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Test Elasticities to Create More Profitable Sales From Adjusting Prices

Most companies set prices to optimize profits assuming similar selling volumes. In either price-elastic markets or where marginal costs are low, that is a mistake.

Further, many companies look only at their own prices rather than what it costs a customer or end user to acquire and employ the offering. While not every offering can be vastly more attractive at a lower total cost to the customer or end user, many will. Companies need to vastly increase their testing to identify opportunities to expand volume profitably through changed pricing structures.

With a flick of your pen you can change your profits by adjusting your prices. That's a lot easier to do than finding and implementing a lot of subtle value improvements at the same price.

Do you know what price adjustments you should make? A spreadsheet can tell you the profit impact . . . if you know what the volume effects can be. But you know that most of your volume estimates will be way off the mark.

To overcome those potentially expensive errors, you need to test new prices first. But you already test prices. What's different from what you have been doing if you are to create an improved business model?

You now sell a product at one dollar a unit. You want use price to increase your profits from this product. Normally, you would test a slightly higher price in one geographic market to see how it goes. That price might be $1.05. Your average cost is $0.80 for the product.

If the sales stay about even with what you expect, you will probably make that price increase in all territories. That apparently profitable change in price could be a major missed opportunity, but you'll never know it.

Consider an example to help illustrate other ways to think about changing prices.

Let's consider an alternative that you probably didn't test. Because it would only cost you $0.25 (the marginal cost of the product) to sell more of this product, you decide to sell it at $0.80 instead. If the volume you sell increases by at least 50 percent, you make more money.

If you don't have to invest in more equipment or working capital and you are the low cost producer, this is a better deal because competitors will have a harder time making inroads against you in the future and you have just increased your relative cost advantage. If you are a high cost producer, all that may happen is that you will set off a price war that you will lose.

The competitors may ignore your test, which will make the test results misleading. But they will not ignore a full roll-out.

Now, consider a second alternative that you probably didn't test. The product's price stays at $1.00 for the volumes purchased in the last year, but for increased purchases above that level the price is $0.70. If total volume increases by at least 15 percent, you make more money. Again, if you don't have to add assets to make this money and you are the low-cost producer, you are ahead. The price war risk is much less if you are not the low cost producer.

Then, look at what else these customers purchase. Maybe they need another product to go along with this one. The other product costs $0.10 and sells for $1.00. In this test, you price the first product at $1.00 on present volumes, and the increased purchases at $0.40. If the volumes purchased of both products go up by at least 5 percent, you make more money before considering required changes in investments.

If customers need both products, you also should consider how price elastic the first product is versus the second one. You may make more money by cutting the price of the second product for incremental volumes and holding the price of the first product.

Now, all of this evaluation could easily be faulty. Why? Well, the customer may simply be storing the product in a warehouse somewhere and there is no real increase in consumption.

This would occur if the benefit of the better prices solely went to increase profits of the customer, and you already had 100 percent of that customer's business. If you were a small market share competitor, the strategy of one of these price reductions might be the right one. If you were a large market share competitor, it is less likely to work well except in the two product example.

Instead, you could aim your incremental price reduction at the end user. This might mean that you offer a rebate to consumers who haven't tried your customer's product before and are likely to find your product desirable. Or you might share the cost of free samples for new accounts that your customer has not done business with before. Depending on whether or not the end user was more or less price elastic than your customer, this would or would not be a good idea.

Imagine that we are talking about services instead. In many cases, the extra cost of supplying more services is extremely low (such as more hours of connection time to an Internet Service Provider). In this case, the price of the extra service might be $1.00 and the cost of providing more might be $0.01. In many cases, one service also affects the usage of another service. In such a case, the correct price to optimize profits (before considering increased investments) could be vastly lower than where it is today, assuming that you could supply all of the demand that was stimulated. Done quickly, competitors might not be able to respond at a time when they are out of capacity, and you might also grasp large relative improvements in average costs at the same time.

Do you still think that keeping the current pricing structure and testing small increases is the way to go? I hope not.

Copyright 2008 Donald W. Mitchell, All Rights Reserved

About the Author

Donald Mitchell is chairman and CEO of Mitchell and Company, a strategy and financial consulting firm in Weston, MA. He is coauthor of seven books including Adventures of an Optimist, The 2,000 Percent Solution, and The Ultimate Competitive Advantage. You can find free tips for accomplishing 20 times more by registering at: www.2000percentsolution.com

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