Sunday, December 2, 2012

Pricing decisions - the volume / revenue trade-off

Whenever you adjust your pricing, you're volume will change, and you impact your revenue.  In this post we'll discuss how to think through those dynamics.  What happens to your revenue - and more importantly, profit - when you raise or lower price and what you need to know to predict the outcomes.

It's worth noting that if you're changing price as part of a promotion, the volume increase is only one part of potential value created and deciding whether or not it's worth doing.  See the related post on price promotion benefits beyond additional revenue for more information.


In this post we'll deal with:
  • What happens to your revenue when you raise prices?  Is it worth it?
  • What happens to your revenue when you lower prices?  Is it worth it?
  • What do you need to know to predict these outcomes?  How price sensitive are your customers?

 

RAISING PRICE - YOUR VOLUME WILL DEFINITELY DECREASE...

If you raise prices, demand for your product will definitely decrease.  When you raise the price of your product, two things will happen.  1) you'll get more revenue for every unit you sell, but 2) you'll sell fewer units.

As you raise your price, you're product will be more expensive than the WTP of some of your current customers.  Demand for your product will fall as some customers stop buying because they exit the market, go to a competitor, or find some substitute product.

So why consider doing it?  Because you'll get more money from the customers you retain.


...BUT YOUR REVENUE COULD STILL INCREASE

You can still end up increasing your sales while raising prices.  The danger here is that your price increase could drive away too many customers.  The math is simple, the but information you need can be difficult to capture.  You need to determine the following:
  • What is the price increase you have in mind?
  • How much will your demand decrease based on the price increase?
To illustrate the calculation, let's assume you currently sell 100 widgets at $100 each, bringing in $10,000 in revenues.  You plan on raising prices 10% to $110 per widget.

Scenario 1:  You think your price increase will cause demand to drop by 10%
In this scenario, you will still sell 90 widgets.
At $110 per widget, you bring in $9,900.
Your revenue has decreased by $100

Scenario 2:  You think your price increase will cause demand to drop by 5%
In this scenario, you will still sell 95 widgets
At $110 per widget, you bring in $10,450.
Your revenue has increased by $450

As you can see, what you believe about the impact of price on demand is a critical part of this concept.  I'll go over some methods for predicting that impact at the end of this post.

Now let's consider the opposite...

DECREASING PRICE - YOUR VOLUME WILL DEFINITELY INCREASE...

The outcome of decreasing price is exactly the opposite of what we just discussed for raising price.  As you lower price, your volume will definitely increase. When you raise the price of your product, two things will happen.  1) you'll sell more units but 2) you'll make less money per unit.

As you lower your price, your product will begin attracting new customers as your price drops below their willingness to pay (WTP).  You might be attracting them away from competitors or drawing brand new customers into your market.

So why wouldn't you do it?  Because you're also decreasing the price for all of your current customers who would've bought your product anyway.  The price of attracting new customers is giving up revenue from your current customers.


...BUT YOUR OVERALL REVENUE COULD STILL DECREASE

You can still end up decreasing your sales while increasing demand through lower prices.  The danger here is that your price cuts are too deep and you give up too much revenue to your current customers compared to the new revenue you'll get from new customers.  Again, the math is simple, the but you need that critical information on what impact your price change will have on demand...
  • What is the price decrease you have in mind?
  • How much additional demand will that attract?
To illustrate the calculation, let's again assume you currently sell 100 widgets at $100 each, bringing in $10,000 in revenues.  You plan on lowering prices 5% to $95 per widget.

Scenario 1 You think your price decrease will attract 5% incremental demand
You attract 5 new customers, for a total of 105
But all of your customers - including the ones who used to pay $100 - now only pay $95
You make a total of $9,975
Your revenue has decreased by $25

Scenario 2:  You think your price decrease will attract 10% incremental demand
You attract 10 new customers, for a total of 110
But all of your customers - including the ones who used to pay $100 - now only pay $95
You make a total of $10,450
Your revenue has increased by $450


PRICE SENSITIVITY OR PRICE ELASTICITY OF DEMAND

Price sensitivity is just what it sounds like - it defines how strongly will your customers react to a change in price.  High price sensitivity - or price elasticity of demand - means a relatively small change in price will drive a big change in demand.  Low price sensitivity means even large changes in price will cause little change in demand.

Luxury goods and pleasure travel have high elasticity or are highly price sensitive.  Essentials like fuel, medicine, and and food staples often have low elasticity or are not very price sensitive.
  • High price sensitivity means raising prices is risky - a small price increase might result in a big drop in demand.  But lowering prices could drive a big increase in demand.
  • Low price sensitivity means lowering prices is risky - you might lower prices a lot and not see much increase in demand.  But it might be safe to raise prices since your customers are less driven by price.
  • If your product is a commodity and not highly differentiated from what your competitors sell, your customers are likely to be highly price sensitive.

FOUR METHODS FOR PREDICTING PRICE SENSITIVITY

If you can figure out how your customers will react to price changes, you can make the right pricing decisions.  Here are some approaches you can use to get a sense of how price sensitive your customers are.

1.  UNDERSTAND HOW YOUR CUSTOMERS VIEW YOUR PRODUCT

You probably have a sense of how price sensitive your customers are.  Will a small % change in price create a small % change in demand or a large % change in demand?  You can probably answer these questions with reasonable accuracy if you know your customers well

2.  RUN AN EXPERIMENT

You can run targeted price promotions to test the impact of price changes on your customers.  This will allow you to gain insights into the change in demand driven by specific changes in price, while limiting the potential damage to your revenues in case the outcomes are not in your favor.  By comparing the % change in demand relative to the % change in price during the test, you can get a sense of your customers' price sensitivity.  The challenge is to find a way to give discounts in a way that ensure (a) you can get the offer to enough non-customers and (b) you can limit the number of current customers who get it.

3.  UNDERSTAND CUSTOMER LOYALTY AND THE COMPETITIVE LANDSCAPE

Does your product or brand give customers reasons to remain loyal to you?  Examples include unique products, on-going service contracts, or high switching costs.  If so, your customers might be less price sensitive.  But if you are selling a commodity that is not highly differentiated from what your competitors sell, your customers might be more price sensitive.

Also, how are your products priced relative to the competition?  If other competitors are charging a big premium, you might have room to increase prices.  If other competitors are highly competitive on price, you might not be able to raise prices.

4.  FIND BENCHMARKS OR ANALOGIES

Someone might already have this information for you.  There might be an industry trade association that has benchmarked price elasticities for you.  Many academic sources and government studies have information on price elasticities.  And there is no shortage of firms that would be happy to provide you with this data, for a price.

If you cannot find data for your product or industry, consider what information is available for comparable products.  Is there something your customers buy that they view similarly to your product?  If so, the data for those analogies could be good places to start.

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