Mind Your Margins: Lessons From Behavioral Economics

 

Price reductions are a frequent tactic to increase sales and, hopefully, profit. Whether the price reduction increases profit depends on just how much unit sales increase.

Managers often use a mental shortcut, believing sales must increase by the same percentage as the price reduction in order to maintain the same level of gross profit. That is, many managers would intuitively respond that a 10% price reduction requires a 10% increase in unit sales to maintain the same level of gross profit. This is incorrect.

A small reduction in price can dramatically reduce the unit margin. The unit sales increase needed to maintain the same level of profit is often much larger than expected. This error is explained by several cognitive processes identified by behavioral economics.

A. Base-rate neglect causes decision-makers to focus on the percentage change in price while ignoring the “base” of the original margin (Tversky & Kahneman, 1974).

B. Attribute substitution leads people to answer the easier question: “What volume increase seems proportional to the price decrease?” instead of completing the full gross profit calculation (Kahneman & Frederick, 2002).

C. Proportionality bias leads people to intuitively assume that small changes in price require proportionally small changes in quantity to maintain status quo (Ebel-Lam, Fabrigar, & Macdonald, 2010).

D. System 1 Thinking intuitive judgments often override deliberate analytical reasoning (Kahneman, 2011).

Gross profit depends on unit sales, the price per unit, and the cost per unit:

Gross Profit = Units Sold x (Price per Unit – Cost per Unit)

The difference between the price per unit and the cost per unit is called the unit margin:

Unit Margin = Price per Unit – Cost per Unit

Example: A sporting goods store currently sells a baseball glove for $100. The baseball glove is bought from their supplier for $80. The unit margin is:

Unit Margin = $100 - $80 = $20

The sporting good store sells 20 baseball gloves per month at the $100 price.

Gross profit is:

Gross Profit = 20 baseball gloves x $20 unit margin = $400

The sporting goods store trials a 10% price reduction to increase sales and profit. The new price for the baseball glove is $90. The new unit margin is:

Unit Margin = $90 - $80 = $10

To determine the unit sales required to maintain the $400 profit, the Gross Profit equation above is rearranged:

Units Sold = Gross Profit / Unit Margin

Units Sold = $400 / $10 = 40 units

This is double the number of original units, just to break even! Put another way, the 10% price reduction requires a 100% increase in sales to maintain the same level of profit.

If one looks at the Gross Profit equation closely, the reason for this dramatic increase in unit sales required is the importance of the unit margin. In our example, the unit margin decreased by 50% when the price was reduced by only 10%. The percentage increase in unit sales required to maintain profit is magnified as the unit margin is reduced, as shown in the table below:

As the unit margin progresses towards zero, the unit sales required to maintain profit rapidly increases. In fact, when the unit margin is zero, no amount of sales will ever be profitable.

Conclusion: Neglecting margins can have serious consequences. Explicit calculations should be performed rather than relying on intuitive judgments.

References:

1. Ebel-Lam, A., Fabrigar, L, & Macdonald, T. (2010). Balancing causes and consequences: The magnitude-matching principle in explanations for complex social events. Basic and Applied Social Psychology, 32(4), 348-359.

2. Kahneman, D. (2011). Thinking, fast and slow. Farrar, Straus and Giroux.

3. Kahneman, D., & Frederick, S. (2002). Representativeness revisited: Attribute substitution in intuitive judgment. In T. Gilovich, D. Griffin, and D. Kahneman (Eds.), Heuristics and Biases: The Psychology of Intuitive Thought (pp 49-81). Cambridge University Press.

4. Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185(4157), 1124–1131.