advanced revenue management

7/25/2019 Advanced Revenue Management

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Opportunities for Action in Consumer Markets

Profit Parabolas: Bringing Science

to the Art of Pricing


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Profit Parabolas: Bringing Scienceto the Art of Pricing

Pricing is rapidly becoming more science than art.

But because the science is complex, most managersstill rely far too heavily on artor instinct. As a result,they almost always miss the pricing sweet spot andleave millions of dollars of profit and several points ofshare on the table. Learning and applying the scienceof pricing are opportunities to create a new kind of

competitive advantage.

Pricing scientifically begins with asking two simplequestions:

If I increase my products price by 1 percent, what

will happen to profits?

If I decrease my products price by 1 percent, whatwill happen to profits?

If the answer to both questions is that profit declines,

youve reached the point of maximum profit. In ourexperience, however, fewer than 10 percent of man-agers responsible for pricing decisions can answereither question with any degree of confidence. Apowerful, fact-driven tool called theprofit parabolacan help.

What Is the Profit Parabola?

The profit parabola, which takes its name from itsshape, shows the total profit pool available at a given

price. The goal of managing price is to reach thepeak of the parabolathe point of maximum profit.(See Exhibit 1.) Failure to understand how pricingaffects profits along the parabola can lead to serious


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mistakes. For example, the three major competitorsin the fast-food industry were locked in a lethal price

war not long agoall attempting to improve their

consumer value propositions with price cuts. However,they hadnt understood the full implications of theprofit parabola. The price reductions increased vol-umebut not enough to offset margin decreases.The corporate parents continued to earn their feeroyalties, but the franchisees suffered considerable

declines in margins. Those results could have beenavoided if the participants had used the profit parabo-la correctly and selectively applied pricing stimuli tothe right products and value packages.

Profit parabolas are the next frontier of pricing sci-

ence. Applied appropriately, they can boost profitsand devastate competitors. To create a first-generationprofit parabola, you will need specific analytical andtesting capabilities and a comprehensive database forfive key inputs:

1. Current price and volume

2. A range of historical prices and corresponding vol-umes to determine elasticity, or consumer demand

Price

Profit

SOURCE

: BCG analysis.

Exhibit 1. The Parabolas Point of Maximum Profit


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3. Cost and margin per unit at a range of differentvolumes to calculate profit by price point

4. A range of competitive prices and your corre-sponding volumes

5. A calculation of the entire value chains economics,including both suppliers and retailers costs

The first three inputs provide the most basic profitparabola. Adding the fourth input creates a cross-

brand profit parabola that allows you to factor in thecompetition. Incorporating the fifth makes it possibleto analyze the profits of the full set of value chainpartners so that you can optimize prices across all ofthe partners. (See Exhibit 2.)

1. Current priceand volume

Price

Profit

2. Consumer demandby price point

3. Cost and marginper unitby price point

Basicprofitparabola

4. Competitorsprices and theirimpact on yourvolume

Parabolathat reflectscompetitivedynamics

5. The entirevalue chainseconomics

Parabolathat reflectsall playerseconomics

+

Supplier Retailer

Win-win point

+

Profit

Price

Profit

Price

SOURCE: BCG analysis.

Exhibit 2. Basic and Complex Profit Parabolas


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Using the Profit Parabola

The effective use of the profit parabola requires adeep understanding of consumer demand, competi-tors prices, the profit pool, and the profit pool split.

Consumer Demand. Consumer demand for a productat a range of price points is expressed through elastic-ity. Elasticity is simply the change in volume for a 1percent change in price, everything else being con-stant. What is difficult about measuring elasticity is

holding everything else constant. Merchandising con-ditions, competitors prices, holidays, and a variety ofother factors can influence consumers purchases andconfound the impact of price alone. Retailers use var-ious methods to work around such problems.

A leading food retailer, for example, calculated elas-ticity for a portion of its product line and found prod-ucts with demand curves like the one in Exhibit 3.

When prices fell by 50 percent, volume increasedmore than six times. Other products were much

2x

4x

6x

8x

10x

12x

0x 0.5x 1.0x 1.5x

Weeklyvolumerelative to

averagedemand(index)

Price relative toaverage price (index)

Volume increases more thansix times with a 50 percentreduction in price


Exhibit 3. A Typical Pricing-ElasticityDemand Curve


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less elastic. Using these elasticities, the retailer wasable to segment its products into different families.Products that had high elasticities and brought peo-ple into the store were candidates for decreases inprice. Products that had low elasticities but were likely

to be bought once someone was in the store (im-pulse purchases, for example) were candidates forfewer promotions and could even be consideredfor price increases. In the past, the retailers approachto price promotions had been sporadic and unsystem-atic. Now, armed with this new knowledge, it was able

to unlock potential increases of $650 million in salesand $100 million in profits. Whats more, the changesthat would bring such gains were easier to executeand test than many other opportunities of compara-ble size.

Competitors Prices. Cross-price elasticity (or theimpact of competitors prices on a products sales) isprobably the most poorly managed element of thepricing parabola. Managers, salespeople, and WallStreet analysts all keep an eye on competitive pricegaps, yet few companies understand their own prod-

ucts cross-price elasticities. Is cross-price elasticityconstant across a wide range of price gaps? Or can abrand sustain its market share as long as it doesntallow the gap to exceed a certain threshold? How,and against which competitors, should price gaps bemeasured?

Most managers answer these questions with a combi-nation of instinct and company folklore. Even whencompanies have studied these issues, the answers tendto come back so buried in statistical arcana that theorganizations arent able to act on them.

Exhibit 4 shows what one packaged-goods companyfound when we analyzed the cross-price elasticitybetween its own brand and a private-label offering.


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Each time the price gap between its brand and its

competitors private label increased, the companyssales fell sharply. The correlation was unmistakable.Many brands have an equally direct relationshipbetween price gaps and sales. The key is to developthe data that can allow these relationships to be seen.

The Profit Pool. The profit for the entire value chainis simply the sum of the manufacturers profits andthe retailers profits. This pool is probably the easiestelement of the profit parabola to understand and cal-culate. Understanding the total profit pool at everyprice point can help manufacturers and retailersdetermine whether certain price points (a two-for-onepromotion, for example) are worth contemplating.

The Profit Pool Split. Once managers understandhow volume and profitability vary by price point, theycan begin to take control of one of the most con-tentious aspects of price changes: renegotiating themanufacturer/retailer margin split. Many brand man-agers, when trying to change prices, find themselves

0

0.5

1.0

1.5

2.0

5

3

1

1

3

5

Unitsalesper week

(millions)

Pricegapper

unit(cents)


Exhibit 4. A Typical Analysisof Cross-Price Elasticity


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beholden either to retailers directly or to their salesforces claims about retailers. The profit parabola can-not in itself change this dynamic. It can, however,illustrate how much value is created by a price changeand thus make clear how much money a manufactur-

er is giving away by keeping the retailers margin, orpenny profit, fixed.

Our experience with a packaged-goods supplierillustrates how powerful this approach can be. Themanufacturer analyzed its primary brands at a leading

retailer and discovered that it was on the far side ofthe peak for both its own profit parabola and theprofit parabola of the manufacturer and retailer com-bined. Most strikingly, the manufacturer found thatthe price elasticity for consumers at that particular re-tailer was nearly three times higher than at other

retailers. As a result, there was a much greater oppor-tunity to drive profits with lower consumer pricing.

The manufacturer developed a new consumer-pricingand promotion strategy for a selection of its products,giving up some margin per unit in order to drive

greater overall profitability and share. More impor-tant, the retailer recognized the value of the opportu-nity and also agreed to take a lower margin per unitin the interest of increasing overall profits. Workingtogether, the manufacturer and the retailer were ableto achieve consumer price reductions of approxi-

mately 10 percent, with total profit increases of 20 to30 percent.

Once the database of price points, volumes, revenues,and profits is established, the profit parabola can gen-erate many opportunities for discussions founded on

facts rather than opinions. The parabola allowsmanagers to be much more explicit, scientific, andprecise about the share and profit tradeoffs that aprice change entails.


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Dealing with Value Chain Partners:Retailers, Distributors, and Suppliers

When a company understands the impact of pricechanges in a concrete way, it can dramatically alter

the competitive landscape of an entire industry. Theprofit parabola can help manufacturers both in nego-tiations with their suppliers and distributors and indiscussions with retailers about how the profit poolis split.

One of the most frequent reasons manufacturers givefor not raising prices is that Wal-Mart wont accept aprice increase. As noted above, a profit parabola forthe entire value chainone that calculates the wholeprofit pool, not just the manufacturers sharecandemonstrate to retailers the overwhelming impact on

profits of a small price change. In some cases, thisinformation alone can help persuade retailers toincrease prices. For retailers that remain philosophi-cally opposed to price increases, using profit parabo-las to reset pricing across a product line can create apowerful argument for change: If we raise the price

of product A by 3 percent, we can afford to lower theprice of product B by 4 percent. Well make moremoney and improve our consumer value proposition.Since profit parabolas foster fact-based discussions,they counter the need for aggressive, one-sided nego-tiations.

What about decreasing prices? We often hear the fol-lowing complaint: The trade would love it, but we

would reduce our profits. Again, the profit parabolafor the entire value chain can demonstrate the profitpotential of a lower price point. Sales forces can then

use the profit parabola in a discussion about chang-ing the distribution of profits at that new point. Forexample, a promotion that drops the price at theexpense of the manufacturer (while maintaining the


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retailers margin) will likely drive substantial volumebut not the manufacturers profit. Manufacturers,however, can use the profit parabola to persuaderetailers to share the burden. By demonstrating the

volume potential of the promotion, a manufacturer

can show that a decrease in price will be profitable forboth parties, even with a lower margin for the retailer.

Understanding the Impactof Competitive Response

Profit parabolas and cross-price elasticity can also beused to help you understand what kind of impactcompetitors reactions to price changes have on yourshares and profits. One of the most frequent reasonsthat retailers give for not increasing price is, What

will our competitors do? A profit parabola that trackscross-price elasticity can help you calculate the impacton your market share and profits when a competitorrespondsor doesnt respondto your price change.

Although the profit parabola cannot predict the likeli-hood of a competitive reaction (it takes a thorough

competitive analysis to do that), it does lead to a moreinformed understanding of the consequences of areaction.

* * *

A company with a strong pricing capability can sharp-en its customer segmentation and use its deeperknowledge of each segment to fine-tune prices. It canmonitor competitors prices and learn how their pric-ing affects its own position, enabling it to respondintelligently to competitors moves or ignore them. It

can test incrementally new or radically different pric-ing offers. It can bundleor unbundleproductsand services.


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Most important, a company with a strong pricingcapability can orchestrate the implementation of pric-ing policies and strategies throughout the organiza-tion in a disciplined, timely fashion.

Marin GjajaSims HulingsPeter Stanger

Marin Gjaja is a vice president and director and Sims

Hulings a manager in the Chicago office of The BostonConsulting Group. Peter Stanger is a vice president and

director in the firms Toronto office and leader of the Pricing

Innovation topic area in the Americas.

You may contact the authors by e-mail at:

[email protected]@bcg.com

[email protected]

The Boston Consulting Group, Inc. 2003. All rights reserved.


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