Updated on 10/27/2010: Today’s Journal features an article on Small Business pricing and has the same famous 1% price increase quote from McKinsey “study”.
A price rise of 1% at an average company in the S&P 1500 index, which includes large-, mid- and small-cap companies, would generate an 8% increase in operating profit if sales volume stays steady, the study found
As you read below, the study is not a market experiment. It simply looked at current margins of S&P 500 firms and plugged in the numbers to see how much the income will change. It is sad that a simple what-if analysis gets quoted as indisputable research.
Now on to the article —
The idea is very simple and appealing and managers are smitten by the beauty of this rule. It is the 1% price increase rule. Its origin is unknown but it became popular when it was described in the book The Price Advantage. Now there is another book out called The 1% Windfall. The premise is,
“1% increase in price will increase your profit by 10-12%”
It is true because it is an artifact of the simple math on revenue and profit calculations. You apply any multiplier to the factors, the calculated metric moves as well. The only take way from the concept should be, notes in parenthesis and edits added by me:
(Under certain conditions for some businesses), increasing focusing on pricing will yield higher profit better results than decreasing focusing on costs, which is due to the fact that price increases flow directly to profit.
But the problem is the 1% is now considered the magical number and in the process of simplification the nuances and caveats are lost. This makes it look as if the way to increase profit is just turning knobs on a proverbial pricing dial. Increase prices to increase profits.
Here are the key problems with 1% argument:
- Elasticity: It ignores where in the demand curve is the current pricing (or states it as footnote and not as primary argument). Only products that are currently priced at inelastic part of the demand curve, will see change in demand from a modest price increase.
- Reductio Ad Absurdum: So if 1% is good, is 2% better? 10%? Suppose we did the 1% price increase and achieved profits, can we keep at it? This brings us back to first point on where in demand curve is the product. This means the 1% rule is a gross generalization.
- Why just 1%? This is flip side of above two points. If your current prices are in the inelastic part of demand curve, shouldn’t you find the true price increase needed before profit starts dropping off?
- Roughly Right Vs Precisely Wrong: If the product is priced wrong, there are other ways that are needed to get it right. For example, is the product targeting the right segment and offers right value at the price the segment is willing to pay? In fact, instead of increasing prices a reduction may be needed to maximize profits. The 1% rule will fine tune a wrong price and achieve precision but will still be wrong.
- Versioning: Focusing on 1%, you shut yourself from the opportunity to develop and deliver high value products to segments that are willing to pay much higher prices or lower value version at lower prices to others.
The 1% price increase is just a catchy tagline – simple, popular and irrelevant. Effective pricing starts with segmentation and targeting and not dialing knobs. 1% price increase may be relevant to businesses that already have the right segmentation and versioning but not when the marketing and pricing strategy are wrong.
Final note, the book 1% Windfall that talks about how successful companies use price to profit and grow is discounted 45% on Amazon (wonder why not 44%).