Chapter 14
Developing Pricing
Strategies and Programs
14-1
Copyright © 2003 Prentice-Hall, Inc.
Key Points for Chapter 14
1.
2.
3.
4.
5.
6.
7.
8.
Common mistakes in pricing
Reference prices
Price-quality inferences
Pricing objectives
Price sensitivity
Estimating demand curves
Experience curve (Learning curves)
Target costing
14-2
Copyright © 2003 Prentice-Hall, Inc.
Key Points for Chapter 14
9. Three C’s for price setting
10. Selecting a Pricing Method
11. Geographical pricing
12. Promotional pricing
13. Differentiated pricing
14-3
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Understanding Pricing
Many Names of Price
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Rent
Tuition
Fee
Fare
Rate
Interest
Salary
Wage
Commission
 Toll
 Premium
 Honorarium
 Bribe
 Due
 Assessment
 Retainer
 Income Tax
14-4
Copyright © 2003 Prentice-Hall, Inc.
Understanding Pricing
Pricing Trends`
 Negotiated price
 Throughout most history
 Fixed price
 At the end of 19th century
 One price for all buyers set by the seller
 Fixed price and Negotiated price
 Fixed pricing for mass merchandise
 Internet brings back negotiated pricing
14-5
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Understanding Pricing
 A Changing Pricing Environment
 How Companies Price
 Consumer Psychology and Pricing
14-6
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A Changing Pricing Environment
 Buyers can
 Get instant price comparisons from
thousands of vendors
 Name their price and have it met
 Sellers can
 Monitor customer behavior and tailor offers
to individuals
 Give certain customers access to special
prices
14-7
Copyright © 2003 Prentice-Hall, Inc.
How Companies Price
 Prices are set by
 the owner in small businesses
 division or product-line manager
 pricing department in some industries
 Aerospace, Railroad, Oil companies
14-8
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How Companies Price
 Common Mistakes in Pricing
 Pricing is too cost-oriented
 Price is not revised often enough to capitalize
on market changes
 Price is set independent of the rest of the
marketing mix; Product, Place, &
Promotion
 Price is not varied enough for different
product items, market segments, distribution
channels, and purchase occasions
14-9
Copyright © 2003 Prentice-Hall, Inc.
How Companies Price
 Importance of Pricing for Profitability
 McKinsey & Company’s reports on 2,400
companies in 1992
 A 1% improvement in price led to 11.1%
improvement in operating profit
 A 1% improvement in variable cost, 7.8%
 A 1% improvement in volume, 3.3%
 A 1% improvement in fixed cost, 2.3%
 Table 14.6: A 1% price increase results in a
33.33% profit increase
14-10
Copyright © 2003 Prentice-Hall, Inc.
Consumer Psychology and Pricing
 Purchase decisions are based on how
consumers perceive prices and what they
consider to be the current actual price- not the
marketer’s stated price
 Influences on consumer’s perception of prices
 Reference Prices
 Price-Quality Inferences
 Price Cues
14-11
Copyright © 2003 Prentice-Hall, Inc.
Reference Prices
 When examining products, consumers often
employ their Reference Price
 Price that buyers carry in their minds and refer to
when they look at a given product
 Possible consumer reference prices, Table 14.1
 Consumers often compare the observed
price to
 an internal reference price (pricing
information from memory) or
 an external frame of reference (such as a
posted ”suggested retail price”)
14-12
Copyright © 2003 Prentice-Hall, Inc.
Reference Prices
 Sellers often manipulate these reference prices
by
 Situating their products in a separate section
carrying expensive products. Women’s apparel
 Stating a high manufacturer’s suggested retail price
to indicate that the product was priced much higher
originally
 Pointing to a competitor’s high price
 Breaking the price down into smaller units: $500
yearly membership to $50 per month
14-13
Copyright © 2003 Prentice-Hall, Inc.
Price-Quality Inferences
 Many consumers use the price as an indicator
of quality, when accurate information about
quality is unavailable,
 Especially in purchasing ego-sensitive products such
as perfumes, expensive cars, and expensive watches
 A $100 bottle of perfume might contain $10 worth of
scent, but gift givers pay $100 to communicate their
high regard for the receiver
 Consumer Perceptions Versus Reality for Cars,
Table 14.2
 Some brands of luxury goods adopt exclusivity
& scarcity as a means to justify premium
pricing
14-14
Copyright © 2003 Prentice-Hall, Inc.
Price Cues
 A product price with “9” ending conveys the
notion of a discount or bargain, because
consumers tend to process prices in a “left-toright” manner
 $299 vs. $300
 Demand was increased one-third by raising the
price of a dress from $34 to $39, but demand was
unchanged when the price was increased from $34
to $44
 “Sale” signs next to prices have been shown to
spurt demand
 Total category sales are highest when, some, but not
all, items in a category have sale signs
14-15
Copyright © 2003 Prentice-Hall, Inc.
Setting the Price
 A firm must set a price for the first time
 When it develops a new product
 When it introduces its regular product to a new
distribution channel or geographical area
 When it enters bid on new contract works
 The firm must decide where to position its
product on quality and price
 Most markets have three to five price points or
tiers.
 Marriott: Vacation Villa (highest price), Marriott
Marquis (high price) Marriott (high-medium price),
Renaissance (medium-high price), Courtyard
(medium price), Towne Place Suites (medium-low
price), and Fairchild Inn (low price)
14-16
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Nine Price-Quality Strategies
1,5,9 can all coexist in the same market. 4,7,8 overpricing
14-17
Copyright © 2003 Prentice-Hall, Inc.
Six-Step Procedures for Setting
the Price
Step 1: Selecting the Pricing Objective
Step 2: Determining Demand
Step 3: Estimating Costs
Step 4: Analyzing Competitors’ Costs, Prices,
and Offers
Step 5: Selecting a Pricing Method
Step 6: Selecting the Final Price
14-18
Copyright © 2003 Prentice-Hall, Inc.
Step 1: Selecting the Pricing
Objective
1.
2.
3.
4.
5.
6.
Survival
Maximum Current Profits
Maximum Market Share
Maximum Market Skimming
Product Quality Leadership
Cost Recovery
14-19
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Survival
 The objective of a company is to stay in
business.
 When faced with overcapacity or intense
competition, or changing customer wants
 The firm chooses the price to cover
variable costs and a part of fixed costs.
 Should be only a short-run objective
14-20
Copyright © 2003 Prentice-Hall, Inc.
Maximum Current Profits
 A firm chooses the price that produces
maximum current profit
 It estimates the demand and the costs associated
with alternative prices and choose the price that
produces maximum current profit.
 It needs to know the demand levels at different
prices
 This strategy assumes that a firm has knowledge of
its demand and cost at different prices. But these are
difficult to estimate
 Example: Fixed costs of $300,000 and constant
unit variable costs of $10.
14-21
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Profits at Different Prices
(1)
Price
(2)
Unit
Demand
Needed to
Break Even
(3)
Expected
Unit
Demand at
Given Price
$14
16
18
20
22
75,000
50,000
37,500
30,000
25,000
71,000
67,000
60,000
42,000
23,000
(4)
(5)
(6)
Total
Revenue
(1) X(3)
Total Costs
Profit
(4)-(5)
$994,000
1,072,000
1,080,000
840,000
506,000
$1,010,000
970,000
900,000
720,000
530,000
-$16,000
102,000
180,000
120,000
-24,000
14-22
Copyright © 2003 Prentice-Hall, Inc.
Maximum Market Share
 A firm sets a price low enough to maximize its
market share
 Use market-penetration pricing by setting the lowest
possible price.
 It works best when
 Market is highly price-sensitive, and a low price
stimulates market growth,
 Production and distribution costs fall with
accumulated production experience and increased
volume and
 Low price discourages actual and potential
competition: Texas Instruments (TI)
14-23
Copyright © 2003 Prentice-Hall, Inc.
Maximum Market Skimming
 A company introducing new innovations sets
high prices to maximize market skimming
 Sonny’s HDTV Prices: $43,000 in 1990, $6,000 for
28-inch HDTV in 1993 and $1,200 for 42-inch
HDTV in 2004
 Conditions for Market Skimming Pricing
 A sufficient number of buyers have a high current
demand
 The unit costs of producing a small volume are not
so high that they cancel the benefit for charging
what the traffic will bear.
 The high initial price does not attract more
competition to the market
 The high price communicates the image of a
superior product
14-24
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Product Quality Leadership
 Offers a high quality product for a
premium price.
 A company aims to be the product-quality
leader in the market
 More for more strategy. Maytag washing
machines, Mercedes-Benz
14-25
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Cost Recovery
 Set a price to recover
 Partial cost by universities
 Full cost by non-profit hospitals
14-26
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Step 2: Determining Demand
 Each price will lead to a different level of
demand.
 The relation between alternative prices
and the resulting demand is captured in
demand curve.
 Marketers need to find out
 Price Sensitivity
 Estimating Demand Curves
 Price Elasticity of Demand
14-27
Copyright © 2003 Prentice-Hall, Inc.
Price Sensitivity
 Customers are most price-sensitive to, in
general,
 high-cost products or
 frequently purchasing products
 Less price-sensitive to
 low-cost products or
 infrequently purchasing products
 when price of a product is a small part of the total
cost or total income of a buyer
14-28
Copyright © 2003 Prentice-Hall, Inc.
Price Sensitivity
 Factors associated with lower price sensitivity. Table
14.3
 More distinctive or has unique value
 Less aware of substitutes
 Cannot easily compare the quality of substitutes
 A smaller part of the buyer’s total income
 Small compared to the total cost of the end
product
 Borne by another party, shared cost
 Used in conjunction with assets previously bought
 Have more quality, prestige, or exclusiveness
 Cannot store the product
14-29
Copyright © 2003 Prentice-Hall, Inc.
Estimating Demand Curves
 Statistical Analysis
 Statistically analyze past prices, quantity sold, and
other factors to estimate their relationships
 Longitudinal (over time) analysis or
 Cross-sectional ( different locations at the same time)
analysis
 Price Experiments
 Charge different prices for the same product and
see how sales are affected
 Surveys of Buyers
 Ask buyers to state how many units they would
buy at different proposed prices. Might understate
higher price purchases on purpose
14-30
Copyright © 2003 Prentice-Hall, Inc.
Price Elasticity of Demand
 Determination of the effect of a change in price on
a change in demand
 If demand changes considerably with a small change in
price, it is elastic.
 If demand hardly changes or changes less than the
change of a price, it is inelastic
 If demand is elastic, seller will consider lowering the price.
A lower price will produce more total revenue
14-31
Copyright © 2003 Prentice-Hall, Inc.
Price Elasticity of Demand
 Price Indifference Band
 The range within which price changes have
little or no effect on demand
 McKinsey’s pricing study
 17% for mouthwash
 13% for batteries
 9% for small appliances
 0.2% for certificate of deposit
14-32
Copyright © 2003 Prentice-Hall, Inc.
Step 3: Estimating Costs
 Types of Costs & Levels of Production
 Accumulated Production
 Target Costing
14-33
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Types of Costs & Levels of
Production
 Fixed costs (overhead)
 Do not vary with production or sales volume
 Variable costs
 Vary directly with the level of production
 Total costs
 The sum of the fixed and variable costs
 Average costs
 Unit cost at different levels of production per
period
 Fig. 14.3 Cost per Unit at Different Levels of
Production per Period
14-34
Copyright © 2003 Prentice-Hall, Inc.
Types of Costs & Levels of
Production
 Activity-Based Cost Accounting
 Today’s firms adapt their offers and
terms to different buyers
 ABC accounting tries to identify the real costs in
serving each customer
 It allocates indirect costs like clerical costs, office
expenses, supplies, and so on, to the activities that
use them
 The key to effectively employing ABC is to define
and judge activities properly
14-35
Copyright © 2003 Prentice-Hall, Inc.
Accumulated Production
 Experience curve (Learning curve)
 The average cost declines with accumulated
production experience
 Experience-curve pricing
 Starts with a initial low price to beat
competitors and increase sales volume which
will result in further lower cost: Texas
Instrument
 Aggressive pricing may give the product a
cheap image
14-36
Copyright © 2003 Prentice-Hall, Inc.
Target Costing
 A firm establishes a new product’s desired
functions through market research
 Determines the price at which the product will
sell, given its appeal and competitors’ prices
 Deducts the desired profit margins from this
price to get the target cost
 Examines each cost element-design,
engineering, components, manufacturing, and
sales
 Reengineers components or eliminates some
functions to bring down suppliers’ costs
 Brings the final cost projections into the target
cost range
14-37
Copyright © 2003 Prentice-Hall, Inc.
Step 4: Analyzing Competitors’ Costs,
Prices, and Offers
 The firm must take into account competitors’
 Costs
 Prices
 Price reactions
 The firm should first consider the nearest
competitors’ prices
 The firms must know that competitors can also
change their prices in reaction to the price set
by the firm
14-38
Copyright © 2003 Prentice-Hall, Inc.
Step 5: Selecting a Pricing Method
 Three C’s for Price Setting
 Costs: Set a floor to the price
 Customers’ demand (assessment): Establishes
the price ceiling
 Competitors’ prices and prices of the
substitutes: Provide an orienting point
14-39
Copyright © 2003 Prentice-Hall, Inc.
Step 5: Selecting a Pricing Method
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Markup Pricing (Cost-plus Pricing)
Target-Return Pricing
Perceived-Value Pricing
Value Pricing
Going-Rate Pricing
Auction-Type Pricing
14-40
Copyright © 2003 Prentice-Hall, Inc.
Markup Pricing (Cost-plus Pricing)
 A firm adds a standard markup to the
product’s cost
 Ignores current demand, perceived value or
competition
 Still popular
 Simplifying the pricing task
 Less price competition
 Fairer to both buyers and sellers
 Retailers, Construction companies
 Unit Cost = variable cost + (fixed cost/unit sales)
 Markup price= unit cost/ (1 – desired return on
sales)
14-41
Copyright © 2003 Prentice-Hall, Inc.
Target-Return Pricing
 Determines the price that would yield the
target rate of return on investment (ROI)
 Prepares a break-even chart to learn total revenue,
total cost, and target profit at the various sales levels
with varying prices
 Target-return price =
unit cost + (desired return x investment capital)/unit sales
 Break-even volume
Break-even volume = fixed cost / (price – variable cost)
 Public Utilities, GM 15 to 20% ROI
 Question is whether the market will buy the desired
quantity at the target return price
14-42
Copyright © 2003 Prentice-Hall, Inc.
Figure 14.6: Break-Even Chart for Determining Target-Return
Price and Break-Even Volume
14-43
Copyright © 2003 Prentice-Hall, Inc.
Perceived-Value Pricing
 A firm bases its price on the customers’
perceived value according to their perceptions
 Perceived value is made up of several elements:
 Buyer’s image of the product performance
 Delivery channel
 Warranty quality
 Customer support
 Supplier’s reputation, trustworthiness, and
esteem
 The seller must know how to accurately determine
the buyer’s perceived value of the seller’s offering
14-44
Copyright © 2003 Prentice-Hall, Inc.
Perceived-Value Pricing
 Each customer places different weights on the
different elements
 Price buyers: Offer stripped-down products and reduced
services
 Value buyers: Offer innovating new value and aggressively
reaffirm their value
 Loyal buyers: Invest in relationship building and customer
intimacy
 The key to perceived-value pricing is to deliver more
value than the competitors and to demonstrate this
to prospective buyers
14-45
Copyright © 2003 Prentice-Hall, Inc.
Value Pricing
 A firm offers fairly low price for a high
quality offering
 Reengineering the company’s operations to
become a low-cost seller without sacrificing
quality
 Everyday low pricing (EDLP): Wal-Mart, IKEA,
Southwest Air
 High-low pricing: Higher price on an everyday
basis but frequent sales promotions
 High-low pricing has given way to EDLP
14-46
Copyright © 2003 Prentice-Hall, Inc.
Going-Rate Pricing
 A firm bases its price largely on
competitors’ prices.
 Going-rate pricing reflects the industry’s
wisdom
 It yields a fair return and does not
jeopardize industry harmony
 Steel, paper, fertilizer, & gasoline
14-47
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Auction-Type Pricing
 English auctions (ascending bids)
 Dutch auctions (descending bids)
 Sealed-bid auctions
14-48
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Effect of Different Sealed Bids
on Expected Profit
Company’s
Bid
Company’s
Profit
Probability
of Getting
Award with
This Bid
(Assumed)
Expected
Profit
$ 9,500
$ 100
0.81
$ 81
10,000
600
0.36
216
10,500
1,100
0.09
99
11,000
1,600
0.01
16
14-49
Copyright © 2003 Prentice-Hall, Inc.
Step 6: Selecting the Final Price
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Impact of Other Marketing Activities
Company Pricing Policies
Gain-and-Risk Sharing Pricing
Impact of Price on Other Parties
14-50
Copyright © 2003 Prentice-Hall, Inc.
Adopting the Price
 Price Discounts and Allowances
 Promotional Pricing
 Differentiated Pricing
14-51
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Price Discounts & Allowances
 Firms adjust their list price or give discounts and
allowances:
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Cash or Prompt payment discount; 2/10, net 30
Quantity discount
Functional discount (Trade discount)
Seasonal discount and
Allowances for participating in ad or sales promotion
or trade-in
14-52
Copyright © 2003 Prentice-Hall, Inc.
Promotional Pricing
 Loss-leader pricing
 Dropping price of well-known brand to stimulate
additional traffic to a store
 Special-event pricing
 Back-to-School or Anniversary of a store
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Cash rebates
Low-interest financing
Longer payment terms
Warranties and service contracts
Psychological discounting
 Was $399, now $299
14-53
Copyright © 2003 Prentice-Hall, Inc.
Differentiated Pricing
 Customer segment pricing
 A lower admission fee to students and senior citizens
 Product-form pricing
 Different forms of the product are priced differently
 Image pricing
 Same product at different prices based on image
differences of different packages
 Channel pricing
 Different prices to different channels
 Location pricing
 Different prices for different locations, Theater seat
 Time pricing
14-54
Copyright © 2003 Prentice-Hall, Inc.
Differentiated Pricing
 For price discrimination to work
 A market must be segmentable and segments must
have enough demand
 Buyers in low-price segments must not be able to
resell the product to the higher-price segments
 Competitors must not be able to undersell the firm
in the higher-price segments
 Cost of segmenting and monitoring must not exceed
the extra revenue derived from price discrimination
 The discriminatory pricing must not breed customer
resentment and ill will
 It must not be illegal
14-55
Copyright © 2003 Prentice-Hall, Inc.
Differentiated Pricing
 Price discrimination in the same trade group is
illegal
 Predatory pricing is illegal.
 Selling below cost with the intention of destroying
competition
14-56
Copyright © 2003 Prentice-Hall, Inc.
Initiating and Responding to
Price Changes
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Initiating Price Cuts
Initiating Price Increases
Reactions to Price Changes
Responding to Competitors’ Price Changes
14-57
Copyright © 2003 Prentice-Hall, Inc.
Initiating Price Cuts
 Circumstances for initiating price cuts
 Excess plant capacity or Excess inventory
 Declining market share
 Drive to dominate the market through a lower price
 Possible traps of a price cutting strategy
 Low quality trap
 Consumers will assume that the quality is low.
 Fragile-market-share trap
 A low price buys market share but not market loyalty
 Shallow-pockets trap
 The higher-priced competitors may cut their prices to the same
level or even below the firm’s price and may have longer
staying power
14-58
Copyright © 2003 Prentice-Hall, Inc.
Initiating Price Increases
 A successful price increase can
considerably increase profits. Table 14.5
 Circumstances for initiating price
increases
 Cost inflation
 Overdemand
14-59
Copyright © 2003 Prentice-Hall, Inc.
Initiating Price Increases
Table 14.5: Profits Before and After a Price Increase
Before
Price
Units sold
$ 10
After
$10.10 (a 1 percent price increase)
100
100
$1000
$1010
Costs
-970
-970
Profit
$ 30
$ 40 (a 33 1/3 percent profit
increase)
Revenue
14-60
Copyright © 2003 Prentice-Hall, Inc.
Initiating Price Increases
 Methods of Price Increase
 Delayed quotation pricing
 Escalator clauses
 Unbundling
 Reduction of discounts
14-61
Copyright © 2003 Prentice-Hall, Inc.
Initiating Price Increases
 Possible responses to higher costs or overhead
without raising prices include:
 Shrinking the amount of product instead of raising the
price
 Substituting less expensive materials or ingredients
 Reducing or removing product features
 Removing or reducing product services, such as
installation or free delivery
 Using less expensive packaging material or larger
package sizes
 Reducing the number of sizes and models offered
 Creating new economy brands: Generic items
14-62
Copyright © 2003 Prentice-Hall, Inc.
Reactions to Price Changes
 Reactions of customers to a price cut
 The item is about to be replaced by a new model
 The item is faulty and not selling well
 The firm is in financial trouble
 The price will come down further
 The quality has been reduced
 Reactions of customers to a price increase
 The item is hot and represents an unusually high
value
 The price will increase further. Unless the customer
buys now, he will pay more later or cannot buy at
all
14-63
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Reactions to Price Changes
 Competitor Reactions
 Competitors are most likely to react when
 the number of firms is few,
 the product is homogeneous, and
 buyers are well informed
 Competitors react according to their selfinterest
14-64
Copyright © 2003 Prentice-Hall, Inc.
Responding to Competitors’
Price Changes
 Responses to a price cut in homogeneous
product markets
 Firms must search for ways to enhance its
augmented product or
 Meet the price reduction
 Responses to a price increase
 Firms may follow the price increase to make
more profits or
 May not match it to increase a market share
14-65
Copyright © 2003 Prentice-Hall, Inc.
Responding to Competitors’ Price
Changes
 Brand leader can respond in several ways
 Maintain price
 Maintain price and add value
 Reduce price
 Increase price and improve quality
 Launch a low-price fighting brand
14-66
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