| By Chuck Schaeffer
How Demand Elasticity & Price Elasticity Uncover Revenue Opportunities
Most companies apply uncounted hours to cost management but invest little more than occasional guesswork to strategic pricing. That's unfortunate as price optimization using price and demand elasticity models creates powerful levers to confidently change prices and increase revenues and margins.
Elasticity shows how price changes impact the quantity sold. Your elasticity calculation shows not just how price and demand are connected but also when to raise and lower prices to increase total revenues.
Elasticity (E) is equal to the percentage change in demand divided by the percentage change in price.
E = %ΔD / %ΔP
When your product demand is inelastic – that is elasticity is less than 1 – changing the price will have a lesser impact, or no impact, on the quantity sold. Therefore, increasing the price will increase total revenues and decreasing the price will reduce total revenues. Some obvious examples of inelastic products include medications or gasoline.
But when your product demand is elastic – that is greater than 1 – changing the price will have a proportionally higher impact on the quantity sold. So increasing the price will decrease total revenues and decreasing the price can increase total revenues.
Here's how to apply this information to increase revenues.
- The end of goal of strategic pricing is to make products inelastic for price increases, and elastic for price decreases. That permits price to be raised with a lesser impact to quantity sold which increases revenues and margins, or to periodically lower price using promotions, to increase the quantity sold, which increases revenues.
- For products with inelastic demand, increasing price will offset a lesser impact to quantity sold and thereby increase revenues and margins. For example, if E = .75, then increasing the price 10% will decrease demand by 7.5%, as shown below:
.75 = X/10%, therefore X = 7.5%
- For products with elastic demand, changes in price create bigger changes in quantity sold, so decreasing price will increase quantity sold and thereby increase revenues. For example, if E=3, then decreasing the price 20% will increase demand by 60%, as shown below:
3 = X/20%, therefore X = 60%
One important point with inelastic demand is that there must be sufficient market demand, or the company must ramp up advertising or promotions to create market demand to ensure the price decline attracts otherwise untapped customers to achieve the increased revenue goal.
Calculating Your Product Elasticity
Here are some of the methods to calculate price and demand elasticity for your products.
Price modeling. Price experimentation done pursuant to a test model is the most accurate and quantifiable method. Rather than change product prices, it's generally advisable to apply limited period discounts to test price change effects. Price testing with A/B or multivariate testing and a control group will provide market tested data for the price model. There's no need for across the board price manipulation as it is normally wiser to test by a limited but representative geography, target market or customer segment. For companies with indirect sales channels, the manufacturer may test pricing with one or a few distribution or resale partners. The manufacturer can also use spiffs, rebates or margin adjustments to compensate the partner for increased promotional costs and reduced sales pricing. It's important the price experimentation is clearly stated as for a limited period of time.
Competitors and comparisons. You can create an elasticity model by comparing the pricing and quantities sold of substitute products. You will need to include multiple substitutes in the model to get a reasonable confidence level. This method is not as precise as market experimentation but can be done more quickly and without altering product pricing.
Product launches. New product introductions provide a unique pricing opportunity. Using crowd sourcing to vet pricing scenarios, rolling out new products by territory to test and refine pricing models, and applying a skimming strategy whereby the initial product price is set high but systemically lowered over time are methods to create a price elasticity model. Price skimming is particularly useful for innovative product releases as it allows the company to capture market surplus, quickly recover its sunk costs and attract market share before competition enters and creates price pressure.
Note that I didn't include Breakeven Analysis as method to determine price optimization. Breakeven analysis is the most popular method, in large part because it's quick, easy and can be done without market analysis, but it's shortsighted and it doesn't really work. Breakeven calculations can compute the number of products needed to sell to break even. However, without product and demand elasticity models, the next actions of increasing or decreasing prices to determine revenue impact are nothing more than unsupported guesswork. Breakeven analysis can be used with elasticity models but is near worthless without them.
Price and demand elasticity for your products isn't constant and may shift due to environmental or engineered factors. Here's how to change your product elasticity for improved revenues.
Grow company brand
Brand equity is the commercial value derived from customer perception of the brand name. It enables price premiums, fends off lower cost competitors and shifts product elasticity from elastic toward inelastic.
Promote product differentiation
Increasing the product value proposition and decreasing the number of actual or perceived substitutes will lower price elasticity. Patented medications are more inelastic and drive higher prices than generic drugs as they are perceived to be different and better.
Build customer affinity
Delivering relevant, personalized and contextual customer experiences and building relationships with customers creates customer affinity and loyalty, and shifts product elasticity from elastic toward inelastic. In fact, customer affinity is one of only four sustainable competitive advantages.
Grow loyalty program
The goals of a loyalty program are to acquire more customer intelligence, increase sales of higher margin products, grow customer lifetime value and shift customer loyalty from products to the brand. When loyalty programs increase the customers' emotional connection with the brand, product elasticity becomes more inelastic.
Create barriers to churn
Costs related to switching vendors shift price elasticity. Exit, termination or contract penalty costs have some influence on customer churn, but for many customers, the time and effort to switch brands is far more significant than the expense. The best strategies to retain customers are to increase customer engagement and customer share. Growing customer share by cross pollinating the number of different products sold to the customer will decrease the likelihood the customer will switch brands.
Use exclusive distribution
Limited distribution or reseller partners and channels can lower price elasticity. Limited channels often promote premium products and can convey limited availability, greater value and higher quality.
Small changes to product price can create big changes to company profits. Knowing product price and demand elasticity, how to shift elasticity to your advantage and how to adjust prices for predictable revenue impact are powerful levers to realize untapped revenue and unlock profit.