The four profit levers moved one per cent each on one company's books, why price beats volume by 3.63 to one, and the base most people compute it on wrongly.
A 1 per cent price increase at unchanged volume is worth pocket revenue times 1 per cent, less the commission that rises with it. For Ravensworth, a 56.1 million business earning 5,739,363 of operating profit, that is 549,194, or 9.57 per cent of operating profit. One per cent more volume is worth 2.64 per cent, one per cent off variable cost 6.93 per cent and one per cent off fixed cost 1.64 per cent. A point of price is worth 3.63 points of volume.
Worked in full in Pricing Strategy by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
This is the comparison every pricing case is built on, and it is usually quoted as a rule of thumb from somebody else's company. It is a five-minute calculation on your own books, and the answer depends on two ratios: your operating margin and your contribution margin.
| Line | Amount |
|---|---|
| Revenue at list | 69,880,000.00 |
| Invoiced revenue | 60,253,524.93 |
| Pocket revenue, after off-invoice deductions | 56,124,433.13 |
| Variable cost of goods | 39,780,000.00 |
| Sales commission, 2% of invoice | 1,205,070.54 |
| Contribution | 15,139,362.59 |
| Fixed costs | 9,400,000.00 |
| Operating profit | 5,739,362.59 |
Pocket revenue is 80.3 per cent of list. The pocket contribution margin is 26.97 per cent and the operating margin on pocket revenue 10.23 per cent.
=(B4-B6)*0.01/B9 for the price lever, with pocket revenue in B4, commission in B6 and operating profit in B9| Lever | Operating profit | % of operating profit | Equivalent points of volume |
|---|---|---|---|
| Price +1% | 549,194 | 9.57% | 3.63 |
| Variable cost −1% | 397,800 | 6.93% | 2.63 |
| Volume +1% | 151,394 | 2.64% | 1.00 |
| Fixed cost −1% | 94,000 | 1.64% | 0.62 |
A point of price is worth 3.63 points of volume. Without commission it would be one over the contribution margin, 3.71; the commission takes a little back because it rises with every invoice price. The same margin gives the volume a price move can afford, holding the commission per unit fixed: a 1 per cent increase can lose 3.57 per cent of volume before contribution falls, and a 1 per cent cut needs 3.85 per cent more volume just to stand still. The general break-even, and why it must be run on contribution rather than EBITDA margin, is worked in how much volume a price increase can lose before EBITDA falls.
Read the table the other way round and it is a warning. A 1 per cent discount handed out across the book costs the same 549,194 in operating profit, and winning it back through volume needs 3.85 per cent more units sold. Most discounts are given in the belief that the volume will come; very few are checked afterwards.
| Contribution margin | Operating margin | 1% price | 1% volume | Price / volume |
|---|---|---|---|---|
| 20.0% | 5.0% | 20.0% | 4.0% | 5.0 |
| 27.0% | 10.2% | 9.8% | 2.6% | 3.7 |
| 35.0% | 15.0% | 6.7% | 2.3% | 2.9 |
| 50.0% | 20.0% | 5.0% | 2.5% | 2.0 |
| 70.0% | 25.0% | 4.0% | 2.8% | 1.4 |
Two rules fall out. One per cent of price as a share of profit is one over the operating margin: the thinner the margin, the more a point of price matters. And price beats volume by one over the contribution margin: a distributor at 20 per cent needs five points of volume to replace a point of price, a software business at 70 per cent only 1.4. There is no universal multiplier; there is your own pair of margins.
Computing the point on list revenue. 1 per cent of 69,880,000 is 698,800, or 12.18 per cent of operating profit. It overstates the true figure by 27.2 per cent, because a fifth of list never reaches the company. Computed on invoiced revenue, 602,535, it is still too high: the off-invoice rebates and allowances come after the invoice.
Assuming the announced increase is the realised one. The lever is worth 549,194 a point only for points that reach the pocket. In the book's own price increase, 5.0 per cent was announced and 2.3 per cent realised, 46 per cent of it. Value the increase on the realised rate, not on the letter to customers.
Ignoring the commission. A commission on invoiced revenue rises with every price increase and falls with every discount. Leaving it out overstates the price lever slightly, by 12,051 a point here, and the ratio to volume from 3.63 to 3.71.
The free workbook for this case, on the Pricing Strategy companion page, computes the four levers from inputs and carries a blank calculator for your own book. Where the fifth of list goes before it reaches the pocket is worked in how to calculate pocket price from list price.
Extra price drops almost entirely to profit, while extra volume brings its variable cost with it. At a 26.97 per cent pocket contribution margin, 1 per cent of price is worth 549,194 and 1 per cent of volume 151,394: price wins by 3.63 to one. The ratio is roughly one over the contribution margin, so it is largest in low-margin businesses.
At unchanged volume, yes: a 1 per cent cut across Ravensworth's book removes the same 549,194 of operating profit that an increase adds. The asymmetry is in the volume. Holding commission per unit fixed, a 1 per cent increase can lose 3.57 per cent of volume before contribution falls, while a 1 per cent cut needs 3.85 per cent more volume just to break even, so discounts are harder to earn back than increases are to defend.
On pocket price, what the company keeps after every on- and off-invoice deduction. Measured on list revenue of 69,880,000, one point looks like 698,800, or 12.18 per cent of operating profit, overstating the true 549,194 by 27.2 per cent. Only the part of an increase that reaches the pocket counts.
This article is one calculation from Pricing Strategy. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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