Author: Sergio Mendoza, PhD, Cofounder & CEO Airnguru, Senior Advisor Pricinguru
Why use promotions?
Promotions are a very powerful business tool and can be tremendously important in driving growth when demand is affected by a downturn or other factors. However, there are legitimate questions that arise when discussing a promotional strategy:
What long-term effects can promotions have?
What are the key factors in defining a promotion to make it profitable?
How good an idea is it to maintain a promotional program and eventually get consumers used to waiting for promotions to buy?
Wouldn't we be better off always securing a low price and positioning that in the minds of our customers, rather than frequently raising and lowering prices?
Do we gain anything by running promotions if the competition does the same?
Depending on a number of conditions and variables, including desired price positioning and some industry and market characteristics, promotions can be a good or a bad idea, and can be profitable or unprofitable.
What objectives can a promotion fulfill?
In the context of this discussion, we consider a promotion to be a proactive Pricing action, accompanied by advertising, limited in time and inventory, that offers attractive prices with respect to consumers' expectations. Promotions are carried out with several possible objectives, among which we highlight three:
Every business that introduces a new product or service to the market has the need to make it known, to "launch" the product so that potential customers learn of its existence, try it, get to know it, and give an initial boost to demand, thus shortening the period until the break-even point of the business is reached.
When we have perishable inventory (e.g. food or seasonal clothing) that we foresee that we will not be able to sell before its expiration date at the current price, we have several possibilities, among which we highlight: (1) store the remainder in a warehouse or destroy it, (2) donate the remainder before its expiration, and (3) try to sell it at an attractive price to accelerate demand before its expiration.
When we enter a "low" season (in seasonal businesses), or when demand declines for some other reason (arrival of a new competitor, weakening economy, etc.), businesses usually seek to stimulate sluggish demand by running promotions.
Can promotions produce added value?
In the long term, the value of promotions as a structural strategy for a business should be evaluated according to its desired price positioning, the industry's own characteristics and the market context. An industry with high fixed costs and stimulable, seasonal demand will probably find long-term value in a structural promotions strategy for seasons of low industrial demand. On the other hand, if industrial demand is relatively inelastic we would challenge the value of a structural promotions strategy, and it may be responding to a suboptimal competitive dynamic (prisoner's dilemma) rather than a positive-sum strategy. Between these two extremes there is a wide range of possibilities.
Given the right structural conditions in an industry, promotions can definitely produce added value for the business. However, to accomplish this requires a relatively rigorous process of
(1) Planning ==> (2) Execution ==> (3) Measurement ⇒ (4) Learning.
1. Good planning establishes the investment budget, the scope of the promotion, the assumptions and hypotheses of demand behavior, and the expectations of results and profitability of the promotion.
2. Good execution ensures that the parameters under our control perform as planned and that we deliver on our promise to the customer.
3. Rigorous measurement tells us whether or not the promotion was successful: how well we executed it, how far we strayed from the sales, margin and profitability budget, how much we deviated from the assumptions underlying the budget, how customers felt about it, what impact it had on customer loyalty, and so on.
4. Learning is key to establish best practices within the organization, adjust the parameters and assumptions of our promotional planning models, and establish a process of continuous improvement that allows us to make promotional activity a successful tool.
What variables should we consider for a promotion?
Critical variables to consider when planning and executing a promotion should at least include:
Promotion parameters are the levers the business has control over to generate the desired impact:
list of products to be included;
discount on normal price;
volume of inventory to be made available;
start date and deadline;
sales channels to be included;
amount of investment in advertising media;
amount of investment in extraordinary logistics, administration and operating costs;
The underlying assumptions, i.e., those variables that are not under the direct control of the business but that will directly impact the outcome of the promotion, are key in modeling the promotion, performing ex-ante sensitivity analyses and setting the promotion parameters:
expected base sales (i.e., without promotion) of impacted products during and after the promotional period;
base sales of substitute products during and after the promotional period;
base sales of complementary products during and after the promotional period;
price elasticity of direct demand for promoted products;
price elasticity of indirect demand for complementary products;
cross-price elasticity of demand for substitute products;
reactions of competitors;
The Yield Management (or Capacity Optimization) analyst within the Revenue Management area should forecast the demand expected without the promotion, setting the "base" sales levels for the promotion period and during a certain post-promotion period. These base sales levels becomes the references for the ex-post evaluation of the promotion.
On the other hand, determining the elasticities is typically the task of the Pricing analyst within the Revenue Management organization (sometimes both functions, Pricing, and Yield Management, are performed by the same person). The Pricing analyst uses statistical, econometric, Machine Learning, and or simulation tools to model demand as a function of price and foresee the impact of price changes.
The budget establishes the ex-ante expectations of the business regarding the results of the promotion and, in short, both the profitability of the promotion and the qualitative benefits. The budget should include at least:
amount of money to be invested in advertising;
amount to be invested in logistics, administration and exceptional operations;
expected incremental sales (units and $) of the products being promoted during and after the promotion;
expected loss of sales of substitute products;
expected carryover sales of complementary products;
expected net incremental contribution margin ($);
ROI of the promotion;
The challenge here lies in being able to estimate these quantities correctly, considering the complex repercussions that a promotion has on direct and indirect, present and future demand.
The promotion results reflect the impacts of having executed the promotion. We should include all measurable cannibalization effects. Promotion results shall include the direct impact on demand (sales, revenue, margin) for the promoted products and the indirect impact on demand for substitute and complementary products. Similarly, we should measure the effect on the sales channels where we promote and on those where we don't. In addition, we must calculate the impact of the promotion execution on customers. The results should include at least:
Variation in sales (units, revenues and contribution margins) of the promoted products during the period of the promotion with respect to the base sales levels;
Anticipated future sales of the promoted products (alternatively include a post-promo period in the analysis to account for this effect)
Impact on sales, revenue and contribution margin of complementary products;
Impact on sales of substitute products (same and different brands);
Incremental contribution margin;
ROI of the promotion;
Impact on customer sentiment and loyalty;
How to proceed?
If you would like to have a conversation about the use of promotions in your business, and how systematic processes, supported by analytical models, simulation, machine learning, automation and/or other Revenue Management tools can help you make better decisions in the specific context of your industry, leave us your contact details here to arrange a meeting:
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