Pricing for Long-term Profitability

Pricing for Long-term Profitability

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Prentice Hall

Pricing for Long-termProfitability

ALAN WARNER

AND

CHRIS GOODWIN

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About the authors

Chris Goodwin read economics at Cambridge and also qualified as a Chartered

Accountant. After being involved in the training of candidates for accounting

examinations, he joined Ashridge Management College and managed a wide range

of financial and general management training programmes. He left Ashridge to

become a founding partner of MTP and has since worked with a range of major

company clients, now teaching mainly in the areas of marketing and strategy.

Alan Warner is a Chartered Management Accountant who worked as a financial

manager in industry before moving to Ashridge. He was Director of Studies,

Senior Programmes before also becoming an MTP founding partner. He has

written a wide range of articles on financial, management and HR issues,

appearing in The Times, Management Today, Personnel Management and all the

major accounting journals. He was joint author of Shareholder Value Explained

published by Financial Times Prentice Hall as part of this ‘Executive Briefings’

series and has written a number of business novels, designed to make difficult

topics easy to understand and apply.

MTP was formed in 1987 as the Management Training Partnership and has

grown rapidly to become one of the largest UK providers of tailored management

training. MTP designs and delivers tailored programmes in three core areas: finance,

marketing/strategy and people skills. It has a range of blue-chip clients including

Boots, BP, GlaxoSmithKline, ICI, Pearson, Shell and Unilever, and employs 16 full-

time tutors – all specialist communicators with management experience.

For further information please contact:

Alan Warner

MTP PLC,

3 Prebendal Court,

Oxford Road,

Aylesbury,

Bucks.

HP19 8EY

Tel: +44(0) 1296 423474

Fax: +44(0) 1296 393879

E-mail: [email protected]

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Contents

Preface xi

A framework for pricing 1

The problem of price inertia 3The complexities of pricing 4A framework for pricing decisions 5The concept of value 6Organizational responsibility for pricing 7Price reviews 9Steps to pricing effectiveness 9Economic theory 10

Generic pricing strategies 11

Business strategy as the starting point 13Porter’s generic business strategies 13Generic pricing strategies 14Choosing between skimming and penetration 15Subsidiary pricing strategies 18Practical applications 19Pricing and the product life cycle 19A summary of life cycle pricing strategies 22The importance of competitor analysis 22

Understanding the competition 23

Competitor aware but not competitor driven 25The problems of analysis 25The context of competitor price assessment 26Some principles of competitor analysis 27From competitors to customers 32

The drivers of consumer price sensitivity 33

The need for understanding and insight 35The nature of the product 36Emotional or functional benefits? 37

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Contents

Market environment 38The context of the purchase transaction 40A complex web of factors 43

Price as part of the marketing mix 45

The marketing mix framework 47The place of price in the marketing mix 47Segmentation 48Pricing and product 49Pricing and promotions 52Pricing and distribution channels 54Analyzing the value package 56The link of pricing strategies to financial results 58

Price, value and profitability 59

Definitions of quality 61The PIMS research 61Linking value to profitability and market share 63Summary of rankings 64PIMS, Porter and pricing strategies 65Financial implications 66

Analyzing the financial impact 67

The case for cost and profitability analysis 69The link to financial objectives 69The financial analysis of price change options 70Cost structure 71The impact of price reductions 75The price/volume breakeven concept 76The impact of different cost structures 78The causes of variation in cost structure 79Long-term fixed costs 81

Cost structure and pricing behaviour 83

The breakeven chart 85The temptations of a high fixed cost structure 86Marginal pricing 87The pros and cons of marginal pricing 89

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Contents

Price behaviour in the high variable cost business 93Understanding competitors’ cost structures 93

Cost plus pricing revisited 95

The case against 97The case in favour 98The costing process 98Activity-based costing 101Profit objectives 102The concept of ‘required contribution’ 103The value of financial assessment 105

Pricing, business objectives and value creation 107

From value pricing to value to shareholders 109Relating financial to marketing objectives 110Evaluating marketing objectives 110The underlying assumptions 116Conclusion 117

Appendix The economic theory of pricing 119

References 129

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xi

Preface

This book sets out to provide an overview of pricing issues and principles,

covering the topic from a balanced perspective, including strategic, marketing and

financial factors.

It starts with a statement of some key issues and complexities in the pricing

decision-making process and affirms that the best decisions are based on the

concept of value maximization for customers. A step-by-step framework is

suggested to ensure that all factors are taken into account and this framework

provides a structure for the chapters that follow.

The starting point is the broad strategy of the business as a whole, followed by

an assessment of competitor prices and of the factors which impact price

sensitivity. There is then coverage of price as only one element of the marketing

mix and its relationship to the other components.

After a reference to some research which shows the relationship of broad pricing

strategies to the financial performance of the business, the book then moves on to

cover the key financial issues involved in pricing, including the evaluation of

price/change options, the importance of cost structure to pricing behaviour, and

the reasons why cost plus pricing is still important in some businesses.

The final chapter covers the need for pricing decisions to maximize value creation

over the long term and suggests the ways in which this can be assessed financially,

confirming the link between value to customers and value to shareholders.

This book is suitable for use on any course or other learning activity involving

the topic of pricing, either as pre- or post-course work on fundamental principles.

Its comprehensive and practical nature demonstrates the skills and ability of MTP

to provide user-friendly and effective learning for managers.

1A framework for pricing

The problem of price inertia 3

The complexities of pricing 4

A framework for pricing decisions 5

The concept of value 6

Organizational responsibility for pricing 7

Price reviews 9

Steps to pricing effectiveness 9

Economic theory 10

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A framework for pricing

This book covers the topic of pricing by providing principles, frameworks,

concepts and guidelines for any manager in business with responsibility for pricing

decisions. This is a tough call because there are so many factors in the pricing

decision that vary because of different businesses, products, histories and customer

relationships. It is difficult to produce even the broadest guidelines that can be

applied at one extreme to the brand manager of Coca-Cola and at the other to the

jobbing builder quoting for a house extension. Indeed, the question has to be

asked: can there ever be general principles that apply across the whole spectrum?

We hope to provide a positive answer and this first chapter sets us on the way.

THE PROBLEM OF PRICE INERTIA

The basic economics of a business can easily be complicated too much. At its

simplest, there are three main variables in business that managers can influence to

create value for shareholders. These are:

■ sales volume

■ cost levels

■ price levels.

There is a danger that, because of pressure from top management for volume

growth – often driven by real or perceived shareholder needs – and the natural

desire to match competitors’ cost efficiency, the price element of the equation

receives inadequate attention. There is a natural tendency for prices to stay as they

are because in the face of market uncertainty, this seems the best approach.

Managers thus allow inertia and risk aversion to dominate their thinking and,

in so doing, avoid the considerable effort involved in making a change,

particularly when the move is up rather than down. It is easier to avoid preparing

that difficult communication to customers and to leave things as they are. Such an

approach means that managers may be much too passive; they will wait for costs

to rise, for customers to complain, for another competitor to move or for

shareholders to express concern about the levels of profitability before they take

action to change price.

This is a flawed and lazy approach because the price level is such a vital element

of marketing strategy and such a major driver of value creation that there should

always be clear, proactive thinking about current and future price levels, based on

regular and analytical review. There should be a clear policy on pricing and a set of

agreed practices to carry it out. Costs and competitors should be key factors in the

decision, but your own management should have control and should set the agenda.

The passive and reactive attitude to pricing had its origins in the days when

inflation was much higher than it is now and when a key objective of accounting

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was to remove the impact of inflation, to look for measures that expressed growth

in ‘real terms’. Price increases and inflation became much too closely connected in

the minds of managers in all functions. The legacy of this thinking is still around

today as managers quote ‘real volume growth’ in their internal reports or in their

annual reports to shareholders. Though there is some validity in knowing these

figures as part of managing any business, excessive emphasis on ‘real’ growth can

cause the pricing lever to be neglected or to be deliberately managed down. A

number of international companies have recently reviewed this ‘real terms’

thinking as they realize that shareholders and the analysts who advise them are

interested in increases in cash flow and profit, rather than in ‘real’ volume.

THE COMPLEXITIES OF PRICING

A vital point to understand as you start this book is that pricing is complex. There

is no one perfect answer to the decision about what price to charge. There are

many business models – retailer, consumer goods distributor, industrial goods

manufacturer, service supplier, project deliverer – each of whom will look at

things from a different perspective and have their own approach to pricing.

To illustrate this complexity and to provide a broad overview of what follows

in later chapters, let’s think about the decision process for launching a new

product, any product. Think of a new product which you might launch in your

own business or one which you see in the supermarket. What should be the basis

for the price? Let’s look at the possibilities.

Your own costs plus a required margin?

Cost will be a factor in the decision, but there are a number of problems about

using ‘cost plus’ as a basis for pricing. For one thing your customers don’t know

or care about your costs and required profit levels; they will buy only if they see

the product as having value for them. Another point is that your costs may be

higher than those of your competitors, in which case such a basis would make

your selling price unrealistic. And finally, a point which is vital but which is often

misunderstood, it is impossible to determine precise and unarguable cost levels

because costing, and its conversion into price, is a complex and inexact science

(we will explain the reasons for this in more detail in Chapter 9).

Your competitors’ prices?

Certainly these will be a factor and sometimes a starting point, but competitor prices

can be no more than a guide because rarely is there a uniform product or a simple


direct choice for consumers. In everything but the most basic commodity business,

other factors in the value equation impact the buying decision. Therefore you need

a marketing strategy to determine your own positioning, and an assessment of your

overall value package in relation to these competitors, before you can use their

prices as a benchmark.

Your customer’s willingness to pay?

This is clearly not separable from the issue of competitor prices because willingness

to pay is always dependent on the choices available. A further practical problem is

that it may be expensive or even impossible to find out the amount that customers

are willing to pay, because the factors in the choice are so complex. In any case it

can be dangerous to price high on the basis of what the market will bear unless that

price is linked to an offer of good value, because the high profit margins may invite

new competitors into the market and eventually reduce overall profitability.

The key point to note and retain, one which will become an ongoing theme of

this book, is that price can be seen only in the context of a marketing strategy

because it is the total value proposition rather than the price which customers are

assessing when they make their buying choice. Furthermore, researching that

complete value proposition before a new product is launched is much more

difficult than researching price alone, which is perhaps one reason for the high

proportion of new product failures in most sectors.

A FRAMEWORK FOR PRICING DECISIONS

The outcome of this complexity is that the pricing decision should be seen as the

combined result, expressed or intuitive, of the analysis and interaction of a number

of factors which can be summarized in Figure 1.1.

This is why there are no easy answers. Selling prices must be arrived at as the result

of a series of analytical and strategic processes that are designed to arrive at an

assessment of perceived customer value. This must be assessed as the critical element

of the decision-making process because it is the key to successful pricing strategies.

The establishment of this principle also helps to clarify the role of cost in the pricing

decision. As Figure 1.1 shows, the cost of the product must at some point be matched

with this agreed ‘value’ price, to arrive at the profit level that will be achieved from

sale. The calculation of this profit level enables management to assess whether the

company is getting an adequate return from the current price, as a guide to both

short- and long-term decisions. Clearly the willingness of the company to continue in

business at that profit level will, in the long term, determine whether the selling price

and the business model are sustainable.

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Fig. 1.1 The factors which determine the pricing decision

However, the concept of ‘cost plus’ pricing cannot be rejected entirely and, for this

reason, all of Chapter 9 will be devoted to this topic. In some project-based

industry sectors, for example construction or shipbuilding, cost has to be the

starting point for pricing because there is no standard, visible benchmark in the

market when the project is conceived. Cost plus may also have a place when

market forces are not applying – because the customer has chosen to trust the

supplier to take the cost plus route, or because the market has monopolistic

features. We would argue, however, that the above framework still applies to these

situations and in the long term customers or governments will allow cost plus to

continue only if they feel that they are receiving value from the arrangement.

THE CONCEPT OF VALUE

The use of the concept of value as the basis for pricing will recur many times

during the book, so we should start with a clear idea of its meaning. It is one of

many generic words which entered the management vocabulary during the latter

part of the 20th century and it has been used in many, often conflicting, ways.

Dictionary definitions refer to desirability, worth and utility, which help us to

some extent. Confusion may also be caused by the fact that accountants,

economists and marketers often have their own different ways of defining value,

so we will aim for simplicity.

Competitoranalysis

Customeranalysis

Marketingmix

Perceivedcustomer

value

Price Cost

Profit Requiredprofit levels?


In Chapter 5 and elsewhere we will be emphasizing the principle that price is

only one element of the marketing mix. The offered price will always be seen by

the customer in relation to the other benefits provided, as part of the total

marketing proposition. We can thus convert the customer’s buying transaction to

a simple equation:

■ Benefits = the total gain for the customer from the purchase.

■ Price = the cost to the customer.

■ Value = the net gain of Benefits less Price.

To make the purchase the consumer must believe that the benefits she will receive

from that purchase will exceed the cost. However, this is rarely seen in isolation

because there will be competitive offerings available. Therefore prospective

customers will measure the value from each offering and will choose the one that,

for them, has the largest positive gap between benefits and price. They will not

always choose the cheapest; they may prefer the more expensive product because

the value of its extra benefits exceeds the price differential. These benefits may be

perceived rather than real – the critical factor is that the consumer believes them

to be important enough to trade them off against price.

This definition of value inevitably adds to the complexity of the pricing decision

because perceptions of value will vary from one person to another, from one

market region to another, from one distribution channel to another. Therefore

pricing is not easy because marketing is not easy; if it were easy it could be

determined by quantified analysis from accountants and computers. Such

quantified analysis will have a part to play, but the pricing decision must be based

on informed and expert judgement, applied to each segment of the market.

ORGANIZATIONAL RESPONSIBILITY FOR PRICING

One clear implication of what we have covered so far is that the pricing decision

should be considered in long-term strategic, rather than short-term tactical, terms.

It should also not be confined to any one person or department; at the very least

it requires inputs from a marketing specialist and a financial analyst, combined

with close contact with top management to ensure coherence with strategic

objectives. There should also be inputs from those responsible for sales and

marketing intelligence. For all this to happen it is vital for there to be an agreed

price review process, which enables pricing decisions to be taken in a strategic and

cross-functional context. However, to allow the necessary responsiveness and

flexibility, there must also be processes that enable day-to-day decisions to be

made in a practical and speedy way, within agreed parameters.

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If, for purposes of day-to-day practicality, it is necessary to come down in

favour of one function having overall authority, this must lie with those who have

strategic marketing responsibility in the business. These individuals may not

always have the word ‘marketing’ in their title – particularly in non-consumer

businesses – but, as the guardians of product positioning and marketing strategy,

they must have control and, if necessary, the final say. In smaller businesses with

simple pricing structures, this may be managed personally by the chief executive

– certainly this is where the buck should stop in every case.

Allowing the finance function to take the lead in pricing decisions can be

dangerous. It may lead to the cost plus approach becoming too dominant in routine

operational thinking. For example, the lazy and ill-considered practice of

automatically passing on cost increases may become embedded in financially driven

processes. Financial managers may say, ‘costs have gone up by 10 per cent so prices

must follow’ irrespective of the reasons for the cost increase, the likely competitor

reaction and the impact on customer perception.

Though sales managers and their teams clearly have an input in the pricing

decision, it can be dangerous to allow the sales function to dominate the process too

much, unless they have clear marketing responsibilities and are encouraged to think

broadly as part of their role. A good test is whether sales people are targeted

exclusively on sales volume or whether other factors – revenue per unit, profitability,

customer satisfaction – are part of their interest, motivation and reward system. If

volume is their main focus and key success factor, they should not have the final say.

The obvious and ideal solution is for pricing responsibility to lie with a cross-

functional team, though the practicalities of this easy statement will depend on the

day-to-day realities of the business and its interactions with customers. It is not

possible in every business for each price quotation or discount decision to be

assessed by a group; it all depends on the extent of standardization of the product

and the frequency of pricing judgements, factors that are unique to each sector.

The following structure represents an ideal position and should be applied and

adapted to the operating realities of each business:

■ a cross-functional team to set the strategy and the processes to implement it; this

will normally be the board of directors or an executive committee at that level;

■ a subsidiary group, also cross-functional, to operationalize the strategy and

carry out price reviews (see below);

■ clear responsibility with the marketing function (or equivalent) for interpreting

the strategy on a day-to-day basis;

■ agreed parameters for discretion, with processes for authorizing deviations and

interpreting grey areas.


PRICE REVIEWS

Whatever structure is agreed, it is critical that a full pricing review takes place at some

point and that it involves the cross-functional inputs mentioned above. The review

must take into account all the factors in the above ‘value’ framework, and must be

comprehensive rather than ad hoc, strategic rather than tactical. A good test of an

effective review process is whether it avoids the common mistakes of ill-considered

and reactive pricing decisions. To achieve this aim the review process should:

■ look at the complete range of offerings; it should always consider the overall

market position and the impact of one price decision on other products;

■ respond to a price increase by a competitor – say the market leader – in a

considered way, by analyzing the likely cause of the change, the expected

reactions of other competitors and the response of customers;

■ in businesses which require price quotations – such as shipbuilding,

construction, engineering, consultancy – maintain a consistent pricing policy, in

particular avoiding the temptation to agree low prices for a period because

there are ‘fixed-cost’ people available to carry out the work;

■ in all businesses, maintain a consistent policy on discounts and special

reductions, avoiding as much as possible the granting of discounts to customers

to retain or gain business, without full consideration of the relative offerings

and the longer-term implications.

It is difficult to generalize about the time period between reviews because this will

depend on the speed at which the industry moves and the way in which it is

customary in the sector for prices to be changed. There has to be a careful balance

when deciding upon an appropriate review time. It must not be a six-monthly or

annual ritual that becomes too procedural and automatic, yet it must not be

continually postponed because the time is not right. It is also important that

reviews should not just take place in times of crisis, for example as a gut reaction

to a competitor attack, or in response to a short-term profitability problem.

STEPS TO PRICING EFFECTIVENESS

One way to ensure that price reviews are sufficiently comprehensive is to have a

structured process which ensures that the required analysis is carried out. Figure

1.2 shows the ten steps of this process, each of which will be further developed as

we go through the various chapters of the book.

The way in which these steps are applied, in particular the starting point, the

sequence and the timescale, will depend on a number of factors – for example,

whether the pricing decision is proactive or reactive, whether it is a new or existing

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product, whether or not competitor prices are easily available and the nature of the

customer interface. Whatever the context, however, these steps are a structure and

a discipline which will help to ensure the best possible pricing judgement.

Fig. 1.2 The ten steps of price review analysis

Many of the steps are interrelated and real-life application will not be as structured

and as sequential as it seems here. The best use of this framework is as a checklist

to ensure that, in the unique context of each business, these steps are carried out,

however intuitive, judgemental and informal the processes may be. Failure to do so

may result in decisions that lack economic rigour, missed profit opportunities and

an ineffective marketing strategy.

Following this framework, Chapter 2 will focus on the starting point for any

pricing decision, the overall competitive strategy of the business and the broad

pricing strategy which emerges from it.

ECONOMIC THEORY

This book does not focus on economic theory but on the practical issues of pricing

decisions in business. It often proves, however, that an understanding of the

micro-economic theory of pricing is a useful underpinning for what follows in

later chapters. We are therefore offering a chapter on this topic as optional

reading for those who have not studied economics and who would find it helpful

before moving on to Chapter 2. It can be found as a separate appendix on p. 119.

Makepricing

judgement

Developbusinessstrategy

Assesscompetitor

prices

Assesscustomer price

sensitivity

Analyze themarketing mix

Assess therelative value

positionConfirmpricingstrategy

Estimateimpact on

volume

Evaluatefinancial

implications

Re-assessfinancial and

strategicobjectives

2Generic pricing strategies

Business strategy as the starting point 13

Porter’s generic business strategies 13

Generic pricing strategies 14

Choosing between skimming and penetration 15

Subsidiary pricing strategies 18

Practical applications 19

Pricing and the product life cycle 19

A summary of life cycle pricing strategies 22

The importance of competitor analysis 22

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Generic pricing strategies

BUSINESS STRATEGY AS THE STARTING POINT

At the end of Chapter 1 we suggested a series of steps in the pricing decision and

this framework confirmed that the starting point has to be the development of a

strategy for the business as a whole. Many frameworks and concepts of business

strategy were developed as management thinking evolved during the second half of

the 20th century and perhaps the most influential writer has been Michael Porter, a

Professor at Harvard Business School. Porter’s work is highly relevant to pricing. He

argues that the most successful companies are those that make fundamental choices

about how to compete in clear, unambiguous terms. He says that the first and key

question that must be asked and answered by top management when developing a

strategy is: what is our primary and fundamental competitive position?

The evidence of Porter’s research is that less successful companies do not make

such fundamental choices and try to compete in a number of ways, ending up

being ‘stuck in the middle’.

PORTER’S GENERIC BUSINESS STRATEGIES

Porter has developed this idea of fundamental choices by identifying three possible

generic business strategies:

■ overall cost leadership

■ differentiation

■ focus.

We will examine the implications for pricing of each of these three strategies.

Overall cost leadership

A business which achieves overall cost leadership has the ability to produce at

lower costs than all competitors. Porter puts forward the following advantages of

this approach:

■ The cost leader can apply a low pricing strategy and can earn a profit at that

level when other players in the market are not doing so. Indeed, the cost leader

can encourage the rivalry and price competition which reduces the margins of

the weaker players.

■ The firm has a defence against powerful customers because they can only exert

power to drive down prices to the level of the next most efficient competitor.

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Differentiation

This strategy is to create a product or service that is perceived by customers as

being unique. Porter argues that this can be an effective strategy because:

■ it provides protection against competition because customer loyalty will result

in a lower sensitivity to price;

■ the product uniqueness will make it possible to compete even if the cost base is

higher than that of competitors;

■ the power of customers is reduced because they do not have comparable

alternatives.

Focus

Porter’s third generic strategy is to focus on a particular group of customers, type

of product, or geographic market. For this strategy to be effective the business must

be able to serve its focused target market more effectively than its competitors can.

As a result of this focus, the firm can achieve competitive advantage in three

possible ways: by better serving customer needs or by achieving lower costs, or

both. In this situation either low or high pricing strategies may be appropriate,

depending on the competitive situation and the long-term business objectives.

GENERIC PRICING STRATEGIES

Porter’s work links very closely to the two most frequently quoted generic pricing

strategies of skimming and penetration. These are extreme positions and are

rarely adopted in their absolute form, but they help us to consider the range of

pricing options in broad terms.

A low price ‘penetration’ strategy

This strategy is called ‘penetration’ because the aim is to penetrate the market and

achieve a higher market share than competitors. The strategic choice is to compete

primarily on price in the belief that the resulting gain in market share will enable

the business to achieve profitability. Porter’s valuable insight was that this strategy

can be adopted only in parallel with cost leadership, as it will only lead to high

profit levels if the firm’s costs are below those of the competition.


A high price ‘skimming’ strategy

This strategy is called ‘skimming’ because the business tries to ‘skim’ the market,

targeting only those who most value their offer and are willing to pay a premium

price. Management is making a deliberate choice to sell at higher prices than the

average competitor. Businesses adopting this strategy are willing to sacrifice

potential market share because they believe that, in the long term, the resulting

margins will result in high profit levels. This approach to pricing must be adopted

in parallel with a strategy of differentiating the value package and Porter argued

that this will succeed only if customers perceive a significant and superior

difference to competitors.

CHOOSING BETWEEN SKIMMING AND PENETRATION

The following factors will combine to determine the choice of pricing strategy.

The nature of the product

A key factor is the extent to which the product is homogeneous, with each

supplier’s offering being of a broadly similar nature, without significant scope for

differentiation. Though confident marketers will claim that there need be no such

thing as a commodity and that you can differentiate anything by good marketing,

there are bound to be limits because of the very nature of the product.

Price sensitivity is lowest for products which are commodities of uniform type

and quality; a good guide to extreme examples is if the product can be traded

unseen on commodity markets – for example, cotton, sugar, grain, oil. The more

the product has commodity features, the more a penetration strategy, geared to

cost efficiency, will be appropriate.

The product life cycle

If the life cycle of the product is short, a skimming strategy is likely to be more

effective. The business that responds quickly can enter the market and make

attractive margins while there is limited competition. By the time competitors

enter the market, demand for the product may be declining and customers will be

moving on to other products.

If the life cycle is expected to be long, it is more likely that a penetration strategy

will succeed. The goal of growing market share will enable the business to take

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advantage of the economies of scale and experience curve (see below) which will

help to deliver low unit costs and high profitability.

Competitor response

If competitors are slow to respond to changes in the market environment and to

initiatives taken by other players, a skimming strategy will be appropriate. It will

be possible for the quick mover to maintain a premium price for a significant time

before competitors catch up. Conversely, if competitors are quick to respond, a

penetration strategy will be more effective.

Impact of economies of scale

Economies of scale occur when unit costs decline as total output increases. This

occurs primarily through the impact of volume on fixed costs. In many businesses,

a significant proportion of costs will remain fixed – at the same level in money

terms – over large variations of sales volume. An example is the cost of research

and development involved in the launch of a new product; once the launch has

taken place there will be little or no further research and development costs. As

sales increase, the research and development cost per unit and as a percentage of

sales will fall. The impact of this can be seen in Figure 2.1.

Fig. 2.1 Research and development costs fall following the launch ofa new product

Uni

t co

st

Volume (units)


If the economies of scale are significant, a penetration strategy will be more

effective as this will lead to higher volumes and lower unit costs than those of

competitors. This cost advantage will enable more aggressive price competition

and the potential to earn higher returns than the market average.

The proportion of fixed costs is a key issue in many aspects of pricing and will

be covered in more depth in Chapter 8.

Experience curve

The operation of the experience curve is similar to that of economies of scale and

is a second reason why unit costs fall over time. As each firm has more experience

of producing and delivering the product, it will become more skilled and efficient,

thus reducing the cost per unit. The impact on cost is similar to that for economies

of scale, except that the horizontal axis of the graph now represents total

cumulative rather than annual production (Figure 2.2).

Fig. 2.2 The experience curve effect

It can be seen from the figure that the impact of cost savings is greater at low

levels of cumulative production. Therefore the experience curve effect is likely to

be most relevant at the early stages of the product life cycle, or where there has

been a step change in technology.

If the experience curve effects are high, a penetration strategy is more appropriate,

in order to achieve volume and drive unit costs below those of competitors.

17

Uni

t co

st

Cumulative volume (units)

18


A summary of the circumstances in which the different pricing strategies will be

most effective is shown in Table 2.1.

Table 2.1 The circumstances in which different pricing strategies will bemost effective

High price/ Low price/skimming strategy penetration strategy

Product homogeneity Low High

Product life cycle Short Long

Competitors Slow to respond Rapid response

Economies of scale Small Substantial

Experience curve Small Substantial

SUBSIDIARY PRICING STRATEGIES

There are further subdivisions of the two strategy types, which help to match the

strategy to particular competitive situations and business objectives.

Pure skimming

The aim is to make a profit in the short term before competitive forces operate to

bring prices down. Examples would include products that are technologically

innovative such as mobile phones and DVD players, which are launched with high

prices and strong demand. However, as the product life cycle develops, prices

come down and so does the potential for profit.

Prestige skimming

The aim is to maintain the price premium throughout the life cycle of the product.

Examples would include Porsche cars and Rolex watches.

Pure penetration

The aim is to grow market share and to dominate an industry where price is

important to the purchase decision. An example is McDonald’s strong position in

the fast food market.


Pre-emptive penetration

The aim is to charge a low price which makes it difficult for new competitors to enter

the market, for example Microsoft’s pricing of its Windows software. The large

economies of scale of research, development and marketing enable management to

apply this strategy effectively.

PRACTICAL APPLICATIONS

In practice it is unusual to find that all the conditions for pure skimming or

penetration strategies are present in any one business or industrial sector. Managers

with responsibility for pricing need to consider the overall position and the factors

which have the strongest impact in their markets and then decide upon the most

appropriate pricing strategy. For example, a large pharmaceutical company will have

the opportunity to achieve economies of scale after the launch of a new drug because

the research and development costs will not increase thereafter. As sales increase, the

unit cost of the research will reduce significantly and these circumstances clearly

indicate a penetration strategy.

However, it is normal for new drugs to be introduced at a high price because of

other factors that have a stronger bearing on the decision. There is scope for clear

differentiation because the drug performs a unique function that alternative

products cannot deliver. Competition may be reduced by the operation of patents,

so the ability of competitors to react quickly is often low.

In the face of such conflicting indications, a balanced judgement needs to be made,

examining each factor and choosing the appropriate strategy to match market

conditions at each stage of development.

PRICING AND THE PRODUCT LIFE CYCLE

We have mentioned the importance of the product life cycle in deciding on an

appropriate pricing strategy and we will now focus more specifically on this issue.

When using this concept as a guide to pricing strategy, it is important to think in

terms of the market as a whole rather than just the market position of one

business. The definition of the life cycle should be based on the total sales of the

product, from its launch by the first mover to its demise.

Four separate phases of the life cycle have been identified and these are important

to pricing strategy. They are shown in Figure 2.3.

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Fig. 2.3 The four phases of the life cycle

Some examples of products that are, at the time of writing, in different phases of

their life cycle are shown in Table 2.2. A range of different strategies will be

appropriate at these four stages of the life cycle.

Table 2.2 Products in different phases of their life cycle

Introduction Flat TV screens

Growth Digital cameras

Maturity CD players

Decline Leaded petrol

Introduction

During the introduction phase the aim is to build sales and customer loyalty for the

future. The main priority therefore is to ensure that the product is effectively meeting

customers’ needs so that quality is seen as higher than that of current and potential

competitors. This creates a foundation on which to build as the market expands. We

have seen already that price sensitivity is likely to be low during this early stage.

The pricing level therefore needs to support this strategy and to provide a clear

message to consumers. For example, if the new product is positioned as a

substitute to an existing one, the message must be either that the new product

performs the same function at a lower price – perhaps due to technological

innovation – or it offers superior performance.

Sal

es

Introduction Growth Maturity DeclineTime


However, it would be dangerous to assume that the ‘same function, lower cost’

message will always result in success at this stage of the life cycle. It makes the all

too common assumption that competitors will not react. It will succeed only if

your price is lower than that which competitors are prepared to charge when

faced with such competition. The key to success is to predict the speed and nature

of the likely competitor response.

If the message is ‘superior performance’, it will be appropriate to launch at a

price premium to existing products. This is because it will be difficult to convince

customers that the new product has superior quality if it is being offered at the

same or lower price than competitors’. In reality technological innovation or other

factors might make this possible, but customers will not normally believe that

they can have ‘something for nothing’. The higher price position helps to create

their feeling of perceived value.

Growth

In the growth phase of the life cycle the key strategic aim is to achieve a market

share position that will deliver high profit levels during the later maturity phase.

It will be much harder to enter the market or gain substantial share during the

maturity phase, as this will require gains at the expense of existing competitors –

always a difficult task.

During this phase it is less likely that price will be the key driver of buying

behaviour because the main focus will be on developing products and services to

meet consumer needs. Insight into consumers’ needs becomes more important than

price. The successful players will be those whose consumer insight enables them to

achieve differentiation and therefore lower price sensitivity. If differentiation cannot

be achieved, price will continue to be the dominant factor.

Maturity

During maturity, which normally lasts longer than the previous phases, the focus is

on the achievement of maximum profitability and the pricing strategy should support

this aim. This is the stage where the hard choices mentioned earlier in the chapter

have to be made: management must opt for either a high price/differentiation or a

low price penetration strategy and avoid being ‘stuck in the middle’.

During this phase of the life cycle the successful players will increase sales by

innovations to meet the needs of new customer groups. Innovation is critical

during this phase of the life cycle for a number of reasons. It can continue to

prevent existing products from being seen as undifferentiated commodities and

thus avoid the resultant greater emphasis on price. Innovation can also extend the

total period of the life cycle. Indeed, there are some marketers who believe that

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the theory of the product life cycle is no more than a self-fulfilling prophecy. They

believe that marketing managers accept the eventual decline too easily and cut

back too much on innovation and marketing spend, thus encouraging its onset.

They point to long-lasting products such as soap or beer where there appears to

be no prospect of decline after several hundred years.

Decline

However, in most markets the product does eventually decline. During this phase

the strategic aim should be to develop a pricing strategy that will maximize cash

flow. There is a danger that a company will over-invest in fixed assets during this

period, thus creating capacity that will not be used in the future. This is an easy

trap to fall into because the product will be generating high cash flows and the

money for investment will be available. The better target for these cash flows is

investment in new products in the early stages of their life cycle, thus ensuring the

company’s future viability.

A SUMMARY OF LIFE CYCLE PRICING STRATEGIES

Table 2.3 summarizes the pricing strategy at each stage of the life cycle.

Table 2.3 Pricing strategy at each stage of the life cycle

Life cycle stage Strategic objective Pricing strategy

Introduction High relative quality To support customer perception of quality

Growth Market share To enable achievement of market share objective

Maturity Profitability To achieve maximum profitability

Decline Cash flow To maximize cash flow as the product is phased out

THE IMPORTANCE OF COMPETITOR ANALYSIS

No pricing strategy can be developed without as full an understanding of competitor

prices as is possible and cost effective. After the development of the broad business

and pricing strategy, this analysis is the next important step towards effective pricing

decisions. It is therefore the subject of the next chapter.

3Understanding the competition

Competitor aware but not competitor driven 25

The problems of analysis 25

The context of competitor price assessment 26

Some principles of competitor analysis 27

From competitors to customers 32

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Understanding the competition

COMPETITOR AWARE BUT NOT COMPETITOR DRIVEN

Chapter 1 introduced the principle that a pricing strategy must be based on an

assessment of perceived value to customers and suggested a step-by-step process

to carry out the necessary analysis. Chapter 2 emphasized that the overall business

strategy must be the starting point for the development of a broad pricing strategy,

determining the overall competitive position. In this chapter we will look at the

obtaining and assessment of competitor information to support that strategy,

together with the issues and pitfalls involved in this difficult process. It is vital to

know everything there is to know about competitor prices before making any

final judgement about your own price levels.

We should emphasize, however, that being fully informed about competitor

prices is very different from competitor-driven pricing, which is not desirable and

will not usually lead to the optimum pricing decision. We quoted an example of

this in the first chapter – the passive approach of waiting for the market leader to

move and then following meekly. When this involves following a competitor’s price

reduction, it is often based on the marketing manager’s desire to maintain or

achieve a market share goal at all costs. In practice you may have to follow the

market leader, but only if, after that price decrease, your value proposition is less

appealing to the customer than that of the competitor, and only if it is the best way

of achieving long-term profitability rather than short-term market share goals.

THE PROBLEMS OF ANALYSIS

Pricing decisions should never be taken without as full an analysis of competitor

prices as is possible and cost effective. Ignorance of competitor prices within a sector

is likely to lead to damaging price competition as the players make invalid

assumptions about the intentions of others, often encouraged by customers who will

gain from ignorance and invalid information. Sometimes it may be possible to gain

from the ignorance of others, for example by being the only competitor who resists

the temptation to bring down price in response to falsely rumoured customer

attitudes or market conditions. In every case it is important to develop your pricing

strategy while knowing as much, or preferably more, than your competitors.

Monitoring and analyzing competitor prices will rarely be easy or simple, but it

should not be avoided. Partial or estimated information is better than having no

information at all and better than basing your decisions on invalid assumptions –

‘it is better to light a small candle than to curse the darkness’. The difficulty of

finding competitor prices should never be a reason for failing to try.

In many business sectors the task of competitor assessment is becoming more

and more difficult. The range of competitors is widening and new players are

emerging. Consumer goods companies find that their retail customers can quickly

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become their competitors by developing ‘own label’ products. Companies enter

markets where previously they were not seen as likely competitors, for example

the move of confectionery companies like Mars into the ice cream market. More

advanced thinking in marketing and market research determines that the

definition of competition should be seen more widely, that it often comes from

sources that were previously not seen as competitive. For example, soft drinks

companies may be competing with ice cream, snack and chocolate suppliers for

the customer’s limited spending power on ‘impulse treats’.

In the ‘business to business’ sector, the problems are even greater because there is

not the same public availability of data. This has been exacerbated because major

international customers are increasingly developing strategies to reduce cost through

a global approach to procurement. This brings to the market new international

competitors who were not there before and about whom it will be even more

difficult to obtain pricing data. Conditions of greater secrecy and complexity will

apply while at the same time price becomes an even more important part of the

customer decision-making process.

In these circumstances, customers are less loyal, less susceptible to personal

relationships and, in many cases, less likely to take into account the other factors

in the value proposition. The global buyer may deliberately use the policy of

secrecy to play off one customer against another as a way of achieving the lowest

price, via a closed tendering process. They may even encourage misinformation,

implying that others are prepared to reduce price and making price seem more

important than it really is in the final decision.

THE CONTEXT OF COMPETITOR PRICE ASSESSMENT

The first two chapters emphasized that the pricing decision is at the centre of a

wide range of different but interconnected forces. It is useful to summarize these

again as we begin to look at competitor analysis in more depth – see Figure 3.1.

It is significant that the step-by-step decision-making process suggested in

Chapter 1 and which to some extent determines the structure of this book places

competitor price analysis at an early stage, well before we look at our cost base

or our profit requirements. As we made clear in that chapter, there is no point in

making financial requirements the driving force of pricing decisions if competitors

can and will undercut you, however unfair it may seem and however difficult to

understand it may be. Customers are not interested in our problems and concerns;

their point of comparison is the price of their choices and that needs to be the

focus of our attention.

The scope and complexity of the framework in Figure 3.1 and all that we have

covered so far should make it clear that any survey of competitive prices cannot be a


mechanistic task which leads to simplistic conclusions. Competitor prices can rarely

be assessed as a direct comparison. The judgement arising from the price comparison

has to be seen in the context of customer perceptions of the total value packages

offered by the competitors and, just as important, the business situation of each one.

Fig. 3.1 The forces impacting upon the pricing decision

For instance, when analyzing competitor prices prior to the development of a

broad pricing strategy, it is vital to take into account the financial position – in

particular the size and cost structure – of each competitor. There is no point in the

long term in trying to go for a low price, penetration strategy if that competitor

has the ability to produce at significantly lower cost. Different marketing or

supply chain strategies to overcome the cost disadvantage will be needed in these

circumstances and this will require an understanding of that competitor in both

financial and strategic terms.

SOME PRINCIPLES OF COMPETITOR ANALYSIS

It is not possible to be fully prescriptive about the required approach to the

assessment of competitor prices because it depends so much on what is possible

and what is cost effective, and this will depend very much on sector and country.

There are, however, some general principles which can be followed and these are

offered as guidance for management judgement.

27

Businessjudgement

Pricingdecision

Marketpositioning

Strategicobjectives

Customerperceptions

Competitorofferings

Estimatedcost

Requiredprofitability

28


Competitor definition

Competitors should be defined as widely as possible, including all possible

alternative purchases available to customers. Coca-Cola would clearly regard

Pepsi as its main competitor but its price comparison would be likely to include

all drinks and food products that represent alternative purchases for customers.

In some markets this might mean tea and coffee, in other markets diluted soft

drinks or ice cream.

However, there has to be a balance – too wide a comparison will make the

analysis complex and potentially misleading; too narrow a comparison will miss

out on vital information. The key principle is to think from a consumer

perspective when deciding the competitor set against which to benchmark. What

does the consumer view as the alternative choices?

The key test is: who loses when we win? If we sell another product, what is it

replacing? It is important to avoid conventional definitions and industry

classifications which encourage production-oriented thinking and a superficial

definition of competition. An apparently similar product – for example a low

price, low value soft drink sold in down-market retailers – may not be a relevant

competitor to a company operating at the premium end because it is not an

alternative purchase for the consumers being targeted. Such prices may still be

quoted to provide different perspectives and reference points, but they should not

be the main focus of the analysis.

Price definition

Prices should be defined as widely as possible. In the case of consumer goods

manufacturers selling to retail outlets, this will mean coverage of prices to retail

trade customers as well as to the ultimate consumer. This should confirm once

again that comparisons can rarely be exact or easy. It is relatively straightforward

for the brand manager to find out the price at which competitors’ chocolate bars

are selling in Tesco or Walmart in particular areas. It will not be easy to find out

the price at which Tesco and Walmart are buying from your competitors; that

needs knowledge of discount and margin structures that will be individually

determined and difficult to compare.

It is also likely that discount structures will make the comparisons complex to

interpret. For instance, how do you treat cash discounts if they are linked to special

payment terms that do not apply to your dealings with that customer? How can you

find out about and take into account special retrospective rebates, granted on

achievement of sales targets? Special deals will also cause difficulties when surveyed

at the retail level – there will be problems of comparison because of promotions,

special offers and extra value packs, which may be offered on a temporary basis and


which may differ between channels and regions. It is important that a comparative

survey embraces these complexities rather than pretending they don’t exist, even if it

makes the analysis of information and the judgement calls that much more difficult.

It is also important to compare like with like. If the directly comparable chocolate

bar has a different weight by a factor of (say) 10 per cent, should the comparison

be per bar or per unit of weight? There are never perfect answers to this kind of

question, but the best guideline is to make the comparison in the same terms as the

customer decision – if the customer makes the buying decision in terms of price per

bar rather than price per gram, the results of the survey should be expressed in these

terms too.

Coverage

A price survey should cover all segments in which you are competing, for instance

different geographical areas, channels and classes of customer. Experienced

managers in consumer goods companies often warn of the dangerous practice of

wide ranging pricing judgements being made on the basis of a few isolated

comparisons in the chief executive or marketing director’s local supermarkets,

which have little validity elsewhere. Surveys must be as wide and statistically valid

as possible if they are to be used for across-the-board pricing decisions.

One important principle to make comparisons and conclusions more

meaningful is that the focus should be on relative as well as absolute prices. The

analysis of the different segments is likely to be much more helpful if the results

are expressed as a discount or a premium to a mean or median price, or in relation

to particular competitors. However, it is important not to get too hooked onto

just one competitor, perhaps the market leader, and forget the other competitors,

direct and indirect, which might be alternative purchases in customers’ minds.

The need for a broad picture

In Dolan and Simon’s excellent book Power Pricing, they suggest four

characteristics of what they call ‘power pricers’ – their label for those who adopt

the proactive and value-based approach that we are advocating. One of these

characteristics is the building up of ‘fact files’ to provide a comprehensive

information base about each major competitor so that price comparisons are seen

in the required broad context. These should include information about a

competitor’s cost structure, financial performance, business history, capabilities,

strategy and target-setting processes. The latter elements of this information may

not be easy to obtain and may not be available in precise form, but their collection,

analysis and subsequent discussion is critical to success.

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The term ‘fact file’ perhaps underplays the vital need for such information to be

used interactively. All data on competitors, hard and soft, must become the driver

of discussion and proactive decision making, rather than lying in its fact file, waiting

for external events to drive the pricing decision. It is also important for the right

person to have the responsibility for obtaining and maintaining this information, to

avoid it becoming dated and sterile. Such a person must combine knowledge of all

information sources, with the energy to be creative and proactive.

Information sources

Information which can be purchased from market research companies is likely to

be the main source of price information in many consumer goods sectors and,

where it is available on an ongoing basis at realistic cost, it is likely to be a good

investment. Though it may be perceived that the value of such information is

reduced because all competitors have access to it, this does not make it any less

important to obtain. The critical point is that you will be at a disadvantage

compared with competitors if you do not take it and use it.

There is more doubt as to whether it is cost effective to commission ‘ad hoc’ price

research on an ongoing basis because this is often expensive, though it might

sometimes be justified as a ‘one off’ survey linked to a particular strategic review.

If market research data is not available or proves not to be cost effective or reliable,

there may be other good sources, particularly for general background information

to supplement the price data. Trade associations, independent industry analysts,

consultants and stockbroker analysts are useful sources to supplement the market

research data and your internal efforts. These internal efforts will also be much

more effective if you have someone with the necessary time and expertise to search

the Internet on a regular basis in order to keep the fact files up to date.

One aspect to consider in the brief given to the person or department with

responsibility for competitor information is the extent to which it should be

actively and directly sought from the competitors themselves. Clearly there are

tactics by which this can be obtained secretly, and these should be encouraged

within legal and ethical limits, but an open and co-operative approach should also

be considered.

It is often assumed that keeping competitors in the dark is always the right

approach and that the best way to achieve competitive advantage is by unshared

research. This may work well, particularly if your research resource is as good as,

or better than, any in the market. However, you should remember our earlier

point – that if every competitor in the market is in a state of ignorance, often

encouraged by customers who want to play off one against the other, this may

result in low pricing strategies, adding to pressures on margins and reduced

overall profitability. If an industry co-operates in the sharing of price and general


business information, it may work in the interests of all competitors, though it is

always important to be sceptical about the validity of information being

submitted by less scrupulous operators.

Maximize sales force information – but beware

It is also important that the fact files should include sales force intelligence on a

systematic basis. Clearly the prices seen by sales people as they visit channels and

have conversations with customers can be a major source of price information.

There should be strong encouragement for such information to be sought

proactively. Sometimes sales people do not know their competitors’ prices simply

because they have never asked their customers and they should be encouraged to

seek as much information as possible during every sales contact. It is particularly

important to use information from loyal customers; if it is a long-term and

trusting relationship, customers may be more willing to share information about

competitors than is often believed.

However, it is important to be questioning and challenging about such information,

particularly where business-to-business transactions are involved. The key reason for

this need to challenge is that price is often the easy answer to the question, ‘why did

we lose this business?’ It may be sincerely believed, but it may also be wrong. It is

often the customer’s explanation when a contract is not secured because it is easier

to blame price than to say, ‘we did not like you or your pitch’. Sales and marketing

people, reluctant to shoulder the blame for the problem and face the more difficult

issues, may willingly buy into this easy explanation. There is also an inevitably one-

sided aspect to sales force information on price. Customers are likely to tell sales

people when business is lost because prices are too high; however, they will not tell

them when prices are too low and when the business could still have been gained at

a higher price level.

Therefore, though it is vital to use sales force intelligence to gather data where

it is not easily visible, the results should be interpreted with care. In particular,

outdated, anecdotal information from a few individuals must not become the

conventional wisdom that is never challenged or compared. The best way to avoid

this is to keep the information fresh and to make sure that it is assessed and

discussed before becoming the basis for action.

Cost effectiveness

Each organization has to make its own judgements about the cost effectiveness of

pricing surveys and to decide when the value of extra, more detailed research

ceases to make it worthwhile. Even in the most visible and standardized of

industries, such judgements have to be made. Examples of extremes are useful to

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show the relative degrees of difficulty and the need for compromise at both ends

of the spectrum.

At the ‘easy’ extreme are the retail supermarket operators which can carry out

a price survey simply by sending someone to a competitor store with a notebook,

or by buying off-the-shelf data from a market research agency. Contrast this

situation with an example of the ‘difficult’ end – a management consulting

company which, when trying to find out competitor prices, will be hampered by

confidentiality, complexity and difficulties of comparison; for example, what level

of consultant, what type of work, what unit of measurement? For the retailer the

question is: to what level of detail does the research go? How many stores, over

which period, how many product variants? For the management consultant the

question may be: is it cost effective to carry out competitor price research at all?

Would we be better to concentrate on optimizing our value package and its appeal

to customers, using customer reaction as the best gauge of competitor challenges?

In many cases the answer may have to be a reluctant ‘yes’.

FROM COMPETITORS TO CUSTOMERS

Competitor prices are an important starting point for pricing decisions but it is the

customers’ perceptions of, and reactions to, these prices that are critical to buying

behaviour. These perceptions will vary by product, by market and by customer

group, so the next chapter will focus on the key factors which drive price sensitivity.

4The drivers of consumer price sensitivity

The need for understanding and insight 35

The nature of the product 36

Emotional or functional benefits? 37

Market environment 38

The context of the purchase transaction 40

A complex web of factors 43

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The drivers of consumer price sensitivity

THE NEED FOR UNDERSTANDING AND INSIGHT

The key to effective pricing decisions is insight into the consumer’s perception of

value and their sensitivity to price as part of the marketing mix. If sensitivity is

well understood, it can help the marketer in a number of ways. It can enable

agreement of upper and lower limits when developing a product range or

organizing market research. It can also be a valuable guide to deciding which

markets to target in order to achieve marketing and financial goals. Finally, and

most importantly, knowledge of sensitivity can lead to strategies which are

designed to overcome it, by the development of an appropriate value package and

a communication strategy which emphasizes other benefits.

Rarely will the factors determining price sensitivity be simple, because there is not

one single consumer and behaviours will vary over time, between different channels,

regions and countries, in different market conditions and life circumstances. A

wealthy consumer might be prepared to pay thousands of pounds for a cold drink

in thirsty conditions in the desert, but will become as price sensitive as everyone else

when back home and faced with the many choices on the supermarket shelves.

There is also an inherent uncertainty in all markets which should make any manager

wary of those who think they have all the answers. A pricing strategy has to be

flexible and subject to constant review; it cannot and must not be the subject of

universal truths and accepted wisdom about consumer behaviour.

There are four main factors which will affect price sensitivity and they each have

a number of separate dimensions. They are also closely related to each other, as

shown in Figure 4.1.

Fig. 4.1 Four factors affecting price sensitivity

We will now examine these factors in turn.

35

The natureof the

product

Emotional orfunctionalbenefits

Marketenvironment

Consumerprice

sensitivity

The contextof the purchase

transaction

36


THE NATURE OF THE PRODUCT

We have already examined some aspects of this factor in Chapter 2. The extent of

product homogeneity and the stage of the product life cycle were said to be key

factors in the development of pricing strategies and this is largely because of their

impact on consumer price sensitivity. However, there are a number of other factors

within the product itself which will have an impact.

Transparency of cost

We will discuss in later chapters the links between cost and price; so far we have

emphasized the lack of likely and necessary connection between the two. However,

there are cases where consumers will be influenced by their knowledge and beliefs

about cost and this occurs mainly where the constituent elements of the product

can be clearly seen and understood. If the product is the provision of services that

are clearly unskilled and where the customer can see the time taken (for instance

the provision of household or garden services), there will be a high degree of price

sensitivity. If, on the other hand, it is a service with more complexity, requiring

more specialist skills (such as consulting in information technology) the price will

be less easy to assess and therefore less price sensitive. The customer will be blinded

by the technical mystique and by a lack of understanding of the tasks required, and

will therefore be able to challenge price only through competitor comparison.

Product risk

If the potential risk of poor quality is high, it is more likely that the product will

have low price sensitivity. Few customers will, within reason, be influenced by

price when buying a child’s car seat; other factors, particularly reliability and

durability, will be much more influential in the buying decision. If the risk to the

buyer is low because the purchase is a small amount and failure is of less

importance – for example, an impulse buy of a child’s toy – price sensitivity will

be much higher. The consumer will easily be deterred from buying and quality will

be much less important.

Risk is also a key factor in business-to-business transactions. It is well known

that there is a tendency for risk-averse managers to ‘buy IBM’ when faced with a

complex decision to purchase computer facilities, often because of the likely

adverse consequences of such a purchase going wrong. This tendency among

corporate buyers also makes it less likely that customers will easily switch

suppliers of vital services, unless the gains through lower prices are substantial

and the risks of failure are low.


Price as a quality indicator

With some products the price itself is a key indicator of quality. There are two

main factors causing this to occur. The first is where there are no other obvious

clues about quality from seeing and feeling the products because they all appear

to be much the same. This can happen with prestige products such as perfume or

watches, or with basic commodities like fruit and vegetables. The second factor,

which will apply to perfumes and watches though not to fruit and vegetables, is

where the buyer values prestige and exclusivity and where the price is indicating

that kind of value, saying something about the person who is willing and able to

pay that price.

This factor impacts different markets in different ways and there will be various

points of sensitivity. Someone buying a watch may be reluctant to pay below a

certain level – say £5 – because the product is assumed to be of poor quality if it

is below that price. There will also come a point – perhaps over £100 – where the

purchaser will expect a prestige brand to justify that price. Between these two

levels the price will be giving a message about quality – the £70 watch is assumed

to be of higher quality than the £50 watch and the consumer may choose that one,

even if they both have the same appearance, quality and brand recognition. This

may apply particularly to those who are buying gifts for others, where the price

is saying something about personal regard for the recipient. The purchase of the

lower priced watch may not be acceptable, whatever the apparent benefits.

EMOTIONAL OR FUNCTIONAL BENEFITS?

This factor is closely related to the nature of the product but is worth treating as

a stand-alone factor. This is because it is one of the most important and, via

marketing communication, one of the most controllable elements of consumer

price sensitivity. The concept of product benefits was raised in Chapter 1 as

fundamental to the definition of value. Benefits are the reasons why customers

buy the product, the ways in which they are better, feel better, or can do things

better after the purchase has been made (see Figure 4.2). Marketers go further by

classifying these into functional and emotional benefits.

Functional benefits are the logical, rational reasons for buying – that the

product will fulfil the function for which it was intended: food to ease your

hunger, a car to take you from A to B, clothes to keep you warm. Emotional

benefits are those that make you feel good, either because the product is giving

you pleasure or because it is saying something about you. The Ferrari does more

than take you from A to B, it gives a message about your image and status, as does

the Armani suit or the Rolex watch. The more these emotional benefits are, or can

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be made to be, part of the product proposition, the less there will be price

sensitivity. This is the reason why a lot of modern advertising is aimed at these

emotional benefits: to develop the brand strength that makes them sustainable

and justifies higher prices than would otherwise be possible.

Fig. 4.2 Functional and emotional aspects of product benefits

MARKET ENVIRONMENT

Each separate market will have unique conditions and a number of these are

fundamental to pricing strategy. This is one reason why ‘global’ marketing often

falls down and why it is impossible to have a universal pricing strategy for any

product, unless it is flexible and adaptable to the needs of each market. These

environmental factors can be broken down into a number of constituent parts.

Economic conditions

The overall stage of economic development will inevitably have a major impact

on the consumer’s attitude to price. Though there are other factors in this chapter

which can move things the other way, one general rule applies: the lower the

development of the economy of a country or region, the more likely it is that price

will be dominant in the purchase decision. The less the discretionary spending

power, the more price sensitive is the consumer. Those buying a loaf of bread or

Benefits

Functionalvalue

Based onrationality

High pricesensitivity

Low prices

Emotionalvalue

Based onfeelings

Low pricesensitivity

Higher prices


a car in a developed economy will be influenced by brand, by advertising and by

perceived quality; those buying in the developing world are more likely to choose

the cheapest option.

Cultural norms

It would be misleading, however, to suggest that this is a general and inflexible

rule. There are some countries and regions where consumers are more likely to

buy on price than others because of the way their people think and act when

making purchases. The most obvious example is that most developed market of

all, the USA, where, despite the high incomes and discretionary spending power,

consumers in many markets are still strongly focused on price. American buyers

like to find a ‘good deal’ for most of the products they buy, and then they like to

tell others about it. This is one reason why almost every shop in New York or

Miami seems to have permanent sales and special offers; this style of marketing

appeals to the American psyche, everyone likes to think that they are getting a

lower than normal price.

At the other end of the spectrum is the UK where it is well known that

supermarkets can make higher margins and cars can be sold at higher prices than

elsewhere in Europe because UK consumers are relatively ‘lazy’ about price in

many of their purchases.

Consumer mindset

The history of the marketing of each product and the environment within which it

has developed creates a unique set of circumstances which in turn creates mindsets

for consumers. These will be a major factor in determining the perceived value of the

product and therefore the parameters within which marketing people can work in the

development of a pricing strategy. Mindsets will determine the range of pricing

options, in particular the psychological maximum beyond which it is impossible to

go, whatever the perceived quality. Even if there was unlimited spending power and

the best possible combination of other marketing variables, consumers will not pay

more than a certain amount for a bicycle or a washing machine.

One factor in this mindset is the concept of ‘fairness’. In certain industries price

sensitivity is increased because of suspicion about the motives and objectives of

the operators in that market, often fuelled by hostility from the media. This can

apply particularly to products that are seen as necessities of life and where

suppliers are seen as exploiting the dependence and vulnerability of consumers.

Examples in recent years are the oil and pharmaceutical sectors, where no amount

of logical argument about investment in exploration or research has been able, in

the short term, to change the mindset that prices and profits are excessive.

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THE CONTEXT OF THE PURCHASE TRANSACTION

Price sensitivity will be significantly affected by the nature of the purchase and its

context in the life of the consumer. There will be a number of factors involved here.

Significance to financial position

The purchase that takes a high proportion of the consumer’s income (or, in the

context of an industrial purchase, constitutes a high proportion of cost and profit)

will be more likely to be price sensitive. Thus a regular purchase such as newspapers

or bread will have high price sensitivity because the consumer will realize the

importance of that purchase to her total financial position. In addition, the regularity

of purchase will make the buyer more informed and more likely to shop around.

It is not all to do with regularity, however. A high proportion of income can also

be taken by the one-off, big-ticket purchase, such as a house, car or domestic

appliance. Extra price sensitivity will apply in this case too, because of its significance

to income and because of the resultant willingness to carry out research. The one-off

purchase that is low in financial significance – for instance the hairdryer or the coffee

maker – will generally have relatively low sensitivity because the total impact on

income is small. For similar reasons, businesses that supply other companies with

small-ticket, one-off purchases such as books, directories or pictures can find

extremely low sensitivity and often charge very high prices, knowing that the cost is

relatively insignificant to the person who authorizes it.

In business-to-business transactions, this factor can be used to advantage by the

intelligent sales person. Those who are involved in what is often called value

selling will know that a key requirement for effective pricing is to have a clear

understanding of the place of your product in the customer’s total cost structure,

and to know the likely impact on cost and profitability levels of price changes in

both directions. If you are supplying fundamental raw materials that make up 50

per cent of total cost or selling price, then price sensitivity will be high; if you are

selling a component which makes up only 5 per cent of total cost, sensitivity will

be much lower, particularly if the impact of inferior quality is likely to be serious.

Unit of purchase

Price sensitivity will be much greater when there is an obvious and accepted unit

of purchase, which is commonly accepted throughout the industry. This is clearly

so in many sectors – consumers will buy a newspaper, a car or a television with

the clear ability to make direct and meaningful comparisons. There will still be


differences of type and quality, but a car is a car and only one car is being bought

at the time of purchase.

In other cases, however, the unit of purchase is less clear and this may be

compounded by changes over time, for example the move to the metric measurement

system in some Western countries has made it much more difficult for the consumer

to make comparisons and assess value. Though the purchase of vegetables and petrol

may be relatively price sensitive for other reasons quoted in this chapter, the lack of

uniformity and common understanding caused by the change in measurement system

has worked the other way. Consumers become confused and will make comparisons

in different ways; some will look at the cost per unit of cauliflower, some per pound

and others per kilo.

One other significant and related factor is whether the decision will be ‘yes/no’

or ‘variable purchase’. Will a high price cause the consumer to refuse to buy at all,

or will the decision be to buy a lower quantity? If the consumer is faced with

highly priced vegetables or petrol, she may well decide to buy less for the amount

of money that she is willing to pay. Clearly this will be dependent on alternative

options and competitor prices, but the very fact that a variable quantity purchase

is available will reduce the sensitivity, particularly if the purchaser is under short-

term pressure to buy. If you are low on petrol and the next station is some distance

away, you will put £5 of petrol in your tank almost irrespective of price.

Individual or corporate purchase

It is a fact of life that most people are less careful with their employers’ money than

they are with their own. In fact, it is often held to be an example of good management

practice if staff can be influenced to spend the company’s money as they would their

own, but this is the exception rather than the rule. Therefore the price sensitivity of

corporate purchases can be much lower than those of the individual.

A revealing example of this lower sensitivity is the purchase of airline tickets.

The individual purchaser is usually highly price sensitive, buying largely on price

because it is a major purchase from the personal budget. There may even be a

certain kudos from obtaining a good deal, which may be shared with friends at

dinner parties. Yet that same individual, when buying an air ticket for personal

use through the company, may not be price sensitive at all because the company

is paying. In fact, the conversation at the dinner party will emphasize the high cost

as a sign of status, showing that the company is prepared to pay many times more

for business or first-class travel. Clearly this is partly to do with the extra benefits

which come with higher-class travel, but it is interesting that these benefits are less

appealing when the individual is paying!

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Specialist knowledge of the buyer

In practice, not all companies allow their staff to choose how they travel and the

price that is paid. Increasingly, large international businesses are realizing that the

cost of air travel is a major one and needs to be controlled more closely, using

specialist buying expertise. This is an illustration of what is probably the key factor

in price sensitivity in business-to-business transactions – whether the company has

a specialist buyer who is dealing with the purchase and who has developed superior

knowledge, experience and expertise. Price sensitivity will be at its lowest when the

purchase is a one-off acquisition of a product or service where the main decision

maker is a functional specialist who is not used to handling such transactions. An

example would be the occasional purchase of training or consultancy services by a

line manager who does not often do such deals.

Understanding of this element of sensitivity can lead to a segmentation strategy

that expressly avoids those companies which are likely to involve specialist buyers

in the purchasing process. If dealings can be kept informal and friendly,

competitors can be kept out of the picture and price sensitivity can be maintained

at a low level. This is one reason why relationship marketing has become such a

key issue in business-to-business transactions – a good relationship can keep price

well down the agenda compared with other factors and can avoid the formalities,

and the greater emphasis on price, which comes with competitive tendering.

This business-related example illustrates a broader principle which is fundamental

to price sensitivity in all markets – the extent to which consumers are generally well

informed about the alternatives that exist and the prices that are charged in the

market. The more informed they are and the more research they carry out, the

higher will be the price sensitivity.

In consumer markets two important developments have helped consumers to

become more informed. One has been the introduction of consumer magazines,

which increase the information available to buyers while also reassuring them (or

otherwise) about relative quality. The other has been the Internet, which has made

it much easier for consumers to search for more information and to find out the

range of price options. The information available to a competent Internet user

with a search facility represents an interesting contrast to what is accessible in a

single retail store or in a single mail order catalogue.

Time and occasion of purchase

The time and occasion of purchase will have a major impact on price sensitivity

of many products in the service sector and will allow the adoption of what is often

called ‘differential pricing’. This means the fixing of different prices for what is

essentially the same product, because of the impact of time and occasion on the


likely demand from customers. The most obvious example is the type of ‘peak

time’ pricing which is typical of air and rail travel – the provider is fixing price to

maximize the return from the scarce resources available at busy times, while also

using it to transfer some of the demand into quieter periods. The key to success is

still to provide value to the target customers in the different time segments so that

they are not tempted to turn to alternative times or to choose to use other services.

A COMPLEX WEB OF FACTORS

Even this wide range of factors simplifies the reality of marketing and pricing in

a diverse, global and multi-channel economy. Consider the price sensitivity of a

ubiquitous and globally known product such as Coca-Cola. We all buy similar

products and would probably claim to have a good idea of our likely price

sensitivity when making the purchase – the maximum price we are prepared to

pay in the supermarket before moving to a competitive or substitute product. Yet

how likely would we be to behave that way when the time comes to make the

buying decision? How many other factors would come into play which make it

difficult to predict our behaviour? Though we might make a statement about our

likely attitude to price when talking to a market research interviewer, the reality

may be very different.

Two factors would be the mood we are in and the time we have; if we are in a

hurry we are much less likely to look at, never mind compare, prices. It could also

depend on the timing of the purchase, whether it is just after the payment of our

salary, or just before when we are right out of cash. An even more important

factor is the place where the purchase is made; we also buy Coca-Cola in bars and

restaurants where the price is likely to be much higher and the consumer much

less price sensitive. That same consumer who was so careful to check the price

compared with the supermarket brand on Friday morning will go to the bar that

same evening and order ‘three Cokes’ without knowing or caring about the price.

And maybe the following week he or she will go away on a business trip and pay

three times the usual price for a Coke from the hotel mini-bar, because the

company is paying.

This illustration and the other factors mentioned in this chapter confirm once

again that pricing decision makers should be wary of scientific formulae and easy

solutions, and should challenge and question anyone who claims to have all the

answers. It should also be remembered that all the price sensitivity factors that we

have mentioned are closely interrelated and that most of them can be influenced by

the marketing strategy of the business. Customer perceptions and mindsets can be

changed by the right advertising campaign. A strong brand and an effective

differentiation strategy can reduce consumer price resistance. The use of promotions

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and the way in which the promotional price is expressed can pass a special message

to the consumer. The positioning of products in particular segments and channels

can create new perceptions about price and relative value.

In other words, price can and should be managed in conjunction with other

elements of the marketing mix, which is the topic of the next chapter.

5Price as part of the marketing mix

The marketing mix framework 47

The place of price in the marketing mix 47

Segmentation 48

Pricing and product 49

Pricing and promotions 52

Pricing and distribution channels 54

Analyzing the value package 56

The link of pricing strategies to financial results 58

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Price as part of the marketing mix

THE MARKETING MIX FRAMEWORK

The position of price as one of four constituents of the marketing mix almost goes

without saying. Those who study marketing will find at an early stage that price

is presented as only one of the ‘four Ps’ which marketing experts manage to

implement their tactics and achieve their strategic objectives. The ‘four Ps’ are

shown in Figure 5.1.

Fig. 5.1 The ‘four Ps’ which make up the marketing mix

The marketing mix is a simple but powerful framework, though if applied rigidly it

can be seen as too narrow. In the desire to make each element begin with the letter

‘P’ there is a danger of simplifying too much and the definitions need to be broadened

if all the important variables are to be covered. ‘Product’ should cover the complete

range of offerings to customers, the packaging and names which are used, and the

strategies behind them. ‘Promotion’ should include all types of advertising and

market communication. ‘Place’ should include all channels of distribution and all the

means by which products are made available to customers.

THE PLACE OF PRICE IN THE MARKETING MIX

Price differs from the other three elements of the marketing mix in a vital way.

The other three provide the functional and emotional benefits referred to in

Chapter 4. Price is different because it reflects the cost that the customer has to

sacrifice to obtain those benefits.

However, the place of price in the marketing mix is more complex than that

because, in many cases, it can also contribute to the benefits. As we saw in the last

47

Price

Product

Promotion

MARKETINGMIX

Place

48


chapter, price provides a message about likely value – customers can be reassured

by a higher price level and may make negative assumptions about the benefits if

the price is too low.

The marketing mix framework is therefore an important reminder of two

important aspects of pricing: first that it cannot be seen in isolation from other

marketing variables, and second that it has to be managed proactively in tandem

with them. Pricing decisions have to be compatible with management of the other

elements of the mix. For instance, high price strategies must be accompanied by

products and advertising campaigns that reinforce a high value positioning and by

availability in channels which attract the right sort of customer. Low price

strategies must have functional products, supported by price-based promotions

and availability in channels which attract price-sensitive customers. The four Ps

must be in total harmony.

SEGMENTATION

Market segmentation is fundamental to marketing and is an important factor in

managing a pricing strategy in harmony with the other elements of the marketing

mix. Its technical definition is ‘a group of customers who respond in a similar way

to a given set of market stimuli’. It involves the separation of customers into smaller

groups with different needs, so that these needs can be met more effectively by

tailored, targeted offerings. These tailored offerings can then have greater focus and

more concentrated resources, with a marketing mix that matches their needs.

Segmentation is an important and effective approach to marketing because it

recognizes that no business can please all people all the time in a way that is better

than its competitors. It opens the door to decisions to differentiate the offers for each

segment, thus channelling resources more effectively. It is, for example, fundamental

to the differentiation and focus strategies advocated by Michael Porter and

mentioned in Chapter 2; differentiation can be achieved most effectively if an offering

is directly targeted towards those who have been defined as having similar needs.

Segmentation can be structured in many ways. The classic approaches have been

through demographic factors such as age and social class, or in a business-to-

business context, company size, industry or location. These are relatively easy to

identify and apply but are not necessarily geared towards the key variables in the

market environment. Recent trends have been towards more sophisticated

methods that differentiate between more subtle and relevant characteristics, such

as consumer lifestyles, benefits sought, buying behaviours, personal attitudes and

types of usage.

Whatever method of segmentation is chosen, key factors in the selection are

likely to be those which have been covered in Chapters 3 and 4 – competitor


offerings and consumer price sensitivity. Unless you are the lowest cost operator

and adopt a cost leadership strategy, the ideal targets will be those segments where

competitors are unable or unwilling to compete at the same or lower prices than

you will offer, and where consumers will display low sensitivity to price when

offered your value package.

It may even be possible to segment on the basis of attitude to price if this is

compatible with the marketing strategy. The last chapter showed the factors that

influence price sensitivity and these are certain to vary between different types of

customers. Indeed, a segmentation strategy based on (say) high, medium and low

price sensitivity could be more helpful than the conventional ways of thinking and

might provide clearer guidance for the other elements of the mix – the products to

offer, the promotions to launch and the channels to distribute. Even if price sensitivity

is not the main driver of segmentation, it will almost always be a key factor in

defining the segment characteristics. For example, segments based on social class,

income levels or amounts of discretionary spending will often be defined that way

because of their different attitudes and sensitivities to price.

In the long term, each segment needs two characteristics if the company is to

achieve its objectives: first the agreed offering must be able to create sustainable

competitive advantage, and second the segment must have the potential for long-

term profitability. The successful companies are those which manage prices in

tandem with the other three elements of the mix and create sustainable competitive

advantage in their chosen segments.

We will now examine the other three elements of the mix and consider the links

to price.

PRICING AND PRODUCT

Product positioning

The price of a product is making a statement to the customer about its positioning

in the market place. Where there is the potential to offer several products within a

range, price becomes a means of giving messages about the relative quality of each

one of those products, within the chosen segments and in relation to competition.

Marketers often use a framework of ‘price lining’ to position their products in the

various segments. They categorize their products into a limited number of price

brackets, each of which is making a separate statement about absolute and relative

quality. A traditional approach, which frequently ties in with segment structures,

has been to have three price levels – ‘good, better, best’ or ‘economy, midpoint,

premium’ – with each of the three products in the range having clear differentiation

with different combinations of price and benefits. In simple markets using

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conventional segmentation methods, three offers is often felt to be the ideal number.

It achieves the right balance between simplicity for supplier, retailer and consumer,

and also provides reasonable choice in the buying decision. However, much will

depend on the market, the type of consumer and the method of segmentation.

There is a danger that this ‘three level’ policy, carried out by many retailers, will

oversimplify a complex market structure and will restrict the choice for the consumer,

thus making this limited segmentation a self-fulfilling prophecy. It may also be

difficult to maintain this structure during times of inflation and where the market is

undergoing rapid change for other reasons. The critical need is for price lines to be

reviewed regularly and tested out with market research, then to be checked against

the current thinking on segmentation. For instance, the development of new

segments, with different levels of discretionary income, may require the addition of

further price line choices.

One other argument in favour of increasing the number of product offerings is the

creation of different ‘reference points’ for price. One common approach is to

introduce a new top-of-the-range offering, the main objective of which is to create a

‘halo’ effect, boosting the range as a whole and making the other product lines seem

to be of better value. It is common to position the customer viewing of a store or

catalogue so that the higher priced item is seen first, thereby creating a higher

reference point for the next item in the range. However, it is always easy to argue the

case for more product lines as more sophisticated marketing techniques and other

innovations are developed. The counter argument is that this can lead to higher costs

and lower focus, because of the resultant complexity and fragmentation.

However many price lines are chosen, they should be backed up by clear quality

differentiation, or at least they must be seen that way. This ‘perceived quality’ – the

only sort that really matters – will not be based purely on functional benefits;

emotional benefits will also be important. Brand development through advertising

is the classic way of delivering the emotional side of perceived quality: designer

clothes may or may not be of higher quality in the functional sense, but they are

perceived to be because of the emotional impact of the advertising, brand reputation

and image that is supporting them.

Product bundling

This is a popular pricing strategy which has a number of objectives and a number

of implications. Price bundling means including a number of products and/or

services together as a ‘one price’ package – a package holiday, a car sold with free

insurance and servicing, a computer with free software, a television with servicing

beyond the guarantee, a store offering a low price teddy bear for those who

purchase more than a certain amount, a McDonald’s Happy Meal – everywhere

we see examples of bundling as part of modern marketing.


One purpose of bundling can be to make it difficult to compare prices directly,

thereby adding to the confusion and uncertainty which may cause the consumer

to fall back on the familiar brand. It can also be an effective method of segment

targeting – preparing bundles of services that will be attractive to different types

of consumer, perhaps as a means of differentiating from competitors who do not

have the ability to offer the whole package. There can be sustainable competitive

advantage from a bundle that others cannot replicate and, if presented effectively,

it can be achieved at higher prices than would be possible by other means.

Bundling may be positioned as the only offer, often called ‘pure’ bundling, a

strategy which will be effective if you are sure of the strength of your value

package and your segmentation, though it can often restrict customer choice too

much. ‘Optional’ bundling will be taken only by those customers who want it,

and it will often require a strong price incentive to persuade the customer to go

for the bundled deal. Optional bundling can also be used for the purpose of cross

selling, to introduce the customer to new types of product which they would

otherwise not try.

One important requirement for effective selling through price bundling is for the

customer to be clear about the value they are receiving, particularly in comparison

with competitive offers. In the face of price resistance it may then be possible to

make the offer of lower prices through unbundling, while showing the customer

the value that is being lost. This can often have the effect of lowering resistance

and persuading the customer to accept the higher value of the bundled deal.

New products and occasion blocking

One other way of developing the product range to remove price resistance is

through the introduction of new products which change the occasion of the

purchase, often known as ‘occasion blocking’. Successful examples include the

development of ‘party size’ versions of soft drinks, gift versions of chocolates and

‘multi-packs’ of ice cream or breakfast cereal.

There is a dual benefit of occasion blocking for the company that is first to find

the right product variant. They are offering extra value to those customers for

whom these special versions of the product meet their needs more effectively, and

this may mean that a price premium per litre or kilo is achievable. They are also

changing the language of the product, thereby making the price comparison more

difficult for the consumer and thus reducing sensitivity. Occasion blocking can

result in a true ‘win/win’ situation – a consumer who prefers the smaller party

packs of Coke and is willing to pay a price premium per litre over the standard

can. As long as the cost of the extra complexity does not cancel out the price

premium, everyone is better off. Only the entry of competitors with a similar

product at lower prices can ‘spoil the party’.

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PRICING AND PROMOTIONS

The objectives and benefits of promotions

We have already shown that price cannot easily be separated from the other elements

of the marketing mix and this is never more so than with promotions. Indeed, it is

often difficult to differentiate between the two because many ‘promotions’ are no

more than temporary price reductions. This overlap is confirmed by the fact that

there will often be disagreements between accountants about whether such

promotions should be shown in the accounts as costs or as reductions of sales.

Indeed, marketing people will often be keenly interested in the debate when it has an

impact on their available promotional budget!

A promotion is a means of stimulating sales volume in the short term by a

temporary improvement in the value package. Promotions will be introduced for a

variety of reasons, some negative, some positive, some financially driven, some

marketing driven. At the negative, financially driven end of the spectrum would be

a promotion to get rid of unwanted stock or to achieve short-term volume targets;

at the positive, marketing driven end would be a promotion to persuade new

consumers to try the product or to carry out an experiment in price sensitivity.

The key requirement to justify any promotion, and particularly one linked to a

price concession, is to have clear objectives which link to marketing strategy. The

excessive and indiscriminate use of promotions linked to price will only serve to

confuse the customer, devalue the product and distort the price positioning. On the

other hand, their intelligent, selective use can have a positive impact, for instance

the positioning of a temporary price reduction as a special promotion can help to

preserve the original full price in the mind of the consumer.

The key argument for price-linked promotions is that, in most transactions and

circumstances, customers will respond more positively when a price is expressed as

an apparent reduction from a base price, even in circumstances where few customers

have ever paid that price. Most of us do not like to miss out on a chance to save

money, thus the expression of a price as a discount or reduction is likely to attract

extra sales, particularly from new or irregular customers.

One problem, and a key reason why the financial viability of many promotions

is often questioned, is that the offer also has to be made to existing loyal customers

who would have bought anyway and who may take the opportunity to increase

their purchase quantity.

Types of promotions

One well-known and often controversial type of promotion used by larger retailers

is the ‘loss leader’. These are frequently used as a means of persuading consumers


into the store or a particular section of it, and thus encouraging them to buy other

products. Though there are serious dangers in this approach as a general and long-

term pricing strategy (to be covered in more depth in Chapter 8), loss leaders can

be highly effective as a short-term means of gaining attention, building store traffic

and leading consumers to other products.

One popular way of promoting the product without impacting the long-term price

structure is to offer some other way of providing extra value, such as a larger pack,

a BOGOF (buy one get one free) or some kind of free gift. Apart from being a more

attractive offer to some consumers, the key advantage is that price positioning is not

compromised and it is easier to move back to normal value levels.

Some marketers in consumer goods companies believe that, at the macro level,

promotions tend to have a negative impact on the bottom line – all they do is

manipulate volume temporarily and create complexity and volatility in the supply

chain. They believe that many promotions merely allow existing consumers to stock

up in advance at lower prices and argue that ‘everyday low prices’ are a better

strategy for suppliers, retailers and consumers. The problems of accurate evaluation

make this a difficult argument to justify or challenge and, while some competitors

are using promotions as a marketing tool, it is difficult for others not to follow.

Advertising and brand strength

Within the framework of the ‘four Ps’, advertising is contained within the broad

heading of promotion. Our definition of advertising in this context is any investment

in the delivery of messages about benefits to consumers through the communication

media. One critical decision for the marketing manager in most consumer businesses

is the allocation of the advertising budget between promotion and advertising. It is

frequently a classic choice between allocating resources for short- or long-term

investment: short-term promotions to achieve volume this year against long-term

advertising to strengthen the brand for the future. The more the short-term option is

chosen, the more the product is likely to remain or become price sensitive; consumers

and trade customers begin to expect promotions or price reductions as the norm and

do not understand or value the other benefits. On the other hand, investment in the

right kind of longer-term advertising is likely to reduce price sensitivity because it is

increasing the strength of the brand which becomes, in the consumer’s mind, a vital

part of the value package.

It is interesting to observe in any supermarket those categories where lower

priced ‘own label’ products have taken a major share of the shelf space and where

consumers seem more prepared to choose the lower price option. This is naturally

most likely to happen with commodity type products where there is limited scope

for differentiation, for the reasons mentioned in the last chapter. However, it is

much more than that. There are some products – for instance tomato ketchup,

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baked beans, breakfast cereals, washing powders – that could be regarded as

having commodity features yet where, in many markets, own label has still made

only limited impact.

Consumers and manufacturers would argue that this is because the quality of the

branded products is superior and there may be some cases where this is a key

factor. However, it seems mainly to happen where the brands are strongest because

companies such as Heinz, Kellogg’s and Unilever have consistently invested in long-

term advertising to strengthen their brand equity. On the other hand, where brands

have not received sufficient advertising investment, own label and other low priced

products have been more likely to gain a significant market share. The conclusion

must be that a well-chosen and directed investment in advertising can be a highly

effective way of reducing price sensitivity.

The only instance where media advertising will not reduce price sensitivity and

will indeed have the opposite effect is if the advertising message is directly linked

to price. Such advertising can frequently be seen in newspapers and on television,

often linked to short-term promotions. Though this can be effective as a short-

term means of attracting customers, it will achieve long-term objectives only if

there a competitive advantage based on cost leadership.

PRICING AND DISTRIBUTION CHANNELS

The range and variation of channels

So far, in order to emphasize general principles, we have avoided some of the real-life

complexities of modern marketing. Think of the manager who has responsibility for

managing an international soft drinks brand like Pepsi or Coca-Cola. Our illustration

of the different price sensitivities on different buying occasions in Chapter 4 confirms

that there are many distribution channels served by such companies, for example:

■ retail supermarkets

■ small shops

■ vending machines

■ catering institutions

■ wholesalers

■ bars

■ hotels.

For each channel there are different costs, different customers, different buying

decisions, and a pricing strategy has to be developed for each one. The strategies need

to reflect the customer segments and the competitive offerings in each channel, as


well as taking into account the impact of each channel on others. For example, will

the prices charged to wholesalers and in vending machines have any impact on the

price sensitivity and image of the product in retail outlets? For each channel there has

to be a judgement about price sensitivity and consideration of the total value package

against competition, which may be different in each separate regional market. There

may also have to be judgements about whether certain channels are worth serving at

all, either because of the cost of serving them or the impact on brand image.

The critical factor in managing distribution channels is to have good relations

with the direct customers who stand between you and the consumer, and to

maintain the maximum possible influence on price and other factors in the

marketing mix. It is beyond the scope of this book to examine such relationships

in every type of channel, so we will touch upon the one that is most important for

consumer goods suppliers – the relationship with the retail trade.

Pricing to the retail trade

During this and the previous chapter most of our attention has been focused on the

consumer – the final buyer of products in retail channels – with the implication that

the brand managers of these products have freedom of action when developing pricing

and marketing strategies. However, for the suppliers of these products – companies

such as Mars or Procter & Gamble – the direct customers are the retail traders and it

is their management who will normally have final control over the eventual selling

price and the way that the products are presented and promoted in store.

Therefore the key pricing issue for the sales people of these companies that are

selling to major retailers like Tesco, Carrefour and Walmart is how much discount

the customer has to be given to retain the listings and maintain the relationship.

These ‘trade terms’ can often dominate price decisions and will be fundamental to

price sensitivity at the macro level. The relative size and power of the customer on

the one side, and the strength of the brand on the other, will be the key determinants

of how this power struggle is carried out and how price sensitive that customer will

be. In the end, prices to the retailer will be determined by negotiations that reflect

how much the two parties need each other.

The objective of the marketing and sales teams of the consumer product companies

is to negotiate trade terms that provide their own company’s required level of

profitability while also encouraging the retailer to sell at prices which are in line with

marketing strategy. This means understanding the retailer’s margin structure and

pricing strategy, and influencing their management to adopt in-store policies that are

compatible with the brand objectives. Special promotions and incentives for that

retailer may be one of the means of exerting this influence.

Sometimes there may have to be tough choices. For instance, it could be that, by

supplying a particular retailer on the generous terms which are necessary to get the

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business, you are allowing them to break your normal price structure and draw

consumers away from other, higher priced retail competitors. In that case it may be

better to resist or even not to supply, though the final choice will depend on the

significance of that retailer’s business to the supplying company. Only those with

the strongest brands and the most effective marketing strategies can withstand the

sort of price pressure that comes from these major international retailers.

One common strategy for brands with ‘designer’ status is to refuse to supply

certain types of retailer because of the impact on image and reputation and

because it will damage the price structure. For instance, perfume companies will

not supply ‘down-market’ retailers, designer goods suppliers will not supply

supermarkets. Some supermarkets have even gone to the lengths of obtaining

supplies from the ‘grey market’ to overcome this restriction and suppliers have

gone to law to try to prevent them, as evidenced by the Tesco versus Levi court

case, which at the time of writing was still ongoing. In this action, Levi and Tesco

are disputing through the courts Tesco’s right to sell Levi products purchased from

other ‘grey’ sources because Levi wants to keep control over the outlets it supplies

and preserve its brand equity.

ANALYZING THE VALUE PACKAGE

A key message of this book so far has been that price has to be seen as only one

part of the total value package if effective judgements are to be made. Price has to

be central to that value package because it is the element that is most easily visible

to the consumer, and will represent the ultimate constraint.

If we now remind ourselves of the factors in the market place which determine

whether consumers choose our value package and its unique marketing mix, we

can see the variables shown in Figure 5.2.

Fig. 5.2 Factors which determine consumer choice

Competitivevalue

packages

OWN VALUEPACKAGE

Segmentationstrategy

Consumerwillingness

to pay

Consumerneeds andpreferences


If the pricing judgement within this framework is to be made effectively, it is

necessary to go to a further and deeper level of analysis than the other three ‘Ps’

and to look at all the benefits of the value package in quantifiable terms. There

are a number of techniques that are similar in nature and which are used in

market research. These require the following stages of analysis:

■ split the value package into its various benefits, both functional and emotional;

■ produce weightings of the relative importance of each one;

■ produce an analysis of the weighted average for each product in each segment;

■ compare with competitive offerings to assess price implications.

Thus, for the purchase of a car, there would be a number of benefits apart from

price, for example:

■ power

■ safety

■ economy

■ environment

■ appearance

■ extras

■ brand image.

Having identified this list of benefits from a sample of the target group, the

market research analyst would then allocate weightings to each benefit, based on

further analysis of the preferences and priorities within the sample. Potential

customers would then be asked to score each benefit, leading to a weighted

average score of all benefits for the product in question, which would be

compared with a similar analysis of competitive offerings. These scores would

then be related to the existing price (or for a new product the proposed price)

compared with competition, to assess the match with total benefits. The higher

the total benefit score in relation to competition, the higher the potential price can

be because it is providing better value than the alternatives.

A further development of this technique – conjoint or trade-off analysis – includes

price with the list of benefits, the price in relation to expectations being shown as an

additional factor in the purchase decision. This allows analyses at different levels of

price for the same product, to see how the relative importance of price varies as it

moves up or down. If the price moves close to or outside the customers’ minimum

or maximum expected price level, the importance of price in the purchase decision

is bound to increase. This is because customers will either be unable to resist a low

price bargain or will be unwilling to pay a high price, whatever the nature of the

other benefits may be. If the marketing strategy is to build a value package that

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moves the customer away from price, a guide to optimum pricing will be the price

level at which price scores lowest against other benefits.

There is a danger that techniques of this kind give a false impression of the

ability to find the optimal price by scientific means. It is therefore important to

stress that the output is no more than an aid to judgement and is only likely to be

as good as the information inputs. There will be four sources:

■ analysis of past data

■ market research surveys

■ experimentation

■ expert judgement.

The choice and balance will depend on the resources available for market research

and the information available in-house. In practice, a mix of all four methods may

be the best option, with common sense judgement complementing and checking

the outputs.

THE LINK OF PRICING STRATEGIES

TO FINANCIAL RESULTS

So far we have provided little coverage of the link of pricing strategies to financial

results, making the assumption that pricing on a value-maximizing basis will also

achieve the best return for stakeholders. This assumption could be questioned unless

it can be shown that such a strategy has a close link to financial performance. The

next chapter shows this link by the best possible means: through research into the

links of various pricing strategies to the long-term financial performance of a

number of different businesses.

6Price, value and profitability

Definitions of quality 61

The PIMS research 61

Linking value to profitability and market share 63

Summary of rankings 64

PIMS, Porter and pricing strategies 65

Financial implications 66

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Price, value and profitability

DEFINITIONS OF QUALITY

In the first five chapters we established that value is critical to pricing and is

defined by relating price to benefits, both functional and emotional. However, it

is common for managers of companies that do not have a marketing orientation

and that do not invest in market research to have a different perception of value

compared with that of their customers. This may be encouraged by conventional

wisdom about what is generally accepted as ‘quality’ in the industry. Here are

three examples of different perspectives:

■ Manufacturers in the computer industry may believe that processing speed is

the critical determinant of quality for computers. Yet the users may feel that

ease of use or compatibility with other systems are more important factors.

■ Manufacturers in the clothing sector may believe that a key aspect of quality in

a sports shirt is the texture and durability of the material. Yet the wearer may

feel that the brand name (be it Manchester United or Ralph Lauren) is much

more important than either of these benefits.

■ The newspaper industry may talk about ‘quality’ newspapers when referring to

the broadsheets, yet the reader may feel that quality is more about sports

coverage and easy readability.

It should be noted that we are using the term ‘quality’ for the first time, as this is

the terminology used in the research findings that follow. We have not used this

term so far because it can have an indefinite meaning. However, definition is

straightforward when related to previous chapters – quality is a term that

summarizes in one word all the benefits of a product, both functional and

emotional, as perceived by the customer.

As the above examples show, the only way to establish its true nature is to ask,

and keep asking, the customer.

THE PIMS RESEARCH

The analysis and frameworks in this chapter are based on the work of the Strategic

Planning Institute, an organization formed in 1975 and based in Cambridge,

Massachusetts. Its PIMS (Profit Impact of Market Strategy) research programme

originated in General Electric in the 1960s and was originally picked up by Harvard

Business School, which gave it the PIMS name. The research, which continues to the

present day, analyzes confidential data from inside a large number of companies and

explores linkages between different strategies and financial performance. This work

in the area of pricing and value is particularly revealing and provides valuable

guidance in the formulation of broad pricing strategies.

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The research introduces five different value positions in competitive markets

and explores how each one correlates to financial performance. The five positions

are shown in Figure 6.1.

Fig. 6.1 The five value positions in competitive markets

Source: PIMS Associates, 2002

The two axes on the graph show relative positions compared with others in the

sector. The vertical axis shows the price compared with others and the horizontal

axis the quality compared with others, as perceived by the customer. It is therefore

possible to plot each player in an industry on a point that combines these two

factors and thus shows their value position.

Positions A, B and C all offer average value. They are positioned on the ‘quality

for price’ curve, along which quality rises in tandem with price. This confirms that

a business can offer average value in one of three ways:

■ average quality at average prices (position B);

■ superior quality at a premium price, compared with the market average

(position A);

■ inferior quality at a discounted price compared with the market average

(position C).

Thus, in each case, the analyst can think of the price and quality positions as being

‘in balance’.

Higher

E. Worse valueA. Premium

B. Undifferentiated

C. EconomyD. Better value

Quality forprice curve

Lower

Inferior Superior

Relative quality

Relativeprice


However, there are two situations when these positions can be out of balance.

First, when a competitor is offering ‘better value’ (superior quality at the same or

lower price, as shown in position D) or second, ‘worse value’ (inferior quality at

the same or higher price, as shown in position E).

LINKING VALUE TO PROFITABILITY AND MARKET SHARE

The major insight provided by the PIMS research has been to show the relationship

between the different value positions and long-term profitability, as measured by

return on assets (operating profit as a percentage of the assets invested in the

business). However, before examining this relationship we can also look at the impact

on another key measure with a strong link to profitability – market share.

Companies that are positioned along the quality for price curve (positions A, B and

C) and which provide the customer with average value, tend to have stable market

shares. On the other hand, companies in the ‘better value’ position will achieve

market share growth. However, since companies can only grow share at the expense

of others, someone has to lose out and it is the ‘worse value’ companies that will find

their share reducing. The conclusion is clear: only those companies that provide

superior value will achieve market share growth.

However, growth does not always link directly to profitability and it is

profitability that matters to stakeholders. Therefore we need also to look at the

return on assets position. Businesses in the premium category – position A, high

price, high quality – will, on average, achieve the highest rates of profitability.

This is driven by the higher margins they achieve when adopting this strategy.

These margins will be achievable because in some cases it may be possible to

increase quality without increasing costs, for example by implementing changes in

service levels as a result of better understanding of customer needs.

However, in most cases the companies that offer higher quality will have a

higher cost base than their competitors, for example the cost of producing a BMW

is higher than the cost of producing a Ford of similar specification. In these

circumstances the research indicates that the higher margins are still achievable

because customers are usually willing to pay a price premium in excess of that cost

to the companies that deliver high quality.

A more surprising outcome is that companies in the better value category –

position D, low price, high quality – are the second most profitable, nearly at the

same level as those in the premium position. This is because, although they charge

average prices, they have lower unit costs, and there are two reasons for this. First,

their growth in market share allows their assets to be highly utilized which, when

combined with better recovery of fixed costs, leads to a high return on assets.

Second, they do not need to spend as heavily on marketing as their competitors

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since the high value they are offering will cause a more favourable rate of repeat

purchases from satisfied customers. It is also likely that their reputation for good

value will become more widely known through customer recommendation.

Third place in the profitability rankings goes to economy – position C, low price,

low quality. In any market there will be some customers who wish to minimize

their spending, either because they have low cash availability or because they do

not regard the product as an important priority. An example would be producers

of cheap pens – there will always be some consumers who wish to buy a pen purely

for short-term functional reasons and who are not concerned about appearance,

image or long-term performance. A company that offers the cheap option to meet

these needs is likely to achieve adequate, but not superior, profitability.

In fourth place in terms of profitability is undifferentiated – position B, average

price, average quality. Customers do not perceive the offer of any one firm as

being different from others. This leads to price-led competition, with margins

being driven down in the battle to maintain market share.

In some countries financial services businesses selling to the mass market have

found themselves to be in this position. Customers do not perceive any one

company as being different from others, so even though it is a business that

depends on personal service, the feeling for customers is similar to buying a

commodity. The claims in such firms’ marketing communications that they are all

offering superior customer service ring hollow because, in reality, no competitor

has managed to achieve differentiation by this means. Only if one competitor

makes a major innovation in management of the customer interface will that

situation change.

The fifth and least successful position of all is worse value – position E, high

price, low quality – with a return on assets significantly below the other positions.

Many managers find this surprising and often those from the finance function are

the most surprised. They make the invalid assumption that companies with low

quality will, therefore, have lower costs than the other players in the market. They

then make the accounting-based judgement that the combination of high prices

and low costs must result in higher profits. The weakness in this argument is that

the companies offering low value will inevitably lose market share. This results in

under-utilized fixed assets and fixed costs – research, marketing, administration –

that do not match the lower levels of sales volume. This results in the lowest level

of profitability of any of the five positions.

SUMMARY OF RANKINGS

The above analysis is summarized in Table 6.1.


Table 6.1 Return on assets ranking of the five value positions

Return on assets ranking Position Examples(highest first)

1 A Premium ‘Premium’ motor manufacturers(BMW, Mercedes), Swiss watchmakers (Rolex)

2 D Better value Leading supermarkets in Europe(Tesco, Carrefour), direct sellers ofpersonal computers (Dell)

3 C Economy Manufacturers of cheap pens(Bic), Low-cost airlines(Southwest, Easyjet, Ryanair)

4 B Undifferentiated Many full-service airlines(American Airlines, Sabena)

5 E Worse value Once successful companies thathave lost their reputation forquality (Rolls-Royce, Maserati)

PIMS, PORTER AND PRICING STRATEGIES

The PIMS research has strong links to the work of Michael Porter, as covered in

Chapter 2. Porter argues that firms need to make a choice as to whether to compete

through differentiation or cost leadership. PIMS confirms that this will result in

above average profitability, particularly if differentiation is the chosen strategy.

The PIMS research has a further interesting implication to support Porter’s views

and to place differentiation as the favoured choice. It suggests that if differentiation

is achieved successfully, the price level does not, within reason, have a major impact

on overall financial performance. A strategy of high price levels will deliver a high

return through the price premium; a strategy of average prices will deliver a high

return through market share growth and lower per unit marketing spend.

The implication of PIMS for companies that choose the cost leadership option

is less encouraging. It will be less successful in financial terms than differentiation

because it will place them in the Economy position. However, it will still be

profitable and will certainly be preferable to being ‘stuck in the middle’.

It is here that there is the clearest link between PIMS and Porter. The

undifferentiated category, revealed by PIMS to have below average returns, is clearly

equivalent to Porter’s definition of being ‘stuck in the middle’ without a clear generic

strategy. Such companies offer customers similar products at similar prices to their

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competitors and are forced to compete primarily on price. Once in this position it is

difficult to escape because even if they try to differentiate their offer, competitors

will usually find it easy to follow, thus returning to price-based competition.

FINANCIAL IMPLICATIONS

This chapter has introduced the financial implications of pricing decisions in a

strategic long-term context. Yet this is only one aspect of the financial evaluation

of pricing. The next chapter looks at financial evaluation in a more detailed,

tactical context.

7Analyzing the financial impact

The case for cost and profitability analysis 69

The link to financial objectives 69

The financial analysis of price change options 70

Cost structure 71

The impact of price reductions 75

The price/volume breakeven concept 76

The impact of different cost structures 78

The causes of variation in cost structure 79

Long-term fixed costs 81

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Analyzing the financial impact

THE CASE FOR COST AND PROFITABILITY ANALYSIS

In previous chapters we have stressed that the pricing decision should be, to a

large extent, independent of the cost of the product or service. The message has

been that price is an element of the marketing mix that cannot be seen as

independent of the other elements in that mix and that must relate to perceived

customer value. As customers do not know or care about your costs when they

make their buying decisions, any attempt to price on a ‘cost plus’ basis is likely to

succeed only if, by chance, you hit the level which matches their value perceptions.

However, the rejection of ‘cost plus’ as a direct approach to pricing does not rule

out the use of techniques of cost and profitability analysis as part of the pricing

decision-making process, because it is important to know the financial impact

before making the final judgement. Even if your price is exactly in line with

customer perceptions, it cannot be maintained if it is not sufficiently profitable to

meet financial objectives. Therefore the next three chapters cover a number of

areas where such analysis will play an important part.

On the other hand, the introduction of financial techniques does require a

reminder of the need to maintain the right balance in that decision-making process.

The very introduction of financial evaluations and apparent ‘right’ answers can lead

to over-reliance on the numbers. The correct balance will be achieved only if all

those involved in the process remember the fundamental principle that marketing

and strategic factors should prevail in the final judgement, but the decision makers

need to be as well informed as possible about the financial implications of the

various options.

The critical factor in the achievement of this vital balance is a positive and

co-operative relationship between the finance and sales/marketing functions, so

that evaluations are available when required and are the subject of full

consideration and discussion. The advent of the ‘marketing accountant’ in many

top companies has been a healthy step in the creation of the right balance.

Management accountants are provided to support marketing managers, with the

specific brief to provide the right kind of information and advice.

THE LINK TO FINANCIAL OBJECTIVES

Before we look at financial analysis techniques as a support to pricing, there is

another fundamental point to make. Businesses exist to make profit and, if the

marketing-oriented approach which we are advocating does not generate sufficient

levels of return to satisfy shareholders, there is clearly a fundamental problem. This

problem is even more serious, and maybe insoluble, if competitors are apparently

satisfied with that profit, or if the industry – like, for instance, the airline sector –

seems to operate on low margins for historical or structural reasons.

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Here again there is a case for financial analysis to support the decision-making

process and to help avoid the main danger of this situation – that management

will sit on their hands and do nothing. Financial analysis should enable

management to examine their cost structure, to compare it with others, and to

evaluate the various options to reduce existing cost levels. If this proves to be

impossible for internal or external reasons, other strategic options have to be

considered, including exit from that product or sector. Again financial analysis

can and should play a big part in this process by assessing the long-term profit

potential and by evaluating the financial impact of exit strategies.

THE FINANCIAL ANALYSIS OF PRICE CHANGE OPTIONS

We start our coverage of financial analysis by looking at the evaluation of price

change options. The type of question to be answered by this kind of analysis

relates closely to our coverage of price sensitivity/elasticity in Chapter 4. There is

a danger that a marketing person, having studied the economics and assessed

likely price sensitivity, might say: ‘If price is reduced by 5 per cent and volume

increases by (say) 10 per cent, we will be better off because both sales and market

share will be increased.’

This is obviously true, but it is not only sales and market share which must be

considered, there is also the question of short- and long-term profitability. As we

will see later, a 5 per cent price reduction followed by a 10 per cent volume

increase will not necessarily increase profitability, indeed it could even reduce it,

depending on the cost structure of the product. This is not to say that the impact

on profit should be the only driver of the decision, but that the full, true impact

must be known before the decision to reduce price is made.

This chapter will show evaluations of a number of similar decisions and will

show that the answers are rarely simple or predictable. Other key questions to be

answered are:

■ If price is increased by 10 per cent and volume falls by 10 per cent, will this

increase profit, decrease profit or keep it the same?

■ How much can we afford volume to fall after a 10 per cent price increase to

keep profit the same as before?

■ How much does volume need to rise after a 10 per cent price reduction to keep

profit the same as before?

■ How do the above questions apply to competitors?

The answer to these questions if expressed in general terms is always going to be

‘it depends’ and the reason is cost structure. This simple fact should encourage

marketing people never to make simplistic assumptions or to carry out ‘back of the


envelope’ calculations. Informed financial analysis is needed to know the impact

on profitability, and understanding of cost structure must be the starting point.

COST STRUCTURE

The critical factor in the understanding of the impact of price increases and

decreases, and in the understanding of many other factors in pricing, is the ratio

of fixed to variable costs. Variable costs are those which increase directly as a

result of a volume increase, fixed costs are those which stay the same.

Two simple graphs, shown in Figure 7.1, demonstrate the behaviour of a variable

cost compared with a fixed cost.

Fig. 7.1 How variable and fixed costs compare

It should be noted that this relationship is to volume, not price; generally variable

costs will stay the same after a price increase. This is the reason why price

increases and decreases are so sensitive to the bottom line and explains a lot of

what follows in this chapter. Sales through volume increases earn profit after

variable costs have been covered; sales through price increases earn profit which

goes straight to the bottom line. Therefore, all things being equal, price increases

have the more positive impact on profitability.

As with most concepts in the financial area, the definitions of variable and fixed

costs depend on assumptions, in particular the timescale and the range of volume

assumed. To help us to move on at this stage, we will assume that the range of

volume change is relatively small, say 10 per cent or so, and the timescale

relatively short, within an annual planning period. However, it is important to

note that, by making these assumptions, we are assuming a tactical rather than a

strategic decision-making context.

The ratio of variable to fixed costs is the critical factor in determining the

financial impact of pricing decisions and it depends entirely on the nature of the

71

Cost behaviour – variable costs

£

Volume

Cost behaviour – fixed costs

£

Volume

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product and the sector. Managers often make simplistic assumptions about this

ratio, for instance that service industries are always ‘high fixed’ and that

manufacturing industries are always ‘high variable’. It is much more complex than

that. It is also important to understand that competitors in the same sector may

have different cost structures because of their different product processes and

organizational structures. This may also occur because of their different cost

strategies, for example some may outsource key services, some may not.

The best way of understanding and estimating the likely cost structure in a

company or sector is to start by assessing the likely variable costs, so that the fixed

costs will fall out as the balancing figure. There are not that many potential

headings under the ‘variable’ label and the list is likely to include the following:

■ materials

■ labour

■ energy and other ‘consumables’ in the production process

■ distribution

■ sales commission

■ some types of sales promotion.

All these costs are likely to be variable because more money will be spent on them

if extra volume is made and sold. In the case of labour and distribution costs, this

will depend on the way the business is organized, indeed there may be both fixed

and variable elements to both these cost headings. This is but one example of the

potential complexity of the analysis and of the ways in which competitors in the

same sector could have different cost structures. We will return later to the product

and business characteristics that can cause the cost structure to be high variable or

high fixed; in the meantime we will demonstrate the financial analysis process.

The logical next step, having made our assessment of variable costs, is to

calculate a variable margin, sometimes called a contribution ratio. Let’s assume

that this is a business with sales of £100m, total costs of £90m, therefore making

an operating profit of £10m. Let’s also assume that the variable cost structure is

as follows:

Sales 100

Materials 30Labour 10Energy and consumables 5Distribution 7Sales commission 3Sales promotion 2

Total variable costs 57


Profit after variables (contribution) 43

Variable margin (contribution ratio) 43%

As the business makes £10 operating profit, the balancing figure of fixed costs

must be £33 or 33 per cent of sales. Thus the profit and loss account would be

completed as follows:


Fixed costs 33

Operating profit 10

This enables us to work out the variable to fixed ratio as:

Variable 57 = 1.73Fixed 33

The relationship shown by this ratio is the key to understanding the financial

impact of pricing decisions: the higher the ratio of variable to fixed, the more

sensitive price changes will be. As a quick first illustration of its importance, let’s

look at the impact of a 10 per cent price increase on this business, assuming that

it will cause a 10 per cent loss of volume. This is often called ‘unitary elasticity’

by economists and is an outcome that might be considered acceptable by sales and

marketing managers. To enable the full impact to be understood and to help later

evaluations, we will do this calculation in two stages, firstly the 10 per cent price

increase without any volume decrease, then the impact of volume:

+10% price –10% volume

Sales 100 110 99

Variable costs 57 57 51.3

Profit after variables 43 53 47.7

Variable margin 43% 48.2% 48.2%

Note how the variable costs do not change as price increases, thus the extra £10

goes straight to the profit line. Yet when volume falls, there is a reduction in

variable costs because 10 per cent fewer products are being produced to achieve

the new sales level.

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If we now add the fixed costs to the equation, we can see the impact on the

bottom line:


Sales 100 110 99




Fixed costs 33 33 33

Profit 10 20 14.7

There are a number of things to note about this calculation which are fundamental

to the understanding of the financial impact of price changes and to a lot of what

follows. These are:

■ The impact of this +10 per cent, –10 per cent combination is, in this instance,

very favourable to the bottom line – profit has increased from £10 to £14.70.

■ The extent of this impact is dependent upon cost structure; the higher the

variable to fixed cost ratio, the more the impact of a price increase on profit is

likely to be favourable. An example to follow later will show that the same

price/volume combination for a business with only 20 per cent variable costs

will improve profit by only £1 compared with the above £4.70.

■ Note how, with this cost structure, a price increase has a dramatically beneficial

impact on net profit if there is little or no volume decrease as a result. In this

case the 10 per cent net margin would be doubled to 20 per cent because the

extra £10 profit from the increase falls straight through to the bottom line.

Naturally such an outcome is likely only in businesses with unusually low price

sensitivity characteristics; very few businesses could increase prices by 10 per

cent without significant volume falls.

■ The variable margin percentage will also be improved by a price increase and

the extent to which this happens will again depend on the cost structure. In this

case it has moved up by 5.2 per cent (from 43 per cent to 48.2 per cent) and

one impact of such a change could be to make this a more desirable product to

sell compared with others if profit maximization is the criterion.

■ It is also possible to extend this analysis further to work out the level of volume

which could be lost, while still keeping the profit at its previous level of £10.

This type of breakeven analysis will be of great value to managers who are

looking at price change options and we will return to it shortly.


Before moving on to other examples, including a similar evaluation for a price

reduction decision, it is important to confirm the relationship of this kind of

evaluation to our previous statements that pricing is dominantly a marketing issue.

Having a marketing-oriented approach to pricing does not mean that the financial

implications of different pricing strategies should be ignored or that simplistic

assumptions can be made. Nor does it mean that the financial evaluation should

necessarily drive the decision.

In the above case, for example, it would be quite valid for the manager in charge

of pricing to decide to forego the extra profit which would come from a 10 per

cent price increase, as long as he or she did so with full awareness of the amount

of profit at stake. It would not be valid to reject the price increase option without

knowing the potential benefit, which is a temptation for a marketer who wishes

to protect market share at all costs. A deliberate choice to forego the potential

short-term profit is acceptable, but ignorance of the financial impact is not.

THE IMPACT OF PRICE REDUCTIONS

When it comes to price reductions, there is a similarly sensitive impact on the

bottom line and again the extent depends on cost structure. The impact here is

even more important to understand; it is so easy for a sales or marketing manager

to advocate price decreases to achieve sales volume targets, without being aware

of the financial implications.

We will use the same figures as the earlier example, but this time the +10 per cent,

–10 per cent assumption is reversed. We are assuming a 10 per cent price reduction,

followed by a 10 per cent volume increase. Again we will show the comparison in

two stages.

–10% price +10% volume

Sales 100 90 99





Profit 10 – 3.3

Here we can see the reverse impact of the earlier example – a price reduction

without any increase in volume converts a profitable business with a 10 per cent

net margin into one that only breaks even. The way in which price reductions go

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straight through to the bottom line is plain to see. Some might question whether

the first stage in this scenario is too pessimistic even to need evaluation, and

whether such a significant price reduction could ever fail to increase volume. In

practice there may be circumstances in which this is indeed the outcome. For

instance, substantial price reductions may often be necessary to protect business

from going to competitors; or it may be that competitors retaliate with similar price

reductions, thus making the planned volume increase impossible to achieve.

When we examine the impact of the 10 per cent volume increase as a result of

the 10 per cent price reduction, we can see clearly that with this cost structure

such an increase is nowhere near enough to compensate for the profit lost through

the price reduction. The profit of £3.30 is £6.70 down on the profit before the

price increase and the variable margin percentage is well down too, from 43 per

cent to 36.7 per cent. This is not surprising when we remember the principle

stated earlier: that a price reduction is straight to the bottom line whereas the

volume increase is at the margin after variable costs. As this is a relatively high

variable cost business, this ‘–10 per cent, +10 per cent’ scenario is bound to be

very damaging to profitability.

THE PRICE/VOLUME BREAKEVEN CONCEPT

These examples should make it clear how important it is for management to

consider this type of price/volume evaluation before major pricing decisions are

made. However, a common, and to some extent justifiable, objection is that it is

usually difficult, if not impossible, to predict the likely volume changes.

One way of helping managers to cope with this problem is to work out the

‘volume breakeven point’ for a particular price decision. By this we mean the

amount by which we can afford volume to fall, or need volume to rise, in order

to maintain existing levels of profitability. We will demonstrate this first using the

above example of a proposed 10 per cent price reduction to show how much

volume is needed to compensate for the loss of profitability. For managers who

are not used to such evaluations, the result is surprising and difficult to predict

beforehand, which emphasizes the importance of the analysis. It is true that this

result applies only to this particular cost structure, but a variable cost at 57 per

cent of sales is not too extreme and is typical of many consumer products.

To calculate the breakeven, we need first to repeat the earlier calculation:


Sales 100 90 99






Profit 10 – 3.3

We need to find the level of volume increase that takes the profit back to £10. To

achieve this we need to add the required profit to fixed costs and thus arrive at a

‘required variable margin’ – £10 + £33 = £43.

The variable margin is bound to move directly with increased volume as its

component parts – sales and variable costs – both do so. To move from £33 to £43

requires an increase of just over 30 per cent. Therefore we can say that, at this cost

structure, a 10 per cent price reduction requires a 30 per cent volume increase to

achieve the same level of profit as before – which must be valuable information for

a marketing manager contemplating a price reducing promotion, or a sales manager

proposing to offer a discount. The strategy may still be implemented, but there can

be no doubt about the potential short-term loss if this level of volume is not achieved.

To confirm the position, we can examine the profit and loss account if the 30

per cent volume increase is achieved:


Sales 100 90 +30% = 117

Variable costs 57 57 +30% = 74

Profit after variables 43 33 +30% = 43



Profit 10 – 10

There is a further important point to make about this outcome. We stressed earlier

that our definition of variable cost is related to short-term movements within a

relatively narrow range. This volume increase of 30 per cent is likely to be well

outside that range assumption, and many of the ‘fixed’ costs could well become

variable if volume rose to that extent. Thus even a 30 per cent volume increase

might not maintain the required levels of profitability because some of the profit

would be taken away by these ‘creeping’ fixed costs. We will return later in this

chapter to this important issue of long-term fixed cost behaviour.

We can now carry out a similar calculation before a proposed price increase:

how much volume can we afford to lose after the 10 per cent price increase and

still break even? It is not valid just to reverse the above 30 per cent answer – the

mathematics does not work like that. Again you have to look at the profit and loss

to make the calculation:

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Sales 100 110 99





Profit 10 20 14.7

Again we can use the concept of ‘required variable margin’. We can afford for this

to come down by £10 to £43 after the price increase, compared with its theoretical

‘post increase’ level of £53 – 10 as a percentage of 53 is just under 19 per cent.

Therefore we can say that, at this cost structure, volume could fall by 19 per

cent after a 10 per cent price increase and the same level of profit would still be

achieved – which must be valuable information for a marketing manager

contemplating a price increase. It could also be a stimulus for management to

initiate an increase they had not contemplated previously.

The practical application of such price/volume evaluations can work in a number

of ways. The number of potential combinations of variables in the cost, price and

volume mix makes this an ideal application for a spreadsheet, with financial and

marketing people working together on likely scenarios to complement their decisions.

We have also seen sales people in the automotive sector in the USA carrying around

pre-calculated cards that show the breakeven levels for every feasible variable margin

and price/volume combination. Sales people in that business have no doubt about

how much extra volume they have to achieve if they choose to offer discounts. Even

more important, because they are targeted and rewarded on the basis of profit rather

than sales or volume, they have every reason to study their cards before quoting

prices to customers.

THE IMPACT OF DIFFERENT COST STRUCTURES

So far we have assumed one cost structure, which provided a variable margin of

43 per cent of sales and a 1.73 variable to fixed ratio. We will now show two

opposite extremes: a variable margin of 20 per cent with a variable/fixed ratio of

8.0 – typical of a commodity business where most of the cost is raw material –

and a variable margin of 80 per cent with a variable/fixed ratio of less than 0.30

– more typical of a service business like an airline or a software house.

If we take the business with a 20 per cent variable margin and consider a plan

to reduce price by 10 per cent, the situation is even more extreme than the earlier


example. Moving straight to the ‘breakeven’ scenario, it can be seen that the 10

per cent price reduction requires a 100 per cent volume increase to restore the

profit lost by the price reduction:


Sales 100 90 180

Variable costs 80 80 160

Profit after variables 20 10 20

Variable margin 20% 11% 11%


Profit 10 – 10

If we look at the same evaluation for the low fixed cost business we see a very

different picture. The price reduction strategy is much more feasible because of

the lower variable and higher fixed costs:


Sales 100 90 103





Profit 10 – 10

One implication of these two examples is that cost structure is likely to be key to

the pricing strategies adopted by the operators in a particular sector. The higher

the variable costs, the less feasible will be a price reduction strategy; the higher the

fixed costs, the more likely this is to occur.

THE CAUSES OF VARIATIONS IN COST STRUCTURE

From the above it can be seen that cost structure – the ratio of variable to fixed

costs – is fundamental to understanding the impact of price changes and to the

prediction of competitors’ pricing behaviour. It is therefore important to examine

the factors that cause a business or product to have a particular level of variable

costs and to consider the extent to which this can be changed.

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First let’s examine again the assumed cost structure which led to our 43 per cent

variable margin and the relatively high 1.73 variable/fixed ratio:

Sales 100

Materials 30Labour 10Energy and consumables 5Distribution 7Sales commission 3Sales promotion 2

Total variable costs 57


This proportion of material costs to sales is perhaps the biggest factor in determining

cost structure, and also the hardest to change. If you are in the business of food

trading or processing, for example meat or vegetables, the proportion of variable

costs is always going to be high. If, on the other hand, you are in a high added value

business such as pharmaceuticals, where materials are often much less than other

costs such as selling, research and marketing, the proportion of variable costs will be

much lower. It will be difficult if not impossible to change this situation and

competitors are likely to be in the same position.

The most extreme examples of businesses with low variable costs and therefore

high fixed costs are those with no raw material costs at all, for example service

businesses such as management consultancies, telecommunications or advertising

agencies. The cost of taking on extra business is very often negligible because the

dominant cost is the salaries of professional and technical people who, unless

there is major restructuring, are likely to be employed whether or not new

business comes in. This has enormous significance for likely pricing behaviour,

which we will examine in the next chapter.

However, reservations always have to be made when discussing and comparing

cost structures. It is usually possible to change the normal cost behaviour to some

extent by management action. In most cases such action moves costs from fixed

to variable, firstly because this is usually easier to achieve, and secondly because

this is the direction that management frequently wish to take to reduce the level

of risk in the business.

A classic and extreme example of such a move would be a company moving its

entire sales force to a commission-only remuneration basis, a strategy sometimes

undertaken by financial services organizations wishing to reduce their risk and

fixed cost exposure. Or a management consulting organization moving some or

all of its professional staff to a freelance employment basis so that payment is

made only when work comes in.


Another common way of converting costs from fixed to variable is to move

distribution costs from being a self-managed fixed overhead to an outsourced

variable cost, via a contract which ensures that costs are incurred only when sales

are made. Note that this and other outsourcing strategies do not automatically

change the cost structure; this happens only if the terms of the contract move the

fixed cost risk to the supplier. Many outsourcing deals leave the company with

costs that are just as fixed as before.

Costs can and do move in the other direction, from variable to fixed, though it

is often as a by-product of other management strategies rather than as a deliberate

intention to change the cost structure. A higher proportion of fixed costs often

occurs through growth and investment; as processes become more mechanized,

capital investment takes place, a greater proportion of staff become salaried and

a supporting infrastructure of shared services is created. For this reason it is

usually true that the larger the player in the market, the higher will be the

proportion of fixed costs compared with smaller competitors.

These comments should make it clear that businesses in the same sector, with

different sizes, histories and strategies, will not necessarily have the same cost

structures, even if their products are identical. Therefore it is vital to understand

your own and your competitors’ cost structures, as part of an effective pricing

strategy. The next chapter will take us further down that road.

LONG-TERM FIXED COSTS

One final point to confirm before we move on. A possible conclusion from the

earlier example of a low variable/high fixed cost business is that a price reduction

strategy is much more feasible than it would be for those businesses with high

variable costs, for example only 14 per cent volume increase was required after a

10 per cent price reduction as follows:


Sales 100 90 103





Profit 10 – 10

If, however, we remember what was said earlier – that the definition of ‘variable’

would change if a longer period and range of activity were to be assumed – the

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scenario could be very different. In practice, fixed costs are rarely fixed for ever,

they usually go up in steps with volume; in practice most of them are long-term

variable costs. Figure 7.2 shows the fixed cost line over a period of years.

Fig. 7.2 The fixed cost line over a period of years

If, therefore, decisions to reduce price and increase volume were to be made

consistently over a period of years, the impact would be to increase the fixed cost

base of the business and remove the potential profit. This issue will be revisited in

the next chapter when we discuss the pricing of marginal business.

Cost behaviour – long-term fixed costs

£

Volume

8Cost structure and pricing behaviour

The breakeven chart 85

The temptations of a high fixed cost structure 86

Marginal pricing 87

The pros and cons of marginal pricing 89

Price behaviour in the high variable cost business 93

Understanding competitors’ cost structures 93

■

■

■

■

■

■

83

Cost structure and pricing behaviour

THE BREAKEVEN CHART

The previous chapter established the principle that cost structure determines the

impact of pricing decisions on the bottom line. It therefore follows that cost

structure is also one of the keys to the prediction of pricing behaviour by the

various players in the market place. We can illustrate this further by showing the

cost behaviour graphs again, but this time with the variable and fixed cost lines

on the same axis (Figure 8.1). Note that, as the variable cost line is inserted above

the fixed cost line, the top line represents total costs.

Fig. 8.1 Cost behaviour: total costs

It can be seen that this graph represents a business with a relatively high fixed, low

variable cost structure, which causes the total cost line to rise fairly gently with

volume. To confirm the likely characteristics which could determine this structure:

■ low material cost

■ automated processes

■ professional staff

■ high capital investment

■ high research and marketing costs

■ large supporting infrastructure.

Though high fixed cost characteristics are often associated with the larger players

in the market, the type of product and industry sector are more likely to be the

dominant factors. We also mentioned in the previous chapter that management

actions can sometimes change cost structure to some extent, so therefore each

competitor needs to be examined in its own unique context.

In order to consider further the likely pricing behaviour of a business with such

a cost structure, the picture can be completed by the insertion of the sales line on

this graph, thus making it into a breakeven chart (Figure 8.2). The sales line rises

85

£

Volume

Total costs

Variable costs

Fixed costs

86


directly with volume until the point where it crosses the total cost line and achieves

breakeven. Note that the implied assumption here is that a standard, consistent

price is charged on all products, thus the line is straight and diagonal.

Fig. 8.2 Breakeven chart

THE TEMPTATIONS OF A HIGH FIXED COST STRUCTURE

Businesses with this kind of financial structure need to have a firm, consistent

pricing strategy, together with strong nerves. Top management need a clear policy

based on perceived value to the customer, rather than responding to short-term

cost and profit considerations. This is essential at any time for such a business, but

is particularly important when times are hard and business is in a downturn.

Let’s examine the day-to-day reality of decisions in a business with such a low

variable, high fixed cost structure. We will assume the variable to fixed ratio of

0.29 (20/70) from the example in the previous chapter, thus the profit and loss

account looks like this:

Sales 100

Variable cost 20

Profit after variables 80

Variable margin 80%

Fixed cost 70

Profit 10

The company might be in management consulting or advertising with a highly paid

professional staff whose salaries have to be paid whatever the current level of

£

Volume

Total costs

Sales

Breakeven point

Variable costs

Fixed costs


business. Or perhaps an airline which is committed to a particular number of

scheduled flights and which pays salaries to the full-time staff necessary to run them.

In these circumstances it is vital that the pricing strategy encourages management to

maintain prices on a full value basis, however tough the current business climate

may be. They should not be deterred from their long-term strategic goals by the need

for short-term profit and should choose the options of staff reductions and/or

reduced profitability rather than compromising the integrity of the pricing structure.

That’s the theory – the practice can be very different. Perceived customer value

is a valid basis for pricing only if the competitors play the same game and avoid

that all too common temptation – the sometimes justifiable but potentially

disastrous slippery slope of marginal pricing.

MARGINAL PRICING

Marginal pricing is a term that can be used loosely, so we will start with a working

definition:

Marginal pricing is the pricing of products at below full cost and normal

market price, based on a calculation of marginal cost.

Clearly this requires a definition of marginal cost. This is defined as:

Marginal cost is the extra cost incurred as a result of accepting more

business.

The latter has been adapted from the common textbook definition of ‘the cost of

one more unit’ in order to make it more practical and wide ranging. This

definition enables the marginal cost concept to be extended to service businesses

and to larger slices of business than the next unit – for example, a new contract,

a new product or a new customer.

Clearly there has to be a close link between variable cost and marginal cost and

in many cases they are identical, particularly for small increases in volume. They

diverge when the extra volume requires a step increase in fixed costs, in which

case marginal cost will be the variable cost caused by the extra volume, plus the

extra cost of the step.

There is often confusion between marginal cost and marginal price, caused by

treating them as if they were the same concept. This is misleading and dangerous.

Marginal costing is an important and valuable costing technique that is used to

support many types of business decision. It does not necessarily have to lead to a

lower than normal price, it merely highlights the potential profitability of different

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decision options in a clear, incremental form. Marginal pricing is the use of marginal

cost to justify a lower than normal price and does not necessarily have to follow from

marginal cost; that decision depends on pricing strategy and management judgement.

Let’s remind ourselves of the profit and loss account of this high fixed, low

variable cost structure:

Sales 100

Variable costs 20


Variable margin 80%

Fixed costs 70

Profit 10

Let’s now assume that there is an opportunity for extra business and that the

variable cost is £2. There will be no step increase in fixed costs, thus this figure of

£2 will be the marginal cost too.

Imagine that you are running this business and times are hard, cash is short and

you are desperate for some extra profit to meet the shareholders’ profit target.

Should a marginal price be quoted to bring in the business? In these circumstances

the first question to be asked and answered is: what is the maximum price which

will deliver the business? Too often a marginal cost evaluation can encourage

management to quote lower than is necessary because of perceived pressure from

customers and competitors. Sometimes marginal pricing reflects the insecurity and

uncertainty of management who are unsure of their competitive position. For the

purposes of this example, we will assume that a price of £5 is judged to be

necessary to deliver business from this customer or contract.

The temptation to accept business at marginal prices is great because the stakes

can be so high, particularly where there is spare capacity in the industry. Assuming

that the current pricing strategy represents value to customers, the ideal price for

this extra business would presumably be something in the region of £10, which

would be necessary to maintain the existing variable margin level of 80 per cent;

thus we are being asked to accept a price at half the normal level. Yet any price

above £2 is going to help the bottom line in the short term and the impact can be

considerable. If we take on this marginally priced business, the profit and loss

account will now look like this:

Sales 105

Variable costs 22



Variable margin 79%

Fixed costs 70

Operating profit 13

Note that the overall variable margin has declined by 1 per cent because of this

new business and this is an important control on the effectiveness of pricing

strategy implementation. However, a management team with under-utilized

resources and a short-term profit target to deliver may find this reduction to be

an acceptable sacrifice when compared with the bottom line benefit. The £3

variable margin (£5 sales less £2 variable cost) comes straight through to the

bottom line and increases operating profit by 30 per cent (from 10 to 13). This is

the kind of leverage that can be achieved by marginal business for a high fixed

cost organisation, which is why marginal pricing is so tempting.

We can see the impact of marginal pricing in visual form if we look at a revised

breakeven chart (Figure 8.3). For illustration purposes we are assuming that the

marginally priced business is accepted only after breakeven has been achieved. The

new dotted line on the graph clearly shows that, even though the post-breakeven

sales are at lower price and margin levels, they easily cover the incremental total

cost and deliver significant extra profit.

Fig. 8.3 The impact of marginal pricing

THE PROS AND CONS OF MARGINAL PRICING

It would be wrong to suggest that marginal pricing should never take place. It

would also be naïve to suggest that it is not practised by many companies, in many

sectors. Sometimes this is because they choose to do so, in other cases they may

be forced into such a practice by competitors and by circumstances. It is, however,

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£

Volume

Total costs

Sales

Breakeven point

Variable costs

Marginally priced business

Fixed costs

90


a pricing practice which is fraught with dangers, the most commonly quoted of

which are outlined below.

The slippery slope

Good pricing requires discipline. Once management weaken their stance and

accept that any price over variable cost is worthwhile because it provides ‘a

contribution’, the floodgates can open. It can start as one contract in ‘unique’

circumstances that will not be repeated, or as one new product that will not be a

substitute for others, or as one new customer whose business has been chased for

years. These arguments may be valid in some circumstances, but once this kind of

reasoning takes hold, it can become impossible to avoid that slippery slope which

makes marginal pricing the norm. In these circumstances the breakeven chart

takes on a very different shape as the whole sales line changes its slope, creating

lower profitability and a higher breakeven point (Figure 8.4).

Fig. 8.4 How marginal pricing can affect the breakeven chart

Customer spread

It is often difficult to prevent information about special prices from spreading from

one customer to another. The importance of this factor depends to a large extent on

the visibility of pricing levels and the extent to which customers can make

comparisons. This is often underestimated at the time when special price concessions

are made. What was intended to be a unique price or discount for a major new

customer can become the standard concession that eventually spreads to all

customers of a particular type. It may not only be the customers who make the

request – it may be sales people who manage different accounts and who want their

own customers to have the same price concession as others, particularly if they are

motivated and rewarded on volume rather than profit targets.

£

Volume

Total costs

Sales

New sales

Breakeven point

Variable costs

Fixed costs


Creeping fixed costs and complexity

A key argument in favour of marginal pricing is that the fixed cost base is already

there and that any contribution of variable margin will go straight through to the

bottom line. This impact can often be sensitive and transformational, as we saw

in the earlier example. Once again, however, we must remember the limitations of

the conventional definition of variable costs and appreciate that step increases in

fixed costs will take place at a number of stages along the way.

This is perhaps the biggest danger of all in marginal pricing. A number of

individual decisions may be taken on a separate basis, each of which seems to be

justified on its own because it adds incrementally to the bottom line. Yet the

cumulative impact of these decisions is to cause an increase in the step of fixed

costs, because capacity is finally exhausted or because more complexity has

gradually been created. The marginal approach to costing and pricing ignores this

factor and this is a major reason why fixed costs are often allocated for the

purposes of pricing and profitability assessment. There will be more about fixed

cost allocation in the next chapter.

Despite all these dangers and reservations, and despite our emphasis on value

pricing in earlier chapters, marginal pricing can and should be a valid strategy in

certain circumstances. The ‘pro’ arguments are as follows.

Competitor attack

Marginal pricing can be used as a deliberate strategy to embarrass or weaken a

competitor. In these circumstances there may be conflict with the laws and

business regulations of certain countries and clearly such a strategy is valid only

if it is legally acceptable. If we leave aside this factor and the ethical issues

involved, there is no doubt that, in the right circumstances, marginal pricing can

be a highly effective competitive weapon. The large player, perhaps with higher

fixed and lower variable costs than competitors, can use its financial strength

temporarily to drive prices down to levels that the smaller, weaker competitors

cannot sustain, thus forcing them out of the market. On the other hand, in some

markets the smaller player, with lower fixed costs and more flexible profit

objectives, can use similar tactics to take business away from the market leader.

Competitor pressure and survival

It is possible that your business may be the one under attack. If you have

competitors which are, for whatever reason, pricing marginally while providing

equal value, you may have little choice but to follow suit. In the long term a

business cannot deliver value by pricing its products on a marginal basis, but to

achieve long-term objectives it is necessary to survive and sometimes marginal

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pricing is essential just to keep afloat. Any variable margin or contribution is

better than nothing if you have a wage bill to cover, and sticking to a principled

and consistent ‘value’ pricing strategy is no argument when the receivers move in.

In the long term you must hope and expect that this situation will change,

otherwise there may be no future for your business in that market. If that change

is unlikely to come about through external factors, it is vital to develop an

effective new marketing strategy that makes your business less vulnerable to this

kind of competitive price pressure. This would be likely to involve the strategies

mentioned in Chapters 2 and 5 – the targeting of particular segments and the

creation of differentiation through other elements of the marketing mix.

One-off opportunities

This is perhaps the most valid and acceptable use of marginal pricing. There might

be a ‘one-off’ opportunity to use spare resources on activities which deliver

contribution without jeopardizing the mainstream business. This would have to

be in a separate segment with no links to mainstream business and with no

likelihood that quality of products or service to existing customers would be

adversely affected. There must also be no adverse impact on image, reputation or

staff motivation. If all these demanding criteria are met, if the pay-off is worth the

trouble and provided the activity is within core competences, marginally priced

business can and should be accepted.

New segments

Sometimes marginal pricing can be a deliberate strategy that is aimed at particular

segments with different characteristics to the main business. Typical examples

would be companies that have a special pricing policy towards export markets,

and consumer goods companies supplying to catering or industrial outlets as well

as to retail customers.

However, though such a strategy can work and can provide valuable incremental

profit for a period, it is unlikely to prove valid in the long term. At some stage there

are likely to be resource constraints and new investments in capacity will have to

be made. In these circumstances new fixed costs will be created and the ‘marginal’

business will have been the indirect cause, yet at marginal prices the profitability

levels are unlikely to be sufficient to justify the investment. Management must be

sure that such new segment business is priced at a level which has the long-term

potential to be profitable in its own right, otherwise it should not become a major

new source of business.


PRICE BEHAVIOUR IN THE HIGH VARIABLE

COST BUSINESS

We have focused so far on the high fixed cost business because this provides the

richest and most challenging scope for assessment and speculation about competitor

behaviour. In the high variable cost business it is all much more predictable, with less

room for manoeuvre. As we saw in the previous chapter, there is much less scope for

price reductions because the margins are so small and it will be the maintenance of

profit, rather than the creation of volume, that will be the highest priority.

There will be much less scope for marginal pricing because the major elements of

cost are variable, usually with a broadly similar structure for all competitors. The key

to a successful pricing strategy therefore is to know where you and your competitors

are likely to have cost advantage and to act accordingly. If a major competitor is able

to buy and/or produce at significantly lower variable cost, it will be necessary to

develop a marketing strategy to counter their cost advantage. The starting point must

be to make as informed and accurate a comparison as possible.

UNDERSTANDING COMPETITORS’ COST STRUCTURES

It will not normally be possible to obtain a fully accurate and complete picture of

all competitors’ cost structures because insufficient cost analysis is available in

published accounts; however, it will usually be possible to make some informed

assessments from the available data. The starting point should be the one area

where you have full information – your own cost structure – and further analysis

should then be carried out to make the best possible estimate of differences

between your position and that of the other main players.

Using the first example from the previous chapter, assume that your own cost

structure is as follows:

Price 100

Variable costs 57


Variable margin 43%

An assessment should then be made of the extent to which your competitor will have

a similar list of variable costs and how these will vary from your own situation – for

example, by better buying power on raw materials, different labour arrangements,

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94


distribution patterns, sales remuneration systems, etc. Note again that at this stage it

is not necessary to look at fixed costs, only variables, because the fixed costs will fall

out as the residual figure.

So assuming that this is a larger competitor with better buying power and more

fixed cost remuneration, we can now estimate that this competitor’s variable costs are

50 per cent of sales compared with our own 57 per cent. We now look at the profit

and loss account in their published accounts. Let’s assume that it looks like this:

Sales 200

Costs 170

Operating profit 30

Operating margin 15%

We can now restructure the competitor’s profit and loss account to show variable

costs and to compare with our own on the same basis:

Them Us

Sales 200 100

Variable costs 100 (50%) 57 (57%)

Variable profit 100 43

Variable margin 50% 43%

Fixed costs 70 33

Operating profit 30 10

Operating margin 15% 10%

Note that we arrived at the competitor’s fixed costs as a balancing figure once we

knew the variable cost and operating profit numbers. Note also the different

variable to fixed ratios – their 100/70 or 1.43 compared with our 57/33 or 1.73.

This competitor has a lower proportion of variable costs and therefore a higher

proportion of fixed costs than we do.

With this information and with the comparative price data and other competitor

information that was recommended in Chapter 3, we now have valuable information

to help us develop a marketing strategy, and through it a pricing strategy, which

enables us to compete in the most effective way. We may for instance need to find

segments where our smaller size, greater flexibility and lower fixed cost base provide

us with competitive advantage.

The next chapter covers another area of pricing where financial evaluation is

necessary – those circumstances where we have no choice but to start our pricing

evaluation on a ‘cost plus’ basis.

9Cost plus pricing revisited

The case against 97

The case in favour 98

The costing process 98

Activity-based costing 101

Profit objectives 102

The concept of ‘required contribution’ 103

The value of financial assessment 105

■

■

■

■

■

■

■

95

Cost plus pricing revisited

THE CASE AGAINST

By now it should be clear that cost plus pricing methods are not compatible with

the marketing, value-based approach to pricing which has been advocated in the

book so far. To repeat the point we have made several times, customers do not

know about your costs and do not care about your costs, so why should costs come

into the pricing equation? A cost plus calculation may arrive at a price which is

above the correct value-based level, in which case few if any customers will buy; or

it may arrive at a price below that level, in which case the wrong value message is

being given to the customer and a profit-making opportunity is being lost.

A further argument against the use of cost plus is that it simply isn’t necessary.

In most market situations all the data you need to develop a pricing strategy is

available from the current positioning of competitors in the market place. An

existing player in a market should know the pricing structure of the key

competitors and a new entrant can find out the position by observation and

research. The place of cost analysis is not to calculate a desired price but to work

out the margin being achieved at various levels of profitability, the sort of

price/volume evaluations described in Chapter 7.

The final argument is that cost plus evaluations are, in practice, impossible to

achieve with absolute accuracy and the use of costing techniques in this context

may present a false impression of precision which misleads the pricing decision

maker. To develop this point further, there are two critical steps in the building up

of a typical product costing:

■ Work out the direct costs, which will include variable costs plus identifiable,

incremental fixed costs.

■ Assess existing general fixed costs and agree a basis for apportioning them to

the product.

The first of these steps is relatively straightforward; the second is fraught with

difficulty and is, in nearly every case, impossible to achieve in a way that is

accurate and unquestioned. Each accountant and analyst, each pricing specialist

within each competitor, is likely to have different views about the best way to

achieve fixed cost apportionment, so no one company is likely to have the

universal truth. There have been improvements to the accuracy of costing systems

in recent times through the introduction of activity-based costing (ABC)

approaches, but the use of ABC is patchy and inconsistent. Only if there are

standard methods of costing in the industry (as exists in the building sector to

some extent through the use of quantity surveyors) will there be any degree of

uniformity. We will return to ABC later in this chapter.

97

98


THE CASE IN FAVOUR

Despite all these reservations about cost plus pricing, we are to spend the rest of

the chapter on its coverage and this requires an explanation. The reason is that

there are circumstances where the cost plus approach has to be adopted because

there is no choice. This occurs where there is no standard product in the market

place and no reference point for the assessment of a market price. The most

obvious example would be a unique ‘one-off’ house or ship-building contract;

cost has to be the starting point because there is no similar product or contract to

benchmark against.

There are other situations where, despite its limitations, cost plus has a role to

play in the price decision-making process, for example:

■ a proposal to introduce a new product where there is limited or conflicting

information about the likely appeal and value to the customer;

■ your response to a new product introduction from another competitor, where

you are uncertain about the validity of their price;

■ where cost plus is the industry convention, with generally accepted methods of

costing and where you are looking for guidance on the likely price position of

new and existing competitors;

■ as part of a strategic review, to calculate the ideal price you would like to charge

in order to cover all fixed costs and make the required margin to meet

shareholder objectives. Even if it is not possible to implement the results of such

a calculation, a realistic assessment of the gap between the current position and

the ideal requirement can provide valuable guidance to management when they

are assessing strategic options.

We are not saying that cost plus will necessarily determine the final price in the above

scenarios; we are saying that a calculation on this basis will be a valuable support to

the decision-making process. One problem about introducing any kind of cost plus

approach into a business is that it can become too dominant and can reduce

management’s ability to be flexible and to apply common sense. All the reservations

about the limitations and potential inaccuracy of the costing can be forgotten when

a cost-based price is introduced into discussions. It is therefore necessary constantly

to remind management of the inevitable inexactness of the costing process.

THE COSTING PROCESS

The two stages in the calculation of a typical costing can be complemented and

completed by a third stage that converts the costing into a desired price – the

addition of required margin. Thus we have a three-stage process:


■ calculate the ‘direct’ cost – those costs which are clearly identifiable with the

product or contract;

■ add on the ‘indirect’ costs – an apportionment of general fixed overheads;

■ add on a profit margin to arrive at the required price.

It should be recognized that a costing of this kind becomes progressively less

precise as you move through the process; it also becomes less and less comparable

with what competitors may be calculating and therefore a less useful guide to their

likely pricing behaviour.

We will not dwell on the first stage – the direct costs – because these are likely

to be relatively straightforward and dependent on the nature of each product,

service or contract. There is, however, one important assessment to make in

parallel with your calculation of direct costs – your view on the comparative cost

levels of key competitors. As mentioned in the previous chapter, you need an

assessment of their advantage or disadvantage in buying power of raw materials,

their utilization of labour, their efficiency of production, their distribution and

other operating costs. The more that these differences are considered as the

costing progresses, the more the final result is likely to be used in the right way.

The tendency to pass on relative cost inefficiencies to customers by means of cost

plus pricing is one of its biggest dangers and is sure to end in tears. Conversely,

the passing on to customers of relative cost efficiencies may result in a lost profit

opportunity and a price that does not reflect true value.

It is in the latter two stages of the costing – the addition of overhead and the

calculation of required margin – that problems arise and this is an area where

there is much misunderstanding. We will illustrate the problems with an example

of a new product introduction; we have to simplify to make some general points.

The key simplifying assumption is that there is a standard unit of product and that

the new product can be measured in the same terms.

Product x

Direct costs – materials, labour, variable overhead £5.00 per unit

Units produced during most recent period 200,000

Total existing fixed overhead £600,000

Forecast volume for new product 15,000

Total capacity 300,000

The problems can be illustrated by listing the likely questions that should now be

asked by those who are preparing the costing, for example:

■ How can we forecast the new product volume accurately when we don’t yet know

the price? This is the classic circular and intractable problem of ‘cost plus’ pricing.

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100


■ Assuming that fixed overheads of existing products are now being costed at

£3.00 per unit (£600,000/200,000), do we now reduce their costing to a lower

figure, for example, £2.79 (£600,000/215,000)?

■ Is this new rate of £2.79 also the correct rate for the new product?

■ Should the overhead rate be based on capacity rather than existing utilization?

■ What if the volume forecast for the coming period is more than 200,000?

These questions should illustrate the difficulty of establishing the ‘correct’ basis

for fixed cost apportionment. However, it is much easier to highlight the problem

than it is to provide the right answer. The best but by no means satisfactory way

of solving the problem is to produce total overhead and sales volume forecasts for

the coming period and, assuming that the latter is within realistic capacity

utilization, to use this for the unit cost calculation. For example, assuming no

change to overheads and a total volume forecast for all products of 250,000 units,

the unit cost rate would be £2.40 (£600,000/250,000) and this would apply to

both existing and new products.

Those who already have doubts about the cost plus approach and who also

realize how unreliable volume forecasts can be will probably put away their

calculator at this stage, deciding perhaps that market-based pricing is not so bad

after all. Their doubts might be exacerbated by two further important questions

that add even more to the complexity:

■ Should we include non-production items – sales, marketing, research, admin,

etc. – in our definition of overhead, and if not, why not?

■ Is the ‘per unit’ apportionment method really an effective way of charging these

and other costs to products?

The answer to the first question is undoubtedly yes – all fixed costs should be

brought into a cost evaluation of this kind. However, it is interesting that, when

you examine cost plus pricing systems as operated in many companies, it is

common to find that the non-production costs are treated quite arbitrarily, almost

as an afterthought. There may be great detail, even spurious accuracy, when

arriving at detailed apportionments of factory costs; but then the other overhead

costs – which are frequently a high proportion of the total – are lost within some

vague and general mark-up on production cost. This is not logical; there is no

difference in principle and if these other costs are to be included, they should be

analyzed to the same degree of detail as those of the factory.

However, the inclusion of all fixed costs makes the answer to the second

question even more likely to be ‘no’. The use of arbitrary apportionment methods

like ‘per unit’, ‘percentage of sales’ or even ‘per labour hour’ is not likely to reflect

the true way in which resources are used by new and existing products. One man


– Professor Robert Kaplan of Harvard Business School – has highlighted this

problem through his advocacy of the technique of activity-based costing.

ACTIVITY-BASED COSTING

Like many successful management concepts of the 20th century, ABC is an

essentially simple and common sense approach. It was used by good financial

analysts way before Kaplan provided that important service delivered by the best

academics – he gave the technique a label and a memorable acronym. More

importantly, he alerted management to the dangers of relying on conventional

costing methods and accepting them as absolute truths.

Kaplan’s work was not aimed at pricing alone but, by implication, this was a key

element of his thinking. He claimed that the arbitrary allocation of overhead costs

often led to products being costed inaccurately. This in turn led to price levels that

did not reflect the true utilization of resources; it also led to inaccurate perceptions

of product profitability. He criticized particularly the early approaches to product

costing in manufacturing organizations, which required overheads to be charged to

products on the basis of labour hours. He said that this may have been an

appropriate basis for costing in the early days of manufacturing, but as factories

become more automated and more complex, more sophisticated methods of

costing are required.

The principles of ABC are simple. Each cost heading is looked at individually

and the true ‘driver’ of cost is identified. For cleaning costs, the driver would be

the space to be cleaned; for supervision costs, the number of people to be

supervised; for depreciation costs, the number of machine hours in operation; and

so on. This is not rocket science, merely common sense and the ideal practice of

good financial analysts well before Kaplan provided the label. However, these

analysts were frequently concerned about the cost effectiveness of the process

because analysis to that level of detail is time consuming and expensive.

This issue of cost effectiveness is the key problem with ABC and this has held

back its widespread application in business. If ABC is to be carried out properly,

it requires time and much more detailed information about cost behaviour than is

commonly available in an average business. A substantial investment of resources

therefore has to be made and this can be justified only if there is a significant pay-

off as a result of the analysis. Each business has to decide whether in its own

unique context the benefits of ABC evaluations justify this investment.

Two interesting changes of emphasis have taken place, which have extended the

application of ABC to different contexts and different businesses. First has been its

extension to non-production costs, thus helping to provide a more accurate and

101

102


effective means of bringing these items into the cost and profitability evaluation

processes. Second has been the move towards placing ABC in a strategic rather than

an operational context, seeing it as a means of providing more accurate long-term

profitability evaluations rather than guidance for day-to-day decisions.

This fits very well with the fourth and last of the possible uses of cost plus

pricing mentioned earlier – to provide insight for a strategic review of the

business. An ABC costing can tell you what, in an ideal world and in the long

term, you would like the price to be to cover full costs and achieve required profit

objectives. It can provide calculations of current and likely future profitability

under a number of different scenarios. This can concentrate the mind on the range

of long-term strategic options, which might involve cost reduction, ways of

increasing prices or even exit from the market.

Such evaluations can be carried out without ABC methods, but if so there will

always be doubt about the validity of the answers. Advocates of ABC will quote

examples where the traditional arbitrary methods proved to be so wrong as to be

misleading, even worse than having no information at all. One food company in

the Netherlands discovered from an ABC analysis that half its product range in

one category was pricing below full cost when previously it was thought to be

highly profitable. The lesson they learnt from the experience was that such

costings should be carried out properly with ABC or not at all.

PROFIT OBJECTIVES

The final stage of a ‘cost plus’ pricing evaluation, the addition of a required

margin, is no less easy than the apportionment of cost. It is, however, an essential

step if the costing is finally to arrive at a selling price. The mark-up for margin has

to reflect the full extent of what needs to be covered, for example if non-

production costs are excluded in the first-stage cost evaluation, the margin

requirement must include their recovery in addition to the required profit.

The problem with this process is that building on a required margin to cost is

not the logically correct way of apportioning profit requirements to products or

parts of the business. The objective of a business is to create value for its

shareholders, which means making a return on investment in excess of its cost of

capital. Therefore the way in which profit objectives should be apportioned to

products or business units is on the basis of capital employed, not sales. Those

products with large investments in fixed assets and working capital should have

higher profit margin targets than those without such investment.

Thus there should be investment-based profit targets which are converted into

detailed financial plans with agreed margin goals and it is these that should form

the basis of the final stage of the pricing evaluation. This is now demonstrated,

using the earlier example and adding some extra information as follows:


Product x

Direct costs – materials, labour, variable overhead £5.00 per unit


Total forecast fixed overhead £600,000


Total forecast volume 250,000

Total forecast sales £2,000,000

Profit target £400,000

Note that the forecast profitability of the business requires a 20 per cent operating

margin (400,000/2,000,000), and the costing assumption is that every product

must deliver its share. The final cost/price calculation would now look like this:

Direct cost £5.00

Share of fixed costs (£600,000/250,000) £2.40

Total cost £7.40

Required profit margin (25 per cent on cost) 1.85%

Total required price £9.25

Note that the margin has to be 25 per cent on cost to deliver the required 20 per

cent margin on sales (1.85/9.25 = 20 per cent). This confirms a simple but

commonly misunderstood point: that margin percentages marking up on cost will

need to be different from, and higher than, those which are related to sales.

THE CONCEPT OF ‘REQUIRED CONTRIBUTION’

It can be argued that the separation between fixed overhead and required profit

margin is an artificial one that creates unnecessary complication and inflexibility.

In the above example there might be a reluctance to go below £7.40 because we

are ‘losing money’ when in fact the circumstances might warrant such a price. As

we saw in the last chapter, marginal pricing is sometimes justified and anything

over the incremental cost will provide a contribution to fixed overheads.

There are two further arguments in favour of combining fixed overhead and

profit requirements. First, it can be argued that profit is just another form of fixed

cost that has to be covered to meet the needs of shareholders. Interest payable to

banks is usually treated as a fixed cost, therefore so should the return required for

103

104


shareholders. Second, as it is so difficult to be sure that fixed cost apportionments

are accurate, the separation may encourage managers to place more reliance on

the cost numbers than is justified by the evaluation.

The language of fixed cost apportionment is avoided if an alternative approach

is used – to work out for each period and each product a figure of contribution

required. The argument is that, for a business to thrive, it needs to cover its fixed

costs and make a return on investment too, and each product has to contribute its

share. Using the earlier example and assuming that the operating profit number is

a target based on the capital employed for that product, we can now demonstrate

the required calculation:

Direct costs – materials, labour, variable overhead 5.00 per unit


Total forecast fixed overhead £600,000


Total forecast volume 250,000

Total forecast sales £2,000,000


Required contribution

Fixed overhead £600,000


Total contribution required £1,000,000

Forecast volume 250,000

Required contribution per unit – 1,000,000/250,000 = 4.0

The costing for the new product would now be simplified by the new approach

as follows:

£

Direct cost 5.00

Contribution required 4.00

Required price 9.00

This price varies slightly from the £9.25 quoted earlier because the required profit

is now being apportioned per unit rather than as a percentage of sales, which may

or may not be a more accurate reflection of reality. However, if we think back to


the earlier point that profit needs are driven by capital employed rather than sales

levels, it is likely that the unit measure, although imperfect, is a better basis for

this evaluation.

THE VALUE OF FINANCIAL ASSESSMENT

After seeing the judgement areas and the complexities which can arise from even

the most simple example, readers will see that not only is ‘cost plus’ a

questionable approach, it is also very difficult to apply in practice. Nevertheless

the reasons why it may be necessary and helpful still stand: it can be used for

unique ‘one-off’ products, for products which are new to the market, to comply

with industry norms and to carry out strategic evaluations of ‘ideal’ prices. Each

company has to make its own judgement about the cost effectiveness of cost plus

pricing in the achievement of one or more of these objectives, and about the

degree of detail and complexity that is required. Costing has to be cost effective

to be worthwhile.

The final chapter extends the coverage of financial evaluation and rounds off the

book by covering the more complete and long-term assessment of the effectiveness

of pricing decisions: their impact on shareholder value over time.

105

10Pricing, business objectives andvalue creation

From value pricing to value to shareholders 109

Relating financial to marketing objectives 110

Evaluating marketing objectives 110

The underlying assumptions 116

Conclusion 117

■

■

■

■

■

107

Pricing, business objectives and value creation

FROM VALUE PRICING TO VALUE TO SHAREHOLDERS

Our main theme throughout this book has been the vital need to fix prices on the

basis of value to customers rather than on market opportunism or internally

driven cost calculations. However, this begs the question about another – and in

many ways more important – concept of value, the value which is delivered to

shareholders. Those who own the brand or the business will accept the principle

of pricing on a value basis only if they believe that this also provides maximum

financial benefit for them. It is only because of our belief in this long-term

correlation that we advocate the value approach to pricing.

The concept of shareholder value has been increasingly topical during the last

decade of the 20th century and so far during the first decade of the 21st. There

are a number of internal and external performance measures which have been

developed because they are believed to have a positive correlation to long-term

shareholder value – for example return on capital employed, earnings per share,

economic value added, free cash flow – and there is one common assumption that

underpins them all – the value of any company, business unit or brand at any one

time is the present value of the future cash flows during the remainder of its life

span (Figure 10.1). It therefore follows that such value will be maintained only by

the subsequent generation of that cash flow, and increased only by improvement

upon it.

Fig. 10.1 The value of any company, business unit or brand

This framework may not be quite so easy to apply to organizations that are not

owned by shareholders, but the same principles are relevant to any organization

with business objectives. Cash flow maximization is, in the long term, in the

interests of all stakeholders. Different types of organization may decide to use that

109

Cash flows

The presentvalue of future

cash flows

110


cash flow for different purposes, but the cash has to be generated in the first place

if business success is to be achieved.

RELATING FINANCIAL TO MARKETING OBJECTIVES

On several occasions in earlier chapters we have discussed the need for pricing

decisions to balance financial and marketing objectives, with marketing factors

taking priority in cases of conflict. Financial objectives have to be achieved in the

long run if the company is to stay in business, but pricing is such an integral part

of the marketing mix that marketing factors must be the driver of the decision. We

have also mentioned on several occasions the need to avoid sacrificing long-term

marketing objectives at the altar of short-term sales and profit maximization.

However, such sentiments are meaningless unless they can be related to long-term

value for those who own the business and are required to invest in it. If the objective

of all pricing decisions is clearly understood to be the maximization of the present

value of future cash flows, this allows all the trade-offs and judgements to be

evaluated within a meaningful and quantifiable framework.

EVALUATING MARKETING OBJECTIVES

There are a number of marketing objectives that can be achieved, directly or

indirectly, via pricing decisions. A number of these have been mentioned during

the book so far, for instance:

■ price low to gain market share;

■ price high to maximize short-term profitability;

■ create a loss leader to encourage sales of other products;

■ launch a new premium product to create better ‘price lines’ for others in the range;

■ price on a marginal basis to enable survival in the short term;

■ price on a marginal basis to hurt the competition.

These can all be justifiable strategies because pricing decisions need judgement

and flexibility and must be based on the day-to-day reality of competitive

markets. However, the key test of their validity is whether they will create more

long-term shareholder value than would be produced by other options, including

the option of doing nothing. This comparison may or may not be quantifiable in

detailed cash flow terms, but the creation of more present value than other

options should always be the explicit or implied aim of a pricing decision.


Take the first objective, the gaining of market share, which is a common priority

among ambitious brand managers. Too often market share growth is assumed to

be a good thing in itself, without considering the high cost of the price reductions

or marketing spend which are necessary to deliver it. This assumption that high

market share is the best way of maximizing value may be true in many markets,

but can also become the justification of a poorly conceived and evaluated strategy.

If we think back to the price/volume evaluations in Chapter 7, these were

examples of the difficult choices that have to be made between short-term and

long-term return. Should we reduce price to achieve a volume increase, even

though the contribution this year will be significantly reduced by so doing? Should

we increase price and lose market share because the extra contribution will help

this year’s profits?

Those evaluations were essentially short-term because that was the context we

were discussing at the time. However, if the base data is available and if managers are

willing and able to make the necessary assumptions, the only valid way to make the

judgement would be to compare the cash flows over the remaining life of the product

for each option and see which one generates the most value for shareholders.

To illustrate this point we will have to simplify. We will take two options for

price change similar to those illustrated in Chapter 7, one for a 10 per cent price

increase, one for a 10 per cent price reduction. The existing situation is as follows:

■ market size 1,000 units;

■ no expected market growth;

■ price £100;

■ existing share 30 per cent, 300 units;

■ variable costs £35 per unit;

■ fixed costs £10,000;

■ promotion and advertising support 7.5 per cent of sales;

■ product life forecast as ten years.

The ongoing profit and loss account if no price change takes place therefore looks

like this:

£

Sales 30,000

Variable costs (10,500)

Fixed costs (10,000)

Promotion and advertising (2,250)

Operating profit 7,250

111

112


The assumptions for the price change options are as follows:

10 per cent price increase

■ Market share falls from 30 per cent to 25 per cent over next five years.

■ Fixed and variable costs stay the same.

■ Promotion and advertising support has to increase to 10 per cent of sales to

support the price increase.

10 per cent price reduction

■ Market share rises from 30 per cent to 45 per cent over the next five years.

■ Fixed costs rise by a step of £2,500 after year 5.

■ Promotion and advertising support reduces to 5 per cent of sales.

■ Capital expenditure of £50,000 is necessary in year 5 to cope with higher volume.

From this information it is possible to build a ten-year cash flow of the two

options and thus make a real assessment of value – see Tables 10.1 and 10.2.

The figures in the right-hand columns tell us the net amount of cash which will

be generated by the two options. The final step is to convert these future cash

flows into their present values so that we can have a true comparison of the

shareholder value that will be created by each option. The price increase option

will create more value in the early years but will tail off later as the share

decreases; the price reduction option comes into its own after year 5 and generates

substantially more cash flow in years 6 to 10.

It is not possible here to provide a full explanation of the principles of

discounted cash flow for those who are not familiar with them. It is hopefully

enough to say that discounting is a technique which converts future cash flows to

their present value, based on an agreed discount rate that represents the average

cost of financing debt and equity investment. We will assume this rate as a fairly

typical 10 per cent.

Effectively this technique is quantifying the obvious reality that the longer we

have to wait for our money, the less it is worth. This calculation can be made as

a standard function from any spreadsheet, but we will show the year-by-year

calculation to help understanding.

If we convert these cash flows into their yearly and total present values, we will

have a better understanding of the real value generated by the two options – see

Tables 10.3 and 10.4.

Year

Pric

eM

arke

tM

arke

tVo

lum

eSa

les

Varia

ble

Fixe

dAd

vert

isin

gCa

pita

lN

et c

ash

size

shar

eco

stco

stan

d pr

omot

ions

inve

stm

ent

flow

Now

10

0 1,

000

0.30

30

030

,000

(10,

500)

(10,

000)

(2,2

50)

7,25

0

111

0 1,

000

0.29

29

0 31

,900

(1

0,15

0)

(10,

000)

(3

,190

) 8,

560

211

0 1,

000

0.28

28

0 30

,800

(9

,800

) (1

0,00

0)

(3,0

80)

7,92

0

311

0 1,

000

0.27

27

0 29

,700

(9

,450

) (1

0,00

0)

(2,9

70)

7,28

0

4 11

0 1,

000

0.26

26

0 28

,600

(9

,100

) (1

0,00

0)

(2,8

60)

6,64

0

5 11

0 1,

000

0.25

25

0 27

,500

(8

,750

) (1

0,00

0)

(2,7

50)

6,00

0

6 11

0 1,

000

0.25

25

0 27

,500

(8

,750

) (1

0,00

0)

(2,7

50)

6,00

0

7 11

0 1,

000

0.25

25

0 27

,500

(8

,750

) (1

0,00

0)

(2,7

50)

6,00

0

8 11

0 1,

000

0.25

25

0 27

,500

(8

,750

) (1

0,00

0)

(2,7

50)

6,00

0

9 11

0 1,

000

0.25

25

0 27

,500

(8

,750

) (1

0,00

0)

(2,7

50)

6,00

0

10

110

1,00

0 0.

25

250

27,5

00

(8,7

50)

(10,

000)

(2

,750

) 6,

000

Tabl

e 1

0.1

Pric

e in

crea

se o

ptio

n

Year

Pric

eM

arke

tM

arke

tVo

lum

eSa

les

Varia

ble

Fixe

dAd

vert

isin

gCa

pita

lN

et c

ash

size

shar

eco

stco

stan

d pr

omot

ions

inve

stm

ent

flow

Now

10

0 1,

000

0.30

30

0 30

,000

(1

0,50

0)

(10,

000)

(2

,250

) 7,

250

1 90

1,

000

0.33

33

0 29

,700

(1

1,55

0)

(10,

000)

(1

,485

) 6,

665

2 90

1,00

0 0.

36

360

32,4

00

(12,

600)

(1

0,00

0)

(1,6

20)

8,18

0

3 90

1,

000

0.39

39

0 35

,100

(1

3,65

0)

(10,

000)

(1

,755

) 9,

695

4 90

1,

000

0.42

42

0 37

,800

(1

4,70

0)

(10,

000)

(1

,890

) 11

,210

5 90

1,

000

0.45

45

0 40

,500

(1

5,75

0)

(10,

000)

(2

,025

) (4

0,00

0)

(27,

275)

6 90

1,

000

0.45

45

0 40

,500

(1

5,75

0)

(12,

500)

(2

,025

) 10

,225

7 90

1,

000

0.45

45

0 40

,500

(1

5,75

0)

(12,

500)

(2

,025

) 10

,225

8 90

1,

000

0.45

45

0 40

,500

(1

5,75

0)

(12,

500)

(2

,025

) 10

,225

9 90

1,

000

0.45

45

0 40

,500

(1

5,75

0)

(12,

500)

(2

,025

) 10

,225

10

90

1,00

0 0.

45

450

40,5

00

(15,

750)

(1

2,50

0)

(2,0

25)

10,2

25

Tabl

e 1

0.2

Pric

e re

duct

ion

optio

n


Table 10.3 Price reduction option

Year Cash flow Discount factor Present value

1 6,665 0.91 6,065

2 8,180 0.83 6,789

3 9,695 0.75 7,271

4 11,210 0.68 7,622

5 (27,275) 0.62 (16,911)

6 10,225 0.56 5,726

7 10,225 0.51 5,215

8 10,225 0.47 4,806

9 10,225 0.42 4,295

10 10,225 0.39 3,988

Net present value 34,866

Table 10.4 Price increase option

Year Cash flow Discount Present valuefactor

1 8,560 0.91 7,790

2 7,920 0.83 6,574

3 7,280 0.75 5,460

4 6,640 0.68 4,515

5 6,000 0.62 3,720

6 6,000 0.56 3,360

7 6,000 0.51 3,060

8 6,000 0.47 2,820

9 6,000 0.42 2,520

10 6,000 0.39 2,340

Net present value 42,159

This analysis shows that the price increase option, with its assumed reduction to

25 per cent market share, will generate more value for stakeholders than the

option to reduce prices and gain a 45 per cent share. This situation might be

different if the life was extended beyond ten years or if other assumptions were

changed, but as things stand, management would not be justified in reducing

prices to gain share, even in the longer term.

115

116


There is still the third option of doing nothing and leaving price as it is, with an

ongoing cash flow of £7,750. A similar evaluation to the above will show that the

present value of £7,750 per annum over ten years is £44,515.

On this basis the course of action which creates most value for shareholders is

to leave the price unchanged.

THE UNDERLYING ASSUMPTIONS

Building this kind of detailed cash flow forecast would be difficult to say the least,

and some would say impossible. For instance, the questions that would have to be

answered to arrive at the base numbers in the cash flow would be many and

complex. Most of them have been raised and discussed in the various chapters of

the book; for instance, consider the following.

Competitor analysis

■ If we reduce price, what will be their reaction? Will they follow or change their

offer in other ways?

■ If we increase price, will they take advantage by increasing theirs too?

■ Which competitors are likely proactively to change their pricing strategy and

tactics?

■ Will new competitors enter the market?

Consumer responses

■ How price sensitive are the various segments?

■ Will the price reduction raise doubts about our quality and positioning?

■ Will the price increase cause loyal customers to move to competitors or to

substitutes?

Marketing mix

■ What impact will the price changes have on other products in the range?

■ What will be the balance of spending between promotion and advertising?

■ Will there be different price sensitivities for different channels?


Financial implications

■ What impact will the industry cost structure have on pricing behaviour?

■ What is our own cost structure likely to be, in both the short and the long term?

■ What will be our breakeven point at different pricing levels?

And the critical question

■ How will our overall value package compare to competitors’ and will it

continue to allow us to achieve the market shares we are assuming?

CONCLUSION

It would be unrealistic to suggest that managers and marketers should carry out

this sort of detailed cash flow evaluation every time they make a pricing decision.

It might be possible to build such a cash flow during strategic planning sessions

or at other times when major choices have to be made, but usually pricing

decisions have to be made more informally and instinctively. Yet every time

pricing judgements are made, those responsible are effectively trying to answer the

above questions, using their expertise and knowledge of the market to build their

own intuitive model with all its complex trade-offs and difficult judgements.

As it is not possible on an ongoing basis to assess all these complex variables in

a detailed way, managers need a principle to guide them, a principle which is likely

to generate the most value for stakeholders. Our view, the view that has been a

continuing theme throughout the book, is that the best principle to guide decisions

is always to strive for the price level which aligns with value to customers.

Because alignment with value to customers will, in the long term, drive maximum

value for stakeholders.

117

119

The economic theory of pricing

INTRODUCTION

Knowledge of the basic principles of economic pricing theory is important if

managers are to understand how prices are determined in practice. Such theories

rarely match the complex realities of day-to-day business, but it is helpful to have

a theoretical underpinning against which to compare that reality.

First some terminology. Economists use the term commodity to mean a good or

service which has some value to a consumer. In some chapters of the book we use

the term commodity in a narrower and slightly different context, but in this

appendix the broader meaning will apply.

Prices of commodities are determined by the forces of demand and supply. We

will look at each of these in turn.

THE DEMAND CURVE

The demand for a commodity is the quantity that consumers are able and willing

to buy. In the case of almost all commodities, the quantity demanded increases as

the price of the commodity falls. This is because, as price falls, the commodity

becomes cheaper relative to its substitutes and therefore competes more effectively

against these substitutes for the consumer’s buying power. If, for example, the

price of tea falls significantly, some consumers may buy more tea and less coffee.

This tendency can be plotted on a graph as shown in Figure A.1.

Fig. A.1 The demand curve

Appendix

Pric

e

Demand

Quantity

120

Appendix

This ‘demand curve’ shows the normal relationship between the price of the

commodity and the quantity that consumers wish to purchase. It is, however,

based on the simplified assumption that income levels, tastes and other prices

remain constant. We will now explore these factors.

Income levels

Consumer demand for a commodity is influenced by their level of income. In most

cases, the larger the income, the higher the quantity demanded. In a few cases

demand for a product can fall as income rises – what are known as ‘inferior’ goods.

An example would be potatoes, rice or bread, the reason being that consumers may

switch to more varied and exotic foods as their income rises.

Taste

Consumer demand for a commodity is influenced by their tastes. One of the main

purposes of advertising is to influence consumer tastes, thus increasing the

demand for some products and reducing the demand for others.

Prices of substitutes and complements

Consumer demand for commodities can be influenced by the prices of other

commodities. In some cases the demand for one commodity will increase along

with the price of another, while in other cases the demand for one commodity will

decrease as the price of a second one increases. The price behaviour of petrol is a

good example. If the price of public transport increases, more people will wish to

make journeys by car, therefore the demand for petrol will rise and cause an

increase in the price. Public transport and petrol are substitutes and as the price

of one rises, so does the other. Consider, on the other hand, the relationship

between the price of cars and the price of petrol. Petrol and cars are known as

complementary goods (or complements). As the price of cars rises, consumers are

likely to reduce the number of journeys made by car. The demand for petrol will

fall, resulting in a decline in its price.

THE SUPPLY CURVE

Having looked at the demand side of pricing economics, we will now examine the

supply side. By the supply of a commodity we mean the quantity of units that

producers are able and willing to offer for sale.

Appendix

Generally, the higher the price of a commodity the greater will be the quantity

supplied. It is more profitable to sell a commodity at a higher price so, at higher

price levels, existing producers will increase the volumes they offer for sale and

new producers will be encouraged to enter the market. This can be shown on a

similar graph to demand as shown above (Figure A.2).

Fig. A.2 The supply curve

The ‘supply curve’ for a commodity shows the normal relationship between the

price of that commodity and the quantity producers wish to sell. It is drawn on

the assumption that all factors that influence supply are constant. However, as

with demand, there are other factors which affect supply and the following are the

most important.

The goals of producers

If producers are pursuing a goal of sales maximization, the quantity supplied at

any price may be different from what would happen if the goal was to maximize

profits. Sometimes a producer may go for a sales maximization goal even if lower

profits are produced in the short term, for example as part of a long-term strategy

to achieve a target market share.

Prices of other commodities

If the prices of other commodities increase, this will make the production of one

commodity relatively less attractive. Suppliers will therefore move their emphasis

away from that commodity and the supply will fall.

121

Pric

e

Supply

Quantity

122

Appendix

Prices of factors of production

Factors of production are the inputs necessary for production – materials, labour

and capital. Changes in the price of factors of production will cause changes in the

relative profitability of different commodities and therefore changes in their supply.

Technology

Over time developments in technology will affect the relative costs of production,

which will also have an impact on producers’ willingness and ability to supply.

PRICE DETERMINATION

Prices are determined by the interaction of supply and demand, and this interaction

is shown by combining the supply and demand curves into one graph, illustrated

in Figure A.3.

Fig. A.3 The interaction of supply and demand

The point where the two curves intersect is, in theory, the market price – P1. The

quantity demanded, Q1, and the quantity supplied are the same.

At any price higher than P1 (say, P2), the quantity consumers wish to buy (Q2)

is less than the quantity that producers wish to sell (Q3). We call this excess

supply, as shown in Figure A.4.

In a position of excess supply, the market price will fall. Producers who are

unable to sell all their output will offer some at lower prices. Consumers who see

unsold goods will begin to buy at these lower prices.

Pric

e

Supply

Demand

QuantityQ1

P1

Appendix

Fig. A.4 Excess supply

At any price below P1 (say, P3), the amount that consumers wish to buy (Q4) is

greater than the amount that producers wish to sell (Q5). We call this excess

demand. It is shown in Figure A.5.

Fig. A.5 Excess demand

In a position of excess demand the market price will rise. Consumers who are unable

to buy as much as they would like at current prices will offer higher prices. Suppliers

who are able to sell all their production will charge these higher prices to consumers.

Thus, at any price above P1 the price begins to fall and at any price below P1

the price begins to rise. At a price of P1, the quantity demanded and the quantity

supplied are equal and market prices will remain unchanged. This point, at which

the supply and demand curves intersect, is called the equilibrium price.

123

Pric

e

Supply

Demand

QuantityQ3Q1

P1

P2

Q2

Pric

e

Supply

Demand

QuantityQ4Q1

P3

P1

Q5

124

Appendix

THE FUNDAMENTAL THEORY OF PRICE

We have so far covered the following:

■ Demand curves slope downwards continuously.

■ Supply curves slope upwards continuously.

■ An excess of demand over supply causes prices to rise.

■ An excess of supply over demand causes prices to fall.

This means that there is only one price at which demand and supply are equal. If

either the demand or supply curve shift, the equilibrium price will change. The impact

of shifts in demand and supply curves can be demonstrated in the following figures.

A rise in the demand for a commodity (from D1 to D2) causes an increase in

both the equilibrium price (P1 to P2) and equilibrium quantity (Q1 to Q2) (Figure

A.6). The reverse is also true. A fall in demand for a commodity causes a

reduction of both the equilibrium price and the equilibrium quantity.

Fig. A.6 The effect of a rise in the demand for a commodity

We can also consider the impact of a change in the supply curve (Figure A.7). A

rise in the supply of a commodity (S1 to S2) causes a decrease in the equilibrium

price (P1 to P2) and an increase in the equilibrium quantity (Q1 to Q2). Again,

the reverse is true. A fall in the supply of a commodity causes an increase in the

equilibrium price and a decrease in the equilibrium quantity.

This application of economic theory supports what we observe in practice. If the

demand for a product increases (for example due to a change in taste), we would

expect the market price and the quantity sold both to increase. If the supply of a

good rises (for example due to new companies entering the market), we would

expect the price to fall and the quantity sold to increase.

Pric

e

S

D2

D1

QuantityQ4Q2

P1

P2

Q1

Appendix

Fig. A.7 The impact of a change in the supply curve

ELASTICITY OF DEMAND AND SUPPLY

So far we have considered the likely directional impact on price and volume of a

change in demand or supply. We have not yet considered how large the likely

change of each will be. The concept of elasticity enables us to do this.

Consider the two situations in Figure A.8. The supply curve and equilibrium

price are the same in both cases but the demand curve is different. Now, consider

what happens when there is a reduction in supply. This is represented by a shift

in the supply curve from S1 to S2. As a result the equilibrium quantity and

equilibrium price decrease in each case (Figure A.9).

Fig. A.8 The concept of elasticity

125

Pric

eS1

S2

D

QuantityQ2Q1

P2

P1

Pric

e

S1

D

QuantityQ1

P1

Pric

e

S1

D

QuantityQ1

P1

126

Appendix

Fig. A.9 The impact of a reduction in supply

In the first case the change in the equilibrium quantity is high but the change in the

equilibrium price is small. We describe this type of demand curve as elastic – for a

relatively small change in price, a large change in volume will occur. There is the

opposite impact in the second case. Here the same shift in supply results in a large

increase in price but a small increase in quantity. We describe this type of demand

curve as inelastic – a large change in price can occur without much impact on volume.

Economists have developed quantitative methods to measure elasticity of

demand, but we do not deal with these here. However, it is important to

understand the implications of these two extremes of elasticity of demand because

we will be looking at the financial implications in detail in Chapter 7. This is

shown in Figure A.10. The first graph shows a demand curve that can be

described as having zero elasticity. In other words, however much price changes,

the quantity demanded will not vary. The second graph shows a demand curve

that is perfectly elastic. In this case consumers are not willing to pay more than a

given price for a product.

While these may be extreme cases and may rarely occur in practice, they are

useful frameworks for analysis in business. Take the second example of an elastic

demand curve, which would apply to a business selling a product that is not

differentiated from its competitors. At a price below that of its competitors, the

firm would be likely to sell all its output. At a price even a little above that of its

competitors, nothing would be sold as consumers would be able to satisfy their

demand elsewhere.

Apart from differentiation and competition, there are two other main factors

that determine elasticity of demand.

Pric

e

S1

S2

D

QuantityQ1Q2

P1P2

Pric

e

S1

S2

D

QuantityQ1Q3

P1

P3

Appendix

Fig. A.10 An illustration of elasticity

The availability of substitutes

If substitutes are available, the demand is likely to be relatively elastic, since

consumers will buy the substitute if the price of the original product rises.

The degree of necessity of the product

The more consumers perceive a commodity to be essential, the more inelastic the

demand is likely to be.

A good example of a product with relatively inelastic demand is commuter rail

travel. Customers often have few practical alternative forms of transport and it is

necessary for them to travel to work. Rail companies can therefore often increase

price without experiencing much decline in volume. A good example of a product

with elastic demand is a standard vegetable, for example broccoli. There are many

similar vegetable alternatives and few consumers would continue to buy broccoli

if the price rose significantly. The price rise would therefore cause a significant fall

in volume.

OVERALL SUMMARY

We have established the following:

■ A demand curve shows how the required quantity of a commodity will increase

as price decreases.

127

Pric

e

Quantity

Pric

e

Quantity

128

Appendix

■ The demand for a product is influenced by a number of factors, including

consumers’ income, the prices of other commodities and taste.

■ A supply curve shows how the quantity of a commodity produced by suppliers

will increase as price increases.

■ The supply of a product is influenced by a number of factors, including the

goals of companies, the price of other commodities, the prices of raw materials

and other inputs, and technology.

■ Market prices are determined by the interaction of supply and demand.

■ If there is excess supply, prices are likely to fall.

■ If there is excess demand, prices are likely to rise.

■ The extent of any price change resulting from a change in supply is influenced

by the elasticity of demand.

■ If demand is inelastic, a small change in price will have little influence on the

volume sold.

■ If demand is elastic, a small change in price will have a large impact on the

volume sold.

129

References

Buzzell, Robert D. and Gale, Bradley T. (1987) The PIMS Principles. Free Press.

Dolan, Robert J. and Simon, Hermann (1996) Power Pricing. Free Press.

Fletcher, Tony and Russell-Jones, Neil (1997) Value Pricing. Kogan Page.

Hanna, Nessim and Dodge, Robert H. (1995) Pricing Policies and Procedures.

Macmillan.

Lewis, Gregory (1992) Pricing For Profit. Kogan Page.

Johnson, Thomas H. and Kaplan, Robert S. (1991) Relevance Lost. Harvard

Business School Press.

Johnson, Thomas H. (1992) Relevance Regained. Free Press.

Nagle, Thomas H. and Holden, Reed K. (1987) The Strategy and Tactics of

Pricing. Prentice Hall.

Porter, Michael (1985) Competitive Advantage. Free Press.

Porter, Michael (1980) Competitive Advantage. Free Press.

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