Do Price Elasticity Techniques Work for B2B Pricing?

The nirvana state for many pricing professionals has been to set prices based on "willingness to pay". By setting prices based on willingness to pay for each segment (or customer), companies can extract the most value from their customers. The classic approach to quantifying "willingness to pay" involves the calculation of elasticity. This approach has been used with some degree of success in selected B2C companies. One of the key reasons for success has been the availability of large volume of historical transactions to yield statistically significant results.

Even where it has been used with success in B2C, the elasticity approach presents a number of challenges. First, it generally requires sophisticated demand modeling techniques to account for non-price effects (seasonality, marketing/promotions, product lifecycle, stock-outs to name a few) and strip them out to isolate the effect of price on quantity sold. In addition, the generation of elasticities is generally viewed as a "black box", in that the demand models are typically developed and maintained by Ph.D.'s and incorporated into software whose inner workings are not accessible by the end users.

As challenging as the elasticity approach is in B2C, it presents a number of additional challenges when applied to typical B2B situations.

1. Data issues: Compared to B2C, in B2B there are generally fewer transactions, albeit with higher quantities. Moreover, data often don't exist to strip out effects of important non-price factors, which can often swamp the effect of price
2. Ill-defined "price": In B2C, there is generally only 1 price (shelf price = price paid at register). In B2B, there can be several, including list price, invoice price, and pocket price.
3. Changing (list) price doesn't show through in volume impact: Sometimes shows through instead in discounting behavior by sales team, who simply alter discounts that negate list price changes
4. Lowering price doesn't grow the market: For example, for a B2B light manufacturer, lowering the price of headlights won't increase the overall sales of cars. At best, you might get more market share, but that is often eroded by competitors matching price changes. B2B transactions are more a "binary" situation, i.e. you either win a deal or you don't, as compared to B2C in which for example lowering the price of 12-packs of soda generally leads to a proportionate increase in sales.
5. Doesn't address the issue of how to set approval levels: This is important for many B2B companies in which deals below pre-determined price thresholds require escalation to managers for approval.

Price optimization that is founded in elasticity based approaches is generally not effective in B2B industries. B2B companies should be wary of a solution that relies solely on elasticity methods, which are insufficient in most B2B situations. Over the next few posts, we will explore alternatives to the elasticity approach in B2B pricing.

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