Two of the most common metrics businesses use to measure profitability are gross profit and earnings before interest, taxes, depreciation and amortization (EBITDA). Regardless of which metric is being analyzed, all measures of profitability begin with revenue. Revenue is the amount of income generated from the sale of goods or services and is calculated by multiplying the selling price of a product by the number of items sold for a given period. Product pricing, therefore, can have a dramatic impact on profitability at every level, including gross profit and EBITDA.
If all else remains equal, an increase in product pricing generates a corresponding increase in revenue and profit. If company ABC normally sells 10,000 widgets at $5 each, its typical revenue is $50,000. If the company increases the selling price of each widget by $1 and sales remain stable, revenue is increased by $10,000.
How Revenue Affects Gross Profit
A bump in revenue has a trickle-down effect on profitability metrics. Gross profit, for example, is equal to total revenue minus the cost of goods sold (COGS). Thus, if a company increases the selling price of its product but sales and COGS remain stable, the gross profit is given a boost equal to the increase in revenue. If company ABC has typical COGS of $5,000 for the 10,000 widgets its sells each year, its gross profit jumps from $45,000 to $55,000 as a result of the $1.00 price increase, assuming everything else remains unchanged. This is important because the higher a company's gross profit, the more revenue remains to take care of the myriad 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.
How EBITDA Benefits From Increased Revenue
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 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.