It’s easy to set your price so that you don’t lose any customers. But will this give you the maximum profit? Here’s a graph to help you think about it
If we line up all our customers in order of how much they will pay (even though we’ll never know this for sure!) let’s imagine it’s a gradually increasing line up, shown by my vertical line shape.
If we charge the price that the lowest customer will stand, we price at the red line, and if the blue line is our costs then the rectangle between them is our profit.
But what if we put our price up a bit?
Well, all the customers below the intersection point will say “I’m not paying that” and leave, but we will make more profit from the others (who all still think we are cheap – they would have paid more). The big question is “Does this profit outweigh what we have lost?
The amount we gain is the yellow rectangle on the right – we are charging more to half our customers. The triangle above it is money we could have made from those people but we haven’t charged enough to get that – never mind!
The amount we lose is the yellow rectangle on the left – all the profit between the old price and our costs, that has now gone. The triangle above it is money we weren’t getting before (we didn’t charge enough) and we’re not getting now (the customers have gone).
We have lost more than we have gained!
But if your costs are higher – and normally they ARE – it’s a different picture:
Leaving aside fixed and variable costs for the moment, most companies only make 10% net profit if they are lucky, so costs are 90%, and as you can see (above) the amount we gain by pricing out half our customers is greater than what we lose (even before you start on the fact that the price obsessed customers are often more trouble than the others too!).
There IS a limit to the price increasing though:
You can see from the above that we have lost so much that even the big gain from the others is not enough.
So where is the optimum point? I think it’s probably at the 50% point – I’m not good enough at maths to be able to prove it but I do suspect it.
Clearly the angle of the slope (also known as elasticity of demand) does affect it, and there are questions of whether the line is straight or not in real life (is it an S curve?), and then there’s the question of fixed costs and marginal pricing (just getting work in to keep the fixed costs occupied, sometimes known as ‘contribution’) – but still, I think this diagram says you should be losing approximately half your business on price.
Here’s a summary diagram of all that:
Don’t take my word for it but do the analysis yourself, on your real figures, using estimates of what you think people might pay, (even do some experimental pricing maybe), and see what you get! And let me know, I’d be interested to hear from you.
Onwards and upwards!