Pricing Tests and Price Elasticity for one product

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Pricing Tests and Price Elasticity for one product

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Description of the Price Elasticity model

Thes model helps you solve two common pricing policy questions. Challenge #1: How do we set the price for a single product to maximize its revenue? This application uses results of pricing tests to estimate impact of prices on unit sales and revenue. The results can help you optimize revenues with limited pricing experiments. The key to estimating sales from pricing tests is to estimate the price elasticity from test results. The mathematics of price elasticity is described in the appendix below. The model computes revenue as price * sales units. The model includes two types of price elasticity analysis. Simple (or constant) price elasticity. (This is the only elasticity model in the Standard version.) This is the standard 'textbook' model of price elasticity, based on the relation sales units = constant x price^elasticity, where elasticity is a constant derived from pricing test data. Generalize (or non-constant) price elasticity. (Advanced versions offer both elasticity models.) This type of analysis allows the elasticity to change as a function of price. For a given set of pricing test data, this method is better at identifying prices that maximize revenue or profits.

Challenge #2: How do we set the price for a single product to maximize profits? The model computes profit margin as Revenue Costs. Costs can be cost of goods or total costs or whatever you choose, in order to compute gross margin, operating margin or any other profit margin you choose. The key step in computing profit margins is to estimate costs as a function of sales levels, as described in the Technical Notes below. The model includes Excel charts that provide graphical views of key variables. These charts are part of the model, and they are included by default in exported Excel workbooks. You can add more charts, import them, and the new charts will be included in exported Excel workbooks. As you explore the model, we suggest that you Read some of the Excel comments that are attached to Analysis Variables throughout the workbook. These comments also appear in ModelSheet in convenient places. View worksheet "Formulas" which shows the named variables and symbolic formulas of the model in a compact and readable form. The symbolic formulas are not active in this Excel workbook, but they give you some idea how the model works, and how it looks in ModelSheet. ModelSheet is a trademark of ModelSheet Software, LLC page 2 of 13

Pricing Tests and Price Elasticity for one product

Technical Notes
Challenge #1: How do we set the price for a single product to maximize its revenue? The model assumes that, at a reference price (variable Reference_Price), sales units are known (variable Reference_Sales_Units). Assume we have a number of test markets, each of which sells a known number of units (variable Test_Ref_Sales_Units) at the reference price. The characteristics of test markets that affect the validity of pricing tests are described in the appendix below. The model uses the test results (variable Test_Sales_Units) at prices (variable Test_Prices) that you specify for each test market to estimate the price elasticity (Test_Elasticity) using the regression formula Test_Sales_Units = Test_Ref_Sales_Units * (Test_Price/Price0) ^ Test_Elasticity Where does this equation come from? This equation is the exponentiation of the linear regression equation Ln(Test_Sales_Units) = Ln(Test_Ref_Sales_Units) + Ln(Test_Price/Price0) * Test_Elasticity This equation is the exponentiated equivalent of a linear approximation, or a first-order Taylor series. Both of these equations come from accepting the approximation that Test_Ref_Sales_Units and Test_Elasticity are constant over a range of prices. Their greatest weakness is that, in reality, the elasticity may change as price changes. Using the results of the regression, the application predicts sales units (Predicted_Sales_Units) for a range of prices (Prediction_Prices) acording to the formula Predicted_Sales_Units = Reference_Sales_Units * (Prediction_Price / Reference_Price) ^ Test_Elasticity Challenge #2: How do we set the price for a single product to maximize profits? You provide a value for costs at the reference level of sales units, and an estimate of elasticity of costs with respect to sales units (variable Cost_Elasticity). This cost model enables you to provide accurate cost information at one sales level, and to model non-linearities in costs due to economies of scale and capacity limitations. The model estimates costs at each predicted level of unit sales using the formula Predicted_Cost = Reference_Cost * (Predicted_Sales_Units / Reference_Sales_Units) ^ Cost_Elasticity

Appendix: Introduction to Price Elasticity

Price elasticity is important because it tells how price affects sales levels. Definition of price elasticity (denoted epsilon) Let's denote the sales units of a product by Q (for quantity) and the price by P. Price elasticity relates changes in price to changes in unit sales, according to the formula Q/Q = epsilon P/P . Price elasticity, denoted by 'epsilon', is defined as epsilon = Q / P * P / Q This can be stated more compactly as ModelSheet is a trademark of ModelSheet Software, LLC

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Pricing Tests and Price Elasticity for one product

epsilon = ln(Q) / ln(P) Use of price elasticity to predict sale units at a given price For price P, the unit sales Q will be, for some constant K, Q = K * P ^ epsilon If we have a reference price P0 at which we know that unit sales are Q0, then the relationship can be stated as Q = Q0 * (P/P0) ^ epsilon If prices rise by 1%, then unit sales change by epsilon * 1%, and revenues change by (1+epsilon) * 1%. Different ranges of values for price elasticity indicate different types of reaction to price changes. epsilon > 0: increasing prices increases unit sales. This occurs for some luxury goods with status appeal. epsilon = 0: changing price will not affect unit sales, so revenue grows directly with price. -1 < epsilon < 0: increasing price decreases unit sales, but increases revenues. epsilon = -1: increasing price decreases unit sales but does not affect revenues at all. epsilon < -1: increasing prices decreases unit sales so much that revenue declines. Goods with price elasticities in these ranges often have the following characteristics. epsilon > 0: luxury goods with status appeal epsilon = 0: price-inelastic goods epsilon 0: normal commodities epsilon < -1: commodities that are overpriced Using pricing tests to estimate price elasticity If you can offer different prices in different markets, you can measure the impact of price changes on sales. Many factors can distort the results of pricing tests. The different markets may have different distributions of customer behavior, so that combining them in one test will distort results. Extraneous factors may distort results unevenly across test markets, such as seasonal effects, amount of advertising and other promotion, strength of distribution channels. Price sensitivity may differ over the range of prices tested. To get accurate estimates of price sensitivity, you must perform separate tests over smaller price ranges. Customers in one market may find out about lower prices in other markets. This may cause people to buy in markets where you did not expect them to buy, which is likely to distort test results. Customers may learn that the prices are temporary. If this happens, lower prices will generate artificially high sales, and higher prices will generate artificially low sales, as people wait for the test to end. If your test design minimizes the impact of these problems, you can probably perform a pricing test that yields a good estimate of price elasticity. Cost elasticity We can use price elasticity and cost elasticity to estimate the price that maximizes profits. Assume we know that, when sales are Q0 units, then costs are Cost0. (This can be cost of good or Cogs pluas opertating expense, depending what kind of margin you want.) Assume costs as a function of units sold are: Cost = Cost0 * ((Sales Units) / Q0) ^ Cost_Elasticity Then profit margin is Margin = Revenue - Cost = Price * (Sales Units) - Costs ModelSheet is a trademark of ModelSheet Software, LLC page 4 of 13

Pricing Tests and Price Elasticity for one product

Challenge #1: How do we set the price for a product line with several products to maximize its revenue? This application uses results of pricing tests to estimate impact of prices on unit sales and revenue for several related products. The results can help you optimize revenues with limited pricing experiments. The key to estimating sales from pricing tests is to estimate the price elasticity for each product, and price cross-elasticities for each pair of products from test results. The mathematics of price cross-elasticity is described in the appendix below. The model computes revenue as sum(price[product] * sales_units[product], product in product line) Challenge #2: How do we set the price for a product line of several products to maximize profits? The Advanced version of the model computes profit margin as Revenue Costs. Costs can be cost of goods or total costs or whatever you choose, in order to compute gross margin, operating margin or any other profit margin you choose. This model assigns costs to each product, but costs can be joint costs of several products. The key step in computing profit margins is to estimate costs as a function of unit sales levels for the products, as described in the Technical Notes below. As you explore the model, we suggest that you Read some of the Excel comments that are attached to Analysis Variables throughout the workbook. These comments also appear in ModelSheet in convenient places. View worksheet "Formulas" which shows the named variables and symbolic formulas of the model in a compact and readable form. The symbolic formulas are not active in this Excel workbook, but they give you some idea how the model works, and how it looks in ModelSheet.

This Excel workbook was generated by ModelSheet on July 4, 2010, except for this worksheet of comments. Copyright 2009, 2010 ModelSheet Software, LLC ModelSheet and the ModelSheet logo are registered trademarks of ModelSheet Software, LLC.

ModelSheet is a trademark of ModelSheet Software, LLC

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The predictions in these graphs are based on the Generalized Elasticity method.

Sales Units versus Price in Test Markets

160 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 $80 $85 $90 $95 $100 $105 $110 $115 $120

Predicted Sales Units versus Price

100 95 90 85

80
75 70 65 60 55 50 $80 $85 $90 $95 $100 $105 $110 $115

The predictions in these graphs are based on the Generalized Elasticity method.

Normalized Sales Units versus Price in Test Markets

1.40
1.30 1.20 1.10 1.00 0.90

0.80
0.70 0.80 0.85 0.90 0.95 1.00 1.05 1.10 1.15 1.20

Predicted Revenue and Profit versus Price

$1 $1 $1 $1 $1 $1 $0 $0 $0 $0 $0 $90 $95
Predicted Revenue

$100

$105
Predicted Margin

$110

ABC, Inc. Widgets Price Test with Standard Product Price Test
Shaded cells are input cells. You can enter data in them. Excel formulas in shaded cells are starting suggestions. You can overwrite them. Company Name Product Name of Test ABC, Inc. Widgets Price Test with Standard Product

Reference Information
Reference Price Reference Sales Units $100.00 1,000.00

Test Prices
Prices Test 1 Test 2 Test 3 $95.00 $105.00 $116.00 Prices Normalized Test 1 Test 2 Test 3 0.950 1.050 1.160

Test Sales Units

Test Ref Sales Units Test 1 Test 2 Test 3 Total 333.33 333.33 333.33 1,000.00 Test Sales Units Test 1 Test 2 Test 3 Total 0.00 Sales Units Normalized Test 1 Test 2 Test 3 Total 0.000 0.000 0.000 0.000

Regression Statistics
Simple Elasticity (log-linear regression) Elasticity Regression equation: Sales_Units/Ref_Sales_Units = (Price/Ref_Price)^Elasticity Generalized Elasticity Elasticity Coefficients 1 2 Generalized Elasticity #VALUE! #VALUE! Std Error Coefficients 1 2 #VALUE! #VALUE! R squared #VALUE! #VALUE! Std Error Elasticity #VALUE! R squared #VALUE!

Price 1 Price 2 Price 3 Price 4 Price 5 Regression equation:

#VALUE! #VALUE! #VALUE! #VALUE! #VALUE!

Sales_Units/Ref_Sales_Units = (Price/Ref_Price)^Elast1 + (Price/Ref_Price)^(2*Elast2)

ABC, Inc. Widgets Price Test with Standard Product Sales Predictions
Shaded cells are input cells. You can enter data in them. Excel formulas in shaded cells are starting suggestions. You can overwrite them. Genearalized Elasticity? TRUE

Sales Predictions
Prediction Prices Price 1 Price 2 Price 3 Price 4 Price 5 $90 $95 $100 $105 $110 Predicted Sales Units Price 1 Price 2 Price 3 Price 4 Price 5 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! Predicted Revenue Price 1 Price 2 Price 3 Price 4 Price 5 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!

Sales Units = Reference_Sales_Units * (Prediction_Price/Reference_Price)^Units_Elasticity

Cost and Margin Predictions

Predicted Costs Price 1 Price 2 Price 3 Price 4 Price 5 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! Predicted Margin Price 1 Price 2 Price 3 Price 4 Price 5 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! Predicted Margin % Price 1 Price 2 Price 3 Price 4 Price 5 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!

Cost = Reference_Cost *(Predicted_Sales_Units/Reference_Sales_Units)^Cost_Elasticity

Cost Parameters
Reference Sales Units 1,000.00 Reference Cost $72,000.00 Cost Elasticity 0.70

ABC, Inc. Widgets Price Test with Standard Product Formulas

Variable Company_Name Cost_Elasticity Non_Constant_ElasticityQ Non_Constant_ElasticityQ_plt Predicted_Costs Predicted_Margin Predicted_Margin_pct Predicted_Revenue Predicted_Sales_Units Prediction_Prices Prediction_Units_Factor_NonConst Product_Name Reference_Cost Reference_Price Reference_Sales_Units Test_Elasticity Test_Elasticity_NonConst Test_Elasticity_NonConst12 Test_Ln_Prices_Normed Test_Ln_Prices_Normed_Sq Test_Ln_Sales_Units_Normed Test_Name Test_Prices Test_Prices_Normed Test_R_squared Test_R_squared_NonConst Test_Ref_Sales_Units Test_Sales_Units Test_Sales_Units_Normed Test_StdError_Elasticity Test_StdError_Elasticity_NonConst Display As Company Name Cost Elasticity Genearalized Elasticity? Genearalized Elasticity? Predicted Costs Predicted Margin Predicted Margin % Predicted Revenue Predicted Sales Units Prediction Prices Prediction Sales Units Factor Product Reference Cost Reference Price Reference Sales Units Elasticity Generalized Elasticity Elasticity Coefficients Ln Prices (Ln Prices)^2 Ln Sales Units Name of Test Prices Prices Normalized R squared R squared Test Ref Sales Units Test Sales Units Sales Units Normalized Std Error Elasticity Std Error Coefficients Tests Global Non_Constant_Terms Roll-up: Test_Sales_Units/Test_Ref_Sales_Units Data: linest(2, 1, false, ranged("Tests", Test_Ln_Sales_Units_Normed), ranged("Tests", Test_Ln_Prices_Normed)) Data: linest(2, dimitemnum("Non_Constant_Terms"), false, ranged("Tests", Test_Ln_Sales_Units_Normed), ranged("Tests", Test_Ln_Prices_Normed), ranged("Tests", Test_Ln_Prices_Normed_Sq)) Tests Tests Global Global Data: round(1.1*prevde(1.1^(-0.5*length(ranged("Tests", Test_Prices)))*Reference_Price, "Tests"), 0) Data: Test_Prices/Reference_Price Data: linest(3, 0, false, ranged("Tests", Test_Ln_Sales_Units_Normed), ranged("Tests", Test_Ln_Prices_Normed)) Data: linest(3, 0, false, ranged("Tests", Test_Ln_Sales_Units_Normed), ranged("Tests", Test_Ln_Prices_Normed), ranged("Tests", Test_Ln_Prices_Normed_Sq)) Global Predictions Non_Constant_Terms Tests Tests Tests Data: linest(1, 1, false, ranged("Tests", Test_Ln_Sales_Units_Normed), ranged("Tests", Test_Ln_Prices_Normed)) Data: var(Test_Elasticity_NonConst12["Non_Constant_Terms.1"]+2*Test_Elasticity_NonConst12["Non_Constant_Terms.2"]*ln(Prediction_Prices/Reference_Price), "Predictions") Data: var(linest(1, dimitemnum("Non_Constant_Terms"), false, ranged("Tests", Test_Ln_Sales_Units_Normed), ranged("Tests", Test_Ln_Prices_Normed), ranged("Tests", Test_Ln_Prices_Normed_Sq))) Data: ln(Test_Prices_Normed) Data: Test_Ln_Prices_Normed^2 Data: Ln(Test_Sales_Units_Normed) Global Non_Constant_Terms Predictions Predictions Predictions Predictions Predictions Predictions Predictions Data: True Data: Non_Constant_ElasticityQ Data: var(Reference_Cost*(Predicted_Sales_Units/Reference_Sales_Units)^Cost_Elasticity) Data: Predicted_Sales_Units*Prediction_Prices-Predicted_Costs Data: Predicted_Margin/Predicted_Revenue Data: Prediction_Prices*Predicted_Sales_Units Data: var(Reference_Sales_Units*if(Non_Constant_ElasticityQ, exp(Prediction_Units_Factor_NonConst), (Prediction_Prices/Reference_Price)^Test_Elasticity)) Data: 5*round(minr(ranged("Tests", Test_Prices))/5+(dimitemnum("Predictions")-2)*(maxr(ranged("Tests", Test_Prices))-minr(ranged("Tests", Test_Prices)))/diminfo("Predictions.", 6)/5, 0) Data: var(ln(Prediction_Prices/Reference_Price)*Test_Elasticity_NonConst12["Non_Constant_Terms.1"]+ln(Prediction_Prices/Reference_Price)^2*Test_Elasticity_NonConst12["Non_Constant_Terms.2"]) Dimension Index Formula / Data

ABC, Inc. Widgets Price Test with Standard Product Labels

Variable Company_Name Cost_Elasticity Display Label Company Name Cost Elasticity Comment Name of the company or organization doing the pricing test The elasticity of cost with respect to changes in units sold; that is, the price sensitivity of costs to unit sales. The cost used in the model can be cost of goods or operating cost, depending on what kind of profit margin you want to measure. Controls whether simple constant elasticity method or the generalized elasticity method is used to predict sales based on price. Enter 'True' or 'False'. The generalized elasticity method builds on constant elasticity by adding nonlinear terms (quadratic in ln(price)) to the elasticity factor. Non_Constant_ElasticityQ_plt Predicted_Costs Predicted_Margin Predicted_Margin_pct Predicted_Revenue Predicted_Sales_Units Prediction_Prices Prediction_Units_Factor_NonConst Product_Name Reference_Cost Reference_Price Reference_Sales_Units Test_Elasticity Test_Elasticity_NonConst Genearalized Elasticity? Predicted Costs Predicted Margin Predicted Margin % Predicted Revenue Predicted Sales Units Prediction Prices Prediction Sales Units Factor Product Reference Cost Reference Price Reference Sales Units Elasticity Generalized Elasticity The cost incurred when sales units equal the reference amount (Reference_Sales_Units) The reference price at which we know that sales units equal Reference_Sales_Units The number of units sold when the price is the reference price (Reference_Price) Elasticity of sales units with respect to changes in price, estimated from pricing tests Elasticity of sales units with respect to changes in price, as a function of price level. Estimated from pricing tests. Note on definitions: Price elasticity it defined by the local relationship of sales units and price: elasticity = price/units * d(units)/d(price). Only in the case of constant elasticity does this imply the well-known relationship units = constant * price^elasticity over a range of prices. Test_Elasticity_NonConst12 Test_Ln_Prices_Normed Test_Ln_Prices_Normed_Sq Test_Ln_Sales_Units_Normed Test_Name Test_Prices Test_Prices_Normed Test_R_squared Test_R_squared_NonConst Elasticity Coefficients Ln Prices (Ln Prices)^2 Ln Sales Units Name of Test Prices Prices Normalized R squared R squared Coefficients that define non-constant price elasticity of sales units with respect to changes in prices, estimated from pricing tests Ln(Test_Prices / Reference_Price), for use in the regression equation Ln(Test_Prices / Reference_Price)^2, for use as quadratic term in nonlinear regression equation for price elasticity Ln(Test_Sales_Units / Reference_Sales_Units), for use in the regression equation A name that uniquely identifies this pricing test The prices used in the various pricing tests The ratio (test price)/(reference price) for each test market. The log of this variable is used in the regression equation to compute elasticity. The coefficient of determination (commonly known as r-squared) for the regression of log units versus log prices in test markets The coefficient of determination (commonly known as r-squared) for the regression of log units versus log prices in test markets Controls whether simple constant elasticity method or the generalized elasticity method. Used for graphs. The predicted costs for each level of unit sales predicted by the price elasticity and cost elasticity analyses The predicted profit margin (e.g. contribution margin or operating margin) at each price level using the predictions for sales units and costs The predicted profit margin percentage, defined as (profit margin) / revenue, for each prediction price level The predicted revenue at each price level using the predictions for sales units The predicted sales units at each price level The prices at which sales units of the product are predicted The prediction factor for sales units at each price level

Non_Constant_ElasticityQ

Genearalized Elasticity?

Test_Ref_Sales_Units Test_Sales_Units Test_Sales_Units_Normed Test_StdError_Elasticity Test_StdError_Elasticity_NonConst Dimension (item) Non_Constant_Terms 1 2 Predictions Price_1 Price_2 Price_3 Price_4 Price_5 Tests Test_1 Test_2 Test_3

Test Ref Sales Units Test Sales Units Sales Units Normalized Std Error Elasticity Std Error Coefficients Display Item As Non-Constant Terms 1 2 Predictions Price 1 Price 2 Price 3 Price 4 Price 5 Tests Test 1 Test 2 Test 3 Total Tests Tests Total Predictions Predictions Total As Total Level As Non-Constant_Terms Nonlinear_Order

The reference sales units that can be sold in each test market when the price is the reference price (Reference_Price) The sales units measured at the test price in each test market in the pricing test The ratio (test sales units)/(test reference sales units) for each test market. The log of this variable is used in the regression equation to compute elasticity. The standard error of the estimate of the elasticity from the market test The standard error of the estimate of the elasticity from the market test Comment

A list of the price levels at which sales units are predicted from the market test data

A list of the test markets where the pricing test is performed