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Two common metrics to measure profitability are gross profit and earnings before interest, taxes, depreciation and amortization (EBITDA). Regardless of which metric is used, all measures of profitability begin with revenue. Revenue is income generated from the sale of goods or services and is calculated by multiplying the price of a product by the number of items sold. Product pricing, therefore, can dramatically impact profitability at every level, including gross profit and EBITDA.
If all else remains equal, an increase in price generates a corresponding increase in revenue and profit. If Company ABC sells 10,000 widgets at $5 each, its revenue is $50,000. If Company ABC increases widget prices by $1 and sales remain stable, revenue is increased by $10,000.
Key Takeaways
- Raising the price of a product can directly increase a company’s revenue and profit, assuming sales volume remains unchanged. For instance, if Company ABC raises its widget price by $1, resulting in increased revenue by $10,000 from stable sales, profitability metrics like gross profit and EBITDA will also benefit.
- An increase in product pricing can improve gross profit when the cost of goods sold (COGS) remains steady. For Company ABC, a $1 price increase raised gross profit from $45,000 to $55,000, highlighting the relationship between product pricing and profitability.
- EBITDA, which excludes interest, taxes, depreciation, and amortization, also benefits from a price increase when expenses remain constant. Company ABC’s EBITDA rose from $40,000 to $50,000 due to a $1 increase per widget, illustrating how price changes can affect this metric.
- While increasing product prices can boost revenue and profits, it may also risk decreased sales if prices exceed consumer tolerance. This underscores the importance of balancing price increases with maintaining product value to customers.
Understanding the Impact of Revenue on Gross Profit
A bump in revenue flows through to profitability metrics. For example, gross profit is equal to total revenue minus the cost of goods sold (COGS). Thus, if a company increases product prices but sales and COGS remain stable, gross profit is given a boost equal to the increase in revenue.
If Company ABC has a $5,000 COGS for the 10,000 widgets it sells, its gross profit jumps from $45,000 to $55,000 as a result of the $1 price increase, assuming everything else remains unchanged. This is important because the higher a company’s gross profit, the more revenue remains to cover other expenses required to run a business. Businesses with weak gross profits tend to have less than robust net profits, making them less desirable to investors.
The Relationship Between Increased Revenue and EBITDA Growth
Earnings before interest, taxes, depreciation and amortization (EBITDA) also benefits from increased revenue, though its calculation is more complex. Because EBITDA reflects the amount of revenue that remains as profit after accounting for all expenses except interest, taxes, depreciation and amortization, it is often calculated by adding these costs back into the net profit figure, or bottom line. As with gross profit, an increase in selling price means a corresponding increase in EBITDA, if all expenses remain stable.
Assume Company ABC, by selling only 10,000 widgets annually, generates net profits of $30,000 when each widget is sold for $5. The difference between Company ABC’s bottom line and its gross profit is $15,000, meaning the business has total expenses of $20,000, including COGS. Say of that $20,000, interest expenses total $2,000, taxes total $4,000 and depreciation and amortization clock in at $2,000 each. When each widget sells for $5, the company’s EBITDA is $30,000 + $2,000 + $4,000 + $2,000 + $2,000, or $40,000.
If revenue jumps to $60,000 as a result of a $1 increase in selling price and all expenses remain stable, the company’s net profit becomes $40,000. EBITDA also enjoys a bump: $40,000 + $2,000 + $4,000 + $2,000 + $2,000 = $50,000.
However, price changes are rarely so straightforward, and often a price increase must be accompanied by an improvement in product quality commensurate with the higher cost to consumers. If the price of a product is increased too much, sales may falter as customers choose to do business elsewhere, leading to lower revenue and diminished profits.
