How many times have you asked your team, “If we cut price, what will be the impact on volume and/or share?” Pricing is the moment of truth in any transaction and often has enormous impact on profitability and shareholder value.
There can be very divergent answers to the question, depending on management’s perspective on meeting financial commitments vs. the microeconomic price elasticity of demand. Although this debate has been going on for decades and its underlying mathematics are well known, it requires revisiting as new generations of managers come along and there is significant pressure on the pricing of products and services.
In this exercise, I will demonstrate that if you side with your chief economist, the odds are you will miss meeting your financial commitments. I argue that at the end of the day, satisfying those commitments must win. You need to find a way to deliver rather than to give in to standard economic theory.
Most business leaders and managers are aware of the power of price. In a situation where one drops price and holds everything else constant, the price reduction creates the worst possible negative operating leverage. Depending upon contribution margin (CM), the classic example illustrates how a -1% change in price can easily result in a -10% change in operating profit, a condition that is typically far worse than the negative leverage that occurs from losing -1% in volume.
Consider the example in the graphic below:
In this example, assuming price elasticity of demand for the product or service offering is 1.5 with a 20% price reduction, we would anticipate 130 units of demand. Naturally, this assumes many other things are held constant, such as competitor reactions. Though volume would increase, it would do so at the cost of missing the commitment plan of $400. To meet the plan commitment would require a 100% increase in volume.
So, I maintain that this is the very first equation every business leader should know:
% Change in Volume = – % Change in Price / (CM % + % Change in Price)
The example with values substituted reads as follows:
% Change in Volume = – (-.20) / (.40 + -.20) = .2/.2 = 100 %
A more visual representation of the equation is in the graphic below. The left axis shows the price drop, the right axis shows the initial CM percentage (i.e., before price drop), and the X-axis illustrates the volume response. Reading across from the 20% drop on the left to the intersection of the curves that correspond to the CM percentage shows the respective volumes applicable to the aforementioned problems.
The relationship as presented ignores productivity. Increased productivity would reduce the volume needed to offset the price decline per the equation. A logical case can also be made that the incremental volume itself would generate some variable cost economy of scale (e.g., supplier leverage). For example, if the 100% increase in volume simply was not feasible and with a -20% price shock and 40% CM, it would take 33% ($6 to $4 variable cost per unit) variable cost productivity (VCP) to maintain your commitment. Is that realistic? When was the last time you had 33% VCP? Even masters of VCP and Lean Six Sigma rarely see more than 4% to 5% on an annual basis.
Before initiating a price drop or starting a price war, consider the possible consequences. Have your finance team model the equation (or make sure its logic is built into your econometrics) and have everyone in your sales organization carry the resulting graph with them. Listen to your chief economist about macroeconomic uncertainty, but find a way to get beyond those concerns to ensure that you always meet your financial commitments.
Tom Conine, Ph.D., is president of TRI Corp., which specializes in corporate education, experiential leadership and simulation programs to help clients develop leaders, sharpen financial acuity and improve executive business acumen. He is also a professor of finance at Fairfield University in Connecticut.