The economy is slowing, sales are dropping and profitability is on the decline. Should you drop your prices and reduce your gross profit margin? In order to answer that question, let’s look at an example. You are a retail store with sales of $1 million and your gross profit margin is 40%. The average sales price in the store is $20. That means that you sold 50,000 items for $20 on average. Between staff and overhead, your fixed costs are say $500,000 so that you earned an average profit of $100,000 in good times.
Consumers are buying less. You want to increase sales because sales have dropped by 20% due to the economy. If you drop your gross profit margin to say 20% from 40%, you will now make $3 per average sale vs $8 before. In order to maintain $400,000 of gross profit, you will now have to sell 133,333 items or 2.67 times the quantity when you had the higher gross profit margin. If you do not achieve this sales volume and your overhead is fixed, you will be losing money. You will have to double the sales from $1 million to $2 million in order to be in the identical position. When the economy improves, will you be able to increase your sales from $15 back to $20? That is a 25% increase and it will be very difficult to do.
It is easy to drop prices but will you ever recover. If you drop your prices and your competitor drops their prices, will you dramatically increase your sales to compensate for the lower margins? That will depend on the business and the number of competitors that you have. Remember, it is very easy to drop prices, it is very difficult to increase prices.
If you do not believe that you can increase your sales dramatically, a significant price reduction may increase the quantity of sales but not enough to make up for the lower margins. Now you will be worse off, your solution did not work.