Pricing is a powerful performance lever. In the world of distribution, price optimization helps players to increase their margins and sales.
It makes a major contribution to improving their profitability.
However, the extent of the potential gains depends very much on how you define your pricing strategy.
At present, pricing is essentially based on competitive alignment. This strategy involves adjusting your prices in line with those of your competitors, in order to maintain or expand your market share. However, it does not take into account the customer and his sensitivity to price.
In many cases, putting the customer at the heart of the equation helps optimize prices and boost profitability.
Why measure price elasticity?
Definition
It is a crucial measure of the responsiveness of demand to the pricing of a product or service. In other words, it assesses the change in demand in response to a change in the price of a particular supply. This concept, both economic and marketing, is of vital importance to companies, enabling them to determine their optimal pricing based on trends and demand.
Companies that integrate it into their strategy can effectively anticipate how their customers will react to planned adjustments. By appropriately aligning their tariffs with market expectations, and taking into account the percentage variation in the tariff, they facilitate the process of stimulating demand, thus promoting incentives to purchase.
Calculating the percentage variation enables companies to quantify precisely the impact of price changes on consumer behavior. For example, if a company finds that demand for a product increases by 5% following a 10% price reduction, it can use this percentage change to adjust its future pricing strategy.
This proactive approach, based on a detailed understanding of the mechanisms of price elasticity, gives a significant competitive advantage to well-informed companies. By continuously monitoring the percentage change in demand as a result of price changes, companies can optimize their pricing policy and maximize revenues.
Why measure price elasticity?
Thisproduct refers to the relationship the relationship between price variation and demand variation. To calculate it, we use the following formula:
Elasticity = % change in demand / % change in pricing
Using this formula, you can identify the extent to which a rate change affects demand.
Example of elasticity calculation
The price of a scarf has risen from €20 to €24, while the number of units sold has fallen from 2,500 in October to 2,000 in November, with the price change taking effect at the beginning of the latter month.
Applying the calculation formula, we obtain :
= (2000 – 2500) / 2500 / (24 – 20) / 20
= -25 / 20
= – 1,25
Putting the customer back at the heart of pricing strategies
In practice, there are ways of calculating.
The simplest is based on your costs and the margin you want to achieve. In this case, you don’t take competitors or consumers’ price sensitivity into account.
You’ll soon come up against a number of pitfalls:
- Outrageous prices compared to your competitors
- An unreadable and confusing price image for your customers
- A competitive deficit
This is why, today, retailers rely mainly on rules engines to calculate their rates. They establish calculation rules that apply according to different input variables Competitor pricing, variations in purchasing costs and costs, inventory levels, etc.
In this operating mode, pricing is the consequence of the chosen rule. Upstream, this method involves using the right influencing factors. In a context where data is omnipresent, input variables tend to multiply. We can add seasonal variables and weather data to try and optimize rates.
Here again, however, pricing remains disconnected from demand and the value perceived by customers. Customer sensitivity to rate changes remains a blind spot as long as we don’t rely on the measurement of elasticity. And yet, taking the customer into account in this calculation makes it easier to achieve sales targets.
The value of this measurement lies in the combined optimization of price and demand. It helps define the ideal pricing to maximize your sales or margin.
The operational challenges of price elasticity
In theory, it’s a powerful lever, but in practice, it’s often difficult to translate into action.but, in practice, it is often difficult to put into practice, for a number of reasons.
Understanding the evolution of short- and long-term price elasticity
One might expect lower rates to lead to higher demand. And, conversely, one might think that an increase would have a negative impact on sales. But this is not necessarily true in practice, even when it increases.
Firstly, some products are particularly inelastic. Price variation has little or no effect on demand. This is the case, for example, for luxury products, but also for products based on a strong brand such as Coca-Cola or Nutella. The percentage change in demand for these products remains low despite significant price changes.
Moreover, elasticity is not linear. In the case of a product with high elasticity, the slightest price reduction leads to a significant increase in demand, but only up to a certain point. If you continue to lower it, you’ll reach a plateau with stagnant sales. Here, the percentage change in demand decreases as the price continues to fall after reaching a critical threshold.
Consequently, when you include demand elasticity in your calculations, it’s essential to monitor it continuously and consider its impact on various performance indicators. By analyzing the percentage change in sales versus price changes, companies can adjust their strategy to optimize results.”
Take cross-elasticity into account
If we consider a specific product, we can indeed detect a relationship between price variation and demand variation. But this approach overlooks the impact of variations on other substitutable or associated products.
Let’s imagine, for example, that you drastically increase the price of a product when there are several other substitutable products in your ecosystem. The non-increase in these substitutable products also has an impact on demand for the original product.
In other words, we would have to extend its calculation to all related products. This is what we call elasticity of cross demand.
Let’s take a concrete example to illustrate this point.
You significantly reduce the selling price of a jar of strawberry jam. You maximize your sales of this product, as expected. But at the same time, some customers who bought the strawberry jam did not buy the raspberry or apricot jam they usually buy.
So you’ve had a negative impact on demand for your other products.
How can you incorporate price elasticity into your pricing strategy?
The different types of elasticity
Understanding this is an essential key to developing intelligent pricing strategies. Let’s take a closer look at the different types of elasticity and their impact on business decisions.
1. Price Elasticity of Demand (EPD):
EPD measures the sensitivity of demand to a change in tariff. If the EPD is greater than 1, it is called elasticity, indicating demand sensitive to price changes. If it is less than 1, demand is inelastic, showing little responsiveness to price fluctuations.
2. Cross-Price Elasticity (CPE):
The EPC evaluates the reaction of demand for a product in response to a change in pricing for a complementary or substitutable product. This can help retailers adjust their pricing to maximize sales of related products.
3. Price Elasticity of Supply (POE):
EPO measures the variation in quantity offered in response to a change in price. Understanding this is essential to anticipate the impact of tariff adjustments on supply and production.
4. Price Elasticity of Cross Supply (EPOC):
EPOC examines how a change in the pricing of one product can influence the supply of a complementary or substitutable product. This understanding can guide retailers in implementing coordinated pricing strategies.
By integrating and analyzing the rate of change of demand into pricing strategy, retailers can make more informed decisions to stimulate demand, optimize revenues and maintain a strong competitive position in the ever-changing retail market.
When to use price elasticity?
Using this method, you can maximize your performance by optimizing both the price level and the demand level of a product.
To take full advantage of this, we need to measure the elasticity of demand on an ongoing basis, and take into account contextual factors that can change the situation. Indeed, even with a multi-factor predictive analysis, a crisis or an unexpected event can profoundly alter customers’ sensitivity to price and quantities demanded.
Consumer price sensitivity helps optimize sales performance over the long term. However, it makes tariff evolution less predictable than competitive alignment.
Indeed, competitive alignment may offer less potential for profitability, but offers greater security, provided we don’t get drawn into a price war.
In practice, it’s best not to choose, but to rely on the complementary nature of the two approaches. For example, you can opt for either strategy depending on your product segmentation. It is also necessary to use performance indicators such as price image, market share and sales to optimize pricing strategy.
Integrating price elasticity into a multifactor approach
This approach to pricing helps to take into account the customer’s perceived value. Finally, it raises the question of the right price that the customer is willing to pay for a product.
But this perceived value is personal, relative and not fixed in time. A pricing strategy based on price elasticity alone would be difficult to understand, as variations would be incessant.
And the brand’s price image would suffer. This could be considered if the retailer had a monopoly on the product. In practice, however, it is part of an ecosystem that requires it to take other factors into account.
This is why the choice of a pricing strategy is not a partisan quarrel. The sensible solution today is to integrate all influencing factors, including price elasticity, into rate calculations.
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Measuring and analyzing price elasticity brings an additional dimension to the definition of pricing strategies.
This approach puts the customer back at the heart of pricing strategies by focusing on price sensitivity. However, its integration generates operational challenges:
- How can we understand the short- and long-term evolution of elasticity?
- What about cross-elasticity?
- How can strategy be steered when elasticity is so sensitive to changes in context?
All these questions suggest that price elasticity is not destined to become the alpha and omega of pricing strategies, but rather a key to further reading and analysis.
By combining it with other approaches such as competitive alignment, you gain a better understanding of the impact of pricing and optimize your pricing process.
Do you want to integrate price elasticity into your price calculations to improve your profitability?
Discover how our Optimix XPA pricing solution helps you optimize your prices thanks to its multi-factor approach.
