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Chapter 8

Pricing Strategy
and Management
In this chapter, you will
learn about
1. Pricing Considerations
Price as an Indicator of Value
Price Elasticity of Demand
Product-Line Pricing
Estimating the Profit Impact from Price
Changes
2. Pricing Strategies
Full-Cost Pricing
Variable-Cost Pricing
New-Offering Pricing Strategies
Pricing and Competitive Interaction
8-2
The Importance of Price

Price is a direct determinant of profits (or


losses)
Price indirectly affects costs (through
quantity sold)
Price determines the type of customer and
competition the organization will attract
Price affects the image of the brand
A pricing error can nullify all other
marketing mix activities

8-3
Relationship between
Price and Profits

Profit = Total Revenue Total Cost

Total Revenue = Price per Unit x Quantity Sold

Total Cost = Fixed Cost + Variable Cost

8-4
Pricing Considerations

Pricing Objectives have to be


consistent with an organizations
overall marketing objectives
Examples of Pricing Objectives:
Maximization of profits
Enhancing product or brand image
Providing customer value
Obtaining an adequate return on
investment or cash flow
Maintaining price stability
8-5
Pricing Considerations

Demand sets the price ceiling


Direct (variable) costs set the
price floor

Campbell Soups Intelligent


Quisine (IQ) line
Consumers found the
products too expensive
Lower price could not
cover variable costs
8-6
Pricing Considerations
Conceptual Orientation to Pricing

Demand Factors (Value to Buyers)


(Price Ceiling)

Competitive Factors
Final Initial
Pricing Pricing
Discretion Corporate objectives and Discretion
regulatory constraints

Direct Variable Costs)


(Price Floor)

Source: Kent B. Monroe, Pricing: Making Profitable Decisions, 3rd ed. (Burr Ridge, IL; McGraw Hill/Irwin, 2003).
Pricing Considerations
Factors narrowing pricing discretion

Government regulations

Price of competitive offerings

Organizational objectives and


policies

8-8
Pricing Considerations
Other factors affecting the pricing
decision

Life-cycle stage of product or service

Effect of pricing decisions on profit margins


of marketing channel members

Prices of other products and services


provided by the organization

8-9
Pricing Considerations
Price as an Indicator of Value

Value can be defined as the


ratio of perceived benefits to
price:

Value = perceived benefits


price

8-10
Pricing Considerations
Price as an Indicator of Value

Price affects perception of quality

Price affects consumer perceptions of prestige

Example:
Swiss watchmaker TAG Heuer
Raised average price of its watches from
$250 to $1000
Sales volume increased sevenfold!

8-11
Pricing Considerations
Price as an Indicator of Value

Consumer value assessments are often


comparative worth and desirability of a
product relative to substitutes that satisfy the
same need (e.g., Equal vs. sugar)
Consumers comparison of costs and benefits
of substitute items gives rise to a reference
value

8-12
Pricing Considerations
Price Elasticity of Demand

Price Elasticity of Demand is a concept used


to characterize the nature of the price-quantity
relationship
The coefficient of price elasticity, E, is a
measure of the relative responsiveness of the
quantity of a product demanded to a change in
the price of that product

E = percentage change in quantity demanded


percentage change in price

8-13
Pricing Considerations
Price Elasticity of Demand

If the percentage change in quantity


demanded is greater than the
percentage change in price, i.e., E>1,
then demand is said to be elastic.
If the percentage change in quantity
demanded is less than the percentage
change in price, i.e., E<1, then demand
is said to be inelastic.
8-14
Pricing Considerations
Factors affecting Elasticity of
Demand

The more substitutes the product or


service has, the greater the elasticity
The more uses a product or service
has, the greater the elasticity
The higher the ratio of the price of the
product or service to the income of
the buyer, the greater the elasticity

8-15
Pricing Considerations
Product-Line Pricing

Cross-Elasticity of Demand relates the price


elasticity simultaneously to more than one
product or service
The Cross-Elasticity Coefficient is the ratio of
the change in quantity demanded of product A
to a price change in product B
A negative coefficient indicates the products
are complementary (camera and film); a
positive coefficient indicates they are
substitutes (apple and pear)
8-16
Pricing Considerations
Product-Line Pricing

Product-line pricing involves determining:

1. the lowest-priced product and price


plays the role of traffic builder

2. the highest-priced product and price


positioned as the premium item

3. price differentials for all other


products in the line
reflect differences in their perceived
value of the products offered
8-17
Pricing Considerations
Estimating the Profit Impact from
Price Changes

Impact of price changes on profit can


be determined from:

Cost data
Price data
Volume data for individual
products and services

8-18
Pricing Considerations
Estimating the Profit Impact from
Price Changes

Unit volume necessary to break even on a price


change is:

% change in unit - (percentage price change)


volume to break =
even on a price
change (original contribution margin) +
(percentage price change)

8-19
Pricing Considerations
Estimating the Profit Impact from
Price Changes

For example, if a product has a 20% contribution


margin, a 5% price decrease will require a 33%
increase in unit volume to break even:

- (-5)
+ 33 =
(20) + (-5)

8-20
Estimating the Profit Impact from Price Changes

Product Alpha Product Beta


Cost, Volume, and Profit Data
Unit sales volume 1,000 1,000
Unit selling price $ 10 $ 10
Unit variable cost $ 7 $ 2
Unit contribution (margin) $ 3 (30%) $ 8 (80%)
Fixed costs $1,000 $6,000
Net profit $2,000 $2,000
Break-Even Sales Change
For a 5% price reduction +20.0% +6.7%
For a 10% price reduction +50.0% +14.3%
For a 20% price reduction +200.0% +33.3%
For a 5% price increase -14.3% -5.9%
For a 10% price increase -25.0% -11.1%
For a 20% price increase -40.0% -20.0%
Pricing Strategies

Full-cost Price Strategies


Considers both (direct) variable
and (indirect) fixed costs

Variable-cost Price Strategies


Considers only (direct)
variable costs

8-22
Pricing Strategies
Full-Cost Pricing

Full-Cost Pricing

Rate-of-
Mark-up
Return
Pricing
Pricing

Break-even
Pricing

8-23
Pricing Strategies
Markup Pricing

Selling price is determined by adding a fixed


amount, usually a percentage, to the (total)
cost of the product
Most commonly used pricing method (e.g.,
groceries and clothing)
Simple, flexible, controllable
Example: If a product costs $4.60 to produce
and selling price is $6.35, the market on cost
is 38% and markup on price is 28%.
8-24
Pricing Strategies
Breakeven Pricing

Equals the per-unit fixed costs plus the per-


unit variable costs

Useful tool for determining the minimum


price at which a product must be sold to
cover fixed and variable costs

Often used by non-profit organizations, or by


profit-making organizations that may have a
short-term breakeven objective

8-25
Pricing Strategies
Rate-of-Return Pricing

Price is set so as to obtain a pre-specified


rate of return on investment (capital) for the
organization

Assumes a linear demand function and


insensitivity of buyers to price

Most commonly used by large firms and


public utilities whose return rates are closely
watched or regulated by government
agencies or commissions

8-26
Pricing Strategies
Rate-of-Return Pricing

revenues - cost PxQCxQ


ROI = Pr / I = =
investment I

where P = Unit Selling Price; C = Unit Cost;


Q = Quantity Sold
Solving for P, we get:

ROI x I x CQ
P =
Q
8-27
Pricing Strategies
Rate-of-Return Pricing Example

An organization desires an ROI of 15% on an


investment of $80,000. Total costs per unit are
estimated to be $0.175. Forecasted demand is
20,000 units. The necessary price to attain
15% ROI is:

(0.15) x $80,000 + $0.175 x 20,000


P = = 0.775
20,000

8-28
Pricing Strategies
Variable-Cost Pricing

Represents the minimum selling price at


which the product or service can be
marketed in the short run. It is often used to:

Stimulate demand (lower fares for seniors)


Can increase revenues, and hence, lead
to economies of scale, lower unit costs,
and higher profits
Shift demand (weeknight calling plans)
Away from peak load times to smooth it
out over extended time periods
8-29
Pricing Strategies
New-Offering Pricing Strategies

1. Skimming Pricing Strategy (Gillette Mach3)


price initially set very high and reduced
over time

2. Penetration Pricing Strategy (Nintendo)


price is initially set low to gain a foothold in
the market

3. Intermediate Pricing Strategy


between the two extremes; most prevalent

8-30
Pricing Strategies
When to Use Skimming Pricing

Appropriate when:
1. Demand is likely to be price inelastic
2. There are different price-market segments
3. The offering is unique enough to be protected
from competition by patent, copyright, or trade
secret
4. Production or marketing costs are unknown
5. A capacity constraint in producing the product or
providing the service exists
6. An organization wants to generate funds quickly
7. There is a realistic perceived value in the product
or service
8-31
Pricing Strategies
When to Use Penetration Pricing

Appropriate when:
1. Demand is likely to be price elastic
2. The offering is not unique or protected by
patents, copyrights, or trade secrets
3. Competitors are expected to enter market quickly
4. There are no distinct and separate price-market
segments
5. There is a possibility of large savings in
production and marketing costs if a large sales
volume can be generated
6. The organizations major objective is to obtain a
large market share
8-32
Pricing Strategies
Pricing and Competitive Interaction

Competitive Interaction refers to the


sequential action and reaction of rival
companies in setting and changing
prices for their offering(s) and
assessing likely outcomes, such as
sales, unit volume, and profit for each
company and an entire market.

8-33
Pricing Strategies
Pricing and Competitive Interaction

Advice for managers to avoid nearsightedness


of not looking beyond the initial pricing decision:

1. Managers are advised to focus less on


short-term outcomes and attend more to
longer-term consequences of actions
2. Managers are advised to step into the shoes
of rival managers or companies and answer
a number of questions

8-34
Pricing Strategies
Pricing and Competitive Interaction

1. What are competitors goals and objectives?


How are they different from our goals and
objectives?
2. What assumptions has the competitor made
about itself, our company and offerings, and
the marketplace? Are these assumptions
different from ours?
3. What strengths does the competitor believe it
has and what are its weaknesses? What
might the competitor believe our strengths and
weaknesses to be?
8-35
Pricing Strategies
Pricing and Competitive Interaction

A Price War involves successive price cutting


by competitors to increase or maintain their unit
sales or market share. Happens when:

Managers lower price to improve market


share, unit sales, and profit

Competitors match the lower price


Expected share, sales, and profit gain from
initial price cut are lost
8-36
Pricing Strategies
Pricing and Competitive Interaction

To avoid a price war, managers should


consider price cutting only when:

1. The company has a cost or technological


advantage over its competitors
2. Primary demand for a product class will
grow if prices are lowered
3. The price cut is confined to specific
products or customers and not across-
the-board
8-37
Pricing Strategies
Pricing and Competitive Interaction

Industry Characteristics and the Risk of Price Wars


Risk Level
Industry Characteristics Higher Lower
Product/Service type Undifferentiated Differentiated
Market growth rate Stable/Decreasing Increasing
Price visibility to competitors High Low
Buyer price sensitivity High Low
Overall industry cost trend Declining Stable
Industry capacity utilization Low High
Number of competitors Many Few