Cutting prices by 20% and yet maintain your margin

imagesNews source at:

http://finance.yahoo.com/career-work/article/108119/the-accidental-hero.html?mod=career-selfemployment

Business finance flow in a very simple manner, it starts from the top (gross revenue) to bottom (profit).

Now between that two point, there’s cost, cutting numbers from the revenue until they reach profit.

Equation wise, R – C = P (totally simplified)

So, one would suspect that a significant in reduction in revenue would cause similar reduction in profit.

[0.8 R – C] would be far less than [R-C]

Well, that’s not the case with Subway, in a business move bound to spawn pricing case studies, Subway cut prices for some of their 30 cm (1 foot) sandwiches from 6 dollar to 5 dollar.

Again, you cut your price by 20%, all things being equal, revenue drop by 20%, and since you’re selling the same stuff, cost stays at past level, and there goes your profit.

In turns out that all thing are not equal, it turns out that human psychology plays a huge role in pricing (surprise surprise). Customers LOVE the 5 dollar price, 5 dollar is a round number, not cheap, but round. 5 dollar allows you to stuck out one 5 dollar bill, instead of 2 bill (one 5 dollar and one 1 dollar).

Revenue soars and yet margin stays…

Now, the effect of the 5 dollar is great, and is heavily explored on the article above. The 5 dollar explain why revenue soars.

But it didn’t explain why margin stays, because you’re bound to have margin pressure due to cost.

Now, my guess margin stays because 3 things:

1. Subway’s sandwiches has been grossly overpriced all along, so even when they cut prices by 20%, they have a ton of cushion on their margin

2. Subway has a lot of idle capacity in its stores (labor and machine), whether these capacity is running at 10% or 100%, they cost about the same. So, the increase volume allows Subway to optimize resource capacity at its stores. The additional cost is minimal, and margin stays

3. Significant increase in unit volume allows them to reduce cost of goods from their supplier and lower the per unit cost from fixed cost items (this one is very theoriticall)

Interesting right? A key lesson here, is that maybe this strategy can be applied to industries where they have capacity lying around, and costing them the same whether being used at 10% or 100%. This opens room to increase volume (by cutting prices), optimizing the idle capacity, and thus in the end, maintain margin but with higher

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