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Pricing Introduction
Outline Types of Prices Pricing Approaches Pricing Process
Prof. Metin Çakanyıldırım used various resources to prepare this document for teaching/training. To use this in your own course/training, please obtain permission from Prof. Çakanyıldırım.
If you find any inaccuracies, please contact [email protected] for corrections.Updated in Fall 2018
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Cost vs Price
Manufacturer
Supplier’s facility cost
Supplier Distributor Retailer Customer
Manufacturing cost Trucking cost Holding cost
A supply chain and its costs.
Find out the costs from accounting records, decide on the price.
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List (Catalogue) Price and Pocket Price
Bargaining Buyer offers a lower price than the list price and brings up the offer. Seller rejects offers until the price is sufficiently high. How much to discount?
Supply Chain
Price is42.95
Catalogue
Bargain:Offer32.95
$42.95 is list price
$38.95 is pocket price
Bargain:Offer38.95
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Why List Price differs from Pocket Price?The Case of B2B Transactions
Retailer Performance (quantity, quality, time) Annual volume bonus: An end-of-year bonus paid to a retailer who buys a certain amount.
– Last year you bought 50% more than average retailer, so your price drops to … Stocking allowance: Quantity based discount often before a seasonal consumer demand
increase.– For Labor day sale, you qualify for 10% markdown if you order 20% more ….
Performance penalties: Penalties charged to retailer if performance targets in terms of quality or delivery times are missed.
– As a licensed retailer of our tires, you are to install tires on the same day of accepting a car. In the last few months, a few customer cars stayed overnight. This increases our liability so your price increases to …
Advertising and Promotion Cooperative advertising: An allowance paid to the retailer for locally advertising the
supplier’s product. – If you advertise Ford trucks in the DFW market, we will offer you a discount of …
Market-development funds: A discount given to retailer to promote sales in specific segments of the market.
– If you sell our mattresses in the new market of Northwestern states, you can get them at a lower price of … End-customer discount: A rebate paid to a retailer for discounting a product for a strategic
customer.– We want to sell our study desks to university students and are willing to charge them less if they show a valid
university id. Off-invoice promotions: A discount given to retailer during a specific promotion.
– To move extra inventory from distributor to retailer quickly, the wholesale price is revised down to …
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Why List Price differs from Pocket Price?The Case of B2B Transactions
Logistics Freight: Supplier may assume transportation cost.
– If ATT does not expedite the delivery of cables, the cable supplier can deliver them for free … On-line order discount: Discount for retailers ordering over the Internet.
– Telecommunication equipment is discounted for online orders …– Flower Galore discounts online orders of flowers from the local grocery store …
Slotting allowance: Paid to retailers to secure shelf space.– P&G pays grocery stores to rent their shelf space for its cleaning products; this rent can be applied against the
price to reduce it …Transaction Accounting Consignment cost: The cost of funds when a supplier owns retailer’s inventory.
– Car manufacturers own the car dealer inventory for the first 90 days after delivery to the retailer and factor the cost of this ownership into wholesale price
Receivable carrying cost: The cost of funds to be received (long) after invoicing.– WalMart can pay its suppliers up to 90 days after invoicing and is subject to higher prices
Cash discount: A deduction from the invoice price if payment is received quickly, <15 days.– Fresh Bakery offers baked goods at a lower price to local WalMart if it is paid in 15 days after invoicing of the
delivery.
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Price Waterfall from List Price
↓ Pocket Price
If the pocket price differs from the list price by 50%, what is the appropriate margin? Some argue that we should compute pocket margin instead:
Pocket margin = Pocket price – direct cost – indirect cost – cost to serve a specific account The last cost is big with customized products.
For example, Tempered (toughened) special cut glass for heavy trucks, farm and construction machinery.
Source: The power of pricing, McKinsey Quarterly, February 2003.
30%-90% wide range of pocket price band
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Pocket Price Band
Pocket price band: the histogram of the pocket prices obtained, as a % of list price. – From the last page, 2.5% of the customers pay 85% of the list price
A wide pocket price band does not necessarily indicate bad pricing policy. It may indicate just the contrary.
Sophisticated buyers ask for / bargain for various prices. A company, in response to a buyer’s wish, should offer a responsive price. Customer characteristics specify the offered price
– Customer size: Small pays big. Recall annual volume bonus.– Customer’s disposable income: Rich pays big.– Willingness to buy (pay): Enthusiast pays big. – Future sales potential: Low potential pays big. Recall market development funds.– Past history: Friendship matters. Enemies pay big.– Access to alternatives matter: Isolated customers pay big.– Negotiation effort, alternative product search effort matter: Lazy pays big.
Price Optimization on seller’s part ⇒ A wide pocket price band.
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Expensive Bargaining Lesson from Istanbul: 1) Act like you couldn't care about the wares. If you're interested in something, walk past it at first. 2) Do NOT linger. Then pick it up like it's a dead stinky fish and you've seen a million like it and say "How much?". 3) Never compliment the beauty of the items, and frown incredulously at the price they quote you, then walk away with a look of "What kind of fool do you take me for". 4) Don't buy at the first 5 places you come to. The items are the same everywhere in the bazaar. The prices are inflated at least 200%. When you finally do buy, stop comparison shopping, because inevitably the next place you go to will be selling the same item at a third of the price you just paid. Ignorance is [a] bliss.
Based on a flickr.com comment by the lady who bought the jewelry box
“This is the man who gouged [overcharged] me bad for a jewelry box that smelled like fish.”
Food (a wrap and tea) is served for “the body”
Music (“Ney” instrument) is served for “the soul”
What is the list price of a jewelry box? Why do you pay the list price when you shop?
Why List Price differs from Pocket Price?The Case of –Ever Going Out-of Business– Carpet Sellers
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Mini Case Study: Pricing at JC Penney
Pocket price distributionat a carpet seller
Pocket price distributionat JCP before Oct 2011 Pocket price distribution at
JCP between Nov 2011-Apr 2013
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From
JCP
2014
10-K
filin
g
JC Penney before October 2011J. C. Penney headquartered at 6501 Legacy Drive, Plano, Texas
Operates ~1100 department stores Sells Women’s apparel 24% of revenue; Men’s apparel and accessory 22%, Home 12%, Women’s accessories
12%, Children’s apparel 10%, Family footwear 8%, Fine jewelry 7%, Services (styling salon, optical, portrait photography, and custom decorating) and other 5%.
14 distribution centers (9 owned, 5 leased) in the SC with a total of 16 million square feet space.
Profitless Prosperity: Revenue flat in 2010-2011, profit margin 1-2% unlike 4-5% of competitors Under CEO Mike Ulmann over 2004-2011, company developed its own brands: Linden Street (furniture), St.
Johns Bay for clothing. Competitors:
High-end department stores: Nordstrom, Neiman Marcus, Saks Fifth Avenue Kohl’s now after fast expansion out of Midwest; Macy’s then Sears with its own problems and 2005 merger with K-Mart Mass merchandisers: WalMart and Target
Pre Oct 2011, JC Penney offers frequent price discounts; list price/pocket price ~ 2. About 600 sales leading to 72% of sales from items discounted at least 50%.
2014 2013 2012 2011 2010
JCP Revenue in $M 12,257 11,859 12,985 17,260 17,759
JCP Sales change 3.4% -8.7% -24.8% -2.8% 1.2%
JCP Ebitda in $M 242 -636 -396 1,054 1,596
JCP Year-end stock price 6.29 8.74 20.62 34.96 30.72
Macy’s Revenue in $M 28,105 27,931 27,686 26,405 25,003 From Macy’s 2015 Factbook
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1. Branding
November 2011 – April 2013 Seeing lackluster results of JCP in 2010-11, Pershing Square Fund managed by Bill Ackman believes that he can
improve the JCP performance. He invests fund’s money to buy JCP stock and in return gets board positions. He looks for a new CEO in 2011 to spice things up.
In Nov 2011, Ron Johnson starts as a new CEO. Previously, he worked at Apple and Target on branding (association of a product with high value) and merchandising (using trends to forecast or build demand and carry demanded products).
Johnson implements 2 new major strategies: Branding and Pricing
Boutiques (Izod, Martha Stewart) aligned around a “town square”; Complimentary services (ice-cream, balloons, haircuts for kids).
2. Pricing
Clearance
Less discounts;Fewer coupons
Boutiques were argued to tidy up the scrambled merchandises in the stores and to serve as a channel for big brands (Adidas, Levi’s) that do not open their own retail stores in the malls.
To open space for boutiques, stop JCP private brands. Lifestyle marketing: “You must have a white shirt.” Signed to sell Martha Stewart
Products and sued by Macy’s which had a contract with Martha Stewart. Court sides on Macy’s and limits items that can be sold by JCP.
Better looking stores ok butSelling while renovating is tricky
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After May 2013 Aug 12, JC Penney posts $147 M quarterly loss. Penney's sales at stores (open >1 year) declined 22%. Fearing
liquidity problems ahead of the holiday season, Moody’s lowers debt rating two notches from Ba3 to Ba1. CFO Kenneth Hannah responds:
– “… it's important to note … when you look at some of … downgrades .., it's not because of … liquidity. It's a question as to whether or not we are going to be able to execute the pricing … strategy."
» K. Talley. 2012. “Sales Plunge Another 23% at Penney”. WSJ Aug 10 issue.
In Spring 13, Johnson is forced to leave JCP after the losses due to branding and constant pricing strategies became apparent. Ironically, these strategies were successful at Apple.
Johnson wanted to quickly end the addiction of JCP customers to discounts but drove them away to other stores (such as discounter T.J. Maxx, see Aug 17, 2013 The Economist article “Hard Knocks: Department stores have been losing customers to other retailers for decades”, which also has the chart below).
In August 15, M. Ellison becomes the CEO of JCP. He will talk at Goldman’s retailing conference on Sep 9, 15 at
3:10pm: http://ir.jcpenney.com/phoenix.zhtml?p=irol-eventDetails&c=70528&eventID=5202317
Mike Ulmann was re-hired quickly as an acting CEO who would transfer the post somebody else.
In Aug 13, Ackman (Pershing Square) sells his JCP shares (18% of the company) and leaves the board after continuous disagreements about the leadership changes. He says: “Clearly, retail has not been our strong suit.”
Are Department Stores anybody’s strong suit?
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Pricing Approaches and Optimization
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Traditional Pricing ApproachesCost Plus Pricing
Cost Plus Pricing: Add a surcharge to the cost of a product to find its price.– Finance departments insist on margins to ensure profitability
» 5% for established products» 50% for design/customized products» In a non-profit business, mark up by once; price about the cost. » In restaurant business, mark up
food by 3 times beer 4 times liquor 6 times
of the direct cost Cost plus pricing is an introverted process for ignoring
– Customer– Competition
Cost plus pricing is very common Fixed costs complicate the computation of cost-plus prices
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Traditional Pricing ApproachesCost Plus Pricing: Millie’s Cider Shop
Millie is an entrepreneur-spirited SOM graduate. She wants to open a non-alcoholic cider shop at “Shops at Legacy”.
– She will buy ciders at $2 per bottle from the wholesaler. – Besides this wholesale cost, her major cost is the shop rental of $1000/month. – She aims for 20% margin. What should the price of a cider bottle be?
Cost plus pricing approach requires the allocation of $1000 rental cost to the bottles sold over a month. It is important to find out average monthly sales.
Her market analysis shows that she can monthly sell – 1500 bottles if the price is less than $3.50; – 1000 bottles if the price is between $3.50-4.00; – 500 bottles if the price is between $4.00-5.00. – 0 bottles if the price is more than $5 per bottle. – We can call customers low, medium and high-end, each segment demands 500.
Millie ignores the low-end customers and targets medium and high-end customers. Then monthly sales is 1000 and Millie should charge
(1+0.2)(2 + 1000/1000) = 3.6 dollars per bottle. If Millie targets low end customers as well, she can sell 1500 per month. She then should charge
(1+0.2)(2 + 1000/1500) = 3.2 dollars per bottle. Targeted market affects demand which affects the fixed cost allocation.
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Traditional Pricing ApproachesMarket Based Pricing
Market-based pricing takes competition into account but ignores customers and to some extent costs.
Market-based pricing suggests adjusting prices to match market prices.– Matching is typically by lowering own price preferably while keeping it above the cost– This decreases profit margins but can increase the number of units sold (sales volume)– Price-matching strategies are common in marketing
Market-based pricing is applied in new markets to capture market share– Alamo car rental initially priced to be less than both Hertz and Avis– In 1990’s, Japanese car manufacturers priced their cars below American manufactured cars.– In 2010’s, Korean car manufacturers may underprice to capture North American market.– In 2020’s, Chinese aircraft manufacturer Comac may underprice ….
Recall that Millie is charging $3.6 per cider bottle.– Millie is concerned that the next door Starbucks is charging an average of $3.5 per drink.– What should Millie do? Perhaps bring her price down to $3.5. This little adjustment makes
her prices competitive with those of Starbucks.
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Traditional Pricing ApproachesValue Based Pricing Value-based pricing takes each customer’s valuation of a product into account. It can be named as personalized or one-to-one pricing. Finding each customer’s value is hard in a B2C transaction as there are many customers
– Group customers and assign values to groups by using surveys, focus group analysis» Disney prices differently for Orlando residents, AAA members, etc.
– Use Internet to record each customer’s characteristics and previous purchases» Amazon is the leader; Supermarket’s membership discount cards
In a B2B transaction, there are fewer and bigger customers.– Caterpillar’s sales people know more about their customers such as municipalities, port
authorities, transportation authorities, mining companies, construction companies.– Siemens Infrastructure Group surveys airports for luggage handling equipment.– Knowing your customers goes a long way to assess their valuation of your product.
Customers value your products not in absolute isolation but relatively. – Market matters, maybe indirectly
Recall that Millie is charging $3.5 per bottle. Yet some can pay up to $5.– What should Millie do? Create two forms of service and charge $3 and $5 simultaneously.
» In Europe, to-go (called to-take-away) drinks are cheaper than for here (to-stay) drinks.» Do you value Pastries or Presence more at a café?
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Pricing at Cafés: 2P: Pay for Pastries or Presence?
In the traditional model, patrons buy beverages & pastries and pay only for these tangible items.In a version of the traditional model, – Higher “to-stay price”: A patron pays more if chooses to stay at the café to consume beverages & pastries. – Lower “to-go price”.
The price gap between to-stay and to-go prices can be larger.
Pay-for-stay pricing model for cafés: – Patrons get free standard beverages & pastries but pay for the time
they stay at the café.– Case in point: Ziferblat cafés. A few of them are spread from
London to Moscow. English newspaper Guardian writes about the London location at 388 Old Street:
» The idea is guests take an alarm clock from the cupboard on arrival and note the time, then keep it with them, before, quite literally, clocking out at the end. There's no minimum time. Guests can also get stuck into the complimentary snacks (biscuits, fruit, vegetables), or prepare their own food in the kitchen; they can help themselves to coffee from the professional machine, or have it made for them.
– V. Baker. 2014. London's first pay-per-minute cafe: will the idea catch on? Guardian, Jan 8 issue.– The pay-for-stay prices
» London location: £1.8/hour = 3 pences per minute in Jan 2014 according to Guardian.» Liverpool location: £3.6/hour in Oct 2015.
– To learn more, especially about events at Ziferblat London: https://www.facebook.com/ZiferblatLondon/ Coffice (café & office) concept, Urban Station in Buenos Aires, http://enjoyurbanstation.com/
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Traditional Pricing Approaches vs. RM
Combine these pure approaches to have hybrids Alternate between pure approaches
Use cost plus with high margin for new products because market or competition may not exist
Market and value based with mature products
Approach Based on Ignores Liked byCost plus Cost Competition, Customers FinanceMarket based Competition Cost, Customers SalesValue based Customers Cost, Competition MarketingRevenue Management Capacity Mostly Competition Operations
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Setting Price
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Setting Price
Who sets the price?– Company, classical – Customer, revolutionary– Collaboration, classical, think of auctions and negotiations– Market, classical, commodities
Why should a company delegate pricing, in part or whole, to customers?– Company wants value-based pricing but does not know the value of a product for the customer– Company learns the value by delegating pricing for a while– Company does not need to delegate if knows the value or implements cost- or competition-based pricing
Market
Company
Customer
Cost-based pricing
Competition-based pricing
Value-based pricing
Price Setter Price Methodology
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Yes
Yes
Flowchart towards a Pricing Approach
Value knownto firm?
Value revealingprice menu?
Value unknown to customer?
Limitedsupply?
NoYes
1. Firm optimizes prices; Customize / personalize
No
No
2. Present the price menu
4. Auction
3. Negotiation; Increase product awareness
YesNo
6. Pay-as-you-wish
Maybe5. Name-your-own price
More company controlLess customer input
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Pricing Approaches 1. Price optimization: To be detailed later2. Building a value revealing price menu
Not always possible Consider often vertically differentiated versions of the same product, i.e., versions that are slightly better/worse
than each other Ex: Among economy seats on a plane, Exit row seat ≻ Aisle seat ≻ Window seat ≻ Middle seat
Price better version slightly higher and present a menu of prices and versions Ex: For economy seat prices DFW-PHX, Exit row seat = Aisle seat+30 = Window seat+50 = Middle seat+60
3. Negotiation One-on-one and iterative interaction with customer for selling an expensive product
Ex: Car dealers, home sellers, mortgage loan officers, house repair and remodeling work, labor market Ex: 86% of mobile phone service customers and 85% cable TV customers got a discount after a negotiation. Interestingly,
discounted price for 46% of phone service and 26% of cable service was not for limited time. See http://blogs.which.co.uk/technology and 15 Nov 2013 posting ``Which mobile network is most likely to give you a better deal?” and 17 Jul 2013 posting “Save £100s by haggling for your TV, broadband and phone bill”.
4. Auction One-to-many interaction with customers for selling an expensive product with limited supply Auction takes an effort to set up but can result in faster and sure sale
Ex: Antique car, lake-front home sale, art work5. Name-your-own-price (NYOP)
Single-shot one-on-one interaction with customer for selling an opaque product An opaque product has hidden characteristics such as an airline ticket with unspecified departure time or carrier
Not even a destination, but destination categories such as beach, shopping, culture; see Blind Booking at Germanwings.com Opacity is used to avoid value dilution of the underlying product Firm has a value (opportunity cost) for the product in mind and sells if customer offers more The number of offers per time is limited to avoid the customer’s discovery of firm’s value
Greentoe.com accepts nyop for a product (e.g., camera) and searches its network to find a retailer to sell at that price 6. Pay-as-you-wish (PAYW): Detailed on the next page
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PAYW (Pay-as-you-wish) Examples Summit Law Group http://www.summitlaw.com says “you decide how we should be compensated through our
innovative fee arrangements. … Summit proposes a fee each month based on the time incurred. The customer is asked to pay the proposed monthly fee or adjust that fee – up or down – for the value, as perceived by the customer.”
Open-source software, Wikipedia, 10 Oct 2007 digital release of Radiohead’s “In Rainbow” album after their contract ended with EMI; Album available at https://www.youtube.com/watch?v=HSx6hXHzRHc.
Computer game seller Humble Bundle https://www.humblebundle.com has
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Altruism leads todonations especially
for childrenhttp://www.unicef.org
PAYW: Pay-as-you-wish
• There is cost albeit possibly low, how to ensure cost coverage on average? I. Prompt customers by setting price expectation or establishing a reference price
See the average price statistics of Humble Bundle on the previous page Announcing average donation amount to free museums Print 15% and 20% tip amounts on restaurant receipts
II. Shift customer focus to fairness, altruism, reciprocity See Humble Bundle donations to charity on the previous page Reciprocity is mentioned among car dealers while transshipping cars Reciprocity of earthquake prone regions: California, Turkey, Nepal, Japan
III. Explain to customers that bankruptcy of the supplier would be troublesome If customers consistently pay less than the cost, the supplier, not
recovering the cost goes bankrupt. GM arguably bankrupted its suppliers in 2000s by negotiating discounts of 2-3% year after year.
If your favorite and low-cost restaurant goes bankrupt, where to eat the lunch buffet?
• Extreme case of PAYW is donation
Additional potential benefits of PAYW and NYOP 1. Learning customer valuation of the product2. Customer engagement and better customer relationship management3. Creating a perception of trust in own product and its quality4. Reducing competition: your competitor is unlikely to adopt PAYW or NYOP.
• Variable cost is either almost zero or mostly sunk and demand is limited: Supply ≫ Demand
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PRO (Price-Revenue Optimization) Scope Scope of pricing depends on 4 factors:
– Product– Segment– Channel– Time
» The textbook lists the first three, but time should be added.
Prices change over products, segments, channels, or time. Example different age groups of women buying apparel online
What is the Product, Segment, Channel, Time?
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Rules of the GameCommitments of a Seller to a Buyer
Customer commitments: Products/services provided now or in the future to a customer.Examples: Trivial: Products, services, prices Nontrivial
– Time period over which the commitment will be delivered» Manufacturer’s warranty period: 3 years for Dell keyboards; 1 year for pool motors; » 4 years free maintenance service for cars; Forever for your UTD education.
– Expiry date of an offer » The introductory pricing is valid until …..» Contractual pricing: Special price for a certain buyer for a certain time window
– Payment terms» Buy now pay in 6 months» Rebate coupons
– Return policy» Returns are acceptable with a restocking fee.
Vivint alarm monitoring company charges restocking fee for the alarm equipment Best Buy does not but suffers from returns of items such as high-end cameras and flat screen TVs.
– Risk sharing» If a new car has flat tire, the buyer is responsible; if it has engine problem, manufacturer is responsible.» The buyer can also buy flat-tire insurance from a dealer.» Refundable airline tickets» Nonrefundable Mavericks tickets
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PRO Process
Determine market
response
Segment market
Set goals and
constraints
Update market
response
Analyze alternatives
Choose the best
alternative
Execute pricing
Monitor and evaluate
performance
The Market
Operational PRO Activities
Supporting PRO Activities
PriceSensitivity
Goal: Maximize sales volume, profit.Restriction: Price matching with competitor.Segment: To-go vs. to-stay customers.Market response: Price sensitivity.
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Summary
Types of Prices: List vs. Pocket price Traditional Pricing Approaches
– Cost plus– Market based– Value based
PRO ProcessBased on Phillips (2005) Chapter 2M. Bertini and O. Koenigsberg. Summer 2014. When Customers Help Set
Prices, MIT Sloan Management Review, Vol.55, Iss.4: 57-64.http://sloanreview.mit.edu/article/when-customers-help-set-prices
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How do consumersdecide to buy a bike?
