Download Pricing: A Value

9-500-071
REV: NOVEMBER 3, 2003
ROBERT J. DOLAN
Pricing: A Value-Based Approach
As described in the Note on Marketing Strategy (598-061), a firm’s marketing program is directed
to creating value for its customers. Understanding customers’ wants is the foundation for building
the marketing mix consisting of:
!
A product meeting the wants;
!
An information program conveying the value of the product to customers;
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A distribution program making the product readily available.
Each part of this value creation process obviously costs money. Pricing’s role in the marketing mix is
to tap into the value created and generate revenues to (i) fund the current value creation activities, (ii)
support research activities for future products and for most organizations, (iii) generate a profit from
the firm’s activities.
A complete pricing program has many components. For example, consider U.S. Pioneer’s pricing
of its DVD player, model DV-525:
!
A unit price to dealers/distributors had to be set.
!
Accompanying terms and conditions specified, e.g.,
–
any quantity discounts
–
when payment was due
–
any discounts for payment in that time interval
–
whether price included shipping or not
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The Manufacturer’s Suggested Retail Price (MSRP) was set at $425.00.
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For Christmas season 1999, a $50 consumer rebate was offered for this model.
!
Terms and conditions set for the rebate.1
1 The rebate only applied to bricks-and-mortar retail purchases and at the two Pioneer authorized internet sellers (Crutchfield
and Circuit City).
________________________________________________________________________________________________________________
Professor Robert J. Dolan prepared this note as the basis for class discussion.
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Thus, in addition to setting the unit price to dealers for the DV-525, Pioneer’s pricing policy also
included decisions on (i) terms and conditions governing the sale, (ii) how to “position” the product
in its DVD line via the $425 MSRP, (iii) a “sale” offered to consumers for a limited time, (iv) the form
that “sale” would take (a direct-to-customer mail in rebate), (v) restrictions on where the “sale”
would be available.
Pricing decisions have a broad scope and a highly levered effect on net income. Consider the
impact of being able to increase average price received from customers by 1% while still holding unit
sales volume. This could be done, for example, by finding 10% of customers for whom the product
was “underpriced” by 10%, or 20% for whom it was “underpriced” by 5%, and raising prices
accordingly. How much would that impact net income? Given a cost structure typical of a large
corporation, a 1% boost in price realization yields a net income gain of 12%.2 Thus, “getting pricing
right” is a big deal. However, pricing is often an afterthought in corporate strategy. If:
Profits " [Price ! Cost] * Unit Sales
there is often more emphasis on the Cost and Unit Sales parts of the profit equation than Price. Price
is seen as “determined by the market” or “something we really don’t have much control over.”
Marketers with this reactive attitude typically miss great profit opportunities.
This note covers some of the important fundamentals behind “pricing right.” It builds on The
“Note on Low Tech Marketing Math” (599-011) which presents the margin and break-even analysis
useful in pricing decision making. The three major sections of this note address the following:
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Determining Customer Value and Sensitivity to Pricing
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Customizing Price to the Value Delivered
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Integrating Price with the Other Mix Elements
The note closes by consideration of important legal and ethical issues.
Determining Customer Value and Sensitivity to Pricing
Pricing should be driven primarily by the value of the product to the customer. There are a
number of ways in which this value can be estimated. This value analysis should be complemented
by an analysis of just how important price is in the customer’s decision-making process. This price
sensitivity varies markedly across situations.
Consider, for example, an interventional cardiologist preparing to do surgery on a heart patient
with an artery blockage. The best solution is to insert a “stent” into the artery to hold back the plaque
against the artery walls, allowing blood to flow freely again through the artery. There are three major
stent suppliers in the market. How important is the price of the stent to the doctor in choosing which
one to insert?
Not very. Because this is a life-or-death situation for the patient, product performance is the key.
Second, the doctor is a very knowledgeable, sophisticated decision maker, aware of stent features and
the advantages/disadvantages of each for various types of blockages. Third, he or she may have
more experience inserting one type of stent or another and would prefer not to shift away from the
2 See R.J. Dolan and H. Simon, Power Pricing (Free Press, 1997), p. 4 for specific firm examples and discussion.
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“usual brand” if it is appropriate for the situation. Finally, perhaps the fact that the doctor is not the
one paying for the stent would be an added factor in depressing the sensitivity to price.
Much of this may seem pretty intuitive or common sense. But, a systematic approach can be
helpful in judging price sensitivity and seeing how it may even be influenced by marketing efforts.
Five major areas to be considered are now discussed in turn.
1. Product Category Factors
Price sensitivity tends to be lower in low-cost product categories, e.g., a 10% price differential may
not be a big deal when the issue is choosing among hammers in the $5 price range, but a bigger deal
when considering $1,500 personal computers. Three factors should be considered:
A.
Absolute Dollar Cost.
B.
Dollar Cost to be a “regular user” of the product. This accounts for purchase frequency. For
example, a “no-name” golf ball may cost $2.00 and a Titleist $3.00. But a retired individual
playing golf 200 times per year on a water-hazard-filled course may see it as a decision on a
yearly supply of three balls per day, making it a $1,200 versus $1,800 decision, not a $2.00
versus $3.00 decision.
C.
Dollar Cost of item as a percentage of total cost. Particularly in business-to-business
situations, it is important to understand the proportion of the total cost represented by the
item. The lower the percentage, the lower will be the price sensitivity. Dolan and Simon3
give the example of a chemical whose use accounted for 50% of the cost of producing heat
insulation and 5% of the cost of producing polyesters. A 10% price increase for the chemical
would increase the heating insulation manufacturer’s total cost by 5%; polyester producer’s
by only .5%. The polyester producer was less sensitive to any price increases.
2. Who Pays?
Some things the user of the product pays for; sometimes not (as demonstrated by the intervenetional cardiologist example). Situations vary from ones wherein the decision maker pays no portion
of the cost, to shared cost situations (e.g., the decider pays some percentage of the cost), to cases
where the decision maker bears full responsibility. To the extent that the decider is responsible for the
costs, the greater is the price sensitivity.
3. Competitive Factors
A number of competitive factors influence price sensitivity. Price sensitivity is higher to the extent
that:
A.
The decision maker does not perceive significant differences in alternative products.
B.
(A slight variation of #1)—the more knowledge a decision maker has about alternative
products and their prices (a corollary of this is that price sensitivity is higher when such
information is easy to obtain).
3 R.J. Dolan and H. Simon, Power Pricing (Free Press, 1997), p. 130.
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C.
It is easy to compare products and their price schedules. Some comparisons are apples-toapples (e.g., two life insurance policies paying $1 million if the holder dies). Easy
comparison on product features highlights price. Price sensitivity is dampened when
products are not easily compared (e.g., two disability policies varying in number of days
after disability that payments begin, maximum number of days of coverage, and type of
injury/certification required to qualify). Price sensitivity is also dampened when price is
hard to compare, viz. price schedules are stated differently (e.g., one vendor is 10¢ per unit
consumed in the month, another is 8¢ per unit plus a $10 per month fee).
D.
It is easy for the decision maker to switch products. Difficulty in switching can arise for
psychological reasons (e.g., a perception of risk and the desire to stick with the familiar
brand) or functional ones (e.g., other systems have been set up anticipating being used in
tandem with this particular item, loyalty programs such as frequent flyer miles, or
investments in training).
4. Reference Prices
In some situations, the consumer develops a “reference price” which forms the foundation from
which the suitability of actual prices is judged. The reference price may be function of (i) what is seen
as “fair” (based perhaps on some estimate of the cost of production), (ii) a competitor’s price for a
similar item, (iii) the price last paid for the item, and (iv) what others are paying for the item.
Reference prices are subjective formulations in the consumer’s mind and thus are possibly influenced
by many factors including the firm’s marketing program. Price sensitivity is greater to the extent that
price moves above this “reference” value.
5. Price/Quality Relationships
In some categories, particularly ones in which product quality is difficult to judge by inspection
before purchase (e.g., perfume, consulting services), price can be used as cue to product quality. Price
being used in this way dampens price sensitivity.
There is no formula to blend these various considerations together but a systematic consideration
of these, which may individually point in different directions, helps assess overall sensitivity.
Assessing a Product's Value to Customers
Once price sensitivity is understood, regardless of the summary judgment on how great or small it
is, it is important to develop an understanding of the product’s value to customers. The major
methods of assessing this value, whose applicability varies by situation, are:
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Judgments based on an understanding of the buyer’s cost structure
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Surveys in which customers are asked either directly or indirectly about value.
1. Cost Structure Studies
In a cost structure study, one assesses the “true economic value” (TEV) of a product to a customer
by understanding the competitive alternatives, the price and performance of those alternatives, and
the buyer’s costs.
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TEV has two major components:
TEV = Cost of the Alternative + Value of Performance Differential
If the buyer has several alternatives, the calculation has to be relative to the “best” alternative. For
example, what is the value of a flight on the Delta Shuttle to a busy advertising agency executive
needing to get from Boston to New York? One could calculate the TEV relative to going on the bus;
but, this leads to an irrelevant number, as the “best” alternative is the U.S. Air Shuttle, flying
essentially the same departure-every-hour schedule as Delta from the same airport. In this case, the
“Value of the Performance Differential” is likely to be very small, as there is little product
differentiation. Hence, in this situation, the executive’s TEV for Delta would be very close to U.S.
Air’s price.
This approach is more useful when there is a performance differential to be considered. A product
may be superior to the reference alternative in some dimensions, but inferior in others. For example,
consider a “reference product” and “new product” with the following characteristics:
Operating Cost/Hour
Probability of System Crash
Price
Reference
New
$10
20% over one year
$75,000
$15
1% over one year
To be determined
The “New” product has higher operating cost per hour but a significantly lower probability of
System Crash.
Consider a customer obtaining a one-year useful life of the system and operating it 2500 hours over
that time. To assess the TEV of “New” to this potential customer one needs to estimate the cost of a
system crash. If this was $100,000 (and both “Reference” and “New” agree to bear the cost of any
crash after the first one in the year):
TEV = Price of Reference + System Crash Savings – Added Operating Cost
= $75,000 + [.2(100,000) - .01(100,000)] – {[2500 hours X $15/hour] – [2500 hours x $10/hour]}
= $75,000 + $19,000 – $12,500
= $81,500
While this is the true economic value, it may not be the economic value the customer perceives. For
example, if the customer perceived the cost of a system crash to be only $50,000, the perceived value
of “New” would be seen to be $72,000. In many situations, marketing’s job is to make the perceived
value approach true economic value. This is done by customer education. For example, in this case,
“New” would have established the cost of a system crash in the customer’s mind and also provide
compelling evidence that its probability of failure was only 1% as compared with Reference’s 20%.
TEV’s is important because it usually sets an upper bound to what a customer will pay. It can be the
case that the customer perceived the value to be greater than the TEV, e.g., if in the above example
the customer perceived the cost of the system crash to be $250,000. The common case though is that
marketing’s task is to educate the customer to push perceived value up to TEV.
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2. Customer Surveys
A second way to assess customer value relies on survey methods. Two fundamentally different
methods are commonly used to obtain price response data from customers:
A.
Directly ask for reaction to certain prices, price changes, or price differentials.
B.
Infer the response from an analysis of data on customers’ expressed preference for one
product over another.
Direct Price Response Surveys
In a direct response survey, the respondent is typically asked
a question such as:
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What is the likelihood you would buy this product at a price of $25?
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At what price would you definitely buy this product?
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How much would you be willing to pay for this product?
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How much of this product would you buy at a price of 99¢?
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At which price difference would you switch from product A to product B?
Eastman Kodak Company used this method to set price for a new line of cameras. Respondents
were provided a description of a new generation of cameras, presented prices of $150, $80, and $40
and asked to indicate their purchase intention on a seven-point scale, from “Definitely Not Buy” to
“Definitely Would Buy.” Results were:
Purchase Intention for Camera
$150
1.
2.
3.
4.
5.
6.
7.
Definitely Would Buy
Probably Would Buy
Probably Not Buy
Definitely Not Buy
4%
-7%
1%
22%
2%
65%
Stated Price of Camera
$80
5%
-14%
2%
34%
2%
54%
$40
15%
2%
30%
4%
18%
1%
30%
The fact that 47% of people responded at the “probably would buy” level or higher for the $40 price
(as opposed to only 19% for the $80 price) was instrumental in Kodak’s introducing the line at a
suggested retail price of $39.95.
The direct questioning method is simple, easily understood, and inexpensive, but has important
limitations for some situations. It can:
!
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Induce unrealistically high price consciousness in respondents.
Pricing: A Value-Based Approach
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Suffer from bias in that respondents may be reluctant to admit that they cannot afford a
premium product or that they ”buy cheap.” Under these circumstances, they would overstate
their willingness to pay.
Preference-Based Inference: Conjoint Measurement
Conjoint measurement is a relatively new but powerful procedure which has been widely applied
for both consumer and industrial products and services to overcome some of the limitations of the
direct questioning method. It has been used in the pricing and design of many products ranging from
computer hardware and software to hotels, clothing, automobiles, and information services.
Its superiority stems from the fact that the questions posed to respondents replicate the realistic
scenario of a customer facing an array of competitive alternatives with different features and prices
and having to choose among them. For example, in the camera situation a consumer might be asked
which is preferred “A” or “B” where features were:
Image Size
Camera Weight
Camera A
Camera B
3 X 5 inch
4 X 6 inch
1.2 lbs.
1.8 lbs.
Built-In Flash
No
Yes
Price
$75
$100
A series of this type of preference questions for different product profiles yields the input data to a
statistical method whose output is the customer’s tradeoff of price versus product features. The
procedure is discussed in detail in the note “Analyzing Consumer Preferences” (9-599-112).
Customizing Price to Value Delivered
Upon adopting the perspective of pricing-to-value, one quickly realizes that in many cases the
value varies markedly across individuals. For example, the value of the latest innovation in golf-club
technology is more highly valued by someone trying to make a living on the professional tour than it
is by even the serious amateur. A number of factors cause value variation across potential customers,
e.g.,
!
The simple matter of taste—some people think Godiva Chocolates are the greatest; others
would just as soon have a Hershey bar.
!
Knowledge/availability of substitutes—those with access to and knowledge of the availability of the Boston Globe newspaper “on-line” may value home delivery of the “hard copy”
less.
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Prices/“deals” made available by substitute providers—one hotel’s “50% off for senior
citizens” rate on weekends creates value variation by age group for rooms at the hotel
adjacent to it. If viewed as substitutes, the adjacent hotel’s value will be less for those able to
access the “special deal” of the competitor.
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!
Importance of performance differentials to the user—the experienced computer user values
speed and storage capacity more than the novice user.
!
Ability-to-pay—the executive, retiring after an Internet IPO, simply has more capacity to pay
for a high-definition television set than a true television fan of lesser economic means.
!
Intensity of use—convenience features on a cell phone are more highly valued by a person
using the device regularly as compared with those in “emergency use only” mode.
Since value can vary greatly across customers, part of the pricing program must consider the
advisability of customizing prices to the values, i.e., getting those who value the product more highly
to pay more for it.
The four primary methods of customizing prices are:
1.
Product line sorting: This entails offering “high-end” products with many features for the
high-value customer and more basic models for lower value. For example, most new
automobiles come from “stripped” to “loaded” and customers placing high value on the
options simply select that option. Generally, the higher-featured items yield greater margins.
2.
Controlled availability: This involves making different prices available only to certain
groups. For example, a direct mail operation can vary the prices in the catalog sent into a
home depending on past purchasing history. Online sellers have the same ability to “address”
prices to individuals. Delivering money-off coupons to selected households for redemption at
the point-of-purchase is another method for selective pricing.
3.
Price based on buyer characteristics: Here, one looks for some characteristic of buyers which
correlates with willingness-to-pay. For example, common buyer characteristics observed are:
4.
!
Age—children and “senior citizens” discounts.
!
Institution type—end user versus reseller.
Price based on transaction characteristics: Price is tied to the particular features of the
transaction, e.g., when the airline ticket was bought, quantity discounts schemes in which the
number of units of material bought impacts price.
Integrating Price with Other Mix Elements
A key to effective pricing is to have pricing’s value extraction “in synch” with the value creation
process of the other elements of the marketing mix. For example, when Glaxo introduced its ulcer
medication Zantac at a substantial price premium to market incumbent Tagamet, it was still able to
become the market leader because the product was superior and Glaxo invested in the marketing
effort necessary to communicate that superiority to consumers. In other words, the core product itself
established a TEV and Glaxo’s marketing effort pushed the customers’ perceived value up to TEV. In
turn, the high margins generated by the premium pricing funded that marketing effort.
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The pricing/marketing spending choices can often be captured in the following 2X2 matrix:
High
No Unit
Sales
Feasible
Low
Feasible
No Unit
Contribution
Price
Low
High
Marketing Expenditure
As shown, two strategies are feasible. The company can follow a low marketing expenditure and
low price (relative to TEV) strategy. The product must speak for itself in establishing value; but,
because of the low price, the hurdle to purchase is not high. Similarly, it can follow the Zantac
“high/high” strategy: investing in marketing to boost perceived value but pricing to capture the
perceived value thereby created, attaining the margins necessary to fund marketing effort.
Conversely, the other price/expenditure combinations are not feasible in the long-term. High
price/low marketing fails because the perceived values do not get pushed high enough to justify the
price; consequently, unit sales are low. Low price/high marketing, on the other hand, generates sales
but at unattractive margins.
Legal/Ethical Issues
Pricing is an area that can raise a number of legal and ethical issues whose resolution requires full
consideration of the specific context.4 Only several can be covered in this brief note. Since
consideration of price customization has been advocated in this note, it is important to state that it is
not illegal to charge different prices for the same product. Some, however, view the practice as
“unfair” or “unethical.” Some studies have, for example, shown that poor people, lacking mobility
and access to alternative sources, pay higher prices for groceries in local supermarkets. Others have
criticized the pricing of pharmaceuticals particularly of life saving variety, such as AIDS-drugs. In
some cases, the criticism has been about how high prices are in a market (e.g., United States) versus a
neighboring region (e.g., Canada). In others, the criticism has been about too much price similarity
across markets, advocating instead very low prices in countries with low per capita incomes and
overall low ability to pay.
Legal questions arise whenever pricing actions including price customization are seen as
potentially having the impact of reducing competition. Pricing actions with potentially anticompetitive effects include:
4 See “Ethical Issues in Pricing” by G.K. Ortmeyer in C. Smith and J. Quelch, Ethics in Marketing (Irwin, 1993) and Chapter 14,
“The Law and Ethics” in T. Nagle and R. Holden, The Strategy and Tactics of Pricing (Prentice-Hall, 1995).
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Predatory pricing—price “low” for a time to drive a competitor from the marketplace.
!
Price fixing—setting prices in a cooperative agreement with competitors.
!
Price Maintenance—requiring that distributors/retailers of goods sell only at a specified
price level. One may suggest reseller prices (as noted for Pioneer at the beginning of this
note), but may not require that such prices be maintained.
!
Price Customization—charging competing resellers of a product different amounts so as to
reduce one’s ability to compete (this has been alleged by mom-and-pop pharmacies as drugs
are sold to big chains at lower prices).
A company can be charged by the government and/or sued by customers or competitors for anticompetitive acts. The situation is not easy to navigate, e.g. one observer noted “. . . when pricing
tactics are illegal is not always clear. The laws themselves are vague.”5 This means that pricing
practices need to be subjected to both investigation from an ethical perspective and informed legal
review within the company before being implemented.
5 T. Nagle and R. Holden, ibid., p. 386.
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