As Price Goes Up, Sales Go Down
Price is an area in which you just cannot guess what will happen. There are three common relationships between price, the number of buyers, and revenue. For example, as price moves from high to low, the number of buyers may move from low to high. As price moves from low to high, the number of buyers may move from high to low. Or the number of buyers may move from low to moderate and then drop.
Consider the next illustration which shows the results of a pricing study we did for one client. We were looking at three different services for a giant home appliance company. The company was considering three different businesses: home security systems, home energy management, and major appliance repair. The common element was wires into the house; they could use new technology to communicate back at a central office if your house was being burglarized or on fire, if your heating/cooling system was out of whack, or if your refrigerator or washer broke down. Three very different businesses and they wanted to understand the market’s price sensitivity.
The study found three different relationships (which makes it ideal to illustrate our point). We found the burglar alarm concept to be very price sensitive. As the price rose, the number of buyers fell steadily. With the appliance repair concept, however, the relationship was exactly opposite. Few people expressed interest in the concept at a low price, but as the price rose more and more people said they would buy. For the home energy management concept, relative few buyers expressed interest at the low price; interest peaked at a moderate price and then declined as the price continued to rise.
This of course contradicts intuitive thinking, which is that sales rise as the price declines. They may, but then again they may not. In any event, depending on the original margin, they may have to rise considerably for the business to make as much as it would without the price cut. For example, assume that our product sells for $10 and that we make $4.50 on each one (a 45 percent gross margin). Every time we sell 4,000 units, we make $18,000. Suppose we cut the price 5 percent; how many more do we have to sell to make the same $18,000?
The arithmetic is straightforward. With the price cut, our widget is $9.50 and we are making $4.00 on each (a 42 percent gross margin) Now we have to sell 4,500 widgets to make $18,000. We need a 12.5 percent increase in units to offset a 5 percent decrease in price.
This very simple example assumes, of course, that costs remain the same, but as everyone in business knows, costs may rise or fall as volume rises. At some point the plant has to add another shift, we need another truck to make deliveries, or more warehouse space. Suddenly (or imperceptibly) we’re not making $4.00 on our very popular item; we’re only making $3.60 and we have to sell 5,000 widgets to make our $18,000. That is, we’ve got to increase sales 25 percent just to stay even.
This is not abstract theory. Business Week reported that Boeing had offered deep discounts to keep Airbus Industries from stealing customers. “Boeing had done so well racking up orders, in fact, that it wound up with a huge production bottleneck that is costing it billions to untangle.”
We once had a product manager tell us, “I’ve really moved share. We gained three share points in the past year.”
We asked, “What did you do?”
He said, “I dropped my price and sales started to move significantly.”
“Did they move enough to make up for the lower revenue per unit?” He looked at us blankly. Nobody had asked that question. Everybody was just happy that sales went up. Does anybody notice there’s a problem here? Often, they don’t.
This is especially true with promotion managers who spend their careers chasing revenues with bigger, better, bolder deals. “Buy one, get one free,” Peyton Manning says. “Buy one large pizza and get a second for 3 bucks.” “Use this coupon for 50 cents off.” “Buy this tablet and get a free Hunger Games cover.”
Promotions almost always increase demand and revenues and almost always reduce profitability. As a result they need to be used sparingly and with caution.
So what is our point? The hypothesis is that as price goes up, sales go down. Is this true? Well sometimes. Other times the result is precisely the opposite.
What we know for certain is that the product (with its features, benefits and perceptions), its positioning, where and how it’s sold and its price are all related. The only way to know what the effect of price will be on demand is to test it in context.