Pricing Programs

Chapter 9

Topic Outline
Establish the pricing objectives Analyze the price-elasticity of demand Identify key factors acting on price competition Examine the relationship between price changes and volume, cost, and profit changes Basic types of pricing programs Impact of the planned pricing program on any product line, substitute or complements

Pricing Program
A pricing Program is the firms selection of general level of pricing for a given product relative to the level of pricing being charged by the competitors The general type of pricing programs 1. Penetration pricing 2. Parity pricing 3. Premium pricing Pricing program should be supportive of marketing strategy

Pricing Objectives
The primary role of pricing decisions is to help management implement its chosen marketing strategy. Pricing is central thrust of marketing strategy Price will play a minor role in buying process, When: Buyers are concerned about other attributes and benefits The differences in price among competitors are minimal Pricing can be supportive of primary demand oriented strategy if lower price can: Increase the number of users Increase the rate of use or repurchase within the product form or class

Pricing Objectives
In early stages of PLC, an important goal is to generate new users. A lower price may: Reduce the risk of trail Enhance the value of a new product relative to old one The use of pricing programs to support primary demand strategies is limited Market demand must be price elastic for such strategies to be successful ( early stages of life cycle) Industry prices tend to decline over life cycle , leaving less margins available for future price cuts The effectiveness of price in selective demand strategy depends on:

Pricing Objectives
the importance customers attach to price in making choices within product form or product class Nature of demand interrelationship within the product line - Firms seeking to expand their served market through line extensions must consider the pricing of a new product in the context of existing products - Too low a price on an extension targeted to price sensitive segment can enhance the probability of cannibalization on existing product sale - If the extension is a high end quality oriented addition, the higher price may signal high quality If the firms strategy is retention of existing customers, the role of price is to meet the price charged by the competitors Price can used to sell complimentary products to customers through tactics like Price leaders and bundling Price may be a critical factor in acquiring competitors customers either by Becoming the low price leader

Pricing Objectives
High price to underscore a quality based differentiation In most price categories price differences among competitors decline overtime as: Consumers become more knowledgeable about products Quality differences are harder to maintain Pursuit of competitive advantage through pricing programs requires a very thorough understanding of competitive forces The ability to successfully use price to implement a given market strategy will be limited by: The price elasticity of the market and company demand Competitors actions and reactions Cost and profitability consequences Product line consideration

Marketing Strategies and possible pricing objectives Marketing Strategies Primary Demand Strategies
Increase number of users Reduce economic Risk of trail Offer better value than competing product/ classes Enhance frequency of purchase Enable use in more situations Serve price oriented segment Offer high end versions of product Undercut competitors on price Use price to signal high quality Eliminate competitors price advantage Expand sales of Complimentary Products

Pricing Objectives

Increase Rate of Purchase

Selective Demand Strategy

Expand Served market Acquire Competitors customers Retain/Expand current customers

Considerations Involved in the success of Pricing Program

Pricing Programs Penetration Parity Premium Elasticity of Demand Cost and Profitability Contribution to achieving Marketing Strategy Competitors Actions Cross Elasticity Substitutes Compliments

 Unlike other productivity relationships, a change in price has two fold effect on the firms sales revenue A change in the units sold A change in revenue per unit Managers should not be concerned merely: With price sensitivity of the market Must also be concerned with the change on total dollar volume Price elasticity is not simply another way to express sensitivity If a change in price causes a change in units sold , demand is somewhat price sensitive When using the term price elasticity, the impact of price change on total revenue should be examined

Price Elasticity Of Demand

 Specifically Price-elasticity of demand is measured by the percentage change in quantity divided by percentage change in in price Given an initial price P1 and an initial quantity Q1, the elasticity of change in in price from P1 to P2 is calculated by: e = Q2 Q1 / 1 ( Q2 + Q1 )
2

(P2 P1) / 1 (P2 + P1 ) 2

Effects Of Different Types of Elasticity

Value of e e>-1 e=-1 Type of Elasticity inelastic Effect On Total Revenue Of Price increase Price Decrease increase decrease no change

unitary elastic no change

e < -1

elastic

decrease

increase

The important number to keep in mind is - 1 If elasticity is -1 0r smaller (-2 or -3) then demand is very sensitive to price and the change in revenue change will be in opposite direction (increase or decrease) of the price change If elasticity is greater than -1 such as -1/2 or +1/2, then demand is not very price sensitive and an increase (or decrease) in price will result in an increase (decrease) in revenue

Price Elasticity Of Demand

In practice it is difficult for managers to develop a precise, reliable estimate of elasticity By simply determining e is greater than 1 or less than -1 will enable managers to understand the impact of a change in price or revenue In making estimates of elasticity, managers need to distinguish between elasticity of market demand and elasticity of company (or brand) demand and to recognize that differences in elasticity may exist across segment within a market

Market Segments, and Company Elasticity

Market elasticity indicates how total primary demand responds to a change in the average prices of all competitors Company elasticity indicates the willingness of customers to shift brands or suppliers (or new customers to choose a supplier) on the basis of price Example table salt: the market demand for table salt is inelastic: people cannot consume much more if prices are lowered If one producer lowers its price, that producers is likely to gain market share Although market demand may be inelastic, company demand at the same time can be elastic because buyers may be very sensitive to competitive price differences

Market and Market Segment Demand Schedule

Weekly Market Sales Weekly Trip Undiscounted Rate $350 $325 $300 Units Total Revenue $ 14.0 mill. $ 14. 625 mill $15.3 mill.

40,000 45,000 51,000

Weekly Sales Business Class

Weekly Trip Undiscounted Rate
$ 350 $ 325 $ 300 Units Revenue

Weekly Sales Economy Class

Unit Revenue

24,000 25000 26,000

$8.4 mill. $ 8.125 mill $ 7.8 mill.

16,000 20,000 25,000

$ 5.6 mill. $ 6.5 mill. $ 7.5 mill

 Airlines which target business segment need not use aggressive pricing as the basis for marketing strategy Whether a firms individual marketing strategy is effective will depend on company elasticity of demand Even if the industry prices declines in the price elastic segment, a firm might conceivably experience inelastic demand if it could clearly differentiate its products/ services in terms of some other determinant attribute If so that firm could continue to charge prices higher than competitors without reducing profitability If the pricing objective reflect primary demand strategies (increasing rate of purchase for the product form, or increase in demand among users) then managers should be concerned about market demand elasticity If pricing objective reflect selective demand strategies ( retention or acquisition of customers) then managers should be concerned about elasticity of company demand

 It is not necessary that demand be elastic in order to achieve a pricing

objective
Managers may be very committed to retaining or acquiring new customers when the objective is to maintain share or increase market share This commitment may be so strong that manager will be willing to risk some reduction in total revenue in order to maintain or establish a strong position in the market

Price $ 2.00 $ 1.50 $ 1.00

Demand 500,000 600,000 750,000

Total Revenue $ 1,000,000 $ 900,000 $ 750,000

Demand is inelastic, as total revenue decrease as price is reduced Buyers are still sensitive to price. If the impact of higher volume on total revenue and profit is acceptable, then a manager will decide to lower the price, sacrificing some degree of profitability for market share and sales volume

Factors underlying Elasticity of Demand

Factors Suggesting Elastic Market demand
1. Many alternative forms or classes exist for which product could be substituted 2. Only a small percentage of potential buyers currently purchase or own the product because of the high price and because the product represent a discretionary purchase 3. The rate of purchase or the rate of replacement can be increased through lower price

Factors Suggesting Elastic Company Demand

1. Buyers are knowledgeable about a large number of alternatives 2. Quality differences do not exist or are not perceived 3. The supplier or brand can be changed easily and with minimal efforts or costs

Estimating Price Elasticity

1. Historical Ratios: When using this approach, managers must have historical data of : Company sales and its prices Industry sales and competitive prices To estimate market elasticity must determine the historical relationship between industry sales and some average of industry prices Both pieces of information are also needed to estimate companys elasticity of demand The effect of a companys price on selective demand will depend on how much companys price differs from competitors - If, in the past a firm has consistently raised its price without any loss in sales, management cannot necessarily infer that company demand is inelastic. Why? - Competitors may also have been raising prices

 Estimates of companys elasticity cannot be made without considering changes in industry sales Increase in companys sales may result in increase in market share or an increase in industry sales Accordingly managers should examine the historical relationship between a companys relative price (relative to competitors prices) and market share when attempting to access companys elasticity Historical ratios will only reveal price elasticity if no changes in other important variable or environmental variables have occurred

Estimating Price Elasticity

2. Field experiments: Price experiments are conducted using scanner panel experiments Stores in particular regions are selected In control stores price of the product remain same through out In experimental stores sales levels are recorded at different price levels The impact of price on sales is calculated to form opinion about price elasticity Limitation Time consuming

Estimating Price Elasticity

3. Controlled Choice experiments: Prediction of what consumer might do in store environment can be made by surveys or choice experiments conducted in controlled setting The most widely used approach is the conjoint analysis method This method analyses how buyers trade-off attributes in making choices The biggest trade-offs consumers make are usually between various levels of benefits and price This method is relevant in: Understanding price sensitivity Designing and pricing new products because it allows management to consider the contribution of price and non price attributes in market acceptance

 Whether the concern is market or company elasticity, competitors reaction to price change must be considered If change in price is met by all competitors, then no change in market share should result In such case price will have no impact on selective demand Managers should attempt to determine what competitors pricing reaction will be It will be useful to examine historical patterns of competitive of competitive behavior in projecting price reactions

Competitive Factors

 Some competitors may price their products on the basis of cost. These firms often do not shift their pricing policies over time. Instead: They either price very competitively( if they are trying to take advantage of experience curves or economies of scale) Attempt to maintain consistent contribution margins and avoid direct price competition By analyzing competitors historical pricing behavior, insights regarding the customers reaction to price change may be obtained If an industry has historically been characterized by extensive price cutting buyers will more likely to be price sensitive

Competitive Factors

 Competitors response can also be analyzed by knowing their strengths and weaknesses and the degree of intensity of competition Even when the price is decision issue at hand managers should assess both the non price reaction as well as direct price reaction in a market because competitors non-price reactions may influence price elasticity Research has drawn the following conclusions 1. An increase in price-oriented advertising in the market leads to greater price sensitivity among consumers 2. An increase in non-price advertising in a market leads to lower price sensitivity among consumers

Competitive Factors

 Many firms use cost plus approach to pricing Price is determined by taking the cost per unit and then adding a dollar or percentage- target contribution margin An illustration of Cost plus Pricing for a liquid Dishwashing Detergent
Variable cost per case ( materials, packaging) Plus allocated share of manufacturing overhead Plus allocated share of advertising Total unit cost plus target profit per case Manufacturers selling price to retailer $ 6.80 1.70 6.50 $ 15. 00 $ 2.00 $ 17.00

Cost Factors

 In order to estimate the fixed cost per case, the company must have some estimate of the number of cases that will be sold because Fixed cost per case = Total Fixed cost/ number of cases A key issue in using cost plus method is determining the true unit cost In many cases some costs are fixed arbitrarily Fixed cost will include direct fixed cost plus some contribution to company overhead Since the amount of fixed cost must be based on some estimate of the number of units sold, the company is implicitly assuming demand will not vary dramatically with any change in the factory price In the above example assume that total annual advertising and selling expenses are expected to $26million. In order to determine the share of these costs to assign to each case sold a manager must have some estimate of expected sales volume, even though the total cost( and thus the final price) has yet to be determined $ 6.50 allocation per unit must mean sales are expected to be 4 million cases

Cost Factors

 $ 6.50 = $ 26 million / 4 million cases The above example is the use of full cost approach in which all cost are included in setting the minimum price Alternative approach is variable cost pricing approach If a firm is operating in a price elastic market at less than full capacity it may be able to improve total profitability through pricing below the average unit cost As long as the company is pricing the product above variable cost each unit sold makes some contribution to fixed cost If managers assume that demand is inelastic the variable cost pricing option is not used

Types of Pricing Programs

1. 2. 3. Pricing program is selected after: Establishing pricing objective Assessed price elasticity Assessed competitive and cost situation Three basic types of programs Penetration pricing Parity pricing Premium pricing

1. Penetration Pricing
Designed to use low price as the major basis for stimulating demand Firms are attempting to increase their degree of penetration in the market by either: Stimulating primary demand Increasing the market share ( acquiring new customers) on price The success of penetration pricing requires that either market( primary) demand or company (selective) demand be elastic If market demand is elastic the market demand and total industry revenue will grow with reduction in industry prices Even if competitors match the price cut, the increase in market demand will make all competitors better off

1. Penetration Pricing
If economies of scale exist or the product has many complements, the benefits of increased volume are even greater If market demand is inelastic, then penetration pricing can make sense only if selective demand is elastic If competitors cannot or will not match lower prices The failure of competitors to match the lower prices could reflect: a lack of competitiveness on cost Willingness to concede market share in exchange for higher profits Low price appeals to minor segment of the market

Conditions Favoring a penetration pricing program

1. Market demand is elastic 2. Company demand is elastic, and competitors cannot match price because of cost disadvantage 3. The firm also sells higher-margin complementary products 4. A large number of potential competitors exist

5. Excessive economies of scale exist, so variable cost approach can be used to set premium price
6. The pricing objective is to accomplish either of the following:

Build primary demand

Acquire new customers by undercutting competition

 Setting price at or near competitive levels Attempt to downplay the role of pricing Other marketing programs are primarily responsible for implementing marketing strategy This approach will be selected when company demand is elastic industry demand is inelastic Most competitors are willing and able to march any price cut In such situations managers should avoid penetration pricing because:

2. Parity Pricing

 Any cuts will be offset by competitive retaliation Resulting in lower industry prices Without significant gain in industry sales Total revenues and profit margin will decline Parity pricing is comparable with cost plus pricing In many industries cost structures will be similar for various competitors ( similar labor contracts, raw materials, technologies and distribution channels) The potential gains for any economies of scale would go unrealized, meaning variable cost floor price is impractical

2. Parity Pricing

Conditions favoring a parity pricing program

1. Market demand is inelastic company demand is elastic

2. The company has no cost advantage over competitors 3. There are no expected gains from economies of scale to the price floor 4. The pricing objective is to meet the customer

Premium Pricing
Setting pricing levels above competitive levels This approach will be successful if a firm is able to differentiate its products in terms of: Higher quality Superior features or special services Establishing an inelastic demand curve Firms that successfully implement this approach will: Generate higher contribution margin Insulate them from price competition Advantage that allows a firm to set a premium price may not last for ever These programs must be reviewed regularly

Conditions Favoring Premium Pricing Program 1. Company demand is inelastic 2. The firm has no excess capacity 3. There are very strong barriers to entry 4. Gains from economies of scale are relatively minor. So full cost method is used to determine the minimum price 5. The pricing objective is to attract new customers on quality

Product Line Pricing

Pricing decision for one product can influence sales of other products Price cross elasticities are the relationship that exist when a change in in the price of one product influence the sales volume of a second product Price elasticity are of two types: 1. Substitute Products: When an increase (decrease) in price of one product result in increase (decrease) in sales of second product 2. Compliment products:

Product Line Pricing

If the price increase (decrease) in price of one product results decrease (increase) in sales of second product Product line extension can be of two types: Vertical or horizontal In vertical product line extensions different offerings provide similar benefits at different price and quality levels In horizontal extensions each offering has distinctive non price benefits In both cases cannibalization is the potential problem.

Product Line Pricing

In vertical line extension cannibalization due to price difference is much greater In horizontal line extensions cannibalization that results from price difference is not very significant. Why? Differentiation among offering s in the line is related specialized benefits, usage situations, or preferences that will override price in the choice process In such cases consumers would have a relatively wide range of acceptable prices relative to their reference price

Product Line Pricing

A reference price is a psychological standard against which observed prices are compared to judge their reasonableness When products in the same broad category are evaluated , the reference price range is likely to be wide because the range of actual prices the consumer is aware of is also wide In vertical extensions, products within the line are likely to be similar, different only on one or two dimensions other than price

Product Line Pricing

In this case an important principle is anchoring Anchoring is the effect a price stimulus has on the reference price buyers use to assess price When two or more products offer similar type types of benefits, buyers evaluate a price in the context of the overall range in which they are confronted Adding a new price at the higher or low end of the range will change the standards by which customers evaluate each item

Pricing Complements
Leader pricing: If the demand for product is elastic, and if the product has number of complements that either enhance its value or can be purchased more conveniently by buying from the same source, that product may be used as leader The expectation is that sales of complements to new customer will increase more than enough to offset the reduced profit on the leader In selecting a leader, one must avoid: Products that customers are likely to stock up during special prices When strong substitution effect will lead to simple shifts in sales from high-margin to low margin products

Characteristics of a good price leader

1. The product is widely used by individual buyers in the target market 2. The products prevailing market price is well known 3. The product has a high degree of price elasticity 4. The product has many complements which enhance the value of the leader or are convenient to purchase when buying the leader 5. The product has few or no substitutes 6. The product is not usually bought in large quantities and stored

 Two or more products or services are bundled together for a special price Most firms employ mixed bundling Buyers are given choice of buying two products in a package or buying the products individually Buyers who place a low value on one of the two products will avoid the bundle The economic incentive of a lower price on one item will lead to additional sales of both products to some buyers who otherwise will buy only one When complementary relationships are very strong, the effects of special prices are even greater

Price Bundling

Price Bundling
Mixed price bundling can be accomplished through two approaches 1. Mixed leader form: The price of a lead product is discounted on the condition that the second product will be purchased 2. Mixed joint bundling: Two or more products or services are offered for a single packaged deal

Characteristics of Successful Mixed Price Bundling

Mixed Leader Programs 1. Demand for lead product should be price elastic 2. Complementarity is based on the leader being enhanced by other product(s) or on convenience 3. If the objective is to cross-sell complements to regular customers; The leader is the lower margin product (so that the lost profit from price reduction is minimized) Sales volume for the leader exceeds that of other products Mixed Joint Programs 1. Demand for the total package is price-elastic 2. Complementarity is bi directional (each product in the bundle enhances the value of the others) or is based on convenience 3. If the objective is to cross sell complements to regular customers, the various products the bundle are approximately equal in volume and profit margins so that sales gains from regular purchasers of any product are about equal