Last time, we talked about price theory and various pricing strategies. Today, let’s look at the idea of raising prices in an effort to raise profit. Sometimes it works, but not always. Read on to learn about elasticity, and why perception matters in pricing.
You see it all the time. Company A is running a tight budget or business is down. Profit margins narrow, or perhaps the cost of doing business has increased. Maybe they begin to get a little concerned, so they jump the gun and raise their prices.
This may seem to be a quick solution. Maybe you think it’s only a temporary increase until the situation stabilizes. However, you start to notice that your price increase has the opposite effect. Not only are profits not improving, but your overall sales are slumping.
It may seem like a no brainer: if you charge more money, you’re going to make more money.
But, that isn’t always the case. More goes into making a profit than raising prices.
Perception, Price, and Profit
In business, there’s a concept called elasticity. This is the relationship between how you valuate a product or service for sale in relation to how many people are willing to pay that amount for what you’re offering.
It’s not just about supply and demand. There’s also perception.
You may think that customers see a higher price as a mark of quality. Depending on the product and market saturation or availability of similar products, the customer may take a different view. This is specially true if the price increase is sudden without any noticeable improvement in the level of service or the product itself.
You always run the risk of losing customers, and therefore revenue, because it’s more expensive to purchase. On the flip side, lowering the price might mean seeing lower profits per sale but an overall increase in revenues because more people are able to afford what you’re selling.
How do you determine elasticity?
Products that are necessities or marketed to a specific niche tend to be more in demand than a product that’s widely available or deemed a luxury item.
It also depends on the overall economy. When times are tough, consumers will put off buying some products. They may even see a sudden price increase as an attempt to make up for loss of business revenue at their expense.
In order to justify higher prices, you need to determine the elasticity of the market for your particular product. It’s also important to understand the difference between your profit and your profit margin.
Profits and Profit Margin
Gross profits are the overall amount of money you make when you make a sale. Your net profit is what you have left after you figure in expenses. This is pretty straight forward and measured in a dollar amount.
Your profit margin is determined by calculating your net income divided by revenue. What percentage of your total earnings do you actually get to keep out of every dollar amount in sales?
Your profitability, and therefore, profit margin, can be increased by lowering the cost of doing business, by attracting new business, increasing the sales per transaction, or by raising prices.
Let’s take a look at the possible implications of each.
Increasing Revenue by Reducing Your Profit Margin
Let’s say that you decide to increase your revenue by attracting new business. In order to do so, you launch a new ad campaign and double your sales force. The increase in the cost of doing business does result in attracting more customers or reaching a new audience.
However, you may also have reduced your profit margin in the process, resulting in fewer profits per sale due to the increased cost of doing business. You’ve got more money on your balance sheet, but your company is less healthy financially.
Increasing Revenue by Reducing Costs
Rather than increasing your prices or incurring additional expenses in an effort to increase profits, maybe you decide you’re going to improve your bottom line by cutting expenses. This is another common mistake companies make.
It looks good on paper, but often those cuts are made in places that hurt your business in the end.
For example, one of the biggest expenses is payroll. You’ll think that reducing your staff will save money when in reality, you risk providing sub-par service and lowering staff moral. That’s always bad for business.
Reducing your marketing budget might seem like a way to lower expenses. This will only work if you are able to maintain the same reach with less budget, and that can be risky. You can’t entirely rely on free advertising via social proof or social media.
As a last resort, perhaps you try to reduce costs somewhere in the supply chain, either by finding cheaper materials or a supplier who offers discount rates. This approach could also backfire if the cheaper materials result in lower product quality or the discount supplier is unreliable.
This brings us back to the option of raising your prices. This can be done and work successfully by understanding your market and your company’s ability to properly gauge market elasticity.
Determining Market Elasticity
In order to do this right, it takes a measure of keen insight into market forces and trends mixed with some research and analysis. Technology can help with this by providing an overview of sales during the same time period in the previous year, by analyzing factors that influence consumer behavior, and by exploring new market segments.
For example, what is the fair market value of your product or service? In other words, how much a people willing to pay for what you offer regardless of the overall economy? What are your competitors getting for a similar service? Do you have much competition, and how can you differentiate your company from theirs? Are there untapped or under served markets you haven’t considered?
What about your current customer base? Statistically speaking, the bulk of your revenue will come from your current customers rather than new business.
All of these factor go into determining the affect of a price increase on your profitability.
Let’s face it, companies are always on the lookout for ways to increase profits. However, this should never be attempted at the expense of quality or customer satisfaction. Understanding the various metrics and means of profitability will allow you to streamline your business so that it is both efficient and profitable.
One sure way to justify a price increase without sacrificing service or lowering the quality of your profits is by building a strong brand identity. If you need help stepping up your branding game, Level343 has strategies that work.