Insights

Pricing In An Economic Crisis – Navigating Through Uncharted Territory
Article

Pricing In An Economic Crisis – Navigating Through Uncharted Territory

Mark Laceky, Vice President, North American Pricing Practice, The Nielsen Company

SUMMARY: The economic downturn continues to put stress on consumers causing accelerated changes in basic purchasing patterns. An important part of the overall equation for consumers is the relationship between price and value. As consumers develop new value systems, how should manufacturers and retailers view and manage the other side of the equation – price?

In 2008, U.S. consumers experienced a stunning string of economic shocks to the system. Gasoline and food prices shot up as housing prices plummeted. Stock market declines accelerated into crashes as unemployment rose at alarming levels. As $50 trillion of national wealth evaporated, the country and the world slid into the worst economic downturn in generations. Amid these calamities, it’s hardly surprising that consumers are changing their behaviors to adapt—cutting back on spending while trying to increase household savings.

Purchases are being reexamined with an eye toward necessity and basic value…

Shifting priorities

Consumer shopping behavior is undergoing a tectonic shift. Consumers are crippled with fear of the new economic reality and they know that fundamental changes are necessary in order to shepherd their families through a new tumultuous landscape.

Tighter budgets are driving a fundamental resetting of household priorities—feeding the family is first and foremost while luxuries are expendable. And everything in-between is being re-evaluated. Eating out at restaurants is down, and home cooking is up. Purchases across all categories are being reexamined with an eye toward necessity and basic value.

Do tighter budgets = greater price sensitivities?

The overall shift in households’ perception of value is a form of increased price sensitivity—consumers have less to spend, so price and value are more important than ever. But at what level?

Consumers are now reallocating their purchases across categories based on a new value paradigm. Value is the key factor at a macro-level across categories. But how does this affect pricing within categories—are consumers more price-sensitive in a recession to item-level price changes? To answer this, Nielsen modeled over 300 brands/sizes (both manufacturer and retailer brands) across 50 top categories. Price sensitivity was measured for full year 2007, and for the first and second halves of 2008.

Within categories, consumers are behaving the same…

Surprising stability

Nielsen found that while some items became more sensitive during the recession and some less, the average price elasticity of the 300 items increased only slightly over time (from -1.33 to -1.35 to -1.37). Indicating that, within categories, consumers are behaving in much the same way as they have been. While consumer sensitivity to “value” is indeed changing, changes are at a higher level than a reaction to changes in individual items’ prices.

With that said, however, some categories were found to have become more price sensitive and some less. Items that have high-price-sensitive characteristics include those with frequent purchase cycles, and include categories such as beverages, comfort foods/drinks and shelf-stable items. Lower price-sensitive characteristics include items that have high unit prices of greater than $5, have longer purchase cycles and include frozen/refrigerated and fresh categories. The grid below shows starting elasticity horizontally and the change in elasticity vertically:

Retailer brands are 30% less price sensitive to price changes than manufacturer brands…

And consider this: retailer brands are 30% less price sensitive to price changes than manufacturer brands. That may seem counter intuitive since consumers typically buy retailer brands because they are lower-priced, making them more price sensitive. In reality, however, consumers who buy retailer brands have already made their price decision and don’t need to put as much thought into pricing decisions after that. They are actually less sensitive to changes in item prices.

Commodity price bubble bursts

After an unprecedented run-up in commodity prices in late 2007 and the first half of 2008, many manufacturers were forced to increase prices—some dramatically and more than once. Categories such as rice, cooking oil, tuna, pasta, mayonnaise, margarine, eggs and peanut butter were some of the hardest hit.

However in mid-2008 the commodity bubble burst and prices dropped back down to historical levels. This naturally led to the obvious question (and pressure from retailers)—when will manufacturers reduce prices?

There are many factors weighing against price rollbacks…

Rollback risks

For manufacturers, there are many factors weighing against price rollbacks:

  • A price reduction by one brand (especially the leading brand) is likely to be followed by other brands and price wars are devastating to manufacturers’ bottom lines.
  • Commodity market volatility means the cost of goods might go back up.
  • In the years before 2007, many manufacturers did not pass on cost-of-good increases, so recent price hikes have additional justification.
  • Frequently, only 70%–90% of a price rollback is passed through to consumers.
  • Most items are not sensitive enough to changes in price to make a price rollback profitable.
  • Trade promotion strategies and tactics must be entirely reworked.

And while price rollbacks may not be a priority for manufacturers, do the same factors hold true for retailers? Be careful what you ask for—as there are frequently overlooked downsides from the retailer’s point of view:

  • Manufacturer price rollbacks are market-wide. That is, they don’t result in any competitive advantage for individual retailers.
  • Nielsen research shows that for most categories, price rollbacks reduce category dollar sales. Category price sensitivity (usually between -0.30 and -0.70) is much smaller than item-level sensitivity. The bottom-line result is that, for most categories, price rollbacks actually lower total dollar sales.

Pricing process is paramount

Volatility means speed and flexibility are more important than ever. With commodity prices swinging wildly and consumers changing behaviors, it is crucial that the pricing process be on-going rather than sporadic. Constantly updated cost of goods forecasts combined with a data-driven, portfolio-perspective and constant tracking results in a competitive advantage.

Two key strategies for the current pricing environments…

Situation drives strategy

The situation for every manufacturer and brand is unique and these situational considerations drive pricing strategy. The brand’s role in the corporate portfolio—current price positioning, category role, price sensitivity, intersection of price and promotion strategy, price thresholds, margin needs—all play an important role in determining the best pricing strategy for a brand.

If a brand is not the category leader, it is typically a price follower and is in much less control of its pricing destiny. Recent exceptions to this are smaller brands and retailer brands that did not lock in high commodities contracts and have more pricing power to steal share from the category leader in the near term. For category leaders, two key strategies for the current pricing environment should be considered:

Scenario #1: If you are the category leader and your competitors are letting you lead pricing in the category, in order to recoup profits, keep prices up as long as possible as long as category sales are not damaged and retailer pressure is manageable.

Scneario #2: If you are the category leader and you believe your competitors will be lowering their prices, maintain leadership by leading the size of the price rollback, but delay it as long as possible because the cost of goods could rise again.

In a time when consumers are fundamentally resetting their priorities, values and behaviors and when commodity prices have fluctuated wildly, it is more important than ever to constantly review pricing choices and the results of pricing actions. Price rollbacks may be implemented in 2009 as commodities contracts expire and if costs don’t re-inflate. In this scenario, the winner would be neither the manufacturer nor the retailer, but rather the consumer instead.