Pricing Strategy

ROLES AND IMPORTANCE OF PRICING

Our tendency is to think of price purely in financial terms. After all, price figures into so many of the

financial calculations associated with business operations, both on the revenue side (i.e., the price we

charge) and the cost side (i.e., the price we pay). There’s certainly nothing wrong with considering price

in financial terms, however, thinking of price in purely financial terms is a narrow perspective. Price is

much more than that. Think about the different roles of price in consumer markets, for example.

Price acts as a signal to buyers. It’s a communication tool that consumers use to make inferences about

the characteristics of the products and its suitability to their needs. The natural assumption, particularly

for consumers unfamiliar with a product category, is that price signals higher quality or greater prestige.

While these are not always safe assumptions, they often are, so especially to novices in a category, price

is a powerful means of communication to customers.

Price is a competitive weapon. While products are certainly priced in an absolute sense, they are also

priced relative to one another as well, and customers use this information to make comparisons.

Therefore and obviously, price plays a major part in the competition between brands. This is true in

both the long term positioning of brands and in short term efforts to increase sales or encourage trial,

especially when attempting to draw customers of a competitive brand to yours.

Finally, price is a tool of financial performance. In addition to its effects on the decision processes of

buyers and on the actions of competitors, price has very large financial implications. While marketers

often shy away from this aspect of pricing in order to focus on its customer and competitor implications,

marketers cannot ignore how price affects finances. All marketing activities should produce

measureable financial returns, and price is pivotal in those efforts.

PRICE CHANGES IN THE CURRENT STRATEGIC SITUATION

In order to develop pricing strategies, marketers must understand how consumers respond to price and

in particular, changes and differences in price. If price remained constant, the pricing strategy would be

easy. After setting an initial price, the strategic dimension of price would be over. But prices change,

and depending on the product, they change frequently. For example, at the consumer level, gasoline

prices change daily in response to commodity price changes. While food prices do not change quite as

frequently, they also respond quickly to changes at the producer level, so grocers are constantly

changing prices on products, often putting them on sale for set periods of time.

Pricing Strategies 2

Sale prices or other promotional effects on price are the most common reasons for price changes.

Marketers offer special promotional prices for two main reasons. One is to account for the actions of

competitors. When a company drops prices, competitors frequently must follow suit. Second, products

may be put on sale to help move excessive inventory. If marketers underestimated demand for a

product and produced too much, sale prices may help clear the backlog of inventory. These temporary

price reductions account for the majority of day-to-day price fluctuations we see at the retail level,

however, they also occur in channels. Producers such as Procter and Gamble offer temporary discounts

to major retailers or receive temporary discounts from their own suppliers. Indeed, some of the retail

discounts we see at the stores we shop originate with discounts the retailer received further up the

distribution channel.

Price Elasticity of Demand

The fact that prices change in the normal course of events is not terribly interesting. What is interesting

is why and the effects of the changes. In particular, marketers are interested in how changes in price

will affect a changes in quantity sold. That’s because that amount of change actually determines overall

revenue. Marketers want to find a price that, for a given level of demand, can maximize revenue. To

figure this out, marketers must understand a concept called price elasticity of demand, or just price

elasticity for short. Price elasticity simply reflects how much quantity sold will change for a given change

in price. Elasticity is calculated with the simple formula:

𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 = %Δ𝑄

%ΔP=

(𝑄2 − 𝑄1) 𝑄1⁄

(𝑃2 − 𝑃1) 𝑃1⁄

Elasticity ranges simply from low to high. The differences between the two is explained below. Before

jumping into those explanations, it would be helpful to suggest that you think about elasticity of

demand in terms of brands. In other words, when a price change occurs, think of the price change as

occurring at the brand level. For example, consider competing brands of Ketchup such as Heinz, Hunts,

Del Monte, etc. The question that analysis of elasticity attempts to answer is what the effect on sales a

change in price of one brand will have.

Relatively Elastic Demand. The formula expresses elasticity as the proportion of change in quantity to

change in price of some brand. When Elasticity is greater than one, meaning that the numerator is

larger than the denominator, the percent change in quantity is greater than the percent change in price,

indicating that demand is relatively elastic. Said another way, a small change in price yields a

proportionately larger change in quantity sold. The phenomenon of relatively elastic demand is shown

in Exhibit 1 on the next page. Graphically, the diagram shows that when priced at P1, the brand sells Q1

units. When price drops modestly from P1 to P2, unit sales jump from Q1 to Q2. As a proportion, the

difference between Q2 and Q1 is far greater than the difference between P2 and P1.

The strategic question facing marketers when such circumstances occur is where do all these extra sales

come from? While a little analysis with tools such as the substitution index we learned about earlier,

marketers can arrive at a fairly detailed answer. However, with a little logic, we can narrow down the

possibilities here. Let’s continue the ketchup example. Suppose Del Monte ketchup drops its price and

notices a big jump in sales afterwards. One source of the extra quantity sold may be people who

Pricing Strategies 3

Exhibit 1. Price Change Under Relatively Elastic Demand

normally buy Del Monte, see that it’s on sale, and decide to pick up a couple of extra bottles. These

shoppers are called stockpilers and under many circumstances are not particularly helpful to the brand

because once the price goes back up to its original level, even these loyal customers will not be buying

soon because they stickpiled a few bottles of ketchup. A second source of additional sales is from

people who normally buy other ketchup brands, but decide to buy the Del Monte while it’s on sale.

These people, called brand switchers (obviously), see their regular brands and Del Monte as easily

substitutable. Unlike stockpilers, brand switchers represent new sales for Del Monte, who hopes that

they will like the ketchup so much that they continue to buy it. The same is true for category switchers,

who are shoppers who may buy other types of condiments or sauces, but switch over to Del Monte

ketchup because of the price drop. For example, a shopper who was looking for a can of sloppy joe

sauce may opt to make their own with ketchup. Finally, first time shoppers may decide to try a bottle of

sale-priced ketchup. While this seems a little unlikely with a staple product such as ketchup, it is

certainly not beyond the realm of possibilities. For example, a person new to the United States whose

native foods do not include ketchup may decide to try it because it is at a reduced price.

Brands whose prices are relatively elastic generally share several commonalities that can affect

marketing strategy. One, elasticity assumes consumers are price aware. That is, they notice the price

changes of competitive brands. Second, elasticity indicates that consumers are price sensitive. That is,

for the product category and brands in question, they respond behaviorally to changes in price. Third,

consumers are not brand loyal. They are willing to use price as a reason to switch from an otherwise

preferred brand. Fourth, elasticity suggests that competitive brands or close categories are seen as

substitutable. If all brands of ketchup are the seen as essentially the same or just as good, then

substituting one for another is no big deal. Fifth, when prices are relatively elastic, price is often the

only effective competitive tool. Brands that are perceived as equally suitable may have little available to

distinguish themselves from competitors, leaving only price as a tool of competition.

Relatively Inelastic Demand. When the elasticity equation on the previous page yields a value of less

than one, it suggests that large changes in price produce proportionately smaller changes in quantity

sold. In other words, the numerator is less than the denominator. Relatively inelastic demand is

illustrated in Exhibit 2 on the following page.

P

Q

P1

P2

Q2 Q1

D

Pricing Strategies 4

Exhibit 2. Price Change Under Relatively Inelastic Demand

Exhibit 2 shows an opposite set of circumstances to Exhibit 1. In Exhibit 2, the drop in price from P1 to P2

is substantial, yet the increase in sales from Q1 to Q2 is small by comparison. This situation implies

several things to marketers as well. One is that the slight increase in quantity sold is probably from

stockpilers but not from customers who usually buy something else. That’s because relatively inelastic

demand suggests high levels of brand loyalty. The customers buying more of your product are brand

loyal to your product. However, your price decrease is not enough to draw loyal customers of other

brands to your brand. Products are not seen as substitutable and consumers are not as price sensitive.

Under these circumstances, price is often a poor competitive weapon because products are well

differentiated from each other in ways that make the perceived costs of switching high.

Residual Price Elasticity

Now that you have some refresher on the basic concepts of elasticity, let’s make the concept somewhat

more realistic. The explanation of price elasticity above leaves out an important facet of competitive

markets: the competitive part. That is, the price elasticity discussion above assumes that competitors to

a firm that lowers its price will not respond with lower prices of their own. This is often a very

unrealistic assumption. Competition often responds within minutes to changes in pricing by a

competitor. For example, when airlines have fare wars or when gas stations at an intersection change

prices, competitive response can be nearly instantaneous.

Does this mean that when a competitor responds to a price change with one of its own, that its price

change completely negates the effects of the first one? No it does not. For one thing, the elasticity of

one brand may not be the same as the elasticity of a competitive brand. In other words, Del Monte

ketchup may get more from a price drop than Hunts does. If Hunts drops its prices in response to a drop

by Del Monte, it could be that Hunts’ price drop only partially offsets the gains by Del Monte. Second,

P

P1

P2

Q1 Q

2

Q

D

Pricing Strategies 5

competitors may not respond with a price drop that equals the original. So if Del Monte drops its

ketchup price by twenty percent, Hunts may respond with a ten percent drop.

The concept of residual elasticity is intended to account for the effects of competitor responses to price

changes. That is, residual elasticity is the proportional effect on quantity sold of a price change after

accounting for competitors’ responses. To understand residual elasticity, we need to define a few

terms. First is own elasticity, which is simply the price elasticity of the first company to change prices.

Own elasticity is what we discussed in the previous section. Second is competitor reaction elasticity.

This is the proportional effect on competitor prices produced by a change in our prices. For example, if

Del Monte drops its prices twenty percent and Hunts responds with a ten percent price drop, then the

competitor reaction elasticity is 0.50. If Del Monte drops its ketchup price by twenty percent and Hunts

responds with a forty percent price drop, then the competitor reaction elasticity is 2.0. Third is cross

elasticity, which is the effect of a competitor’s price change on our quantity sold. Cross elasticity for two

brands is calculated as:

𝐶𝑟𝑜𝑠𝑠 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦𝑂,𝐶 = %Δ𝑄𝑂

%Δ𝑃𝐶=

(𝑄𝑂2 − 𝑄𝑂1) 𝑄𝑂1⁄

(𝑃𝐶2 − 𝑃𝐶1) 𝑃𝐶1⁄

where QO = Quantity sales of our brand and PC = Price of competitor brand.

Note that this is essentially the same elasticity equation as shown on page two except that this equation

calculates the percent change in our sales that results from a competitor’s drop in price. If a competitor

brand drops its price and we do not drop ours, we can expect our quantity sold to decrease. If we

respond with our own price cut then we will gain back some or all of that loss. That’s in part what

residual elasticity tries to account for. Our price changes and our competitor’s price changes have

opposing effects on our quantity sold. Exhibit 3 on the following page illustrates how residual elasticity

works and gives the very simple calculation. Data for these calculations are relatively easy to obtain in

many consumer markets because of scanner data.

Exhibit 3. Diagram of Residual Price Elasticity (Adapted from Farris et al. 2007)

Our Price

Change

Competitor Price Change

Our Quantity

Change

Competitor Reaction Elasticity

(B)

Own Elasticity

(A)

(C)

Cross Elasticity

Residual Elasticity = A + (B × C)

Pricing Strategies 6

Profit, Promotion, and Time Dimensions of Price Changes

Many if not most price reductions are temporary and occur as part of a promotion, whether directed

toward consumers or one between channel members. As a general rule, because of inflation, base

prices trend upward, albeit slowly sometimes, so significant reductions in prices are rarely permanent.

Therefore, it’s important to factor in the profitability of temporary price reductions in a way that

accounts for the behavior of customers before, during, and after the price promotion. In this section,

we examine how price reductions affect profitability from two perspectives. One is the retail

perspective. That is, a retailer reduces the price on a branded product carried in the retailer’s stores.

The other is from a channel perspective. That is, a retailer receives a discount on a branded product it

carries from the product’s producer. We’ll begin at the retail level.

Price Promotions Offered by Retailers to Consumers. Retailers put products “on sale” all the time.

Reductions are offered in-store, online, through coupons, in bundles, and any other creative means of

getting consumer attention and ultimately response. The question for retailers is, will the price

reduction be profitable? The simple answer to the question rests largely with whether the loss in per

unit revenue from the price reduction is sufficiently made up by an increase in volume (hence, the

importance of elasticity). Said another way, will total revenues with the price reduction exceed the

revenue of not offering the promotion at all?

Exhibit 4 shows the effect on brand sales of a promotion that lasts one time period, during all of period

t2. The profitability of the promotion depends on whether the sales bump produces sufficient revenues

Exhibit 4. Profitability of Price Reduction Offered to Consumers (Source: Tellis 1998)

Unb

Time (t)

Brand

Sales

t1 t2 t3 t4 t5

b

increased sales from

promotion (“sales

bump”)

regular anticipated

sales

Pricing Strategies 7

to overcome the costs that produced the sales bump in the first place. The sales under time periods t1

and t3 through t5 represent the normal anticipated sales of the brand with no promotion. The sales at t2

represents the bump caused by the promotion. The area above the regular sales line (b) represents the

additional sales from the promotion.

To figure whether the promotion would be a profitable investment, we must consider a few variables.

First, we should account for the margin produced by the product at its regular unpromoted price. We

will label this variable m. Next, we must include the reduction of product margin caused by the

promotion. In the case of a simple price reduction, we reduce m by the amount of the price reduction.

In the case of premiums or other nonprice promotions, we reduce m by the per-unit cost of offering the

promotion. Both cases result in a reduction that we will label as d. Referring to the diagram in Exhibit 4,

the promotion will be profitable if:

𝑏(𝑚 − 𝑑) > 𝑡1𝑑

The left hand side of the inequality represents the additional profits gained by the promotional offer.

The increase in sales over normal levels during the promotional period (b) occur at a lower level of

margin than regular sales; that is the regular margin less the discount or cost of the promotion (m-d).

The product of these variables represents the additional profit earned by holding the promotion.

The right hand side of the inequality represents the opportunity cost of holding the promotion. Had the

promotional offer not been made, the firm would have achieved its normal level of sales (t2). During the

promotional period, these customers who would have purchased at the regular price can take

advantage of the promotion. Multiplying this figure by the discount (d) provides the lost profit of

offering the promotion to people who would have bought without the offer. As the inequality

demonstrates, unless the increase in profits from having the promotion exceed the lost opportunity of

not incurring the costs of the promotion the promotional offer should not be made.

Price Promotions Offered by Producers to Retailers.

The preceding discussion assumes that the retailer offers a discount on a product that it bought at the

regular price from the producer. In today’s channel environments, that scenario has a good chance of

being wrong. Retailers have the power in most distribution channels and frequently use that power to

extract price concessions from producers. As such, they often will only put products on sale to

consumers when they receive discounts from producers on those products. For example, suppose you

went into your local Kroger grocery store and saw that Tide detergent was reduced in price by a dollar.

Chances are that Kroger reduced the retail price by a dollar because they received a price reduction

from the producer, Procter and Gamble. Therefore, Kroger’s profits are reasonably well protected. But

what about P&G? Before offering Kroger the discount, they probably did analysis to see whether the

price reduction would be profitable to them.

Any temporary price reduction relies on estimating whether the additional profits garnered by the

promotion exceed the opportunity costs of selling at discount to those who would have purchased at

the regular price. In the case of price reductions offered between channel members (i.e., P&G offering

Kroger a temporary price reduction on Tide), we can examine the sources of additional profits more

closely because tracking these sources presents less of a problem in a channel environment than it does

Pricing Strategies 8

Exhibit 5. Evaluating the Profitability of a Temporary Price Reduction (Source: Tellis 1998)

in a retail environment. This is because there are fewer retailers and other trade customers than there

are consumers. Moreover, producers carefully track the promotional deals offered to and purchases

made by retailers. Therefore, the analysis that follows is written in the context of a producer such as

P&G offering a temporary price reduction to a retailer such as Kroger on a branded consumer product

such as Tide detergent.

Take a look at Exhibit 5. The graph shows how sales of a product, shown with the blue line, tracks over

the time before, during, and after a temporary price reduction. The graph is somewhat similar to Exhibit

4, however, some important differences need to be explained. First, the sales line does not stay level in

the period prior to the trade deal; instead it dips slightly in anticipation of it. This is because the

manufacturer’s salesforce likely makes many retailers aware of the pending promotion and advises

them to delay their purchases until the promotion begins. Second, the sales curve during the

promotional period assumes something of a v-shape at the top. This shape results from retailers

purchasing on deal twice (i.e., at the reduced price) during the promotional period. Many make an

initial purchase, determine how much to pass through, divert, or stockpile, and then purchase additional

amounts toward the end of the promotional period if necessary. Third, the sales line dips below its

average baseline level following the promotion, showing the effects of stockpiling and forward buying.

Finally note that in this example, the promotional offer lasts for two periods. While trade promotion

offers vary in duration, they typically last somewhat longer than many consumer-oriented sales

promotions.

Time (t)

Brand

Sales

t1 t2 t3 t4 t5 t6

increased

sales during

promotion

b1

b2

b3

time of price reduction

“baseline” sales

Pricing Strategies 9

For the sake of clarity, brief definitions of the terms stockpiling, diverting, and passthrough would be

helpful. As you probably guessed, stockpiling occurs when retailers buy as much of a product as possible

while its price is reduced. They then store the product so that they have additional inventory to sell

even after the producer returns the price to regular levels. Diverting occurs when retailers send product

bought at reduced prices to stores where the reduced prices are not available. For example, suppose

P&G offers the discount on Tide detergent to a retailer’s stores in the Northeast and Midwest, but not

on the West Coast. If the discount is significant enough, it may be worthwhile for the retailer to buy as

much product as possible at the discount and then send a portion of the inventory to stores where the

deal is not available. Producers hate the practice of diverting, but there is little they can do to stop it. If

the discount is deep enough to cover shipping, retailers will continue diverting. Finally, pass through

refers to the percent of a producer’s discount to a retailer that actually winds up being “passed through”

to consumers. The main reason producers discount their products is to provide incentives for retailers

to lower the price to consumers. However, retailers may choose to not pass through any of the discount

they received, or they may pass through only a portion of it.

The increased sales during the promotional period itself may be decomposed or broken down into three

sources. The area under the sales curve labeled b1 represents incremental increases by the retailer in

anticipation of increased retail sales to consumers. As noted earlier, we refer to this as forward buying.

Of course, the increase from forward buying presumes some degree of pass through by the retailer. The

area labeled b2 represents increased purchases due to retailer brand switching. That is, the retailer’s

increased purchases of the promoted brand may come at the expense of other brands in the product

category. The area labeled b3 comes from stockpiling and diverting. That is, retailers buy extra

quantities of the promoted brand on deal, and then store the product to sell later at regular price, or

buy extra quantities and ship then to stores in areas where the promotion is unavailable.

To evaluate profitability, we must account for some additional variables. The time periods labeled t1

through t6 in Exhibit 4 show the sales activity prior to and following the promotional period. Sales

during t1 and t6 are assumed to occur at some “baseline” level of sales when the product is sold at its

regular price. We use m to refer to the normal profit margin enjoyed by the producer and d to

represent the amount of discount given by the producer to the retailer. Finally, we introduce f as the

fixed costs associated with offering the promotion. These costs do not change with the amount of the

promoted brand sold to retailers and can include costs of administration or preparation of promotional

materials offered to retailers.

With these variables in place, and referring to the diagram in Exhibit 5, a trade promotional will be

profitable if:

(𝑏1 + 𝑏2)(𝑚 − 𝑑) > (𝑡1 − 𝑡2)𝑚 + (𝑡3 + 𝑡4 + 𝑏3)𝑑 + 𝑓

The value to the left of the greater-than sign represents the increase in profits resulting from the trade

promotion. In this example, only b1 and b2 add to the producer’s profits; b3 does not. When retailers

stockpile or divert, they buy discounted merchandise they would have purchased at regular price during

one or more future periods. This is represented in Exhibit 1 as b3, which accounts for sales decline in t5

following the promotional period. The increased profit from b1 and b2 is calculated by multiplying them

by the difference between regular margin m and the amount of the trade discount d.

Pricing Strategies 10

To the right of the greater-than sign are the fixed and opportunity costs of offering the promotion. The

first part of the expression, (t1 – t2)m, accounts for the dip in sales just prior to the promotional period.

The assumption is that the dip is in part made up by purchases under b1. But because the sales would

have occurred at baseline had the promotion not been offered, the small decline represents an

opportunity cost. Similarly, the sales that would have occurred at regular prices during the promotion

had it not been offered as well as the future sales lost due to stockpiling are captured in the part of the

expression, (t3 + t4 + b3)d. Finally, fixed costs are given by f.

So as always, offering a sales promotion deal adds more to profits than not offering it if the incremental

increases in profit from offering the deal exceed the opportunity costs associated with offering it.

SETTING BASE PRICES

While we have discussed the effects of price changes to this point, we have yet to cover setting base

prices for products. Obviously when prices change, they must change from something to something else.

Generally, these are done relative to a base price, which is the “standard” undiscounted price against

which other price calculations are performed. At the University of Dayton, the full base price for tuition

and housing is something over forty thousand dollars per year. You and your family learned of your

charges by receiving financial aid discounts and scholarships against that base price. In private education,

the base price is especially important because varying discounts and financial aid packages apply to

virtually every student enrolled. The same principle applies to automobile sales. The base price serves as

the point of comparison for calculating the “sticker price,” which is the base price plus additional options,

and then the negotiated price, which is what a buyer pays after haggling with the salesperson.

Exhibit 6 shows a price setting process suggested by Peter and Donnelly (2009) that generally describes

the decisions needed to set base prices. In fact, the process would probably work well for evaluating

price changes assuming time and data were readily available to perform the analyses called for in the

process. Many promotional price changes occur quickly and in response to competition, so an intuitive

understanding of their likely effects would be very useful to managers. Base price setting is a more

deliberative process, particularly for new products, when managers have time to consider the various

inputs and effects of their decisions. Let’s look at each step in the process. Some of the material

pertinent to each step has already been covered in this topic or in previous topics.

Setting Pricing Objectives

As with all major activities in marketing, objectives are a must and pricing is no exception. As mentioned

in the opening comments to these notes, pricing serves a variety of purposes, and as such, should relate

to many of these purposes. First and foremost, pricing objectives must relate to so-called ultimate

objectives, which usually pertain to the financial and marketplace performance of the product. For

example, it’s not difficult to see how pricing relates to profitability, sales, and market share. However,

pricing to achieve profit, sales, and share levels may be more complicated. That said, even though the

relationships may be complicated, they cannot be ignored. Prices must be set with these ultimate

objectives in mind.

Pricing Strategies 11

Exhibit 6. Steps to the Price Setting Process (Source: Peter and Donnelly 2009)

According to Peter and Donnelly (2009), most pricing objectives pertain to financial performance. These

authors identify the four most frequently used pricing objectives, three of which are financial in nature:

pricing to achieve a target investment return, stabilization of price and margin, and pricing to achieve a

target market share. The fourth commonly used pricing objective cited by Peter and Donnelley (2009) is

pricing to meet or prevent competition, which should be a consideration in objective setting for any

function of marketing. However, this particular type of pricing objective relates closely to brand

positioning and the relationship of one brand’s price to others in its category, the details of which are

discussed next.

Evaluate Product-Price Relationships

Because price is often used as an indicator of product quality, especially when customers lack

confidence or experience purchasing in certain product categories, price plays a very large role in how

customers perceive one brand relative to competitive brands. Therefore, price is a critical and usually

Set Pricing Objectives

Evaluate Product Price

Relationships

Estimate Costs and Other

Price Limitations

Forecast Profit Potential

Set Base Price Structure

Adjust Prices Where

Necessary

Pricing Strategies 12

unavoidable variable in positioning brands. The key to using price as a positioning variable is that

consumers must find price’s relationship to a particular brand to be credible. They must believe that

their mental calculations of value (see web notes on nature strategy) are consistent with the price of

brands under consideration.

Logically, prices can be set relative to competition in three ways. One, prices can be set lower than

relevant competition. Under this commonly employed strategy, brands must position themselves as

better values than overpriced alternatives, which may be more than customers need. Recall the Sparkle

paper towel commercial that asks if people really need a paper towel that can pick up a bowling ball.

This line refers to premium paper towel commercials that tout their strength.

A second approach is to price at or near major competition. The idea here is to position the brand as

solidly “middle class,” high enough quality to provide better value than high priced options, but high

enough that customers do not worry about being ripped off or being too cheap. For example, for many

years, UD set its prices such that we were at the median of a group of peer Catholic universities.

Finally, brands can make the “you get what you pay for” argument and position themselves as the high

priced but secure value alternative. Many Apple products take this approach, for example. Some mass

market brands have been known to take it a step further and actually point out their high prices. In the

1970s, a brand of television called Curtis Mathes proudly proclaimed in its advertising that it was “the

most expensive television in America and darned well worth it.” The strategy worked well for about ten

years, but eventually televisions imported from Asia, which were of very high quality and much lower

priced than American brands, sent Curtis Mathes, along with all U.S. television companies, into

bankruptcy or out of business. Another example is L’Oreal hair color, which also claimed to be the

“most expensive hair color in the world,” and then added, “But you’re worth it.”

Estimate Costs and Other Price Limitations

Obviously, profit is the goal of any business endeavor, meaning that products must also account for the

costs associated with making and selling them. In all likelihood, you have already learned about

breakeven analysis, which is a simple analytical technique that helps estimate the sales and price

necessary to just cover expenses. While the tool has been criticized for oversimplifying complex pricing

and costing situations, breakeven analysis can provide reasonable price and quantity estimates if the

input costs used to make the estimates are fairly accurate.

The relationships underlying breakeven analysis are shown in Exhibit 6 on the following page. The

diagram shows the simple idea that when the total cost curve intersects the total revenue curve, then

profits will be zero, but so will losses. That is, the firm will just break even. The cost and revenue curves

are shown as straight lines, which some argue reflects a weakness in breakeven analysis. The analysis

assumes that average costs increase monotonically with output, which is generally not the case because,

among other things, economies of scale produce per unit savings at higher levels of output. On the

revenue side, price elasticity of demand is typically not linear. However, these criticisms miss an

important point about breakeven analysis. The analysis is not meant to set a precise price. The analysis

is intended to give a rough idea of what level prices cannot fall below. The actual setting of prices is far

more complex. In fact, with sufficiently accurate data, the breakeven analysis could be conducted to

reflect nonlinear price and revenue. In general, however, given the usual purpose of breakeven analysis,

the effort is really not necessary.

Pricing Strategies 13

Exhibit 6. Illustration of the Breakeven Quantity at a Given Price

The calculation of the breakeven point is really pretty straightforward. The formula, expressed as

breakeven quantity is given below. (We’ll express it in terms of price later.)

𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 𝐶𝑜𝑛𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

You should already understand what fixed costs are. Fixed cost contribution represents the amount of a

product’s selling price that’s available to pay for fixed costs. In other words, it’s price once average

variable costs (or variable costs per unit) is removed:

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝑃𝑟𝑖𝑐𝑒 − 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠

We can now substitute the formula for fixed cost contribution into the denominator of the original

breakeven formula, which yields:

𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠

𝑃𝑟𝑖𝑐𝑒 − 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠

The average variable cost formula gives the variable costs attributable to each unit produced. It’s

calculated as follows on the next page:

Units

Fixed Costs

Total Costs

Total Revenues

Breakeven

Point

$

Breakeven Quantity

Breakeven

Revenue

0

Pricing Strategies 14

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 = 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠

𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑

The formula for average variable costs can now be substituted into the breakeven formula. With this

final substitution, the breakeven equation looks like:

𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠

𝑃𝑟𝑖𝑐𝑒 − (𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑⁄ )

With this equation, marketers can input different estimates for costs and price and then determine how

many units must be sold to break even. By changing price, and therefore breakeven quantity, marketers

can develop a sense of how price interacts with costs. With estimates about demand and price

elasticity, marketers can also calculate a profit maximizing price. Of course, the estimate is just that: an

estimate. But at least it is empirically based. The actual price must be set with many other marketplace

variables in mind. Also, long term strategies must be taken into consideration. Breakeven analysis is

more in tune with short term planning.

Forecast Sales and Profit Potential

Forecasting sales is a notoriously tricky and sometimes inaccurate exercise that is nonetheless critical to

many businesses. As we will learn later in the semester, sales forecasts help managers in all functional

areas of the business plan for the allocation of company resources. However, as important as it is,

predicting the future is fraught with uncertainty.

This step and the previous step are closely related. However, when forecasting sales, we need two

things that breakeven analysis does not provide. One is an estimate of what future sales will actually be

at a given price, not just the number to breakeven. Making such forecasts frequently involve regression

modeling past sales data with other pertinent data and using the predicted values of the estimated

regression model to predict future sales under varying conditions.

The other is some sense of how desired profits affect the estimate. Here, the basic breakeven approach

can be used, but with an allowance for either a necessary rate of return or some minimum fixed dollar

profit amount. These approaches are illustrated in Exhibits 7A and 7B on the following page. Exhibit 7A

shows how a fixed amount of profit could be added to fixed expenses, which effectively raises the total

cost curve and making the level of sales necessary to cover expenses and achieve the desired dollar level

of profit. Fixed dollar amounts of profits are not often used as profit targets, but if the amount

represents some minimum needed amount, for example, to meet an upcoming dividend payment, I can

be used to analyze a minimally acceptable circumstance. Figure 7B shows how a rate of return can be

incorporated into a standard breakeven analysis. Note that as the desired rate rises, it increases the

slope of the TC+Rate curve, thereby increasing the breakeven number of units. These approaches are

similar in their basics to breakeven analysis, but with the added dimension of profitability.

Pricing Strategies 15

Exhibit 7. Breakeven Analysis with Profitability Added

Set Base Price Structure

The term, base price structure, refers to the variations that can be used in establishing a pricing policy.

The nature of these variations have much to do with the type of product and the competitive

environments in which firms compete. The price structure is generally formulated against a base price

for a standard model of product. Variations in price are typically made relative to the base price. While

some of the preceding discussion pertained to estimating the base price based on factors such as costs

and even the reactions of some major customers, the price structure is intended to provide a system for

the variations in price around the base price.

Pricing structures include such policies as optional product pricing, where a standard model at the base

price can be purchased and then options and upgrades can be added to it. Automobile manufacturers

commonly use optional product pricing, where options in engines, transmissions, interiors, trim, audio,

and other gadgets can be added to the standard model. Computers bought online also use optional

product pricing. After selecting a standard model, buyers can upgrade monitor size, memory, and other

options.

The opposite pricing approach is called product bundling, where a standard model may exist at a base

price, but only in theory; they are not for sale. What’s offered for sale are product configurations that

include various combinations of options over the standard model, with no flexibility in choice. Buyers

can choose any of the configurations, but cannot modify or change anything. Think of a restaurant that

offers various meals but will not allow substitutions.

Structured discounts are another way of varying price but in permanent and predictable ways.

Structured discounts are not temporary promotional price reductions. Structured discounts include such

things as quantity discounts, which lower per unit product prices when large orders are placed.

Seasonal discounts may be offered during specific times of year. Seasonal discounts are generally

offered for purchases made during months of slower sales. Cash discounts may be offered to customers

who pay immediately or within a few days of placing the order. The typical cash discount is offered as a

two percent discount if the invoice is paid in full within ten days. This is where the phrase “two-ten, net

Units

$

TR

TC + Fixed Profit

Desired Fixed Profit

Acceptable

Minimum

Sales

Units

$

TR Acceptable

Minimum

Sales

TC

TC +

Return

Desired Return

FC

(a) Breakeven Plus Profit

Expressed as Fixed Dollar

(b) Breakeven Plus Profit

Expressed as Rate of Return

FC

Pricing Strategies 16

thirty” comes from. Customers receive a two percent discount if they pay their invoice in ten days, or

the full amount if paid within thirty days. The common thread linking these discounts is that they are

not temporary promotional offers. They are permanent discounts built into the pricing structure of the

firm.

Make Necessary Price Adjustments

Adjustments to price are typically temporary, situational, and offered as promotional discounts. Base

prices may change, but in general marketers prefer for base prices to change infrequently. With a

relatively stable base price, marketers have a constant point of reference around which to offer

discounts and make other price and promotional concessions. The ability to put things “on sale” both at

the retail level and in the channel is an important competitive tool that not only gives customers a

financial incentive to speed up their purchase decisions, but also communicates things psychologically to

customers that affect impressions of the brands involved. Obviously, many luxury brands must use price

concessions judiciously for fear of diminishing the perceived status of the brand, but for the bulk of

everyday mid-priced and economy brands, promotional pricing around a stable base price is a standard

but important marketing tool.

Base prices do change from time to time, but generally, they rise rather than fall. Base prices most often

change when producers or retailers face rising costs. For example, in the past few years, energy costs

have affected the prices of many goods, many of which reflect significant transportation costs. In other

cases, competitive conditions may permit a price rise. For example, when low cost or discount airlines

pull out of some smaller markets, the remaining major airlines raise base prices on those routes simply

because they can. Finally, general economic conditions, such as high inflation, may force base price rises

in order to keep pace with currency devaluation. Overall, however, the majority of price changes, which

were discussed earlier in these notes, occur because marketers offer promotions of one kind or another.

Pricing Strategies 17

REFERENCES

The diagram and a portion of the discussion on residual elasticity was adapted from

Farris, Paul W., Neil Bendle, Philip E. Pfeifer, and David J. Reibstein (2006), Marketing Metrics: 50+

Metrics Every Executive Should Master. Upper Saddle River, NJ: Wharton School of Publishing.

The section on retail and channel price promotions and profitability draws from

Tellis, Gerard J. (1998), Advertising and Sales Promotion Strategy, Reading, MA: Addison-Wesley. The diagram on setting base prices was adapted from Peter, J. Paul and James H. Donnelly, Jr. (2009), Marketing Management: Knowledge and Skills, 10 ed. New York: McGraw-Hill-Irwin.