Two common metrics for measuring profitability are gross profit and earnings before interest, taxes, depreciation and amortization (EBITDA). Regardless of the metric used, all profitability measures start 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 can therefore have a significant impact on profitability at all levels, including gross profit and EBITDA.
If all other things remain 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 increases by $10,000.
How Revenue Affects Gross Profit
An increase in revenue affects profitability measures. For instance, gross profit is equal to the total income minus the cost of goods sold (COGS). So, if a company increases product prices but sales and COGS remain stable, gross profit receives an increase equal to the increase in revenue.
If Company ABC has a COGS of $5,000 for the 10,000 widgets it sells, its gross profit goes from $45,000 to $55,000 as a result of the $1 price increase, assuming that all the rest remains unchanged. This is important because the higher the gross profit of a business, the more income is left over to cover other expenses needed to run a business. Companies with low gross profits tend to have less-than-robust net profits, making them less attractive to investors.
How EBITDA benefits from increased revenue
EBITDA also benefits from the increase in turnover, even if its calculation is more complex. Since EBITDA reflects the amount of revenue that remains as profit after taking into account all expenses except interest, taxes, depreciation and amortization, it is often calculated by adding these costs to the net profit or net income figure. As for gross profitan increase in the selling price means a corresponding increase in EBITDA, if all expenses remain stable.
Suppose company ABC, by selling only 10,000 widgets per year, generates net profits of $30,000 when each widget is sold for $5. The difference between ABC Company’s net income and its gross profit is $15,000, which means that the company has total expenses of $20,000, including COGS. Let’s say that of that $20,000, interest costs total $2,000, taxes total $4,000, and depreciation and amortization add up to $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 increases to $60,000 as a result of a $1 increase in selling price and all expenses remain stable, the net profit of the business becomes $40,000. EBITDA also increases: $40,000 + $2,000 + $4,000 + $2,000 + $2,000 = $50,000.
However, price changes are rarely that simple 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 rises too much, sales can falter as customers choose to do business elsewhere, resulting in lower revenue and profits.