Ch12 Pricing Decisions

Ch12 Pricing Decisions 12.1: A Process for Making Pricing Decisions A manager’s freedom to select a price for a given good or service is constrained by several factors: First: the firm’s costs determine the floor of the range or feasible prices. At the other extreme, the price sensitivity of demand for the product determines the ceiling of the range of acceptable prices. Beyond some price level, most potential customers seek less costly substitutes, such as private labels or do without the good or service. This process is particularly appropriate for first-time pricing decisions as when a firm introduces a new product or enters a bid for non-routine contract work. It includes several steps involving detailed analyses of demand, costs, and the competition. I. Strategic Pricing Objectives: Maximize Sales Growth: When a firm is an early entrant into a new product-market with the potential for substantial growth, its objective may be to maximize its product’s rate of sales growth (in units). This suggests it should set a relatively low price to attract as many new customers as quickly as possible and to capture a large share of the total market before it becomes crowded with competitors. This low-priced strategy is called penetration pricing. Penetration pricing is appropriate when, in addition to a large market: 1. Target customers are relatively sensitive to price. 2. The firm’s costs are low compared to competitors’ and the SBU is pursuing a low-cost strategy. 3. Production and distribution costs per unit are likely to fall substantially with increasing volume. 4. Low prices may discourage potential competitors from entering the market. There is a major risk in using low prices to achieve maximum sales growth in the short term as a base for future profits. If market, competitive, or technological conditions change, those future profits may never be realized. Maintain Quality or Service Differentiation When a firm has a strong competitive position based on superior product quality or customer service, its primary pricing objective is to generate sufficient revenue to maintain that advantage. Such a firm usually asks a premium price for its product for two reasons: First, it needs additional revenue to cover the R&D, production, distribution, and advertising costs it takes to maintain both the reality and the perception of superior quality or service. Second, customers are usually willing to pay more for a superior offering; high quality decreases the elasticity of demand. A premium price policy is most appropriate for businesses pursuing differentiated defender strategies Maximize Current Profit Skimming When firms pioneer the development of a new product-market, sometimes their pricing objective is to maximize short-run profits. They adopt a skimming price policy, setting the price very high and appealing to only the least price-sensitive segment of potential customers. Skimming is most relevant to a small market & appropriate for businesses pursuing prospector strategies involving investments in the development and commercialization of a stream of new products with proprietary technology. At the other end of the life cycle, some product-markets decline rapidly as customer preferences change or new technologies and substitute products are introduced. Skimming is most relevant to a small market because a large market is more apt to attract competitors. Harvesting Often it’s too late to divest the product and earn a reasonable return, so firms facing the situation adopt a harvesting strategy to maximize short-term profits before demand for the product disappears. This typically involves cutting marketing, production, and operating costs of the product, while setting a high price to maintain margins and maximize profits. This is an appropriate strategy only where there is no way – such as by making product improvements or increasing promotion – to sustain market demand or the item’s competitive position very far into the future. Businesses with an established product in a market expected to grow or experience stable demand well into the future run into trouble because of strategic mistakes, such as failing to adapt to customers’ changing desires or to competitive threats, or building excess capacity. Survival If such mistakes are correctable, the firm may adopt a pricing objective of Survival, i.e. simply keeping the product alive while strategic adjustments are made. Because short-term profits are less important than survival for products, this situation usually demands a low price to attract enough demand to keep the plant operating and maintain cash flow. So long, as the price covers variable costs and at least contributes to fixed costs, the firm may be able to buy time to correct its competitive weaknesses. Social Objectives Some organizations may forgo possible profits – at least among some price-sensitive customer segments – by offering a low price to those customers to achieve some broader social purpose. This is most common among not-for-profit organizations such as performing arts organizations and public hospitals, especially if subsidized by government agencies, foundations, or private contributions and not relying on sales as their sole source of revenue. II. Estimating Demand and Perceived Value Demand sets the ceiling on the range of feasible prices for a product. The familiar demand curve depicts this variation in the quantity demanded at different prices. In most cases there is an inverse relation between a product’s price and the quantity demanded: the higher the price, the less people want to buy. Thus, the typical demand curve has a negative, or downward, slope. However, luxurious products and those whose quality is difficult to objectively judge sometimes have positively sloping demand curves. Some customers use price as an indicator of the prestige or quality of such products, and they are induced to buy more as the price increases. Factors Affecting Customer’s Price Sensitivity The demand curve sums the reactions of many potential buyers to the alternative prices that might be charged for a product. The curve’s degree of slope reflects the fact that different buyers have different sensitivities to the product’s price. Thomas Nagle identified specific factors influencing variations in sensitivity to price across customers and products. Those factors are: Unique Value effect: customers are less price sensitive when they perceive the product or service provides unique benefits; there are no acceptable substitutes Price quality effect: customers are less price sensitive when they perceive the product or service offers high quality, prestige or exclusiveness. Substitute awareness effect: customers are less price sensitive when they are relatively unaware of competing brands or substitute products or services. Difficult comparison effect: customers are less price sensitive when it is difficult to compare objectively the quality or performance of alternative brands or substitutes. Sunk investment effect: Customers are less price sensitive when the purchase is necessary to gain full benefits from assets previously bought. Total expenditure effect: Customers are less price sensitive when their expenditure for the product of service is a relatively low proportion of t their total income. End benefit effect: Customers- particularly industrial buyers purchasing raw materials or component parts- are less price sensitive when the expenditure is a relatively small proportion of the total cost of the end product. Shared cost effect: Customers are less price sensitive when part of the cost of the product or service is borne by another party Inventory effect: Customers are less price sensitive in the short run when they cannot store large quantities of the product as a hedge against future price increases. Price Elasticity of Demand The larger the proportion of price sensitive customers in a product’s market, the more sensitive overall demand is to change in the product’s price. This degree of responsiveness of demand to a price change is referred to as the price elasticity of demand. Price elasticity of demand (E) = Percent change in quantity demanded Percent change in price If for instance a seller raised the price of a produced by 2 percent and demand subsequently fell by 6 percent, the price elasticity of demand for that product would be -3, indicating substantial elasticity. Conversely, if a 2 percent increase produced by a 1 percent decline in the quantity demanded, then price elasticity is -1/2 indicating that demand is inelastic. If a 2 percent price increase leads to a 2 percent decline in quantity; price elasticity is unitary. In such a case the seller’s total revenue stays the same because the smaller quantity sold is offset by the higher price. There are major problems in using price elasticity and they are: failure to consider the response of competitors to the company’s change in price; that demand may be inelastic for a given price change, but elastic for a larger amount; that elasticity is; that a lowering of price may affect the sales of other items in the company’s product line’ and that it ignores any social benefits accorded the company for benefiting low- income segments via a price reduction. Estimating Costs A firm’s costs take two forms: Fixed and variable. Fixed costs (or overhead): are constant in the short term, regardless of production volume or sales revenue. They include rent, interest, heat, executive salaries, and functional department Because total fixed costs remain constant in the short term regardless of volume, the fixed cost per unit of a product declines as a firm produces and sells more of the product in a given period Variable costs: vary in magnitude directly with the level of production, but they remain constant per unit regardless of how many units are produced. They involve such things as the costs of materials, packaging, and labor needed to produce each unit of the product. Total costs equals sum of fixed and variable costs for a given level of production. The product’s price must cover this total cost figure- divided by the number of units produced. Marketing mix costs: may include both fixed and variable costs, and other costs such as retailers or distributors markups. Setting a high price with too little promotional support is likely to lead to sales problems. Similarly, setting a low price alongside an aggressive promotional programme can lead to profit and cash flow problems, as many dot-com retailers have learned the hard way. Price setting for a product cannot occur in isolation. It requires considering the costs, of the planned overall marketing mix for the product, including product, promotion, and distribution decisions. Measuring Costs Activity- based costing systems: allocate costs across individual products by directly observing the level of various functional activities such as: shipping, receiving, supervising, and selling that are devoted to each item in the line- often generate very different estimates of the total costs associated with a given product that does the firm’s standard cost control system. Such activity- based cost estimates are often more useful for making strategic marketing decisions, such as setting prices, because they reduce some of the distortions inherent in the allocation of indirect costs within standard cost accounting systems while avoiding the imprecision of the contribution margin approach. Cost and Volume Relationships A product’s average cost per unit- and the price necessary to cover that cost varies with the quantity produced. Managers take two different volume- cost relationships into account when making pricing decisions: Economies of scale- In the short run, companies can gain further economies by constructing larger and more efficient facilities. The average cost per unit is high if few units are produced, but it falls as production approaches the plant’s capacity because fixed costs are spread over more units. If the company tries to produce more than capacity, average costs per unit would rise. The overworked machinery would break down more often, workers would get in each other’s way, and other inefficiencies would occur. Experience curve- the fall in production and marketing costs per unit as a firm gains accumulated experience. Its average costs per unit decline as it gains experience. Its production workers discover efficient shortcuts, procurement costs fall, and the accumulated impact of past advertising and marketing efforts may enable the firm to succeed with smaller per-unit marketing expenditures. Analyzing Competitors Costs and Prices To implement a low- cost strategy, the manager must be sure that the product’s costs are truly lower than any competitor’s offer and that those lower costs are reflected in the product’s relative price. The manager needs to learn and track the price, costs, and relative quality of each competitor’s offer. A manager can estimate competitor’s relative cost positions in a service industry by comparing their numbers of employees or the number and size of outlets and then looking at efficiency ratios like sales per employee or sales per square foot. 12.2: Methods Managers Use to Determine an Appropriate Price Level - Various pricing methods fall into three categories: cost- oriented pricing, competition-oriented pricing, and demand or customer- oriented pricing. Cost-Oriented Methods Cost- plus or markup pricing: does not explicitly consider the price sensitivity of demand or the pricing practices of competitors. It is convenient and easy to apply- when a firm faces hundreds or thousands of pricing decisions each year. It is widely used among firms that must submit competitive bids for a variety of projects. The typical procedure for determining price under the markup approach is to first calculate cost per unit by adding variable cost to fixed costs divided by an expected level of unit sales: This approach largely ignores the price sensitivity of demand. It assumes a level of sales before the price is set. If the manager’s assumption about likely sales volume is wrong, the desired markup is not achieved. A shortfall in units sold would mean that fixed costs would be spread over fewer units and the realized markup would be smaller than desired. Rate-of-return or target return pricing – brings one or more cost element into the pricing decision- the cost of capital tied up in producing and distributing the product. The objective is to set a price yielding a target rate of return on investment. This pricing approach demands that managers: (1) estimate the unit sales volume of the product, (2) figure unit costs, (3) estimate the amount of capital involved in producing and selling the product, and (4) select a target of return on investment. When managers make these estimates accurately, the target return methods results in a more rational pricing decision that then simpler markup method. This method does not explicitly consider the interaction between alternative prices and demand. As with markup pricing, the realized return falls below the target level because fixed costs have to be covered by a smaller unit volume. The impact of such variations in volume can be examined by preparing a break-even analysis. Competition-Oriented Methods A common industry price structure reflects the collective wisdom about finding the price that will yield a fair return and minimize the chances that a price war will jeopardize the profits of all industry firms. Firms that pursue a competition-oriented pricing approach do not ignore cost or return-on- investment considerations. Instead, they try to control costs to make adequate returns at prices consistent with those of competitors. But if this cannot be done, the target rate or return may be the factor that is changed. Firms adopt a going-rate or competitive parity pricing approach, where they maintain prices equal to those of one or more major competitors. Price virtually ceases to be a controllable element of the marketing mix under such circumstances. No firm can increase its price without some assurance that others will follow, because most customers would switch to lower-priced competitors. A firm would be reluctant to price below the competition lest other companies also cut their prices and reduce profits for all concerned. Prices are usually quite stable in such industries until a price leader decides an increase in industry prices is necessary to meet increased costs and maintain returns. The ability of a firm to be a price leader whose pricing decisions are emulated by other companies is not determined solely by its size or market share. The leader also tends to be one of the most efficient firms in the industry; that is, it is one of the last to feel the need for a price increase. Often leaders are also perceived to have good marketing expertise and have had past success in making price increases stick. In industries where product quality, service, or availability vary across brands, a firm may still base its pricing on what its competitors are charging, but try to hold its prices either below or above the competition. Such discount or premium price policies usually reflect differences in positioning strategies. Sealed bidding is common with dealing with the government. Buyers request a formal bid with no later opportunity for change. In public procurement the bids are opened publicly, enabling bidders to learn what competitors bid. Such is not typically the case with private bidding. One approach used to set a bid price is an expected value : E(X)= P(X)Z(X) Internet Auction Sites Make Accurate Cost Estimates More Critical Some business-to-business sites focus on seller’s auctions. These sites are usually specialized by industry and facilitate global spot markets for relatively standardized materials, component parts, used equipment and the like. Buyer’s auction sites have emerged in a number of industries where qualified suppliers are invited to compete for a contract where the buyer has specified all the technical requirements and purchase criteria in detail, except the price. To be profitable selling goods or services at auction a firm must work to hold its costs down relative to its competitors, and it must have an accurate understanding of what those costs are. When selling excess inventory on a seller’s auction site, the firm may be willing to accept a bid that is below its full cost as long as that bid covers variable costs and makes a contribution to fixed costs. The selling firm must know what it’s fixed and variable costs are with some certainty before it can decide whether a given bid will provide enough revenue to cover variable costs and therefore be worth accepting. Customer-Oriented Methods Pricing to Capture the Value Perceived by the Customer The essential purpose of the price level set by the marketing manager, then, should be to enable the firm to capture the value of the product as perceived in the mind of the customer. The only thing important to customers is the value they are likely to receive for the price they pay. One danger of cost-oriented pricing methods is that they can produce prices that are lower than perceived value, causing the firm to “leave money on the table”. The perceived value of a given product offering can vary from customer to customer. When setting a price level within a strategic marketing programme, the manager should try to determine an “average” perceived value for the customers in a particular target market segment. Exhibit 12.6 Methods for estimating perceived customer value Industrial engineering methods: Internal engineering assessment: Physical laboratory tests within the firm. Field value-in-use assessments: Customer interviews determining economic benefits to using the product. Indirect survey questions: Customer estimates of the effects of product changes on firm’s operations used to infer the value of product attributes. Overall estimates of customer value: Focus group value assessment: Willingness-to-pay questions in a small group setting. Direct survey questions: Willingness-to-pay questions in a survey format. Decomposition approaches: Conjoint analysis: A method for estimating customer trade-offs of product attributes. Benchmarks: Customer indication of willingness to pay for incremental (or fewer) attributes that can be compared to an example from the product category. Compositional approach: Direct customer questions about the value of product attributes. Importance ratings: Customer rank ordering or rating of the importance of product attributes as well as comparisons between competitors. Estimating Customer Value by Assessing Value-in Use Value-in-use: the assessment process begins with the selection of a reference product, usually the product the customer is currently using or a major competitor’s product. The manager then calculates the incremental benefits to the customer of using his or her product instead of the reference product. These benefits may be the result of improved performance and additional features, or improved efficiency and reduced costs over the life cycle of the product. The additional monetary value of the manager’s product added to the price of the reference product equals the economic value of the manager’s product to the customer: the maximum amount the customer should be willing to pay, assuming that she is fully informed about the product and the offerings of competitors. Other Perceptual Pricing Issues A number of psychological factors can influence customers perceptions of the relationship between a product’s price and its value. Thus, many firms use such practices as customary pricing, pricing lining, psychological pricing, and promotional pricing. Customary price: when increasing costs put pressure on manufacturer’s margins, they elected to reduce the size of the bar rather upset customer’s expectations by raising the price. Price lining is another customer-oriented pricing practice, especially among retailers. It involves selling all products in a category at one of several predetermined “price points” or levels. Each price line represents a different level of quality. Psychological pricing the firm takes advantage of the fact that many consumers use price as an indication of quality. Another common psychological pricing practice is called odd pricing. For instance, a product or service might be priced at $29.95 instead of $30.00. Promotional pricing to transmit a message about the product in conjunction with or sometimes in lieu of , advertising or other forms of promotional activity. An example is : SALE. 12.3: Deciding on a Price Structure: Adapting Prices to Market Variations - The final step in the pricing process is usually to develop a price structure that adapts the price to variations in cost and demand across geographic territories, national boundaries, types of customers, and items within the product line. Geographic Adjustments: FOB origin pricing: the manufacturer places the goods “free on board” a transportation carrier. At this point the title and responsibility passes to the customer, who pays the freight from the factory to the destination. DISADVANTAGE: the manufacturer may be at a cost disadvantage when trying to sell to customers in distant markets. Freight absorption pricing: the seller picks up all or part of the freight charges. New competitors trying to penetrate new markets and smaller competitors in maturing industries trying to increase their share use this approach. Uniform delivered pricing: a standard freight charge is assessed every customer, regardless of location. This lowers the overall cost to distant customers, but raises costs for customers near the company’s plant. Zone pricing: a compromise approach that falls between FOB and uniform delivered pricing. The company divides the country into two or more pricing zones. It charges all customers within the same zone the same delivered price, but a higher price is set for distant zones than for those close to the plant. Global Adjustments Firms attempt to minimize complications by adopting a highly standardized global pricing policy similar to an FOB origin policy in the domestic market. They charge the same price around the world and require each customer to absorb all freight and import duties. This policy fails to respond to variations in local demand or competitive conditions. Other firms charge a transfer price to their various national branches or subsidiaries but then give local managers in each country’s wide latitude to charge their customers whatever price they think most appropriate. Such a policy may lead to arbitrage involving the transshipment of goods across countries when price difference exceed the freight and duty costs separating the markets. Most firms follow an intermediate approach to global pricing. Corporate management establishes an acceptable range of prices. Local country managers are then given the flexibility to select the price within that range that is best suited to local demand and competitive conditions, though their decisions are often subject to strategic review and approval by top management. Countertrade When selling to customers in developing economies, they usually lack sufficient hard currency to pay for their purchases. Such customers may offer items other than money as payment. EXHIBIT 12.8: Countertrade which occurs in international transactions where the potential customer lacks sufficient hard currency to pay for a purchase can take a variety of forms. These include: Barter. Barter involves the direct exchange of goods with no money and no third party involved. For instance, a German firm might agree to build a steel plant in Mexico in exchange for a given amount of Mexican oil Compensation deals. Here the seller agrees to take some percentage of the payment in cash and the rest in goods, as when Boeing sells aircraft to Brazil for 70 per cent cash and an agreed-upon number of tons of coffee. Buyback arrangements. Under such arrangements a seller offers a plant, equipment or technical expertise to a customer and agrees to accept as partial payment products manufactured with the equipment or training supplied. For example, a US chemical company built a plant for an Indian company in return for some cash and a volume of chemicals to be made in the plant. Offsets. The seller is compensated in cash but agrees to spend a substantial amount of that cash with the customer or its government over a stated time period. For instance, Pepsi sells its cola syrup to Russia for rubles and agrees to buy Russian vodka at a given rate for sale in the United States. Discounts and Allowances: Firms relying on independent wholesalers and retailers to distribute their products must adjust their list prices to motivate and reward these firms to perform needed marketing activities. Trade Discounts Trade (or functional) discounts: discounts vary depending on the intermediary’s wholesale or retail level in the channel and the specific activities they are expected to perform. Quantity Discounts Quantity discount: to purchase more of the product, a manufacturer might offer a price reduction for ordering in large quantities. It often increases as order size increases. The price of such discounts should be justified by the cost savings that manufacturers gain by filling larger orders. These savings include reductions in per-unit selling, order processing, transportation, and inventory carrying costs. Quantity discounts help move more inventory closer to the ultimate customer, thereby encouraging more impulse purchases and reducing the probability of stockouts occurring among wholesalers or retailers in the distribution system. Cash Discounts Cash discount: is a price reduction to encourage customers to pay their bills promptly. A common example of such a discount is “2/10 , net 30”. This means that payment is full is due within 30 days, but the buyer can deduct 2 percent from the price if payment is made within 10 days. Such discounts help reduce the capital the seller has tied up in accounts receivable and lower collection costs and bad debts. Allowances They are inducements to encourage channel members or final customers to engage in specific behaviors in support of the product. Trade-in-allowance: a price reduction granted to customers for turning in an old item when buying a new one. It helps customers recoup the value from their used products and thereby encourage more frequent replacement purchases. Promotional allowances: reward distributors or retailers for advertising the product at the local level. It may include retailers to devote more shelf space to the product or to encourage middlemen’s salespeople to provide more aggressive selling support. Price- Off Promotions A temporary reduction in the product’s price. It may be the most effective way to boost sales temporarily. Disadvantages: They only transfer future sales to the present as loyal customer stock up. Another problem is that competitors can easily copy them. Also, they may lead consumers to the notion that the product should be bought only below the suggested retail price when a promotional deal is offered. Coupons, Rebates, and Refunds Cents-off coupons: coupons can be an effective way to target discounts to specific customer segments, particularly as information technology makes it possible for firms to collect more detailed information about customers. A marketer can direct coupons to the most price sensitive households while maintaining higher regular prices for less price-oriented buyers. Coupons are useful for accomplishing specific strategic marketing objectives, such as motivating first-time buyers to try a product or encouraging the purchase of larger package sizes. Rebates: reduce the price of the product through a money refund offer. It requires the consumer to mail some proof of purchase to the manufacturer to receive the refund. Premiums: attempts to attract buyers by offering a product or service free or at a substantially reduced price to encourage the purchase of another product. Premiums can be included in a package, sent by mail, or via another product. Differential Pricing Differential pricing (discriminatory pricing): occurs when a firm sells a product or service at two or more prices not determined by proportional differences in cost. This is done to adjust to differences in the price sensitivities or preferences of various customer segments. Prices may even vary on a customer-to-customer basis in organizational markets or consumer durable categories where the final price is determined through negotiation. Common differential pricing adjustments targeted at particular customer segments include: Time pricing: prices might be adjusted seasonally, across days of the week , or across hours of the day to capitalize on predictable fluctuations in demand over time.(example movie theaters) Location pricing: The same product or service might be priced differently at various retail locations to capitalize on local demand or the intensity of competition. Customer segment pricing: Perhaps the most common differential pricing practice or to charge different prices to customer segments that vary in their willingness or ability to buy. Conditions Allowing Differential Pricing First: there must be identifiable customer segments with different price sensitivities. Second: the customer segments must either be physically separated from one another or the firm must institute control procedures to ensure that the segment paying the lower price cannot resell the product to customers paying the higher price Third: the cost to the manufacturer of segmenting and monitoring the market should not exceed the extra revenue generated by the discriminatory pricing. Fourth: the company should be confident that resentment among customers asked to pay the higher price, or competitive conditions in the market, will not leave it vulnerable to competitive attacks in the high price segments. The Internet Facilitates Differential Pricing Internet makes it easier to identify and charge different prices to customer segments with different price sensitivities. It enables firms to do more differential pricing by allowing them to change prices quickly at different times of the day or week or in response to unused capacity. Legal Considerations To legally offer different prices for the same product to retailers, distributors, or industrial buyers, the manufacturer must be sure that the buyers involved are not in direct competition, or that the difference in prices offered is justified by differences in the cost of doing business with the different buyers. The Sherman Act prohibits both horizontal and vertical price fixing. Former: competitors agree to maintain a given price. Latter: involves an agreement between manufacturers and retailers to sell products at a certain price. Predatory pricing is also illegal under the Sherman Act because it involves selling below cost to drive one or more competitors out of the market. Differential price adjustments can raise some ethical issues as well. One such issue concerns the inherent “fairness” of charging higher prices to some customers simply because they are not very price sensitive. Product- Line Pricing Adjustments Firms need to adjust the prices of various models to reflect customers’ perceptions of their relative value. Producers should determine the prices for all the products in the line simultaneously, taking into account not only the price elasticity of demand for each mode, but also the cross-elasticity among them. Cross-elasticity: is the percentage change in sales of one product induced by a 1 percent change in the price of another product that is assumed to be a close substitute. The best thing that managers can do is to price each item separately and then adjust those prices to reflect the likelihood that customers will trade up or down and will perceive the prices of the related items to be fair and reasonable. Sellers often bundle the various items in their product line and sell the bundle at a price less than the total of the items if priced separately. Since some customers may not want the bundle, provision must be made to allow purchase of individual items.