Archive for the 'Price-Margin Metrics' Category

Inelastic Price Metric

Published on March 1, 2010 by Roger Best in Price-Margin Metrics. 0 Comments

Estimating Price-Volume

When the price for a product is inelastic, a percentage change in price results in a smaller percentage change in volume sold. For example, the medical instrumentation product above has a current selling price of $50,000. At this price the company is able to sell 1000 units per year. Their cost per unit is roughly $20,000, a 60 percent profit margin. What would happen if they changed the price, up or down?

The marketing and sales team estimated that at a price of $55,000 (a 10% price increase) they would lose 250 units sold per year. This would lower the units sold but increase sales from $50 million to $53.63 million. More importantly, this price move would increase gross profits from $30 million to $34.13 million as shown above.

Inelastic Price Metric

An important marketing metric to uncover from price-volume is the elasticity of this product. As presented in the table above, a 10 percent price increase is estimated to reduce volume sold by 2.5 percent. As shown below, price elasticity is the percentage change in volume per one percent change in price and in this example yields a price elasticity metric of –.25.

Price Elasticity = % Change Volume / % Change in Price
=    -2.5%  / 10.0%
=   -.25

When the price elastic metric is smaller than -1.0 the price is inelastic. At the company’s current price point this means for every one percent change in price the product will experience a .25% change in volume. This could be different for a price decrease, or different for large changes in price.

What’s the Right Price Move?

When we have an inelastic price, the price move is easy. Up! A price increase, while lowering the unit volume sold, will result in higher sales and gross profit as shown in the table above. In the graphic below we provide a simple set of guidelines when a product has an Inelastic Price. Lowering price when the price is inelastic would be disastrous. A price decrease would lower sales, lower margins and lower profits. A price increase when the price is inelastic should result in higher sales, higher margins and higher gross profits.

Boundary Condition Elasticity

Because the marketing and sales team estimate of price-volume change was subjective, it is useful to understand the bandwidth for error that they can operate within and still be making the right price move. The Boundary Condition in this case is the price elasticity needed to maintain current gross profits with the recommend price change. In the table above, the Hold Profits column estimates the price elasticity boundary condition. At this level of price elasticity, the gross profits would be maintained. At any level of higher price elasticity, the gross profits would decrease. Given the difference between the estimated price elasticity of -.25 and boundary condition elasticity of -1.43, there appears to be sufficient room for error in the teams’ estimate.

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Market-Based Price Metric

Published on March 1, 2010 by Roger Best in Price-Margin Metrics. 0 Comments

Cost-Based Pricing

Cost-based pricing is a common practice among internally, finance-focused businesses. Price is set based on cost and a desired margin. In the example below we assumed a unit cost of $300 and a desired margin of 50 percent. As shown, a 50 percent margin requires a 100 percent markup on the product’s cost. This yields a cost-based price of $600 (the orange dot in the graphs above).

Cost-Based Price =  Cost + Margin  =  Cost + Percent Markup on Cost
=  $300  +  100% of Cost
= $600

The problem with cost-based pricing is that it has nothing to do with the reality of what customers will pay for a product. Thus, a cost-based price may be over-priced and result in limited sales volume and lower profits, or under-priced and result in high volume but low margins and lower profits. It is the responsibility of the marketing function to provide a market-based view of price and purchase behavior and to guide pricing based on customer preferences and price sensitivity.

Market-Based Pricing – Mac Users vs. PC Users

Market-based pricing starts with customers. For example, potential customers were asked what is the most they would pay for Apple’s new iPad. Of those surveyed, 41 percent of current Mac users would pay over $800, while only 16 percent of current PC users would pay over $800. At the $600 price point, 68 percent of Mac users would buy, but only 35 percent of PC users would buy.

The two price curves above were created from the survey data obtained. Mac users are less price-sensitive and would buy higher volumes at higher price points than PC users. PC users are not interested in this product until it is priced below $600. What is the best price for this product?

Mac User Market-Based Price – $700

The market-based price for Mac users is $700 (blue dot on curve). This is the point that the maximum gross profit is obtained for this combination of customer price sensitivity and a unit cost of $300.

Cost-Based Price
Sales   =  $600 x  68% x 1,000,000
=  $408  million
Gross Profit = ($600 – $300) x 68% x 1,000,000
=  $204 million

Market-Based Pricing
Sales =  $700  x  55%  x  1,000,000
=   $385 million
Gross Profit  =  ($700 – $300) x 55% x 1,000,000
=  $220 million

PC User Market-Based Price – $700

The price that yields the highest gross profit is $500 (blue dot on PC Price Curve) based on the PC user price sensitivity and the assumed unit cost of $300. Let’s examine the profit impact of the $700 Mac User price on the PC User market.

Cost-Based Price
Sales   =  $600 x  35% x 1,000,000
=  $210  million
Gross Profit = ($600 – $300) x 35% x 1,000,000
=  $105 million

Market-Based Pricing
Sales =  $700  x  28%  x  1,000,000
=   $196 million
Gross Profit  =  ($700 – $300) x 28%  x 1,000,000
=  $112 million

What is the Right Pricing Strategy?

The $700 price is the best choice to lead with. The Mac User segment offers a better opportunity for sales and profits at the $300 unit cost. As the unit cost is driven down with cumulative production experience we would be able to lower price and capture more of both segments of the market for this product.

Differences in price sensitivity and product attractiveness should also signal an opportunity to offer multiple products at various price points to adequately serve both markets’ price and product needs.  Again, this is a strategy often pursued after crossing the chasm with a very focused core segment strategy.

To learn more, visit www.marketingmetricshandbook.com, view the  Intro Video, and download a 30-day demo.

(*) This example is for educational purposes and does not represent actual Apple price and unit cost.