By Brian Elliott, Partner and Head of Innovation at Periscope By McKinsey

The question how demand will change subsequent to a price increase, a promotion, or a portfolio restructuring program isn’t new. In the past, companies have often relied on experience and intuition to ‘guesstimate’ such effects. But as portfolios are growing, consumer decision making is evolving, and commercial cycles are getting shorter, the experience of even seasoned experts is insufficient for robust portfolio decision making. Some players are using discrete choice models and econometric modelling to predict the impact of demand flows. While such methods work well for limited ranges, they are unable to account for the cross-effects of pricing and assortment moves across large portfolios at the unit level.

In collaboration with leading academics, we have developed an approach that does justice to the complexity of today’s portfolios and consumer decision journeys. The demand transfer matrix approach describes how volume flows in response to commercial decisions such as pricing changes, promotions, and assortment restructuring. Our approach is based on net elasticity of demand, in addition to elasticity at the SKU level. In other words, it reflects the total effects of a pricing or assortment change across a company’s entire portfolio of brands and products in the same category as well as those of its competitors. It accounts for “good volume flow” within a company’s portfolio as well as for “bad volume flow” to competitor brands. What is more, the demand transfer matrix approach uses observed, actual switching behavior as derived from robust sources (e.g. household panel data, retail point of sale data, online website browsing traffic) to create a precise understanding of product substitutability. In addition, it can also account for non-existing products through simulation based on attributes of the new products. The demand transfer matrix combines the strength of purchase structure modelling – understanding how shoppers make choices and trade-offs in a given category – with the greater precision of econometric net elasticity calculation across the entire portfolio.

Because it lets companies quantify the net elasticity of demand across large portfolios in the same category and reflects actual substitutability, the demand transfer matrix approach is superior to experience based portfolio management, traditional discrete choice models, and pure econometric approaches. It has been widely tested and applied in industries including FMCG and CPG, as well as across channels including modern trade, such as retail and convenience, as well as traditional trade in multiple countries. Functional applications include portfolio innovation, assortment management, pricing, and promotion management. While the demand transfer matrix approach is powerful, it is also analytically complex and hungry for data. We strongly recommend it to companies that manage large portfolios of brands and products in the same category. It is especially helpful for companies that have acquired brands that compete directly with their own brands, enabling them to take value-based decisions about portfolio consolidation in a post-merger situation. For these companies, evaluating only priority brands in isolation will often produce incorrect results that can lead to decisions that destroy value. Added to this, it can also be used for big changes in tariffs and taxes to assess the shift in demand. That said, for companies with narrower assortments, or multiple brands in categories with little or no overlap, traditional discrete choice and econometric models might work just as well.

To get further insight into how our demand transfer matrix approach works, download the full white paper here