MARKETING
Too many ad hoc pricing decisions
Key determinants: consumption expandability and brand equity
Consider competitors and channels last
ACKAGED GOODS COMPANIES have long recognized that pricing is a key
P
lever in managing brands for profitability. Even so, pricing is so
underleveraged in practice that improving price management can raise
margins by as much as 5 percent. Companies seeking to capture this potential
must not only make eƒforts to understand the behavior of consumers but also
find ways to apply this understanding to the thousands of front-line pricing
decisions they make every year.
This opportunity exists because of a widespread assumption that marketing
departments set prices and make them eƒfective. Yet any consumer’s shopping
experience will demonstrate that this is a misconception.
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TELEGRAPH COLOUR LIBRARY
K. K. S. Davey
Andy Childs
Stephen J. Carlotti, Jr
Not long ago, an acquaintance bought a box of cereal for $3.79. He was
unhappy because he had paid $2.49 for the same brand in the same
supermarket just two weeks earlier, when he had also used a 75¢ coupon to
pay a net price of $1.74. To add insult to injury, he knew that a nearby
supermarket always sold this brand for $2.99. These variations in price
confused him. In fact, they are entirely normal, and centralized pricing
decisions are responsible for very few of them.
K. K. Davey is a consultant and Andy Childs is a former consultant in McKinsey’s New Jersey
oƒfice; Steve Carlotti is a principal in the Chicago oƒfice. Copyright © 1998 McKinsey &
Company. All rights reserved.
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WHY YOUR PRICE BAND IS WIDER THAN IT SHOULD BE
In category aƒter category, the end prices consumers pay for the same goods
vary widely. Some variations result from promotions by manufacturers, such
as temporary price cuts, circular ads, coupon ads, end-of-aisle displays, preprice packs, and bonus packs. Within a channel, prices vary as a result of
retailers’ pricing and promotion strategies, such as EDLP or hi-lo,* doublecouponing (the process by which a retailer oƒfers to double the face value of
a manufacturer’s coupon for shoppers in its stores), and loyalty cards. In
addition, prices vary from channel to channel because of diƒferent value
propositions: convenience at a higher price or less variety and service at a
lower price, for instance. These variations apart, consumers themselves adjust
pricing by responding to consumer promotions, notably free-standing inserts,
checkout coupons, and onExhibit 1
pack coupons. We call this
Consumer price bands
range of prices for an SKU
Example: Cereal
Weeks in store Units bought (stock-keeping unit) within a
at
each
price,
at
each
price,
Any promo price
percent
percent
market the consumer price
1.0%
$1.00–1.49 0.1%
Range band (Exhibit 1).
of prices 3.8
1.50–1.99
paid by consumers 2.00–2.19
1.1
2.20–2.39
1.4
27.5
5.7
At most packaged goods companies, the complex decisions
3.3
6.8
2.40–2.59
about list prices, trade pro2.0
2.60–2.79 1.5
motions, and consumer pro3.4
3.6
2.80–2.99
motions that drive the con1.2
3.00–3.19 1.6
sumer price band are made
10.6
6.1
3.20–3.39
19.9
13.9
3.40–3.59
by several diƒferent internal
16.4
10.1
3.60–3.79
organizations, each inspired
17.0
9.6
3.80–3.99
by its own goals or definitions
19.0
8.7
4.00–4.49
of success. Prices controlled
0.9
>4.50 0.5
centrally by senior management reflect a company’s revenue and profit aspirations, the level of inflation, and competitive pressures.
Trade promotion budgets are determined at the account level by salesforces,
and oƒten come into play to meet short-term volume targets. Consumer
promotions, on the other hand, are controlled centrally by brand managers,
and are frequently based on competitive dynamics. All these separate pricing
decisions usually create a wide price band.
3.4
Yet companies are seldom aware of this state of aƒfairs. Ask most managers
why their companies set prices at a given level, and they will tell you that this
is the highest price consumers are willing to pay. But if that is so, why do list
prices keep rising while a substantial portion of the increases go to finance
≠ EDLP (everyday low price) is a retail pricing strategy in which the retailer charges a constant,
relatively low everyday price with no temporary price discounts. Hi-lo retailers, by contrast,
charge higher prices on an everyday basis and run frequent promotions in which prices
temporarily fall below the EDLP level.
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trade and consumer promotion budgets? In any case, few companies can tell
how much product they sell at full price to end consumers.
Ask the same managers who actually makes their companies’ price decisions,
and the response is likely to be the “brand people” at HQ, who are specialists
with the necessary tools for the job. Both impressions are false. Roughly
12 percent of sales come under trade promotion budgets, more than half
of which (and growing) are controlled in the field. Frontline salespeople
therefore direct a good deal of the tactical pricing for any brand.
Yet few companies have taken the vital steps to hire and train the right
salespeople and to provide them with the data and analytical tools they need
to measure the profitability of their promotions. Even relatively simple
metrics like purchase cycles and pantry loading are rarely linked to tactical
promotional strategies. As with many other changes in the marketing mix,
variations in pricing are seldom based on an analysis of their impact in
specific consumer segments. Even leading packaged goods companies are
confused about the correct interpretation and use of price elasticity. As a
result, companies oƒten make major pricing moves that substantially reduce
their profitability.
Prices are set in an ad hoc way for several reasons. First, companies generally
use discounts to meet competition, an approach that their customers, retailers,
strongly encourage. Second, promotional spending is typically budgeted on a
highly unfocused “what we spent last year plus 5 percent” basis. Third,
customer (retailer) strategies oƒten drive pricing: EDLP accounts, for
example, may demand that manufacturers set an everyday price lower than
the list price plus average customer margin. For many manufacturers, this
not only forces down the top end of the price band but also reduces its
potential width.
Sensible pricing calls for a deep knowledge of consumer behavior and a welldefined process to translate this knowledge into local pricing decisions. An
understanding of consumers is the only basis for doing what companies claim
to do: price at the highest point consumers will pay. Although knowledge
about competitors, channels, and retailers is vital, it should supplement rather
than replace this understanding; everything else is secondary. In setting price
bands, the objective should be to increase volume from price-sensitive
consumers by lowering the price to them, and to increase profits from priceinsensitive segments by capturing the value inherent in the product oƒfering.
Determining the ideal price band
A wide array of consumer-related drivers can aƒfect pricing, among them the
dynamics of usage and purchase occasions, loyalty to product attributes, and
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WHY YOUR PRICE BAND IS WIDER THAN IT SHOULD BE
local market preferences. Two consumer drivers are particularly important:
first, the extent to which consumption in a category can be expanded through
price/promotion policy; second, brand equity.
It is possible to raise sales volumes in expandable categories, such as salty
snacks, cookies, and soƒt drinks, by raising consumption among current or
new users through attractive prices or promotions. Pepsi, for example, believes
that as much as 50 percent of the incremental volume generated by promotions may come from increased category consumption. Wider price bands
are usually appropriate in expandable categories, since incremental volume
can increase total profits despite reducing profit per unit.
The second driver, brand equity, refers to a consumer’s relationship with a
product’s tangible or intangible benefits. Power brands – those with high
equity – command a price premium and also allow their owners great
flexibility over pricing.* Such brands as detergent Tide and snack food
Doritos capture consumer surpluses by oƒfering shallow price discounts
(narrow price bands) to encourage pantry loading by loyal consumers or to
attract switchers or formerly loyal consumers of competing brands. They
can also use periodic deep discounts (wider
price bands) to attract buyers who would not
Understanding consumer
normally buy products in the category.
drivers makes it possible
to determine the proper
width of a price band
Understanding these two drivers makes it
possible to determine the proper width of a
price band. If category consumption appears
to be highly expandable and a manufacturer has the strongest brand, for
example, it should adopt a very wide price band: that is, set the everyday
price high and promote heavily. This will capture the benefit of loyal consumers’ willingness to pay while simultaneously increasing volume among
occasional or new users through profitable promotions.
Suppose, however, that a brand in an expandable category lacks high brand
equity. In this case, narrower price bands, combining moderate everyday
prices with moderate levels of promotional activity, are appropriate. It is
unwise to charge high everyday prices for such a product, but profitable
promotions can still increase brand (and category) consumption.
Imagine that the expandability of a category is low but the equity of a brand
within it is high, as it is for leading brands of toilet paper and detergent, as
well as many luxury goods. The right policy is to deploy the narrowest price
bands and to use promotions sparingly. Such brands do not benefit from
promotions in the long run, because the sales thus generated are likely to be
≠ David C. Court, Anthony Freeling, Mark G. Leiter, and Andrew J. Parsons, “If Nike can ‘just
do it,’ why can’t we?,” The McKinsey Quarterly, 1997 Number 3, pp. 24–34.
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made at the expense of future sales of the brand or to come from switchers
who buy on a deal-by-deal basis. Reducing promotions of such brands (and
encouraging competitors to do likewise) will probably reduce the size of the
deal-by-deal switching pool.
Once the ideal width of a price band has been established, four issues must be
addressed before it can be implemented in the marketplace:
• What should the everyday price be?
• How wide should the price band be? In other words, exactly how far below
the everyday price should a company set the promotional price level?
• What mix of promotional levers is most eƒfective?
• How oƒten should a company promote?
Setting everyday prices
To determine the profit-maximizing everyday price for an SKU, a company
needs a good understanding of price elasticity, key threshold prices and price
diƒferentials, and company margins. Sophisticated econometric modeling
of sales and price data by such marketing information suppliers as Nielsen
and IRI can help companies estimate the price elasticity of their brands. In
some cases, it may be necessary to employ other methods, such as in-store
experiments and various forms of choice modeling (for instance, conjoint
or discrete choice).
Threshold price points – say, $1.99 – are levels above which consumer demand
falls sharply and below which consumer demand fails to rise in proportion.
They exist for key items in a category and for the brands competing in it.
Oƒten, threshold price points are specific to a market or region; in some cases,
they are specific to an account as well.
The price diƒferential is the point at which the diƒference between the price of
a brand and that of a key competitor becomes large enough to reduce the
brand’s sales velocity substantially. Detailed analysis of price diƒferentials
can be valuable: we found that one company aimed for a certain price
diƒferential against a key competitor nationally, but the key competitor and
the optimal price gap actually diƒfered from region to region. A national
analysis was not suƒficient to assess the appropriate diƒferential.
As a rule, companies undertake a systematic analysis for one major package
or size of a brand and then use judgment and conventional wisdom to
extrapolate the findings to other packages or sizes. But if small sizes appeal
chiefly to occasional users and large sizes to heavy loyal ones, prices should be
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proportionally higher on the large size to maximize the surplus, and lower
on the small size to bring in occasional users. In one documented case,
adopting this approach pushed margins up by 5 percentage points – an
extraordinary increase in profitability.
Setting the width of the price band
Once a company has identified appropriate everyday prices, it must set
the lower bound of the price band. Empirical studies suggest that price
reductions eventually cross a threshold beyond which further cuts fail to
attract more switchers and new users and add only slightly to incremental
volume (Exhibit 2). Although optimal promotional discounts are likely to be
Exhibit 2
Lo
ya
ls
Co
m
lo pe
ya ti
l s ti v
e
Sw
itc
he
rs
Finding the price reduction threshold
Example: Household product
Thousands of units
12.6
Everyday price
6.05
10% price cut with in-store display
0.5
6.05
35.0
7.7
20% price cut with feature advertisement
16.8
10.5
40.0
14.0
12.0
14.0
Source: A. C. Nielsen
Exhibit 3
Determining price bandwidth
Aggregate data
500
Feature
advertisement
and in-store
display
Price band
Sales index
400
In-store display only
300
Feature advertisement
only
200
Temporary
price
reduction only
100
0
10
20
30
40
brand specific and must be
determined empirically, an
analysis of 30 product categories across many US markets shows that consumer
responses flatten for price
discounts steeper than 30 to
35 percent (Exhibit 3). This
suggests a lower limit for
price bands.
Adjusting the price band
through diƒferent
promotional levers
Manufacturers should understand which promotions
appeal to which consumers.
Our experience suggests that in general, feature advertisements attract a
disproportionate number of brand loyalists, while in-store displays lure
switchers. We have also found that inserting coupons into flyers distributed in
stores targets price-sensitive consumers more eƒfectively than does cutting
prices at the shelf. Only about half of the shoppers who buy the promoted
Discount, percent
Source: A. C. Nielsen
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brand take advantage of these coupons; other consumers ignore them and
pay a higher price.
Although these findings cannot be generalized to all brands and categories,
manufacturers can use promotional levers in a fairly targeted way to attract
the price-sensitive segments that they seek. To do so, however, they must
undertake detailed analyses of the consumer data that is increasingly
available at market and account levels. Companies must be creative in
designing promotions, measuring their sales and profit impact on target
segments, and identifying those that will allow them to customize their prices
while generating profitable incremental volumes.
Determining the right frequency for promotions
Consumers’ responsiveness to the frequency of promotions varies by geography, category, and brand. Two key issues to consider are reference prices
and category dynamics. Reference prices formed by consumers help them
determine whether products give good value. Manufacturers should aim to
keep reference prices and the everyday prices consumers see when they shop
as high as possible, since evidence suggests that for most consumers, frequent
promotions can push the reference price of a product far below its everyday
price. By contrast, less frequent or random promotions make consumers feel
they are getting a bargain – a more desirable result.
Two kinds of category dynamics are important. The first is the category and
brand purchase cycle of the segment being targeted: if consumers purchase
a product in a given category once every two months on average, weekly
promotions are not likely to be productive. The second is the frequency with
which the brands in a category have been promoted in the past. Many categories are promoted excessively. If past practice has created certain expectations among consumers about promotions for a given category, it can be
hard to change them. It will be necessary to take a gradual approach, moving
steadily toward the optimal lower level of promotion.
Adjusting the price band
Although price bands should be based on a deep understanding of consumers, traditional concerns about competitors and channels cannot be
neglected. The study of consumer dynamics does implicitly take some of
these concerns into account, but it is worth keeping an eye on them directly
to fine-tune pricing strategy.
Competitors
Some companies react to the pricing and promotional moves of all competing companies in the same way, failing to realize that all competitors
are not equal. Consumer analysis suggested that one company’s brand
stole share from a key competitor whenever it was promoted. Yet when the
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competitor promoted its own brand, the first company’s sales were not
aƒfected. Asymmetrical competition of this kind is common, particularly
when consumers feel that brands vary in quality and a category is divided
into distinct price tiers. Consumers trade up relatively easily to better-quality,
more expensive brands, but resist trading down to lower-quality brands even
if they represent a bargain.
In adjusting price bands in response to competitors, there are several key
issues to consider:
• If a company wants to create a wide price band for its brand, how should
it respond if competitors do not follow its lead, or even take steps to narrow
their own price bands?
• If a company wants to narrow the price band for its brand, how should it
respond to competitors who buy market share by means of aggressive
unprofitable promotions?
• How does a company go about influencing its industry if it wants to lower
the level of promotional activity in an unexpandable category?
Companies spend large amounts of their money on trade and consumer
promotions that discount prices to competitive levels, thus widening the price
bands of their brands. They should think twice before doing so. The desire to
meet competition is rarely a sound basis for pricing decisions; indeed, it is
unlikely to raise the profits of any of the competitors. Why? Because retailers
hardly ever advertise or discount competing products at the same time; the
“meet the competition” philosophy means that one company’s product will be
discounted this week, another company’s next week. Since discounting is
oƒten unprofitable, this approach tends to depress a company’s profits twice:
once when its competitor discounts, and again when it takes its turn.
One company battled it out in this kind of promotional war with its only
major competitor in a certain region. Both players eroded shareholder
value by oƒfering attractive prices to retailers almost continuously. The
retailers, fierce competitors themselves, used this category to build traƒfic
for their stores. The two companies were trapped in a vicious cycle of
price discounting.
A thorough analysis of everyday price and promotional elasticity and consumer behavior persuaded the company to implement consumer-driven
pricing strategies. It narrowed its price bands, used targeted promotions
to reach specific segments in some channels, and increased margins by
4 percent. The competitor followed suit by narrowing its price bands –
presumably with positive results as well.
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Channels
Consumers purchase packaged goods from many retail channels, each with
its own distinct value proposition; even retailers within a given channel
have a variety of formats. Grocery stores, which oƒfer convenience and a wide
assortment of products, oƒten charge relatively high prices for items that are
not in the grocery line, such as diapers and toothpaste. By contrast, warehouse
clubs targeting price-sensitive consumers oƒfer the lowest prices, but have
only a limited assortment of package sizes, primarily large. Many brands sell
in multiple channels, with multiple positionings.
For some products, consumer price bands should be adjusted channel by
channel. Consider the pricing of beer. Category and brand consumption can
be expanded much more readily in supermarkets than in bars. This suggests
that a wide price band is more appropriate for supermarkets. (Happy hour
discounters beware!)
More generally, companies must answer three key questions:
• Is a given strategy suƒficiently flexible for all channels, and in particular
for the major accounts within them?
• Do consumers use a product to judge the
overall value proposition of a channel or
retailer? What role does the category play in
the retailer or channel value proposition?
Pricing strategies must be
flexible enough to accommodate
diƒferent retailers without
jeopardizing a brand’s overall
price positioning
• How can a pricing and promotion strategy
be tailored to work both for manufacturer and for retailers?
Bear in mind that retailers as well as manufacturers have price positions they
wish to project to consumers. If a manufacturer adopts a pricing strategy
that is based on heavy promotion, such as hi-lo, it can easily fail if the primary
channels for selling the product are oriented to EDLP. Pricing strategies must
be flexible enough to accommodate diƒferent retailers without jeopardizing a
brand’s overall price positioning. Companies should ask themselves what
price bands are appropriate for retailers whose maximum diƒferential between
high and low prices is as low as 20 percent. This approach to the overall
design of pricing programs may seem merely common sense, but in our
experience, it is seldom pursued.
Executing the price band in the field
Even well-designed pricing programs oƒten fail because of inconsistent or
weak execution. Since final prices reflect many local decisions, field capabilities and incentives must be aligned with a company’s overall pricing structure.
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Poor execution in the field has many causes. Some companies buy whatever
information they need to manage their top accounts and brands, but fail to
put all of it in the hands of the people who could really use it to improve
brand movement, volumes, and profits. Few companies go so far as to
measure their returns on promotions. If they did, many would find they are
negative. One manufacturer discovered that more than 10 percent of its
promotional spending on a particular food category was wasted, since
increases in consumption peaked at a discount level of 20 percent, yet many
of its promotions cut prices by 50 percent
or more. By adjusting price targets, this
Few companies go so far as
company gained almost an extra percentage
to measure their returns on
point in profits.
promotions. If they did, many
would find they are negative
The same account-level data that can be used
to determine whether a manufacturer and an
account have made a profit on individual trade deals can be mined even more
deeply to isolate the impact of price levels and price bands. But in order to
glean such insights, a company must make both its data and the right tools
available to its frontline salespeople, since input from them can help it build
a robust picture of what is happening in the real world. Discipline is needed
if a company is to create a suitable base of knowledge and synthesize it across
regions and channels.
Packaged goods manufacturers can boost their bottom line by taking several
steps to increase the eƒfectiveness of their salesforces:
• Recognize the critical role frontline salespeople should play in the pricing
process.
• Equip the salesforce to handle this role by giving it account-level pricing
and profitability data, easy-to-use tools, and support functions specific to
account-level pricing. (This might include data gathering, financial analysis,
or local marketing expertise.)
• Maintain pricing discipline by continually measuring the impact of price
levels on the eƒfectiveness of promotions, and intensively educating the
salesforce on best practices by account and by channel.
• Use a bonus program to reward salespeople for devising price levels that
build brand equity and increase the profitability of brands and accounts.
Easy though these steps may sound, most packaged goods companies have
diƒficulty taking them, largely because they entail an enormous change in
mindset. Field sales organizations must become more analytical and more
focused on profits. The marketing function must be willing to give the
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salesforce more flexibility to set pricing than it has previously enjoyed.
Finally, marketing and sales must agree on the level of sales they want to
achieve, and why.
Shiƒting the orientation of pricing strategies for packaged goods from the
current fixation with competition and channels to an approach that takes
fuller account of consumer behavior oƒfers promising opportunities to
improve profits. But a new mindset at headquarters, new techniques for
measurement and analysis, and new capabilities are needed before a company
can recognize and capture the profit potential of innovative pricing. Once
these are in place, it can turn to the diƒficult challenge of training frontline
salespeople, providing them with adequate decision support tools, and
adjusting their incentives. What lies ahead is no easy task. But a margin
improvement of 2 to 5 percent is quite an incentive.
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