Interesting Math
For Determining Pricing Increases
Recently, I read an interesting article by Charles Kyd, who publishes a lot of great Microsoft Excel help ideas for spreadsheets. He shared formulas for charts showing how increasing or decreasing prices can be analyzed.
Many times we either think about raising prices but we fear the consequence of raising them too far. Or what about the effect of lowering prices – will that help to attract more customers? Let’s take a look at the math using Company X as an example.
Last year Company X sold $100,000 in custom framing. They paid $28,000 for the materials to make those products, giving them $72,000 in gross profit dollars to cover operating expenses. This $72,000 represents a gross margin percentage of 72% ($72,000/$100,000). The company has an average ticket of $150, meaning they do 667 projects per year.
Company X, like all of us, wishes to maximize their profits on the $100,000 in sales and management is considering a 15% overall price increase, but they wonder what will the impact of higher prices will be on sales…
Using this formula, we can determine how far sales would need to drop before the 15% increase actually hurts the profitability of their business.
[Gross Margin %/ (Gross Margin %+Price Change %)] -1 =
Sales Change %
So, with our example, Gross Margin Percentage is 72%. The price change is 15%. Working the formula would look like this:
72% / (72%+15%) – 1 x 100%= -17%
What this math tells us is if company X increases prices 15%, it will take more than a 17% loss in sales to cause a decrease in gross profit. This means sales would need to decline from $100,000 a year to below $83,000 before this price increase would be detrimental to company profits. Because average ticket will raise from $150 to $172.50, the company could do nearly 100 fewer projects per year and still make the same profit. This means labor can be reduced because many less projects can be created to create the same profit margin.
Now, company X wants to consider the effects of reducing prices by 15%. That math is the same formula except the “+” sign now becomes a “–” :
72% / (72% – 15%) -1 = 26%
So cutting prices 15% would mean that company X would have to grow sales by 26% to make the gross profit they are making now, meaning sales would need to grow $126,000 to stay even with current profits. Since average ticket also falls by 15%, it would now take more than 300 additional projects to achieve this level of gross profit, meaning that labor costs will be much higher.
It’s interesting to see the impact price increases and decreases can have on your business. Doing the math as part of making pricing decisions can help you see the effect on future profits.
Wow, very interesting Ken. Going to plug some of my own numbers into this as we have a higher average sale. But I’m sure this will still make sense.
Great article!