We often have more than one lever that can affect how a key resource is changed:.
- Both hiring and promotion change the number of employees in a particular level of some staff group.
- The number of products in a development pipeline depends both on the number of new ideas being generated, and on the fraction that are screened out.
- The number of items of equipment in a large system that are in a reliable state at any time depends on decisions about both maintenance and replacement.
A common pair of decisions interfering with each other is price and marketing. Both may affect customer flows, and both may affect purchase rates. In addition, price directly affects gross profit, and marketing spend is a significant cost, so together the two decisions immediately affect operating profit.
Consider a consumer electronic product being launched into a market with an estimated 5 million users. Increasing advertizing spend raises the fraction of consumers reached, a process aided by word-of-mouth. The product is assumed to fully meet customers’ needs for functionality. Price determines the fraction of would-be customers who find the product affordable, so moderates the number of first-time customers buying, whether due to advertizing or to word of mouth. Advertizing reach and price also affect the fraction of existing customers who replace the product each month.
The initial price is chosen to be $150 compared with an initial production cost of $120, giving a gross profit of just $30 per unit. This unit cost will fall, though, as experience curve effects drive improved efficiency (see Briefing 46). Here, each doubling of cumulative sales volume will cut unit costs by 15 %. The rule for deciding on advertising spend is to keep increasing that spend to some ceiling, so long as customers are won at some minimum rate, and cut it if that rate is not achieved.
But a conflict arises right from the start between the advertizing and price policies. With a margin of just $30 per unit, advertizing of $0.5m/month must capture about 7000 new customers to be justified. But a low advertizing rate means that few potential customers are encouraged to consider the product, and only a few of those find the price affordable, so unit sales do not generate enough gross profit to justify the advertizing. The advertizing policy therefore includes a rule not to cut it until sufficient time has passed for sales to have started growing – a perfectly common policy element for new initiatives.
With a reasonable initial advertizing rate sustained for the first few months, the firm can now set a policy for pricing aimed at helping to capture new customers. Research finds that only 17 % found the price of $150 affordable, so the company decides to reduce the price. Three questions then arise – how often should this price be reviewed, by how much should the price be cut, and should the price continue to be cut until every last customer finds it affordable, or should there be some floor below which price will not be reduced?
Even in fast moving markets, it can be hard to know whether information on customer responses in a short period is reliable, so this firm reviews the price level every three months, rather than monthly. With such a low fraction of customers finding the product affordable, the firm would likely consider substantial price moves so as to make a significant shift in this key parameter, say 20 % rather than 5–10 %. The first price cut would therefore be from $150 to $120. Management can, however, be reasonably confident that unit costs will have dropped substantially by that stage, so gross margin might just be sustained.
To answer the third question, management could compare the cost of a further $1 cut across all the sales they would receive with the likely gross profit they would add from capturing the small extra fraction of customers that the price cut would win. Such a policy is complicated in this case by the repeat sales made by existing customers, so for simplicity, we will stop cutting price when 85 % of potential customers find the price affordable.
The pricing policy is therefore:
- set an initial price of $150
- every three months, cut price by 20 % if the fraction of customers who find the product affordable is less than 85 %
The result of adopting these policies for advertizing spend and price is shown in Figure 1.
Figure 1: Coordinated policies for advertizing and pricing for a consumer electronic product. (Click image to view larger)
The advertizing policy ensures that spending continues while the product’s price is brought to an affordable level, at which point sales to new customers start to grow. After six months, the profit contribution on new sales justifies testing significant increases in advertizing expenditure. This works increasingly well, so causes still further spending increases until research shows that the entire potential market is being reached by the advertizing spend. Meanwhile, checking on the product’s affordability has led to progressive price cuts, but the escalating sales have driven unit costs down, so the product remains profitable.
Until next time…
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“Anchor and adjust” in making decisions
Anchoring and adjustment is a psychological phenomenon that affects how people assess probabilities. Following a rule of thumb, or heuristic, defined by the anchor-and-adjust principle, people start with an implied reference point (the “anchor”) and make adjustments to it to reach their estimate. For example, people asked if they think the population of Shanghai is more or less than 10 million will on average make higher estimates of the actual number than those asked if it is more or less than 5 million. The phenomenon has now been so widely observed and replicated in experimentation that it is widely regarded as axiomatic of the way in which people make judgments.
It is a small step to see how this principle gets built into decision-making. Given the need to work out the best decision for something today, people reasonably anchor their thinking with recent decision values. It is even formalized in budgeting processes, where people start with last year’s sales or spending, then make a case for some percentage change on that base value. Whilst anchor-and-adjustment can make decision-making easier, the danger is clear – what if the starting value you adjust from is itself wrong? This could be in either direction – you could be targeting sales growth of 10% when it would be difficult even to sustain last year’s rate, or the potential could be for many times that rate. Likewise, you could bid for a 10% rise in marketing spend when the correct spend could be zero, or many times last year’s spending.
This briefing summarises material from chapter 8 of Strategic Management Dynamics, pages 550-553.
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