Chapter 8 Pricing Strategy and Management

8-2 In this chapter, you will learn about… 1.Pricing Considerations Price as an Indicator of Value Price Elasticity of Demand Product-Line Pricing Estimating the Profit Impact from Price Changes 2.Pricing Strategies Full-Cost Pricing Variable-Cost Pricing New-Offering Pricing Strategies Pricing and Competitive Interaction

8-3 Price is a direct determinant of profits (or losses) Price indirectly affects costs (through quantity sold) Price determines the type of customer and competition the organization will attract Price affects the image of the brand A pricing error can nullify all other marketing mix activities The Importance of Price

8-4 Profit = Total Revenue – Total Cost Relationship between Price and Profits Total Revenue = Price per Unit x Quantity Sold Total Cost = Fixed Cost + Variable Cost

8-5 Pricing Considerations Examples of Pricing Objectives: Maximization of profits Enhancing product or brand image Providing customer value Obtaining an adequate return on investment or cash flow Maintaining price stability Pricing Objectives have to be consistent with an organization’s overall marketing objectives

8-6 Pricing Considerations Demand sets the price ceiling Direct (variable) costs set the price floor Campbell Soup’s Intelligent Quisine (IQ) line Consumers found the products too expensive Lower price could not cover variable costs

Pricing Considerations Conceptual Orientation to Pricing Source: Kent B. Monroe, Pricing: Making Profitable Decisions, 3 rd ed. (Burr Ridge, IL; McGraw Hill/Irwin, 2003). Final Pricing Discretion Demand Factors(Value to Buyers) Initial Pricing Discretion Competitive Factors Corporate objectives and regulatory constraints (Price Ceiling) (Price Floor) Direct Variable Costs )

8-8 Pricing Considerations Factors narrowing pricing discretion Government regulations Price of competitive offerings Organizational objectives and policies

8-9 Life-cycle stage of product or service Effect of pricing decisions on profit margins of marketing channel members Prices of other products and services provided by the organization Pricing Considerations Other factors affecting the pricing decision

8-10 Value = perceived benefits price Value can be defined as the ratio of perceived benefits to price: Pricing Considerations Price as an Indicator of Value

8-11 Price affects perception of quality Price affects consumer perceptions of prestige Example: Swiss watchmaker TAG Heuer Raised average price of its watches from $250 to $1000 Sales volume increased sevenfold! Pricing Considerations Price as an Indicator of Value

8-12 Pricing Considerations Price as an Indicator of Value Consumer value assessments are often comparative – worth and desirability of a product relative to substitutes that satisfy the same need (e.g., Equal vs. sugar) Consumer’s comparison of costs and benefits of substitute items gives rise to a “reference value”

8-13 E = percentage change in quantity demanded percentage change in price Pricing Considerations Price Elasticity of Demand Price Elasticity of Demand is a concept used to characterize the nature of the price-quantity relationship The coefficient of price elasticity, E, is a measure of the relative responsiveness of the quantity of a product demanded to a change in the price of that product

8-14 If the percentage change in quantity demanded is greater than the percentage change in price, i.e., E>1, then demand is said to be elastic. If the percentage change in quantity demanded is less than the percentage change in price, i.e., E<1, then demand is said to be inelastic. Pricing Considerations Price Elasticity of Demand

8-15 The more substitutes the product or service has, the greater the elasticity The more uses a product or service has, the greater the elasticity The higher the ratio of the price of the product or service to the income of the buyer, the greater the elasticity Pricing Considerations Factors affecting Elasticity of Demand

8-16 Pricing Considerations Product-Line Pricing Cross-Elasticity of Demand relates the price elasticity simultaneously to more than one product or service The Cross-Elasticity Coefficient is the ratio of the change in quantity demanded of product A to a price change in product B A negative coefficient indicates the products are complementary (camera and film); a positive coefficient indicates they are substitutes (apple and pear)

the lowest-priced product and price plays the role of traffic builder 2.the highest-priced product and price positioned as the premium item 3.price differentials for all other products in the line reflect differences in their perceived value of the products offered Product-line pricing involves determining: Pricing Considerations Product-Line Pricing

8-18 Cost data Price data Volume data for individual products and services Impact of price changes on profit can be determined from: Pricing Considerations Estimating the Profit Impact from Price Changes

8-19 Pricing Considerations Estimating the Profit Impact from Price Changes Unit volume necessary to break even on a price change is: % change in unit volume to break even on a price change - (percentage price change) (original contribution margin) + (percentage price change) =

8-20 Pricing Considerations Estimating the Profit Impact from Price Changes For example, if a product has a 20% contribution margin, a 5% price decrease will require a 33% increase in unit volume to break even: (-5) (20) + (-5) =

Estimating the Profit Impact from Price Changes Product AlphaProduct Beta Cost, Volume, and Profit Data Unit sales volume 1,000 Unit selling price$ 10 Unit variable cost$ 7$ 2 Unit contribution (margin)$ 3 (30%)$ 8 (80%) Fixed costs$1,000$6,000 Net profit$2,000 Break-Even Sales Change For a 5% price reduction+20.0%+6.7% For a 10% price reduction+50.0%+14.3% For a 20% price reduction+200.0%+33.3% For a 5% price increase-14.3%-5.9% For a 10% price increase-25.0%-11.1% For a 20% price increase-40.0%-20.0%

8-22 Pricing Strategies Full-cost Price Strategies Considers both (direct) variable and (indirect) fixed costs Full-cost Price Strategies Considers both (direct) variable and (indirect) fixed costs Variable-cost Price Strategies Considers only (direct) variable costs Variable-cost Price Strategies Considers only (direct) variable costs

8-23 Pricing Strategies Full-Cost Pricing Full-Cost Pricing Mark-up Pricing Rate-of- Return Pricing Break-even Pricing

8-24 Selling price is determined by adding a fixed amount, usually a percentage, to the (total) cost of the product Most commonly used pricing method (e.g., groceries and clothing) Simple, flexible, controllable Example: If a product costs $4.60 to produce and selling price is $6.35, the market on cost is 38% and markup on price is 28%. Pricing Strategies Markup Pricing

8-25 Equals the per-unit fixed costs plus the per- unit variable costs Useful tool for determining the minimum price at which a product must be sold to cover fixed and variable costs Often used by non-profit organizations, or by profit-making organizations that may have a short-term breakeven objective Pricing Strategies Breakeven Pricing

8-26 Price is set so as to obtain a pre-specified rate of return on investment (capital) for the organization Assumes a linear demand function and insensitivity of buyers to price Most commonly used by large firms and public utilities whose return rates are closely watched or regulated by government agencies or commissions Pricing Strategies Rate-of-Return Pricing

8-27 Pricing Strategies Rate-of-Return Pricing ROI = Pr / I = revenues - cost investment P x Q – C x Q I = where P = Unit Selling Price; C = Unit Cost; Q = Quantity Sold Solving for P, we get: P = ROI x I x CQ Q

8-28 Pricing Strategies Rate-of-Return Pricing Example An organization desires an ROI of 15% on an investment of $80,000. Total costs per unit are estimated to be $ Forecasted demand is 20,000 units. The necessary price to attain 15% ROI is: P = (0.15) x $80,000 + $0.175 x 20,000 20,000 = 0.775

8-29 Stimulate demand (lower fares for seniors) Can increase revenues, and hence, lead to economies of scale, lower unit costs, and higher profits Shift demand (weeknight calling plans) Away from peak load times to smooth it out over extended time periods Represents the minimum selling price at which the product or service can be marketed in the short run. It is often used to: Pricing Strategies Variable-Cost Pricing

8-30 Pricing Strategies New-Offering Pricing Strategies 1.Skimming Pricing Strategy (Gillette Mach3) price initially set very high and reduced over time 2.Penetration Pricing Strategy (Nintendo) price is initially set low to gain a foothold in the market 3.Intermediate Pricing Strategy between the two extremes; most prevalent

Demand is likely to be price inelastic 2.There are different price-market segments 3.The offering is unique enough to be protected from competition by patent, copyright, or trade secret 4.Production or marketing costs are unknown 5.A capacity constraint in producing the product or providing the service exists 6.An organization wants to generate funds quickly 7.There is a realistic perceived value in the product or service Pricing Strategies When to Use Skimming Pricing Appropriate when:

Demand is likely to be price elastic 2.The offering is not unique or protected by patents, copyrights, or trade secrets 3.Competitors are expected to enter market quickly 4.There are no distinct and separate price-market segments 5.There is a possibility of large savings in production and marketing costs if a large sales volume can be generated 6.The organization’s major objective is to obtain a large market share Pricing Strategies When to Use Penetration Pricing Appropriate when:

8-33 Competitive Interaction refers to the sequential action and reaction of rival companies in setting and changing prices for their offering(s) and assessing likely outcomes, such as sales, unit volume, and profit for each company and an entire market. Pricing Strategies Pricing and Competitive Interaction

Managers are advised to focus less on short-term outcomes and attend more to longer-term consequences of actions 2.Managers are advised to step into the shoes of rival managers or companies and answer a number of questions… Pricing Strategies Pricing and Competitive Interaction Advice for managers to avoid nearsightedness of not looking beyond the initial pricing decision:

What are competitors’ goals and objectives? How are they different from our goals and objectives? 2.What assumptions has the competitor made about itself, our company and offerings, and the marketplace? Are these assumptions different from ours? 3.What strengths does the competitor believe it has and what are its weaknesses? What might the competitor believe our strengths and weaknesses to be? Pricing Strategies Pricing and Competitive Interaction

8-36 Pricing Strategies Pricing and Competitive Interaction A Price War involves successive price cutting by competitors to increase or maintain their unit sales or market share. Happens when: Managers lower price to improve market share, unit sales, and profit Competitors match the lower price Expected share, sales, and profit gain from initial price cut are lost

The company has a cost or technological advantage over its competitors 2.Primary demand for a product class will grow if prices are lowered 3.The price cut is confined to specific products or customers and not across- the-board To avoid a price war, managers should consider price cutting only when: Pricing Strategies Pricing and Competitive Interaction

FewMany Number of competitors HighLow Industry capacity utilization StableDeclining Overall industry cost trend LowHigh Buyer price sensitivity LowHigh Price visibility to competitors IncreasingStable/Decreasing Market growth rate DifferentiatedUndifferentiated Product/Service type LowerHigherIndustry Characteristics Risk Level Industry Characteristics and the Risk of Price Wars