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Chapter 8 Pricing Strategy and Management
Chapter 8
Pricing Strategy and Management
8-2
In this chapter, you will learn about…
1. Pricing ConsiderationsPrice as an Indicator of ValuePrice Elasticity of DemandProduct-Line PricingEstimating the Profit Impact from Price Changes
2. Pricing StrategiesFull-Cost PricingVariable-Cost PricingNew-Offering Pricing StrategiesPricing and Competitive Interaction
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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
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Profit = Total Revenue – Total Cost
Relationship between Price and Profits
Total Revenue = Price per Unit x Quantity Sold
Total Cost = Fixed Cost + Variable Cost
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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
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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 expensiveLower price could not cover variable costs
Pricing ConsiderationsConceptual Orientation to Pricing
Source: Kent B. Monroe, Pricing: Making Profitable Decisions, 3rd 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)
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Pricing ConsiderationsFactors narrowing pricing
discretion
Government regulations
Price of competitive offerings
Organizational objectives and
policies
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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 ConsiderationsOther factors affecting the pricing
decision
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Value = perceived benefitsprice
Value can be defined as the ratio of perceived benefits to price:
Pricing ConsiderationsPrice as an Indicator of Value
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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 ConsiderationsPrice as an Indicator of Value
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Pricing ConsiderationsPrice 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”
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E = percentage change in quantity demanded percentage change in price
Pricing ConsiderationsPrice 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
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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 ConsiderationsPrice Elasticity of Demand
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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 ConsiderationsFactors affecting Elasticity of
Demand
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Pricing ConsiderationsProduct-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)
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1. the lowest-priced product and priceplays the role of traffic builder
2. the highest-priced product and pricepositioned 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 ConsiderationsProduct-Line Pricing
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Cost data
Price data
Volume data for individual
products and services
Impact of price changes on profit can be determined from:
Pricing ConsiderationsEstimating the Profit Impact from
Price Changes
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Pricing ConsiderationsEstimating 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)
=
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Pricing ConsiderationsEstimating 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:
+ 33- (-5)
(20) + (-5)=
Estimating the Profit Impact from Price Changes
Product Alpha Product BetaCost, Volume, and Profit Data
Unit sales volume 1,000 1,000
Unit selling price $ 10 $ 10
Unit variable cost $ 7 $ 2
Unit contribution (margin) $ 3 (30%) $ 8 (80%)
Fixed costs $1,000 $6,000
Net profit $2,000 $2,000
Break-Even Sales ChangeFor 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%
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Pricing Strategies
Full-cost Price StrategiesConsiders both (direct) variable
and (indirect) fixed costs
Variable-cost Price StrategiesConsiders only (direct)
variable costs
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Pricing StrategiesFull-Cost Pricing
Full-Cost Pricing
Mark-up Pricing
Rate-of-Return Pricing
Break-even Pricing
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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 StrategiesMarkup Pricing
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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 StrategiesBreakeven Pricing
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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 StrategiesRate-of-Return Pricing
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Pricing StrategiesRate-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
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Pricing StrategiesRate-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 $0.175. 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
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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 StrategiesVariable-Cost Pricing
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Pricing StrategiesNew-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 Strategybetween the two extremes; most prevalent
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1. Demand is likely to be price inelastic2. There are different price-market segments3. The offering is unique enough to be protected from
competition by patent, copyright, or trade secret4. Production or marketing costs are unknown5. A capacity constraint in producing the product or
providing the service exists6. An organization wants to generate funds quickly7. There is a realistic perceived value in the product
or service
Pricing StrategiesWhen to Use Skimming Pricing
Appropriate when:
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1. Demand is likely to be price elastic2. The offering is not unique or protected by patents,
copyrights, or trade secrets3. Competitors are expected to enter market quickly4. There are no distinct and separate price-market
segments5. 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 StrategiesWhen to Use Penetration Pricing
Appropriate when:
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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 StrategiesPricing and Competitive Interaction
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1. 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 StrategiesPricing and Competitive Interaction
Advice for managers to avoid nearsightedness
of not looking beyond the initial pricing decision:
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1. 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 StrategiesPricing and Competitive Interaction
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Pricing StrategiesPricing 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
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1. 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 StrategiesPricing and Competitive Interaction
Pricing StrategiesPricing and Competitive Interaction
FewManyNumber of competitors
HighLowIndustry capacity utilization
StableDecliningOverall industry cost trend
LowHighBuyer price sensitivity
LowHighPrice visibility to competitors
IncreasingStable/DecreasingMarket growth rate
DifferentiatedUndifferentiatedProduct/Service type
LowerHigherIndustry Characteristics
Risk Level
Industry Characteristics and the Risk of Price Wars
