Focus on Strategic Pricing

Pricing as a strategic lever of revenue and profit growth is under-managed at most companies. This is especially troubling given the power of pricing to transform the P&L of a company. After all, price is the most sensitive lever of profit a company can influence. In fact, a 1% increase in price yields 4X more in operating profit than a 1% increase in volume.

Packaged goods companies invest significant financial and organizational resources to maintain and improve volume-driving capabilities such as Marketing, Sales, Advertising, etc. Yet when it comes to pricing, many companies manage it reactively, as a way to maintain operating profit in response to fluctuations in input costs.

Best-in-class companies treat pricing differently in several critical areas:

Proactive vs. Reactive

Best-in-class companies treat pricing as a strategic lever of revenue and profit growth in any economic environment.

Companies that use Strategic Pricing as a controllable lever of growth do not price only in response to rising commodity and input costs. These companies think of price as a strategic growth driver, as important for revenue growth as new products or advertising campaigns, and even more critical as both a driver and measure of brand equity. That's because these companies don't simply 'drop the impact of pricing' to the bottom line. Instead, they price to drive profit AND simultaneously invest in advertising, brand building, R &D, etc. This improves competitive effectiveness and brand equity and reduces price elasticity, setting the table for a virtuous circle of further pricing action, investment and brand building. Simply put, consumers are willing to pay a premium for outstanding and differentiated brands. And great CPG companies are presumably in the business of creating and nurturing great brands. If a brand can't price, it hasn't earned the right to do so.

Senior management at best-in-class companies sets expectations of greatness for its brands. They insert Strategic Pricing actions into strategic and operating plans alongside new positioning, new advertising campaigns and new product launches. These companies demand a certain amount of revenue and profitability growth from Pricing over the planning horizon, over and above the margin protection from inflationary commodity costs.

In this way, Strategic Pricing becomes equal in importance to the other activities against which Marketing, Sales and General Management focus organizational energy. As an equal partner in growth, Strategic Pricing becomes as important organizationally as outstanding advertising, marketing and customer strategies. Instead of engaging in ad hoc pricing projects to cover the margin erosion caused by rising input costs, great companies put the right focus, organizational investment and resources against Strategic Pricing. That becomes a capability that enables durable competitive advantage.

Strategic vs. Tactical

Best-in-class companies begin by creating a pricing strategy that is consistent with a brand's positioning and its role in a company's portfolio.

Companies that us the market structure framework to position brands more effectively can use the same information to identify potential pricing leverage. For instance, suppose the market structure for a frozen dinner brand showed that it competed well with food from high end quick-serve restaurants; as a result, the brand decided to position its benefits against those competitors.

Given the very large and lucrative competitive frame of reference, Aggressive Growth should be the expectation for this brand. And since the appropriate reference price is meal types at quick serve restaurants (not other frozen dinners and entrees in the grocery store), this brand has tremendous opportunity to use Strategic Pricing as a lever for revenue and profit growth. Such brands often identify a pricing principle (for example, parity to high end quick-serve restaurants) and lay out steps to achieve that target over the planning horizon.

Brand & Category Elasticity vs. Item Elasticity

Once best-in-class create a pricing strategy, they use Total Brand & Category Elasticities vs. Item Elasticities.

Even if companies have the right pricing strategies and principles, they may turn to traditional item-level elasticity models to more precisely identify how much pricing they can actually take. These models are difficult to work with because they estimate the volume impact of a price increase on each item in a brand's lineup individually.

However, when consumers are faced with a price change on a favorite item, they often move to a different item within a brand in a given store, or will shop for that item in a different channel. The problem is that traditional item-level elasticity models do not take this intra brand switching into account, and over-estimate the volume losses associated with pricing actions. Consequently, many manufacturers and retailers under price their brands even in this inflationary environment. They leave significant revenue and margin on the table.

Market structure can help. The market structure that was used to define the positioning was generated with switching data at the brand vs. item level. It can also be used to factor out intra- brand switching, and thus to calculate a "True Brand Elasticity." True Brand Elasticity is a far more accurate predictor of price-driven demand changes than classic item-level elasticity. Why? It captures consumers' behavior within and across channels.

Great companies also calculate and use Category Elasticities as a way to help them understand the perspective of their retail partners. True Brand Elasticity provides a manufacturer with a clear view of the impact of pricing action on an individual brand within a category. Category Elasticity helps a retailer understand what happens within its stores when one, several, or all brands take pricing action.

Understanding this information is often critical to selling in a pricing action. It shows a robust understanding of category dynamics, as well as an appreciation for the impacts pricing can have on a retailer's P&L. At the category level, many CPG products are highly inelastic. Retailers need to understand the category dynamics so they can feel confident about their own pricing actions in the context of their profit requirements.

Market structure, once again, provides the information necessary to calculate Category Elasticity. Because the market structure is a picture of the entire competitive frame of reference from a consumer's perspective, it contains information regarding all the brands in a category. This category view is tailor made for retail application.

Total Brand Spend-Back vs. Trade Spend-Back

Best-in-class companies spend some of the profit increase they obtain from pricing on Advertising, not Trade.

Some companies create the right pricing strategy, use the True Brand Elasticity information to generate the right level of actual price increase, and still fail when executing a pricing action. That is because they nullify the revenue and profit gains they could make from their pricing action by 'spending back trade dollars.' They are wary of the short-term volume losses they will see due to the pricing action.

Whether it is to hit "critical everyday price points," maintain "critical price gaps vs. competition or private label," or "hit hot promotional price points," the net effect is the same: dilution of the price impact against which they have worked so diligently.

Great companies look at "spend-back" much more holistically. They have confidence in their brand building activities – and in particular their advertising and equity building activities – to maintain or even grow volume in the face of price increases. In fact, great companies hold or decrease trade and promotional spending and increase advertising while taking pricing action.

How? Companies that use market structure have an analytical framework that can be combined with a brand's P&L to determine the total spending level and mix that maximizes brand profitability. The engine that underpins this framework, based on mathematical principles used in quantum physics, can maximize profitability under a variety of spending, pricing and competitive scenarios simultaneously. The math may sound fancy, but it produces a result that is consistent with what many marketers know instinctively: increasing advertising spending during a pricing action maximizes the profit impact of the increase, while increasing trade spending undermines it.

Companies that treat the lever of pricing in the manner that we have discussed have made it an integral part of their growth strategies on an ongoing basis. They recognize the positive impact that pricing can have on overall profitability. They view the ability to price as a barometer of overall brand health.

They don't wait for conditions to be "right" to take price. They take a leadership stand to make pricing an equal partner in growth other, more traditional brand activities such as advertising or new product development. They build pricing into their strategic and operating plans proactively and on an ongoing basis. And they are richly rewarded. Our experience has shown that approaching pricing in this very strategic fashion can yield x-y% revenue and x-y% profit growth for even the most mature brands.