Profitability: the Power of the 1%
Only three factors influence a company's profitability. What are these factors? The total costs of the operation, the total sales volume of whatever the company is selling, and the price of whatever the company is selling. These are the only variables that impact if a company is profitable or not and the level of that profitability. What if you changed one or all of these variables by just 1%? That is my 1% challenge to you.
There have been multiple studies into what happens if an average company changes one of these variables by 1%. First, consider how it would affect profitability. If you increase your sales volume by 1%, profitability goes up by three and a half percent. If you can reduce your costs by 1%, profitability goes up for the average company by five and a half percent. And if you can reduce your discount or increase your prices by 1%, profitability goes up 11.3%. Rather spectacular, isn't it?
Of course, this is for an average company, but no company is average. So, why is that? If you increase your sales by 1%, your costs also go up, even if what you're selling is a piece of software, for example. You know that the cost of sales will increase, the cost of customer support will go up, and so forth. So even if the marginal cost to sell one more copy is almost zero, other costs related to that extra sale are not visible. Obviously, if you sell hardware of some kind, it's understandable that the cost of goods goes up just as a sales volume increases and revenue increases. Now, if you can reduce cost by 1%, I said the profitability goes up five and a half percent. We want to reduce the cost as much as possible, and there is no doubt that another 1% makes a difference.
Price is a Bigger Number
Why is the price or lack of discounting so powerful compared to the other two variables when it comes to profitability? It's straightforward. It works on the top line; it has the highest leverage. If you compare with cost, 1% of the price is a bigger number than 1% of the cost. This is, of course, assuming that your company is profitable.
There's something else to consider when it comes to this. Companies spend considerable resources on people, software, marketing, and processes, which means they are already spending a lot on increasing sales and decreasing costs. Pricing strategy is almost always an afterthought. In many companies, pricing strategy is just something they pull out of a hat, maybe by looking at pricing on competitors' websites and doing the same thing. Or perhaps the company does cost plus and simply uses the rule of thumb for margin uplift in their industry. It only takes someone about five minutes to establish the price. One of the most significant issues in making companies profitable is that so few resources are allocated to establishing a pricing strategy, yet pricing has the highest leverage.
Several years ago, my company did a funny marketing campaign. We sent out what we called Rubber Duck letters in FedEx boxes. These were nicely worded letters addressed to the CEO of about 250 Fortune 500 companies. Then, of course, we followed up on those letters. We didn't get hold of any CEOs, but we did get hold of 75-100 out of 150 of the executive assistants to those CEOs. And they all said that we nailed it with the rubber duck, it was funny and unique, and they had never seen anything like it before. We glued a little yellow rubber duck to the letters, making them memorable. We told the executive assistants we wanted to help with their pricing strategies. We had very, very surprising feedback. The surprising feedback was that nobody within these large companies' senior executive teams had any idea who set the prices. They didn't know whether it was done somewhere in finance, or whether it was done somewhere in marketing, or maybe somewhere in product management. They just didn't know. And, of course, if the executive team doesn't know where pricing is set, how can they emphasize it?
Sales Volume is not Profitable
There's another data point that's particularly interesting here. A few years back, we did a research project on about 550 or 600 CEOs of mid-market companies. And again, we asked the question: out of sales volume, cost, and price, which has the highest profitability leverage? 84% said sales volume, which is crazy because it's not sales volume. Only 6% said that pricing strategy has the most significant influence on profitability.
As I mentioned, I want to challenge you. I want you to make a straightforward calculation of the impact a 1% change would make on your company, be it a 1% change in pricing or a 1% decrease in discounts. Find out how that 1% change would affect your company and its profitability. What impact would it have on your revenue? You'll be surprised by the result. For simplicity, there is a calculator on my website that you can use. If you Google Price Whisperer, it will take you straight to my website. Now you can go to your sales force and ask them to stop, for example, giving 20% discounts and instead giving only 10%. They will complain about it and say they'll lose every deal. Of course, they will not lose every deal, but they will have to work harder selling. But that's what you're paying them for.
In the same way, you can tell your product managers or finance department that you're going to increase your prices by 3% every six months or 8% annually, whichever works best for you. At the time of writing, it's Fall 2022, and there's very high inflation, so these rises need to be more frequent, but inflation will eventually subside, and we will return to a more normal situation. So, what does this mean? Well, if you can do it with 1%, you can do it with 5%. Suddenly you have 50% more profits, which is a lot of money, regardless of the size of your company. What are you going to do with that money? Reinvest it, of course, and make sure you have more money to spend to be more competitive. So, you can develop more products. So, you can define more services. So, you can serve your customers better. So, you can increase your marketing spending to increase demand duration. It means that you can not only increase your sales force and customer support, but also you can afford to hire the best. Because now you have the money to do it.
All of this means that by considering your pricing strategy, looking at the 1% challenge, and considering the power of 1% in your company as it relates to profitability, you'll be able to elevate your company to the next level. This won't happen overnight, but over a period of time, this knowledge will influence many small decisions in your company. After a few years, you'll look around your marketplace and find yourself the high-price, high-value, high-benefit market leader with the highest shareholder value. And who wouldn't want that?
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