Easy. This calculator combines the essential elements of our price elasticity calculator with a formula to calculate the optimal price point for your business. The optimal price uses the price elasticity curve and your marginal variable cost (direct cost of next unit of production) to maximize total contribution margin.
And hit the calculate button. The tool will calculate the price elasticity of demand and change in aggregate revenue.
The firm maximizes profit by producing that quantity of output where marginal revenue equals marginal cost. The theory here is that every additional unit produced where marginal revenue exceeds marginal cost is contributing to the aggregate operating profit of the firm, albeit in steadily decreasing amounts per unit. We use price elasticity to understand the firm's demand curve and thus - its marginal revenue potential. You can estimate marginal cost by looking at your cost reports (include direct materials, labor, shipment, and direct sales costs like commissions and digital advertising). The formula is: Price = Marginal Cost x (Elasticity / Elasticity + 1).
The formula doesn't work for certain levels of price elasticity; you're not picking up any incremental value from the change in price. The optimal price becomes the highest price you can charge, or something along those lines.
We're using the midpoint formula, or arc elasticity as it is known in academic circles. For both the initial derivation of the price elasticity co-efficient and the estimate of quantity given the optimal price.
Three reasons. First, while the essence of the answer is balancing marginal cost against marginal revenue, it is helpful to understand how fixed costs play into the overall performance of the firm. Consistently finding optimal prices that don't cover fixed costs is an extremely powerful signal that you need to change the game. Second, based on twenty years of coaching business executives, there is a natural tendancy to bury more things in fixed costs than necessary. Sure, SG&A (Selling, General, and Administrative) is usually a big bucket we dump all kinds of cost into - but certain portions are going to vary with volume (commissions, for one, and servicing costs). Finally, as my favorite private equity operating partner once reminded me: "In the long run, all costs are variable...."