Why reducing prices by 10% can lead you to bankruptcy

Managing Price strategies in any company is not an easy task; it is even more complicated in the online world where the dynamism and the price competition are notably higher.

By using a simple example, we are going to explain how applying an incorrect pricing management can cause serious damage to the profit of your company and even lead you to bankruptcy.

We will use for this example a virtual company called “PFD” (Pet Food Distribution) specialised in online sales of pet food, a recent development and eager to compete among the first line of top companies from its sector.

The gross average profit margin of PFD is approximately 30%, so 30€ of profit for every 100€ sold.

After the first 3 months of operations and the first sales results, PFD decides to take action and establishes a very aggressive price strategy so to enter the last cent battle, for example, they match the cheapest competitor´s price and reduce it by 5 cents to gain the cheapest price in their sector.

In general terms, the application of this strategy implicates an average discount of 10%, a percentage that PFD does not know exactly as they do not have tools to continuously measure this. Unfortunately, as we will see following this supposes great negative impact to their economic results. Let’s analyse in detail this discount to find out exactly what will happen.

Before starting this new Price strategy, PFD paid in 30€ for every 100€, but after the 10% discount over the final price, the gross margin has been reduced to 20%,  actual margin is in fact is 50% inferior, which will implicate having to sell 50% more just to equal previous sales.

If we translate this previous explanation into numbers, and suppose that PFD sold 100 units of product before starting their new strategy, their final profit was 3.000€. As their new margin is 20%, to reach their previous profit they would need to sell at least units (150unts*20€/unit=3.000€).

With great difficulty they will manage to increase their sales by 50%, and even if they did there would be a larger preparation, logistic and human resources cost to be able to manage this large increase.

So, a discount has to always be accompanied by a strong growth in sales to compensate the loss margin; even a 5% discount forces us to sell 20% more to equal the loss. Striking a balance between these two variables is our objective, so as to benefit from a reasonable profit margin that also allows us to be competitive in the market.

How could PFD have avoided this important profitability loss?

As the saying goes, “what can´t be measured, can´t be managed. By using a pricing tool, PFD could have known before-hand how their gross profit margin would be affected over time, allowing them to establish a balanced strategy between competiveness and cost effectiveness. Let´s see an example of how they could have applied an intelligent Price strategy in 5 simple steps:

1. Identify the competitors in which we will base our strategy, eliminating those that are not comparative in service or quality to us. In many cases we will eliminate small competitors that are not really significant and that have excessively low prices.

2. Establish dynamic Price rules for products, categories and brands, guaranteeing for each reference that our gross profit margin does not go below a minim level.  These rules should take into account the competitions stock, as we will ignore those prices in the competition where the product is not available.

3. Run these rules on a daily basis, so that our prices are reduced in a controlled manner and so that we are always competitive. Likewise the price will increase when it is necessary to guarantee our minim margin. Not forgetting that the main objective is to avoid being the cheapest or most expensive.

4. Review on a daily or weekly basis the Price evolution using the main Price index metrics, winning Price, losing Price and tendency changes.

5. Based on the results, make necessary adjustments in a progressive manner to the Price rules to maintain the balance between margin and competitiveness.

Take this previous example as to understand the importance of designing successful Price strategy, reinforced with a pricing intelligence tool that can foresee and better our economic results in medium and long term.