Download m5zn_47cec91e976fd7b

Chapter 10
Pricing Products: Understanding and Capturing Customer Value
Learning Objectives
1. Answer the question, “What is price?” and discuss the importance of pricing in
today’s fast-changing environment.
2. Discuss the importance of understanding customer value perceptions when setting
prices.
3. Discuss the importance of company and product costs in setting prices.
4. Identify and define the other important internal and external factors affecting a
firm’s pricing.
Chapter Overview
Price goes by many names in our economy. In the narrowest sense, price is the amount of
money charged for a product or service. This meaning, however, has been broadened.
Today, despite the increased role of nonprice factors in the modern marketing process,
price remains an important element in the marketing mix.
The most important aspect to consider when setting price is customer value. When
customers buy something, they are exchanging something of value in order to get
something of value. For this reason, various value-oriented pricing strategies can be
employed, including value-based pricing, good-value pricing, and value-added pricing.
In addition to customer value, company costs are important in considering the setting of
price. Both fixed costs and variables costs can affect the optimal price. Such costs are
also important in calculating break-even points and target profit.
Additionally, other internal and external factors affect price. Internal factors include the
firm’s marketing objectives, marketing mix strategy, and organizational factors. External
factors that influence pricing decisions include the nature of market and demand,
competition, and other environmental factors like the economy, reseller needs, and
government actions. In the end, the consumer decides whether the company has set the
right price.
Chapter Outline
1.
Introduction
a. Toys “R” Us took the toy industry by storm by growing its market share to
25 percent in the 1980s and 1990s. It did this by offering variety,
convenience, and everyday low prices year round.
252
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
b. Now, Toys “R” Us is getting a taste of its own medicine. Wal-Mart has
been undercutting it on price for the better part of the last decade. WalMart has surpassed Toys “R” Us in terms of market share.
c. Companies today face a fierce and fast-changing pricing environment. The
challenge is to find the price that will let the company make a fair profit
by harvesting the customer value it creates.
2.
What Is Price?
a. In the narrowest sense, price is the amount of money charged for a product
or service. More broadly, price is the sum of all the values that consumers
exchange for the benefits of having or using the product or service.
Use Key Term Price here.
b. Price is the only element in the marketing mix that produces revenue; all
other elements represent costs. Price is also one of the most flexible
elements of the marketing mix.
c. Pricing is the number one problem facing many marketing executives. Yet
many companies do not handle pricing well.
i. One frequent problem is that companies are too quick to reduce
prices in order to get a sale rather than convince buyers that their
products are worth a higher price.
ii. Other common mistakes include pricing that is too cost oriented
rather than customer-value oriented, and pricing that does not take
the rest of the marketing mix into account.
Use Discussing the Concepts 1 here.
Use Chapter Objective 1 here.
3.
Factors to Consider When Setting Prices
a. A company’s pricing decisions are affected by both internal company
factors and external environment factors. See Figure 10.1.
Use Figure 10.1 here.
Value-Based Pricing
b. Pricing decisions must start with customer value because customers will
ultimately decide whether the product’s price is right.
c. Value-based pricing uses buyers’ perceptions of value, not the seller’s
cost, as the key to pricing. Value-based pricing means that the marketer
cannot design a product and marketing program and then set the price.
Price is considered along with the other marketing mix variables before
the marketing program is set.
d. Figure 10.2 compares cost-based pricing with value-based pricing.
i. Cost-based pricing is product driven.
253
Part 3: Designing a Customer-Driven Marketing Strategy and Marketing Mix
ii. Value-based pricing reverses this process. The company sets its
target price based on customer perceptions of the product value.
Use Key Term Value-Based Pricing here.
Use Figure 10.2 here.
Use Discussing the Concepts 2 here.
Use Focus on Technology here.
e. A company using value-based pricing must find out what value buyers
assign to different competitive offers. Measuring perceived value can be
difficult.
i. Sometimes, companies ask consumers how much they would pay
for a basic product and for each benefit added to the offer.
ii. Or a company might conduct experiments to test the perceived
value of different product offers.
f. There has been a fundamental shift in consumer attitudes toward price and
quality. Good-value pricing is defined as offering just the right
combination of quality and good service at a fair price.
g. In many cases, this has involved introducing less expensive versions of
established, brand name products.
i. An important type of value pricing at the retail level is everyday
low pricing (EDLP). This involves charging a constant, everyday
low price with few or no temporary price discounts.
ii. In contrast, high-low pricing involves charging higher prices on an
everyday basis but running frequent promotions to lower prices
temporarily on selected items.
iii. The king of EDLP is Wal-Mart, which practically defined the
concept.
Use Key Term Good-Value Pricing here.
Use Discussing the Concepts 3 here.
h. In many business-to-business marketing situations, the challenge is to
build the company’s pricing power—its power to escape price competition
and to justify higher prices and margins without losing market share.
i. To retain pricing power, a firm must retain or build the value of its
marketing offer.
ii. In such cases, many companies adopt value-added pricing
strategies. Rather than cutting prices to match competitors, they
attach value-added services to differentiate their offers and thus
support higher margins.
Use Key Term Value-Added Pricing here.
Use Applying the Concepts 1 here.
Use Real Marketing 10.1 here.
Use Chapter Objective 2 here.
254
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
Company and Product Costs
i. Costs set the floor for the price that the company can charge.
j. Cost-based pricing involves setting prices based on the costs for
producing, distributing, and selling the product plus a fair rate of return for
its effort and risk.
i. A company’s costs take two forms.
a. Fixed costs (also known as overhead) are costs that do not
vary with production or sales level.
b. Variable costs vary directly with the level of production.
c. Total costs are the sum of the fixed and variable costs for
any given level of production.
Use Key Terms Cost-Based Pricing, Fixed Costs, Variable Costs, Total Costs here.
Use Chapter Objective 3 here.
ii. Management wants to charge a price that will at least cover the
total product costs at a given level of production.
iii. If it costs the company more than competitors to produce and sell
its product, the company will have to charge a higher price and
make less profit, putting it at a competitive disadvantage.
iv. To price wisely, management needs to know how its costs vary
with different levels of production.
a. Figure 10.3A shows the typical short-run average cost
curve (SRAC).
b. Figure 10.3B shows the long-run average cost curve
(LRAC).
Use Figure 10.3 here.
v. Average cost tends to fall with accumulated production experience.
This is shown in Figure 10.4. This drop in the average cost with
accumulated production experience is called the experience curve
(or the learning curve).
a. A single-minded focus on reducing costs and exploiting the
experience curve will not always work. The aggressive
pricing might give the product a cheap image. The strategy
also assumes that competitors are weak and not willing to
fight it out by meeting the company’s price cuts. Finally,
while the company is building volume under one
technology, a competitor may find a lower-cost technology
that lets it start at prices lower than those of the market
leader, who still operates on the old experience curve.
Use Key Term Experience Curve (Learning Curve) here.
Use Discussing the Concepts 6 here.
Use Figure 10.4 here.
255
Part 3: Designing a Customer-Driven Marketing Strategy and Marketing Mix
k. The simplest pricing method is cost-plus pricing—adding a standard
markup to cost of the product.
i. Unit cost is calculated as follows:
Unit cost = Variable cost + Fixed costs
Unit sales
ii. Supposing a manufacturer wants to earn a certain percentage as a
markup, the following would be applied:
Unit cost
Markup price = (1- Desired return on sales)
iii. Does using standard markups to set prices make sense? Generally,
not. Any pricing method that ignores demand and competitor
prices is not likely to lead to the best price.
iv. Markup pricing remains popular for many reasons.
a. Sellers are more certain about costs than about demand. By
tying the price to cost, sellers simplify pricing—they do not
have to make frequent adjustments as demand changes.
b. When all firms in the industry use this pricing method,
prices tend to be similar and price competition is thus
minimized.
c. Many people feel that cost-plus pricing is fairer to both
buyers and sellers. Sellers earn a fair return on their
investment but do not take advantage of buyers when
buyers’ demand becomes great.
l. Another cost-oriented pricing approach is break-even pricing, or a
variation called target profit pricing.
i. The firm tries to determine the price at which it will break even or
make the target profit it is seeking.
ii. Target pricing uses the concept of a break-even chart that shows
the total cost and total revenue expected at different sales volume
levels. Figure 10.5 shows a break-even chart.
iii. Break-even volume can be calculated using the following formula:
Fixed cost
Break-even volume = Price - Variable cost
iv. The manufacturer should consider different prices and estimate
break-even volumes, probable demand, and profits for each. This is
done in Table 10.1.
256
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
Use Key Terms Cost-Plus Pricing, Break-Even Pricing (Target Profit Pricing) here.
Use Figure 10.5 here.
Use Table 10.1 here.
Use Applying the Concepts 2 here.
Other Internal and External Factors Affecting Price Decisions
m. Whereas costs set the lower limit of prices, customer perceptions of value
set the upper limit. However, the company must consider a number of
other internal and external factors. These include the overall marketing
strategy, objectives, and mix.
n. Before setting price, the company must decide on its strategy for the
product. If the company has selected its target market and positioning
carefully, then its marketing mix strategy, including price, will be fairly
straightforward. Pricing strategy is largely determined by decisions on
market positioning.
o. General pricing objectives include survival, current profit maximization,
market share leadership, or customer retention and relationship building.
p. Price decisions must be coordinated with product design, distribution, and
promotion decisions to form a consistent and effective marketing program.
Decisions made of other marketing mix variables may affect pricing
decisions. Companies often position their products on price and then tailor
other marketing mix decisions to the prices they want to charge.
i. Target costing reverses the usual process of first designing a new
product, determining its cost, and then setting a price. It starts with
an ideal selling price based on customer considerations, and then
targets costs that will ensure that the price is met.
ii. Other companies de-emphasize price and use other marketing mix
tools to create nonprice positions. Often, the best strategy is not to
charge the lowest price, but rather to differentiate the marketing
offer to make it worth a higher price.
a. If the product is positioned on nonprice factors, then
decisions about quality, promotion, and distribution will
strongly affect price.
b. If price is a crucial positioning factor, then price will
strongly affect decisions made about the other marketing
mix elements.
Use Key Term Target Costing here.
Use Discussing the Concepts 5 here.
Use Applying the Concepts 3 here.
Use Real Marketing 10.2 here.
q. Within the organization, management must decide who sets the price. In
small companies, this may be set by top management. In industrial
markets, salespeople may play a role. Still other industries utilize pricing
departments.
257
Part 3: Designing a Customer-Driven Marketing Strategy and Marketing Mix
r. The seller’s pricing freedom also varies with different types of markets
and the relationship between price and demand.
i. Under pure competition, the market consists of many buyers and
sellers trading in a uniform commodity. No single buyer or seller
has much effect on the going market price.
ii. Under monopolistic competition, the market consists of many
buyers and sellers who trade over a range of prices rather than a
single market price. A range of prices occurs because sellers can
differentiate their offers to buyers.
iii. Under oligopolistic competition, the market consists of a few
sellers who are highly sensitive to each other’s pricing and
marketing strategies. There are few sellers because it is difficult for
new sellers to enter the market.
iv. In a pure monopoly, the market consists of one seller. In a
regulated monopoly, the government permits the company to set
rates that will yield a “fair return.” Nonregulated monopolies are
free to price at what the market will bear. However, they do not
always charge the full price for a number of reasons: a desire not to
attract competition, a desire to penetrate the market faster with a
low price, or a fear of government regulation.
s. In the end, the consumer will decide whether a product’s price is right.
Pricing decisions, like other marketing mix decisions, must be buyer
oriented.
i. Each price the company might charge will lead to a different level
of demand.
ii. The relationship between the price charged and the resulting
demand level is shown in the demand curve in Figure 10.6. The
demand curve shows the number of units the market will buy in a
given time period at different prices that might be charged.
Use Key Term Demand Curve here.
Use Figure 10.6 here.
iii. In the normal case, demand and price are inversely related; that is,
the higher the price, the lower the demand. In the case of prestige
goods, the demand curve sometimes slopes upward. Still, if the
company charges too high a price, the level of demand will be
lower.
t. Marketers also need to know price elasticity—how responsive demand
will be to a change in price.
i. The price elasticity of demand is given by the following formula:
% change in quantity demanded
Price elasticity of demand =
% change in price
ii. What determines the price elasticity of demand? Buyers are less
price sensitive when the product they are buying is unique or when
258
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
it is high in quality, prestige, or exclusiveness. They are less price
sensitive when substitute products are hard to find or when they
cannot easily compare the quality of substitutes. Finally, buyers are
less price sensitive when the total expenditure for a product is low
relative to their income or when the cost is shared by another party.
iii. If the demand is elastic rather than inelastic, sellers will consider
lowering their prices.
Use Key Term Price Elasticity here.
Use Discussing the Concepts 6 here.
Use Focus on Ethics here.
u. In setting its prices, the company must also consider competitors’ costs
and prices and possible competitor reactions to the company’s own pricing
moves.
v. In assessing competitors’ pricing strategies, the company should ask
several questions:
i. How does the company’s market offering compare with
competitors’ offerings in terms of customer value?
ii. How strong are current competitors and what are their current
pricing strategies?
iii. How does the competitive landscape influence customer price
sensitivity?
w. When setting prices, the company also must consider a number of other
factors in its external environment.
i. Economic conditions can have a strong impact on the firm’s
pricing strategies.
ii. The company must also consider what impact its prices will have
on other parties in its environment, such as resellers.
iii. The government is an important external influence on pricing
decisions.
iv. Social concerns may have to be taken into account.
Use Chapter Objective 4 here.
END OF CHAPTER MATERIAL
Discussing the Concepts
1. The chapter points out that many companies do not handle pricing well. Beyond
focusing too much on cost, what are some of the other difficulties that marketers
have in setting prices?
Common problems are reducing prices too quickly, which can lead to pricing
wars and loss of profits. It can also signal to customers that price is more
259
Part 3: Designing a Customer-Driven Marketing Strategy and Marketing Mix
important than the value a brand delivers. Also, companies must taking into
consideration the other marketing mix elements.
2. What are the differences between cost-based and value-based pricing?
Cost-based pricing simply adds a standard markup to the cost of producing or
buying the product. Value-based pricing takes into account the buyer’s perception
of value and prices accordingly. Most companies use a combination of the two
strategies.
3. Four recent MBA graduates are starting their own financial services firm. They
plan to promote a “good-value” pricing strategy to their customers. Would you
recommend this pricing strategy?
Students are apt to say that with professional services, good-value pricing does
not work. But good-value pricing does not need to be equated with Wal-Mart. It
means the right combination of quality and service at a fair price. In fact, H&R
Block has become very successful with this strategy.
4. How would the risks of experience curve pricing apply to a new manufacturer of
ink-jet printers?
The printer manufacturer would charge a low initial price to capture a large
share of the market—this price could be interpreted as a cheap and inferior
product. Secondly, the competitors could also lower their price, through rebates
or other deals, so the lower price would not increase share. Finally, while the
company is building volume with ink-jet technology, the market could move in
favor of another technology, laser jet printers in this instance.
5. Pricing is based on customer perceptions of value and costs in addition to other
internal factors. Discuss these other internal factors and how they might affect the
pricing of a new Sony mp3 player.
Sony would first need to select its target market and positioning. Is this a highend product targeted to the sophisticated user who wants many features or a
simpler mp3 player brought out to compete with the lower-end iPod Shuffle?
What is Sony’s pricing objective for this product—is it survival, profit
maximization, market share gain, or customer retention? Sony would have to
make pricing decisions consistent with the other marketing mix decisions,
including distribution, pricing, and promotion.
6. Explain why elasticity of demand is such an important concept to marketers who
sell a “commodity” product?
In a price-elastic market where there is little differentiation between brands, a
small change in price can have a significant impact on the number of units sold.
260
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
Therefore it is imperative for a marketer that competes in a “commodity” market
to differentiate its product from the other competitive offerings.
Applying the Concepts
1. Visit U.S. News & World Report at
http://www.usnews.com/usnews/edu/college/rankings/bvrankindex_brief.php for
a list of schools that offer the best value. How is value defined here? Is this a valid
definition of value?
U.S. News & World Report calculates value based on the academic ranking of the
school in relation to the average cost to a student once financial aid is
considered. It could be argued that this formula does not truly take into account
the customer’s perception of value because it does not survey customers as to the
benefits they perceive they receive from the university.
2. Given the following information, calculate the number of meals a restaurant
would have to sell to break even:
Average meal price = $10.35
Meals sold = 8,560
Food = $27,653
Food labor = $18,386
Management = $4,855
Supplies = $3,133
Maintenance = $2,213
Marketing = $1,650
Insurance/legal = $1,904
Waste management = $988
Utilities = $3,159
Rent = $3,960
(For an online interactive breakeven model, go to:
http://harvardbusinessonline.hbsp.harvard.edu/b01/en/academic/edu_tk_mkt_bre
ak_even.jhtml. Register and download the application. Use it as many times as
you wish but be sure to read and observe the license restrictions.)
261
Part 3: Designing a Customer-Driven Marketing Strategy and Marketing Mix
Break-Even Analysis
Solve for:
Number Units
ANALYSIS
Product Name: Bob's
Break-Even Point
Target Profit
$0.00
Fixed Costs
Management
Rent
Maintenance
Insurance
Waste Mgmt.
Utilities
Item 7
Item 8
Fixed Costs:
Variable Costs per Unit
$4,855.00
$3,960.00
$2,213.00
$1,904.00
$988.00
$3,159.00
Food
Food Labor
Supplies
Marketing
Item 5
Item 6
Item 7
Item 8
Var. Costs/Unit:
$17,079.00
Pricing and Contribution
$3.23
$2.15
$0.37
$0.19
$5.94
Volume
Unit Price:
$10.35
Break-Even Volume:
3,873
Unit Contribution Margin:
$4.41
Expected Sales Per Month:
8,560
Sales per month expressed in:
Units
Dollars
Notes:
Copyright © 1999 President and Fellows of Harvard College
3. What does the following positioning statement suggest about the firm’s marketing
objectives, marketing mix strategy, and costs? “No one beats our prices. We crush
competition.”
This firm has adopted a low-price leader position, and a logical marketing
objective would be to gain share and maintain market share leadership. It relies
heavily on price and less so on the three other elements of the marketing mix. It is
probably the low cost provider and as a result is able to sustain its “No one beats
our prices” position.
262
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
Focus on Technology
Internet users have become used to receiving “for free” information. With some
online revenues razor thin, many Internet operations are interested in moving to more
of a “for fee” model. But customers resist paying and marketers are looking for
creative ways to blend the models. Consider Google, one of the most visited sites on
the Internet and the top search engine. To produce user fees, Google has
supplemented its free search with a service called Google Answers
(www.google.answers.com). This service, introduced in 2006, offers more than 500
carefully screened researchers to answer your questions. The user pays a nonrefundable listing fee of $.50 per question and sets a price that reflects how much he
or she would pay for a well-researched answer. The user is charged this price only if
the question is answered satisfactorily. Google pays three-quarters of the revenue to
the researcher who answers the question and keeps the other 25 percent. Fees start at
$2.50 and average around the $75 point. A recent review of questions shows a $5 fee
to answer a question on whether an artist is working on a new album and a fee of
$150 to find the portion of the music industry’s revenues derived from independent
artists.
1. Is Google Answers using cost-based or value-based pricing? Explain.
It is interesting to think about Google’s costs for this service. The fixed costs are
close to zero since there are no additional fixed costs for this service and Google
only pays researchers when customers have paid for their answers. In addition,
the price a customer pays is often totally unrelated to the researcher’s costs but
rather is based on the researcher’s level and area of expertise. This is clearly
value pricing, in which people will pay more if they perceive more benefits in
some answers compared to others.
2. What are Google’s objectives with this product?
Google is trying to drive customer loyalty by increasing its services and products.
In addition, it could be paving the way for additional “for fee” services.
3. How will increased competition affect Google’s marketing strategy for this
product?
Google will need to focus on creating value for the consumer. It needs to show
that it has the best researchers and that a user’s question can be answered more
thoroughly, affordably, and accurately at Google.
Focus on Ethics
Independent retailers have difficulty competing against megastores like Wal-Mart,
Toys “R” Us, and Best Buy. The larger retailers can usually offer lower prices due to
263
Part 3: Designing a Customer-Driven Marketing Strategy and Marketing Mix
operational efficiencies. They make up for their lower margins with much higher
sales volumes. But what happens when one of these megaretailers prices below its
costs to compete with independent retailers? Best Buy, long accused by independent
music stores as using music as a loss leader, may have crossed the line into predatory
pricing when it priced independent label CDs (indies) below its own wholesale cost.
In 2006, Best Buy ran a promotion including a week-long sale on 20 indie titles at
$7.99, about $2 below wholesale prices. Marketwide, indie CD sales soared during
the week of the sale, up 65 percent from the previous week. The problem, according
to the independent retailers, was that little of that surge came from independent
stores. Music label executives claimed that they were unaware that Best Buy would
be selling their CDs below the $9.99 wholesale price and were concerned about the
future of the independent retailers.
See Todd Martens, “Best Buy Promo Raises Ire,” Billboard, February 18, 2006, page 10.
1. How does the pricing of music CDs fit with Best Buy’s broader marketing mix
strategy?
It is clear that Best Buy is losing money on music to draw traffic into its stores.
The higher margin items, including electronics, are priced more competitively to
make up the lost revenue.
2. Comment on the elasticity of demand for indie music. Do you think Best Buy
broke even on the music?
It is surprising that the demand appeared to be elastic as evidenced by the
increase of sales during the promotion. One would expect the store with the
lowest price to have the most demand, but not to see an overall demand for the
music based on price.
Even though demand increased, it is doubtful that Best Buy would break even on
the music alone. It is important that the customers who bought the indie albums
also purchased regular priced music or other products.
3. Was Best Buy’s promotion legal? Was it ethical? Explain.
The question is whether this is predatory pricing, which is defined as an anticompetitive measure employed by a dominant company to protect market share
from new or existing competitors. Predatory pricing involves temporarily pricing
a product low enough to end a competitive threat. It is doubtful that Best Buy’s
objective in a one-week promotion was to drive its competitors out of business.
Many companies use a “loss leader” to drive traffic to their stores—we see this
every day in the retail grocery business, with milk, soft drinks, laundry detergents,
or disposable diapers often priced as loss leaders.
264
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
It does seem somewhat unfair or unethical for Best Buy to price so low. The other
members in the value chain had no idea that this would happen to the product,
and in fact, count on the small independent stores for a large percent of their
sales.
Company Case Notes
Southwest Airlines: Waging War in Philly
Synopsis
This case depicts Southwest Airlines entry into the Philadelphia market in May 2004.
This event was significant in Southwest’s history because it marked its first head-to-head
confrontation with a major airline, US Airways, in one if its core markets. The battle was
also significant as US Airways, like the other “legacy” airlines, was struggling
financially. As the opening paragraph in the case notes, for US Airways, this battle
represented a life-or-death encounter for the airline.
Southwest built its highly successful business following a marketing strategy that
featured entry into smaller, less expensive, more out-of-the-way airports where it did not
pose a threat to the major airlines. It followed a point-to-point routing pattern that
resulted in more flexibility and lower costs. By 2003, Southwest was the most profitable
airline in the industry.
The entry into the Philadelphia market represented a major change in strategy. However,
US Airways was not going to give up in its home market without a serious fight. Two
years after Southwest entered the Philadelphia market, things had changed. Southwest
had quadrupled its capacity in that market, and all major carriers had dropped their fares.
Shortly thereafter, Southwest entered Pittsburgh, another US Airways hub. Southwest
also announced that it would enter Charlotte, North Carolina, the last of US Airways’
strongholds.
But the case ends by presenting information that questions whether or not Southwest will
be able to continue to have the same effect on the industry that it has had in the past.
Environmental factors are different. And Southwest, the long-time underdog airline, is
seemingly turning into one of the airlines that it has been competing against for more
than 30 years.
Teaching Objectives
The teaching objectives for this case are to:
1. Allow students to understand how a firm’s marketing objectives and marketing
mix strategy affect its pricing decisions.
265
Part 3: Designing a Customer-Driven Marketing Strategy and Marketing Mix
2. Help students understand the nature of costs in the airline industry and how the
relationship of fixed and variable costs affect marketing decisions.
3. Enable students to understand how the nature of a market and market demand
affect pricing decisions.
4. Let students examine the pricing approaches airlines have used.
5. Allow students to make pricing and other marketing recommendations for
Southwest.
Discussion Questions
1. How do Southwest Airlines’ marketing objectives and its marketing mix strategy
affect its pricing decisions?
Students will suggest that although Southwest is smaller than some of the major
airlines, it is pursuing a market share leadership strategy. The example in the
case of its success in the Oakland market versus US Airways indicates that even
though it may not be the biggest overall airline, it tries to dominate any particular
market it enters through its low-price strategy. This should suggest to students
that even though it is entering the Philadelphia market with only 14 flights per
day, US Airways should expect it to expand its number of flights quickly if it is
successful in getting a foothold in the market. Southwest is not pursuing a current
profit maximization strategy, as some students may suggest, even though it has
been highly profitable. This should help students see that low prices do not
necessarily result in lower profits.
As to the relationship with the other marketing mix variables, students should see
that in order to deliver low prices, Southwest must keep the cost of the other
variables low. Thus, it offers a no-frills, point-to-point, air transportation service
(product) at out-of-the-way airports (places) where costs are low, with limited
and low-cost promotion. Price is the only marketing mix variable that produces
revenue, so with low prices the company must keep the cost of the other variables
low. Southwest has done an excellent job of getting the marketing mix variables to
fit with each other.
2. Discuss factors that have affected the nature of costs in the airline industry since
the year 2000. How have these factors affected pricing decisions?
These are key questions for the students to understand. It is helpful to ask students
to think about which costs are fixed and which are variable in the airline
business. Students should quickly see that all the salaries of the pilots, flight
attendants, ground crews, terminal personnel, reservations systems personnel,
and corporate employees are all fixed. The costs of the planes, the gates at the
airports, terminal fees, etc., are also fixed. The only variable costs are the
transaction costs of issuing a ticket (very low with e-tickets), the extra fuel the
266
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
plane uses because of the extra weight of the passenger and luggage, and any inflight food or beverages. The true variable cost of flying one additional passenger
is very low.
So, students should see that air transportation is a very high fixed-cost business.
In such a business, volume is important. The unit price minus unit variable cost
(unit contribution) is high. An airline must have a high volume of passengers to
cover the high fixed costs. Operating below break-even volume results in an
airline losing lots of money quickly. Operating above break-even volume results
in an airline making lots of money quickly. This is why the airlines can have lots
of sales promotions and discounts—they had rather have a passenger in a seat
making some unit contribution than have that seat be empty and produce no unit
contribution. In this type of business, a company varies its pricing to produce the
volume it needs. The text discusses dynamic pricing—charging different prices
depending on individual customers and situations. The airline industry is an
excellent example of this practice.
Students should also see from the information in the case that the older airlines,
like US Airways, have very different cost structures from the newer entrants. Not
only do they have pilots, flight attendants, and ground crews that may be
unionized and have higher salaries, wages, and benefits, but also they may have
high-cost airplanes and infrastructure. Note in the case that Southwest has an
important advantage in that it has no fixed-cost pension system. Rather, it has a
profit-sharing system. This converts pension cost from a fixed cost to a variable
cost, significantly reducing its break-even point.
Since the year 2000, various things have changed in the industry that have
affected the nature of costs. First, the costs associated with travel agencies are
dropping as Internet booking services have replaced that intermediary. While this
is a factor that is improving the cost structure for the legacy airlines, it is not
helping Southwest at all given that they have never worked through travel agents.
Second, fuel prices have gone up considerably. The nature of the fuel contracts
that many airlines have, including Southwest, are changing. In some cases they
may be more favorable. In Southwest’s case, they are becoming less favorable.
Other things that are affecting Southwest’s structure is that it is adding amenities
that it previously did not offer (satellite radio) and it is starting to provide service
out of the big airports that charge higher fees.
3. How do the nature of the airline market and the demand for airline service affect
Southwest’s decisions?
Students will suggest that the airline market traditionally has been an example of
oligopolistic competition—relatively few sellers were highly sensitive to each
other’s pricing and marketing strategies. Students may recall news stories about
how an airline announced a price increase but then had to cancel it because other
airlines did not follow.
267
Part 3: Designing a Customer-Driven Marketing Strategy and Marketing Mix
However, other students may suggest that the airline industry is moving toward
monopolistic competition. As more airlines enter the industry and trade over a
wide range of prices with differentiated offers, the market’s nature is changing.
The text discusses the importance of consumer perceptions. As low-fare airlines
entered the market, their low prices affected the way consumers viewed airline
prices. Consumers saw that they could fly from point A to point B at a much lower
price if they were willing to give up some of the frills and extras that airlines
traditionally offered. This affected their view of what the “right” price was for air
transportation.
The text also discusses price elasticity. Students who are more perceptive will
have noticed the discussion in the case that indicated when Southwest entered the
Oakland market, average one-way fares fell from $104 to $42—and traffic
tripled. This indicates that the demand for air transportation is price elastic.
Using these numbers, we could calculate the elasticity: +300 percent divided by 60 percent = -5. One would expect that as Southwest enters the Philadelphia
market, that market would expand also.
Students will also note that an important external factor in airline pricing is the
price of fuel. Although the case does not discuss oil prices, students will
remember that 2004 was a time of rapidly rising oil prices. These prices put much
pressure on the airlines to cut costs or raise prices to reflect the increased fuel
costs. However, with the low-fare airlines already having lower cost structures,
the older airlines were not successful in raising prices.
4. What general pricing approaches have airlines pursued?
Students will suggest that airlines have traditionally practiced value-based
pricing. They should know that airlines have often charged much more for lastminute purchases as compared with tickets purchased well in advance. This
strategy charged more to the person, often a business traveler, who was willing to
pay more for the availability of that seat. Airlines priced some seats high just to
hold them for these last-minute travelers. Leisure travelers would not and could
not pay such high prices. However, they were willing to purchase in advance and
pay a lower price.
Students will also note that, as the text suggests, the airline industry, led by the
low-fare airlines, is practicing value pricing. The new companies are offering just
the right combination of quality and good service at a fair price. They have
introduced less expensive versions of the “brand name” airlines’ products.
There is also an element of competition-based pricing here. To the extent that
competitors’ prices establish a “going rate” for a particular route, a firm may
have to offer that price also regardless of its particular costs.
268
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
5. Do you think that Southwest will be able to continue to maintain a competitive
advantage based on price? What will happen if other carriers match the low-price
leader?
Based on the last part of the answer to question 3, it is becoming more and more
difficult for Southwest to maintain a big cost advantage. As Gary Kelly states, “I
just don’t see how that can be indefinitely sustained without some sacrifice.” At
the same time, legacy airlines are getting more cost efficient. And, the presence of
low-cost upstart airlines has increased dramatically. Thus, the difference in cost
structure between Southwest and all other airlines in the industry is shrinking. As
a result, other airlines are more capable of matching Southwest’s fares and being
able to sustain those prices without incurring the damage they once did. The
issues with respect to airlines matching Southwest’s prices are different now than
they were 10 years ago. More airlines will do this, and they will hurt less from it.
Thus, Southwest will either have to dig deeper as far as price cuts (which it likely
will not be able to afford to do) or find some additional point to compete on.
Teaching Suggestions
This case provides an excellent opportunity for students to do some research to find out
how Southwest has done in the Philadelphia market and what has happened to US
Airways, both in that market and in general.
In addition to the questions asked, students could be engaged in a discussion of
recommendations. Students may discuss how Southwest should position itself versus the
other low-fare airlines. Southwest has a history of being entertaining. Its flight attendants
often work to get the customers to laugh. At a time when flying has become more of a
hassle due to security regulations, Southwest might want to emphasize that positioning.
Helping its customer relax and have some fun in the midst of what can be a mentally and
physically tiring trip could add value to flying Southwest.
A first recommendation that students may make is that Southwest should use its
promotional tools not only to communicate about its low fares but also to educate
customers about what Southwest is and what it offers. Although many customers may
know of or have used Southwest at a neighboring airport, many potential leisure
customers will not have had that experience. Southwest wants to use these customers to
expand the market. These customers may not have thought about how inexpensive it
might be to fly on their next vacation or family visit. Southwest wants these people to
consider flying versus driving.
Southwest’s strategy is about more than just low price. It has established a brand that
promises a total experience that will be satisfying to its customers. It offers on-time
departures and arrivals, friendly service, error-free baggage handling, the availability of
low fares, an easy frequent-flyer program, and direct flights. Students can suggest any
number of promotion ideas to communicate Southwest’s brand promise to the leisure
traveler.
269
Part 3: Designing a Customer-Driven Marketing Strategy and Marketing Mix
For the thrift-minded businessperson, students will suggest that price may be the most
important factor, but the total experience will be what keeps that customer coming back
to Southwest. It may be that some businesspeople do not think about flying Southwest.
So, promotions should communicate that Southwest also serves businesspeople interested
in saving money. Some students may suggest that Southwest should segment the business
market and target that small business owner or manager who may travel only a few times
per year. There may be locally-oriented business newspapers or magazines that
Southwest can use to communicate with these customers.
The case mentions that other low-fare airlines are beginning to offer some frills, such as
JetBlue making Direct TV available at every seat free of additional charges. This points
out the disadvantage of letting customers focus only on price. Meeting a competitor’s
price may be easy. However, the company has to differentiate itself. A customer who can
get a low fare and free TV may well take that offer. Southwest is going to have to deal
with the issue of what it is going to do as competitors, some of whom have even lower
cost structures, enter its markets with enhanced product offerings. Again, the key will be
to get its customers and potential customers to see the value of the entire Southwest
experience, not just the price.
This case goes well with the other pricing chapter (Chapter 11), with the chapters on
managing customer relationships and company strategy (Chapters 1 and 2), and with the
competitive strategy chapter (Chapter 17).
ADDITIONAL MATERIAL
Barriers to Effective Learning
1. Pricing is always a difficult subject for the average student. It is recommended
that the instructor carefully read the material in this chapter and then plan the
subjects for discussion. In addition, it is also useful to know the students’
backgrounds (or what they already know) before the lecture begins. For instance,
if the students have already had their basic economics and accounting courses,
material on costs and demand can be quickly reviewed instead of pursuing the
material in detail. Focusing on marketing pricing, the first barrier, usually occurs
with understanding all the factors that must be considered when setting prices.
Carefully cover the material in the text that deals with the internal and external
environments (see Figure 10.1). To illustrate these factors it is most useful to
construct an example (use the design of a new computer, new software, or a new
article of clothing). Ask the students how they would assess both of the
environments to determine pricing considerations for the example product(s).
What environmental factors would be of primary importance? Where would they
find data on these environments? How could the Web be used as a resource base?
2. The section on General Pricing Approaches (though explained well in the text)
can be difficult for students who have not had this material before. The best way
270
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
to quickly explain this material (without boring the students that have already had
it) is to take the examples that are usually found in the first paragraph of each
subsection and demonstrate how the technique works. Ask the students to give
examples of when the technique would be preferable. Be sure to indicate to the
students how exam material will be written from this material to avoid later
confusion.
3. The last major barrier to be found in this chapter comes from a lack of
understanding of the concepts of Value-Based Pricing. By using Figure 10.7, the
instructor can demonstrate the above concept. Carefully cover this material to
avoid future confusion. This discussion can be followed with a related discussion
on Competition-Based Pricing.
Student Projects
1. Interview a local business about their pricing philosophy and/or strategy. Use
their terms and then apply what you have learned from them to assess their
approach to those described in the text. What are the similarities and differences?
How successful do the strategies appear to be? How did you make this judgment?
2. Use the local newspaper to compare grocery store ads for price specials. What can
you determine about the competitors’ pricing strategies? How many of the
techniques from the chapter do the organizations seem to be using? What strategy
appears to be the most successful? How did you make this judgment?
3. According to the text, the pricing challenge for many businesses is to find ways to
maintain the company’s pricing power. What does this mean? What are some of
the ways that pricing can be increased?
4. Critically analyze the following general approaches to pricing: cost-based pricing,
value-based pricing, and competition-based pricing. Explain the differences
between these methods.
5. Find examples of products that seem to fit the following marketing objectives for
pricing: survival, current profit maximization, market share leadership, and
product quality leadership. Use different examples than those found in the text,
and explain your reasons for picking the products you did.
6. Find illustrations of markets or products that seem to fit the following situations:
pure competition, monopolistic competition, oligopolistic competition, and pure
monopoly. Use different examples than the ones found in the text, and explain
your reasons for picking the products or markets you did.
7. Take a product or market situation of your choice and demonstrate the concepts of
price elasticity and price inelasticity of demand. Use different examples than
those in the text.
271
Part 3: Designing a Customer-Driven Marketing Strategy and Marketing Mix
Interactive Assignments
Small Group Assignment
1. Form students into groups of three to five. Each group should read the opening
vignette about Toys “R” Us. Each group should then answer the following
questions:
a. What appears to be Toys “R” Us’ primary pricing strategies?
b. Why have the same strategies that led Toys “R” Us to gain so much
market share in the 1980s and 1990s resulted in market share losses now?
c. What is the value that Wal-Mart is providing to its customers? What is the
value that Toys “R” Us is providing to its customers?
d. How can Wal-Mart sell products below cost? Can they really afford to do
that across their entire toy line?
e. What recommendations would you make to Toys “R” Us?
Each group should share its findings with the class.
Individual Assignment
1. Read the opening vignette to the chapter. Think about the answers to the
following questions:
a. What is the relationship between price and demand in the toy industry?
b. Why have the same strategies that led Toys “R” Us to gain so much
market share in the 1980s and 1990s resulted in market share losses now?
c. What is the value that Wal-Mart is providing to its customers? What is the
value that Toys “R” Us is providing to its customers?
d. How can Wal-Mart sell products below cost? Can they really afford to do
that across their entire toy line?
e. Consider the effect of current economic and social issues on the toy
industry.
Share your findings with the class.
Think-Pair-Share
1. Consider the following questions, formulate an answer, pair with the student on
your right, share your thoughts with one another, and respond to questions from
the instructor:
a. What is price?
b. Discuss the role that customer value plays in the determination of price.
c. Explain the difference between value-based, good-value, and value-adding
pricing strategies.
d. What is cost?
e. What are the different types of costs and what are the effects of each on
setting price?
272
Chapter 10: Pricing Products: Understanding and Capturing Customer Value
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
p.
q.
Explain the role that cost plays in the determination of price.
How can companies balance both customer value and cost in setting price?
How do companies create pricing objectives?
Explain cost-plus pricing. Under what conditions does this strategy make
sense?
What is the advantage of break-even pricing?
What are the primary pricing objectives?
What is target costing?
Explain the relationship between price and demand.
Characterize the pricing in the four different types of markets mentioned
in the chapter.
What is price elasticity of demand? What are the factors that affect price
elasticity?
What are the primary methods of competition-based pricing?
Describe some of the major external factors that affect pricing decisions?
Outside Example
The opening vignette for Chapter 10 on Toys “R” Us gives a classic example of a
company that has risen to the top based on providing variety, convenience, and low
prices, only to be outdone at its own strategy by some company that found a way to
execute it better. The chapter case for Chapter 10 is on Southwest Airlines. Southwest
provides another stellar example of an underdog company in a very competitive industry
full of barriers to entry that succeeded based on cost and pricing strategy. Is history likely
to repeat itself? Can Southwest be bested at its own game?
The case itself provides evidence that other upstarts and even legacy airlines may be able
to match Southwest. But a revolutionary approach by some other airline may just set
Southwest on its heels. That airline is Ryanaire and is the focus of the opening vignette
for Chapter 11. This example of an airline that is offering free (yes free) airline service
provides an excellent transition between the two pricing chapters.
1. How can an airline possibly be profitable by offering air service for free?
2. What portion of Ryanaire’s revenue stream do you think has the most potential
for adding to its bottom line?
3. What type of general pricing approach is Ryanaire using? Can others such as
Southwest copy this?
273