Davey, K., Childs, A. y Carlotti, Jr, S. (1998).

Why your price band is wider

than it should be. The McKinsey Quarterly (3) pp. 116 - 127. (AR49024)

MARKETING

WHY YOUR PRICE BAND 1~

Too many ad hoc pricing decisions

Key determinants: consumption expandability and brand equity

Consider competitors and channels last

bave long recognized tbat pricing S a key

P
ACKAGED GOODS COMPANIES
lever in managing brands for profitability. Even so, pricing is so
underleveraged in practice that improving price management can raise
margins by as much as 5 percent. Companies seeking to capture this potential
must not only make efforts to understand the behavior of consumers but also
find ways to apply this understanding to tbe thousands of front-line pricing
decisions they make every year.

This opportunity exists be cause of a widespread assumption that marketing

departments set prices and make them effective. Yet any consumer's shopping
experience will demonstrate that this is a rnisconception.

116 TH E Mc KJN SEY QUARTERLY 1998 NUMBER 3

WIDER THAN IT SHOULD BE

K. K. S. Davey
AndyChilds
Stephen J. Carlotti, Jr

N ot long ago, an acquaintance bought a box of cereal for $3.79. He was

unhappy because he had paid $2.49 for the same brand in the same
supermarketjust two weeks earlier, when he had also used a 75~ coupon to
paya net price of $1.74. To add insult to injury, he knew that a nearby
supermarket always sold this brand for $2.99. These variations in price
confused him. In fact, they are entirely normal, and centralized pricing
decisions are responsible for very few of them.

K. K. Davey is a consultan! and Andy Childs is a former consultan! in McK.insey's New Jersey
office; Sreve Carlotri is a principal in the Chicago office. Copyright 1998 McKinsey &
Company. All rights reserved.

T HE McKI NSEY QUARTERLY 1998 NUMBER 3 117

 WHY YOUR PRICE BAND IS WIDER THAN IT SHOULD BE

In category after category, the end prices consumers pay for the same goods
vary widely. Sorne variations result from promotions by manufacturers, such
as temporary price cuts, circular ads, coupon ads, end-of-aisle displays, pre-
price packs, and bonus packs. Within a channel, prices vary as a result of
retailers' pricing and promotion strategies, such as EDLP or hi-lo.~ double-
couponing (the process by which a retailer offers to double the face value of
a manufacturer's coupon for shoppers in its stores), and loyalty cards. In
addition, prices vary from channel to channel because of different value
propositions: convenience at a higher price or less variety and service at a
lower price, for instance. These variations apart, consumers themselves adjust
pricing by responding to consumer promotions, notably free-standing inserts,
checkout coupons, and on-
-------------------Exhibit1 pack coupons. We call this
Consumer price bands
range of prices for an SKU
Example: Cereal Weeks in store Units bou\lht
Arly promo prke
at each price, at each pnce, (stock-keeping unit) within a
percent percent
market the consumer price
Range $1.00-1.49 0.1% 1 1.0% band (Exhibit 1).
of prices
paid by 1.50- 1.99 3.8 27.5
consumers 2.00- 2.19 1 1.1 - 5.7
At most packaged goods com-
2.20- 2.39 1 1.4 . 3.4
2.40- 2.59 3.3
panies, the complex decisions
- 6.8
2.60-2.79 1 1. 5 2.0
about li st prices, trade pro-
2.80-2.99 3.4 . 3.6 motions, and consumer pro-
3.00- 3.19 1 1.6 1 1.2 motions that drive the con-
3.20- 3.39 - 10.6 - 6.1 sumer price band are made
3.40- 3.59 19.9 13.9 by severa! different interna!
3.60- 3.79 16.4 - 10.1 organizations, each inspired
3.80-3.99 17.0 - 9.6 by its own goals or definitions
4.00-4.49 19.0 - 8.7 of success. Prices controlled
>4.50 10.5 1 0.9
centrally by senior manage-
ment reflect a company's rev-
enue and profit aspirations, the leve! of inflation, and competitive pressures.
Trade promotion budgets are determined at the account leve! by salesforces,
and often come into play to meet short-term volume targets. Consumer
promotions, on the other hand, are controlled centrally by brand managers,
and are frequen tly based on competitive dynamics. All these separate pricing
decisions usually create a wide price band.

Yet companies are seldom aware of this state of affairs. Ask most managers
why their companies set prices at a given leve!, and they will tell you that this
is the highest price consumers are willing to pay. But if that is so, why do list
prices keep rising while a substantial portien of the increases go to finance

* EDLP (cveryday low pricc) is a rctail pricing strategy in which the rctailc r charges a constan!,
rclatively low cveryday price with no temporary price discounts. Hi-lo retai lers. by contras!,
charge higher prices o n a n everyd ay basis a nd run frequ e nt pro motions in which prices
tempora rily fall below the EDLP leve!.

118 TH E McKI NSEY QUARTERLY 1998 NUMBER 3

 WHY YOUR PRICE BAND IS WIDER THAN IT SHOULD BE

trade and consumer promotion budgets? In any case, few companies can tell
how much product they sell at full price to end consumers.

Ask the same managers who actually makes their companies' price decisions,
and the response is likely to be the "brand people" at HQ, who are specialists
with the necessary tools for the job. Both impressions are fal se. Roughly
12 percent of sales come under trade promotion budgets, more than half
of which (and growing) are controlled in the field. Frontline salespeople
therefore direct a good deal of the tactical pricing for any brand.

Yet few companies have taken the vital steps to hire and train the right
salespeople and to provide them with the data and analytical tools they need
to measure the profitability of their promotions. E ven relatively simple
metrics like purchase cycles and pantry loading are rarely linked to tactical
promotional strategies. As with many other changes in the marketing mix,
variations in pricing are seldom based on an analysis of their impact in
specific consumer segments. Even leading packaged goods companies are
confused about the correct interpretation and use of price elasticity. As a
result, companies often make major pricing moves that substantially reduce
their profitability.

Prices are set in an ad hoc way for severa] reasons. First, companies generally
use discounts to meet competition, an approach that their customers, retailers,
strongly encourage. Second, promotional spending is typically budgeted on a
highly unfocused "wbat we spent last year plus 5 perce nt" basis. Tbird,
customer (retailer) strategies often drive pricing: EDLP accounts, for
example, may demand tbat manufacturers set an everyday price lower than
tbe list price plus average customer margin. For many manufacturers, this
not only forces down the top end of the price band but also reduces its
potential width.

Sensible pricing calls for a deep knowledge of consumer behavior and a well-
defin ed process to translate this knowledge into local pricing decisions. An
understanding of consumers is the only basis for doing what companies claim
to do: price at the highest point consumers will pay. Although knowledge
about competitors, channels, and retailers is vital, it shouJd supplement rather
than replace this understanding; everything else is secondary. In setting price
bands, the objective should be to increase volume from price-sensitive
consumers by lowering the price to them, and to increase profits from price-
insensitive segments by capturing the value inherent in the product offering.

Determining the ideal price band

A wide array of consumer-related drivers can affect pricing, among them the
dynamics ofusage and purchase occasions, loyalty to product attributes, and

THE McKJ NSEY QUARTERLY 1998 NUMBER 3 119

 WHY YOUR PR!CE BAND IS WIDER THAN IT SHOULD BE

local market preferences. Two consumer drivers are particularly important:

firsl, lhe extent to which consumption in a category can be expanded through
price/promotion policy; second, brand equity.

It is possible to raise sales volumes in expandable categories, such as salty

snacks, cookies, and soft drinks, by raising consumption among current or
new users through attractive prices or promotions. Pepsi, for example, believes
that as mucb as 50 percent of the incremental volume generated by promo-
tions may come from increased category consumption. Wider price bands
are usually appropriate in expandable categories, since incremental volume
can increase total profits despite reducing profit per unit.

T he second driver, brand equity, refers toa consumer's relationship with a

product's tangible or intangible benefits. Power brands - those with high
equity- command a price prem ium and also allow th eir owne rs g re at
flexibility over pricing.~ S uch brands as detergent Tide and snack food
Doritos capture consumer surpluses by offering shallow price discouots
(narrow price bands) to encourage pantry loading by Joya! consumers orto
attract switchers or formerly loyal consumers of competing brands. They
can also use periodic deep discounts (wider
price bands) to attract buyers who would not
Understanding consumer
normally buy products in the category.
drivers makes it possible
to determine the proper
Understand ing these two drivers makes it
width of a price band
possible to determine the proper width of a
price band. If category consumption appears
to be highly expandable and a manufacturer has the strongest brand, for
example, it should adopt a very wide price band: that is, set the everyday
price high and promote heavily. Th is will capture the benefit of Joya! con-
sumers' willingness to pay while simultaneously increasing volume among
occasional or new users through profitable promotions.

Suppose, however, that a brand in an expandable category lacks high brand

equity. In this case, narrower price bands, combining moderate everyday
prices with moderate levels of promotiona l activity, are appropriate. It is
unwise to charge high eve ryday prices for such a product, but profitable
promotions can still increase brand (and category) consumption.

Imagine that the expandability of a category is low but the equity of a brand
within it is high, as it is for leading brands of toi let paper and detergent, as
well as many luxury goods. The right policy is to deploy the narrowest price
bands and to use promotions sparingly. Such brands do not benefit from
promotions in the long run, because the sales thus generated a re likely to be
'-' David C. Court, Antho ny Freeling, Mark G. Leitcr, and And rew J. Parsons, '' lf Nike can 'just
do it,' why can'l we?," The McKi11sey Quarter/y, 1997 Number 3, pp. 24-34.

120 THE McKINSEY QUARTERLY 1998 NUMBER 3

 WHY YOUR PRICE BAND IS WlDER THAN IT SHOULD BE

made at the expense of future sales of the brand or to come from switchers
who buy on a deal-by-deal basis. Reducing promotions of such brands (and
encouraging competitors todo likewise) will probably reduce the size ofthe
deal-by-deal switching pool.

Once the ideal width of a price band has been established, four issues must be
addressed before it can be implemented in the marketplace:

What should the everyday price be?

H ow wide sho uld the price band be? In other words, exactly how far below
the everyday price should a company set the promotional price leve!?

What mix of promotionaJ levers is most effective?

How often should a company promote?

Setting everyday prices

To determine the profit-maximizing everyday price for an SKU, a company
needs a good understanding of price elasticity, key threshold prices and price
differentials, and company margins. Sophisticated econometric modeling
of sales and price data by such marketing information suppl ie rs as N ielsen
and IRI can help companies estmate the price elasticity of their brands. In
sorne cases, it may be necessary to employ other methods, such as in-store
experiments and various forms of choice modeling (for instance, conjoint
or discrete choice).

Threshold price points - say, $1.99 - are levels above which consumer demand
falls sharply and below which consumer demand fails to risc in proportion.
They exist for key items in a category and for the brands competing in it.
Often, threshold price points are specific to a market or region; in sorne cases,
they are specific toan account as well.

The price d ifferential is the point at which the difference between the price of
a brand and that of a key competitor becomes large enough to red uce the
brand's sales velocity substantially. D etailed analysis of price differentials
can be valu ab le: we found that one company a imed fo r a certain price
d ifferential against a key competitor nationally, but the key competitor and
the optimal price gap actually differed from region to region. A national
analysis was not sufficient to assess the appropriate differential.

As a rule, companies undertake a systematic analysis for one major package

or size of a brand a nd then use judgment and conventional wisdom to
extrapolate the findings to other packages or sizes. But if small sizes appeal
chiefly to occasional users and large sizes to heavy loyal ones, prices should be

T HE McKJNSEY QUARTERLY 1998 NUMBER 3 121

 WHY YOUR PRICE BANO IS WIDER THAN IT SHOULD BE

proportionally higher on the large size to maxirnize the surplus, and lower
on the small size to bring in occas ional users. In one documented case,
adopt ing thi s approach pushed margins up by 5 percentage points - a n
extraordinary increase in profitabi lity.

Setting the width ofthe price band

Once a company has identified approp riate everyday prices, it must set
the lower bound of the price band. Emprica! studies sugges t that price
reductions eventually cross a threshold beyond which further cuts fail to
attract more switchers and new users and add onJy slightly to incremental
volume (Exhibit 2). AJthough optimal promotional discounts are likely to be
----------------------------exhlblt2
Finding the price reduction threshold
Example: Househ old product
Thousandsof units

Everyday price - - -- - - 12.6

6.05 0.5 6.05
10% price cut with
instore display
7.7 16.8 10.5
20%price cut with c:======::r:====---- - -14.0
- - - - 400
feature advertisement
14_0 12.o .
Source: A. C. Nielsen

-------------------Exhlbltl
Determining price bandwidth
brand specific and mu st be
determined e mpiricall y, an
Aggregat e data analysis of 30 product cate-
50 0 - - - - - - - - - - - --
Feature gories across many US mar-
advertisement kets shows that consumer
Price band and instore
d isplay resp onses flatte n for price
discounts steeper than 30 to
..
)(

~
e
ln-store
display only
35 percent (Exhibit 3). Th is
suggests a lower limit for
..
;;; 300 - - - - --

i
Feature
advertisement price bands.
"' only
200 Adj usting the price band
Temporary
price
through different
100 ---.L.__
reduction only promotional/evers
o 10 20 30 40
Discount, percent Manufacturers should un-
Source: A. C. Nielsen
derstand which promotions
appeal to which consumers.
Our experience suggests that in general, feature advertisements attract a
disproportionate number of brand loyalists, whil e in-store d isplays lure
switchers. We have aJso found that inserting coupons into flyers distributed in
stores targets price-sensitive consumers more effectively than does cutting
prices at the shelf Only about half of the shoppers who buy the promoted

122 TH E McK INSEY Q UART ERLY 1998 N UMBER 3

 WHY YOUR PRJCE BAND IS WIDER THAN IT SHOULD BE

brand take advantage of these coupons; other consumers ignore them and
pay a higher price.

Although these findings cannot be generalized to all brands and categories,

manufacturers can use promotional levers in a fairly targeted way to attract
the price-sensitive segments that they seek. Todo so, however, they must
undertake detailed analyses of the consumer data that is increasingly
available at market and account levels. Companies must be creative in
designing promotions, measuring their sales and profit impact on target
segments, and identifying those that will allow them to customize their prices
while generating profitable incremental volumes.

Determining the rightfrequency for promotions

Consumers' responsiveness to the frequency of promotions vares by geo-
graphy, category, and brand. Two key issues to consider are reference prices
and category dynamics. Reference prices formed by consumers help them
determine whether products give good value. Manufacturers should aim to
keep reference prices and the everyday prices consumers see when they shop
as high as possible, since evidence suggests that for most consumers, frequent
promotions can push the reference price of a product far below its everyday
price. By contrast, less frequent or random promotions make consumers feel
they are getting a bargain - a more desirable result.
Two kinds of category dynamics are importan t. The first is the category and
brand purchase cycle of the segment being targeted: if consumers purchase
a product in a given category once every two months on average, weekly
promotions are not likely to be productive. The second is the frequency with
which the brands in a category have been prometed in the past. Many cate-
gories are prometed excessively. If past practice has created certain expec-
tations among consumers about promotions for a given category, it can be
hard to change them. It will be necessary to take a gradual approach, moving
steadily toward the optirnallower leve! of promotion.

Adjusting the price band

Although price bands should be based on a deep understanding of cn-
sumers, traditional concerns about competitors and channels cannot be
neglected. The study of consumer dynamics does implicitly take sorne of
these concerns into account, but it is worth keeping an eye on them directly
to fine-tune pricing strategy.

Competitors
Sorne companies react to the pricing and promotional moves of all corn-
peting companies in the same way, failing to realize that all competitors
are not equal. Consumer analysis suggested that one company's brand
stole share from a key competitor whenever it was prometed. Yet when the

THE McKI NSEY QUARTERLY 1998 NUMBER 3 123

WHY YOUR PRICE BAND IS WIDER THAN IT SHOULD BE

competitor prometed its own brand , the first company's sales were not
affected. Asymmetrical competition of this kind is common, particularly
when consumers feel that brands vary in quality and a category is divided
into distinct price tiers. Consumers trade up reJatively easily to better-quality,
more expensive brands, but resist trading down to lower-quality brands even
if they represent a bargain.

In adjusting price bands in response to competitors, there are severa! key

issues to consider:

+ If a company wants to create a wide price band for its brand, how should
it respond if competitors do not follow its lead, or even take steps to narrow
their own price bands?

If a company wants to narrow the price band for its brand, how should it
respond to competitors who buy market share by means of aggress ive
unprofitable promotions?

How does a company go about influencing its industry if it wants to lower

the level of promotional activity in an unexpandable category?

Companies spend large amounts of their money on trade and consumer

promotions that discount prices to competitive levels, thus widening the price
bands of their brands. They should think twice before doing so. The desire to
meet competition is rarely a sound basis for pricing decisions; indeed, it is
unlikely to raise the profits of any of the competitors. Why? Because retailers
hardly ever advertise or discount competing products at the same time; the
"meet the competition" philosophy means that one company's product will be
discounted this week, another company's next week. Since discounting is
often unprofitable, this approach tends to depress a company's profits twice:
once when its competitor discounts, and again when it takes its turn.

One company battled it out in this kind of promotional war with its only
maj or competitor in a certain region. Both players eroded shareholder
value by offering attractive prices to retailers almost co ntinuously. T he
retailers, fierce competitors tbemselves, used this category to build traffic
for their stores. The two companies were trapped in a vicious cycle of
price discounting.

A thorough analysis of everyday price and promotional elasticity and con-

sumer behavior persuaded the company to implement consumer-driven
pricing strategies. It narrowed its price bands, used targeted promotions
to reach specific segments in sorne channels, and increased margins by
4 percent. The competitor followed suit by narrowing its price band s -
presumably with positive results as well.

124 TI-lE McKINSEY QUARTERLY 1998 NUMBER 3

 WHY YOUR PRICE BAND IS WIDER THAN IT SHOULD BE

Channels
Consumers purchase packaged goods from many retail channels, each with
its own distinct value proposition; even retailers within a given channel
have a variety of formats. Grocery stores, which offer convenience and a wide
assortment of products, often charge relatively high prices for items that are
not in the grocery line, such as diapers and toothpaste. By contrast, warehouse
clubs targeting price-sensitive consumers offer the lowest prices, but have
only a limited assortment of package sizes, primarily large. Many brands sell
in multiple channels, with multiple positionings.

For sorne products, consumer price bands should be adjusted channel by

channel. Consider the pricing of beer. Category and brand consumption can
be expanded much more readily in supermarkets than in bars. This suggests
that a wide price band is more appropriate for supermarkets. (Happy hour
discounters beware!)

More generally, companies must answer three key questions:

Is a given strategy sufficiently flexible for all channels, and in particular

for the major accounts within them?
Pricing strategies must be
Do consumers use a product to judge the
flexible enough to accommodate
overa ll value proposition of a channel or
different retailers without
retailer? What role does the category play in
jeopardizing a brand's overall
the retailer or channel value proposition?
price positioning
How can a pricing and promotion strategy
be tailored to work both for manufacturer and for retailers?

Bear in rnind that retailers as well as manufacturers have price positions they
wish to project to consumers. If a rnanufacturer adopts a pricing strategy
that is based on heavy promotion, such as hi-lo, it can easily fail if the prirnary
channels for selling the product are oriented to EDLP Pricing strategies rnust
be flexible enough to accomrnodate different retailers withoutjeopardizing a
brand's overall price positioning. Companies should ask themselves what
price bands are appropriate for retailers whose maximum differential between
high and low prices is as low as 20 percent. This approach to the overall
design of pricing programs may seem merely common sense, but in ou r
experience, it is seldom pursued.

Executing the price band in the field

Even well-designed pricing programs often fail because of inconsistent or
weak execution. Since final prices reflect many local decisions, field capabili-
ties and incentives must be aligned with a company's overall pricing structure.

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 WHY YOUR PRJCE BAND IS WIDER THAN lT SHOULD BE

Poor execution in the field has many causes. Sorne companies buy whatever
information they need to manage their top accounts and brands, but fail to
put all of it in the hands of the people who t;Oulu really use it to improve
brand movement, volumes, and profits. Few companies go so far as to
measure their returns on promotions. If they did, many would find they are
negative. One manufacturer discovered that more than 10 percent of its
promotional spending on a particular food category was wasted, since
increases in consumption peaked at a discount leve! of 20 percent, yet many
of its promotions cut prices by 50 percent
or more. By adjusting price targets, this
Few companies go so far as
company gained almost an extra percentage
to measure their returns on
point in profits.
promotions. If they did, many
would find they are negative
The same account-level data that can be used
to determine whether a manufacturer and an
account have made a profit on individual trade deals can be rnined even more
deeply to isolate the impact of price levels and price bands. But in order to
glean such insights, a company must make both its data and the rigbt tools
available to its frontline salespeople, since input from them can help it build
a robust picture of what is bappening in the real world. Discipline is needed
if a company is to create a suitable base of knowledge and syntbesize it across
regions and channels.

Packaged goods manufacturers can boost their bottom line by taking severa!
steps to increase the effectiveness of their salesforces:

Recognize the critica! role frontline salespeople should play in the pricing
process.

Equip the salesforce to bandle this role by giving it account-level pricing

and profitability data, easy-to-use tools, and support functions specific to
account-level pricing. (This rnigbt include data gathering, financia! analysis,
or local marketing expertise.)

Maintain pricing discipline by continually measuring the impact of price

levels on the effectiveness of promotions, and intensively educating the
salesforce on best practices by account and by cbannel.

Use a bonus program to reward salespeople for devising price levels that
build brand equity and increase the profitability of brands and accounts.

Easy though these steps may sound, most packaged goods companies have
difficulty taking them, largely because they entail an enormous change in
mindset. Field sales organizations must become more analytical and more
focused on profits. The marketing function must be willing to give the

126 THE McKINSEY QUARTERLY 1998 NUMBER 3

 WHY YOUR PRICE BAND IS WIDER THAN IT SHOULD BE

salesforce more flexibility to set pricing than it has previously enjoyed.

Finally, marketing and sales must agree on the leve] of sales they want to
achieve, and why.

Shifting the orientation of pricing strategies for packaged goods from the
current fixation with competition and channels to an approach that takes
fuller account of consumer behavior offers promising opportunities to
improve profits. But a new mindset at headquarters, new techniques for
measurement and analysis, and new capabilities are needed before a company
can recognize and capture the profit potential of innovative pricing. Once
these are in place, it can turn to the difficult challenge of training frontline
salespeople, providing them with adequate decision support tools, and
adjusting their incentives. What lies ahead is no easy task. But a margin
improvement of 2 to 5 percent is quite an incentive. Q

T H E McKI NSEY QUARTE RLY 1998 NUM BER 3 127

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