What You Must Know About Pricing Elasticity And The Danger It May Bring

What You Must Know About Pricing Elasticity And The Danger It May Bring

Price elasticity is an incredibly powerful tool. However, it should come with a “User Beware!” warning label.

There are numerous factors that impact business performance. These include

  • category trends
  • marketing programs
  • competitive activity
  • cost of raw materials
  • and much more

However, none of these determinants impact a company’s bottom-line to the extent that pricing does.

Elasticity analysis can provide a good guideline for determining how to drive added revenue, market share and profit. Simply put, if you are going to provide any sort of price discount on your product, you want to be sure that it drives ROI for your company… Don’t you?

Elasticity gives the percentage change in quantity demanded in response to the % change in price… “Ceteris Paribus” (holding constant all the other determinants of demand). If markets, categories or brands are highly elastic, it means they are very responsive to changes in price.

While the basics of price elasticity are straight forward, in reality, price elasticity is often misused or misquoted. There are a number of complexities around how to understand and apply price elasticity that this article will explore.

1. Price elasticity is NOT linear

price elasticity chartMany users of price elasticity data will interpret that with an elasticity of -2.0, a -10% price reduction will yield approximately a +20% volume increase. While this can be close-to-true in some instances for quick boardroom discussions, the reality is that price elasticity needs to be used as an exponential function. With a -2.0 elasticity, a price discount of -10% will actually yield a +23% increase in sales.

The above example will make some think, “20%… 23%… close enough!”. The truth is that most promotional elasticities tend to be quite high as a function of consumers looking for deals, and the amount of retail discounting has increased over the past decade. Elasticities of-3.0 and less are common, and retailer promotions often have discount levels of up-to 40%.

If we were to apply a linear relationship, then we would expect to see a +120% increase in sales (-3.0 x -40%). The reality of the exponential nature of demand is that -40%-3.0 = +360% sales increase! This dramatic difference in the volume lift calculation between the incorrect linear calculation (+120%) and correct exponential calculation (+360%) has enormous implications on volume, share & profit.

2. Price elasticity differs by market

Price Elasticity can have significant swings depending on the geography, the channel, and even the retail banner. The range can often as much as 20-40%. A price elasticity of -2.5 in Market A and -3.2 in Market B, represents a 28% range… Not uncommon. This gap can yield sales variances of over 150%. There are a number of factors that can drive these variances. For example, elasticities on many categories are higher in Discount Retailers than Conventional Grocery stores. It is key is to avoid a “one-number-fits-all” approach.

3. Elasticities vary by brand & pack size

Price Elasticity should always be leveraged for planning purposes at the “Price–Pack–Group” (PPG) level. Consumers respond to changes across PPG’s differently. It is common for larger packs to have slightly lower regular price elasticities than smaller packs. Once consumers have already made the purchase decision to buy a larger pack, they are seldom as sensitive to the absolute price point. “Value brands” also tend to have higher price sensitivity than “Premium brands”. Those who attempt to use an average elasticity across a brand or segment tend to oversimplify the nature of elasticity.

4. Category & “price promoted group” elasticity

Let’s consider the disposable diaper category… As a function of pricing/promotional activity for any given brand, it is possible to grow or shrink the sales for that brand. However, it is unlikely that the sales in the diaper category will change dramatically, over an extended period of time, as a function of pricing activity. Just because there is a sale on any of Pampers, Huggies, or Store Brand, it doesn’t make babies poop more!

Category elasticity refers to the degree of potential sales expansion or contraction at the category level. Categories that consumers use at a higher rate when they have it in their household are referred to as “pantry elastic” (E.g. Snack foods, cookies, canned pasta). Such categories tend to have a higher category elasticity. Categories that aren’t as pantry elastic (E.g. Diapers, toilet paper, contact lens solution) tend to have a lower category elasticity.

PPG (Price Promoted Group) pricing elasticities however can vary widely as the sales of a single brand or size often have dramatic effects on the sales of other brands/sizes. PPG’s within a category may all be quite high, while the category elasticity is quite low (A high degree of brand switching occurs).

5. Elasticity varies by season & over time

We acknowledge that “baseline volume” (sales you would expect in the absence of promotions), will vary by season & by year. But, rarely do we think about promotional elasticity as being time sensitive. Consider the sales of sunscreen: it may be true that base sales will be hugely impacted by the weather. It is also true that consumers’ sensitivity to price & promotional activity will be dramatically different by season as well. A -20% price discount on sunscreen in December won’t yield the same lift as a -20% discount in July.

Elasticities can also trend over time. Marketers would hope that their brand’s price elasticity would decrease (i.e. become less price sensitive) as a result of their successful marketing campaigns. While this can be true, the reality is that consumers’ “deal seeking” behaviour has increased over the past decade and most promotional elasticities have increased over time. It is important for companies to stay on-top of elasticity changes on an annual and, preferably, quarterly basis.

6. Price thresholds & gaps DO matter

A $.99 price is a real threshold. So is $1.99, $2.99, etc. Norms for “magical” price points that end in $.99 can outperform elasticity curves, often by as much as 5-to-25% vs. the predicted value. Most of the other price thresholds are often overstated and over-thought. While it is true that “bumps” in sales can happen for other price thresholds, these tend to be small, and often difficult to measure.

Price gaps to competitors should be considered, especially when brands are highly substitutable. Price gaps are managed primarily through regular prices as opposed to promotional prices. When regular prices on a brand move either up or down there is often an impact on sales for competitive brands. This competitive impact is often referred to as “Cross Effects”, or “Price Gap Elasticity”.

As we have discussed above, there are a number of major drivers of elasticity that complicate a company’s ability to fully grasp what it all means. The list could be continued further…

  • Duration of price change
  • Who pays for the product
  • Absolute price point or % of income that it represents
  • Necessity of the product
  • Retailer/Buyer influence
  • Definition of the product (category, brand or item)
  • Brand loyalty

So, coming full-circle, why do we care about price elasticity? We care because all successful pricing strategies start with the consumer. Price elasticity is the best indicator of consumer behaviour. It is not the only consideration in building your pricing strategy, but it is the starting point for meaningful scenario planning and profit optimization.

Cornerstone Capabilities has developed price modeling tools that compute elasticity in order to predict price points and prescribe strategies that optimize revenue or profit for one product or an entire portfolio. We have successfully applied the statistical models required within gold-standard, cloud-based, analytical software, and senior-level consulting expertise.

By |2017-06-13T17:02:24+00:00May 31st, 2017|Categories: CPG|0 Comments

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