It is always tough when we discover that the gold standard for decision support in any business challenge needs an update, if not total rethinking. Such is the case with the broadly accepted “best practice” approach to determining price elasticity and the optimization of the products, features, and prices of almost all products and services.
For decades, companies have depended on choice analysis to identify the features and attributes, the tradeoffs that consumers will make, and the price parameters they will accept when considering a purchase. Choice-based conjoint (CBC) analysis ascended from its inception in the early 1980s to wide acceptance as the preferred methodology for pricing guidance, eventually with adoption of software that in theory makes the process more automated.
As with most more complex analyses that depend on higher level math, tools like CBC are best applied by the experts who understand not only how the algorithms work, but also the basic behavioral and economic science that is foundational to what the analysis is uncovering.
As one of the innovators who were part of the introduction of CBC, we are huge proponents of the elegance and utility of CBC to help marketers understand the drivers of choice. We know that psychologically, consumers assess product purchases based on complex, personal, stated and unstated decision rules, which CBC is perfectly positioned to identify and predict their impact on price.
We have been at this for decades. At some point, we have to take a hard look at the limits of CBC as it is typically implemented. And for the sake of the industry, we are forced to say that we can do better.
So what is the problem? And how can we fix it?
The classic approach to CBC looks at preferences, but ideally you want it to also reflect the constraints that may define the preferences.
Time can be a constraint that impacts price. If I need a product or service within a specific time frame, I might be willing to pay more to obtain it. Or if time is not as pressing, a lower price may be the key attribute that will influence a purchase. We see this principle every day in the choice of shipping options in online commerce.
But beyond preferences, the constraint of a money budget imposes a consideration that may be an even more powerful motivator/demotivator to making a purchase choice. I may want a phone with extended battery life, or a car with luxury accessories, or I may want the luxurious and expensive skin moisturizer. But my money budget constraints, relative to all my other payment obligations, may make those unacceptable choices. Traditional CBC is not structured to accommodate the money budget as an attribute, and its omission distorts the size of those factors that are impacting buyer choice behavior.
Using a money budget in a choice model yields estimates of price sensitivity that are dramatically lower than the price sensitivity estimates found in choice analyses that do not employ a budget. This guarantees drastically different implications for price setting.
How does it work?
Budget Constrained CBC assumes that each person has a fixed budget for purchasing in a product category.
- If a purchase option costs less than their budget, it will be considered and the product may or may not be bought, depending upon the benefits it provides.
- However, if an option costs more than their budget, it will never be bought.
Let’s look at an example. These are the price sensitivity coefficients estimated in a study of purchasing a consumer durable. We studied choice behavior using CBCA with about 500 people who were “in the market” for a new model of this product.
We estimated a price sensitivity value for each person using the standard approach and also the budget constrained method. We can look at the percentiles of the distribution of price sensitivity across all people. This table shows the results.
The price sensitivity for the budget approach is “flatter” than for the standard model and is roughly half the size (-.491 versus -1.080).
The table shows that:
- All price sensitivities are negative, as they should be under economic theory.
- Mean price sensitivity under the standard approach is more than twice as large as the sensitivity under the budget constraint.
- The variability of the price sensitivity under the standard approach is about 50% more variable than under the budget constraint.
By ignoring the buyer’s budget, traditionally applied CBC will yield results that tell you that people will spend more than they actually will do and it tells you that people are much more diverse and variable in their estimated price sensitivity.
Building the Better CBC Model
The defect inherent in the gold standard of is corrected by estimating the buyer’s budget and including it explicitly in CBC.
Budget Constrained CBC overhauls this fundamental flaw and delivers more accurate estimate of willingness-to-pay, better fits to raw data, and deeper insights into buyer behavior.
Seems logical to you? We would love to prove it to you that it works. If you have an old CBC study for which you have the data and would like to see the results delivered by the constrained budget approach, contact steve@in4ins.com to discuss.
