# Are You Optimizing Your Pricing Strategy?

- Posted in Decision-Making / Financial Analysis / Pricing Strategy
- 9 mins read

Most business owners understand that getting pricing right is one of the keys to success. You may be tempted to think of your pricing strategy just in terms of revenue. But profit, not revenue, will determine if you can pay your suppliers, pay your staff, and meet your own financial goals. Understanding the price elasticity of demand for your product will inform you about how your customers will respond to a price change. Understanding your product’s contribution margin will tell you how a price change will impact the profitability of each sale. Understanding these two concepts together is critical to optimizing your pricing strategy.

Understanding Contribution Margin and Price Elasticity

Contribution Margin: __Contribution margin__ represents the difference between a product’s revenue and variable costs. It is the portion of revenue that contributes to covering fixed costs and generating profit. The contribution margin is a crucial metric in determining the profitability of individual products or services and guiding pricing decisions. To keep things concise, we refer to products in this article, but all the concepts also apply to services as well.

The formula for calculating the contribution margin is as follows:

Contribution Margin |
= |
Revenue per Unit |
– |
Variable Cost per Unit |

A higher contribution margin indicates that a more significant proportion of each sale contributes to covering fixed costs and generating profit.

Price Elasticity: __Price elasticity of demand__ measures the responsiveness of consumer demand to changes in price. It helps businesses understand how price changes affect the quantity demanded by customers.

A higher price elasticity (elastic demand) indicates that consumers are highly sensitive to price changes, leading to significant fluctuations in demand with price adjustments. Conversely, lower price elasticity (inelastic demand) signifies that price changes have minimal impact on demand.

The formula for calculating the price elasticity of demand (PED) is as follows:

Price Elasticity of Demand (PED) |
= |
% change in quantity demanded |
/ |
% change in price |

Using this formula, demand is said to be elastic when the PED is greater than 1. This means a change in price will lead to a more significant change in units sold. Demand is said to be inelastic when the PED is less than 1. This means that a change in price will lead to a smaller change in units sold.

Strictly speaking, the formula result would be a negative number since a positive change in price leads to a negative change in demand, and vice versa. It is common to refer to the level of elasticity as a positive number, which is how we will use it here.

Several factors can affect the demand elasticity for a product, including:

- The availability and price of alternative products
- Whether the product is a necessity or a luxury
- How much of a customer’s income is spent on the product
- Brand Loyalty

You may be able to measure the elasticity of demand for your product if you have a history of previous price changes. You can look at how your sales changed with each price change. If your business model allows, you can also test a price change by limiting the change to specific locations or sales channels and comparing sales at different prices. If you do not have relevant data, you can estimate elasticity by considering how your product fits among the abovementioned factors. Do you have a strong brand? Is your product essential to your customers? __How does your product compare to competing products__ regarding features, quality, and price?

Elasticity for a product is not fixed. A measure of elasticity applies to a limited range of price changes over a limited time. You might see a slight change in customer demand with a 5% or 10% price change. But you should expect a different response if you double your price. Elasticity will also be impacted by external factors over time, such as new competitors or a changing economy. The price elasticity of your product might not be the same in the future as it is today.

Related: 10 Pricing Strategy Questions Every Entrepreneur Must Answer

Price Elasticity and Total Revenue

If you understand the price elasticity of your product, it is easy to see how a price change will impact your revenue. If demand is inelastic, price and revenue will move in the same direction. A price increase will lead to fewer units sold but to a lesser degree than the price increase. Therefore, total revenue will increase. If demand is elastic, price and revenue will move in opposite directions. A price increase will lead to a more significant decline in units sold and lower revenue.

To determine the change in revenue, you can use the following formula:

% Change in Revenue |
= | (1 + % Change in Price) | X | (1 + % Change in Units Sold) | – | 1 |

So, if demand for your product is inelastic, with a price elasticity of 0.5 for example, a 10% price increase would lead to a 5% decline in unit sales.

% Change in Revenue |
= | (1 + % Change in Price) | X | (1 + % Change in Units Sold) | – | 1 |

= | (1 + 10%) | X | (1 + (-5%)) | – | 1 | |

= | 110% | X | 95% | – | 1 | |

= | 104.50% | – | 1 | |||

= | 4.50% |

A 10% price increase would lead to a 4.5% revenue increase.

If demand for your product is elastic, with a price elasticity of 2 for example, a 10% price increase would lead to a 20% decline in unit sales.

% Change in Revenue | = | (1 + % Change in Price) | X | (1 + % Change in Units Sold) | – | 1 | |

= | (1 + 10%) | X | (1 + (-20%)) | – | 1 | ||

= | 110% | X | 80% | – | 1 | ||

= | 88% | – | 1 | ||||

= | -12% |

A 10% price increase would lead to a 12% revenue decline. So, when demand is elastic, the way to improve revenue is by reducing prices to spur demand. With the same example of a price elasticity of 2, a 10% price reduction would lead to a 20% increase in unit sales.

% Change in Revenue | = | (1 + % Change in Price) | X | (1 + % Change in Units Sold) | – | 1 |

= | (1 + (-10%)) | X | (1 + 20%) | – | 1 | |

= | 90% | X | 120% | – | 1 | |

= | 108% | – | 1 | |||

= | 8% |

A 10% price decrease would lead to an 8% revenue improvement.

The Interplay of Contribution Margin and Price Elasticity

While it is easy to see how a price change will impact your revenue, the critical question is how it will affect your bottom line.

For that, we can consider two more formulas:

Total Contribution |
= |
Contribution Margin |
X |
Units Sold |

Net Profit |
= |
Total Contribution |
– |
Total Fixed Cost |

From this, you can see that __a price decision that improves total contribution also improves net profit__ since fixed costs do not change with price.

The formula for a total contribution change is similar to that for a revenue change:

% Change in Contribution |
= |
(1 + % Change in Contribution Margin) |
X |
(1 + % Change in Units Sold) |
– |
1 |

Consider a scenario where your product sells for $10, your variable cost is $7, and the price elasticity of demand for your product is 2. The contribution margin for your product is $3 ($10 – $7).

Let’s look at the impact of a 10% price increase. With a price elasticity of 2, we have already seen that a 10% price increase would lead to 20% fewer units sold and a revenue reduction of -12%. But what does it do for profit?

A 10% price increase on a $10 product would raise the price to $11. With variable costs of $7, the contribution would change from $3 to $4, a 33% increase. We can use our formula to see what this does to the bottom line.

% Change in Contribution | = | (1 + % Change in Contribution Margin) | X | (1 + % Change in Units Sold) | – | 1 |

= | (1 + 33%) | X | (1 + (-20%)) | – | 1 | |

= | 133% | X | 80% | – | 1 | |

= | 106.40% | – | 1 | |||

= | 6.40% |

While revenue fell by -12%, the total contribution to profit grew by 6.4% because more of each sale fell to the bottom line.

In this example, the product’s variable cost did not change with the price. But that may not be true for all products. Suppose your variable costs include revenue-based costs like credit card fees, sales commissions, or royalties. In that case, you may need to adjust your variable costs along with the price when determining the change in contribution margin. If the $7 in variable costs in the previous example included a 10% sales commission, then the variable cost would have grown by $0.10 when the price was raised by a dollar from $10 to $11. So instead of growing from $3 to $4, the contribution margin per unit would have grown to $3.90.

Using a Break-even Analysis when Price Elasticity is Uncertain

If you have a reasonable estimate of the price elasticity of demand for your product, evaluating a price change is straightforward. But knowing the price elasticity is often easier said than done. So, what can you do if the elasticity is uncertain? A break-even analysis is one approach. Instead of determining exactly how customers will respond to a price change, it is sometimes easier to figure out at what point a price strategy goes from being a good decision to a bad one. Then, given your knowledge of your customers and market, you can evaluate whether you believe that the sales change will be greater than or less than the break-even point.

To calculate the breakeven

Break-Even Change in Units Sold |
= |
1 |
/ |
(1 + % Change in Contribution Margin) |
– |
1 |

In our previous example of a 33% increase in contribution margin, the break-even sales change would be {1 / 133% – 1}, approximately -25%. So, if you think sales will fall by more than 25%, you should reject the price change. The loss in sales would outweigh the gain in margin and lead to lower profits. If you believe sales will fall by less than 25%, you should move forward.

Even when you do not have complete data, using the right framework for evaluating a decision can lead to better results when combined with your judgment and experience .

Conclusion

When balancing pricing and profitability, understanding the interplay of contribution margin and price elasticity is crucial to success. A high contribution margin coupled with low price elasticity is advantageous. A businesses can safely increase prices and boost profitability. On the other hand, low contribution margins and high price elasticity require strategic adjustments to maintain profitability. Understanding this dynamic empowers you to make informed pricing decisions, boost profits, and secure a competitive edge.

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