There are many factors that a demand forecaster must consider when developing a demand forecast. One of these factors is the pricing power of the company and of the brand. Pricing power will affect demand volume when prices change. It is important that the demand forecaster is familiar with pricing actions taken by the company and anticipate their impact on demand.
Price is an important element of the value perception of the customer/consumer. From a finance perspective, pricing power is also an important consideration for company investors where greater pricing power is typically rewarded with a higher company valuation and/or stock price.
What is Pricing Power?
If a company does not have much pricing power, an increase in their prices reduces demand for their products. A company that has substantial pricing power is often one that provides a rare or unique product with few rivals or substitutes in the market.
Scarcity of resources can also give a company high pricing power. If the resources for a product cannot be easily obtained, the price of those resources will increase because there is insufficient supply to meet demand, which pushes up the price of the final product for customers/consumers.
In these cases of pricing power, if the company raises its prices, the increase may not affect demand much – if at all – because there are no alternative products on the market that consumers can choose instead. So, when forecasting demand, the demand forecaster needs to consider the degree of pricing power the company has, as well as the degree of pricing power of the company’s competitors. A company’s pricing power is linked to price elasticity of demand for its products, a metric which can aid the demand forecaster in understanding how price changes will impact demand.
Price Elasticity
Price elasticity is a measure of the responsiveness of the quantity demanded of a product or service to a change in its selling price. It is calculated as the percentage change in demand volume divided by the percentage change in price. Price elasticity of demand can be classified into three categories: elastic, inelastic, and unitary. If the price elasticity of demand is greater than 1, the product is considered elastic, meaning that a small change in price leads to a large change in quantity demanded. If the price elasticity of demand is less than 1, the product is considered inelastic, meaning that a change in price has less or little effect on the quantity demanded (a strong brand will usually exhibit this characteristic.) If the price elasticity of demand is 1, it is unitary.
Apple iPhone: An Example of Price Inelasticity
An example of inelastic demand is the Apple iPhone. When the iPhone was initially introduced by Apple, the company had strong pricing power because it was essentially the only company offering a smartphone and associated apps. At the time, iPhones were expensive, and there were no rival devices. Even as the first competitor smartphones emerged, the iPhone still occupied the high end of the market in terms of pricing and expected quality.
As the rest of the industry began to catch up in service, quality, and app availability, Apple’s pricing power diminished. Apple began to offer new models of iPhones including cheaper models for budget-minded consumers. Even at that, Apple still reflects very favorable pricing power which contributes to its relatively high value as a high multiple of earnings in the stock market.
Cross Elasticity of Demand
Another metric of value to the demand forecaster is the cross elasticity of demand which measures the responsiveness in the quantity demanded of one product when the price for another product changes. Also called cross-price elasticity of demand, this measurement is calculated by taking the percentage change in demand volume of one product and dividing it by the percentage change in the price of the other product. (Companies often use cross elasticity of demand to determine and set prices of their products and services.)
Products with Perfect Substitutes: The demand forecaster can use the cross elasticity of demand to make comparisons of products that are considered perfect substitutes for one another or those that are complementary to one another. For substitute products, cross elasticity of demand remains positive, which means prices increase when demand for one product rises. Demand for complementary products drops when the price rises for another. This is called negative cross elasticity of demand. (Unrelated products do not affect one another.)
Products with no Substitutes: Products with no substitutes have the ability to be sold at higher prices because there is no cross-elasticity of demand to consider. Incremental price changes for products with substitutes can be analyzed to determine the appropriate level of demand desired and the associated price of the product.
Help Marketing & Sales in Their Pricing Decisions
The metrics above that relate to pricing power can also be used by the Financial Planning & Analysis (FP&A) function within the company to evaluate the financial effects (positive and negative) of pricing strategies and actions. Cooperation between demand forecasting and FP&A is important in aiding Marketing and Sales in their product pricing decisions. Pricing and pricing strategy is an important consideration for profitability and cashflow.
It is important for demand forecasters to understand demand and price interactions and inter-relationships within the product portfolio of the company and with competitor products in the marketplace. Price elasticity analytics can aid in their assessing the effects of promotions, pricing actions of the company, and the pricing actions of competitors. This is important to the demand forecaster’s effort to develop more accurate forecasts for use by management in the supply chain and other management processes of the company.
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