Price cutting a risky strategy

CUTTING prices is often seen as an easy way for businesses to boost their turnover, especially in difficult trading conditions. But it’s a strategy that is fraught with danger.

Accounting and business advisory firm MGI Bridge Partners has developed a simple ready reckoner that illustrates the impact of price changes on profit.

It shows how firms that discount prices need to generate a big increase in sales volumes simply to maintain current profit levels.

For example, if gross margin was 30 per cent and prices were reduced by 10 per cent, then sales volume would need to increase by 50 per cent to maintain profit.

“Rarely has such a strategy worked in the past and it’s unlikely that it will work in the future,” MGI’s Mal Di Giulio said.

He described price discounting as “the lazy manager’s competitive strategy”.

“It is relevant and applicable in only one situation and that is where you have a definite cost advantage over your competitors and your product or service is one where customers are very price sensitive,” Mr Di Giulio said.

Conversely, price increases can have a large and positive impact on profit, even if sales volumes decline.

For example, if gross margin was 30 per cent and prices were increased by 10 per cent, then sales volumes would have to fall by 25 per cent or more before profit was affected.

Put another way, if the impact on sales was held to less than 25 per cent, then the business would be better off.

Mr Di Giulio said many small business operators were reluctant to adopt a premium pricing strategy, since they regarded price as the only factor influencing the buying decisions of their customers.

“If all of your marketing effort is focused on price, then you will be beaten on price every time a competitor comes along with a lower one. In other words, if you make price the critical factor, it will be the critical factor,” he said.

“The only way to get out of the price trap is to promote other features and benefits that you can offer your customers. For example, better quality, longer warranty, satisfaction guarantee, 24-hour accessibility, more convenient location, greater resale value, and the like.”

Mr Di Giulio said that as well as delivering value, businesses had to educate their customers to be aware that they were receiving value.

He acknowledged that some customers only thought in terms of price.

“They are better left to your competitors. What you should be doing is working with those people who are happy to pay for value,” Mr Di Giulio said.

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