By Gerard Loosschilder and Juan Tello, Skim
Setting the right price is vital, because price is a key marketing lever and it expresses brand value in a competitive context. The question is: how far can the brand increase prices while securing revenue? The answer is: up to the point where the price change is no longer offset by the perceived value of the product or service. The tipping point depends on the brand’s and product’s price elasticity. The brand can only raise prices without being penalized if elasticity is low.
The key is to focus on setting the right price in balance with the brand’s value. SKIM’s recent meta-analysis of over 200 pricing studies provides valuable insights on how to achieve that balance. The analysis covers a wide range of categories, brands and retail channels across countries. Here, the focus is on variations in price elasticities across retail channels. The results are applicable to virtually any retail brand.
Price elasticity is the variation in demand for a product or brand as a function of price changes. An elasticity of -1.5 means that if price is increased (or decreased) by 10%, volume decreases (or increases) by 15%. Products with a price elasticity lower than -1 are considered elastic: even small price changes will have strong effects on volume and ultimately revenue. Price elasticity is not linear, it depends on how competitive a certain price range is, and whether there are psychological price barriers within the range (for example crossing the $10 price barrier).
Price elasticity should never be studied in isolation from a competitive context. That is because the demand for a product not only depends on its own price, but on its price relative to competition.
To illustrate this, the market is pictured as a “house,” each floor a “price tier” and each brand a “room.” “Doors” and “stairs” show how demand can migrate. The nature of price elasticity and brand resilience can be seen from the metaphor of the house: demand can move from one room to another and take the stairs up and down. Pricing research can help brands design their pricing strategy as if it were a house, acting like portfolio architects.
Brand resilience is the opposite of price elasticity. Brand resilience is high if price elasticity is low. If so, the brand can increase its prices without losing revenue. To assess brand resilience, one distinguishes between brand-level and SKU-level price elasticity. SKU-level price elasticity is the change in demand when taking the price of a single product (SKU) up or down, with all else being equal. Brand level elasticity is the change in demand when taking the prices of all products of a brand up or down together.
Price elasticity across tiers
Brand-level price elasticity is by definition lower than SKU-level elasticity (unless the brand is represented by only one SKU). That is because when changing the price of a single SKU a significant portion of demand will be sourced from/to within the brand (due to brand loyalty), thus cannibalizing the business. Hence, a line pricing strategy in which prices of all SKUs within a brand move up or down in the same proportion and at the same time can help minimize this effect, while being easier to execute and deploy among the different trade channels.
A natural tendency is to focus on down-pricing elasticity to determine how much share the brand will gain and which competitors it take market share away from. However, up-pricing elasticity – the potential of taking prices up – is also commonly requested by marketers. They want to understand “how high is high”, especially when under pressure of rising commodity prices. More importantly, it helps to understand how to better leverage the strength of the brand.
Intuitively one might think that price sensitivity should be highest in the bottom price tier. It could be because the most price sensitive consumers are found here. However, the middle price tier exhibits the highest price elasticity. Why? The middle tier usually includes more SKUs than the rest.
Also, middle-tier consumers are given the option to upgrade and downgrade making it a more competitive tier. In addition, products in the low tier are already the cheapest in the market so the marginal gain of down pricing is limited. Finally, the distance between price tiers matters: The price gap between middle tier and low tier is usually larger than between middle and high tier prices. This means it is easier to upgrade from a middle tier than from a low tier.
The key is to invest in the brand, providing a good reason for the consumer to pay a higher price tag. One builds resilience and starts to compete with tiers above. Then, increasing prices is not harmful if what is lost at the bottom can be gained back from the tier above.
Drivers of price elasticity
Our research shows that there are many drivers of price elasticity, some having to do with market conditions, product characteristics, and others with shopper profiles. In the U.S. retail landscape, the common belief is that the club and mass channels are the most price elastic vis-a-vis other channels.
Club and mass channels are indeed the most price elastic, for two reasons. First, Club stores offer large pack sizes at a smaller price-per-unit ratio and large pack sizes tend to show higher price elasticity (higher out of pocket effect). Second, Club stores and the mass channel (including European Discounters) attract value-seeking customers. In North America and EU it means that the Club and Mass channels would be more penalized by a lower revenue than Drug and Food channels (focused on convenience) and the Specialty channel, should they increase their prices. The HFS channel (in developing regions) would benefit from increasing prices; it would positively impact their revenues. It also means that brands seeking the opportunity to leverage their strength could primarily do so in the latter channels.
How to use this knowledge?
It is important to assess up-price elasticity because it helps us understand what happens to our business if prices are increased. A brand should optimize prices of its SKUs in conjunction, as a portfolio. It gives consumers the opportunity to switch between SKUs within the brand instead of inviting them to switch to another brand. Investing in the brand can result in stronger brand resilience. Price elasticity studies can provide great insight into brand resilience by identifying the point where price and value are in balance.
Gerard Loosschilder is chief innovation officer at Skim. Juan Andres Tello is director at CPG Americas, Skim. Founded in 1979, Skim is a rapidly growing market research agency with offices in New York, San Francisco, Rotterdam, Geneva, London, Rio de Janeiro and San José, Costa Rica. Combining market and retail specific expertise and knowledge of advanced research methodologies, Skim is a partner for multinational companies seeking for strategic guidance on pricing and portfolio management, communication and new product development.