Impact of Price Reduction on Your Gross Margin

Impact of Price Reduction on Your Gross Margin

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Discounting your prices dramatically impacts the gross margin you will earn on a project.

Everyone loves a sale, everyone loves a deal. But when your business reduces your selling price by even a small percentage it takes a large bite out of the gross margin dollars you will earn. Remember, gross margin is your selling price minus your total cost of goods sold. Out of the total gross margin dollars you generate, you need to be able to pay all of your expenses, and retain some of those dollars for profit.

In this article we are not going to discuss how to create more value for your customers versus your competition, or even why you would need to reduce your price in the first place. Here we are just going to cover the math. Remember, it is about how many gross margin dollars are left over for profit that counts, not your total sales volume.

A simple example will demonstrate how a 10% price discount is a huge reduction in your gross margin.

  • Original Selling Price: $1,000
  • Total Cost of Goods Sold: $700
  • Gross Margin Dollars: $300
  • Gross Margin Percentage ((Sell Price-Cost of Goods Sold)/Sell Price) = 30%

Now, your customer says you can have the job if you cut your price by 10%

  • Original Selling Price: $1,000
    • New Selling Price (10% off) – $900
  • Total Cost of Goods Sold: $700
  • Gross Margin Dollars: $200
  • Gross Margin Percentage ((Sell Price-Cost of Goods Sold)/Sell Price) = 20%

This very simple example show that you my have reduced your selling price by 10% but you cut your profit margin by 30%! 

Put on your sales and marketing cap, and work through the benefits of a 10% price increase.

  • Original Selling Price: $1,000
    • New Selling Price (10% increase) – $1,100
  • Total Cost of Goods Sold: $700
  • Gross Margin Dollars: $400
  • Gross Margin Percentage ((Sell Price-Cost of Goods Sold)/Sell Price) = 36.4%

In this example, your 10% price increase improved your profits by 21%. (A 6.4% additional gross margin percentage is a 21% increase over your original 30% gross margin.) Even if you only increase your price by 1% in this example, you have increased your profits by 3.3%.

The purpose behind this post is to simply drive home what a huge impact reducing, and more importantly, raising your prices has on the health of your business.

 

 

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