Sibling Rivalry

By John Dawes

August 17, 2009

Cutting prices to attract more buyers is always a risky proposition. You never know whether you’ll get enough additional buyers to make up for the lost revenue.

But when trying to decide whether to offer discounts, too many managers miss another part of the puzzle: the impact on sales of other products they sell.

Here’s the problem: Say a company owns three brands of shampoo. A discount on one of those brands is likely to draw some customers away from the other two. So even if a price promotion boosts the company’s revenue from the discounted brand, that gain will be offset to some extent by the lost sales of the other two brands. And if the company loses revenue on the discount for the first brand, its losses will be worsened by the drop in revenue from the other brands.

The Disappearing Margin
That means it’s essential for the manager who runs a portfolio of brands to calculate the effect a price promotion would have on the entire portfolio, not just the effect on the brand being discounted.

Consider this theoretical example: A company sells a product that is normally priced at $10. To promote sales, it decides to temporarily lower the price 10%, to $9. The result is a 30% increase in unit sales.And that gives a 4% boost to the amount of money the brand contributes toward profits—the so-called contribution margin, which is revenue minus variable costs.

Now let’s assume the company owns a second brand in the same product category, and it’s also normally priced at $10. Some people who normally buy this second brand will switch to the discounted brand during the price promotion.

If this second brand has, say, a 5% market share, then we can assume that about 5% of the increased sales for the discounted brand will come from the second brand. The result: We calculate that the decline in sales for the second brand will offset nearly 40% of the gain in the amount the discounted brand contributes to profits. If the second brand has a market share of 10%, its lost sales will offset about 80% of the gain in the discounted brand’s contribution.

In either case, the company might opt to proceed with the promotion, because it will still come out ahead. But if the second brand has a market share of 15% or more, the company would end up losing money on the promotion. And deeper discounts, or less price elasticity, could make things worse.

For instance, if the company in this example chose a 15% discount instead of a 10% discount, we calculate that the gain in the discounted brand’s contribution to profits would drop by half. The loss of sales for the second brand, even at just a 5% market share, would result in a net loss for the promotion.

If the second brand had a 10% market share, the net loss would be larger—and so on for higher market shares.

Price and Demand
Another key variable is price elasticity—the extent to which a change in price affects demand for a product. These scenarios all assume the price elasticity of the products is in the middle of what we consider the likely range. If we assume the products’ price elasticity is at the lower end of that range—meaning demand doesn’t respond as strongly to changes in price—then price promotions become even riskier.

Going back to our original example, we calculate that a 10% discount would result in a 4% decline in the contribution to profits from the discounted product. And lost sales from the second brand would worsen the company’s net loss from the promotion.

The bottom line: Discounter beware. A careful analysis of how any price promotion affects all of a company’s brands will prevent a costly mistake.

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