a) Upper management is unsatisfied with the past year’s profit growth. The SVP of Finance has suggested that you should cut prices by 5% to grow market share and, hence, profits. Given your expertise in pricing, do you agree with this suggestion? Explain.
The suggestion from the SVP finance is not backed up any available data. Reducing the price by 5% may increase the market share, but not necessarily the profits. In fact, reducing the price can erode the profits. The chemicals company has differentiated itself by providing superior customer service, 24 x 7 access to the systems, etc, and hence is able to charge a price with higher contribution margin than the industry standards. Decreasing the price, will impact the contribution margins and hence will directly impact the profitability of the organization. As suggested by the SVP of finance, decreasing the price will gain market share only if the demand is within the elastic region, which we don't know at this stage.
b) Subsequent to your discussions with the SVP of Finance, you commissioned an internal study of your historic sales and price data. Regression analysis generated an estimate of the own-price elasticity of demand of -0.65 (with a standard error of 0.01). The study concludes with an enthusiastic recommendation to increase the contribution margin to 45%. How do you react to this recommendation? What questions might you ask the team in charge of the study?
Since the estimated demand is in the inelastic region, it is less sensitive to the price changes. The recommendation from the internal study to increase the contribution margin to 45% from the current 8% needs to be approached with caution. The result seems to be incorrect. Based on the calculated elasticity,
P(new) = (0.65)/(1+0.65) x 92% P(old)
P(new) = 36.24% P(old)
This is point elasticity only, and elasticity changes as we progress on the demand curve. Hence, it is recommended that we do step increase of the price, rather than a 45% increase. Such a steep increase would not only upset the current customers, but also enable them to look for alternatives, which could impact the chemicals company. The internal analysis performed by the team needs to be investigated for the following: Price variations considered during the analysis. If there is little variation of prices over time, the regression model does not fit well and little information can be produced. Typically the regression models require high quality data, as disaggregated as possible. The input data needs to be checked to ensure for quality. The regression models are efficient on the short term only and need to be updated frequently. On the long term, forecasts without an updated model can be hazardous because price-elasticity can change due to external factors (new alternatives, new competitors, etc.) The price elasticities of the competitor also needs to be considered.
c) To resolve the pricing issue (and the conflict between the opinion of the SVP and the results from the statistical analysis), you decide to hire a pricing consulting firm. After several meetings, you agree with the consultancy’s suggestion to conduct a conjoint analysis. Their main argument is that, although the raw chemicals you sell are commoditized, you differentiate your offering by bundling it with service and quality control.
Segment 1 consists of 20% (100 companies) of the overall market values support over internet and phone the highest, compared to segment 2 (225 companies – 45%) who values On-time delivery more than any other attribute. Similarly Segment 3 consisting of 175 companies (35% of the market), values product quality higher than every other attribute. Segment 1 values support over the Internet & phone, Selection of variants and high product quality more than any other attribute, and value least the frequency of contact with the sales representative. Hence this is potentially a segment, which needs the freedom of choice...
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