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When is Revenue Growth Real?

Recently, I read that a large, publicly traded clothing retailer was reducing prices in order to show a slim 5% revenue increase. In other words, the price reduction stimulated revenue growth by +5% while lowering the gross profit margin by -15%. This tells me that revenue increase is more important to this firm than gross profits. Does this make sense? What is the effect on gross profits?

Let’s work out this situation in several scenarios.  First, we need to make a few assumptions. The company increased revenues a positive 5%, so if revenues were at $100 they went to $105. The cost of good (COGs) sold is assumed to be 50% of the revenue, producing a gross profit of 50% to revenue. Revenues at $100 with COGs at $50 produces a $50 gross profit (GP). Finally, the price reduction of 15% is accomplished through a reduction in the gross profit, or selling more products at lower mark-ups on COGs.

Revenues at $100 with $50 GP was the pre-existing situation. Now revenues increase to $105. Prices reduced 15% means that the GP margin percentage goes from 50% to 35% across the board. Instead of making $50 GP on revenues of $100, the firm makes $36.75 (105 x 35%) on $105 of revenues. The price reduction was 15% but the gross profit dollars dropped (-26.50%).

What would happen if the company did nothing? If a 15% price reduction increased revenues +5%, then doing nothing potentially drops revenues in the opposite direction, or a  (-5%) decline. So instead of revenues of $100, the revenues would go to $95.00. The gross profit margin of 50% would remain the same but 50% of $95 revenues would result in GP dollars of $47.50, or a change of( -5%) in GP dollars instead of a (-26.50%) decline in the actual change that occurred to increased revenues at 5%.

What would sales have to go to at an unchanged 50% GP margin to produce a (-26.5%) decline in GP dollars to $36.75?  If we divide the $36.75 by 50%, GP margin produces revenues of $73.50, or a revenue decline of (-26.50%).

Conclusion: the best policy for the company would have been no change.

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