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Overview
Value for its chosen customers Customers wants and needs A firms marketing efforts

Introduction to Pricing Strategy

Overview and principles of Pricing Pricing and profitability analysis

Overview
Capturing that value falls to the marketing mix, commonly referred to as the Four Ps:
Developing a product that satisfies those wants and needs Designing a promotion program that conveys the value of that product to customers Choosing a distribution program (i.e., place) that makes that product readily available Designing a pricing strategy that simultaneously creates a consumers incentive to buy that product and the firms incentive to sell that product

Overview
Pricings role in the marketing mix is:
to tap in to the value created and to generate revenues:
to fund the firm s current value-creation activities firms value creation activities, to support research that will lead to future value creation, and to generate a profit from the firms activities.

Overview
A complete pricing program has many components. For example, consider the pricing decisions surrounding the launch of a new MP3 player. These might include:
The unit price of the MP3 player to dealers and distributors The accompanying terms and conditions, such as:
whether and to what degree there will be a quantity discount the schedule of payments (i.e., when payments are due) whether there will be discounts for early payments or penalties for late payments

What is a Price?
Price
is the amount of money charged for a product or service. Is the economic sacrifice a customer makes to acquire a product or service. is an expression of value. value is the sum of all the values that consumers give up in order to gain the benefits of having or using a product or service. is the only element in the marketing mix that produces revenue; all other elements represent costs. is one of the four Ps.

The manufacturers suggested retail price (MSRP) to the end consumer Whether there will be any consumer pricing promotions (e.g., mail-in rebates)

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Synonyms for Price

Rent Tuition Fee Fare Rate Toll Premium Honorarium Special assessment Bribe Dues Salary Commission Wage Tax

The Drivers of Profit

Price: High/Low?
Too high a price reduces unit demand, allowing competitors to take away customers; Too low a price encourages more unit sales but reduces the profit margin on each sale. p f g But what price is too high? too low? Just right?

Pricing and Profitability Analysis

Determining Demand
The demand curve shows the number of units the market will buy in a given period at different prices. It represents the relationship b/w price & demand.
Slope of the demand curve (m) = (change in price)/(change in quantity demanded)

Normally, demand and price are inversely related

Higher price = lower demand

For prestige (luxury) goods, higher price can equal higher demand when consumers perceive higher prices as higher quality

Determining Demand
y=m*x+b
(where y is the price, x is the quantity demanded, m is the slope of the demand curve and b is the y-intercept)

Slope (m) = $30-$10/ 250-500 = -0.08 b = $ 50 y = -0.08 * x + $50 Price elasticity of demand = (%age change in quantity demanded)/ (%age change in price)

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Determining Demand

Pricing and Profitability Analysis

Profit as the difference between the revenues taken in and the costs incurred.
Profits = [Unit Price Cost of Goods Sold] * Unit Sales Volume

Two kinds of costs:

Fixed costs (FC) that remain at a given level regardless of the amount of the product produced and sold. Variable costs (VC) that change depending upon the amount of product produced and sold. Total costs (TC) = FC + VC per unit * Quantity Sold

Pricing and Profitability Analysis

Costs at Different Levels of Production

Costs as a Function of Production Experience

Experience or learning curve is
when average cost falls as production increases because fixed costs are spread over more units.

Contribution Margin
Margin calculations
The difference between the per unit revenue received by firm and the variable cost per unit is the unit margin or margin or unit contribution. g g Sometimes, it is useful to state the margin in percentage terms.

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Contribution Margin
Price Materials Costs Labor Costs Fixed Costs CM ($)

Contribution Margin
INDEPENDENT MANUFACTURING $2.00 1.20 .20 .40 $ .60 BETA PARTS, INC. Price Variable Costs Fixed Costs Contribution Margin $ .90 .35 .40 $ .55 ALPHA PARTS, INC. Price Variable Costs Fixed Costs Contribution Margin C ib i M i $ .30 .05 .20 $ .25 25

Total Revenue Annual Unit Sales Annual Pretax Profit

$2 million 1 million 200,000

Break-even Analysis
Break-Evens
What the organization makes in margins helps it to cover its fixed costs and hopefully produce a profit. We term the number of units sold which just enables the company to cover i fixed costs, its break-even quantity its fi d i b k i (BEQ) or volume (BEV). Mathematically, this BEV is given by: BEV = FC/(Price per unit-VC per unit)

Perspectives on Pricing
Prices should cover our costs and enable us to earn a fair rate of return. Prices should reflect the customers willingness to pay. Price cutting is a useful marketing tool for gaining sales. The purpose of good marketing is to avoid competing on price.

Tactical Pricing Orientations

Cost-Driven Pricing Customer-Driven Pricing Competition-Driven Pricing

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Example of Cost-based Pricing

Projected Costs and Revenues at Expected Sales = 1,000,000 units Total
Direct Variable Costs Direct Fixed Costs Administrative Overhead Full Cost Revenue $3,000,000 $3,000,000 $1,500,000 $7,500,000 $9,000,000

Example of Cost-based Pricing

Actual Costs and Revenue at Actual Sales = 750,000 units

Per Unit
$3.00 $3.00 $1.50 $7.50 $9.00 Direct Variable Costs Direct Fixed Costs Administrative Overhead Full Cost Revenue
Profit

Total
$2,250,000 $3,000,000 $1,500,000 $6,750,000 $6,750,000
$0

Per Unit
$3.00 $4.00 $2.00 $9.00 $9.00
$0

Example of Cost-based Pricing

Projected Costs and Revenues with Price Increased to $10.50 Per Unit
Current Price Unit Sales Variable Costs Fixed Costs Admin. Overhead Unit Cost Unit Profit Total Profit $9.00 $ 750,000 $3.00 $4.00 $2.00 $9.00 $0 $0 5% Decline in Unit Sales $10.50 $ 712,500 $3.00 $4.21 $2.11 $9.32 +$1.18 $843,750 33% Decline in Unit Sales $10.50 $ 500,000 $3.00 $6.00 $3.00 $12.00 -$1.50 -$750,000

Example of Cost-based Pricing

Financial Implications of a 10% Price Cut
Current Price Unit Sales Variable Costs Fixed Costs Admin. Overhead Unit Cost Unit Profit Total Profit $9.00 750,000 $3.00 $4.00 $2.00 $9.00 $0 $0 5% Increase in Unit Sales $8.10 787,500 $3.00 $3.81 $1.90 $8.71 -$0.61 -$480,375 33% Increase in Unit Sales $8.10 1,000,000 $3.00 $3.00 $1.50 $7.50 +$0.60 $600,000

Inferences
Higher prices are not necessarily more profitable prices. The financial effect of a price increase depends
on the impact of that increase on sales volume and p on the impact of changes in sales volume on unit cost.

Inferences
The cost question in pricing is not:
What prices do we need to cover costs and achieve our profit objectives?

Th cost questions in pricing are: The t ti i i i

How much sales gain would be required to profit from a price cut? How much sales loss would be tolerable to profit from a price increase? What costs can we afford to incur and still earn a profit?

Lower prices are not necessarily less profitable prices.

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Example
The Solvents Division of the Somerset Corporation is one of many producers of a popular industrial solvent. During this past year they priced this product at $8/bottle. They arrived at this price by applying the directive from the corporate office that the Solvents Division should earn a net profit of at least $80,000 to their projection that 100,000 units would be sold during this past year. Their thinking can be summarized as follows:
Projected unit sales Revenue* Variable costs** Fixed costs Net profit *($8/unit * 100,000 units) **($3/unit * 100,000 units) 100,000 $ 800,000 $ 300,000 $ 420,000 $20,000

Example
The president of the Solvents Division is now making the pricing decision for the upcoming year. His current thinking can be summarized by the following quote: "This past year's problem was that we didn't do a good job of predicting sales. Now that we know that sales will be 80,000 units, we can price this product so we can make that $80,000 of net profit that the corporate office wants. wants Compute the price per unit that is specified by the president's current thinking (you can assume that the past year's fixed costs and variable costs/unit are the same as those for the upcoming year). Do you agree with the president's current thinking? If you agree, explain why. If you do not agree, explain why, and then propose a better way to go about setting the upcoming year's price.

True/relevant Cost
Not all costs are relevant for every pricing decision. Understanding the true/relevant cost
It is incurred if a sale is made, or is not incurred if a sale is not made.

True/relevant Cost
Price Unit Sales Volume Total Revenue Unit Variable Costs Total V i bl C t T t l Variable Costs Unit Contribution Total Contribution Fixed Costs Net Income Before Taxes $10 100,000 $1,000,000 $3 $300,000 $300 000 $7 $700,000 $500,000 $200,000

Identifying true costs

Incremental (not the full cost) Avoidable (not the sunk cost)

True/relevant Cost
Most fixed costs are not incremental Some fixed costs are also incremental for pricing
They are the fixed costs incurred to implement a change in pricing.

Relevant Cost??
In the mid 1960s, McDonald's offered their franchisees breakfast items (e.g., Egg McMuffin) that they could offer in the mornings when demand for hamburgers and fries was not very large. What costs should a franchisee have properly considered in deciding whether to offer a breakfast menu and in determining the most profitable prices to charge for breakfast items?

Variable costs are always incremental

Examples:
Overtime vs. Average cost production; Costs from multiple sources using different technologies (joint product vs. Prime sourcing); Average over different types of customers.

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Approximately Right, Or Precisely Wrong

Determining the true cost requires making adjustments to the full, average costs as calculated for financial purposes.
These adjustments often require that you make judgments about which you are uncertain, and that are debatable. This is not, however, a reason to avoid making such judgments.

Cost-based Vs. Value-based Pricing

Product driven
Only at this stage marketing enters the process

It is better to make pricing decisions based on a rough idea of the true unit cost of your product or service than on a precise accounting of costs that are irrelevant to its profitability! Customer driven

Customer-Driven Pricing
It says that the demands of the market require pricing every product to reflect the customers willingness-to-pay. The purpose of strategic pricing Capturing more value OR more sales?? Profitability p g q g Low pricing is never a substitute for an adequate marketing effort
PRICE

Inferences
The customer question in pricing is not:
What price is the customer willing to pay?

The customer questions in p q pricing are: g

What prices can we convince buyers are supported by the value to them of our products and services? How can we better segment the market to reflect the differences in value to different types of customers?

WILLINGNESS TO PAY Or What the PRODUCT is really WORTH

Competition-Driven Pricing
As per this orientation
Pricing is a tool to achieve sales objectives. More the market share greater the profit??? Price cut?? c t??
probably the quickest and most effective way to achieve sales objectives. BUT is it a good decision financially??

Inferences
The competitive question in pricing is not:
What level of price will enable us to achieve our sales and market share objectives?

The competitive questions in pricing are:

Which shares of the market can we most profitably serve? How can we most profitably serve them?

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Strategic Pricing
The goal of pricing strategy should be to maximize long run profitability
Competition Customers

Strategic Pricing: Asking Right Questions

Tactical Questions Commonly Asked Strategic Questions That Should Be Asked What prices do we need How much sales gain would be required to profit from to cover costs and achieve a price cut? our profit objectives? How much sales loss would be tolerable to profit from a price increase? What Wh t costs can we afford to incur and still earn a t ff d t i d till profit? What price is the customer willing to pay? What prices can we convince buyers are supported by the value to them of our products and services? How can we better segment the market to reflect the differences in value to different types of customers? Which shares of the market can we most profitably serve? How can we most profitably serve them?

Pricing Strategy

Costs

What level of price will enable us to achieve our sales and market share objectives?

ACE MANUFACTURING
Ace Manufacturing earns revenues of $2,100,000 annually on 150,000 unit sales of an industrial part. The part is priced at $14 each. A potential customer, in an industry that the company has not previously served, asks ACE to submit a bid for a similar product that ACE could produce in the same facility using much of the same capital equipment. The new customer would p purchase 30,000 units annually. After evaluating this customer's needs and , y g identifying the substitute product, ACE's sales engineers conclude that a bid in the range of $10 per unit would be required to win this account. However, since the durability required by this customer was below ACE's usual standards, the engineers felt that cheaper materials could be used. ACE's engineers estimate that the variable cost of manufacturing this product, using the cheaper materials, will be $2.50 /unit. ACE will also require some additional production capacity that will increase fixed costs by $90,000. G&A costs to service this account will be approximately $60,000 annually. Revenues Costs Direct Variable Costs Direct Fixed Costs General & Admin. Admin Costs Total Costs Profits

Total Dollars 150,000 units $2,100,000 450000 750000 675000 1875000 $225,000

Dollars Per Unit 150,000 units $14.0 3 5 4.5 45 12.5 $ 1.5

What is the relevant unit cost for making this pricing decision? Is this business sufficiently profitable to make bidding worthwhile?

Calculation
Total Dollars Dollars Per Unit 150,000 units 180,000 units 150,000 units +30,000 +30,000 Revenues Costs Direct Variable Costs Direct Fixed Costs General & Admin. Costs Total Costs Profits 450000 750000 675000 1875000 $225,000 525,000 840,000 735,000 2,100,000 300,000 3 5 4.5 12.5 $ 1.5 2.50 4.67 4.08 11.25 <1.25> 2.50 3.00 2.00 7.5 2.50 $2,100,000 2,400,000 $14.0

Strategic Pricing
Difference b/w conventional pricing and strategic pricing is
The difference b/w reacting to the market and proactively managing them (Kohli & Sahay, 2000).

A right pricing strategy simultaneously creates a consumers incentive to buy that product and the firms incentive to sell that product.

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Strategic Pricing
The pricing strategy should be guided by three fundamental principles. Strategic pricing is:
V l b d Value-based Proactive
What ACTIONS must we take in order to create alignment between VALUE and PRICE??

Strategic Pricing
Strategic pricing is:
Profit-driven
To increase profitability. Requires trade-off b/w PRICE and VOLUME. Two forms:
Willingness to lower PRICE drive VOLUME. Willingness to give up VOLUME by raising PRICE.

The Strategic Pricing Pyramid

The Strategic Pricing Pyramid

The Pyramid includes 5 key elements: Value Creation:
The very FOUNDATION of pricing strategy. Understanding the ECONOMIC VALUE that customers g receive and segmenting markets based on value;

Price Structure:
The MENU of PRICES that enable customers to trade off price paid for value received. Using tools such as price metrics, and segmentation fences. Price is just the tip of the iceberg of a profitable pricing strategy.

The Strategic Pricing Pyramid

Value Communication:
Educating customers about the value they actually receive. Bringing perceptions of value into line with actual value.

Pricing Policy:
The discipline of pricing. pricing The rules, policies, and procedures customers and employees follow for different pricing configurations.

Price Level:
Is determined by all previous layers in the pyramid.