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Let’s Make Things Worse: Cutting Prices
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As can be seen, the typical firm generates $7,500,000 in sales, operates on a gross margin percentage of 27% of sales and brings 2.5% to the bottom line on a pre-tax basis. Things are comfortable, although certainly not as exciting as when sales are growing rapidly.
Like every firm in every industry, this typical PEI member has both fixed expenses and variable expenses. Fixed expenses are overhead expenses that tend to be difficult to shed as sales fall. Variable expenses, including things like commissions, are expenses that rise and fall with sales volume. For analysis purposes, variable expenses are assumed to be 5% of sales—a figure that would be reasonably close for most PEI members.
In the next three columns of numbers, sales have been impacted by recessionary pressures. In the second column, the sales decline is only 5%, which is the sort of reduction experienced in most moderate recessions. The reality, though, is that profit is sharply reduced because of the inability to shed overhead expenses. With a 5% sales decline, profits fall by 44%.
In slower economic times, there is a very natural tendency to lower prices in the hope that such price cutting will jump-start sales volume. The last two columns examine the impact of a 5% price reduction coupled with two very different sales assumptions.
In the third column of numbers, the price reduction has no impact at all on sales volume. This represents a situation where demand is not influenced by price reductions—a very common event in recessions. Under this assumption, two things happen. First, the gross margin percentage falls to 23.2% and second, profits disappear. In short, a bad situation becomes much worse.
The final column of numbers examines how much additional sales would have to be generated due to the price cut just to keep profits at the level they were after the initial sales decline. That is, what sales increase is required to keep profits at $105,000. The answer is a rather staggering 27.5%.
In summary, price cutting is always problematic. In a recession, price cutting does little more than make things much worse. However, in a recession, every competitor seems to resort to price cutting. If the firm doesn't react, it may experience an even larger sales decline. It does not appear to leave the firm with any options other than bad choices. However, with some planning, that may not have to be the case.
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Alternatives to Price Cutting
The title of this section is somewhat deceptive. Realistically, there are no alternatives to price cutting in a down market. However, there are some very legitimate ways to minimize the impact of price cutting to the point that profits can be maintained. There are two major tools at the firm's disposal. They need to be applied, as an old football coach once said, with rigor and vigor.
Targeted Price Cutting — For most firms there are only a few items that are exceptionally price sensitive. These are the ones on which the firm absolutely must be price competitive, even if competitors are making bizarre pricing decisions. They are also the ones where the firm must communicate how price competitive it is. It is not enough to cut prices here; the cut must be known.
Typically, the SKUs that deliver the largest sales activity are the ones that are the most price sensitive. The issue is determining exactly how many of these exist in the assortment. As a general rule, the items that deliver the top 10% of sales volume are the genuinely price-sensitive SKUs. That means that if all of the SKUs are arrayed in order from the highest to lowest sales, the SKUs at the top of the list that provide 10% of sales are the ones where prices need to match competition to the penny.
From a financial perspective, a 5% price cut on items producing the top 10% of sales amounts to only a 0.5% price cut for the total firm. It gives the firm the ability to be competitive without incurring the massive profit loss associated with price cuts made across the board.
It is tempting to cut prices beyond this point. In fact, there may be selected items beyond the top 10% that need to have price cuts, but there are probably only a few of them. The essential marketing point remains. The firm must cut on highly price-sensitive SKUs and brag about it so customers are aware the cuts have been made.
Margin Build-Backs — At the other end of the product spectrum, there are lots of SKUs that are not price sensitive. In addition, during slower sales periods these are products where competition may have reduced inventory and may not have the items in stock. These are the items on which prices can actually be adjusted upwards—even during a recession—to build back gross margin sacrificed in the targeted price cutting.
Probably half of the SKUs qualify as margin build-back candidates. Since they only generate something like 5% of sales, the increase in price needs to be more than a nickel and dime effort. On these items, the value-added that the firm provides is availability. It should be a focal point of the selling effort.
Moving Forward
Price cutting is a fact of life in slow economic times. The challenge for reputable firms is to maintain a competitive posture without destroying its profit structure. If the firm can price competitively where it has to and build back margin where it can, it should be able to minimize the impact of the recession and be in a much stronger financial position when the economy starts to recover.
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