Price must be an integral piece of a comprehensive marketing strategy. Therefore, a company should always avoid reducing price as a knee-jerk reaction to competitive pressure, especially when there has been no corresponding change to the company's overall marketing strategy. Doing so can be disastrous for businesses in a mature industry.

Most companies offer multiple products and or services. Some of these products and services will either adversely (substitute) or favorably (complementary) affect the sales of other products and services offered by the company. For example, automobile dealerships offer economy and luxury vehicles. The sale of an economy vehicle is considered a "substitute" product since the sale of this vehicle is at the expense of selling the higher margin, luxury vehicle. If the same buyer opts for "rust-proofing" or "mag wheels", these add-on product-services are deemed "complementary" since they represent a natural extension of the primary product sale - like popcorn goes with a movie.

Substitutes and complements typically call for an adjustment in pricing. To do so effectively, management must understand the revenue-cost effect of such a change for both the product being re-priced and the other products affected by the change.

Understanding your customer mix and motivation are the keys to substitute product pricing. Remember, a business-owner's inclination is to view all customers the same, but all customers do not buy from you for the same reasons. Consider a simple example to make this clear.

Gas stations typically sell three different grades of fuel, Regular, Special and Premium.

• Regular Price $1.65 Gross Profit .20 cents Margin 12%
• Special Price $2.00 Gross Profit .30 cents Margin 15%
• Premium Price $2.20 Gross Profit .40 cents Margin 18%

If all customers were "price" motivated, gas stations would only sell Regular since it is the cheapest. Does this mean that every customer who purchases Regular Gas is motivated solely by price?

Suppose a certain station increases the price of its Regular Gas by 5% a gallon, which puts this station at least 3 cents higher than any competitor in the area? What do you think will happen? Will every Regular Gas customer leave?

Suppose the price change is initiated and after three months the station's Regular Gas sales are down by 15%. What does that say about the other 85%?

The above calculation tells us that the price increase is beneficial as long as sales of Regular Gas don't fall below (29%). In our example, the change in revenue is (15%), which means that although revenue fell, there was a net increase in overall gross profit dollars, so the price change was beneficial despite the loss of customers.

Now let's look at the ramifications of changing the price on the "high end" of the product set. In this case, the Premium Grade Gas. Assume the station owner leaves the price of Regular unchanged but raises the price of Premium Gas by 5%.

Here is where the "substitution" dynamic comes into play. When there is a change in price on the "low- end" product, such as the Regular Gas in this example, the buyer has two choices: 1) pay the new price or 2) go elsewhere. However, when we increase the price of the "high-end" product, buyers have three choices: 1) they can pay the new price, 2) go elsewhere OR, 3) "substitute" their purchase to the next lower price option. In this example, some Premium Gas customers may be bothered by a 5% increase and as a result, switch to the Special Grade Gas.

We can already assume something about Premium Gas users, can't we? These people are not as price conscious as the Regular Gas customers. These buyers are more heavily "Value" motivated. These are typically the Lexus, Porsche and Corvette owners who want top performance offered by Premium grade octane. On the other hand, some of these "value" buyers may be on the lower end of the spectrum - maybe they prefer Premium Octane because they drive eight cylinder cars but there is a price beyond which, the second best is fine.

Assume that the 5% increase in Premium Gas results in a 6% decrease in Premium sales after three months. However, there is a substitution dynamic in play here. The owner notices that at least half of these customers (3%) have opted to purchase the Special Grade Gas instead of the Premium. He had estimated that this might be the case.

But, was the increase in price of Premium a good idea? Using a two-step Break-Even Formula, we can make this determination as follows:

Step one: Determine the newly adjusted Gross Margin based on the gross profit loss of 30 cents per gallon of Premium, which is offset by a 20 cent pick-up from the substitution of Special.

Adjusted Gross Margin = 30 cents - (50% x 20 cents) = 20 cents / Premium Price $2.20 = 10%

In other words, for every gallon of Premium lost (30 cents), we recovered a gallon of Special (20 cents).

Step two: Calculate the Break Even Point in sales of Premium Gas where the price increase doesn't make sense.

If 50% of all customers bothered by the price increase leave and 50% remain but opt for the substitution of Special Gas:

Assuming that 50% of all Premium Gas customers affected switch to Special and 50% leave, this station will earn more profits unless Premium Gas sales drop below 33.33% of present levels.

Substitute product pricing can be a very effective strategy to improve profitability, even for mature industries, so long as you understand your customer base and each segment's "buying motivation."