Pricing Strategy

What Is a Price? Narrow Definition: The amount of money charged or paid for a product or service. Broad Definition: The sum of all values consumers exchange for the product or service. – Time Costs – Cognitive and Emotional Costs – Transaction Costs

Internal and External Factors Affect Prices

Value-Based Pricing vs. Cost-Based Pricing

Cost-Based Pricing Methods

Cost-plus pricing – Add a standard markup to the cost of the product Break-even pricing – Pricing to break-even (Why?!) Target-profit pricing – Pricing to meet a profit objective. Cost-Based Pricing Methods

Fixed Costs: Costs that do not vary with production or sales levels. Variable Costs: Costs that vary directly with sales or production levels. Mixed Costs: Costs that have both fixed and variable components. Fixed vs. Variable Costs

Estimating Costs Experience/learning curve

Markup Pricing Add a standard markup to the product’s cost

Markup Pricing – Example What should a product be priced at if its unit cost is $10 and the desired return on sales is 30%? Price = $10 / (1 -.30) = $14.29

Target-Return Pricing Price that yields its target rate of return on investment

Target-Return Pricing - Example What should a product be priced at if its unit cost is $10, expected sales are 100,000 units, capital invested in making and selling the product is $500,000 and the desired return on invested capital is 40%? Price = $10 + [(.20 x 500,000) / 100,000] = $12.00

Cost-Volume-Profit Graph

The Cost-Volume-Profit Pricing Formula Profit = Revenues – Variable Costs – Fixed Costs Profit = (Price per unit) x (Quantity sold) – (Variable cost per unit) x (Quantity sold) – Fixed Costs π = profit (target); p = price; q = expected sales quantity (volume); f = fixed costs π = p x q – v x q – f π = (p – v) x q – f p = (π + f)/q + v

CVP Pricing - Example What should a product be priced at if fixed costs to produce and sell the product are $5 million, variable cost per unit is $25, the company expects to sell 8 million units and would like to earn a target profit of $10 million on sales of the product? p = (π + f)/q + v p = (10,000, ,000,000)/8,000, = $26.88

CVP Pricing - Example What should a product be priced at if fixed costs to produce and sell the product are $5 million, variable cost per unit is $25, the company expects to sell 8 million units and would like to break-even on sales of the product? p = (π + f)/q + v p = (0 + 5,000,000)/8,000, = $25.63

CVP Pricing - Example If fixed costs to produce and sell the product are $5 million, variable cost per unit is $25 and the product is priced at $28, how many units must the company sell in order to break- even? π = (p – v) x q – f 0 = (28-25) x q – 5,000,000 0 = 3q – 5,000,000 3q = 5,000,000 q = 1,666,667 units

CVP Pricing - Example If fixed costs to produce and sell the product are $5 million, variable cost per unit is $25 and the product is priced at $28, how many units must the company sell in order to achieve a target profit of $20 million? π = (p – v) x q – f 20,000,000 = (28-25) x q – 5,000,000 20,000,000 = 3q – 5,000,000 3q = 25,000,000 q = 8,333,333 units

Marketing Mix Strategy: – Price must be coordinated with the other three P’s (Product, Promotion and Place) to form a consistent and effective marketing program. Internal Factors Affecting Pricing Decisions

Supply and Demand Price Elasticity of Demand Market Structure Price Sensitivity Competitive Considerations Macroeconomic Considerations External Factors Affecting Pricing Decisions

Supply and Demand

Elasticity Pricing Method

Elasticity of Demand The price elasticity of demand measures the degree to which the unit sales of a product or service are affected by a change in unit price. Change in Price versusversus Change in Unit Sales

Price Elasticity of Demand Demand for a product is inelastic if a change in price has little effect on the number of units sold. Example The demand for designer perfumes sold at cosmetic counters in department stores is relatively inelastic.

Price Elasticity of Demand Demand for a product is elastic if a change in price has a substantial effect on the number of units sold. Example The demand for gasoline is relatively elastic because if a gas station raises its price, unit sales will drop as customers seek lower prices elsewhere.

Inelastic And Elastic Demand

Price Elasticity of Demand As a manager, you should set higher (lower) markups over cost when demand is inelastic (elastic)

Price Elasticity of Demand Є d = ln(1 + % change in quantity sold) ln(1 + % change in price) Natural log function Price elasticity of demand I can estimate the price elasticity of demand for a product or service using the above formula.

Price Elasticity of Demand Suppose the managers of Nature’s Garden believe that every 10 percent increase in the selling price of its apple-almond shampoo will result in a 15 percent decrease in the number of bottles of shampoo sold. Let’s calculate the price elasticity of demand. For its strawberry glycerin soap, managers of Nature’s Garden believe that the company will experience a 20 percent decrease in unit sales if its price is increased by 10 percent. Suppose the managers of Nature’s Garden believe that every 10 percent increase in the selling price of its apple-almond shampoo will result in a 15 percent decrease in the number of bottles of shampoo sold. Let’s calculate the price elasticity of demand. For its strawberry glycerin soap, managers of Nature’s Garden believe that the company will experience a 20 percent decrease in unit sales if its price is increased by 10 percent. Apple Almond

Price Elasticity of Demand Є d = ln(1 + % change in quantity sold) ln(1 + % change in price) Є d = ln(1 + (-0.15)) ln(1 + (0.10)) Є d = ln(0.85) ln(1.10) = For Nature’s Garden apple-almond shampoo. Apple Almond

Price Elasticity of Demand Є d = ln(1 + % change in quantity sold) ln(1 + % change in price) Є d = ln(1 + (-0.20)) ln(1 + (0.10)) Є d = ln(0.80) ln(1.10) = For Nature’s Garden strawberry glycerin soap.

Price Elasticity of Demand The price elasticity of demand for the strawberry glycerin soap is larger, in absolute value, than the apple-almond shampoo. This indicates that the demand for strawberry glycerin soap is more elastic than the demand for apple-almond shampoo. Apple Almond

The Profit-Maximizing Price Profit-maximizing markup on variable cost 1 +ЄdЄd = Under certain conditions, the profit-maximizing price can be determined using the following formula: Using the above markup, the selling price would be set using the formula: Profit-maximizing price 1 +ЄdЄd Variable cost per unit =(1 + ) ×

The Profit-Maximizing Price Let’s determine the profit-maximizing price for the apple-almond shampoo sold by Nature’s Garden. The shampoo has a variable cost per unit of $2.00. Price elasticity of demand = Profit-maximizing markup on variable cost 1 + (-1.71) = = 1.41 or 141% Apple Almond

The Profit-Maximizing Price Now let’s turn to the profit-maximizing price for the strawberry glycerin soap sold by Nature’s Garden. The soap has a variable cost per unit of $0.40. Price elasticity of demand = Profit-maximizing markup on variable cost 1 + (-2.34) = = 0.75 or 75%

The Profit-Maximizing Price The 75 percent markup for the strawberry glycerin soap is lower than the 141 percent markup for the apple-almond shampoo. This is because the demand for strawberry glycerin soap is more elastic than the demand for apple-almond shampoo. Apple Almond

Which pricing method should I use?!

External Factors Affecting Pricing Decisions Market Structure: – Pure competition – Monopolistic competition – Oligopolistic competition – Pure monopoly

What kind of markets do the following companies/products compete in? (Pure competition, Monopolistic Competition, Oligopoly, or Pure Monopoly)

Price Sensitivity

More External Factors Affecting Pricing Decisions Competitive Pricing Considerations – What are our competitors charging? How and why? – How does our value compare to the competition’s? – Will our pricing attract, restrict, or drive out competitors? – How strong/permanent are current competitors? – Avoiding price wars

More External Factors Affecting Pricing Decisions Macreconomic Factors – Inflation (Cost-pull / Demand-push) – Purchasing Power – Business Cycle (Expansion vs. Contraction) – Income-driven vs. Counter-cyclical products

Questions du Jour Which products sell better in a bad (i.e. contracting) economy? Can companies ever raise prices in a bad economy?

Best used when: – Higher quality / ”premium” product. – Lower fixed cost structure. – Competitors with similar quality cannot easily undercut price. – Initially set a high price for a new product so as to “skim” revenues layer by layer from the market. – Lower prices over time, “skimming” revenue from different demand tiers. – Initially make fewer, but more profitable sales. New-Product Pricing Strategies – Market Skimming

Best used when: – Market is highly price sensitive. – High fixed cost structure. – Competitive response does not create a price war. – Set a low initial price to “penetrate” the market quickly. – Possibly raise prices when wide adoption and brand loyalty have been achieved. New-Product Pricing Strategies – Penetration Strategy

Which pricing strategy (skimming or penetration) is normally used when a new prescription drug is introduced in the U.S.? Why?

Product Mix Pricing Strategies Product line pricing Optional-product pricing Captive-product pricing By-product pricing Product bundle pricing

Product Line Pricing Sets price steps between various product line items based on: – Cost differences between products – Customer demand for additional/different features Price-Value Gradients

Optional-Product Pricing Pricing optional or accessory products sold with the main product Examples: – Cruise control added to basic car. – Computer sold with additional RAM (memory) – Rental car sold with “luxury” or size upgrade Ethics alert!! Often abused in “Bait and Switch” tactics

Captive-Product Pricing Pricing products that must be used with the main product Base product is relatively “cheap” or free Replacement product is relatively “expensive” Examples: – Replacement cartridges for Gillette razors. – Toner/ink for printers. – Replacement car parts sold at car dealers

Product Bundle Pricing Multiple products sold together for one price Creates perception of savings Eases decision-making and ordering for consumers Examples: – Computer package: PC, monitor, software, and printer. – McDonald’s Value Meal: Burger, Fries and Drink – Vacation package: Flight, hotel and meals

Question du Jour When are companies better off bundling prices? When are companies better off charging separate prices for each item?

Discount and allowance pricing Price discrimination (Segmented pricing) Psychological pricing Promotional pricing Dynamic pricing Price Adjustment Strategies

Discounts and Allowances Discounts – Cash – Quantity – Seasonal Allowances – Trade-in – Promotional Dangers of discounts Seasonal Discount: Christmas cards purchased out of season, such as in March or July, are often sold at a discount.

Price Discrimination (Differentiated / Segmented Pricing) Selling a product or service for different prices to different people, where differences in price are not driven by different costs. Types: 1. First Degree – by person 2. Second Degree – by volume 3. Third Degree – by market segment Pricing at Disney World hotels varies by time of year.

Price Discrimination Yield pricing

Psychological Pricing Considers the psychological effects of prices – usually irrational responses. Economic consideration of prices diminished. Standard practice among most retailers

Odd-Even Pricing Why do marketers use the following prices?

Question du Jour What impression are consumers left with when they see even-numbered prices like $12 ?

Price as Signal of Quality The typical Price-Quality Inference Effects of price changes on quality inferences When pricing is NOT used as a quality signal – Extensive product knowledge/expertise – Repeat buys

Reference Prices What is a fair price for gas?

Possible Consumer Reference Prices “Fair” Price Average Price Typical price Last price paid Upper-bound price Lower-bound price Competitor prices Expected future price Usual discounted price Phantom prices

Promotional Pricing Techniques Cash Rebates Special-Event Pricing Loss Leaders Longer Payment Period Low-Interest (or Free) Financing Deals (BOGOs) Clearance Sales

Promotional Pricing – Deals, Clearance Sales and 0% Financing Promotional pricing creates excitement and a sense of urgency.

Hi-Low Pricing vs. EDLP Which strategy is more profitable?

Initiating Price Changes Price cuts – Falling sales or market share – demand issues – Grab market share from competitors – Lower production/service costs – Respond to competitor’s price drop – Consumers have less purchasing power Price Increases – Cost inflation – Over-demand – Match competitor’s increase – Market leadership – Time

How would consumers likely react if Joy suddenly cut its price in half? When Cutting Price is a Bad Idea

Assessing and Responding to Competitor Price Changes

Understanding Pricing Pricing in a digital world Dynamic pricing Price comparisons Check/compare prices at the point of purchase Name your price and negotiate prices online Monitor customer behavior & tailor offers Automatic rebates and refunds

Internet Price Shopping Have consumers benefitted?

Public Policy Issues in Pricing