The Price/Volume Trade-Off, Price Elasticity

All businesses have to choose … between price and quantity sold. … That’s the fundamental truth behind the demand curve, … but how do you balance these two factors? This inevitably leads us to the age-old question of the price/volume/profit trade-off, that is also called price elasticity: If I lower my price, can I increase volume enough to generate more operating profit? Exhibit 1 explores how that trade-off works—or, more accurately, does not work. If a business takes steps that effectively reduce average prices by 5 percent, how much of a volume increase would be necessary to break even on an operating profit basis?

Based on global 1200 average ecomomics
Exhibit 1

With economics similar to the Global 1200 average, a 5 percent price decrease would require a 17.5 percent volume increase, not to increase operating profits but just to break even. Such an increase is highly unlikely. For a 5 percent drop in price to generate a 17.5 percent volume rise would require a price elasticity of –3.5:1. That is, every percentage point drop in price would have to drive unit volume up by 3.5 percent. Experiences in real markets show price elasticities commonly reach a maximum of only –1.7:1 or –1.8:1. On rare occasions, usually for consumer items purchased on impulse, it might be as high as –2.5:1. In the real world, –3.5:1 price elasticity is extremely rare. Thus, the basic arithmetic of decreasing price to increase volume to increase profits just does not add up. Note that you should do this calculation using the economics of your own business to confirm how the price/volume/profit trade-off works for you.

1. So the first reason pricing is so important is that profits are extremely sensitive to even minute changes in prices.

2. The second reason managing pricing is so important is because even if nothing changes internally, most companies, whether selling to consumers or to businesses, face unprecedented downward pressure on prices. If nothing is done, these external forces will depress prices and erode profits quickly.

3. The last reason why building a price advantage in your business is so important goes beyond profit economics or market forces to the spirit, heart, and pride of an organization.

Source : From the book of Price Advantage