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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