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34 FEDA News & Views Price-Cutting Economics: Know Before You Go Currently in distribution there is a feeling that firms must become more price-aggressive than ever before. A large component of this perception can be attributed to the emergence of new Internet-based competition, while some of it is simply the feeling that price is a significant driver of purchasing behavior in a slowly-recovering economy. Whatever the reason, a word of caution is in order: Lowering prices can be a successful strategy only when firms achieve two goals. First, the new pricing must produce a significant sales gain. Secondly, lower margins must be offset by lower costs. This report looks at the issues of enhanced price aggressiveness from two distinct perspectives: the economics of price cutting (an analysis of the changes in operating economics required to make price reductions a positive profit move), and marketing realities (a review of the extent to which the world really is becoming more price-oriented). Price-Cutting Economics: Know Before You Go Currently in distribution there is a feeling that firms must become more price-aggressive than ever before. A large component of this perception can be attributed to the emergence of new Internet-based competition, A large component of this perception can be attributed to the emergence of new Internet-based competition, while some of it is simply the feeling that price is a significant driver of purchasing behavior in a slowly-recovering economy. Whatever the reason, a word of caution is in order: Lowering prices can be a successful strategy only when firms achieve two goals. First, the new pricing must produce a significant sales gain. Secondly, lower margins must be offset by lower costs. This report looks at the issues of enhanced price aggressiveness from two distinct perspectives: (an analysis of the changes in operating economics required to make price reductions a positive profit move), and Price-Cutting Economics: Know Before You Go Currently in distribution there is a feeling that firms must become more price-aggressive than ever before. A large component of this perception can be attributed to the emergence of new Internet-based competition, By Dr. Albert D. Bates, President, Profit Planning Group bigal@profitplanninggroup.com continued on page 54 FREE Price-Cutting Analysis Help To help you evaluate how a price-cutting strategy can impact your bottom line, the Profit Planning Group is offering a free Excel® template. It allows firms to tailor the analysis by entering their current results as well as assumptions about the size of price cuts and any changes in sales and expenses—both payroll and all other expenses. To download the template, go to profitplanninggroup.com and click on the Seminars section. At the pull-down, select PriceCutTemplate. The password is ProfitBarriers and is case sensitive. Open in "read only" mode. The Economics of Price Cutting Any profitability analysis of lowering prices must be based upon three factors, all of which are difficult to predict. First, how large of a price reduction is required to get attention in the marketplace. Second, what sales increase, if any, will accrue from the price reduction. Third, to what extent can operating costs be reduced to support a lower gross margin strategy. Every firm will have distinct ideas regarding these three factors. However, some insight into how they interact is presented in Exhibit 1, which examines the financial performance of the typical FEDA member based upon the last "PROFIT Report." The first column of numbers indicates the current operat- ing structure of a typical firm right now. As can be seen, it produces $15,000,000 in sales, operates on a gross margin percentage of 22.5 percent of sales and generates a pre-tax profit of $300,000 or 2 percent. With regard to expenses, payroll and associated fringe benefits are the major expense category to deal with. The last three columns all look at the financial impact of a 5 percent price cut. This does not mean that prices are cut by this much across the board. Instead, there may be selective price cuts in more price-sensitive categories that in aggregate equate to 5 percent cut across the board. The three price-cut scenarios look at very different situa- The Impact of a 5 Percent Price Combined With Sales and Expense Improvements for the Typical FEDA Member -----------5% Price Cut----------- Current Volume Expense Volume Results Increase Cut Expenses Income Statement ($) Net Sales $15,000,000 $16,387,500 $14,250,000 $16,387,500 Cost of Goods Sold 11,625,000 13,368,750 11,625,000 13,368,750 Gross Margin Expenses 3,375,000 3,018,750 2,625,000 3,018,750 Payroll and Fringe Benefits 2,100,000 2,100,000 1,785,000 1,785,000 All Other Expenses 975,000 975,000 828,750 828,750 Total Expenses 3,075,000 3,075,000 2,613,750 2,613,750 Profit Before Taxes $300,000 -$56,250 $11,250 $405,000 Change in Profit (%) -118.7% -96.3% 35.0% Income Statement (%) Net Sales 100.0 100.0 100.0 100.0 Cost of Goods Sold 77.5 81.6 81.6 81.6 Gross Margin Expenses 22.5 18.4 18.4 18.4 Payroll and Fringe Benefits 14.0 12.8 12.5 10.9 All Other Expenses 6.5 5.9 5.8 5.1 Total Expenses 20.5 18.8 18.3 15.9 Profit Before Taxes 2.0 -0.3 0.1 2.5