Answer: Only if you assume you can put price up and nothing happens to unit sales, which is unlikely.
Pricing
Powerhouse consultants McKinsey state that “Pricing right is the fastest and most effective way for managers to increase profits. Consider the average income statement of an S&P 500 company: a price rise of 1 percent, if volumes remained stable, would generate an 8 percent increase in operating profits (Exhibit 1)—an impact nearly 50 percent greater than that of a 1 percent fall in variable costs such as materials and direct labor and more than three times greater than the impact of a 1 percent increase in volume” – source, http://www.mckinsey.com/insights/marketing_sales/the_power_of_pricing.
This storyline has been around for a long time. Bain said the same sort of thing years ago. More recently the columnist Mark Ritson publicised the idea, and there are dozens of consultant web sites echoing this line.
So, getting price up apparently works better on bottom-line profits than either improving sales volume, or reducing costs – percent for percent. Is this true, and if so, how is it possible ?
The answer is yes it is true only IF you can increase price without sales dropping off. That’s a very big IF. We’ll take a look later in this piece at the evidence about what actually happens to brands when they increase price. Second, this statement assumes the effort involved to get price up is cost neutral. That’s another pretty big caveat, in fact it’s pretty unrealistic. Surely you would not rush in and just blindly put prices up on everything, so there would be time, therefore expenses involved in such a process.
The other important point is that the statement ‘price has more effect on bottom line profit than volume or costs’ is that it’s in theory true, but true by definition. It’s simply a function of margin arithmetic. I’m indebted to the late John Scriven, formerly of London SouthBank for explaining this to me years ago, and it took a couple of years for the explanation to stick.
Explanation
In basic terms, the product you sell always has some variable and fixed costs. And those costs – per item – are only a fraction of your selling price. So if you reduce costs it only applies to a fraction of your selling price. And if you increase unit sales, you only retain a proportion of the additional margin, because you’ve got some cost component on every item you sell. But if you increase price, the increase applies to ‘all of your price’. If that’s clear, stop reading now, otherwise here is an example to illustrate.
Example
You make ice creams for 50c and sell them for $1. Contribution, or margin on each one is 50c. You sell 1,000 ice creams.
If you reduce your costs by 1% you save half of one cent per ice cream, which adds 1000 x half a cent = $5 extra profit.
If you sell 1% more ice creams you sell 1000 x 1% = 10 more ice creams and keep 50c margin on each, = $5 extra profit.
But if you increase your price by 1% it’s 1% on a dollar, not 1% of 50 cents. So the extra on the bottom line is 1000 x 1 cent = $10.
But, be sure to note that the assumption, as before, is that your prices have increased by 1% AND your sales have remained exactly as before.
So McKinsey (& Bain & Ritson) are in theory correct, if you accept you can raise prices with no loss of sales. It’s theoretically correct, because of the simple arithmetic linking cost, prices, volumes and profits. Whether you can get prices up with NO loss of sales, and if it’s easier or harder than getting costs down or volume up, is another matter. The McKinseys and Bains will say, you might be giving away unnecessary discounts and they can help you to remedy that. But doing so will probably involve a platoon of consultants and cost a million, so the idea you can get prices up easily or at no cost quickly disappears. And if it were possible to get prices up one percent with no loss, why not two percent or ten percent? Where does it stop?
Let’s now look at real-world price changes.
The Real World – it gets more complicated
In the real world if you increase price your unit sales go down (just as is equally well known that price drops increase sales volume). Another way of saying this that brands are price-elastic. Price elasticity is the change in unit sales for every 1% price change. On average brand price elasticity is -2.5, that is, if price goes up 1% then sales go down 2.5%. This is no mere theoretical concept. It is the result of dozens of studies including several from our own Ehrenberg-Bass researchers. And it varies for big and small brands and according to other factors like competitor prices, signalling and price passing. However, there is no evidence that price elasticity is related to amorphous concepts like brand equity or brand strength (over and above the effect of the brand’s size in market share).
So whether you make more money from putting prices up depends on how price-elastic your brand is, and what its margin is before the price increase. If you have a low margin brand you can gain a lot from even a small price increase, because the proportional gain in margin is huge (e.g. at an extreme, perhaps the price increase could double your margin from previously). But if you have a brand with a high margin already, a price increase that knocks sales down even by a small amount will drop your total margin / contribution. Why? Because you already make so much money from every item sold, that if you sell a few units less you are losing a lot of margin in total.
In summary:
Statements that say price is the most powerful profit lever assume you can raise prices with no impact on unit sales. But ample evidence shows unit sales fall when you raise prices.
On average, brand price elasticity is around -2.5, so every 1% price increase relative to competitors drops unit sales by 2.5%
You have potentially more to gain from a price increase on a brand if its margins are currently low. But you can potentially lose a lot of profit if you raise prices on a brand that already has high margins.