Pricing Strategies Key Learning Points Pricing strategies & tactics (terminology). The concept of value and the price-setting process. Deciding how much of the strategic pricing gap to capture. Linking elasticity to value and estimating the effect of a price change According to McKinsey, “80 to 90 percent of all poorly chosen prices are too low… Companies habitually charge less than they could for new offerings. It’s a terrible habit.”

Pricing Strategies Customer Value Pricing (Demand-focused pricing) Sets price based on the relative sharing of differentiation value); Company Objectives determine how much value to share or capture: Penetration or Market Share Pricing Gives most value to customers, builds share & goodwill & erects entry barriers; elastic demand, no sustainable advantage, market share objective… Skimming or Prestige Pricing Majority of value goes to firm to maximize profits – invites competitive entry; inelastic demand, multiple price segments, sustainable advantage… Intermediate or Neutral Pricing Equal sharing of value Technical, Cost-focused Pricing Full-Cost Pricing – Markup, Breakeven, Rate-of-return Ignores competition and customer; most useful in stable supply & demand situations or unique, bidding situations with high uncertainty Variable-Cost Pricing Ignores fixed costs; useful to stimulate or shift demand for perishable offerings with seasonal demand.

Customer -- Psychological Aspects of Price Value Is the Ratio of Perceived Benefits to Price Evaluated by comparing focal offering to a reference value Creates a price window for competitive offerings

The Price Setting Process Define Price Window Set Initial Price Communicate Prices to Market Set initial price range based on differential value & relevant costs Determine amount of differential value to be captured Develop communication plan to ensure prices are perceived to be fair Key Questions: What is the role of costs in setting my initial price range? What is appropriate price ceiling for this product? How should I incorporate reference prices into my price window? Key Questions: Is price consistent with my business strategy & objectives (skimming vs. penetration)? What are the non-value related determinants of price sensitivity? What are the price-volume tradeoffs & impact on profitability? Key Questions: What is the best way to communicate price (changes) to customers? What are the considerations for implementing significantly higher prices? Topic: Overview of the Price Setting Process Key Learning Points for Students Realize the basic stages of the price setting process that apply to most pricing contexts Introduce the concept of a price window and understand the determinants of the price floor and ceiling Understand the rationale for setting an initial price and then testing in the market place Teaching Recommendations There are a number of new concepts introduced at this point in the chapter. It is recommended to spend some time ensuring students understand ideas like price window, price volume tradeoffs and pricing objectives Discussion Question(s) Divide the class into several groups with each assigned a different product category. Ask the students to make a list of all of the factors they would consider when pricing a new product in that category. Compare their answers and then show where they would fall in the price setting process.

Using Competitive Information to Define Price Window Brand Product of Notes Price per Ounce ($) Gallon ($) Acqua Panna – Natural Spring Italy (Florence) 1 liter glass bottle 0.13162 16.85 Arrowhead – Mountain Spring California Plastic 28-pack 0.02367 3.03 Dasani – Purified Drinking Water USA Plastic 0.08876 11.36 Evian (Nomad) – Natural Spring France (Alps) Plastic 6-pack 0.12318 15.77 Menehune – Purified Drinking Water Aiea, HI 0.07813 10.01 Perrier – Sparkling Natural Mineral France Green Glass 0.08333 10.67 Rosauer’s Finest – Spring Water Canada Plastic/Pop Top 0.02307 2.95 San Pellegrino – Sparkling Mineral Italy (S.P.) 0.08844 11.32 Talking Rain – Mountain Spring Preston, WA Plastic/Flavored 0.06760 8.65 Voss – Virgin aquifer Norway Clear glass cylinder 0.181746 23.26 City of Dallas– Residential Pipes/Lake Water 0.000012 0.00156 The relevant question is: Why are consumers willing to pay relatively steep prices for a commodity product?

Competitive Water Prices & the Price Window Neutral or Intermediate Prices Number of competitive offerings Penetration Prices Skimming Prices $s per Gallon

Conceptualizing the Price Window and Market Segments with a Normal Bell Curve Value Buyers Price Sensitive Price Insensitive Low Price Hi Price Penetration Pricing Intermediate Pricing Price Skimming

Non-normal Distributions with Kinks Suggest Different Segments Frequency of Observed Price Points $s per Gallon

Price Windows for Milwaukee’s Best, Bud & Miller, and Michelob Frequency of Observed Price Points Price Driven Value Driven Brand Driven $s per Gallon

The Price Setting Process Define Price Window Set Initial Price Communicate Prices to Market Set initial price range based on differential value & relevant costs Determine amount of differential value to be captured Develop communication plan to ensure prices are perceived to be fair Key Questions: What is the role of costs in setting my initial price range? What is appropriate price ceiling for this product? How should I incorporate reference prices into my price window? Key Questions: Is price consistent with my business strategy & objectives (skimming vs. penetration)? What are the non-value related determinants of price sensitivity? What are the price-volume tradeoffs & impact on profitability? Key Questions: What is the best way to communicate price (changes) to customers? What are the considerations for implementing significantly higher prices? Topic: Overview of the Price Setting Process Key Learning Points for Students Realize the basic stages of the price setting process that apply to most pricing contexts Introduce the concept of a price window and understand the determinants of the price floor and ceiling Understand the rationale for setting an initial price and then testing in the market place Teaching Recommendations There are a number of new concepts introduced at this point in the chapter. It is recommended to spend some time ensuring students understand ideas like price window, price volume tradeoffs and pricing objectives Discussion Question(s) Divide the class into several groups with each assigned a different product category. Ask the students to make a list of all of the factors they would consider when pricing a new product in that category. Compare their answers and then show where they would fall in the price setting process.

Economic Value Estimation Framework Costs unique to doing business with you Positive Differentiation Value Negative Differentiation Value Your unique value delivery Price to capture a share of this value Competitive Reference Value Total Economic Value Price of Next Best Competitive Alternative This slide shows the basic method for determining the "economic value" to the customer. Economic value estimation is the price of the customer's best alternative (called the reference value) plus the value of what differentiates the offering from the alternative (called the differentiation value). Economic value estimation is an especially useful sales tool when buyers are facing extreme cost pressures and are, therefore, very price sensitive. There are several basic components to economic value estimation. First, identify the closest competitive product to the firm’s product offering. This is the reference product; its cost is the “reference value.” Second, identify all positive factors that differentiate the firm’s product from the competitive reference product; these are sources or drivers of differentiation value. Once the positive differentiation factors have been identified, estimate what each source of differentiation value is worth to the customer. This is done by quantifying the savings and gains that customers would realize by using the firm’s product rather than the competitor’s. In business-to-business contexts savings relate to cost savings, such as savings on salaries, training, inventory, overtime wages, etc. Gains usually are derived from sales volume gains the customer might realize by using the firm’s product, or profit margin gains the customer may be able to realize by selling to customers at higher prices. Third, estimate the negative differentiation value, which reflects sources or drivers of value on which the firm’s product is inferior to the competitor’s product. Finally, sum the reference value and differentiation value to determine the total economic value the customer would receive.

Defining the Price Window (& Objectives) Positively Differentiated Offering Negatively Differentiated Offering Neutral or Intermediate Pricing Topic: Price Windows Key Learning Points for Students Understand the concept of a price window Illustrate how and why price window changes depending on whether the product is positively or negatively differentiated Teaching Recommendations There is an excellent numerical example illustrating the ramifications of pricing above or below the price window. Instructors might wish to illustrate that example on this slide Discussion Question(s) Why is a price window important? How does it help the organization? What would happen if a positively differentiated product were priced bellow the reference price? What are the implications for pricing above the price ceiling? Price skimming captures high margins at the expense of sales volume. Prices are high relative to what the “middle market” is willing to pay. Viable when the profit from the price-insensitive segment exceeds profit from sales to larger market at lower price. Penetration pricing sets price far enough below economic value (not below cost!) to attract and hold a large base of consumers. Generates sales volume (& lower marginal costs) at the expense of higher margins.

Customer -- Psychological Aspects of Price Value Is the Ratio of Perceived Benefits to Price Evaluated by comparing focal offering to a reference value Creates a price window for competitive offerings Linking Elasticity and Value Estimates As differential value increases, elasticity decreases Marketers can effectively use price to signal quality when: Consumers lack information Product quality is difficult to assess before (experience goods) or even after (credence goods) purchase

Estimating Customer Value Estimating Customer Value MKTG 6223: Understanding What Customers Value MKTG 6214: Advanced Pricing Management Estimating Customer Value Economic Value Method Survey-Based Methods Direct Purchase Observation Quantify the objective value of attributes Self-report willingness-to-pay Conjoint studies Estimate price elasticity based on purchase data, perhaps in conjunction with an experiment

Financial Analysis in Marketing K&P Chapter 2 Marketing Pro Formas Breakeven Analysis Customer Lifetime Value (CLV) Sales Forecasts Demand Elasticity Channel Margin Calculus

Price Experiment for Mobile Phone Inelastic demand -.50 Elastic demand -2.83

E = Demand Elasticity wrt Price Necessary to Evaluate Price-Volume Trade-offs % change in demand E = % change in price Price D from 1200  900 (24% - 41%)/24% Ecar phone= = -2.83 (1200-900)/1200 Price D from 600  900 (41% - 45%)/41% Ecar phone= = -.50 (900-600)/900 If the absolute value of E is < 1.0, demand is inelastic If the absolute value of E is > 1.0, demand is elastic

Elasticity – a visual representation . . . . Price Elastic: customers are very sensitive to price changes when there is no differential advantage between substitutes – grains, fruits and vegetables, paper clips, rubber bands P2 P1 P2 Price elasticities on average ≈ -2.5 unit elastic (i.e., e = -1) P1 Inelastic: customers are not very sensitive to price changes when there is strong differential advantage and few substitutes – gemstones, transplant organs Q2 Q1 Q2 Q1 Quantity Demanded

Break-even (B/E) Sales Analysis Formula Price Change (No change in costs): % B/E unit sales D = — %DP %CM’ + %DP — $DP $CM’ + $DP or For example, your current contribution margin is 50%; that is, unit variable costs are 50% of price What % unit sales increase is necessary for a 10% price decrease to breakeven? — %DP %CM’ + %DP 10% 50% - 10% = 10% 40% = 25% = 25% -10% B/Ee = = -2.5

Estimating the Effect of a Price Change See Kerin & Peterson, Ex. 8.2 Cost, Volume, and Profit Data Unit sales volume 1,000 Unit selling price $10 Unit variable cost $5 $2 Unit contribution (margin) 50% $8 80% Fixed costs $3,000 $6,000 Net profit $2,000 Break-even Sales Change PD% QD% e For a price reduction of -20% 66.7% -3.3 33.3% -1.7 -10% 25.0% -2.5 14.3% -1.4 -5% 11.1% -2.2 6.7% -1.3 For a price increase of 5% -9.1% -1.8 -5.9% -1.2 10% -16.7% -11.1% -1.1 20% -28.6% -20.0% -1.0 Topic: Price-volume tradeoffs Key Learning Points for Students Breakeven calculations are an effective way to compare different scenarios associated with different prices. This tool can be used to explore the profit implications of different prices. Starting with the baseline scenario (the row for 0%), suppose you wanted to simulate the effect of lowering price by 5%. The breakeven sales change varies, depending on your product’s baseline Contribution Margin. If your product had a low contribution margin (say 20%), then your unit volume would have to be 33% greater using this slightly lower price -- compared to your baseline scenario of 0%. Teaching Recommendations Ask students to explain a given cell in the Breakeven Sales Change Matrix shown in this slide. Many software companies like Microsoft have high CMs -- perhaps 90%. Suppose Microsoft was considering reducing their prices on Microsoft Office by 20%; how many more units would they need to sell annually to achieve the same profitability they would achieve under the baseline (0%) scenario? Answer: 29%. How would this change for a product with 40% CMs, or 20% CMs? Note that for a 20% CM product, a 25% price reduction would require an infinite increase in sales volume.

Planned Prices and Margins for a Software Product Collaborators -- Channel Margin Analysis Cases May Require Price-Setting to Intermediaries Planned Prices and Margins for a Software Product Retail Price $500 What if you wanted a $400 MSRP? $400 Cost of Goods Sold Manufacturer Price Wholesale Price Retail Price RM 40% Wholesale Price $300 $120 $192 $240 GM goes to 72/192 = 37.5% Or reduce COGS 20% to $96 WM 20% Manufacturer Price $240 GM 50% Start with a retail price for an illustrative product, e.g., a software product that sells at retail for $500. Then calculate the margin retailers receive for retailing the product; for example, software specialty stores would likely receive 40 percent margins for this type of software product. Therefore, to accommodate a 40 percent retail margin the product must have a wholesale price of $300. If wholesale distributors were involved in the channel they would also receive a margin, say 20 percent. Consequently, to accommodate the wholesale margin the manufacturer’s price would have to be $240. If the manufacturer wanted a 50 percent margin, then the target cost of goods sold for the manufacturer would have to be $120. Cost of Goods Sold $120 COGS 50%

Unit Profit Margin Analysis Altius Weighted Average Victor TX Victor Elevate Current Share of Sales 70% 30% Retail price $48.00 $39.00 $27.00 Retailer gross profit Retailer gross margin % 15.0% 20.0% Manufacturer price Manufacturer variable cost Manufacturer unit contribution Manufacturer gross margin % $45.30 $6.80 70% x 48 + 30% x 39 = $7.20 $5.85 $5.40 $33.15 30%  $9.95 $7.75 70% $23.21 64% Value of market share point ($M) ?

Current Market Share and Gross Profit for Altius's Product Line Victor TX Victor Market share, retail dollar sales (%) 55.2% Unit volume (M) Retail sales ($M) - 55.2% of $483M $266.6 $0.00 Retailer gross margin (%) 15.0% Manufacturer sales ($M) Manufacturer gross margin (%) 70.0% Gross profit ($M) Victor TX 70% of unit volume 30.0% Market share, unit sales (%) 45.2%

Victor Price Cut Analysis Current price $2 Retail Price Cut $4 Retail Price Cut Retail price $39 $37 $35 Retailer margin 15% Altius price $31.45 Altius variable cost Altius unit contribution Altius gross margin 70% $33.15 $9.95 $23.21 — $DP $CM’ + $DP BE= = - -1.70 23.21-1.70 — %DP %CM’ + %DP BE= = - -5.1% 70%-5.1% Altius Manufacturer Price Change % Unit sales increase to maintain profit % Retail price change Elasticity required to break even Victor Market Share increase required to break even Victor Market Share required to break even Altius Market Share required to break even -5.1% 7.9%

The Price Setting Process Define Price Window Set Initial Price Communicate Prices to Market Set initial price range based on differential value & relevant costs Determine amount of differential value to be captured Develop communication plan to ensure prices are perceived to be fair Key Questions: What is the role of costs in setting my initial price range? What is appropriate price ceiling for this product? How should I incorporate reference prices into my price window? Key Questions: Is price consistent with my business strategy & objectives (skimming vs. penetration)? What are the non-value related determinants of price sensitivity? What are the price-volume tradeoffs & impact on profitability? Key Questions: What is the best way to communicate price (changes) to customers? What are the considerations for implementing significantly higher prices? Topic: Overview of the Price Setting Process Key Learning Points for Students Realize the basic stages of the price setting process that apply to most pricing contexts Introduce the concept of a price window and understand the determinants of the price floor and ceiling Understand the rationale for setting an initial price and then testing in the market place Teaching Recommendations There are a number of new concepts introduced at this point in the chapter. It is recommended to spend some time ensuring students understand ideas like price window, price volume tradeoffs and pricing objectives Discussion Question(s) Divide the class into several groups with each assigned a different product category. Ask the students to make a list of all of the factors they would consider when pricing a new product in that category. Compare their answers and then show where they would fall in the price setting process.

Happy Pricing!

Review Questions What are 2 Customer Value Pricing (i.e., Demand-focused Pricing) strategies? What are 2 Cost-focused Pricing strategies? How do we define value? What are the three steps in the Price-Setting process? What is the link between pricing strategy and competitive advantage?