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Chapter 8
Pricing Strategy
and Management
The Importance of Price
Price is a direct determinant of profits (or
losses)
Price indirectly affects costs (through
quantity sold)
Price determines the type of customer and
competition the organization will attract
Price affects the image of the brand
A pricing error can nullify all other
marketing mix activities
8-2
Relationship between
Price and Profits
Profit = Total Revenue – Total Cost
Total Revenue = Price per Unit x Quantity Sold
Total Cost = Fixed Cost + Variable Cost
8-3
Pricing Considerations
Pricing Objectives have to be
consistent with an organization’s
overall marketing objectives
Examples of Pricing Objectives:
Maximization of profits
Enhancing product or brand image
Providing customer value
Obtaining an adequate return on
investment or cash flow
Maintaining price stability
8-4
Pricing Considerations
Demand sets the price ceiling
Direct (variable) costs set the
price floor
Campbell Soup’s Intelligent
Quisine (IQ) line
Consumers found the
products too expensive
Lower price could not
cover variable costs
8-5
Pricing Considerations
Conceptual Orientation to Pricing
Demand Factors
(Value to Buyers)
(Price Ceiling)
Competitive Factors
Final
Pricing
Discretion
Corporate objectives and
regulatory constraints
Initial
Pricing
Discretion
Direct Variable Costs)
(Price Floor)
Source: Kent B. Monroe, Pricing: Making Profitable Decisions, 3rd ed. (Burr Ridge, IL; McGraw Hill/Irwin, 2003).
Pricing Considerations
Factors narrowing pricing discretion
Government regulations
Price of competitive offerings
Organizational objectives and
policies
8-7
Pricing Considerations
Other factors affecting the pricing
decision
Life-cycle stage of product or service
Effect of pricing decisions on profit margins
of marketing channel members
Prices of other products and services
provided by the organization
8-8
Pricing Considerations
Price as an Indicator of Value
Value can be defined as the
ratio of perceived benefits to
price:
Value = perceived benefits
price
8-9
Pricing Considerations
Price as an Indicator of Value
Price affects perception of quality
Price affects consumer perceptions of prestige
Example:
Swiss watchmaker TAG Heuer
Raised average price of its watches from
$250 to $1000
Sales volume increased sevenfold!
8-10
Pricing Considerations
Price as an Indicator of Value
Consumer value assessments are often
comparative – worth and desirability of a
product relative to substitutes that satisfy the
same need (e.g., Equal vs. sugar)
Consumer’s comparison of costs and benefits
of substitute items gives rise to a “reference
value”
8-11
Pricing Considerations
Price Elasticity of Demand
Price Elasticity of Demand is a concept used
to characterize the nature of the price-quantity
relationship
The coefficient of price elasticity, E, is a
measure of the relative responsiveness of the
quantity of a product demanded to a change in
the price of that product
E = percentage change in quantity demanded
percentage change in price
8-12
Pricing Considerations
Price Elasticity of Demand
If the percentage change in quantity
demanded is greater than the
percentage change in price, i.e., E>1,
then demand is said to be elastic.
If the percentage change in quantity
demanded is less than the percentage
change in price, i.e., E<1, then demand
is said to be inelastic.
8-13
Pricing Considerations
Factors affecting Elasticity of
Demand
The more substitutes the product or
service has, the greater the elasticity
The more uses a product or service
has, the greater the elasticity
The higher the ratio of the price of the
product or service to the income of
the buyer, the greater the elasticity
8-14
Pricing Considerations
Product-Line Pricing
Cross-Elasticity of Demand relates the price
elasticity simultaneously to more than one
product or service
The Cross-Elasticity Coefficient is the ratio of
the change in quantity demanded of product A
to a price change in product B
A negative coefficient indicates the products
are complementary (camera and film); a
positive coefficient indicates they are
substitutes (apple and pear)
8-15
Pricing Considerations
Product-Line Pricing
Product-line pricing involves determining:
1. the lowest-priced product and price
plays the role of traffic builder
2. the highest-priced product and price
positioned as the premium item
3. price differentials for all other
products in the line
reflect differences in their perceived
value of the products offered
8-16
Pricing Considerations
Estimating the Profit Impact from
Price Changes
Impact of price changes on profit can
be determined from:
Cost data
Price data
Volume data for individual
products and services
8-17
Pricing Considerations
Estimating the Profit Impact from
Price Changes
Unit volume necessary to break even on a price
change is:
% change in unit
volume to break
even on a price
change
- (percentage price change)
=
(original contribution margin) +
(percentage price change)
8-18
Pricing Considerations
Estimating the Profit Impact from
Price Changes
For example, if a product has a 20% contribution
margin, a 5% price decrease will require a 33%
increase in unit volume to break even:
- (-5)
+ 33
=
(20) + (-5)
8-19
Estimating the Profit Impact from Price Changes
Product Alpha
Product Beta
Cost, Volume, and Profit Data
Unit sales volume
1,000
1,000
Unit selling price
$
10
$
10
Unit variable cost
$
7
$
2
Unit contribution (margin)
$
3 (30%)
$
8 (80%)
Fixed costs
$1,000
$6,000
Net profit
$2,000
$2,000
Break-Even Sales Change
For a 5% price reduction
+20.0%
+6.7%
For a 10% price reduction
+50.0%
+14.3%
For a 20% price reduction
+200.0%
+33.3%
For a 5% price increase
-14.3%
-5.9%
For a 10% price increase
-25.0%
-11.1%
For a 20% price increase
-40.0%
-20.0%
Pricing Strategies
Full-cost Price Strategies
Considers both (direct) variable
and (indirect) fixed costs
Variable-cost Price Strategies
Considers only (direct)
variable costs
8-21
Pricing Strategies
Full-Cost Pricing
Full-Cost Pricing
Rate-ofReturn
Pricing
Mark-up
Pricing
Break-even
Pricing
8-22
Pricing Strategies
Markup Pricing
Selling price is determined by adding a fixed
amount, usually a percentage, to the (total)
cost of the product
Most commonly used pricing method (e.g.,
groceries and clothing)
Simple, flexible, controllable
Example: If a product costs $4.60 to produce
and selling price is $6.35, the market on cost
is 38% and markup on price is 28%.
8-23
Pricing Strategies
Breakeven Pricing
Equals the per-unit fixed costs plus the perunit variable costs
Useful tool for determining the minimum
price at which a product must be sold to
cover fixed and variable costs
Often used by non-profit organizations, or by
profit-making organizations that may have a
short-term breakeven objective
8-24
Pricing Strategies
Rate-of-Return Pricing
Price is set so as to obtain a pre-specified
rate of return on investment (capital) for the
organization
Assumes a linear demand function and
insensitivity of buyers to price
Most commonly used by large firms and
public utilities whose return rates are closely
watched or regulated by government
agencies or commissions
8-25
Pricing Strategies
Rate-of-Return Pricing
PxQ–CxQ
revenues - cost
ROI = Pr / I =
=
investment
I
where P = Unit Selling Price; C = Unit Cost;
Q = Quantity Sold
Solving for P, we get:
ROI x I x CQ
P =
Q
8-26
Pricing Strategies
Rate-of-Return Pricing Example
An organization desires an ROI of 15% on an
investment of $80,000. Total costs per unit are
estimated to be $0.175. Forecasted demand is
20,000 units. The necessary price to attain
15% ROI is:
(0.15) x $80,000 + $0.175 x 20,000
P =
= 0.775
20,000
8-27
Pricing Strategies
Variable-Cost Pricing
Represents the minimum selling price at
which the product or service can be
marketed in the short run. It is often used to:
Stimulate demand (lower fares for seniors)
Can increase revenues, and hence, lead
to economies of scale, lower unit costs,
and higher profits
Shift demand (weeknight calling plans)
Away from peak load times to smooth it
out over extended time periods
8-28
Pricing Strategies
New-Offering Pricing Strategies
1. Skimming Pricing Strategy
price initially set very high and reduced
over time
2. Penetration Pricing Strategy
price is initially set low to gain a foothold in
the market
3. Intermediate Pricing Strategy
between the two extremes; most prevalent
8-29
Pricing Strategies
When to Use Skimming Pricing
Appropriate when:
1. Demand is likely to be price inelastic
2. There are different price-market segments
3. The offering is unique enough to be protected
from competition by patent, copyright, or trade
secret
4. Production or marketing costs are unknown
5. A capacity constraint in producing the product or
providing the service exists
6. An organization wants to generate funds quickly
7. There is a realistic perceived value in the product
or service
8-30
Pricing Strategies
When to Use Penetration Pricing
Appropriate when:
1. Demand is likely to be price elastic
2. The offering is not unique or protected by patents,
copyrights, or trade secrets
3. Competitors are expected to enter market quickly
4. There are no distinct and separate price-market
segments
5. There is a possibility of large savings in
production and marketing costs if a large sales
volume can be generated
6. The organization’s major objective is to obtain a
large market share
8-31
Pricing Strategies
Pricing and Competitive Interaction
Competitive Interaction refers to the
sequential action and reaction of rival
companies in setting and changing
prices for their offering(s) and
assessing likely outcomes, such as
sales, unit volume, and profit for each
company and an entire market.
8-32
Pricing Strategies
Pricing and Competitive Interaction
Advice for managers to avoid nearsightedness
of not looking beyond the initial pricing decision:
1. Managers are advised to focus less on
short-term outcomes and attend more to
longer-term consequences of actions
2. Managers are advised to step into the shoes
of rival managers or companies and answer
a number of questions…
8-33
Pricing Strategies
Pricing and Competitive Interaction
1. What are competitors’ goals and objectives?
How are they different from our goals and
objectives?
2. What assumptions has the competitor made
about itself, our company and offerings, and
the marketplace? Are these assumptions
different from ours?
3. What strengths does the competitor believe it
has and what are its weaknesses? What
might the competitor believe our strengths and
weaknesses to be?
8-34
Pricing Strategies
Pricing and Competitive Interaction
A Price War involves successive price cutting
by competitors to increase or maintain their unit
sales or market share. Happens when:
Managers lower price to improve market
share, unit sales, and profit
Competitors match the lower price
Expected share, sales, and profit gain from
initial price cut are lost
8-35
Pricing Strategies
Pricing and Competitive Interaction
To avoid a price war, managers should
consider price cutting only when:
1. The company has a cost or technological
advantage over its competitors
2. Primary demand for a product class will
grow if prices are lowered
3. The price cut is confined to specific
products or customers and not acrossthe-board
8-36
Pricing Strategies
Pricing and Competitive Interaction
Industry Characteristics and the Risk of Price Wars
Risk Level
Industry Characteristics
Higher
Lower
Undifferentiated
Differentiated
Stable/Decreasing
Increasing
Price visibility to competitors
High
Low
Buyer price sensitivity
High
Low
Overall industry cost trend
Declining
Stable
Industry capacity utilization
Low
High
Number of competitors
Many
Few
Product/Service type
Market growth rate