Summer 2016 examination

MG403
Pricing Strategy
Suitable for all candidates

Instructions to candidates
It is compulsory to answer ALL questions. The number of marks for each question is indicated next to the
question.
Time Allowed - Reading Time:
Writing Time:

None
3 hours

You are supplied with:

No additional materials

You may also use:

No additional materials

Calculators:

Calculators are allowed in this examination

LSE ST 2016/MG403

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1. Cost Plus and Economic Value

Jack Clancy was the youngest product manager at Quantum Computing, a large manufacturer of servers
and other high-tech products. He had joined the company six months ago as a newly minted
management graduate of the London School of Economics. He was now getting his first shot at some
real responsibility his task was to develop the pricing strategy for the "Quantum Bundle" (i.e., the new
Cerberus server coupled with the Homer software tool). As his boss, Kavita Gupta explained, the
Cerberus is tailored specifically to meet an emerging U.S. marketplace opportunity. But, she had
said, we really feel that the key to making this product a success is going to be our ability to sell the
server with our new software tool, Homer. Homer will allow Cerberus to perform up to four times faster
than its standard speed, she explained. It had cost Quantum $6,000,000 in development costs to
produce an acceptable version of Homer.
Quantum Computing was the largest player in the overall computer industry. It had been competing in
the server market for 30 years by selling its high-end performance servers, called Janus, to large
enterprise customers. It was now seeking to enter the basic server market, which was dominated by
Wave Computers. Basic servers were used by companies to perform simple, repeatable tasks such
as showing website information. The market for such servers was around 50,000 units, and Quantum
was confident of capturing 20% market share. Wave, with its Hades product line, had concentrated its
efforts solely on the basic server market, and currently had 50% market share. Beta tests had
confirmed that Homer allowed Quantum's basic servers to perform up to four times faster than the
benchmark speed, when loaded with the Homer software tool. That meant th at a business customer
could conceivably receive the same level of performance by buying one Cerberus loaded with Homer
as compared to buying four basic servers. The hope, according to Gupta, was that Cerberus and
Homer are going to help Quantum enter a new market - one that has been dominated by Wave
Computers for longer than I care to remember.
There were several key factors influencing the pricing strategy for the "Quantum Bundle" that Clancy
had to keep in mind. First, he thought about the Server Division's traditional focus on hardware. This
division had placed only limited emphasis on developing and selling software tools that helped to
enhance the performance of their servers; in fact, the general belief was that software tools should be
provided to the customer for free. Second, the division had long relied upon cost-plus pricing analysis
(the standard approach to pricing in the industry) to determine the prices of their servers. The firm used
a 30% margin for all its cost plus pricing. Based on this, the price of the Cerberus had been set at $6000
(Note: This was not something that Clancy could change).
Clancys thoughts turned to one of his favourite classes at the LSE, a course on pricing strategy that he
had taken with a warm and caring instructor named Mo. Looking back at his notes, he considered three
possible ways to go forward with a pricing strategy for the Quantum Bundle.
1.

Stick with company tradition by charging only for hardware and give the Homer
software tool away for free (i.e., the Quantum Bundle would be priced at $6,000).

2.

Charge a price based on a cost-plus approach to pricing Homer (based on the software tool's
development costs). Note that the price of Cerberus has already been determined through this
method to be $6,000 per server.

3.

Charge a price based on the perceived Economic Value of the bundle.

He had access to the relevant cost and pricing information to make an informed decision on the Quantum
Bundle (see Tables 1a and 1b). While servers lasted 3 years on average, his manager had asked Clancy
to be conservative in his calculations, and compute savings assuming a server life of 1 year only.

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Hint: A tip that will greatly simplify your calculations; in case you missed the point in the description above,
Clancy really only has leeway in the pricing of the Homer part of the Quantum Bundle the Cerberus bit
has to be priced, per company policy, at $6,000.
a. Calculate the price the firm would charge if Clancy followed the cost plus approach, using the
firms traditional margin. Make sure you indicate the price of Homer as well as that of the total
Quantum Bundle. (4 marks)
b. What is the Economic Value of the Quantum Bundle? (20 marks)
c. Suggest a price for the Quantum Bundle. Briefly explain your rationale for deciding on this price.
(10 marks)
Table 1a: Cost Information
Cost Information
(per server)

Basic Server
High Performance Server

Electricity

Cost of
Software
License

$750
$1,000

$1500
$2,500

Labour (Number
of servers an
administrator can
manage)
40
20

Note: All numbers above are annual

Notes:

Cost of Electricity: Charge for heating and cooling servers, etc.

Cost of Software Licenses: Assume application software is licensed per server.

Cost of Labour: A server administrator's annual salary is $80,000.

Table 1b: Price Information (per server)
Quantum Basic Server (Cerberus)

$6,000

Quantum High Performance Server

(Janus)

$22,000

Wave Basic Server (Hades)

$5,100

Please turn over for question 2

LSE ST 2016/MG403

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2. Iso-Profit Calculations
Consider a market with three microwave manufacturers, Loki, Baldur and Magni, listed in decreasing order
of market share. Loki is considering a deep price cut for two reasons. First, it is spoiling for a fight because it
feels that engaging in a price war will enable it to grab serious market share from the other two firms.
Second, the firm knows that its production technology is such that an increase in volume beyond a threshold
causes its production cost to decrease by 20% (meaning, all units can now be produced at the lower price).
Relevant information on Lokis costs and volumes is given in Table 2a. Loki has also acquired information
on how its price cuts in the past have affected Baldur and Magni it knows that its cross-price elasticity with
Baldur is 1.25 and with Magni is 0.80 (to clarify, this is the elasticity of change in the competitors quantity
when Loki changes its price). Current volumes and prices for all three firms are given in Table 2b.
a. Loki goes ahead and cuts prices by 20%. How many units would it have to sell to make the same
total contribution as it was making earlier? What is the minimum price elasticity it needs for this to
happen? (8 marks)
b. Loki finds that it actually managed to sell 48,000 extra units. What does this imply about Lokis actual
own-price elasticity? (2 marks)
c. Given what you know about Lokis cross price elasticity with respect to Baldur and Magni, calculate
how much of Lokis gain is due to selective demand and how much to primary. Based on these
numbers, what can you say about the nature of demand in the market? (10 marks)
d. Emboldened by the spectacular success of its last round of price cuts, Loki decides to repeat the
tactic, this time with an even deeper price cut of 30%. Given its new volume (108,000 units),
compute how many more units it would need to sell, to make the same total contribution as before.
Given what you know of its own-price elasticity, should it go for this second price cut? [Note: To
avoid any confusion, the base case for this second price change is the situation that prevails after
the first price cut, i.e., prices, volumes, and costs that prevailed after the cut.] (10 marks)
Table 2a: Loki: Cost Structure
Variable Costs (per unit)
$200
$160

Volume (number of units)

<=100,000
>100,000

Table 2b: Volumes and Unit Price by Firm

Name
Loki
Baldur
Magni

Units sold
60,000
25,000
15,000

Unit Price
$400
$450
$350

Please turn over for question 3

LSE ST 2016/MG403

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3. Life Time Value (LTV)

Muse Financial Group is considering its present marketing strategy with a view to making changes for the
future. The company currently has a customer base of 250,000, split 60/40 between regular and premium
customers. The former subscribe to a basic package of services that include up to 5 financial transactions a
year and 24X7 online access to their account. Premium customers get up to 25 financial transactions a
year, 24X7 online access to their account, and up to 3 consultations with a financial planner annually. It
costs the firm $800 to acquire regular customers and $2,000 to acquire premium ones. The firm charges
each customer a percentage fee based on average assets under management this and other details on
each customer type are given in Table 3.
Table 3: Fees and Costs: Regular and Premium Customers
Regular

Premium

Acquisition cost

$800

$2000

Average assets under

management

$250,000

750,000

Percentage fee charged

1%

0.75%

Cost to serve

$1,250

$3,000

Retention rate

80%

85%

Discount rate

10%

10%

Note: All numbers above are annual, except for the acquisition cost which is incurred only once.
a. What is the LTV of a regular customer? What is her LTVROI? (6 marks)
b. What is the LTV of a premium customer? What is her LTVROI? (6 marks)
c. The firm is now considering one of three options for how it would like to spend its allocated budget
on marketing.
i) Decrease Acquisition Cost for Premium customers to $1,250
ii) Reduce churn for the Regular segment to 15%
iii) Reduce costs to serve for both segments by 20% (i.e., each segments costs to serve go
down by 20%)
Assuming each of these activities cost the same amount, which would you recommend Muse to pursue?
(Note: Your answer has to be backed up with numbers for each of the alternatives.) (18 marks)

Please turn over for question 4

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4. Conjoint Analysis
The output of a conjoint model based on the ratings of an individual consumer is given in Table 4, which
also describes the variables used.
a. What is the most important attribute and what is its importance weight? (3 marks)
b. What is the value of Vespas brand name over GenZe? (3 marks)
Table 4: Regression Output for Conjoint Analysis
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.57
0.32
R Square
Adjusted R
0.32
Square
1.48
Standard Error
Observations
765
ANOVA
df
6
758
764

SS
782.90
1650.09
2432.99

Coefficients
5.60
-0.5
-1.39
-2.21
-0.35
-0.63
-0.74

Standard
Error
0.13
0.11
0.13
0.13
0.11
0.13
0.13

Regression
Residual
Total

Intercept
Fuel Cost
2500
3500
Phone Dock
Yamaha
GenZe

MS
130.48
2.18

t Stat
42.90
-4.42
-10.62
-16.93
-3.12
-4.86
-5.67

F
59.94

P-value
5.5E-20
1.13E-05
1.13E-24
9.26E-55
1.8E-03
1.41E-06
2.0E-08

The variables are defined as follows.

1. Fuel Cost: 3p/km or 6p/km, with 3p/km as the base.
2. Price: 1500, 2500, 3500, coded with 1500 as the base.
3. Phone Dock: 0/1, with 1 implying presence of Dock and 0 as the base.
4. Brand Name: Vespa, Yamaha, GenZe, coded with Vespa as the base.

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