Price Elasticity - A Potential Pricing Tool At IKEA

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Price elasticity- A potential pricing tool at IKEA Sophie Hagströmer & Louise SalomonssonLund Institute of TechnologyDepartment of Production ManagementBox 118SE-221 00 LundKFS i Lund ABLund 2005Printed in Sweden

Price elasticity – a potential pricing tool at IKEA2

Price elasticity – a potential pricing tool at IKEAPrefaceThis Master thesis project has been performed during the fall of 2004 for theBusiness Area Home Organisation, BA10, at IKEA of Sweden, Älmhult. Thepurpose with the thesis has been to develop a theoretical pricing model that willassist as a quantitative tool for future pricing decisions. During the fall the authorshave had the opportunity to work with professionals at IKEA of Sweden, who havecontributed with valuable ideas and comments.The authors would like to express their appreciation to their tutors/supervisors atIKEA of Sweden, Henrik Bergstrand, Mattias Carlsson and Jonathan Catlow, whohave guided and assisted the authors throughout the project. Furthermore theauthors would like to thank their tutor at Lund Institute of Technology, IngelaElofsson, for her guidance, coaching and encouragement during the process ofwriting this Master thesis. Finally the authors would like to thank Jerker Holm, atthe Department of Economics at Lund Institute of Economics and Management, forhis theoretical advices and recommendations.Lund, January 25th 2005Sophie HagströmerLouise Salomonsson3

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Price elasticity – a potential pricing tool at IKEAAbstractTitle:Price elasticity - A potential pricing tool at IKEAAuthors:Sophie HagströmerLouise SalomonssonSupervisors:Henrik Bergstrand, Business Navigator, BA10, IKEAof SwedenMattias Carlsson, Supply Planner, BA10, IKEA ofSwedenJonathan Catlow, Commercial Mangager, BA10,IKEA of SwedenIngela Elofsson, Department of ProductionManagement, Lund Institute of TechnologyResearch questions:How will price altering affect sales volume for IKEAof Sweden Business Area 10’s products? Is itpossible to estimate the products’ price elasticities? Ifso, what data is sufficient and how can theseparameters contribute to future pricing procedures atBA10? What product properties are necessary inorder to retain a reliable analysis? In which way aresales volumes influenced by macroeconomic factorssuch as real income, unemployment and businesscycles? Is there an appropriate way to definehomogenous markets for IKEA? If a model thatdescribes the local behaviour is found, will this modelbe globally applicable or should it be modified to fitdifferent markets? Are there any microeconomicsubstitution or complementary effects outside orwithin the IKEA range? Do internal factors, forexample advertising and service levels, affect thedemand and therefore sales turnover? How can amodel take these effects into consideration?Purpose:The purpose of this Master thesis is to develop atheoretical pricing model that will assist as aquantitative tool for future pricing decisions. The toolwill become a complement to the internal companyfactors and external environmental factors, whichtoday have the greatest impact on the pricingprocedures. In addition the model should preferablybe applicable on both existing and new products.5

Price elasticity – a potential pricing tool at IKEAMethodology:In order to estimate the price elasticity for BA10’sproducts, the authors first had to gain knowledgeconcerning BA10’s products and the business areas’current pricing strategies and procedures. Thereafterthe authors designed a regression model with the helpof academic theory. A demand curve illustrating therelationship between quantity demanded, Q, and theprice, P, of a BA10 product was defined. Thereafteradditional measurable factors that affect demandwere defined, in order to deduct heterogeneity amongcountries. With the aim to attain reliable regressionresults the authors finally created a program, whichperformed all calculations automatically. Theresearch process has been iterative and bothquantitative and qualitative methods have beenapplied.Conclusions:The authors have designed a regression model thatestimates the price elasticities for BA10 products.Products included in the model are currently in therange and have a sales history of at least one financialyear. The authors draw the conclusion that price has astatistically significant impact on sales volumes forthe majority of BA10’s products. Suitable prices aretherefore crucial, in order to maximize turnover. Theproducts belonging to the two lowest price groupshave been identified as the most price elastic. Inaddition the authors have concluded that the demandfor BA10’s products is positive correlated withincome, i.e. the products should be classified asnormal goods. The authors have identified three priorfields of application for the results of this thesis;optimization in price investments, forecasting andprioritisation in range development.Key words:Price elasticity, pricing strategies, pricing model,regression model, forecasting of sales volumes.6

Price elasticity – a potential pricing tool at IKEATable of content1. Introduction. 111.1 Background . 111.2 Problem description. 121.3 Purpose . 121.4 Delimitations . 131.5 Target audience . 131.6 Confidentiality. 131.7 Disposition and outline. 142. IKEA in brief. 172.1 The IKEA organisation . 172.1.1 Vision and business concept . 172.1.2 Ownership structure . 172.2 The pricing procedures at IKEA . 202.2.1 Price style matrix. 202.2.2 Pricing new products. 212.2.3 Activities and time restricted offers . 212.2.4 Implementing prices. 212.2.5 Price meeting . 213. Methodology . 233.1 Investigations . 233.1.1 Explorative, descriptive, diagnostic, explanatory and evaluative study. 233.1.2 Investigations in this thesis . 243.2 Sources of information . 243.2.1 Primary data. 243.2.2 Secondary data . 253.2.3 Primary and secondary data in this thesis. 263.3 The research method . 263.3.1 Quantitative methods . 263.3.2 Qualitative methods . 263.3.3 Quantitative and qualitative methods in this thesis . 263.4 Inductive, deductive and hypothetic-deductive. 273.4.1 Hypothetic-deductive approach in this thesis . 283.5 Creditability. 303.5.1 Validity. 303.5.2 Reliability. 303.5.3 Objectivity. 303.5.4 Criticism of the sources . 313.5.5 The creditability in this thesis. 314. Theoretical framework . 334.1 Demand . 334.1.1 Income . 337

Price elasticity – a potential pricing tool at IKEA4.1.2 The price of the good . 334.1.3 Prices of related goods . 344.1.4 Population. 344.1.5 Expected future prices . 344.1.6 Preferences . 354.2 The demand curve . 354.3 Elasticity. 364.3.1 Price elasticity of demand . 364.3.2 Income elasticity of demand . 374.3.3 Cross-price elasticity of demand . 384.4 Price elasticity and different demand curves. 384.4.1 Elasticity along a straight-line demand curve . 384.4.2 Elasticity along an exponential demand curve . 394.5 Data for economic and econometric analysis. 404.5.1 Time series data. 404.5.2 Cross section data. 404.5.3 Pooled data. 414.6 The classic linear regression model. 414.6.1 Assumptions of the classical linear regression model . 424.6.2 The unobserved error term . 434.6.3 Degrees of freedom. 434.6.4 The coefficient of determination, R2. 444.6.5 The ordinary least squares method. 454.7 Elasticity and the log-linear model. 474.8 Hypothesis tests. 484.8.1 The t-distribution . 484.8.2 Interval estimation . 494.8.3 Hypothesis testing . 504.9 Macroeconomic factors . 534.9.1 Gross national income . 534.9.2 Big Mac index . 535. Design of model . 555.1 Pooled data . 555.2 Demand curve . 555.3 Regressors and parameters . 565.3.1 Derivation of the model’s price elasticity. 575.4 Justification of ordinary least square. 585.5 The regression model as a black box. 585.6 Substitutes . 606. Practical approach . 616.1 Preparations. 616.1.1 Historical sales data . 616.1.2 Choice of program. 636.1.3 Variables. 636.2 Construction of the program. 648

Price elasticity – a potential pricing tool at IKEA6.2.1 Subroutines . 646.2.2 Procedures when constructing the subroutines . 646.2.3 Record of information. 676.2.4 Further adjustments. 687. Preparations for the analysis . 697.1 Significance. 697.1.1 Price and GNI significance. 697.2 Elasticity. 697.2.1 Price elasticity . 707.2.2 Income elasticity . 718. Analysis . 758.1 Comments on model. 758.1.1 Pooled data. 758.1.2 Choice of regressors . 758.1.3 Reliability. 768.2 Analysis of results . 778.2.1 Analysis of overall results. 788.2.2 Analysis of results obtained for Group West . 838.2.3 Analysis of results with respect to GNI classification . 858.3 Comments on price setting meeting . 869. Conclusions and recommendations . 879.1 Conclusions . 879. 2 Fields of application . 889.2.1 Optimize price investments . 889.2.2 Forecasting . 899.2.3 Activities and time restricted offers . 909.2.4 Prioritisations in range development . 909.3 Further research. 9010. Sources . 9110.1 Published sources . 9110.2 Internal material . 9210.3 Electronic sources . 9210.4 Interviews . 93Appendix I . 95Appendix II. 97Appendix III . 99Appendix IV . 1099

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Price elasticity – a potential pricing tool at IKEA1. IntroductionThe objective with this chapter is to provide the reader with a background andcomprehension for this thesis. The introductory background is followed by theproblem description that leads into the purpose. Furthermore the chapter containsselected delimitations, target audience, confidentiality and the thesis’ disposition.1.1 BackgroundPrice is defined as the amount of money charged for a product or service. Morebroadly, it is the sum of all values that consumers exchange for the benefits ofhaving or using a product or service. Perhaps the price of a product has a greaterinfluence on the customers in poorer countries, but it is still an important factor inthe rest of the world. In addition price is a flexible element since it can be changedquickly. At the same time, pricing and price competition is a great problem facingmany marketing executives. 1The price a company charges will be somewhere between one that is too low toattain profitability and one that is too high to create any demand. Therefore productcosts set a floor to the price and the consumers’ perceptions set a ceiling. Furtherthe company must consider competitors’ prices and other external and internalfactors in order to find the best price between the two extremes. 2 But for specialreasons this fundamental theory is not always followed. This is, for example, thecase for IKEA of Sweden. 3IKEA of Sweden, IoS, is a company within the IKEA group which was founded1943 by Ingvar Kamprad. 4 Its responsibilities are development, sourcing, supplyand steering of the IKEA product range. 5 IoS is divided into ten different BusinessAreas, whereas this thesis project takes place at BA10, Home Organisation. 6The business idea of IKEA is “To create good design that works and has a pricethat everybody can afford to pay”. 7 The pricing procedures are therefore crucialand permeate the whole organisation. In line with the business idea IKEA alwaysaims to offer the lowest market prices. As a consequence the products’ grossmargins are not necessarily positive. The absence of any clear pricing method andthe high number of articles and countries, in which IKEA is represented, do notmake the pricing strategies less complex. In order to facilitate the pricingprocedures it would be useful to estimate future effects of price altering. 81Armstrong G, Kotler P (2000), Marketing: An Introduction, p289-290Armstrong G, Kotler P (2000), Marketing: An Introduction, p2993Bergstrand Henrik, 2004-09-104IKEA Services AB (2003), Facts & Figures5www.ikea.com, 2004-09-076Bergstrand Henrik, 2004-09-107Inter IKEA systems B.V. (2003), How We Create the Low Price, p18Bergstrand Henrik, 2004-09-10112

Price elasticity – a potential pricing tool at IKEA1.2 Problem descriptionWith the background in mind the most important issue in this thesis is how pricealtering affects the sales turnover at Business Area 10, IKEA of Sweden. To beable to answer this question several problems have to be considered.Since sales turnover is a function of price and sales volume, both components mustbe taken into consideration. One important question, in order to make effectiveprice investments, is to estimate how the quantity sold will change if the price isaltered. Is it possible to calculate the price elasticity? If so, what data is sufficientand how can these parameters contribute to future pricing procedures at BA10?What product properties are necessary in order to retain a reliable analysis?In which way are sales volumes influenced by macroeconomic factors such as realincome, unemployment and business cycles? Are social factors significant? Is therean appropriate way to define homogenous markets for IKEA? If a model thatdescribes the local behaviour is found, will this model be globally applicable orshould it be modified to fit a different market?Are there any microeconomic substitution or complementary effects outside orwithin the IKEA range? Do internal factors, for example advertising and servicelevels, affect the demand and therefore sales turnover? How can a model take theseeffects into consideration?1.3 PurposeThe purpose of this Master thesis is to develop a theoretical pricing model that willassist as a quantitative tool for future pricing decisions. The tool will become acomplement to the internal company factors and external environmental factors,which today have the greatest impact on the pricing procedures. In addition themodel should preferably be applicable on both existing and new products.12

Price elasticity – a potential pricing tool at IKEA1.4 DelimitationsThe dynamic environment and the large number of factors, that affect the demandfor IKEA’s articles, made it necessary for the authors to demark their area of study.The vague definition and complexity of complementary products within the IKEArange have implied that present complement effects are not considered in thisthesis. In addition, the authors ignore shifts in demand that arise in the presence ofcompetitors.Since the task is to optimise the total sales turnover the authors do not considerhow prices should be set in a cost perspective. Gross margin and gross profit aretherefore ignored.1.5 Target audienceThere are two main target groups for this thesis. The first target group is students atLund Institute of Technology, Lund School of Economics and other universitiesthat have an interest in econometrics, microeconomics and pricing strategies. Thesecond group is the employees at IKEA of Sweden, especially those who have hada tutoring part in this Master thesis, with the ambition to consider estimated priceelasticities when setting future prices.1.6 ConfidentialityBecause of the IKEA confidentiality policies not all figures is presented in thisversion of the thesis and has been replaced by crosses, . However, thisimplication is not considered to affect the informative or academic value of theMaster thesis.13

Price elasticity – a potential pricing tool at IKEA1.7 Disposition and outlineIn this section the authors want to introduce the reader to the disposition andoutline of this thesis. The project consists of the six parts, which are illustrated infigure 1.1.Chapter 1, 2 – INTRODUCTORY PARTChapter 3 - METHODOLOGYChapter 4 – THEORETICAL FRAMEWORKChapter 5, 6, 7- EMPIRICAL STUDIESChapter 8 - ANALYSISChapter 9 – CONCLUSIONS & RECOMMENDATIONSFigure 1.1 Disposition and outline in the thesisThe first part of this thesis consists of two chapters: the Introduction and IKEA inbrief. The chapter Introduction provides a background and comprehension for thisthesis, in which the reader will get presented to the problem description, purposeand delimitations that forms the basis for the study. In the chapter IKEA in brief,the organization structure of IKEA is outlined The aim with this chapter is toincrease the knowledge regarding the Business Area Home Organization’s positionand responsibilities. In addition the Business Area’s current pricing strategies andprocedures are presented.14

Price elasticity – a potential pricing tool at IKEAIn the second part, the Methodology chapter, the authors declare the researchmethods applied in this thesis. In addition the authors will discuss how thesemethods have been implemented and interpreted by the authors.The third part includes the Theoretical framework, which consists ofmicroeconomic and econometric theory. This chapter aims to introduce the readerto necessary theories, in order to follow the empirical studies.In the first empirical chapter, Design of model, the authors design a regressionmodel based on the theoretical framework in chapter three. The regression model islater applied to selected products by the help of a program, created in MicrosoftExcel. The procedures followed when creating this program are described in thesecond empirical chapter, Practical approach. In the third empirical chapter,Preparations for the analysis, the authors have defined criterion and testedhypothesis, which form the basis for the analysis in this thesis.In the two final chapters, Analysis and Conclusions and recommendations, theregression results will be discussed and interpreted followed by conclusions andrecommendations.15

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Price elasticity – a potential pricing tool at IKEA2. IKEA in briefThis chapter will give the reader an overview of the IKEA organisation, in order tounderstand BA10’s position and responsibilities. Furthermore the current pricingstrategies and procedures will be presented.2.1 The IKEA organisationIKEA is one of the biggest global home furnishing companies with more than200 stores in over 30 countries. The IKEA concept was founded in 1943 by the17 year old Ingvar Kamprad. The initial letters in the name of the profounderIngvar Kamprad, the farm Elmtaryd and the village Agunaryd makes up thecompany name, IKEA. Elmtaryd and Agunaryd are located in Småland, Sweden.Pencils, Christmas cards and socks formed a part of the initial product range, thattoday consists of about 10 000 articles 9 .2.1.1 Vision and business conceptIKEA’s vision is to “Create a better day for the many people”. To realise theirvision IKEA offers a wide range of design- and functional home furnishingproducts to prices so low that as many people as possible will afford to buy them.This demands close co-operation between designers, product developers,purchasers and suppliers to insure that the IKEA products are designed,manufactured, transported, sold and assembled in the most cost effective manner.IKEA’s customers contribute to keeping prices low, by transporting theirpurchased items home and assemble them. 10,112.1.2 Ownership structureThe ownership structure and organisation of IKEA, illustrated in figure 2.1, standfor long-term independence and security. The main owner of the IKEA group is thefoundation “Stiching INGKA Foundation” and it is registered in the Netherlands.Stiching INGKA Foundation owns INGKA Holding B.V., which is the parentcompany of all companies within the IKEA group.9IKEA Services AB(2003), Facts & FiguresIKEA Services AB(2003), Facts & Figures11www.ikea.com 2004-09-071710

Price elasticity – a potential pricing tool at IKEAFigure 2.1 0wnership structure and organisation of the IKEA Group(www.ikea.com, 2004-09-07)Inter IKEA Systems B.V. is the owner and world-wide franchiser of the IKEAconcept. According to a detailed expansion plan Inter IKEA systems B.V. grantsnew franchises to new or already existing markets/territories. The IKEA group isthe biggest franchisee of Inter IKEA systems B.V. 122.1.2.1 IKEA of SwedenIKEA of Sweden is located in Älmhult, Sweden and is responsible fordevelopment, sourcing, supply and steering of the product range of IKEA.Furthermore they name all articles. For example, fabrics and curtains are givenfemale names, carpets Danish place names and armchairs Swedish place names. 13IoS is divided into ten different business areas where every business area operatesas “a company in the company”. Some examples of different business areas areKitchen & Dining, Textiles, Children’

Title: Price elasticity - A potential pricing tool at IKEA Authors: Sophie Hagströmer Louise Salomonsson Supervisors: Henrik Bergstrand, Business Navigator, BA10, IKEA of Sweden Mattias Carlsson, Supply Planner, BA10, IKEA of Sweden Jonathan Catlow, Commercial Mangager, BA10, IKEA of Sweden Ingela Elofsson, Department of Production

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