Better Business Idea #62

"We'll Make It Up With Volume" - Not!

© 2003 by Michael C. Gray

April 30, 2003

In times of economic stress (like now), it's tempting to reduce prices to increase sales.

Sometimes this decision is justifiable to turn inventory that is tying up capital and can't be sold into cash. Also, sometimes a business is able to get volume purchase discounts or has operating efficiencies that their competitors do not, like Wal-Mart. Those businesses can temporarily choose acceptable reduced profits with the hope of eliminating competitors (like K-Mart) or creating barriers to entry for new competitors.

Reducing prices is usually an unsound long-term strategy that makes it more difficult to be profitable. Let's look at a break-even analysis to illustrate this point.

Busibuy is a retailer that has been experiencing reduced sales. Traditionally, it has priced goods with a 100% markup over cost, which also could be described as a 50% gross profit margin on sales. Operating expenses are fixed at $300,000 per year. In order to break even, its sales would have to be $300,000 / 50% = $600,000.

What if Busibuy reduced its prices by 10%? That would reduce the gross profit margin to 40%. In order to break even, sales would need to be $300,000 / 40% = $750,000. That means there would need to be at least 25% ($750,000 - $600,000 = $150,000 / $600,000 = 25%) more effort to break even.

What if Busibuy increased its prices by 10%. That would increase the gross profit margin to 60%. How much business could Busibuy lose and still break even? Break even sales would be $300,000 / 60% = $500,000. That means they would need about 16 2/3% less effort ($600,000 - $500,000 = $100,000 / $600,000 = 16 2/3%) to break even.

A similar analysis could be done for a service business by analyzing hourly rates, net of direct hourly costs. Bear in mind that operating costs for given ranges of volume will be fixed.

It's clear that businesses that have operating efficiencies really have a competitive advantage. For example, a competitor to Busibuy is Maxibuy. For the same operating range, Maxibuy's fixed costs are $250,000. When Busibuy is breaking even, Maxibuy will have a profit of $50,000.

Remember this analysis when making pricing decisions for your business. Otherwise, making a knee-jerk response could result in moving from barely making it to a loss.

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