Part 2: How Pricing Can Be Used To Improve Sales Revenues
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).
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:
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 dependant 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]
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:
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 the cases where the products crossed 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.
Based on the research, there are several variables managers and practitioners have to consider when trying to adjust prices (permanently or temporarily):
In the next report, we’ll be looking at how a firm can use distribution more effectively to increase sales revenue.
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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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.