The critical factor in the understanding of the impact of price increases and decreases, and in the understanding of many other factors in pricing, is the ratio of fixed to variable costs. Variable costs are those which increase directly as a result of a volume increase, fixed costs are those which stay the same.
Two simple graphs, shown in Figure 7.1, demonstrate the behaviour of a variable cost compared with a fixed cost.
Fig. 7.1 How variable and fixed costs compare
It should be noted that this relationship is to volume, not price; generally variable costs will stay the same after a price increase. This is the reason why price increases and decreases are so sensitive to the bottom line and explains a lot of what follows in this chapter. Sales through volume increases earn profit after variable costs have been covered; sales through price increases earn profit which goes straight to the bottom line. Therefore, all things being equal, price increases have the more positive impact on profitability.
As with most concepts in the financial area, the definitions of variable and fixed costs depend on assumptions, in particular the timescale and the range of volume assumed. To help us to move on at this stage, we will assume that the range of volume change is relatively small, say 10 per cent or so, and the timescale relatively short, within an annual planning period. However, it is important to note that, by making these assumptions, we are assuming a tactical rather than a strategic decision-making context.
The ratio of variable to fixed costs is the critical factor in determining the financial impact of pricing decisions and it depends entirely on the nature of the
Cost behaviour – variable costs
£
Volume
Cost behaviour – fixed costs
£
Volume
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Pricing for Long-term Profitability
product and the sector. Managers often make simplistic assumptions about this ratio, for instance that service industries are always ‘high fixed’ and that manufacturing industries are always ‘high variable’. It is much more complex than that. It is also important to understand that competitors in the same sector may have different cost structures because of their different product processes and organizational structures. This may also occur because of their different cost strategies, for example some may outsource key services, some may not.
The best way of understanding and estimating the likely cost structure in a company or sector is to start by assessing the likely variablecosts, so that the fixed costs will fall out as the balancing figure. There are not that many potential headings under the ‘variable’ label and the list is likely to include the following:
■ materials
■ labour
■ energy and other ‘consumables’ in the production process
■ distribution
■ sales commission
■ some types of sales promotion.
All these costs are likely to be variable because more money will be spent on them if extra volume is made and sold. In the case of labour and distribution costs, this will depend on the way the business is organized, indeed there may be both fixed and variable elements to both these cost headings. This is but one example of the potential complexity of the analysis and of the ways in which competitors in the same sector could have different cost structures. We will return later to the product and business characteristics that can cause the cost structure to be high variable or high fixed; in the meantime we will demonstrate the financial analysis process.
The logical next step, having made our assessment of variable costs, is to calculate a variable margin, sometimes called a contribution ratio. Let’s assume that this is a business with sales of £100m, total costs of £90m, therefore making an operating profit of £10m. Let’s also assume that the variable cost structure is as follows:
Sales 100
Materials 30
Labour 10
Energy and consumables 5
Distribution 7
Sales commission 3
Sales promotion 2
Total variable costs 57
Analyzing the financial impact
Profit after variables (contribution) 43
Variable margin (contribution ratio) 43%
As the business makes £10 operating profit, the balancing figure of fixed costs must be £33 or 33 per cent of sales. Thus the profit and loss account would be completed as follows:
Profit after variables (contribution) 43
Fixed costs 33
Operating profit 10
This enables us to work out the variable to fixed ratio as:
Variable 57 = 1.73
Fixed 33
The relationship shown by this ratio is the key to understanding the financial impact of pricing decisions: the higher the ratio of variable to fixed, the more sensitive price changes will be. As a quick first illustration of its importance, let’s look at the impact of a 10 per cent price increase on this business, assuming that it will cause a 10 per cent loss of volume. This is often called ‘unitary elasticity’
by economists and is an outcome that might be considered acceptable by sales and marketing managers. To enable the full impact to be understood and to help later evaluations, we will do this calculation in two stages, firstly the 10 per cent price increase without any volume decrease, then the impact of volume:
+10% price –10% volume
Sales 100 110 99
Variable costs 57 57 51.3
Profit after variables 43 53 47.7
Variable margin 43% 48.2% 48.2%
Note how the variable costs do not change as price increases, thus the extra £10 goes straight to the profit line. Yet when volume falls, there is a reduction in variable costs because 10 per cent fewer products are being produced to achieve the new sales level.
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Pricing for Long-term Profitability
If we now add the fixed costs to the equation, we can see the impact on the bottom line:
+10% price –10% volume
Sales 100 110 99
Variable costs 57 57 51.3
Profit after variables 43 53 47.7
Variable margin 43% 48.2% 48.2%
Fixed costs 33 33 33
Profit 10 20 14.7
There are a number of things to note about this calculation which are fundamental to the understanding of the financial impact of price changes and to a lot of what follows. These are:
■ The impact of this +10 per cent, –10 per cent combination is, in this instance, very favourable to the bottom line – profit has increased from £10 to £14.70.
■ The extent of this impact is dependent upon cost structure; the higher the variable to fixed cost ratio, the more the impact of a price increase on profit is likely to be favourable. An example to follow later will show that the same price/volume combination for a business with only 20 per cent variable costs will improve profit by only £1 compared with the above £4.70.
■ Note how, with this cost structure, a price increase has a dramatically beneficial impact on net profit if there is little or no volume decrease as a result. In this case the 10 per cent net margin would be doubled to 20 per cent because the extra £10 profit from the increase falls straight through to the bottom line.
Naturally such an outcome is likely only in businesses with unusually low price sensitivity characteristics; very few businesses could increase prices by 10 per cent without significant volume falls.
■ The variable margin percentage will also be improved by a price increase and the extent to which this happens will again depend on the cost structure. In this case it has moved up by 5.2 per cent (from 43 per cent to 48.2 per cent) and one impact of such a change could be to make this a more desirable product to sell compared with others if profit maximization is the criterion.
■ It is also possible to extend this analysis further to work out the level of volume which could be lost, while still keeping the profit at its previous level of £10.
This type of breakeven analysis will be of great value to managers who are looking at price change options and we will return to it shortly.
Analyzing the financial impact
Before moving on to other examples, including a similar evaluation for a price reduction decision, it is important to confirm the relationship of this kind of evaluation to our previous statements that pricing is dominantly a marketing issue.
Having a marketing-oriented approach to pricing does not mean that the financial implications of different pricing strategies should be ignored or that simplistic assumptions can be made. Nor does it mean that the financial evaluation should necessarily drive the decision.
In the above case, for example, it would be quite valid for the manager in charge of pricing to decide to forego the extra profit which would come from a 10 per cent price increase, as long as he or she did so with full awareness of the amount of profit at stake. It would not be valid to reject the price increase option without knowing the potential benefit, which is a temptation for a marketer who wishes to protect market share at all costs. A deliberate choice to forego the potential short-term profit is acceptable, but ignorance of the financial impact is not.