Pricing and Revenue management
Tom Y
Week02_Workshop_MarginArithmetic.pdf
Week 02 Margin Arithmetic
Understanding Margin Arithmetic
• One of the most common questions in pricing:
• If we lower prices, will it benefit us or hurt us?
Price elasticity
• Elasticity = (% change in quantity demand) / (% change in price)
Price Elasticity
Examples?
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Region 1 Account B
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Nescafe Gold Frozen Dry 100gUnit Sales (1000) Price ($/unit)
Unit sales
Price
Source: Synovate Aztec, 4 Jan 2007
Aggregate store scanner data
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Pr ic e ($ )
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Nescafe Gold Frozen Dry 100g
Price ($)
Unit Sales (1000units)
Source: Synovate Aztec
y = ‐0.821ln(x) + 7.9047 R² = 0.361
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Price ($/unit)
Price & Demand across 104 weeks
Source: Synovate Aztec
• You need two pieces of information to answer this questions • The product’s gross profit margin = (Price – Variable Cost) • The price cut you are considering
The Impact of Lowering Prices
• Answers the question: How much volume change do I need to justify a particular price change?
• Where, ∅ . required break-even volume change % 𝛿 = % change in price 𝜇 = gross profit margin
Margin Arithmetic
Source: Dholakia, How to price effectively, 2017
. C.f., Break‐even point = FC / (Price‐VC)
Q. If the original gross profit margin is 25% and we are willing to decrease prices by 5%, how much volume should increase by to ensure that our price reduction does not reduce profits?
A. BE volume change (%) = ‐(‐0.05)/(0.25 – 0.05) = 0.25 = 25%
Q. At higher margins, say 40%, how much volume should be increased not to affect profit?.
Illustrating Margin Arithmetic
• Suppose the manager of financial services at a bank with 4 branches in the Greater Sydney area (on the next slide) is considering whether to change the prices for financial services.
• You are the pricing analyst making a recommendation. • You know that your gross profit margin for your financial services is 60%. The only reliable data you have to base your decision upon is the number of account transactions (which serves as a proxy for volume) for the past two years and knowledge that you implemented a 10% price decrease last year. (Assume no trends and competitive reactions.)
• Was the price cut effective? What is your recommendation? Should the bank decrease its charges again?
Determining the effectiveness of a price change Assignment
Price Reactions: Change in Sales Volume Scenario 1
Location 2017 2018
North Sydney 230,000 320,000
Redfern 340,000 350,000
Glebe 150,000 180,000
Mosman 260,000 330,000
Total 980,000 1,180,000
Given a gross profit margin and a particular price change (increase or decrease), we can compute:
(a) the break‐even sales volume change that is needed in order for the price change to be effective
Insight
Keeping the gross profit margin and price decrease the same,
Question 1: What is your conclusion if the actual volume increase were 18%?
Question 2: What is your conclusion if the actual volume increase were 24%?
Bank Branch Problem (Contd.)
• “Margin arithmetic” is very sobering. • Temporary price promotions can be very costly unless demand is very elastic (i.e., consumers are very price‐sensitive)
• The short‐run hit in profits from many promotions must be counterbalanced by increased profits from longer‐run strategic factors (e.g., loss leaders to build store traffic, retention of customers, competition with other retailers/manufacturers).
Moral
Let us consider a different scenario. The gross profit margin was 35% and prices were decreased by 8%
Q: What is the break‐even volume change required?
Bank Branch Problem Scenario 1 cont’d
Let us consider a different scenario. The gross profit margin was 35% and prices were decreased by 8%
Q: What is the break‐even volume change required?
Bank Branch Problem Scenario 1
Imagine Price Reactions in Scenario 2
Location 2017 2018
North Sydney 320,000 260,000
Redfern 280,000 230,000
Glebe 340,000 308,000
Mosman 385,000 313,000
Total 1,325,000 1,111,000
, In this case, was the price increase effective? what is your recommendation based on the results for next year?
Gross Profit Margin = 50% Price Increase by 10%
