Pricing Strategies for Maximizing Profitability

A little business exercise.

Photo by Microsoft 365 on Unsplash

Big businesses hire pricing specialists to determine the best price to meet their goals. This article will help the average American think it through.

Imagine we have a product called Excellent X. We believe from our market research that 1 person would buy 1 Excellent X at $10. Two people would buy one at $9. Three people would buy one at $8, etc.

Quantity             Price     Total Revenue
Sold                                      (Quantity x Price)

1                             10           10

2                             9             18

3                             8             24

4                             7             28

5                             6             30

6                             5             30

7                             4             28

8                             3             24

9                             2             18

10                           1             10

Notice that total revenue is the same at the price of $6 or $5. However, at $6 we only manufactured 5 and at $5 we manufactured 6. Profit would be higher at $6.

Now imagine that our costs to manufacture Excellent X are $5 to make the first one, $2 per unit to make four more and $1 to make 5 more after that.

Quantity              Cost     
Made

1                                            5

2                                            7

3                                            9

4                                            11

5                                            13

6                                            14

7                                            15

8                                            16

9                                            17

10                                        18

Now add the total revenue column and subtract the cost from total revenue.

Quantity              Cost      Total Revenue                   Profit
Sold                                      (Quantity x Price)            Total Revenue - Cost

1                             5             10                                           5

2                             7             18                                           11

3                             9             24                                           15

4                             11           28                                           17

5                             13           30                                           17

6                             14           30                                           16

7                             15           28                                           13

8                             16           24                                           8

9                             17           18                                           1

10                           18           10                                           -8

We maximize profit by selling 4 units for $7 or 5 units for $6. That is due to economy of scale. The more Excellent X we produce, the lower the cost of production.

What happens if our supply is limited? What if we can’t find enough raw materials? What if we can’t find enough labor?

Imagine we can only make four units. If we try to charge $8, we will only sell 3 of them. We make even less money. Our revenue is $24 (3 x $8) and our cost is $11 for a profit of $13.

Unless people change their buying-habits and are willing to pay more due to lower supply, we will have lower profit.

One more little twist. What if we invested $15 in machinery to make Excellent X? If we make less than $15 profit we fail to get our money back.

What if government decides to only allow us to charge $3 for our 4 units? Our total revenue is $12, and our cost is $28. We close the business.