Price Elasticity – An Untapped Revenue Growth Lever

Highlights

  • Price elasticity shows how changes in product price impact the quantity sold and company revenues.
  • While it can find the highest price a customer segment will pay for a product or service, it can also show when lowering a price increases total revenues.
  • The goal of price elasticity is to identify the prices that deliver the greatest upside revenue or profit to the company.
Johnny Grow Revenue Growth Consulting

Research published in the Sales Excellence Report showed that companies which calculated price elasticity highly correlated with Best-in-Class sales performance (i.e., the top 15 percent). While only 14 percent of participants regularly calculated price and demand elasticity for a majority of their products or services, 85 percent of that group achieved Best-in-Class sales performance results.

Price Elasticity Adoption

Research findings show only 14% of companies regularly calculate price and demand elasticity for a majority of their products or services, but 85% of that group achieved Best-in-Class sales performance results.

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Failing to understand how shifts in pricing impact revenues and profits is a missed business growth opportunity. That's unfortunate as price optimization using price and demand elasticity models creates powerful levers to confidently change prices and increase revenues and margins.

Here's How it Works

Elasticity shows how price changes impact the quantity sold and when to raise or lower prices to increase total revenues.

Elasticity (E) is equal to the percentage change in demand divided by the percentage change in price.

E = %ΔD / %ΔP

When elasticity is less than 1, your product is inelastic and changing the price will have a lesser impact, or no impact, on the quantity sold. Therefore, increasing the price will increase total revenues and decreasing the price will reduce total revenues. Some examples of inelastic products include medications or fuel.

Price Elasticity Measurement

But when your product demand is elastic, that is greater than 1, changing the price will have a proportionally higher impact on the quantity sold. So, increasing the price will decrease total revenues and decreasing the price can increase total revenues.

Price Elasticity

Here's how to use this information to increase revenues.

  • The goal of strategic pricing is to make products or services inelastic for price increases, and elastic for price decreases. That permits price to be raised with a lesser impact to quantity sold which increases revenues and margins. It also allows you to periodically lower price using promotions, to increase the quantity sold, which also increases revenues.
  • For products or services with inelastic demand, increasing the price will more than offset a lesser impact to a reduced quantity sold and thereby increase revenues and margins. For example, if E = .75, then increasing the price 10% will decrease demand by 7.5%, as shown below:

.75 = X/10%, therefore X = 7.5%

  • For products or services with elastic demand, changes in price create disproportionately higher changes in quantity sold. So, decreasing price will increase quantity sold and thereby increase total revenues. For example, if E=3, then decreasing the price 20% will increase demand by 60%, as shown below:

3 = X/20%, therefore X = 60%

One important point when capitalizing on elastic demand is that there must be sufficient market demand for the product, or the company must ramp up advertising or promotions to create market demand. This is needed to ensure the price decline attracts otherwise untapped customers to achieve the increased revenue goal.

Calculate Your Product Elasticity

Here are four techniques to calculate price and demand elasticity for your products or services.

  1. Price modeling. Price tests done pursuant to experimentation models are the most accurate and quantifiable measurement method. Rather than change product prices, it's advisable to apply limited period discounts to measure price change effects. Price analysis with A/B or multivariate testing and a control group will provide market tested data for the price model. Across the board price manipulation can be avoided by testing a limited but representative geography, market sector or customer segment.

    For companies with indirect sales channels, the manufacturer may test pricing with one or a few distribution or resale partners. The manufacturer can also use spiffs, rebates or margin adjustments to compensate the partner for increased promotional costs and reduced sales pricing. It's important the pricing experimentation is clearly stated to be for a limited period.

  2. Conjoint analysis. This is a survey-based statistical technique that measures how customers attribute value to your product capabilities. It can also isolate the individual or combinations of features, functions or attributes that drive value customers are willing to pay for.
  3. Competitors and comparisons. You can create elasticity models by comparing the pricing and quantities sold of substitute products. You need to include multiple substitutes in the models to get a reliable confidence level. This technique is not as precise as market experimentation but can be done more quickly and without altering product pricing.
  4. Product launches. New product introductions offer a unique price measurement opportunity. Using crowd sourcing to vet pricing scenarios, rolling out new products by territory to test and refine pricing models, and applying a skimming strategy whereby the initial product price is set high but systemically lowered over time are techniques to create a price elasticity model. Price skimming is especially effective for innovative product releases as it allows the company to capture market surplus, quickly recover its sunk cost, and attract market share before competitors enter and create price pressure.

Notice that I did not include Breakeven Analysis as a technique to measure price optimization. While breakeven analysis is the most popular technique, in large part because it's quick, easy and can be done without market analysis, it's shortsighted and does not really work.

Breakeven calculations compute the number of products needed to sell to break even on an investment. However, without product and demand elasticity models, the next actions of increasing or decreasing prices to determine revenue impact are nothing more than unsupported guesswork.

Breakeven analysis can be used with elasticity models but is near worthless without them.

You Can Change Your Price Elasticity

Price and demand elasticity for your products is not constant and can shift due to environmental or engineered factors. Here's how to change your product elasticity for improved revenues.

  1. Expand the brand
    Brand equity has a commercial value based on customer perception of the brand name. Strong brands enable price premiums, fend off lower cost competitors and shift product elasticity from elastic toward inelastic.
  2. Promote product differentiation
    Increasing the unique value proposition (UVP) for each product and decreasing the number of actual or perceived substitutes will lower product elasticity. Patented drugs are more inelastic and drive higher prices than generic medications as they are perceived to be different and better.
  3. Increase customer affinity
    Delivering relevant, personalized and contextual customer experiences and growing relationships with customers creates customer affinity and loyalty and shifts product elasticity from elastic toward inelastic. In fact, customer affinity is one of only four sustainable competitive advantages.
  4. Grow loyalty program
    The goals of a customer loyalty program are to acquire customer intelligence, increase sales of higher margin products, grow customer lifetime value and shift customer loyalty from products to the brand. When loyalty programs increase the customers emotional connection with the brand, product elasticity becomes more inelastic.
  5. Create barriers to churn
    Costs related to switching vendors shift elasticity. Exit, termination, or contract penalty costs have some influence on customer churn. But for many customers, the time and effort to switch brands is a far more significant factor. The best retention strategy is to increase customer engagement and customer share. Increasing customer share by cross pollinating the number of different products sold to the customer will decrease the likelihood the customer will switch brands.
  6. Limit distribution
    Exclusive distribution or limited reseller partners or channels can lower price elasticity. Fewer channels often promote premium products and can convey limited availability, greater value and higher quality.

Even small changes to product pricing can deliver a big impact to company revenues and profits. Understanding product price and demand elasticity, how to shift elasticity to your advantage and how to adjust pricing for predictable revenue impact are powerful levers to realize untapped revenue and unlock additional profit.