Rafi Mohammed

Why High Profit Margins Don't Prove Smart Pricing

Posted on November 4th, 2009 (0 Comments)

Reprinted from the Harvard Business Review Website

I advise companies on their pricing strategies, and I'm surprised how often I hear the same flawed piece of conventional wisdom. Many executives and Wall Street analysts continue to think that a high profit margin signifies good pricing. It's hard not to see that big differential between revenue and costs as a signal that you've got pricing nailed. But if that's right, how do you explain Wal-Mart — with its anemic 3.3% net margin — ranking number 2 in the Fortune 500?

If your profit margin isn't a good gauge of pricing effectiveness, what is? Simple: Just ask, is our profit increasing? Bear with me while I walk through a few scenarios. There's a little arithmetic, but you'll be surprised by what it reveals.

Consider a rose shop with fixed costs of $300 and variable costs of 80 cents per rose sold. At a $2 price, 500 flowers are sold. This results in revenue of $1,000. With costs of $700 [$300 + (500 x $0.80)], profit is $300 and the profit margin is 30%.

Now, consider these scenarios in which the shop lowers its margins, but actually increases its profits:

If rose prices are dropped to $1.50, suppose that 1,000 flowers are sold. Revenue is $1,500 ($1.50 x 1,000) and costs are $1,100 [$300 + (1000 x $0.80). The result is a profit of $400, but the profit margin drops to 26.7%. What would the owner prefer, a 30% profit margin or an extra $100 in profits?

Returning to the original scenario ($2 price, 500 sold), suppose the flower stand offers a coupon (or negotiates a volume purchase) that results in an extra 1,000 roses being sold at 90 cents each. By using a pricing tactic to generate new sales, profits increase to $400 but the profit margin drops to 21%.

A high operating margin does not reflect pricing excellence. In fact, it usually reveals that you're missing growth opportunities. The next time that your company is evaluating a new pricing initiative, focus on what counts the most: will we make more profit?

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