The Greatest Business Lie Ever: We’ll Make It Up In Volume

As I’ve written about quite often over the last few months, we have entered an inflationary environment in labels, packaging, and freight.  It has been quite a while since prices have gone up.  I understand using pricing, especially in a time of price increases, as a competitive tool to gain market share.  I would be lying if I said my business has never done that.

I think it is time to revisit how pricing impacts profitability.  Below is an example that illustrates the impact of absorbing cost increases.  This is nothing fancy and has been done many times.  (I encourage everyone to read Confessions of a Pricing Man by Herman Simon.  It is the pricing book bible and certainly one of the top ten business books I’ve ever read.)

Today 5% COGS Increase, No Price Increase New Revenue Needed to Keep Pretax Income Constant
Revenue  $  100.00  $ 100.00  $     117.65
COGS  $    75.00  $       78.75  $    92.65
GP % 25% 21% 21%
Gross Profit  $    25.00  $       21.25  $   25.00
SG&A  $    15.00  $    15.00  $   15.00
Pretax Income  $    10.00  $     6.25  $    10.00
% Change in Pretax Income -38%
Revenue Growth Required to Keep Pretax Income Constant 17.7%

 

For simplicity, I assumed sales, general, and administrative costs (SG&A) remain constant.  Note the dramatic drop in pretax income.  If you absorb a 5% increase in your cost of goods sold (COGS), you need to grow revenue almost 18% to maintain the same net income!  Doing the math shows why “We’ll make it up in volume” is often met with snickers among business people.  Yet time and time again, companies convince themselves that volume will magically appear if they lower prices.  (Constantly absorbing increases is the equivalent of lowering prices.)

One of my favorite business quips is “I’d rather compete with a crook than an idiot because at least a crook wants to make money.”  Idiots lower profit pools for everyone.  As a customer, I want a good deal and like lower prices.  As a business person and member of society, I also understand profits are necessary for businesses to invest and to improve their products and services.

We live in a competitive world.  My business plays in competitive markets.  Competitive pricing is a given.  We also operate (for the most part) in a free market.  Buyers and sellers are free to transact or not transact with each other.  If a low price is the only value you add to your customer, be prepared for an idiot to come along and lower the price.  The race to the bottom is often lost by everyone.

 

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