This is often a question asked by business owners and managers. Businesses ultimately want to maximize profit, but the reality is that many owners and managers make pricing decisions based on the need to covers costs, the profit margin they desire, and gut instinct. Although very valid factors to take into consideration, these ideas alone can get you into trouble.
DON’T LET THIS HAPPEN TO YOU!
For example, CEO of JC Penny, former head of Apple retail stores and VP of merchandising at Target, Stanford grad, and Harvard MBA, Ron Johnson was looking to maximize profit by increasing in store sales.Taking the idea from a study that concluded that consumers respond strongly to sales and discounted prices, he decided to implement a strategy similar to Walmart’s to offer goods “at everyday low prices.” His thought was that if goods are on sale all the time that this would boost sales.
The strategy failed epically, causing JC Penny’s stock price to drop by 60%. With same-store-sales dropping 32%, it reported a net loss of $985 million dollars in revenue for 2012. Some say it was the worst quarter in retail history and not surprisingly CEO Ron Johnson lost his job. As you can see, it can happen even to experienced executives from the Ivy leagues.
What happened, as a study revealed, was that consumers weren’t aware of the prices that they purchased goods at compared to the prices of other competitors. All the consumers knew was that JC Penny’s prices were lower, not that they were the cost leader of all the products they sold, like Walmart does. Therefore, lowering the prices didn’t incentivize consumers to shop more at JC Penny because of an awareness issue. By having goods “on sale” all the time, this eliminated the urgency for consumers to want to clear the shelves of those deals because they knew they could get it whenever they wanted. Additionally, Ron’s strategy eliminated the leverage that “anchoring” has on consumers’ minds – that is when you display the regular price in contrast to the sale price. It provides a reference point for the consumer to assess if they are getting a good deal. Without that how would consumers know they are getting a good deal if they are not aware of price points in general?
What Ron should have done, is run a pilot or experiment to test his theory. From this he could have seen his strategy didn’t work and modified his strategy. In this pilot we would have liked to see Ron select a few stores to sell at the “everyday low price” to get an idea of what demand would be like compared to previously.
From the new data, he would have been able to plot a simple customer demand curve.Then using the midpoint formula from economics, calculated the elasticity of demand.
What that means is how much do customers react to a price change. The degree of elasticity that would have resulted would have been less than 1, meaning Ron would have seen that demand was inelastic, or that people’s buying behavior did not increase substantially with the new price drop.
If the demand curve had a result greater than 1, then it would mean that demand was elastic and that consumers would respond enthusiastically to the price drop.
Calculating elasticity would have armed Ron with the necessary information to forecast revenue. To demonstrate, he would have to take the current price (P1) and multiply by the quantity sold (Q1) to establish what his starting revenue was. Then he would do the same thing at the new price point (P2 * Q2).
As you can see per the inelastic demand curve, at the original price JC Penny’s revenue drops by 10%, but then sales only increase 4%, so as a result -10%+4%= -6% loss in revenue, hypothetically speaking. The drop in price was not sufficient to boost sales and cover the loss.
On the other hand, if JC Penny’s demand curve was more elastic, like the graph above, then the 10% drop in price would have been more than covered by the 20% gain in sales, resulting in a profit gain of 20%-10%=10%.
By calculating elasticity and forecasting revenue using the elasticity of demand curve, Ron could have saved JC Penny from losing revenue and kept his job.
What do you think Ron should have done instead?
Price Match Program
One possibility is Ron could have started a price match program. The program would signal to customers that they could always get the best deal at JC Penny boosting confidence and trust in their brand. Additionally, not all customers would remember to use the program and therefore preventing all sales occurring at the margin and giving JC Penny the opportunity to still sell items for a larger profit margin than at rock bottom. Best Buy, Target, and Toys R’ Us have had much success with this. And in fact, this is something that JC Penny subsequently ended up doing.
Remember the story of JC Penny when deciding to change your pricing strategy. Using tools such as pilot programs and demand curve elasticity can help you properly forecast future revenue and develop a winning pricing strategy.
Photo “577181671RR065_TechCrunch_D” by TechCrunch. September 23, 2015. https://www.flickr.com/photos/techcrunch/21474941780
Photo “Oak Hollow Mall – JCPenney going out of Business” by Mike Kalasnik. May 15, 2011. https://www.flickr.com/photos/10542402@N06/5725312122