- 2022-07-21
- 11:55 am
- Posted By: Tellusant

The most important decisions in times of high inflation are pricing related. Here we describe methods for how companies should optimize pricing.

These methods are universal. But in inflationary times most factors that go into pricing analyses are in flux. It is therefore critical to track those factors and have an at least semi-automated way to set prices.

Tellusant has considerable experience with pricing analyses and related decision-making. Contact us at info@tellusant.com if you have questions.

In the following we discuss:

- The Tellusant universal profit equation
- Pricing approach in FMCG
- Conclusions

Every company follows the basic equation: profit = revenue − cost. Tellusant has extended it to be more actionable, what we call the Tellusant Universal Profit Equation (TUPE).

It uses one revenue component and three cost components as shown in the equation below.

Executives are used to thinking about variable and fixed costs. Here we explicitly break out discretionary costs that are neither variable nor fixed but chosen at the discretion of management.

The beauty of TUPE is that:

- It is parsimonious (exactly what is required — nothing more, nothing less) and applies to all industries
- It breaks out discretionary costs that a company can choose to incur, or not
- It lends itself to more detailed expansions with elasticities and other commonly used concepts

With this as the starting point, we now turn to pricing in FMCG. We leverage a brilliant paper by Sethuraman and Tellis throughout.¹

TUPE adapted to FMCG is shown below. It includes advertising/promotion and assumes that R&D and other discretionary costs are low.

To make the equation come alive, we introduce three ratios:

Price elasticity ϵ*ₚ* is familiar to any reader.² The contribution-price ratio *k* is intuitive (note that the correct formula is more complex, but this is a good approximation). The pass-through ratio may be less commonly known.

The pass-through ratio is the percentage of a price discount by a manufacturer that is passed on to consumers by retailers. It is by no means a given that if a manufacturer offers a 10% price discount, the retailer also reduces price by 10%.

In affluent countries, modern trade pass through may be 80%. In traditional trade in emerging countries, it may be 40% and in some cases zero.

We also need the fraction of sales that is sold at a discount (*f*).

With this, the extended equation below is derived. We do not give the proof¹ since our focus is on the implications.

The way to interpret this equation is that for percentage change in price (Δp/p). there is a profit gain proportional to *k*ϵ*ₚ* and a profit loss proportional to *f*/*g *since the original price is not realized, and the retailer pass through is less than 1.

There is a breakeven price elasticity. A company takes different actions depending on whether the actual price elasticity is above or below this breakeven.

This breakeven elasticity is derived by setting the term in parenthesis to zero. This gives: