Profitability

Maximization of profits is a frequently stated objective for many companies. Yet, this objective is difficult to implement. Profit maximization requires complete understanding of cost and demand relationships; and estimates of cost and demand for different price alternatives are difficult to obtain. If prices are set too low, marketers’ profits are insufficient; if set too high, no one will buy. Clearly, however, adequate profits are required, and companies are sensitive to changes in profits over time as indications of performance.

Increased prices can affect profitability three or four times more than increases in sales volume at constant prices. One consumer-durable-products company increased operating profits by nearly 30 percent with only a 2.5 percent increase in average prices. An industrial-equipment manufacturer boosted operating profits by 35 percent by raising prices only 3 percent.

Price skimming is a strategy often associated with profit maximization. It includes setting prices high initially to appeal to consumers who are not price sensitive. In sequential skimming, the firm subsequently lowers prices to appeal to the next most lucrative segments. This strategy allows companies to maximize profits across segments. Besides improving short-term profitability, price skimming lessens demand on production capacity, recoups R&D expenditures, and obtains profits before competitors enter the market. Moreover, consumers may associate product prestige and quality with the high introductory prices prevalent in a skimming approach. Du Pont and IBM are well known for using high introductory prices and skimming practices in marketing new products.

Profitability is often related to return on investment (ROI). ROI is the ratio of income before taxes to total operating assets associated with the product, such as plant and equipment and inventory. As for profitability objectives, the evaluation of the effects of alternative prices on ROI requires realistic estimates of cost and demand for a product or service at different prices. Firms attempting to obtain a desired ROI must take a longer-term, visionary view.

Comprehension questions:

1. What does profit maximization require?

2. How can increased prices affect profitability?

3. What is pricing skimming?

4. What is ROI?