A practical case
In a sales meeting in which the main clients were invited, it was mentioned that the company could not continue carrying out price promotions, since the market, which was really depressed, would not absorb the additional volumes necessary to offset the effect of the lower price. Given this statement, I was surprised by the eagerness of several of the attendees to learn a little more about the effects of price variations on the profitability of the company. When I mentioned that it was possible to objectively measure how much additional volume was needed to offset a price cut, they immediately asked me for a little more detail on the subject.In a somewhat impromptu presentation I made some charts on a whiteboard to explain how the additional volume needed to compensate for a lower price could be measured. Many were still surprised, as the price / volume ratio was always handled purely intuitively by most of the customers who had attended the meeting, which was also true for most market companies.
The intuitive approach traditionally used held that any price reduction was satisfactory, provided that at the end of the day it had represented some additional sales volume. But was this volume enough to make up for the lower price we had charged for all units sold? This was unknown, the largest volume achieved, and therefore the largest market share seemed sufficient results to ruin any other type of analysis. The unfortunate thing about these reasonings was the erosion of the profits of the company that this type of actions in most cases finally caused. To avoid this type of confusion, it is useful to develop an analytical framework that allows an objective evaluation of the relationship between price and sales volume.
Volume vs. effect Price effect
For a price reduction to be profitable, the increase in units sold (" volume effect ") must at least offset the lower price per unit that will be charged for all units sold (" price effect ").
Analysis Formulas
To perform this calculation, the MVE (Balance Sales Modification) formula can be applied. This formula indicates the variation (percentage) in the units sold, necessary for the "volume effect" to compensate for the "price effect". In other words, the situation in terms of gross sales margin (in monetary terms, not in percentages) after the indicated variation in the units sold will be equivalent to the situation before making the price reduction.
The MVE can be stated as follows:
CMg0 (%) = percentage marginal contribution before the price change.
The MVE formula assumes that as a result of the indicated variation in the units sold, the fixed costs and the variable costs per unit do not change.
Application Example
To illustrate the use of this formula, the increase in the quantity sold necessary to justify a reduction in the price of 10% can be considered as an example, in the case of a product with a high marginal contribution (“A”), and in the case of a low marginal contribution product (“B”). The data is summarized in the following table:
MVE Analysis Table
|
(%) |
Marginal Contribution (CMg0) |
Price reduction: 10% |
| Product "A" |
70.0% |
16.7% |
| Product "B" |
15.0% |
200.0% |
In the case of product “A”, with a high marginal contribution, the units sold should be increased by 16.7%, to compensate for the drop in profitability from a 10% price reduction. As unit sales increase by 16.7%, the profitability in monetary terms (or absolute value) will remain constant with respect to the situation before making the additional discount.
|
Product "TO" |
Q Pcs. |
P ($) |
CV ($) |
(CMg) (%) |
CF ($) |
Margin Stupid ($) |
| Before |
1,000 |
10 |
3 |
70.0% |
1,000 | 6,000 |
| After |
1,167 |
9 |
3 |
66.7% |
1,000 |
6,000 |
|
Product "B" |
Q Pcs. |
P ($) |
CV ($) |
(CMg) (%) |
CF ($) |
Margin Stupid ($) |
| Before |
1,000 |
10 |
8.5 |
15.0% |
1,000 |
500 |
| After |
3,000 |
9 |
8.5 |
5.6% |
1,000 |
500 |
MVE graphics
Graphic Analysis
In each of the MVE graphs it can be seen that the shaded areas of the rectangles are of equal size. These shaded areas represent the profitability, in monetary values, before and after the price reduction. Equivalence means that profitability, in absolute values (not percentage), remains constant after the price reduction.
Bibliography
- Nagle, Thomas and Holden, Reed (1998), "Strategy and Tactics for Pricing". Granica.
