When companies undertake profitability improvement programmes, they generally focus on cost reductions and efficiency-sharpening measures. Pricing strategy is often neglected since it’s seldom considered a route to profit improvement. Many view pricing purely as an operational tool and business parameter that is very hard, or in fact even impossible, to tamper with on account of competitive pressures, customers’ expectations and the pricing traditions of the industry. Paradoxically, though, price undoubtedly applies the best leverage on your financial results. Other profitability improvement actions all have their limitations and some can even hamper or harm your profits, development and growth.
Optimizing processes and cutting costs are of course healthy exercises that every CEO should focus on. But there’s a limit as to how far you can reduce costs. Eventually, your organisation and operation will be slimmed and trimmed to a point where it starts to hurt. It will hurt your capacity, your quality and in the worst-case scenario the effect of your cost-cutting programme can turn out to be exactly the opposite of what you were aiming for.
A good rule is to ease but not squeeze costs.
It seems like simple arithmetic – if sales volumes increase, so must profits. And it’s true, just as long as the cost structure doesn’t change. But how many companies keep resources and space idle? Which is expensive in the long run. A healthy business optimizes the use of its resources in response to fluctuations in market demand. When sales volumes increase, new resources have to be utilized. Office, storage or factory space might have to be expanded. Sales personnel and marketing efforts may need to be boosted. And so on. In other words, sooner or later fixed costs will rise if sales grow. Depending on the nature of the business, even variable costs might increase.
Irrespective of the nature of your business or the industry you’re in, pricing is unquestionably the business change factor that offers the best leverage on your profitability. This fact is supported by numerous analyses conducted on the world’s 1200 biggest listed companies, Global 1200.
The chart below shows the Gobal 1200 companies’ cost and revenue structure, and demonstrates how a one per cent change in price, variable costs, fixed costs and sales volume affects gross profits. For instance, a one per cent increase in price improves profits four times more than a one per cent reduction in fixed costs.
Even though “soft” factors, like customers’ or competitors’ responses to a price change, are not included in the chart above, it still provides a clear understanding of the different scenarios. The potential to enhance profitability through clever pricing is obviously huge, and even very small price changes can lead to substantial improvements. Just how big the potential is and what kind of pricing strategy it requires depend of course on the nature of your business, on the industry in which you operate, on your product or service, and on the competition and current price levels.