Across-the-board price hikes?

The board of directors of a major consumer goods company made it very clear that their expected increase in average price was 5% for the following year. This was meant to ensure at least 5 points of revenue growth. It was August, and as in most companies, the budgeting process for the next year was underway.

Management proceeded to apply an across-the-board price hike consistent with the board’s target —in a spreadsheet they multiplied the current price list by a factor of 1.05. In December they communicated the new prices to their customers, and they went into effect on January 1. By the end of the first quarter of the new year, more than half of the increases had been reversed, because sales of those products had plummeted. What happened in this case? How can a routine price adjustment put a company’s sales at risk?

​Expensive, cheap, and fair-priced products
In any company’s portfolio of solutions, there are three types of products (or services): fair-priced, expensive, and cheap. Fair-priced products have a price aligned with the value customers perceive; no sales are lost, and no money is left on the table. This is the ideal situation.

Expensive products have a price that exceeds what customers perceive as fair, and sales are likely below their potential. These products are the easiest to identify, as their low turnover usually gives them away.

Lastly, there are the cheap products —the typical top sellers in the portfolio, and everyone is happy because they always exceed the sales budget. What is rarely recognized is that money is probably being left on the table, because their price may be below the value perceived by most of the market.

When a company performs an across-the-board price hike, it increases all prices by the same proportion. This means fair-priced products may become expensive, expensive ones become even more expensive, and cheap products may still not reach their fair price.

The fair price
To avoid this problem, companies must be able to identify the optimal price of each product or service in their portfolio. This requires quantifying the value perceived by different customer segments and calculating the optimal price of each product based on competitive market conditions. This means that identifying optimal prices does not start with estimating elasticity, but with calculating perceived value.

Both elasticity and costs are used to measure the profitability of a price change, not to determine the suggested price level. But this is not an easy task, especially when dealing with hundreds or thousands of different SKUs. The best way to do this is by using analytical tools that automate these calculations, identifying in a fraction of a second which products are fair-priced, expensive, or cheap. Additionally, these tools allow companies to project the financial results they would obtain if they implemented the recommended price changes.

In summary...
The company described at the beginning changed the way it made pricing decisions. The board still sets the annual increase target, but management now analyzes each product; although they usually don’t dare to lower the prices of products identified as expensive, they at least exclude them from the price increase. Fair-priced products are never given an increase above inflation.

​Finally, the average increase requested by the board is achieved through hikes of up to 15% on products identified as cheap. This has allowed them to increase margins beyond the shareholders’ expectations, without jeopardizing the company’s long-term competitiveness.