Pricing 2013

Pricing

Innovation, Entrepreneurship & Design Toolbox

© Imperial College Business School

• Businesses often price a product offering based on

Cost plus pricing – determine a unit cost, then add a percentage mark-up

Competitive pricing – trying to beat or undercut competitors’ value offering

• However, optimal price depends on product’s perceived value to the customer

• Price also affects perceived value

Under-priced products may be perceived as low-value/quality and actually attract fewer customers than a higher price would

• ‘Value pricing’ is usually more appropriate for new/innovative products

though cost must be reviewed to check that your business will be financially viable!

• Revenue models also affect perceived value and determine pricing

Entrepreneurial Pricing and Revenue

models


• Examples:

• Sales– List price

– Customer determined pricing:

• Auction (e.g. eBay)

• match customer-stated price for a type of product, to a specific product in that range (e.g. Priceline.com)

• Rental/leasing

• Franchising

• Licensing – IP or software product– Offer use of (software) product plus technical support for periodic licensing fee (e.g. SAS)

– License the use of a patent to another producer

• Open source – dual licensing– Offer (software) product free for personal use, build a community of users, then charge for any commercial

use

• Website content/advertising– offer free content to attract users and sell space to advertisers (e.g. Google, newspaper sites)

• Subscription (e.g. magazines, premium/specialist online media - FT.com and WSJ online)

Which of these models can unlock the most value for your business and for your buyer? (What is your customer’s likely preferred way of using/paying for your product? Can it be profitable for

you? – Use your Entrepreneurial Market Research)

Revenue models


Cost-Plus Pricing -

Determine a unit cost, then add a percentage mark-up

• With Marginal (aka ‘variable’) costing

Price = (1 + m) (variable cost per unit)

• With Average costing

Price = (1 + m) (Average Cost per unit)

• m is the percentage markup over cost

(markup is different from margin!!)

• variable costs are costs tied to the number of product units produced (e.g.

materials, manufacturing, etc.)

•average costs include variable costs plus allocated fixed costs (overheads)

e.g. cost per unit = £100; with 80% markup, price = £180

Copied and adapted with permission from Dr. Catarina Sismeiro, Imperial College

• Simplicity

- Easy to use, manage, and implement

• Easily justifiable

– Based on “hard” cost data, which managers usually feel they know well

• Sometimes required by the Government

(e.g., aerospace industry)

Arguments For Cost-Plus


• Market and demand conditions never enter the model

the product’s value as perceived by customers is not considered – you might

under- or over-price with respect to customer demand

• Unit or average cost varies with price

Price affects demand and the volume sold

Volume then changes the average cost of production

Volume may also change variable costs (e.g. bulk orders of raw materials are

cheaper)

• Average costs are not relevant costs

Only incremental and avoidable costs are relevant

Pricing decisions should never be based on truly fixed costs, because these

are not influenced by price or volume

Arguments Against Cost-Plus

Copied and adapted with permission from Dr. Catarina Sismeiro, Imperial College

Cost-plus uses

Because of its simplicity, Cost-plus is usually used in corporate environments, where a lot of overhead resources are already in place.

Start-ups have to minimise overheads and maximise revenue, so Value Pricing is more appropriate.


• Economic Value to the Customer (EVC)

A good way to get started for new products and ventures

Provides valuable input to the selling process for any product or service

• EVC can help to

Identify segments

Determine the feature improvements that bring the largest gain in EVC

• EVC analysis can help determine whether

Product is overpriced

Product is under-appreciated

Value Pricing

Copied with permission from Dr. Catarina Sismeiro, Imperial College

Step 1: Identify the cost of the competitive product or best available substitute

process (i.e., the benchmark or reference value)

Step 2: Identify all factors that differentiate the new product from the reference

product or substitute process (+ or - , objective or subjective)

Step 3: Determine the economic value to the customer of the differentiating

factors

Step 4: Sum the reference value and the differentiation value to determine the

total economic value to the customer

Top –Down: Calculating Economic Value to

Customer


Miracle Shield Auto Finish – Consumer EVC

Miracle Shield Auto Finish is a substitute for wax, but it protects and maintains the shine of

a car’s finish at least 20% longer than regular car wax. Regular car wax is sold in a

container that is enough for two applications, costs about £4.00 / container.

About half the cars have oxidized paint (no shine) at the time wax is to be applied,

requiring cleaning with an oxidation cleaner before one can apply regular wax. Oxidation

cleaner costs £2.50 per bottle (good for one application) and can be applied in about the

same time required to apply regular wax (about two hours).

The advantage of Miracle Shield is that it removes the oxidation and shines the car’s

surface in one step. Consequently, Miracle Shield can be applied directly to a car’s

surface that is already highly oxidized.


Miracle Shield Auto Finish EVC

Segment 1

Oxidized Cars

Segment 2

Non-Oxidized

Cars

REFERENCE VALUE

(£4.00 or £2.00 per application) £2.00 £2.00

DIFFERENTIATION VALUE

Savings from not cleaning

Oxidation Cleaner £2.50 NA

Labor Savings of 2 hrs (£5.00 / hr) £10.00 NA

Improved performance

Savings in labor (20% of £10.00) £2.00 £2.00

Savings in wax (20% of £2.00) £0.40 £0.40

TOTAL ECONOMIC VALUE £16.90 £4.40

There are two segments relevant

for determining the EVC


The approach does not provide a definite price but it bounds the pricing problem

• Customer value provides a ceiling

• Variable costs provide a floor

Usually price set < EVC for a new product

(a substantial “inducement” to try the product is usually required)

What degree of inducement is warranted?

• Assess value relative to competitive benchmarks

• Is there potential competitive entry or reaction?

• Will there be large cost experience effects?

• Assess price sensitivity qualitatively

EVC in Practice


Setting Upper and Lower Bounds

Economic Value

Variable Costs

Reference

Product

Perceived

Value

Differentiating

ValuePrice

Contribution

Margin

Possible

Intervention


EVC in Practice (cont.)

Business

Markets

•Usually possible to determine EVC

objectively (product or services associated

with financial savings or increased revenues)

• For some products and services value is

not directly associated with clear benefits

(e.g., consulting, advertising, or auditing)

Consumer

Markets

• In most cases value is less tangible

• Difficult to determine EVC objectively

(unless there are clear cost savings for consumer)

• Rely on inferences from similar products

or choice-based research

(most cases use perceived value and WTP, not

actual value)Copied with permission from Dr. Catarina Sismeiro, Imperial College

• Value to customer is generally based on

• Value of product

(benefits of using the product – cost savings, higher sales, etc.)

• Value of supplier

(timely fulfilment, technical support, extras)

• Cost of switching from currently used product

(not just price of new product, but staff training, transition-related costs, etc.)

• Revenue model

Customer may prefer a lease, license, or other model to an outright sale

Your model might find a way to ‘share’ the financial benefit to the customer, e.g.: you might offer a somewhat higher price than a competitor but include added services which will lower customer’s other costs, and which are cheaper for you to provide than for the customer to have in-house

Determining EVC in a B2B setting


Goals:

• Find a target market price and make sure your costs leave an acceptable profit margin

• Estimate the price/volume relationship likely to yield most profit (see below)

• Look for a win-win situation: where buyers perceive higher value than competing products, and the entrepreneur makes a higher profit thanks to the extra value delivered.

• Avoid leaving money on the table!

Setting an optimal price

Price/unit Units sold @ price Revenue Cost

(£50/unit)

Contribution

(towards fixed costs

and profit)

£100 5000 £500,000 £250,000 £250,000

£150 4000 £600,000 £200,000 £400,000

£200 2500 £500,000 £125,000 £375,000

Also make sure the contribution can cover your fixed costs (overheads) and

also leave a profit!


During your Entrepreneurial Market Research (‘preferred witnesses’)

• Survey and estimate value of benefits your product will create for customer

• Find out about preferred business models (buy, rent, license, etc.)

• Include questions about price

During your later Market testing, e.g.

• Focus groups – for a hypothetical idea only

• In-Market sales testing – observe customers in a real purchasing situation

Direct sales – telephone, trade fairs, special events, shops

Web sales – if properly advertised (banner ads, sponsored listings) a web site can create a high volume of sales traffic in a short time and provide a fast, cheap market test for certain products

Bottom-up: Verifying Economic Value to

Customer


• Avoid asking a customer to express a preference between several possible prices –this is not reliable.

– Start with the higher price you are considering, and if they reject it work your way down.

• Set up a market test (direct or online) where you offer a set number of prices, but only one price to each customer (e.g. three prices, three sets of customers, each 3rdcustomer is offered price no. 3); compare buy/reject responses.

• If you are in a market where customers are likely to communicate and discover (to their dismay) that they were offered different prices, you can

Use different points of sale and/or product names to run several tests

Offer a customisable product, where different combinations of optional components lead to different prices, e.g.: (product(s) + technical support + servicing) x the number of licence users. Even if you change the component prices it is harder for customers with different purchasing plans to compare.

Bottom-up: ways to survey potential

customers on price/volume


• Lodish, L.M., Morgan, H.L. and Archambeau, S., 2007. Entrepreneurial Pricing.

Marketing That Works. New Jersey: Wharton School Publishing, Ch. 3.

References and further reading


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