EF 670 Class 7
Pricing Notes: Putting the theory of the firm into action
What is wrong with the current methods of pricing?
Cost-Plus – a rule of thumb that makes life easier. It is rational if
1. marginal cost is approximately equal to average cost and
2. each product has its own markup based upon price elasticity
Since this is rarely true, this pricing strategy leads to limiting profit. In retail, the first
is often true, and the volume of products makes the second infeasible due to information
overload. Therefore, many firms use cost plus as an approximation, adjusting markups
based upon the development of shortages or surpluses over time. In addition, overstocks
are sold by dropping price, adjusting the future price for this type of product to account
for these surpluses.
Cost-plus does not adjust over time very well to expansions or contractions in the
market. It leads to lags in this adjustment process. This leads to under-pricing in growth
markets and over-pricing in contractions.
Customer Driven Pricing – “Give them what they want at a price that they want.” This
has a number of problems:
1. Customers may not know what they want because they do not know the
alternatives. This is especially true of new products.
2. Customers have an incentive to misrepresent their willingness to pay, undervaluing products. This can lead to not providing profitable products due to
underestimated willingness to pay. It can lead to under-pricing those products
that are provided.
3. Profit is goal, not service.
Competition-driven pricing – Some competitors have an advantage over you, so you
cannot win a pricing battle. Accommodation may be a better strategy. Price wars are
often destructive to both competitors. “Meeting the competition” is a legal defense for
price adjustments. It is not always a profitable strategy. The best strategy is to pick your
battles, choose the markets you want to compete in, and work to create a competitive
advantage in those markets. Be the initiator. That is, proactively choose the markets,
products, and prices for profit. Walk from unprofitable business, or those markets that
are not consistent with the firm’s goals.
Correct Pricing – consider what can create value for the customer, what is a cost
effective means of providing this, whether these are consistent with the firm’s skills and
goals, and how to price to reap the profits from the venture. Cost and price should be
simultaneously determined, taking into account the target customer’s “needs” and the
costs associated with addressing these needs. An additional consideration is the actual or
potential competition in providing this product or service. Who? How? And how soon?
Costs - two primary additions to what we already have discussed:
1. What costs are relevant – only incremental. What is incremental will depend
on the decision being considered. What is incremental is not necessarily
going to be obvious in the current accounting statements. The concepts of
economic value added or activity based costing come the closest to true
measures of economic cost. The former adds a “normal return” on assets, so
necessary to correctly measure the full cost of any activity. The latter
addresses the idea that some costs are affected by particular changes and these
are the costs that are relevant. Two key issues are missing from the normal
accounting data—opportunity costs and incremental costs. Each decision
needs to address explicitly both of these.
2. How should we use costs in actual pricing decisions? The concept of
contribution margin addresses directly the idea that only the net cash flow
changes can cover any losses incurred by a given change. If price is dropped,
the current customers pay less. Additional customers attracted by the price
drop add to revenue AND add to cost. The net addition is available to pay
back the lost revenues. If quantity rises enough, the contribution margin pays
back the lost revenues and then some. Then the change is profitable.
Pricing for Profit – Now the fun begins! (NOTE: The following analysis simplifies the
calculations by assuming fixed per unit variable costs. The more realistic bowl-shaped
average variable cost is more realistic, but this assumption works fairly well for
“reasonable-sized” changes of quantity and price.)
Profit (π) = Total Revenue (TR) – Total Cost (TC)
Total contribution (added net increase to profit from producing) is
Contribution (available to pay π and TFC) = TR – TVC
Contribution margin (per unit)
CM =
TR TVC
–
= P – VC (this is average variable cost; I will use Nagle and
Q
Q
Holden’s acronym for this writeup)
Percent contribution margin is
%CM =
( P  VC )
P
Changing price leads to (potential) change (∆) in profit (π):
Δπ = ΔTR – ΔTC
Δπ = Δ(PQ) – Δ(TVC + TFC)
Δπ = ΔP x Q + (P + ΔP) x ΔQ – ΔTVC + ΔTFC
Δπ = ΔP x Q + (P + ΔP) x ΔQ – ΔTVC + ΔTFC
Assuming that fixed costs do not change with price and quantity changes and that average
variable cost (VC) is constant, the change in profit is the difference between change
(increase) in revenue and the change (increase) in variable costs:
Δπ = ΔP x Q + (P + ΔP) x ΔQ – (ΔQ x VC) + 0
For profit to be unchanged (this is break-even analysis)
Δπ = 0,
-
ΔP x Q = ΔQ x (P + ΔP – VC) = ΔQ x (P– VC + ΔP) = ΔQ x (CM + ΔP)
Break Even % Δ Q =
 P
 CM
Q
=
=
CM  P New CM
Q
If Variable costs change (for all units) as P changes:
Break Even % Δ Q =
 ($P  $VC )
$CM  ($P  $VC )
Notice that this is the same thing a
Break Even % Δ Q = -
 $CM
new $CM
The numerator is the change in contribution to profit and overhead. This is the loss that
is incurred by the change. The negative sign is because a DEcrease in the CM leads to a
need for INcreased quantity to pay for it and an INcrease in the CM allows a DEcrease
in quantity without loss of profit.
The denominator is the rate at which quantity increases profit and overhead. The
resulting ratio gives the percentage change in quantity necessary to maintain constant
profit.
When there is a change in fixed costs incurred by the policy change, this must be paid for
through additional (or allowed decrease) in quantity. This introduces a second term. The
two terms must be converted to the same units due to the ΔP and $ΔVC being a per unit
change while the ΔFC is a specific dollar change.
Unit Break Even Δ Q =
 $CM
$FC
X Intial Q 
new $CM
New $CM
Alternatively:
% Break Even Δ Q =
 $CM
$FC

new $CM New $CM X Intial Q
In both formulas, the first term is the same as that above except for the units conversion
in the first equation. The idea is that the first time “pays back” the lost contribution from
variable elements. The units conversion allows combining the first and second terms.
And the second term “pays back” the fixed cost change.
In the last term, the denominator is the contribution of the initial units at the new
contribution rate. In the last term:
$FC
is the change in cost per unit. Dividing this by the new $ CM (the rate of cost
InitialQ
recovery) gives the percentage change in Q necessary to recover these costs.
In the case of reactive pricing, the contribution margin at an unchanged price is still the
same as it was before. The alternative is to change the price to match the competitor.
This will cause a change in the contribution margin and the current profit. The question
is what volume change makes these two alternatives equal? Matching the price change is
expected to leave quantity the same, so the % loss (or gain) will be equal to the price
change. If the price is left the same, the change in quantity will lead to profit contribution
changes at the rate of the old contribution margin (which is the new one if the price
change is not matched).
% Break Even Δ Q =
 P
CM
The remainder of the chapter deals with setting up tables or graphs to analyze the
outcomes at different volumes and different price changes. Often the firm wants to raise
the price, but does not know how much to raise it. In this case, setting up a breakeven
table or graph showing the necessary quantities at the different price changes will help in
making this decision.
STRATEGIC PRICING:
Strategic pricing is not pricing, given costs. It is proactively choosing an overall pricing
strategy which includes determining what costs are warranted. In this case, it is “better to
ask than to ask forgiveness,” unlike the slogan many use. Analyze what costs are
necessary to create what values and what the customer can reasonably be expected to pay
for the resulting product. All of this must be done within the context of the overall firm
strategy and capabilities.
“The key to greater profitability is to let economic value drive pricing goal and
objectives, and then manage willingness to pay with marketing and competitive activities
that support those goals and objectives.” (Nagle and Holden, p. 149)
Pricing structure involves segmentation fences, needed to qualify for specific prices and
value metrics (bases for pricing), preferably allowing price to vary with value delivered.
In setting price, price discounts should entail (if possible) less value delivered. The
variations need not be proportional, if costs incurred are not. By doing this, you are less
likely to get into downward price spirals that come with showing that your pricing is
negotiable. If customer changes affect your costs, your pricing should reflect this or the
customer will be unlikely to behave in a way to foster your profit.
Value based Marketing
Comprehend what drives sustainable value
Create value of the customer
Communcate the value you created
Tangible features
Intangible features
Convince customers that they must pay for value received.
Capture value with appropriate price metrics and fences.
(Nagle & Holden, p. 164)
The idea is to know what your customer needs (as opposed to what they say they want),
and find a way to economically provide this, communicate this to the customer, and price
and market this in a way to capture the value through sales.
Three alternative general strategies:
1. Skim Pricing – pricing high relative to value (Nordstrom’s). You need a
customer base that is relatively price insensitive. Products warranting this
type of strategy include unique, quality products, impulse buys, third-partypay situations, prestige products, and items with a very strong end-benefit
effect. Variable cost being a large share of costs, leading to a small
contribution margin, often calls for a skim strategy. You need barriers to
competition (or need to develop them through legal restrictions (patents or
copyrights), product quality, reputation, or prestige.
2. Penetration pricing – pricing close to cost in order to develop sales volume.
This is usually a good strategy when the firm has a definite cost advantage
(Wal-Mart). If not, it may be a dangerous strategy as other firms can replicate
or surpass your strategy (look at K-Mart). You also need a price responsive
customer base. Generally, products here tend to be more generic rather than
differentiated. Incremental cost being small makes adding volume more
beneficial due to the larger contribution margin. This also may work for firms
just entering an established market, as they may not attract competitive
response from current (larger) competitors due to the cost of these responses (
AT&T could not afford to respond to Sprint and MCI when they first entered
the market).
3. Neutral pricing – between penetration and skim. This is where most
products fall and where most products should fall. Without a strong incentive
for skim or penetration, use neutral. With competition, penetration pricing
does not attract many customers. Without barriers to entry, skim pricing, with
its higher profit margin potential, will attract entry. Therefore, pricing
strategies are bracketed by competition and potential competition. Neutral
pricing means pricing in “the center of the pack.” In this case, price becomes
less an issue in the consumer’s decision process.