Part 2 - Getting More From Less: How small budgets can achieve more by eliminating waste

Part 2: How Pricing Can Be Used To Improve Sales Revenues

Introduction

In the previous report of this series, we briefly discussed the major concepts of marketing effectiveness. These principles included Effectiveness vs. Efficiency, Penetration vs. Loyalty, and Alternative Financing Options.

In this report (Part two of six), we will tackle the bottom branch of our logic tree; Pricing. As discussed in Part 1, Sales revenue can be broken down into its two components, namely Price x Volume. On the Pricing end, the 2 main drivers are the competitors and the price sensitivity of the market (which includes the brand’s pricing power).

The Theory

Pricing is perhaps the easiest to change of the 4Ps of marketing. The firm doesn’t need to spend millions of dollars producing an ad campaign nor spend money on R&D to develop a new product. With little to no change of marketing expenditure, a firm could significantly impact its sales revenue by simply changing the price.

With pricing, a firm generally has two options. It can either raise prices in the hope of increasing margin without severely impacting sales volume, or it can lower prices in the hope of increasing sales volume. Of course, prices aren't set in a vacuum and the firm needs to consider several factors.?

Firms generally set prices using 3 approaches:

1. Based on inputs such as time, money and production. A common example of this would be the markup method (very popular among SMEs). The firm takes into account the costs involved in production or service delivery and adds a profit margin on top of that.
2. Based on the competitive set. Typically, the firm would look at what the competitors are charging and set a price relative to that.
3. Based on outputs. The firm charges what the market is willing to pay for the product or service.

According to neo-classical economic theory, in a perfectly competitive market, the firm is fairly constrained in pricing decisions. Any price increase will drive demand to the competition and vice versa. However, most markets are not perfectly competitive. Most firms offer distinctly different products (some less so), at different prices.?

Therefore, competitors can influence the pricing decisions of a company in two ways. First, through product differentiation (not to be confused with brand differentiation). A firm can use price competition to differentiate its own products by offering better features or lower prices relative to competitors. Second, through customer segmentation. If two competitors target the same segments, it could potentially lead to a price war with each battling to attract clients at lower and lower prices. This kind of behaviour is detrimental to profitability and can quickly erode margins.?

Now, how the market reacts to price changes is dependent on price elasticity/price sensitivity (or what Behavioural Economists might call Willingness to Pay). If a firm can manage to increase volume and price at the same time, the market is said to not be very price sensitive. Millward Brown’s research has shown that stronger brands command a price premium over weaker and average brands (6% to 13%).[i]

Furthermore, an analysis by McKinsey found that a 1% increase in price, could boost the net income of the typical U.S. corporation by at least 8%, provided that demand stayed the same.[ii] Now, other than an increase in price, marketers and sales directors often use temporary discounts as a way of driving up volume. But as Byron Sharp’s research in “How Brands Grow” pointed out, a great deal of these discounts boost sales in one month, at the expense of the next.[iii]?

That is because price promotions may not always work well for reaching new customers (increasing penetration), and when that is the case you are only slightly changing the customers’ buying timeline. On top of that, there is the risk that the price promotion doesn’t deliver any ROI at all. What could happen is that you sacrifice some margin eg. 50% and are now more reliant on the same amount of customers to buy more. In this case, you’d need to double the amount of sales volume to make the same amount of profit. This kind of behaviour can be very risky for reasons discussed in report 1 (ergodicity economics).

Additionally, research by Steenkamp, Kushwaha, and Rajavi found that temporary price promotions only had a significant impact on sales in 2 distinct scenarios: [iv]

1. During an economic contraction when the brand was selling low-involvement products.
2. During an economic contraction when the brand in question was usually very expensive.

In that research report, Steenkamp and his associates make the distinction between temporary price promotions (as discussed above) and permanent price changes. In the case of the latter, they also note several scenarios where this does have a significant impact:

1. During economic expansion, when the brand is selling high involvement products or services.
2. During economic expansion, regardless of high or low brand expensiveness.

Finally, research from Prof. Larry Lockshin at the Ehrenberg Bass Institute also observed that the effect of pricing changes (discounts or permanent adjustments) could be attributed to the starting price in comparison to key competitors.[v] He notes that consumers view prices in ranges (think low, mid, high), and the effects are more pronounced in cases where the products cross into another range. i.e. sales spiked more when expensive wines were discounted into the mid-range prices. Similarly, discounting wines in the low-end category had very little effect.

Managerial Implications

Based on the research, there are several variables managers and practitioners have to consider when trying to adjust prices (permanently or temporarily):

1. Brand Equity. Price increases are generally more effective for brands with higher brand equity. Consumers are willing to pay a price premium for well-known brands. If the firm in question has little or no brand equity, a price increase might do more harm to revenues than good.
2. Product Involvement. Low-involvement products such as laundry detergents and household cleaners are best discounted during tougher economic times. On the other hand, high-involvement products such as pet food or even conditioners would see more effect from permanent price adjustments during an economic expansion.
3. Starting Price Relative To Key Competitors. Here managers need to consider where their products usually fall in the category price range and be careful not to increase price into an upper range. At the same time, a discount or permanent reduction would be most effective if the prices dip into a lower range.
4. Economic Conditions. Generally, temporary discounts are only effective when they occur during economic contractions. However, permanent price adjustments have a greater effect when they are done during economic expansions.
5. Risk. Temporary price reductions are generally an ineffective tool to significantly raise sales revenue. To be effective, products have to be heavily discounted which can be very risky.
6. Promotional Support Required. To improve the effectiveness of price discounts, more people need to be made aware of the promotion which will require some measure of advertising.

In the next report, we’ll be looking at how a firm can use distribution more effectively to increase sales revenue.

References

i. The Meaningfully Different Framework; Millward Brown, 2013. Shopcom panel data merged with equity survey responses. Based on comparing Power and Premium scores to shopping habits of 1600 consumers. Analysis includes 65 brands in 4 categories. Low = bottom 25%, Medium = middle 50%, High = top 25%.

ii. Read this article by McKinsey on The Power of Pricing.

iii. Buy Byron Sharp’s book: How Brands Grow

iv. The Effect of Marketing Mix Instruments on Brand Equity in Good versus Bad Times; K. Rajavi, T. Kushwaha, J.B. Steenkamp

v. Is It Time To Raise The Price Of Australian Wines?, L.Lockshin, 2017, Ehrenberg Bass Institute for Marketing Science

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Acknowledgements

This report was a collaborative effort and without the aid of our colleagues, it might've looked very different. The following individuals have made significant contributions to this series of reports: J.Moolman, I.Barnard, S.Brealey, and E.Gentle. We thank you all for being so generous with your time.