Inflation Reveals the Need for Better Insights

Dollar Tree, famous for pricing its product line at $1, recently announced that for the first time in its history it will start pricing some of its products above a dollar, with some of its products even reaching $1.50. Management explained that cost prices have increased so much that it became prohibitively expensive to remain committed to its original brand promise. Dollar Tree reaching this breaking point is illustrative of just how strong the ongoing inflationary pressure is.

Inflation is even more worrisome if it starts appearing in unexpected places in magnitudes that are also unpredictable. Adapting becomes like playing a game of Whack-A-Mole. David Taylor, CEO of Procter & Gamble, one of the world’s biggest consumer packaged goods companies, said about the current trend that “it’s inevitable we will see an increase in inflation” but quickly added: “How much? I don’t know”.

Unilever, another consumer packaged goods giant, was recently even downgraded for not being adaptive enough to combat inflation. Their profits started evaporating as prices for raw materials increased. One thing is for sure: not acting is a losing strategy.

However, focusing on rising cost prices alone is not enough to deal with inflation. To sustain and even grow in an inflationary environment, a solid understanding of demand is much more important. Specifically, you want to know where demand is right now and where it’s heading. This requires a new way of understanding and measuring demand.

Historical data is not enough

You can minimize the harm of inflation by knowing what price levels are acceptable and updating these against business objectives quickly. The default approach to understanding and anticipating pricing trends is by analyzing the historical record. This works well if market conditions are relatively stable, considering that statistical models work best in a narrow window.

However, as General Mills CEO Jeffrey Harmening recently told analysts, “we’re kind of [in] an uncharted territory, to be honest with you. And that’s why all elasticity models are always based on historical data, which is useful to a point, but only to a point”.

Elasticity models tell you how sensitive consumers are to potential price changes. The problem with this approach, however, is that inflation does not appear everywhere at the same time or at the same magnitude.

As a result, you cannot use historical data to simply extrapolate. Both how much consumers are willing to pay and how sensitive they are to any price changes can fluctuate strongly over time. The stronger this fluctuation, the less likely classic statistical models are going to be sufficiently accurate.

It’s all about demand, not cost

Price increases are often justified publicly by pointing out that the cost price increased and, thus, the seller is basically forced to increase its prices as well. Indeed, a number of scientific studies show that consumers are more likely to consider a price hike as acceptable if they’re sufficiently convinced the seller is the victim here.

This insight might seem like an argument in favor of cost-based pricing but, actually, fairness considerations among consumers turn out to be relatively minor and temporary. In most cases, cost-based pricing is the wrong approach as consumers don’t care enough or don’t even know what’s happening to the underlying costs.

What sellers should care about is demand: How much are consumers willing to pay today? Kellogg’s CEO Steven Cahillane understood this best, saying that “we can go to the trade and talk about rising commodity prices and all these things […] but the more we spend against our brands in terms of innovation and making sure that they pull off the shelf, the more we earn the right to have those discussions with our retailers”.

To thrive in an inflationary environment a frequent and solid understanding of demand becomes essential. Standard methods focused on historical data simply do not reflect current reality accurately enough. Behavioral approaches that measure actual demand show much more potential to provide timely and accurate insights to update pricing and identify winning products.