Why a 1 Percent Price Increase Beats a 1 Percent Jump in Sales

The Most Underrated Number in Business

Most companies devote their energy to increasing volume and cutting costs and spend surprisingly little on pricing. That's the other way around. A landmark McKinsey study of the world's largest companies found that for the typical business a 1 percent increase in price with no loss in volume raises operating profit by about 8.7 percent. No other everyday lever in business comes close to that. Pricing is the silent decision that influences results more than almost anything else.that a company does and it is usually treated as an afterthought

Why Price Beats Volume and Cost

The reason is simple arithmetic. A higher price reduces almost entirely to the bottom line because selling the same unit for a dollar more costs you almost nothing additional. Selling more units on the other hand carries new costs with each sale - the product itself shipping support - so the profit from additional volume is only a small margin not the full dollar. According to the same study a 1 percent increase in volume increases operating profit by only about a third of what occurs with a1 percent increase in price. Reducing costs also helps but a company can only reduce to a certain point while the price in principle does not have a hard ceiling

A Worked Example: The Same Company, Four Levers

The 8.7 percent figure is constantly cited and almost never demonstrated which is a shame because building it yourself takes about five lines and makes the logic permanent

Take a company with $1 billion in revenue. The cost of goods sold is $650 million and moves with volume. Selling and administrative costs are $235 million and no. Therefore operating profit is 1,000 minus 650 minus 235 which is $115 million a margin of 11.5 percent. This is a pretty run-of-the-mill large company

Lever one increase price by 1 percent without losing volume. Revenue increases by 10 million. Nothing else changes because you are selling the same units to the same customers. Operating profit goes from 115 to 125 million. This represents an increase of 8.7 percent

There it is. The famous number is not a result of research on human behavior it is a division: revenue divided by operating profit multiplied by one percent. With a margin of 11.5 percent one above 0.115 is 8.7. A company with a margin of 5 percent would earn 20 percent. A company with a margin of 30 percent would earn 3.3 percent. The lower your margin the moreviolently the price will move your profits

Lever two: sell 1 percent more units at the same price. Revenue increases by 10 million but the cost of goods increases with it by 1 percent of 650 that is 6.5 million. Selling and administrative costs are fixed. Operating profit increases by 3.5 million from 115 to 118.5 million an increase of 3.0 percent

Third lever: reduce variable costs by 1 percent. The cost of goods falls by 6.5 million directly towards profit. Operating profit reaches 121.5 million an increase of 5.7 percent

Lever four reduce fixed costs by 1 percent. Sales and administration costs decreased by 2.35 million. Operating profit reached 117.35 million 2.0 percent more

Price outperforms volume by almost three to one in these figures which is consistent with what the study reports. And note that ranking is not a matter of opinion or quality of execution. It falls outside the cost structure. Any company for which you can produce an income statement will produce its own version of this table in about a minute

The Catch, and Why It Is Hard

That 8.7 percent figure comes with three words that do all the work: no volume loss. Raise prices to customers who can easily leave and volume will collapse eliminating profit and then some. This is why pricing power and the moat behind it are so important. A company protected by a strong brand a network or high switching costs can raise prices and retain its customers. A commodity company trying the same thing simply loses the sale to a bigger rival.cheap. Pricing power is not the freedom to charge more. It is the freedom to charge more without losing the customer

How Much Volume You Can Afford to Lose

The good news is that the phrase no loss of volume is a stricter condition than the situation really requires and you can calculate exactly how much slack you have

Go back to the company above. The contribution margin that is revenue minus variable costs is 1,000 minus 650 which equals 350 million or 35 percent of revenue. That percentage is the complete answer

Increase the price by 1 percent and the contribution of each remaining unit will go from 35 cents to 36. So you can afford to lose the volume fraction where 36 times what's left still equals 35. Solve it and you get 1 divided by 36 which is 2.78 percent

You can lose up to 2.8 percent of your volume with a 1 percent price increase and still be no worse off. Anything less than that and you'll be ahead and you'll be ahead with lower volume which also means less capital invested less shipping and less support costs

That ratio is the most useful number in a discussion about pricing and it reverses the burden of proof. The question is no longer whether customers will complain about a 1 percent increase because they will. It's whether more than one in thirty-six customers will actually leave. Framed that way a lot of price increases that are talked about outside the room are obviously worth trying

If you do the same calculation on a business with a low contribution margin say 15 percent the tolerance drops to 1 divided by 16 or 6.25 percent so the tolerance is actually higher. Run it on a software company at 85 percent and it plummets to 1 divided by 86 about 1.2 percent. High-margin companies have less room to lose volume not more which is the opposite ofwhat most people assume

Case Study: Netflix, Qwikster, and the Price Increase That Backfired

In July 2011 Netflix announced that it would separate its DVD-by-mail and online streaming services into two separately priced plans. For a subscriber who wanted both the combined cost went from $9.99 a month to $15.98 an increase of about 60 percent. In September the company went further and announced that the DVD business would be split into a separate brand called Qwikster with its own website and billing

The backlash was severe enough that Qwikster was canceled about three weeks after its announcement. Netflix reported losing approximately 800,000 American subscribers in the third quarter of 2011 its first subscriber drop. The stock which was trading near $300 in July fell below $70 in late November

Put that through the framework above. Netflix wasn't testing a 1 percent markup versus a 2.8 percent tolerance. It was testing a 60 percent markup and it was doing so while making the product worse by splitting it across two websites and two invoices. Whatever pricing power it had was being spent on a markup that gave the customer nothing and cost them convenience

The instructive part is the sequel. Netflix has raised prices repeatedly in the years since and it has largely worked because the content library deepened the streaming product improved and the alternatives became less attractive in relation to it. Same company same lever opposite result

Pricing power is not a permanent attribute that a company has or does not have. It is a stock that is built by making the product more valuable and spent by charging more for it and in 2011 Netflix tried to spend more than it had accumulated

Pricing in an Inflationary World

The last few years turned pricing into a live test of which companies really had the power. As costs rose across the economy companies with strong brands and loyal customers passed on the increases directly and in some cases widened their margins while weaker competitors had to absorb the higher costs and watch profits shrink. Inflation doesn't treat all companies equally. It quietly sorts them between those who can raise prices and those who can only hope their own costs come down again

Inflation also does something more subtle: it provides coverage. A price increase attributed to costs is much easier for a customer to accept than one attributed to nothing and companies that had wanted to change price for years used the window to do so. Whether those increases will stick once the coverage disappears is one of the most interesting questions in corporate margins right now

Where the 8.7 Percent Claim Misleads

I just dedicated several sections to defending this number. This is where I think it is misused

It's a one-period calculation with no answer. The table above holds everything else constant which is exactly what doesn't happen. Competitors watch your price and change your price customers renegotiate at renewal time and the procurement departments of your largest accounts have people whose job is solely to figure it out. 8.7 percent is the profit available at the instant before anyone reacts

Leverage goes both ways and no one puts it that way. If a 1 percent price increase adds 8.7 percent to operating profit then a 1 percent discount given to close a quarter eliminates 8.7 percent. Sales organizations routinely approve discounts of much more than 1 percent and almost none of them are shown this arithmetic when they do it. The most valuable pricing job in most companies is not to raise list prices but to stop the leakage that is already occurring in thediscount approvals

Elasticity is taken for granted and the real issue is elasticity. The calculation tells you how much a price increase is worth if it sticks. It doesn't contain any information about whether it will stick which is the only really difficult part. Presenting 8.7 percent without an elasticity estimate is presenting the reward without the risk

Many prices cannot move freely. Multi-year contracts most-favored-nation clauses feed-in tariffs and price protection commitments mean that a large portion of a typical large company's revenue cannot be changed at all this year. The lever exists on paper and is screwed in practice

My view is that the 8.7 percent figure is directionally correct is widely used as a slogan and is most useful when reversed on the discounting question where the arithmetic is identical and the behavior is much easier to change

The Discipline of Pricing Well

Good pricing isn't just about charging the highest possible amount. It's about understanding what a product is really worth to each type of customer capturing more of that value through tiering and packaging and resisting the easy habit of discounting to win a deal which only trains customers to wait for the next markdown. Many companies leave huge profits on the table not because their product is weak but because they never seriously studied what people would actually pay

How I Would Actually Analyse Pricing Power

If I were asked to analyze whether a company could raise prices I wouldn't start with the competition's prices which is where most of these analyzes begin and stall

I would start by building the four-lever table above from the company's own income statement because it establishes the size of the prize before anyone argues about its viability. I would then calculate the volume tolerance from the contribution margin since that single ratio reframes every conversation that follows

Next you would look at the realized price instead of the list price. The gap between what a company publishes and what it actually collects after discounts rebates promotional discounts and credits is usually huge and is usually the cheapest place to find money. A company with an average discount of 12 percent that adjusts approvals to 10 percent has just executed a 2 percent price increase without telling any customers

Then you would segment. A combined elasticity across all customers is almost useless because the answer is almost always that some segments are very price sensitive and others hardly notice. The interesting job is to find the second group and change the price for them without altering the first which is what tiers and packaging are for

Lastly I would look for evidence rather than opinion which in practice means past price changes. Almost every company has already done this experiment usually unintentionally in a region or product line or during a cost shift. What happened then to volume is worth more than any amount of theorizing about what customers might do

This is how I would structure the work. It is not advice about any particular company

Why It Matters for the Role

For a finance team pricing is one of the highest-leverage areas to analyze precisely because a small well-judged change flows almost entirely into profits. Quantifying how much room a company has to raise prices segment by segment and what the lost volume would cost is the kind of analysis that can be worth more than any cost-cutting project. It's also the kind of insight that makes the people who run the business take a financial partner seriously

The Bottom Line

A 1 percent increase in price raises operating profit by about 8.7 percent for a typical large company about three times what a 1 percent increase in volume produces and the reason is more arithmetic than magic: Price flows into profit undiluted while volume drags its costs behind it

The number you should really carry with you is volume tolerance. With a 35 percent contribution margin you can lose 2.8 percent of your customers to a 1 percent increase and still come out even which means the real question is never whether customers will complain but whether more than one in thirty-six will leave

Netflix in 2011 is a reminder that leverage has limits. An effective 60 percent increase combined with a worse product cost it 800,000 subscribers and three-quarters of its stock price. Since then the same company has raised prices repeatedly and succeeded because by then it had already built something worth more. Pricing power is earned first and collected later and companies that reverse that order quickly discover this