10 – The effect of price on profit value and the rest of your life. Part 2: Price Elasticity.
In the previous section, we saw that prices have a direct impact on profitability. This direct impact has one assumption: that the prices are not set so high that demand for the service falls.
The relationship between the price of a service and demand for that service is known as price elasticity. To use the elastic analogy: the more a price can be increased (stretched) without clients deciding it is too expensive and choosing not to buy the service, the more elastic the price is.
The degree of elasticity determines the overall effect of price increases on profit. If prices are relatively more elastic, then increasing prices will not reduce demand. This will mean that the increase in price causes a direct increase in profit.
Determining the degree of elasticity for a given practice is not an exact science. But there are some good indicators of when prices will be more elastic.
The best indicator is how busy a practice is. A busy practice will probably have more elastic prices. That is, a busy business can increase prices without suffering from reduced demand.
This is not to say that the specific clients will not change. Some clients may choose not to pay the higher prices. But in this sense we use the word ‘demand’ to refer to how busy the business is overall. For example, a practice that is fully committed and turning clients away might might have demand equal to 120% of capacity. Unfortunately, the extra 20% above 100% is useless for the business: a business can only operate at 100% of its capacity. If this business increases its prices, demand may fall by (say) 10%. But this simply means demand becomes 108% of capacity. The business will be still operating at 100% of capacity. it won;t be doing any more or any less work. Marginal costs will not change. As a result, the price rise will lead to an increase in marginal revenue, all of which will be reflected in a disproportionate percentage increase in marginal profit.
As we saw in the last section, the exact size of the disproportionate change will depend on the size and mix of fixed and marginal costs within the business.
In contrast, if a business is only operating at 80% of capacity, and its price increase reduces demand by 10%, then the demand falls to 72% of capacity. In order for profit to be increased, the price rise will need to compensate for the fact that less work is being done.
If the price rise more than compensates for the fall in demand, then profitability will still increase. But the increase is restricted by the reduction in overall work.
This is why Dover’s attitude to pricing generally is: (i) get busy; and then (ii) get expensive. It is much easier to raise prices when demand is at or exceeding your capacity. You might lose some clients, but you won’t lose any profits.
In terms of profitability, the best of all worlds is where demand exceeds supply. In this case, the practice is turning away work. This gives the business a greater level of price elasticity. In deciding which work to decline, the practice can now use price. The practice simply keeps increasing its prices and seeing what happens. The price rise will deter clients who are not willing to pay the higher price. Only those clients who are prepared to pay higher prices will remain.
Eventually, the practice should aim at demand being equal to 100% (or a little more) of capacity.
The skill, of course, is for the business to set its prices such that demand hovers around this 100% mark. There are no hard and fast rules here: businesses must rely on their own judgement and there is a degree of trial and error. Most successful practices want to stay busy. They err on the side of caution and increase prices incrementally – say, 10% per year over a series of years. When they reach the upper limit of what most of their clients are prepared to pay, they stop increasing prices.
This gradual increase also gives the practice time to build up a new buffer of demand between each price rise.