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.

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.

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

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).

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.

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.

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.

Total Cost of Ownership – Printers

While price is often the focus of balancing performance and the cost of attaining that performance, the total cost of ownership is an important aspect of measuring and communicating economic value to customers and potential customers. Kyocera seeks to match the performance of competing printers in color quality and speed, while creating superior customer value with their lower total cost of ownership.

The Kyocera advertisement above challenges potential customers to understand the total cost of a Kyocera printer along side of any comparable competing printer. This is accomplished with their TCO Tracker website. A few questions are asked with respect to printing usage and needs along with a benchmark competitor. With this information the TCO Tracker computes the total cost of ownership for both printers and the Kyocera TOC Advantage as shown above.

Total Cost of Ownership – Automobiles

Shown below is a short summary of ownership costs, including the costs of acquiring, installing, using, maintaining and replacing a product. Honda has a higher net price than Ford, but the cost to own is much lower over the life of the product. This creates a savings of $3054, more than making up for the higher net price. A portion of this is savings advantage is derived from a higher resale value at the time of product replacement.

Total Cost of Ownership – Medical Electronics

Tracking ownership costs is even more important for many sophisticated products such as medical equipment. In one company we found that a product priced at $60,000 saved a customer $20,000 more per year than a competing product priced at $50,000. Over a 5-year product life this is $100,000—making the price premium of $10,000 seem trivial. The company’s cost of ownership advantage could be traced to a lower cost per analysis, fewer errors due to ease of use, higher equipment uptime, lower quality control costs due to higher reliability, long product life by one year, and lower cost of documentation.

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

Product Ratings

Consumer Reports (CR) is famous for its product performance ratings of various consumer products. They rate individual product attributes on a 5-category scale that ranges from poor to excellent. Overall product ratings are rated from zero to 100. The sixty inkjet printers displayed in the graphic above received overall ranking ranging from 43 to 73, with an average of 61. Prices ranged from $40 to $350 with an average price of $148.

Relative Product Performance Metric

While actual product performance ratings are of value, creating a Relative Product Performance metric allows for a more strategic interpretation of product performance. In the graphic above, the Relative Performance was computed for each of the sixty inkjet printers, by dividing the printer overall CR rating by the overall average. For example, the HP PhotoSmart Premium had a relative performance of 120, indicating a 20 percent higher performance than the average printer.

Shown in the left graph above is a plot of the relative product performance and price for the sixty all-in-one inkjet printers evaluated by CR.

Fair Value Line

The “Fair Price Line” is a least-squares estimate of the relationship between price and relative performance. All Fair Price Lines run through the average of price and relative importance and can be used to estimate the Fair Price of any Relative Product Performance position. The fair price of the HP Photosmart Premium printer is $205 and the HP price is $140. The difference of $55 is customer value – the incremental financial value of a transaction based on its price and relative product performance.

Customer Value and Price

Of course, for many printers, there is negative customer value. That is, the printer price is higher than the fair price for a given level of relative product performance. The HP printer is a great value, but so are many other printers below the fair price line. There are several printers with average relative product performance that have prices well below the fair price line. These are also great values for customers than do not need, or want, products with above-average performance. Customers looking for a “Value Price” can find printers with lower average product performance but prices below their fair price.

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

Cost of Purchase vs. Price

While price is very important in any purchase, the total cost of purchase should also be considered in communicating value to customers. Southwest Airlines does both—they recognize and communicate their price and total cost of purchase.

The example below was created based on a sample of airline travelers. It is for educational purposes only and we have omitted the names of competing airlines and referred to them by letter. The ratings in the lower portion of the table were obtained using a rating scale that ranged from zero (no cost) to 10 (extremely high cost). These air traveler ratings were based on their perceptions, which may differ from the actual price and cost features shown. While these ratings are of value, creating a relative performance metric allows for greater strategic insight.

Relative Cost of Purchase Metric

We created the Relative Cost of Purchase above by dividing the rating for each area of cost of purchase by the average performance of competitors. For example, Southwest Airline’s relative ticket price is 72.4. This means it is roughly 28 percent below the average of competitors. Competitor A is 32.7 percent higher than the average competitor with respect to average ticket price.

The overall cost of purchase is computed using the cost of purchase for each cost component and its relative importance. Since Southwest Airlines has no cost associated with Seat and Luggage Fees and has a very competitive ticket price, its overall cost of purchase metric is 50.7. This means it is roughly 50 percent lower than the average index of 100.

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

Product Ratings

Consumer Reports (CR) is famous for its product performance ratings of various consumer products. They rate individual product attributes on a 5-category scale that ranges from poor to excellent. Overall product ratings are rated from zero to 100. The sixty inkjet printers displayed in the graphic above received overall ranking ranging from 43 to 73, with an average of 61. Prices ranged from $40 to $350 with an average price of $148.

Relative Product Performance Metric

While actual product performance ratings are of value, creating a Relative Product Performance metric allows for a more strategic interpretation of product performance. In the graphic above, the Relative Performance was computed for each of the sixty inkjet printers, by dividing the printer overall CR rating by the overall average. For example, the HP PhotoSmart Premium had a relative performance of 120, indicating a 20 percent higher performance than the average printer.

Profit Impact

The PIMS Database (www.pimsonline.com) has created a large business unit database from which many performance metrics can be assessed with respect to their impact on pre-tax return on investment. Shown above is the relationship between Relative Product Performance and Pre-Tax ROI. One of the premiere findings in the PIMS research is that businesses with above-average levels of relative product performance are more profitable. It is important to note that the real profit impact goes to products with a meaningful advantage in relative product performance.

Measuring & Managing Relative Product Performance

While overall relative product performance is a key performance metric that helps a business understand its relative competitive advantage, we need to break it down into discrete aspects of product performance to manage this metric. In the lower portion of the table below are the HP ratings for four aspects of product performance as measured by Consumer Reports. We also added four HP competitors with prices comparable to the HP PhotoSmart Premium printer. In the upper portion of the table these ratings are shown as relative performance metrics. HP had a CR copy quality rating of 7 and had a relative performance rating of 155.6.

Because performance priorities across different customer segments will vary, we add the relative importance to each area of product performance. For example, the relative importance of Copy Quality is 30 percent, meaning that it accounts for 30 percent of overall performance. When relative importance is applied an overall relative performance of 126 is obtained. If HP were to improve its Copy Quality from a rating of 7 to a rating of 8, they could improve their overall relative performance from 126 (Yellow Dial) to 133 (Blue Dial). This would extend their competitive advantage relative to benchmark competitors and also have the potential to positively impact the company’s Pre-Tax ROI.

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

Customer Satisfaction

Southwest Airlines (SWA) has built a culture around customer service and customer satisfaction. While the corporate verbiage comes easy, meaningful results are more difficult to achieve. However, there is good evidence to support Southwest Airlines’ efforts. As shown above, SWA has the highest customer satisfaction rating among airlines in an industry that is well below average in customer satisfaction. Another customer performance metric is the customer complaint rate. This is shown above in comparison for other airlines. Some might say “So what?” Does this extra effort and high customer satisfaction scores contribute to higher profits?

Customer Satisfaction and Customer Retention

Customer retention is an important customer performance metric that is a function of customer satisfaction and dissatisfaction. When customer retention decreases, a business has to spend more to attract new customers to replace them—often with customers that buy less than the customers they replaced. There are two ways to estimate customer retention. The first is simply to track customers that are retained from one year to the next. This requires waiting to the end of each year to measure this metric. The second way is to survey a sample of customers and ask them how likely they are to repurchase. This provides a timely metric to track increases or decreases in likely customer retention before year-end. Either metric provides an estimate of overall customer retention.

Customer Retention and Customer Life

Customer retention has a direct relationship to customer life. In the example below an estimated customer retention rate of 67 percent corresponds with a 3-year customer life. The longer a business can retain a profitable customer, the more profitable that customer becomes. A business that can improve customer retention from 67 percent to 75 percent will extend the customer life from 3 years to 4 years. As shown below, there is an exponential effect on both customer life and customer lifetime value as customer retention improves. For Southwest Airlines, higher customer satisfaction scores translate into higher levels of customer retention and profitability.

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

Is Your Customer Profitable?

An important customer performance metric is customer profitability.  A business often spends a considerable amount of money acquiring and retaining a new customer. The customer purchases have to more than offset these expenses over the course of their customer life for that customer to be profitable. Because this happens over time, we need to discount future purchases and expenses in order to determine the Lifetime Value of the Customer. Our example focuses on an average fast-food customer.

Four-year Customer Life – Is The Average Customer Profitable?

In this example the cost of acquisition is $100. The average customer spends $100 per year as a first year customer of this fast food restaurant. The customer buys less expensive items (32 percent margin) in year one, which produces an average gross profit of $32 per year.  The customer life is 4 years. As shown below, each year the average customer buys more and higher margin products. The company spends 5 percent of sales each year on the average customer to retain them. Using a 25 percent discount rate the Lifetime Value of the average customer is $15. This means the rate of return for this customer is greater than 25 percent. The rate of return for this customer cash flow is 32 percent (this is determined by varying the discount rate until the lifetime value is approximately zero).

Five-year Customer Life – Is It Worth Spending More on Customer Retention?

Using this customer performance, we can assess the profit impact of spending more on customer retention in an effort to extend the customer life one more year. As shown above, we made year 5 customer buying the same as year 4, but for each year of the customer life we increased the percent of sales spent on customer retention from 5 percent to 6 percent.  This result in a Lifetime Value of $37, more than double the current Lifetime Value of $15. The rate of return for this customer cash flow is 39 percent.

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

This company’s surgical device offers many benefits with respect to reliability and time required for this heart surgery procedure. However, market share for this high performance surgical product is hindered by equipment needed, reluctance among surgeons to try something new, trial success, and adoption of the product following a successful trial. These share performance metrics and product awareness are built into the Share Tree above in the sequence these aspects of share performance occur.

For each share performance gate in the share tree, the business estimated its current performance.  For example, only 50 percent of the market has the equipment in place to use this high performance surgical product. Of those that have the required equipment in place, 90 percent are aware of the company’s product and procedure. However, 35 percent of those with required equipment and aware of the product are not motivated to try the product/procedure. This results in a share leakage of 18.9 percent as shown in the share tree. When all positive share performance outcomes are multiplied sequentially, an overall Market Share Index of 6.8 percent is computed as shown below.

Market Share Index (MSI)

Using the same share tree, the business team estimated the upper end performance for each share metric. This is their Share Potential Index as illustrated below.

Share Potential Index (SPI)

If we divide the Market Share Index by the Share Potential Index and multiply by 100, we can create a Share Development Index. The current Share Development Index is 30, as shown below.

Share Development Index (SDI)

The blue boxes in the share tree above are share performance benchmarks set by the company. If successful, this will improve their Market Share Index from 6.8 percent to 15.8 percent.  Using the same Share Potential Index (22.4 percent), this would improve their Share Development Index from 30 to 70 as shown in the dial above.

While the Market Share Index computed using the share tree only approximates actual market share, improvements in these measureable share performance metrics should contribute to actual share gains.

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

The Market Development Index is a very important metric that helps businesses gauge their market growth and the approximate year the market will approach full market penetration. As shown above, it is a simple ratio of current Market Demand to Market Potential. However, most businesses do not think about their market potential. Thus, the first challenge in applying this metric is estimating your market potential.

NARROW MARKET DEFINITION – (Orange Dot)

This medical devices business unit produces a surgical device that is used in heart surgeries. They had limited their market definition based on a certain type of hospital that would do this surgery. The current market demand for this disposable device was 35 million per year. Conventional wisdom was that the market was maturing and would reach full Market Penetration of 45 million devices per year in 2020. These estimates would yield a Market Development Index of 78%. This means that they should expect market growth to slow and begin to saturate in 2020.

BROAD MARKET DEFINITION – (Blue Dot)

The team rethought its market definition following a team discussion around why potential customers were not buying their device. As shown below, this raised the market potential to 75 million surgical devices per year, lowering the Market Development Index from 78 percent to 47 percent. In addition, it will now be 2030 before this market can be fully developed with the broader definition of potential customers. Of course, this greatly changes the required marketing strategies and the potential in sales and profit growth over the next 20 years.

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