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%).
Iterative Path 
It’s good to see some challenges to the McKinsey “1% increase in price” line.
I mean, it’s true, but in a sense true by definition.
Price is 100% of price, costs are a fraction of sell price. So the return to a price improvement is a bigger number than the return arising from a cost or volume improvement.
And yes, sure some companies have all sorts of reductions and incentives in their final net price, but in lots of cases they are there for a good reason, like allowance for co-op advertising – if that exposes the brand to consumers then it can be a perfectly acceptable expense.
LikeLike
DrData
I take your point that focusing on pricing is the right first step for profit maximization.
Thanks for reading
-rags
LikeLike
I just ran into your blog as I tried to verify the McKinsy quote. Just wanted to say that I agree with you points on the post. Personally, I have worked in the pricing area for the past 25 years and have run into several myths and fallacies about pricing that have been presented as “the truth.” However, the one thing that I would like to point out about the quote – and your caveats are well taken – is that it is intended to get managers to take this issue much more seriously and with much more rigor than many normally do. It has always surprised me how subjective pricing decisions can be – and the consequences can be significant. My god, this is 2012 and we seem to have more technology than will.
So, is the McKinsey quote a bit of a misrepresentation. The answer is probably (for one thing, who seriously assumes no sales change in response to a price change – answer: my company does it all of the time despite rich elasticity information – and we always get burned). Does the McKinsey quote make the point about the importance of getting the pricing process right. I would say definitely! So, I am willing to cut them a little slack. I have used the quote several times in the past as a motivator.
LikeLike
Chris
My arguments are on stating a simple mathematical artifact as a causation study. If we take any formula and run what-if analysis we will get new answers, that isn’t a study.
Asking businesses to first focus on pricing is a better suggestion but likely won’t sell books.
-Rags
LikeLike
Steven
I agree with the prioritization – focus on better price realization before focusing on cost cuts and yes, most companies focus lot more on costs than they touch pricing. But simple solutions like 1% are dangerous, especially in the hands of someone not asking the second level questions.
-Rags
LikeLike
Well said Rags. I also agree with Reuben and Steven with respect to starting or continuing a conversation around the benefits of a proactive approach to pricing.
Such a conversation should always result in a more focused effort to better understand value drivers and recognize how value drivers distinguish customer segments. A company must decide what value demand they can deliver on and how to do so in innovative ways that result in sustainable value advantages. Of course there is more to be said, but always appreciate your posts.
Key to that last sentence is that innovation drives sustainability. Thanks again for the post.
LikeLike
Excellent post. As I used the one percent story in a recent post on the LeveragePoint blog you had me blushing. You are of course right that the key is to understand the value that you provide to different segments (and how you provide that value) and then use that understanding to set, communicate and negotiate prices. But the 1% meme is a good way of getting the attention of people who have long been focussed on cost cutting and who have allowed commoditization to weaken their pricing position.
LikeLike
Reuben
Thanks for participating.
Two problems I find with the much quoted study are one that it is simply based on a survey of % margins of companies and two it implies scalability.
I would start the conversation with segmentation but I get the power of the leverage of 1%
-rags
LikeLike
Great and thought-provoking post. I agree with your criticisms of the 1% mantra, although I wouldn’t call it a fallacy. It’s a simplistic way to start a conversation and help people appreciate that there’s a big opportunity in pricing better. (Unfortunately, in many cases, that’s also the end of the conversation.)
Also, while your right that being precisely wrong is not good, there are many companies that are in the right ballpark, and need to adjust pricing slightly to see big profit gains. There may be other gains from thinking outside the box, as well. Even in cases where the 1% mantra “applies”, the trick is always in the application. 😉
LikeLike
Very interesting post. Thanks. I agree. I especially like #5 vs. just turning knobs on the dial. I’ve seen this in practice. What I like about versioning is that it forces the organization to experiment to find things that suit customer preferences. Just dialing in price adjustments does not.
LikeLike
Your final note made me laugh :))) Great post Rags.
H.
LikeLike