A numbers example for the busy fool’s syndrome.
Increasing Sales Values Can Be Unprofitable
In our break even graphs, the standard assumption is that as sales volumes increase, contribution increases.
Let’s assume a business makes 40% contribution on its sales.
If sales are £500,000 then contribution is £200,000 (=500,000 *40%)
If sales are £1,000,000 then contribution is £400,000
If sales are £2,000,000 then contribution is £800,000
Sales and contribution increase proportionately as straight lines, separated by the variable cost percentage of sales.
Cutting Selling Prices To Force Growth
Growth may be slow and the business owner may decide to cut prices to create faster growth.
It’s hard to think in terms of percentages and how things change without crunching through the numbers. This means that business owners often make their decisions with their “gut” and it can be very wrong.
Let’s look what happens if the business owner is attracted to the idea of cutting prices by 10% to get a 20% increase in volume. On the face it, that sounds quite attractive.
Assuming variable costs stay the same…
A 10% reduction in selling price, reduces contribution from 40% to 33.3%.
The arithmetic for this is…
If sales were 100 and variable costs 60 before the price cut, giving 40 as the contribution, then after the price reduction sales are 90, variable costs are still 60 and contribution is 30 or 33.3% of sales (30/90)]
Then assume sales volume goes up by 20% because of the price reduction of 10%
Sales are now £1,080,000 – that’s the starting point of £1,000,000 plus the 20% increase in volume of £200,000 less the price reduction of 10% on the total £1.2 million of “volume”.
Contribution at the original prices on £1,000,000 at 40% is £400,000.
But after the growth strategy
Contribution on £1,080,000 at 33.3% is £360,000
Sales volumes have increased by £200,000 at normal prices value but only by £80,000 after the price reduction.
Contribution has reduced by £40,000, despite the 20% increase in volume.
- Increasing sales by £200,000 at 40% without the price reduction would have increased contribution by £80,000.
- The 10% price reduction reduced sales value and contribution by £120,000.
- The net effect of a 10% price cut to get 20% extra volume was a reduction in total contribution margin of £40,000
Don’t worry about the arithmetic, things will become clearer as you become more familiar with the Cost Volume Profit model.
If you’re not familiar with this financial logic, can you be confident that you haven’t reduced price chasing extra sales volume and made yourself less profitable.
Even after crunching the numbers and profit it isn’t true, a 10% price reduction to get a 20% volume increase when original margins are 40% sounds good to the emotional mind.
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