Pricing for Volume Is Just Hard to Justify

Complimentary analysis spreadsheet provided courtesy of the Wiglaf Journal.

At a fast-growing entrepreneurial firm last month, I found myself casually drifting into a dead-serious strategic conversation about pricing.  With growing customer interest and booming orders, the company had recently gone through an expansion in capacity.  Their new capacity would allow for a 3 fold increase in volume, and possibly more.

A recently appointed operations officer expressed his interest in lowering prices to drive up volume and improve capacity utilization at a faster pace.  Standing in the room was one of the two founding partners.  As I listened to their discussion, I could tell that this was not the first time that the strategy of lowering prices to drive volume had been proposed.

On the face of it, lowering prices to drive volume sounds attractive.  Guru-speak talks of “economies of scale” and “tapping into a larger market by entering at a new price point”.  Both are fine arguments and sometimes appropriate.  But, when misapplied, it’s like a psychiatrist that blames everyone’s problems on their childhood relationship with their parents.  Simply unhelpful.

Rather than blindly throwing paradigms at the question, let’s just look at the numbers.

Modeling the Decision

Decisions about pricing are decisions about profitability.  Starting with the familiar relationship of profits being the difference between revenue and costs, followed with some standard assumptions, we get to the familiar business 101 equation of

Profit = (Price – Variable Costs) X Volume – Fixed Costs.

Assuming that the decision maker wants to leave the firm better off, or at least not damage it, we can conduct a “What if” scenario analysis to guide her decision.  She can ask, “What if we dropped our price and went for volume to drive profits? What would happen”  Or, in a more precise manner,  “If the price is dropped by 1%, how large of a volume increase would be required to leave the firm in the same profitability position?”  Posed in this way, it is easily addressed analytically.

This simple analysis usually reveals that even the smallest price decrease requires a large volume increase to justify the decision.  In fact, the company is usually better off by seeking to use some of the other variables in the marketing mix to drive growth.

An Example

Suppose we have a company making an item for 25 and selling it at 33.33.  While the contribution margin isn’t tremendously large, it is still 25%.  Not bad for a manufacturing company, not good for a retailer, and far too high for a commodity broker.  Next, let’s suppose that this company is considering dropping its prices by only 1% in order to drive volume increase.  We can now ask how large of a volume increase is required to leave the firm as well or better off?  We find the answer is 4%. See Figure 1.

That is correct.  A 1% decrease in price for this company would require a 4% increase in volume to “break-even” in the decision.  This would imply that the market’s elasticity of demand must be greater than -4.06.  While some markets are that elastic, most are not.

To get a feel for a reasonable elasticity of demand, let’s look at a couple of markets in the US.  The demand for water is relatively inelastic, with an elasticity of demand of -0.18.  This means that a relatively large change in the price of water will not drive consumers to change their consumption significantly.  On the other hand, the demand for coffee in the US is relatively elastic, with an elasticity of demand of -3.06.  This means that even a relatively small change in the price of coffee will dramatically change the drive consumers to change their consumption.  (Of course, there are bounds within which these arguments are applicable.)

Notice that neither the inelastic market for water nor the elastic market for coffee has an elasticity of demand greater than the threshold required to justify lowering prices by 1% in a market with 25% margins.

The Smaller the Margin, the Tougher to Justify

As margins thin, the threshold grows.  For example, a product with a 10% contribution margin would require a 10% increase in volume to justify a 1% drop in price.  A commodity product with a 3% contribution margin would require a 40% increase in volume to justify a 1% drop in price.  Only products with high contribution margins can be counted upon to regularly hit the required threshold.  See Figure 2 and 3.

Take Away Value

After doing one or two examples, you acquire general rules to set your course.

• Most companies, but not all, do not face an elasticity of demand sufficient to warrant a price decrease to “grow volume”.
• The smaller the margin, the larger the required increase in volume to “break even” on a decision to lower prices.
• Marketing variables other than price are often more efficient at driving volume.

I am not the first person to make these arguments and I doubt I will be the last, but perhaps I have provided a little more clarity to a few more people, that cutting prices to grow volume is usually a really bad idea.

Complimentary analysis spreadsheet provided courtesy of the Wiglaf Journal.