricing to enhance profitability. Business Horizons, 54 (6), 563–573. [this paper cites Baker/Marn/Zawada 2010]
Liozu, S. M. (2021). Pricing - The New CEO Imperative. VIA Publishing.
Liozu, S. M., & Hinterhuber, A. (2013). Pricing orientation, pricing capabilities, and firm performance. Management Decision, 51(3), 594-614.
Marn, M. V. & R. L. Rosiello (1992). Managing price, gaining profit. Harvard Business Review, 70(5) September-October, 84-94.