1. Boundaries of a Good Price
Chapter 1
Boundaries of a Good Price
Using Exchange Value Models to Understand Price Competition and Value oriented pricing

2. Agenda Who is involved in pricing decisions?
Why is pricing so important to the health of the firm?
Can firms influence their pricing power?
What is the nature of a good price?
How relevant are marginal costs and consumer surplus in setting a good price?
How should the comparable alternatives on the market influence the pricing of a product?
How can exchange value models be used to set prices? 2

3. The Importance of Price
If the price is……
Too high
Lost profits from lack of volume
The price is eventually dropped and the company must fight for market interest and perception repositioning
Potential allegations of price gouging and unfairness, leading to public relations and regulatory ramifications
Too low
Forgone profit in an attempt to gain volume which may not come
Incorrectly set expectations for the product category, making future price increases being driven against a headwind of customer expectations
Ultimately, lost profits, revenues, and a shrinking/irrelevant firm 3

4. Cross Functional Nature of Pricing
CFO
Responsible for measuring and reporting performance
Almost always involved in pricing decisions from a quantitative analysis / forecasting perspective
General bias towards higher contribution margins
Sales & Marketing
Responsible for promotion, product strategy, and placement, along with pricing
Almost always involved in pricing decisions from a value positioning perspective
General bias towards discounting and market share
Research & Development
Responsible for developing new products that customers value
Technical individuals often are challenged to understand commercial aspects
Production
Responsible for quality, throughput, and capacity utilization
General bias towards volume to reduce overhead allocation
CEO
Arbitrator between competing stakeholders
Customers
CEO
Shareholders
Executives 4

5. Value Exchange and Profit Capture
Price is the value that the firm captures in a mutually beneficial exchange with its customers
Firm’s reason for existence is to produce value for customers, value which they exchange for cash
Customers purchase because they gain value from the product in excess of the price they pay
Profit
Profit = Quantity X (Price – Variable Costs) – Fixed Costs
p = Q (P – V) – F
Variable Costs (V)
Fixed Costs (F)
Volume or Quantity Sold (hence the Q)
Price (P)
Profit (p) 5

6. 1% improvement for next Quarter
Impacting Profits
Last Quarter
1% improvement for next Quarter
in variable cost
in Fixed cost
in Volume
in Price
Price P
$25
$25.25
Volume Q
80,000
80800
Variable Cost V
$10.00
$9.90
Fixed Cost F
$1,000,000
$990,000
Profitability ∏
$200,000
$208,000
$210,000
$212,000
$220,000
Change in Profitability
$8,000
$10,000
$12,000
$20,000
% Profit improvement 4% 5% 6%
10%

7. The Art and Science of Pricing
The science of pricing refers to the act of gathering information, conducting quantitative analysis, revealing an accurate understanding of the range of prices likely to yield positive results.
The art of pricing refers to the ability to influence customer price acceptance, adapt pricing structures according to competitive strategies, marketing strategies and industrial policies.

8. Setting Prices with Exchange Value Models

9. Exchange Value Models Exchange value models quantify the price models
Knowing the boundaries of a good price narrows pricing discussions to a reasonable range of potential points
Extreme Boundaries
-Define the range of acceptable prices outside of which no rational buyer or seller would ever transact
Narrow boundaries
Define the range of prices that are most likely to encourage customer transactions and the leave the firm most favorable position.
-These are lying within the extreme boundaries

10. Extreme Boundaries Marginal cost define the extreme lower boundary
Seller’s bottom line
Any price lower than the marginal price leaves the seller loosing the business
Thus, marginal costs is the extreme lower boundary of the “right” price.
Consumer utility defines the extreme upper boundary
Buyer’ bottom line
Customer utility refers to the value a customer gains from having the product
The value that buyers place on a product is the utility that they derive from the product.

11. Various Utilities Form Utility Place Utility Time Utility
Ownership Utility
Consumer Surplus
Consumer surplus is the difference between the overall consumer utility and the transaction price.
As long as consumer surplus is positive, customer will value the product.

12. Marginal Costs and Consumer Utility Extreme Boundaries
From this example, we know only two extreme boundaries,
Bottom boundary of marginal cost generously estimated $300
Upper boundary of consumer utility frugally estimated at $5000
Clearly, $300and $5000 is a wide range, with the upper bound a factor of 1000 above the lower bound.
$400
$1000
$3,000
$4000
Managers need a tighter bound than this for decision making.
Blunt force economics of producer cost and consumer utility alone is insufficient.
Consumer Utility
$5000
Range of Potential Prices lies between the Extreme Boundaries
Price Floor
$300
Marginal
Costs

13. Narrow Boundaries
Narrower band is defined by the competing alternatives and differential value
Competition (Direct or Indirect)
Inferior alternatives
Inferior alternatives deliver similar benefits to the one under consideration with less overall consumer utility.
Regulatory constraints

14. Differential Value/ Improvement value
Differential value is the change in consumer utility that a product in comparison to its comparable alternative
It represents the potential incremental satisfaction or profits the customer can expect from this product over those of the reference product.
Exchange value is the price of the competing alternative adjusted for the differential value
Exchange Value = Price of the comparable alternative + Differential value

15. Exchange Value

16. Value Oriented Pricing

17. Value-in-use analysis
Value in Use = Total willingness to pay for a product across all consumers
To calculate the Value in Use, we need to…
Determine the customer's reference product
Customer’s life cycle cost using the reference product
Improvement value of the product relative to the reference product

18. Value-in-use analysis
Reference Product:
Customers next best alternative for meeting the same need as current or proposed new product
Existing model about to be replaced
Competing product
Life Cycle Costs:
All costs that a customer will incur over the product’s useful life.
These costs include Actual purchase price, Startup costs, post purchase costs
Improvement value of the product:
The improvement value of the product represents the potential incremental satisfaction or profits the customer can expect from this product over those of the reference product.

19. Value Based Pricing P max y = LCCx +Ivy –(PPCY+SUCy)
P max y = maximum acceptable price of Product Y
LCCx = Life cycle costs of the reference product X
Ivy = Improvement value for the new product Y
PPCY = Post purchase cost for the new product Y
SUCy = Start up costs for the New Product Y

20. Example Old reference product X, Current Purchase price = $400
Post purchase cost = $300
Start up cost = $300
Hence Life cycle cost for product X,
LCC x = Px + PPCx + SUCx = $1000
Assume “NEW “ product Y is highly efficient and has an Improvement Value, Ivy = $200
PPCy = $200
SUCy = $200
Therefore Max.Accpetable Price, P max y = LCCx +Ivy –(PPCY+SUCy)
Pmax = $800

21. Consumer Surplus
Consumer Surplus = Difference between the maximum amount customers are willing to pay for a product and the amount they actually pay.
Consumer Surplus = Value in Use – Value in Exchange
Question:
In the previous example, if the seller decides to sell the product Y for $500, What is the consumer surplus???

22. Consumer Surplus

23. Limitations of Value based pricing
Sometimes the product offering is so new that its difficult to accurately estimate its relative value to customers
Value of the product may depend on the nature of the buyer, how the buyer uses the product, variations in perceived benefits of the product by different buyers.

24. Summary
Pricing is a strategic challenge with a direct impact on profitability
The science of pricing refers to the act of gathering information, conducting quantitative analysis and getting accurate information of the range of prices likely to yield positive results.
The art of pricing refers to the ability to influence customer price acceptance, adapt pricing structures to shift competitive playing fields and align pricing strategy to the competitive strategy, marketing strategy, and industrial policy.
Extreme boundaries are determined by Cost of Product and Consumer Utility
Narrow boundaries are determined by competition and regulatory constraints
The exchange value is the price of the comparable alternative + the differential value 24