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2013 No. 04

Pricing management Preserving margins and boosting demand





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EDITORIAL BOARD Marco Trombetta Vice-Dean of Research IE Business School Manuel Fernández Nuñez Business Development Director Consumer Products & Retail Ernst & Young Margarita Velásquez General Director IE Foundation Fabrizio Salvador Senior Academic Advisor IE Foundation Alfonso Gadea Project Director IE Foundation


Greetings Dear friends: One of IE Business School’s goals is to be an international center of excellence for research in all areas of management. We pursue this goal in close collaboration with the IE Foundation and the recently established IE University. I would like to present a new initiative of the IE Foundation and IE Business School. We hope it will provide an innovative way to share the results of the joint work of our scholars and partner organizations. The initiative, “IE Foundation Advanced Series on Problem Driven Research”, aims to provide support to organizations facing the new economic structure, featuring unique market rules. Recognizing the importance of retailing for assessing the current situation and the social expectations, we have chosen the “Consumer Goods & Retail” series as our maiden work. The IE Business School seeks to create an environment where we can develop the best talent, while at the IE Foundation we seek to close the loop between the school and businesses by fostering sustainable relationships through the organization. We are confident that this initiative will meet the challenge and offer a new perspective on the issues.

Marco Trombetta Vice-dean of Research at IE Business School Vice-dean Coordination and Research IE University





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Lead researcher IE Foundation cover letter Ernst & Young cover letter Executive Summary 01 Importance of pricing management 02 Managing prices in a downturn 2.1 Tactics: Speed is crucial, but so is control 2.2 Products: Selective management of product-level prices 2.3 Strategy: How low can you go?

03 Multichannel pricing management 3.1 Channel-based price differentiation 3.2 When to differentiate prices 3.3 Price matching 3.4 Open-ended questions

04 Ernst & Young viewpoint

Acknowledgements We would like to thank the Consumer Goods & Retail sector professionals who gave up part of their valuable time to help us with this study through the pricing management surveys.



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Lead researcher


Prof. Martin Boehm

Dean of Programs and Professor of Marketing at IE Business School Martin Boehm is the Dean of Programs and Professor of Marketing at IE Business School in Madrid. He previously served as the Associate Dean of Undergraduate Studies at IE University and the Associate Dean of the Master in Management at IE Business School. Martin’s intellectual interests center on Customer Management. His research provides managerial implications on how to build profitable and long-lasting customer relationships. His primary concern is to quantify the impact of various customer management activities on a customer’s lifetime value – the net present value of the stream of future profits expected over a customer’s lifetime. At the same time, he develops analytical models to estimate or approximate a customer’s lifetime value. As a consultant he works primarily with firms in the financial services industry to provide them with a roadmap for growth. Martin is teaching across IE’s Master in Management, MBA, Executive MBA, and PhD programs. Prior to joining the IE Business School faculty, he studied International Business at Reutlingen University of Applied Sciences and received a Master of Business Administration from the Australian Graduate School of Entrepreneurship. He completed his academic education with a Doctorate in Marketing which he obtained from the Johann Wolfgang Goethe-University in Frankfurt.



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Rafael Puyol

Vice-President, IE Foundation

Margarita Velásquez

Director General, IE Foundation


Among its primary activities, IE Foundation supports the research and the knowledge sharing endeavors of IE Business School’s professors. Through its initiatives IE Foundation contributes to the positioning of IE Bvusiness School as a center of excellence for innovation, and for the creation of knowledge targeted at its productive environment. The IE Foundation aims to create strong ties and alliances with prestigious, public and private, institutions, particularly those in the business domain that can help propel our researchers’ initiatives. As an institution that pursues excellence, research activities are driven by academic rigor and the utilitarian nature seeking to create knowledge. We aim to push innovation and competitiveness to provide answers to the challenges and needs of society. This publication is part of the IE Foundation’s collection on Consumer Goods and Retail, developed in collaboration with Ernst & Young. We would like to extend our gratitude to them for their commitment and their vast experience on this matter. The collection has been designed with the purpose of analyzing the key aspects of the industry through a practicedriven, up to date perspective on key aspects of the industry such as Sustainability, Information Security, Pricing, and Profit Protection. We are in the midst of a major change in the retail industry. The challenge many Spanish organizations face, is being at the forefront of such change and benchmarking best practices in the global market. The IE Foundation looks forward to helping organizations in this process. We hope that this publication will be of interest to you, and we appreciate your support.


José Luis Ruíz Expósito

Partner and Head of Consumer Goods & Retail Manuel Fernández

Business Development Director Consumer Goods & Retail

Consumer Products and Retail companies are developing their business in a much more complex and volatile environment than they have in the past. In this environment, companies’ actions focus on transforming their business processes and protecting their operational margins. In its commitment to innovation and value creation, Ernst & Young has propelled research projects on the issues that will help companies deal with today’s industry challenges. Our research takes into account different actions regarding price dynamics from a brand differentiation perspective. Secondly, we take on the negative economic effect of shrinkage with an analytical approach, to identify its root causes and suggest corrective actions for its mitigation (profit protection). We also seek ways to preserve the information security of an industry that operates, with an increasing frequency, in mobile scenarios and technologies. Finally, we propose the adoption of a business commitment perspective, betting on sustainable initiatives from retailers that take into account manufacturers and consumers. These four areas are experiencing a large change in process. Ernst & Young and the IE Foundation are approaching these challenges from an innovative perspective with the intention of putting them into practice and creating value for the business environment.



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Executive Summary



A range of factors are squeezing business margins, such as decreased consumer spending, increased market transparency via internet and low-cost competition from emerging industrial powers, like China. Executives must focus on pricing, because they can no longer rely on sales growth and inflated mark-ups. As companies’ most powerful profit lever, pricing is the most effective way to boost profits. Before companies can attempt to improve profit by raising

Prices should be managed selectively at product level.

or lowering prices, they need to know what consumers are

Companies should avoid overly aggressive or broad price cuts

willing to pay. Unfortunately, most executives don’t have

when demand is soft. Prices should be adapted for products

the knowledge to make an informed decision. As a result,

that are seeing demand fall. Companies need to identify

management teams often take the easy road; they resort to

demand-sensitive “pockets,” such as customer segments,

cutting prices. A sudden and prolonged drop in prices changes

product lines or usage.

customer and competitor behavior. Companies have to act quickly, even though solid information is hard to come by. However, pricing decisions made now are likely to affect consumers’ perceptions for a long time to come.

Prices must be managed strategically. Companies need to consider where they want their prices to be within three years and not rely on continual discounts to sustain volumes. Longterm, continuous discounts hurt the brand. Companies aiming

In a recession, pricing must be managed on three levels: create

to set prices strategically must try to anticipate what moves

a pricing strategy that is aligned with the company’s broader

their competitors will make in the future.

objectives and positioning, set prices on individual products and deploy disciplined tactics to manage the aspects of the transaction that most affect profitability.

Different segments are willing to pay different prices. Therefore, price differentiation can be a profitable pricing strategy. Multichannel pricing has also become a more

As for tactics, successful companies: 1) assess the impact of

widespread strategy among manufacturers and retailers.

pricing moves based on point-of-sale data, and 2) identify

Different assessments of channel and price sensitivities can

hidden sources of revenue leakage. Discounts offered by

enable a company to implement channel-based pricing.

employees in a bid to up market share can lead to hidden profit leakage. One way for a company to increase its profit is by managing the “price waterfall,” from list price down to the transaction pocket price.

Professionals often advocate equal prices across distribution channels to maintain brand strength. However, the profit opportunities are too big to ignore.



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1. Importance of pricing management Few times since the end of WWII has there been such downward price pressure. Part of this pressure is the result of economic factors (e.g., recession in western economies and Japan), which have dampened consumption. However, pressure is also stemming from new sources. The sharp increase in purchasing power of retailers like Wal-Mart or Mercadona places pressure on suppliers. Meanwhile, internet has increased market transparency, making it easier for shoppers to compare prices. China and other emerging industrial powers are also playing a big role, as their lower unit labor costs have lowered the prices of manufactured goods. The double cycleprice whammy has eroded companies’ price-setting power, causing executives to look all around for ways to maintain margins. A Global Pricing Study, co-directed by IE Business School, shows that 93% of Spanish companies have faced increased pricing pressure over the past two years.


Figure 1: Dramatic increase in pricing pressure 93%
























More aggressive customers and competitors. More than 9 out of 10 companies feel increased pricing pressure. Main reasons: • Customers demand higher discounts (53%) • Lower-price competitors / new market entrants (50%) Source: 2012 Global Pricing Study. Simon-Kucher & Partners, IE Business School, Alimarket



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Specifically, our study on Spanish companies in the Consumer Goods & Retail sector shows that the majority are operating in an industry with falling market prices. 76% of those surveyed said that prices in their industry have fallen in the last year. 21% even said prices had fallen by more than 10%.

Figure 2: How have average prices in your sector changed in the last quarter compared to the year before? 21% Slight increase (between 0% and 10%)

21% Considerable decrease (between 10% and 20%)

3% Stable

55% Slight decrease (between 0% and 10%)

Source: own research

Stiffer competition is one of the key drivers behind the declines in prices in various sectors of the Spanish economy. Most of those surveyed in our study said they are doing business in an increasingly hostile market environment. Competition is not focused on margins. Rather, companies are fighting fiercely for volumes and market share.

Figure 3: How would you assess your environment / company? Competitors focused on profit maximization

Competitors with aggressive pricing strategies

++ Price

Source: own research

+ Price


+ Profit

++ Profit



Executives need to focus more on prices now than ever

1% decrease in direct variable costs (e.g., raw materials, direct

before. They can no longer count on the double-digit sales

labor) and three times the impact of a 1% increase in volume.

growth and wide margins they had in the 1990s to cope with a price deficit. What’s more, many companies just can’t lower operating costs any further. As a result, pricing is one of the few levers they can still tap to increase revenues. Those just starting out now should be poised to reap the full benefits of the recovery when it comes.

Regrettably, there is also a downside to pricing. A 1% decrease in average prices has the opposite effect, ceteris paribus, reducing operating profit by the same 8%. Executives may hope that lower prices will lead to higher volumes and offset the lost revenue, but that doesn’t usually happen. Continuing with our study of typical S&P 1,500 figures, volumes would

Appropriate pricing is the fastest and most effective way to

have to increase by 18.7% to make up for the impact on profit

increase profit. Taking the average income statement of S&P

of a 5% price reduction. Such a degree of demand elasticity

1500 companies, a 1% increase in prices would result in an

to decreases in prices is rarely seen. A price-cutting strategy

8% increase in operating profit assuming volumes remain

to raise volumes and, by extension, profits is destined to fail

unchanged. The impact is nearly 50% greater than that of a

in any market or industry.

These statistics illustrate the potential impact of optimum pricing on a company’s net revenue. A small shift in prices can cause a large shift in income. Nevertheless, before attempting to increase profit by raising or lowering prices, companies need to understand and anticipate how consumers will respond to a change in a product’s price. It’s too bad that so many companies seem to be unable to appreciate a consumer’s willingness to pay the optimum prices. When asked if they were “well informed” about six potential factors in pricing, the executives of a leading US multinational said:

Figure 4: % of well-informed executives about... Variable costs


Fixed costs


Competitors’ product prices


Value attached to the product


How customers would react to a change in prices Willingness of a customer to pay different price levels

34% 21%


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These executives were well informed about

In the same vein, our research on Spanish companies

the costs of their products and the prices of

indicated that less than half based their pricing

competitors’ products. They were well informed

strategies on using the willingness-to-pay function.

about the products’ value. However, they did not

The majority (67%) follow a simple cost-base

know enough about customers’ willingness to pay

approach. However, a pricing strategy based on costs

or their response to potential changes in prices to

results in either lost profit or out-of-market pricing.

set optimum prices. Experience shows that this company is not alone.

Figure 5: What pricing approaches does your organization apply to set prices for clients? (multiple choice)

A mark-up on product costs


Relation with competitors’ prices


A function of elasticity or the customer’s willingness to pay


Source: own research


Similar research shows that executives view price-related issues as a real headache. It appears that prices cause more headaches or sleepless nights than any other marketing decision.

Figure 6: Pricing complexity Prices give marketing directors headaches Question: What is your biggest concern? Prices


Product differentiation


Product quality


New competitors




After-sales service




Source: The Strategy and Tactics of Pricing - Pricing and the Bottom Line, Martin Boehm

This report is designed to reduce some of Spanish companies’ headaches and more pressing issues. Two issues that most companies are dealing with are the economic environment and the advent of internet. In the following pages we offer some tips on how to tackle these two issues.




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2. Managing prices in a recession Confronted by weakening sales and excess capacity, management teams often resort to cutting prices. It’s easy to see why. Price cuts are quicker and easier to implement than, say, introducing new products or improving service levels. Customers often respond immediately to lowered prices. A swift uptick in sales can reinforce executives’ belief that they did the right thing. But there’s a reason promotional price cuts are sometimes called “management heroin.” Price cuts are addictive. Customers quickly develop a craving for big discounts and an aversion to full prices. Companies grow accustomed to the boost in volume and hesitate to raise prices to previous levels for fear that revenues will crater. In a deep recession, when the first goal is survival, some businesses have no option but to cut prices aggressively. But even relatively strong companies experiment with heavy discounts and then wake up to find themselves hooked. Is there an alternative? The truth is, most companies do need to lower prices in a downturn, whether they sell primarily to businesses or to consumers. Demand is down, yet fixed capacity and costs haven’t changed much. So the laws of supply and demand exert strong downward pressure on prices. Still, the range of outcomes can vary widely in both the short term and the long term. What matters most is how effectively companies manage pricing.


Unfortunately, yesterday’s pricing textbook isn’t

the transaction that most affect profitability. A severe

much help with today’s conditions. A sharp, prolonged

downturn presents challenges on all three levels. Pricing

downturn creates a volatile new environment, altering

strategy must address stark differences between the

the behavior of both customers and competitors.

right short-term answers and the long-term health

Companies have to act quickly, even though solid

of the business. Pricing of individual products need to

information is hard to come by. And pricing decisions

reflect dramatic changes in the ways customers make

made now are likely to affect consumers’ perceptions for

purchasing decisions. Tactics must be carefully designed

a long time to come. Few companies in any industry can

and choreographed to let companies execute quickly

say, “We’ll lower prices today and raise them tomorrow,”

without losing control.

at least not without risking a severe customer backlash.

In a normal business environment the best course is

In our experience, companies that get pricing right

almost always to map out your strategy first, then to set

manage it at three levels. They create a pricing

prices for individual products, and finally to design the

strategy that fully supports their broader objectives

suite of tactics that will allow you to execute profitably.

and positioning. They set prices on individual products

But in a recession, time is compressed and tactical

to reflect value to both buyer and seller. And they

decisions take on new importance and urgency. So, we’ll

deploy disciplined tactics to manage the aspects of

start there.



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2.1 Tactics Speed is crucial, but so is control Customer behavior, market and competitors’ actions can all change quickly in a downturn. Executives find that previous assumptions are obsolete and they act faster than ever to adapt. But when companies accelerate tactical pricing moves without accurate information about the real effects of those moves, they can lose control of the prices customers actually pay. The most effective companies typically take two steps to avoid this danger: (1) they quickly assess the impact of pricing moves by gathering lots of fast, fresh point-of-sale data, and, (2) they maximize control by identifying and managing the hidden sources of revenue leakage. Most companies rely on a host of discounts, promotions and other pricing tactics to boost sales and earnings. In a downturn, it becomes essential to analyze which really work and which waste money. The actions flowing from this kind of analysis not only shore up the bottom line, they also lay the groundwork for more effective pricing in the future. One specialty retailer, for example, carried fifty thousand SKUs per store –as much variety as a large supermarket- and relied on promotions to drive a significant portion of sales. When the retailer put its promotions under the analytic microscope, however, it found that discounts on some items had virtually no effect on sales. It also discovered that some forms of promotional pricing were far more profitable than others, even if the costs were similar. Customers loved two-for-the-price-of-one offers, for instance, yet were less impressed with 50%-off sales. The retailer also has relearned the importance of seasonality in pricing tactics. Discounting a highly seasonal product –patio furniture for instance- at the very beginning of the selling season typically attracted a large number of shoppers looking for bargains. Discounting the same item at any other time of the year was essentially fruitless,


because shoppers were more willing to pay full price. After analysis, the store modified or eliminated only 10% of its promotions overall. But that 10% yielded a boost in profitability of 15% to 20%, while sales volume declined less than 2%. The faster you can gather this data and act on it, the more likely you can stay in touch with changing customer needs or preferences. One food-products company, for instance, built quantitative tools that analyzed sales data from competitors along with its own operations every week. Managers could track the relationship between price points and volume and spot the gaps between the company and its competitors. They linked promotional tactics to sales volume, compared actual to predicted results, and adjusted their demand models on a weekly basis. In an industry where monthly sales data and quarterly adjustments were standard, the weekly data helped the company adapt much faster than competitors to changing conditions.



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Our study of Spanish companies showed that the vast majority (88%) collected data on competitor prices. Both of the examples above provide clear evidence that companies need more detailed analysis of their promotional activities. Our study paints a much different picture:

Figure 7: Pricing and promotion practices Question: Indicate to what extent the following statements apply to your company. We study the impact of price thresholds and rounding on customers We use data-gathering tools regularly to determine whether prices are competitive We use data-gathering tools regularly to determine perceived value among customers We have pre-defined volume/ margin targets for promotions We estimate the expected return on promotions through market/ consumer testing Completely disagree Source: own research

Somewhat disagree

Neither agree, nor disagree

Somewhat agree

Completely agree


Less then 30% of those surveyed said they measured

To address the issue, the company sent out a

the impact of promotions on profit. This suggests

short e-mail survey to its sales force asking about

Spanish companies need to hone their price-setting

their discounting and contracting practices. The

skills if they want to remain competitive in an

survey results, along with input from the finance

increasingly global market.

department, allowed managers to simulate the

A downturn increases the pressure on employees to chase or protect volume at any price. Freight terms given by the logistics department, credit terms authorized by finance, free services and accessories authorized by customer care agents -all can create layers of overlapping discounts and hidden leaks that drain away profits. The faster and more aggressively you move on pricing tactics, the more important it is to reassert control. A European machinery manufacturer did just that, with remarkable results. Like many producers of complex products, this company typically realized net prices that were about 55% of list. But those discounts came from a wide range of sources. A product costing €100 might carry several on-invoice discounts totaling €35. Off-invoice terms or incentives

impact of promotional activity and establish guidelines to maximize return on investment. The company also built tracking systems to capture offinvoice trade spending and aggregate the data at the account level to ensure that the company was investing in the most valuable accounts. The result was an increase in earnings before interest and taxes of nearly 20%. Maintaining control of pricing execution requires clear direction to front-line employees about what’s allowed and disciplined processes to find and remedy unauthorized behavior. For big-ticket items, managers need to set clear guidelines for sales scripts and allowable price ranges. They need to have a welldeveloped escalation process for decisions that fall outside company pricing guidelines.

might be worth another €10. Managers had no way

Managers can also ratchet up discipline by tying

of identifying why a particular product was selling

both sales force and channel compensation to price

for less than list, and had little control over which

realization. It’s hard enough maintaining margins

people in the organization were authorized to provide

even in the best of circumstances; in a recession

discounts. Front-line salespeople in particular offered

no company can afford uncontrolled discounting

substantial incentives without oversight by senior

(see section on “price waterfall” for managing


uncontrolled discounts).


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The price waterfall Many companies don’t get a good grip on the broad

pocket price, not the invoice price, is the fair measure

range of factors contributing to final transaction

of the price attraction in a transaction.

price. The table below shows price components for a typical sale by a linoleum asphalt manufacturer to a distributor. The starting point is the list price. From this, a discount for order size and a competitive discount are subtracted, leaving the invoice price.

The table below shows the revenue in the price waterfall from the list price to the invoice price and to the pocket price, or the pocket price waterfall. Each element of the price structure represents lost revenue. A 22.7% decrease from the invoice price to the pocket

In most businesses, especially those that sell products

price is not out of the ordinary. Studies show an average

through distributors, the invoice price does not reflect

decline between the invoice and pocket price of 17%

the real amount of the transaction. There are still several

for packaged consumer goods companies, of 18% for

factors that come into play between the invoice price

chemicals companies, 19% for IT companies, 20% for

and the final cost of the transaction. These include:

footwear companies and 22% for car makers.

discounts for early payment, for volume purchases and cooperative advertising. When the lost revenue caused by these specific elements of the transaction is subtracted from the invoice price, what’s left is the “pocket price” (or final price): how much revenue is really

Companies that do not manage the entire price waterfall actively and, as a result, suffer from multiple and highly volatile revenue leaks, miss out on any opportunity to achieve better pricing.

left in the company’s pockets after the transaction. The

Figure 8: Each element in the price waterfall represents a revenue leak (euros per m2) 6.00€

Manufacturer’s list price

6.00 Order discount

0.12 Competitive discount


Invoice price

0.30 Discount for payment terms

0.37 Volume rebate

22.7% off-invoice 0.35 Offinvoice promotions


Cooperative advertising

0.09 Freight


Pocket price


Pocket price band: At any given point in time, the

Understanding the variation in pocket price bands

pocket price of an article is not the same for all

is essential for a company to exploit the best pricing

customers. Rather, articles are sold within a range

opportunities of a transaction. Executives that can

of prices. This range, for a unit volume of a specific

identify a broad pocket price band and the underlying

product, is called the pocket price band. The following

causes can manage the band better in the company’s

chart shows an asphalt manufacturer’s pocket price

favor. When prices fluctuate in a range of more

band for a single product. There is a 35% difference

than 35%, one could easily assume that appropriate

between the highest and lowest priced transactions.

management could improve the price by several

This pocket price band may seem wide, but much wider

percentage points, benefiting the company.

bands are commonplace.

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Figure 9: Elements of opportunity to benefit from a pocket price band (percentage of volume) 13.4


15.0 13.1 10.1














Pocket prices (€ per m²)








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2.2 Productos

Selective management of product-level prices Falling demand in turbulent times triggers

far as they’re going to. A company needs

a cascade of list-price declines and deep

to understand its customers well enough

discounts off list. Yet many companies

to know which of these factors is more

lower prices too aggressively or too

important. If your customers can afford to

broadly because they fail to answer two

buy but are nervous about doing so, lowering

key questions: Why is demand falling? and

prices may not be the right way to help them

where is it falling most? Answering these

overcome inertia. Rather, companies can

questions requires managers to get inside

find ways-by combining pricing with other

their customers’ heads.

marketing efforts-to send the message that

In a downturn, some consumers and

buying is a low-risk decision.

businesses cut back because they just

Take cars, for example. Plummeting

don’t have the money to spend. Many more

employment doubtless contributed to the

prospective customers have the money but

sharp drop in auto sales in 2008 and early

feel uncertain about the future. Both factors

2009. But fear of job loss probably kept

show up in the price declines that hit the

many more potential buyers out of dealer

transportation sector, for example, where

showrooms. Cars are a big-ticket item, and

average prices fell roughly 13% in the first

most customers can delay purchases by a

few months of 2009. So, which factor should

year or two.

get the greatest attention?

In response, auto companies typically

Spooked consumers won’t buy more until

slash prices in a downturn. Most of the big

they feel that it is safe to do so, or until

players, desperate for sales, did it this time

they decide that prices have dropped as

around. But Hyundai took a different tack.



Recognizing that its customers weren’t likely to respond to the usual rebates or incentives, the Korean car maker announced a plan that would allow customers who lost their jobs to return a new car. The reasoning: A fully employed customer can afford the full-price car nearly as easily as the discounted car. But a customer fearing layoffs is more likely to hold off on big purchases. The strategy is powerful because it addresses what goes on inside a customer’s head, not what goes on in an economics textbook. It carries some risks, but it is not as risky as watching sales plummet-and indeed, Hyundai’s sales were up nearly 5% in the first several weeks of 2009, compared with the same period in 2008. Overall auto sales, meanwhile, had dropped 40%. Rather than relying on highly visible across-the-board discounting, sophisticated pricers find ways to lower average prices in highly selective ways. Almost every company’s business contains “pockets” of real variance in demand- customer segments, geographies, product lines, occasions of use, and so on. In our experience, most companies underestimate how many of these pockets can be addressed effectively through targeted pricing. Faced with a big fourth-quarter sales drop, for instance, L’Oréal recently decided to lure customers with a 20ml “petite” bottle of one expensive perfume, pricing it at $55, compared with $175 for the traditional 100-ml size. The move gave customers a size they could more easily afford but actually created a 57% price hike per milliliter-$2.75/ml versus $1.75/ml.


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Large companies with thousands of products face a significant challenge in pricing appropriately for a downturn. But it’s often possible to apply new pricing rules to categories of products. One European manufacturer of constructionrelated products, for example, had tens of thousands of SKUs. To simplify pricing, it grouped the products into three “buckets.” Bucket #1 included products that were highly differentiated and that customers valued highly. Bucket #3 included commodity-like products over which the manufacturer had little pricing power. In the middle was bucket #2. The company applied cost-plus pricing rules to each bucket, but the “plus” was higher for the buckets with more differentiated or more highly valued products. To gather the necessary data, the company relied partly on internal statistics and partly on its managers, who gathered at workshops to run through lists of products, quickly putting them into one bucket or another. This approach to variable product pricing helped the manufacturer raise its earnings roughly 20%. A company’s options during an acute downturn are determined by its strategic and financial position. A small number of businesses occupy strong positions on both of these dimensions and have truly differentiated products or services, which enables them to maintain price levels. Even then, these companies work hard to deliver higher value for the same price. That can be as costly as cutting prices in the short term, but it preserves pricing integrity for the long term. When Amazon launched the Kindle at $399 in November 2007 ( just before the start of the recession), many analysts thought customers would balk at the price, especially since the Sony Reader was available for $100 less. Instead, the Kindle sold out. The Kindle 2, launched in February 2009 for $359, continued to exceed sales expectations.


2.3 Strategy


How low can you go? While most companies cannot easily hold the line on prices this way, it’s a mistake to lower prices without considering the strategic implications. We must ask ourselves: Where should our prices be in three years? How will short-term actions help us or hurt us on the way to that objective? Aggressive, highly visible discounts, for instance, may cheapen a brand in customers’ minds. It may persuade customers that they paid inflated prices in the past. Slashing prices also

makes it hard to raise prices when conditions improve.

The price/quality relationship: How lower prices hurt brands Research carried out years ago showed that a hosiery

clear however, since the correlation between price

retailer elicited an “enormous” positive response in

and “objective” or actual product quality seemed to

sales by raising its price from US$1 to US$1.14. Appa-

be relatively low. Occasionally higher priced options

rently, consumers felt the higher price was a sign of

were found to be of lower objective quality than low-

a “higher quality”. Such anecdotal evidence of viola-

priced alternatives in the same category. The prevai-

tions of downward sloping demand curves had been

ling wisdom at the time regarding positive price-

observed previously, but dismissed as anomalous.

perceived quality correlations relied on a cognitive

Yet, evidence continued to mount that price might

miser argument. Evaluating more direct (intrinsic)

have attractive as well as aversive properties. In the

information about quality across a bewildering array

economics-oriented literature, as well as in the emer-

of products, each with its own unique set of quality

ging empirical tradition in marketing and consumer

connoting attributes was cognitively daunting, so

behavior, it was becoming increasingly apparent that

most consumers adopted a price-quality heuristic

consumers frequently employed price as a proxy for

because it had worked reasonably well in the past.

product quality. By the end of the 1908s, based on an

That is, consumers consciously chose to rely on the

integrative review of over 40 empirical studies, the

price cut to make quality judgments, because such a

evidence for a robust (though moderate) price-percei-

process was cognitively efficient.

ved quality effect appeared to be incontrovertible.

Therefore, consumers infer low quality from constant

The theoretical basis for this perception, that higher

discounts or low prices. In the long run, constant dis-

prices were associated with higher quality, was less

counts can damage the brand.


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Making the right strategic decisions about pricing can often amount to a chess match. You must consider the whole board and plan several moves in advance. Understanding the market positions of competitors and profit pools in the industry is crucial. But a static view of competitors doesn’t help; you need to anticipate their future actions based on their share of key segments, relative cost position, capacity utilization, and financial health. Your industry structure also plays a key role in determining the pricing strategy that will ultimately maximize your profits. What can you do that your competitors will be unwilling or unable to copy? As we noted earlier, markets are not monolithic, and there will be pockets of opportunity created by high share in one segment or low-cost position in another that allow companies to target the most effective pricing moves. At the same time, companies must be careful not to destroy the profit pool in their industry.

Pricing strategy decisions can amount to a chess match: we must plan several moves in advance and anticipate what moves the competition will make.

Consider the case of a company operating in an industry with high fixed costs and weak competitors. By cutting prices too much, it might risk initiating a price war that is destructive for everyone. One large real estate owner, for example, determined that, while it certainly didn’t want to lose share in a down market, it also didn’t want to gain more than a point or two. Why? Because any scenario in which it gained significant share in the face of falling overall demand would drive competitors to lower prices so much that its own lease rates and profits would plummet.



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Pressure on prices: A problem in Spain? Our survey of leading manufacturers and retailers in Spain shows that most companies (60%) believe they are in a price war. Price wars have racked industry after industry in recent years. All too often, there are no winners. No industry is safe. No company, however well run, is immune. After all, most price wars start by accident, through some apparently trivial misreading or misjudgment of market conditions. Rare is the price war that is initiated as a deliberate competitive tactic.

In the current market, price cuts are driven by a structural situation of demand, although in many cases companies are still looking more at what competitors are doing when establishing prices than at the new price/value relationship demanded by the customer. As a result, the harmful effects of the price war may continue to exist. In sectors like Consumer Goods & Retail, this situation is especially acute because of their unique characteristics and strategic importance. The best way to deal with price wars is to avoid them altogether and, if this is not possible, get out of them as quickly as possible.


Why should we avoid a price war? Numerous studies show that unless a company has a cost advantage of around 30% over another company, competing for the lower price is a suicide tactic. Price reductions are almost always copied immediately. Profits are extremely sensitive even the slightest declines in price levels. Price is the most sensitive lever in business. A real example can be found in S&P 1000 companies. A one percentage-point decline in price can lead to a 12% reduction in profit. Suppose a price war causes a 5% decline in price. Given the marginal contribution of 30% (for the S&P 1000), that means that volume would have to increase by 20% for a company just to break even. This price elasticity of 4 to 1 does not happen in the real world (a 2 to 1 elasticity is found if we’re lucky).

Causes for unwarranted pricing: Complicated statistical or mathematical models are not required to analyze the causes of poorly informed price formation due to the effects of a price war in the traditional sense. Most times, companies get caught up in them because of misreads or misjudgments of competitor actions and market changes. They are rarely started deliberately. Studying the misjudgments, we see that what is really happening in the market is the following: a company cuts prices without disclosing important collateral information (period of the cut and special circumstances) and the response by the competitor is to also lower prices. And so the price war begins and escalates. Competitor A identifies competitor B as the one who started the war and vice-versa.

Is you company currently engaged in a price war? 40% No, we are not in a price war 52% Yes, it was started by a competitor

In fact, our survey of leading Consumer Goods & Retail companies showed that most of them believe the price war was started by a competitor. This is debatable, since most considered themselves to be the price leader. Reckless pricing measures and a strict focus on volume are two of the main causes of price wars. There is widespread lack of knowledge of how much volumes need to increase to make up for

8% Yes, we started it

the price cut and an obsession to win market share, creating a vicious circle of price declines.


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The study conducted by IE Business School showed that 35% of Spanish executives admitted that they are incapable of determining the right volume growth necessary to offset a 5% decrease in price. The remaining 65% that believe they know the right answer could be wrong 80% of the time. The IE Business School Global Pricing Study 2011 revealed a close relationship between a corporate focus on volume and price wars. Markets characterized by the large percentage of companies focused on volume rather than profit are more likely to suffer as a result of a price war. Price wars are, therefore, caused not only by external and uncontrollable factors, but also often because of wrong strategic decisions.

There is a correlation between the focus of a business on sales volumes and price wars. Relationship between the focus on volume and price wars.

Price wars


Few Low

Focus on sales volume


However: for Spanish (and Italian) companies, it seems that volume-orientation is not the only explanation for price wars. Source: 2011 Global Pricing Strategy. Simon-Kucher & Partners, IE Business School, Alimarket

Regarding misjudgments, it is a common belief among company managers that only the lowest-price supplier in a market can ignite a price war. They are mistaken: The culprit can easily be the highest-priced supplier. Consumers do not simply only buy on price; they buy on value (V=Benefit-Price). As a result, a premium competitor can start a chain reaction, triggering a downward spiral in the industry.


How to avoid price wars Some industries run an inherently higher risk than others. Economic theory and our own empirical evidence indicate that when there is a large concentration of big customers in a market, there is greater pressure on competitors. Seven steps have been identified to help avoid a price war: a. Avoid strategies that force competitors to respond with lower prices. Reactions by competitors, coupled with a lack of knowledge or misjudgments, encourage other companies to react incorrectly or overreact. If you want to gain share, do so gradually. b. Avoid all possible misreads. Interpreting market movements is essential. Invest in understanding the competitors’ prices to avoid reacting before understanding the reason behind the price cuts and whether the cuts are proportionate to the consumer’s demand based on price / value. c. Avoid over-reaction as a general rule of thumb. One reason price wars are more prevalent now than in the past is that managers view a price reduction as quick and quickly reversible, when the truth is otherwise. d. Play your value map right. This is another key aspect that is not usually studied correctly. By studying the sensitivity of customers and competitors’ cost structure, the best price can be established. The best price is the highest price the market is willing to bear. e. Communicate your price effectively. This is another key issue, as mentioned previously, to prevent misreads. If we have to cut prices, it is crucial to communicate all the reasons behind it to avoid misinterpretations that result in price wars. f. Jawbone on pricing. In line with the communication mentioned previously, it is important to influence and explain fully the importance and implications of pricing. It helps to speak openly about the horrors of price competition. g. Exploit market niches. While this seems obvious, greater efforts need to be concentrated on exploiting market niches before opting to focus on price as the sole driver of an increase in sales volume.



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3. Multichannel pricing management The website of computer manufacturer Dells asks prospective buyers to declare whether they are a home user, small business, large business or government entity. Two years ago, the price of a 512 MB memory module (part number A0193405) depended on which business segment one declared. At the time, Dell quoted $289.99 for a large business, $266.21 for a government agency, $275.49 for a home, and $246.49 for a small business. What explains these price differences? How does Dell benefit from it? Different segments have different willingness to pay. Dell optimizes its prices, offering lowering prices to relatively price-sensitive segments. An interesting aspect of Dell’s attempt to charge different prices to different customers is that the customers aid Dell in its effort. According to a Dell spokesperson, each segment independently sets prices and the customer is free to buy from whichever is cheapest. This example illustrates that the value is in the mind of the person who values it and different minds value a product differently. To capture this opportunity, companies will discriminate market prices. Price discrimination is a strategy of charging different prices to different customer segments for the same or similar products. In any market, different customers value products differently and, therefore, are willing to pay different amounts for the product. The automobile industry has capitalized on these differences in a very effective manner. Each manufacturer offers a wide variety of models to cater to the preferences of different buyers: from subcompacts to compacts, full-size sedans, SUVs, and sporty cars. Within each category, they also provide numerous options to make the offerings more suited to multiple buyers, who may then pick and choose the options they desire. Similaly, many consumers pay higher prices for electronics items, knowing very well that they will come down significantly over time. And, stores like Gap and Old Navy routinely mark down merchandise after a relatively short time following the introduction of new items; once again, however, many consumers do not hesitate to pay full price. Economic and marketing literature have long recognized that price discrimination can be a profitable pricing strategy. In a market where preferences are mixed and products are viewed differently, companies can boost profits by segmenting consumers and setting different prices, enabling them to extract more from consumers. Empirical research indicates that profit can be as much as 34% higher when companies use price discrimination than when they employ a uniform pricing strategy.


Figure 10: Does your company employ price discrimination? (Multiple choice)

We offer different brands at different prices Prices vary depending on the channel We offer individual and bundled products We offer discounts to certain customer segments Different prices are offered to customers depending on the geographic area We do not engage in price discrimination There are volume discounts We offer different prices to customers depending on the date 10%






In our survey of Consumer Goods & Retail companies, the outcome was that the majority used price discrimination among brands. Many also offered bundles with different prices and discriminated prices based on the channel and customer segment. Among the various types of price differentiation, researchers and professionals have looked particularly at self-selection given its numerous advantages, including low cost and easy application, not to mention its high profitability. In price discrimination by self-selection, a company offers different versions of a product and different prices and allows consumers to choose the one that best suits their preferences.



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The increasing popularity of internet has prompted many traditional retailers to become multi-channel retailers offering consumers the choice between online and offline channels. More and more, Companies are using sales channels without physical stores to increase or complement current processes for delivering products and services. As multi-channel retailing gradually takes over, customers are faced with a wide range of purchasing and communication options. As a result, it is becoming more commonplace for customers to use multiple channels to interact with the company. A study by DoubleClick found that 65% of consumers were multi-channel consumers. Similar research by Forrester Research indicated that more than two-thirds of consumers search for products online, but purchase offline.



Is it a good idea to offer multiple channels? Consumers increasingly like to see products online

of customers using all three shopping mediums grew

before setting foot in the store. Going first to internet,

30% last year, while the number using at least two

they frequently choose what they want before going

jumped 46%.

to the store. However, once they are in the physical store, they usually end up buying some other item.

A recent study by consulting firm J.C. Williams Group showed that J.C. Penney customers who shop just one

After initial worries that the internet would steal

way spend, on average, $150 a year on its internet site,

sales from stores, retailers now are realizing that

$195 in its stores and $201 with the catalog. But Penney

just the opposite is happening. Customers who

customers who shop all three ways spent $887 a year.

“window shop” online are much likelier to spend more

“Any time a customer comes into the store because

overall than those who just go to the store. A study

of the catalog or Internet, there is a high incidence of

by Forrester Research recently found that customers

that customer buying something in the store,” says

who shop three different ways –in stores, on Web

John Irvin, a Penney executive vice president. “This is

sites and with catalogs- spend about four times more

the fastest growing change in customer behavior.”

than customers who shop only through one of those channels. Similarly, customers who shop two different ways spend two to three times more than the singlechannel customer.

The relationship between the use of the channel and profitability is not restricted to the retail sector. A study led by IE Business School on the European financial sector produced several interesting conclusions. The

To take advantage of this behavior, major retailers

results showed that multi-channel customers are far

are looking for new ways to steer shoppers from one

more profitable than single-channel customers. The

channel to another. J.C. Penney, for instance, says it

research also showed different levels of profitability

posts weekly circulars online for customers to use in

between customers using two channels and those

the store. It also offers a broader selection of certain

using three. The results suggest customers should

items, like small appliances, in catalogs to encourage

be encouraged to use two channels, but not three, to

people to shop multiple ways. Penney says the number

interact with the company.


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Given the vast differences between online and offline channels, such as convenience, risk or transparency, customer preferences are mixed regarding the channel, resulting in different perceptions of the channel and price sensitivities. As a result, operating in multiple distribution channels provides an opportunity to apply price discrimination based on channel, whereby the companies can set different prices for the same product offered on the online and offline channel and customers can self-select their preferred channel-price combination. Next, we look at whether multi-channel retailers set different prices of the same product between online and offline channels and determine the scale of the price differentials (gaps). We also analyze the factors influencing a company’s decision to engage in channel-based price differentiation, their extent and management (above all the influence of market, retailer and product factors).


Channelbased price differentiation

Consumers use different retail channels in different ways and, therefore, their perception of the channel varies. Studies show that a buyers’ willingness to pay for a product through offline channels can be 8% to 22% higher than through an online channel. Similarly, studies suggest consumers have a different perception of price between online and offline channels. Therefore, price differentiation based on the channel is

feasible. This, coupled with evidence that price discrimination boosts profits, should spur companies to following a price discrimination strategy whenever they can. However, industry professionals argue that in order to maintain a strong brand, the company offer has to be consistent across channels. Varying prices may lead to customer confusion, anger, irritation and a perception of price unfairness. Since previous research has shown that unfair price perceptions decrease purchase intentions, practitioners advocate channel price integrity.


This is shown in our study of the Spanish market. The vast majority of Spanish companies do not engage in price discrimination by channel. Rather, they charge the same price in direct and indirect channels. Only 20% of Spanish companies set prices with a difference of up to 10% between channels.

Figure 11: If there were a direct channel, would you vary prices between channels? We haven’t studied it


We would use the same price


There would be a difference between 1% and 10%


Source: own research

Empirical studies in the US produced similar results.

The analysis shows that 29.63% of retailers engage

It appears that still only a minority of multi-channel

in price discrimination based on channel. Of these,

retailers engage in price discrimination based on

18.75% charged higher prices in the offline channel,

channel, the extent and management of which

6.25% always charged higher prices in the online

vary from retailer to retailer, and product category

channel, and the remaining 75% followed a mixed

to product category. According to a study of over

strategy, charging higher prices in either the online

a thousand products, different prices were set for

or offline channel depending on the product. In

approximately 20% of the products. For products

summary, we found that retailers in fact engage

with different prices, in around 70% of the cases

in price discrimination.

the offline price was higher. The highest positive price gaps can be found in consumer electronics, such as remote controls and memory devices.



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3.2 When to differentiate prices


It is also interesting to understand the factors determining the extent of channel-based price differentiation. Studies show that the level of online competition has a significant negative influence on the occurrence and extent of channel-based price discrimination. The higher the online competition, the lower the probability of a multi-channel retailer engaging in channel-based price differentiation and the size of the price gap between channels.

Further, the number of distribution channels that multi-channel retailers operate has a negative influence on the extent of channel-based price differentiation, implying that the higher the number of distribution channels, the lower the probability of price discrimination given the complexity of coordinating the channels. More interesting still is that results show that product type influences the extent of price differentiation. The extent of channel-based price differentiation is highest in the case of services, which are less vulnerable to cannibalization due to resale. Among products, we also see a greater extent of channel-based price discrimination in the case of perishable goods (food) than durables (appliances), lending further indication that retailers are less involved in price discrimination for products that are suitable for resale. These results could also explain the large group of retailers that follow a mixed price discrimination strategy adapted to the variety of products offered. The results show that many multi-channel retailers engage in channel-based price differentiation and a certain increase in this trend over time. Nevertheless, retailers still apply consistent prices for the majority of their products. Generally speaking, the 1216% price differential for products between the online and offline channels reflects the differences in consumers’ perception of the channel, although this is relatively low compared to other types of price discrimination. Overall, results show there is channel-based price differentiation, but that the impact among retailers is still relatively limited.


The number of distribution channels that multi-channel retailers operate has a negative influence on the extent of the channel-based price differentiation.

The extent of channel-based price differentiation is highest in the case of services, which are less vulnerable to cannibalization due to resale.

The higher the level of online competition, the lower the probability that a multi-channel retailer will engage in channelbased price differentiation.



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The analysis shows that not all companies

Going further, we see that multi-channel retailers

have the same motivation to engage in price

charge on average higher prices in the offline

discrimination. The results of studies on the factors

channel. This practice is probably driven by the

behind the existence and extent of retail channel

higher perceived risk of the relatively new online

price discrimination suggest that retailers act in

channel and/or the motivation of the company to

accordance with standard microeconomic theory:

steer consumers to the less costly online channel.

for instance, higher levels of online competition

Moreover, retailers may pursue different operating

make retailers less motivated to engage in

targets for the online and offline channels and

channel-based price differentiation. At the same

use the offline channel to enhance their visibility.

time, the burden of coordinating effective multi-

However, there are always exceptions to the rule.

channel price discrimination still hinders some

Online prices are normally higher than offline

retailers from capturing the full opportunities

prices in the food sector. There are basically two

that price discrimination strategy can afford.

reasons for this phenomenon: online food stores

Although the level of price discrimination achieves

offer a high degree of convenience, saving the

the expectations of the microeconomic standard

customer from having to make their weekly trip

in some product categories (e.g., higher price

to the supermarket and instead delivering the

differentiation for services and perishable goods),

products to their doorstep. We have also found

the differences in the nature of the products have

that online food shoppers are typically consumers

not been fully explored yet.

who have little time to shop and, therefore, are more willing to pay a premium price for a delivery service that saves them time. This example shows that the customer’s price sensitivity is the main trigger of channel-based price differentiation.


The results also show companies not only use internet as an additional channel, but rather they can explore this channel further, engaging in channel-based price differentiation. Nevertheless, since a low online reach helps separate markets and encourages channelbased price differentiation, the growing popularity of the internet as a place to shop reduces the opportunities to use this channel for price discrimination. In any event, as online channels become more popular, companies could reduce their number of physical stores. With a lower offline reach, they can still engage in channel-based price differentiation.




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3.3 Price matching

The key to resisting Promising to match competitors’ online prices is becoming the trendiest shopping tactic for four bigbox chains, but retailing experts say the plans may backfire and send more shoppers scurrying to the Internet. A few weeks ago, electronics giant BestBuy and discounter Target said that for the first time they would match the prices offered by the online sites of some rivals, including Wal-Mart and Amazon. The brick-and-mortar chains are trying to combat “showrooming” by shoppers who check out products in stores but buy them on competitors’ websites, often at lower prices. Both retailers’ price-match policies include significant caveats that could wind up confusing and angering customers, retail experts warned. Not only do shoppers have to ask for price cuts, they also may have to prove the existence of a lower price to harried store workers. The stores say they are confident the new efforts will pay off. Best Buy said it has done at least one pilot of its price-matching program in a major market and was pleased with the results. Best Buy will match prices on electronics and appliances –but not other products- from 20 different online rivals. It excluded third-party sellers like those on Amazon, where prices are the most volatile. Best Buy said its staff must verify on a store computer that the rival’s price is actually lower at that moment and that the product is readily available. And a salesperson or manager can refuse to match a price if they deem it too low.


Another risk that retailers run is encouraging even more shoppers to check the internet to compare prices, a comparison that doesn’t favor the big box stores. A recent survey by William Blair found that on average Target’s prices were about 14% higher than Amazon’s, Best Buy’s were 16% higher and Wal-Mart’s prices were 9% higher. The comparison included shipping costs for Amazon, but not sales taxes. And a salesperson or manager can refuse to match a price if they deem it too low.



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Open-ended questions


If manufacturers begin engaging directly with consumers, most likely they will rely less on intermediaries for information on consumers and potential customers. They could even start doing what

intermediaries did before, thereby introducing new price trends in the system. These changes would shape the dependence structure of their relationships with the channel. Similarly, the dependence relationships will not depend again on a single intermediary to act as a channel. Companies with indirect channels that implement multi-channel marketing will need to minimize the potential for the channel’s dysfunctional conflict. Any direct sales by the company to the end customer can be perceived as an attempt to circumvent the intermediaries. However, from the business standpoint, direct contact with customers can help them identify potential customers and leverage up-selling and cross-selling opportunities. Companies like HP, which have a large number of distributors marketing their products and services, are faced with this situation. Although HP has taken a number of actions to mitigate the potential conflicts with the channel –e.g., the prices on its website are higher than those offered by its intermediaries- a conflict with the channel can arise, resulting in decreased sales support by the distributors. The question is still how to strike a balance between reaching the end customer and not offending partners in the channel.





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Pablo González Muñoz Partner Ernst & Young - Advisory Services

Has spent his career in the areas of commercial and customer strategy in several sectors, including Consumer Goods & Retail, where he was a pioneer in the use of real time models for smart customers. Has recently focused strategy development in Social Media & Digital Transformation. He began working at The Boston Consulting Group before joining BNP Paribas group as Marketing Manager. He is Associate professor at Universidad Carlos III in Madrid and ESIC and writer of articles for specialist journals. Has a bachelor’s degree in statistical sciences and techniques from Universidad Carlos III of Madrid and an MBA from London School of Economics


4. Ernst & Young viewpoint The needs and expectations of customers and consumers in Spain are set to change dramatically for a number of reasons: 1) the country’s economic outlook, with flagging activity and rampant unemployment, new social trends shaped by stagnant disposable income and more time dedicated to work –which naturally implies an increase in online time-; 2) demographic changes, whereby purchase decisions will be made by people from the 1970s and 1980s generation -with more individual profiles and greater demands for personalization-; 3) continuous proliferation of new digital technologies, resulting in new capacities to share information and compare the value of products; and 4) an exponential loss of “confidence” in mass advertising. These new needs and expectations will lead consumers to demand individually tailored products and services that offer “greater guarantees of trust” in the products and services they purchase and to reject surprises. Companies will need to personalize price management by geographic environment and customer type and set prices based on product category, the impact of loyalty programs and the role of promotion through different channels. All of this must come alongside easier and more transparent communication and promotional mechanics for the customer, with simplicity becoming a key future driver. This heralds a new era shaped by the personalization-simplicity puzzle, prompting companies to: • Continue advancing on the development of price segmentation skills based on geographic area, competition, product type, customer type, and channel mix. • Anticipate the impact of price strategies and tactics by developing engines that simulate their impact on the income statement. • Exert greater analytical control in implementing the stated policies to prevent distortions in execution. • Optimize the value chain to prevent operational inefficiencies from being transmitted to the customer via price. All of this is dealt with in this study, which is geared towards practices on which some sector players sector and customers we have been working are already working.




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Pricing in Retail & Consumer Goods  

Pricing in Retail & FMCG by Prof. Dr. Martin Böhm from IE Business School in collaboration with Ernst & Young. Directed by Alfonso Gadea.