Strategy&: Four reasons why price elasticity is obsolete

18 September 2014 Consultancy.uk

For decades, economic and business theory on pricing has centered around the concept of ‘price elasticity*’. Yet according to James Walker, a partner with consulting firm Strategy& in London, the concept can be considered as useless in the real world of business. He presents four reasons why in his view it’s time to leave price elasticity behind.

1. It obscures the precise sales impact of price changes.

An e-commerce marketing leader I know recently talked about her frustration with the price elasticity model she was using. It had been programmed with a price elasticity ratio of -5. In other words, a 10 percent cut in overall prices would increase sales volume by 50 percent. But the model said nothing about how this sales increase was going to actually happen. Why should we believe it?

Most businesses, these days, need pricing models that do more than predict sales volume. They need to break down the impact of any given sale into its component parts. When prices go down, for example, how many new customers are acquired? How many trial buyers switch to becoming repeat purchasers? What happens to the frequency of purchases? Are customers likely to spend the money they save elsewhere, perhaps on categories they haven’t bought before? Does a price decrease make them less likely to buy from competitors, and do different customer segments (based on age, gender, or socioeconomic brackets, for instance) respond in different ways?

 Four reasons why price elasticity is obsolete

2. Relative prices matter, not just changes in price.

Price elasticity models tell you only how price changes affect behavior. In many categories, this is irrelevant. For example, in the United Kingdom, where I live, we are currently in the midst of a price war on milk. This is, in effect, a race to the bottom of the supermarket cooler. Price elasticity calculations are useless here, because sales accrue only to the brand with the lowest price. Similarly, having the lowest-priced cigarette pack in a retail store can drive huge increases in sales, regardless of how much the price has changed since last week. These effects are also common when people are purchasing auto insurance, airline tickets, and hotels—indeed, in any milieu where buyers can easily compare prices.

3. Retailers often control the outcome.

When a CPG manufacturer decreases its prices, retail chains often have the clout to demand that their cash margin remain untouched. The manufacturer covers the entire burden. And when the manufacturer raises its prices, the same retailers take a percentage of the increase. In both cases, regardless of whether a pricing move is up or down, the CPG company is worse off. A price increase that produces only a theoretical profit gain for the CPG company may lead to a backlash from retailers; they can demand promotions that push the price back down, making the manufacturer pay both a margin compensation and a subsidy of the promotion. The aggregation of discounts, compensations, and margins, known as the “pricing waterfall,” can dramatically reduce profitability for manufacturers.

4. There is no such thing as a pure ‘price’.

The price of a product reflects many factors, depending on the context. In e-commerce, for example, the price incorporates such things as the minimum order value required for free delivery, the mix of products offered by the manufacturer, and the use of promotions and loyalty incentives (reward points). Sometimes a company undermines its own pricing effectiveness.

Clothes-with-Sale-tags

Recently, at a big data conference, a soft drink company marketing leader quipped that his company’s greatest competitor was in the next cubicle, launching another product. In other words, his biggest concern was cannibalization of his stock keeping unit (SKU) from others in the same company. The price is also affected by consumer perceptions, emotions, and confusion—for example, when consumers have to sort out comparable products from different companies that are offered with varying sizes and weights.

In short, price is neither a simple input variable for a model, nor is the outcome as simplistic as just aggregate sales. Price can no longer be managed by a price elasticity model. The elastic has snapped.

The alternative?

What then do we replace it with? The details will vary from one company to the next, depending on industry, scale, and whether it’s a consumer or a B-to-B enterprise, but the basic principle is the same. To improve overall revenues and profitability, you need to design a holistic analytic model that takes into account not just price changes and absolute price, but other considerations. The factors you consider should meet the following criteria: You have some control over them, they are relevant to the price, and changes in them have a clear impact (that you understand) on new customer acquisition, the size of purchases, the likelihood of repeat purchases, and so on. Examples of specific factors include the promotion schedule, the mix of SKUs, and other aspects of pricing such as the minimum order value required for free delivery and rewards programs.

James Walker - Strategy

These factors have their own complexities that should also go into the models. For instance, to create the optimal rank order of SKUs, you need to be aware of margins, sales levels, market basket analysis (which products are often purchased together), and the potential for other products to cannibalize this one. You need to avoid the kind of promotional price cuts that increase sales on one product, while decreasing sales on the other SKUs you didn’t promote.

In short, for a pricing model to be useful, both the input “price” and the output “sales” need to be dramatically more sophisticated than they are in most price elasticity models today. Think of all these factors coming together in an ecosystem of pricing. Add a gift for baskets above a certain value (such as a set of steak knives for anyone who spends more than US$120), or initiate a rewards or loyalty card, and you affect the components of a sale (customer acquisition, repeat purchase, and advantage against competitors’ offerings). Fortunately, the analytics tools exist to model all these factors, and to track what happens when you make specific changes. But you can only use those models if you’re willing to graduate from simple metrics like price elasticity; the comfort they provide is illusory.

* The basic principle of price elasticity is as follows: an x-percent increase in price leads to a y-percent decrease in sales volume. If the ratio between x and y for a given product is known, then the concept provides an approach for calculating an optimal price.

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Branding the modern consultancy: why reputation hinges on it

03 April 2019 Consultancy.uk

The reputation of firms and brand strength remain a key aspect of business in the management consulting industry. Karla Alexander, Brand Manager at Propero Partners, below reflects on the state of reputation management in the consulting industry.

In a time where public perception is enough to make or break a company, the wise are reminded that when it comes to brand and reputation, the strength of one does not necessarily equate with the quality of the other. Nowhere is this more clearly demonstrated than in the impact a spate of recent issues has had on firms that form the backbone of the industry, including KPMG and Grant Thornton.

Such was the damage to KPMG’s reputation last year, that the Bank of England took the decision to investigate its viability following a string of high-profile corporate scandals. Whether or not the sum total of the firm’s track record is enough to restore its image remains to be seen.

This proves that brand and reputation are not only among the most valuable intangible assets – they are also among the most fragile. And their reach extends into the centre of any firm, regardless of its size or market share.

The lesson here for challenger firms and smaller consultancies is two-fold. As well as learning from the mistakes of their peers, it’s also important not to conflate brand with reputation. While they both share the same objective – to win the hearts, minds, and wallets of clients – brand provides the opportunity to differentiate, whereas reputation provides the opportunity to demonstrate credibility. Far from being the same thing, it’s this very difference that binds them together.

Branding the modern consultancy: why reputation hinges on it

Reputation is the driving force behind a person’s decision to award a firm their business, based on values that align with their own – be it honesty, transparency, integrity, accountability. However, none of these characteristics are particularly compelling or distinctive on their own. To carve out key points of difference, to stand out, and to become known, liked, and trusted among a sea of competitors offering similar services, companies should turn to their brands.

Brand is the culmination of culture, vision, values, and identity, which when used consistently and religiously, can create fresh opportunities for firms. People no longer buy services in isolation but look for a purpose or a lifestyle to buy into. Strong brands create an appetite for themselves and command a higher price tag because people will pay for them. The more pulling power and emotional resonance a brand has, the more successful the firm will be.

Protecting a brand

That’s why, regardless of abundant choice, there is still only one Deloitte, one PwC, one EY – and there’s a reason why the Big Four audit nearly 100% of UK’s top 100 corporations. This relentless focus on building and protecting their brands and reputations on the basis of being the best, has, over time, resulted in a market monopoly. However, problems arise when one is given more weight than the other. This point is particularly relevant in the case of KPMG, and in others where firms have flaunted their reputation for being untouchable in the face of the client.

Brand and reputation working together are directly attributable to significant business outcomes (such as financial performance, loyalty, awareness) and should be treated as such. Focus too much on brand and you risk alienating the people who value credibility, such as prospective and existing clients, shareholders, and the best talent. Focus too much on reputation and you risk stagnating in the market, with a service that no one knows or cares about.

In order to overcome these challenges, the first step for many firms will be to take a step back. Before any meaningful work can begin, consulting firms need to assess the current state of their brand and reputation, and establish key characteristics for both. For brand, this might be relevancy, consistency, positioning, identity, and appeal. For reputation, this might be staff turnover, service quality, growth rate, client relationships, leadership, and diversity and inclusion.

Regardless of the findings, there’s always room for improvement. An uptick in the performance of brand and reputation can be achieved by measuring the impact that one has on the other, integrating business and marketing strategies, and setting strict KPIs.

Guardianship and getting results from this activity isn’t the job of one person or one team. People at all levels of the firm should be thought of as brand ambassadors, and should be willing to do what it takes to protect the reputation of the business no matter the cost. After all, everyone benefits when good things are said about a firm when it’s not in the room.

Related: Why building trust and brand belief is key for consulting firms.