Pricing

Pricing Playing Field Economic Value Variable Costs Company Policies, Goals Competition Customer Company CompetitionCollaborators Price Sensitivity Fairness Goals Situation * Market Share * Costs Situation *Market Share *Costs Cooperation Differentiation Distribution Channels

Managing a price decrease: P&G and EDLP Price reduction Value pricing StrategyCustomerCompetitorCosts Demand for greater value Promotions: Switching excuse Customer confusion Superior quality Value price Rationalize product line Rise of the discounter Prisoner’s Dilemma Private labels Rise of EDLP High cost of promotions Channel inefficiency Strain on manufacturing Brand image through advertising

Why is Price so Critical? Consider a company with an 8% profit margin Suppose the company could raise its price by 1% without it having any impact on sales? What will the increase in margin be? Sales = X Pts Margin = 0.08X Pts; Cost = 0.92X Pts New sales = 1.01X Pts; Cost = 0.92X Pts Margin = 0.09X Pts Increase in margin = 100*(0.09X-0.08X)/0.08X = 12.5% !

Two Key Requirements of a Pricing Policy Policy should complement company’s marketing strategy Swatch: $40 price on basic model has not changed in 10 years Saturn: No negotiation pricing Process of price setting must be coordinated across departments Issue: There are many participants in the process - Accounting provides cost estimates, Marketing communicates the strategy; Sales provides customer input; Production sets supply boundaries; Finance establishes requirements for the bottom line

Coordinating the Pricing Process What is our pricing objective? Do all participants in the process understand the objective? Do all participants have an incentive to work in pursuit of the objective?

Profit Growth, Volume Growth, or Both? Manager’s Dream Tradeoff Zone Manager’s Nightmare Tradeoff Zone Quadrant I Quadrant II Quadrant III Quadrant IV Volume growth negative Volume growth positive Profit growth positive Profit growth negative

Pricing Goal Matrix Volume growth negative Volume growth positive Profit growth positive Profit growth negative Profit Volume Profit Volume Profit Volume Profit Volume Reduction of too high priceIncrease of too low price Increase of price beyond optimumDecrease of price below optimum

8 Steps to a Pricing Decision I. Assess what value your customers place on the product or service II Look for variation in the way customers value the product III Assess Customers’ Price Sensitivities IV Identify an Optimal Pricing Structure V Consider Competitors’ Reactions VI Monitor Prices Realized at Transaction Level VII Assess Customers’ Emotional Response VIII Analyze Whether Returns are Worth the Cost to Serve

8 Steps to Better Pricing: STEP 1 I. Assess what value your customers place on the product or service. What should the appropriate process be? From company To marketplace or From marketplace To company? The trouble with “Cost+” Pricing Expected sales level = 100 units Suppose cost/unit = 10; markup = 20% Price = 12. Suppose you sell only 80 units New cost = 11; markup = 20%; price = 13.2 How many units will be sold?

Examples of Value-Based Pricing Glaxo pricing of Zantac in the US market in 1983 Competition with SK B’s Tagamet (#1 drug in the world) Additional value offered by Zantac Easier schedule of doses Fewer side effects Taken safely with other medication unlike Tagamet Based on greater perceived value, Glaxo charged a 50% premium over Tagamet instead of pricing at parity or below (as in Follower pricing) In 4 years, Zantac was the market leader.

How to assess value? Economic Value-In-Use Market research Conjoint Analysis Employees with direct customer contact Salesforce

Determining Economic Value-In-Use DuPont, Alathon 25 - polyethylene resin used in the manufacture of flexible pipe. Competes with other resins Failure rates of 1-3% compared to 7-8% for competition Economic Value=Reference Value + Differentiation Value Reference Value: Cost of competing product that the customer views as the best substitute for the product being evaluated RV = Price of Competing product adjusted for any difference in quantity used Differentiation Value: Value of product attributes that are different from those of the best substitute DV = Positive if customer likes differentiating attribute, Negative otherwise

Economic Value Analysis from 2 Perspectives Pipe buyers who purchase pipes made of Alathon Pipe extruders who purchase Alathon to make pipes

Analysis for Below-Ground Irrigation (/100ft) Crop Loss Reduction $ $0.48 Crop Loss Reduction $ $0.48 Labor Savings $ $3.60 Labor Savings $ $3.60 Replacement Savings: $0.31-$0.39 Replacement Savings: $0.31-$0.39 Cost of Substitute $6.50 Cost of Substitute $6.50 Differentiation Value Reference Value Total Economic Value $10.21-$10.97 Cost of Substitute=$6.50 Failure Rate from 8 to 3% Value=6.5*1.08/1.03=6.81 Failure Rate from 7 to 1% Value=6.5*1.07/1.01=6.89 Added Value=$0.31-$0.39 Labor cost of pipe replace- ment=$60. Failure rate drops 5-6%, Savings=$3.00 to $3.60 Crop damage cost = $0-40 Probability of $40 = 0.2 Failure rate drops 5-6% Savings=40*0.2*0.05=0.40 =40*0.2*0.06=0.48

Analysis for Pipe Extruders (per pound) Added Value to Extruder’s Product $0.228-$0.275 Added Value to Extruder’s Product $0.228-$0.275 Cost of Substitute $0.280 Cost of Substitute $0.280 Positive Differentiation Value Reference Value Sales Decline -$0.01 Risk -$0.020 Higher Sales Expense -$0.080 Higher Sales Expense -$0.080 Negative Differentiation Value Total Economic Value $0.398-$0.445 Cost of cheapest resin = $0.28 / lb. # lbs. per 100 feet of pipe = Value of 100 feet = $10.21 (min.) Added value / lb = ( )/16.25=$0.228 Sales decline due to lower replacement Risk due to single supplier (DuPont)

Interpreting Economic Value A product’s market value is determined not only by the economic value but also by the accuracy with which buyers perceive that value Weakness of EV:Does not indicate the appropriate price to charge. Gives the maximum price consumers will be willing to pay if they were perfectly cognizant of the economic value and were motivated by economic value to make their purchase decisions Strength of EV: Enables a firm to determine whether a product is selling poorly because it is overpriced relative to its true economic value or because it is under-promoted and consequently, under-appreciated by the market DuPont used this to increase sales by raising price and educating consumers

Other Uses of Economic Value Analysis Indicates which attribute improvements will result in the greatest enhancement of value Can be used by sales reps to highlight the benefits of the product Help firm identify market segments that value the product’s attributes differently Works well for industrial products and for consumer durable goods Not very useful for FPP products and for those with “fuzzy” attributes Use methods like Conjoint Analysis

8 Steps to Better Pricing: STEP 2 II Look for variation in the way customers value the product Polaroid SX-70 instant photography camera Segmentation over time. Initially those placing a high value (in the photo ID card business) were sold product at a high price. Then prices reduced to accommodate others Segmentation and Airline fares: Business Vs. Leisure Magazines: Single issue Vs. Subscriptions Software: Upgrades (low cost) Vs. New Users Heavy users Vs. Light users Different applications: Sealed Air Corporation Business computers Vs. Home computers

What to do with the variation: Price Customization Product-line sort: develop a product line and have customers sort themselves among the various offerings based on their preferences Controlled availability –Coupons –Direct-Mail Catalogs –Geographic Pricing –Restriction on place of purchase (high end products at high end stores) –Negotiating with provider (long distance telephone calls) Sort on Buyer Characteristics –Eurodisney: “Kinder Gratis - vom bis zum ” –Munich airport landing fees ( DM 18600; DM 10100) Sort on Transaction Characteristics

Price Customization Translates As …. Segmenting by Buyer Identification Coupons; Student Discounts; Automobile prices Segmenting by Purchase Location Hair Salons have different prices in different locations Large grocery stores Vs. convenience stores Freight absorption in industrial product markets Segmenting by Time of Purchase Theaters: Matinee Vs. Evening rates Restaurants: Fixed price lunches (Restaurant next door) Peak-Load pricing (Airlines, Electric Utilities, Telephones) Problem of Peak Reversal with long distance calling

8 Steps to Better Pricing: STEP 3 III Assess Customers’ Price Sensitivities

Methods for Price Response Estimation New consumer nondurable introduced in 3 European regions. Managers for the 3 markets were selected as the best experts and asked to provide estimates of 3 points on the response curve Lowest realistic price and year 1 sales volume at that price Highest realistic price and sales volume Expected sales volume at a “medium” price 1. Expert Judgement

Methods for Price Response Estimation What is the likelihood that you would buy this product at $25 At what price would you definitely buy this product? How much would you be willing to pay for this product? How much of this product would you buy for $0.99? At what price differential would you switch from brand A to brand B? 2. Customer Surveys a) Direct price response surveys b) Preference-based Inference: Conjoint Analysis a)

Price Response Estimate for a PC at Vobis

Purchase Intentions for Instant Cameras Kodak’s analysis of a next-generation instant camera - purchase intent on a 7-point scale

Price Response Curve for Instant Cameras

b) Conjoint analysis What would you prefer? Type a number from the scale below to indicate your preference 4-cup Capacity 9-minute Brewing Time $18 8-cup Capacity 3-minute Brewing Time $28 OR Strongly Prefer LeftStrongly Prefer Right

Methods for Price Response Estimation Laboratory; Simulated Shopping or “In-Market” Tests In-market tests: Prices varied across stores, accounts, geographic regions Direct mail catalogs are another medium for experiments In-market test of a German mobile phone manufacturer –Regular price of phone = DM 1200 –At this price 24% of new car buyers bought the phone –Company then varied prices for 3 months in 3 different regions –The results were as follows 3. Price Experiments

Price Experiment for Mobile Phone 3 month period before experiment = 24%

Methods for Price Response Estimation Supermarket scanners are especially useful for this purpose If prices have naturally varied over time, one can analyze how changes in absolute or relative prices affect sales volumes and market shares German market for RTE desserts 4 main competitors at the time of analysis: Gervais-Danone, Nestle, Unilever and Dr. Oetker, togther had more than 80% share Dr. Oetker’s prices varied between DM 0.60 and DM Unit sales varied between 7 million and 12 million for two- month periods. 4. Analysis of Historical Market Data

Price Response Estimate Based on Historical Data Price DM ProfitSales Volume Profit Index Volume (million units)

Evaluation of Different Methods

Empirical Estimates of Price Elasticities

8 Steps to Better Pricing: STEP 4 IV Identify an Optimal Pricing Structure Should Quantity Discounts be offered? Units Buyer A Buyer B 1 $70 $70 2 $20 $50 3 $20 $40 4 $20 $35 5 $20 $30 Above table gives the value of each successive unit of the product to 2 buyers A and B. What price should the company charge if producer’s cost is $20 per unit?

Pricing Structure..... Should Bundle Pricing be offered? Movie distributors often sell packages of films rather than selling individual film rights because the package values vary less across buyers than do values of individual films Buyer ABuyer B Movie 1$9000$5000 Movie 2$1000$5000 Total$10000$10000 Using a la carte pricing can sell movie 1 to both buyers for $5000 each and movie 2 to buyer B for $5000. Total revenue is $ By bundling, both buyers will buy the bundle for $ So total revenue = $20000

Bundling Example: Mobile Phone Operator

Optimal Pure Components Pricing Pv = 8 Ph=8.5 Group 4 Group 3 Group 2 Group 1 Price for Voice Mail Price for Hot Line

Optimal Pure Bundling Price Group 4 Group 3 Group 2 Group 1 Price for Voice Mail Price for Hot Line

Optimal Mixed Bundling Price Group 4 Group 3 Group 2 Group 1 Price for Hot Line Ph=9 Pv=9 Pv+h=13 Price for Voice Mail

8 Steps to Better Pricing: STEP 5 V Consider Competitors’ Reactions In 1994, Kodak’s share of the US film market was 70% but was declining. Flagship product Kodak Gold sold at 17% premium over Fuji Did not because Fuji had gross margin of 55% and could have followed the price cut Launched Funtime film at price lower than Fuji Simple Competitive Reactions Multiple Competitive Reactions AA Value Pricing: AA cut prices; SouthWest responded by advertising: “We’d like to match their new fares, but we’d have to raise ours Game theoretic Analysis

Competitive Interaction Asymmetric Price Tier Competition –Superpremium FujiColor Reala$4.69 Kodak Ektar$4.27 –Premium Kodak Gold Plus$3.49 Agfa Color$3.49 –Economy FujiColor Super G$2.91 Konica Super SR$2.91 ScotchColor$2.69 Prisoner’s Dilemma –Cigarettes in U.S. average price increase 10% from 1982 to 1991 –Instant cameras from 1976 to 1985 declined 76% in price Price Signaling

8 Steps to Better Pricing: STEP 6 VI Monitor Prices Realized at Transaction Level A product may have only 1 list price, but can have several final prices Returns, damage claims, special incentives drive revenue Unfortunately, most companies spend 90% of their effort in setting list prices Need to devote more care and attention to Quality and Logistics (manage returns / damage) and Account Analysis (where are revenues actually coming from?)

8 Steps to Better Pricing: STEP 7 VII Assess Customers’ Emotional Response Manage price perceptions Reference prices and Prospect Theory Market research required to assess customer reaction in terms of both perceived fairness and purchase intention

Effect of purchase context You are lying on a beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite beer. A companion gets up to make a phone call and offers to bring back a beer. He says that the beer may be expensive and asks the maximum price you are willing to pay. If the price is higher, he will not buy it. What price will you tell him if the only nearby place where beer is sold is a fancy resort hotel? What price will you tell him if the only nearby place where beer is sold is a small, run-down grocery store?

Odd pricing For which pair of prices is the lower price more of a bargain? First pair:$0.89$ Second pair:$0.93$0.79 Effect of Advertised Odd-Price Endings on Sales of Margarine: Parkay brand:Price/lb ($)Unit sales Regular price: Discount price (+ 194%) Odd discount price0.5914,567 (+406%)

Order Effects Reference prices when range of prices shown in: ProductAscending orderDescending order Electric shaver After-shave lotion Dress shirt Sport coat Hair spray Hair dryer Dress shoes Blouse

Prospect Theory Reference Price - Actual Price Actual Price - Reference Price Utility Disutility

Reference Pricing –put low priced good next to high priced good. –put “regular” price next to “sale” price (- “was $999, now $799”) –order effects: reference prices influenced by what is seen first. –endowment effect: de-couple acquisition and payment by first endowing buyers with the product. “Buy now, pay later”.

Reference Price effect of a High-end Product Choice (%) Microwave Oven Model:Group 1Group 2 Panasonic II (1.1 cu ft; regular-N.A. -13% price $199.99; sale: 10% off) Panasonic I (0.8 cu ft; regular43%60% price: $179.99; sale: 35% off) Emerson (0.5 cu ft; regular price57%27% $109.99; sale: 35% off)

8 Steps to Better Pricing: STEP 8 VIII Analyze Whether Returns are Worth the Cost to Serve Create a customer grid where each customer is plotted at the intersection of the revenue she or he generates and the company’s cost to serve that customer Need to manage customers for profits, not just sales Avoid “Strategic Accounts” STRATEGIC ACCOUNTS High Low Price Received Low High Cost to Serve Equity Axis

The Pricing Audit Our pricing processHigh/Med/Low Current Performance Poor Excellent (Qualities)Relevance Complements Marketing Strategy 2. Co-ordinated & Holistic (Steps) 1. Assess value to customers 2. Consider variation in value 3. Assess price sensitivity 4. Optimal pricing structure 5. Consider competitive reactions 6. Monitors on transaction level 7. Customer emotional response 8. Analyze revenue Vs. cost to serve Added Comments