Unit K: Pricing Strategies

What you’ll learn to do: explain price elasticity and its impact on price

Now that you understand different pricing strategies, we’re going to tackle one more concept that helps when selecting the right strategy: price elasticity. Elasticity helps us understand how much a change in price will affect market behaviors. If we make a small change in price, will the change have a dramatic impact on the demand for the product or only a small impact? Price elasticity is the measure of the market’s response to price changes.

Elasticity is important to pricing decisions because it helps us understand whether raising prices or lowering prices will enable us to achieve our pricing objectives. Will a discount drive increased sales? Will a price increase cause us to lose many buyers or just a few? We have to answer these questions in order to select the most effective pricing strategy.

When you work through this section, start by trying to get a handle on the concept: elasticity helps us understand whether a price change will have a big impact on demand or a small impact. That’s it. Don’t get too hung up on the math at first. Master the concept; then add the math.

The following video gives an overview of economics that will better prepare you for the readings.

The specific things you’ll learn in this section include:

• Define elasticity
• Explain the impact of elasticity on price changes
• Identify examples of products with elastic and inelastic demand

Elasticity and Price Changes

With a good understanding of what elasticity means and how it is calculated, we can now investigate its impact on pricing strategies. In order to do this, we’ll look at a couple of examples and answer the following questions:

1. How much of an impact do we think a price change will have on demand?
2. How would we calculate the elasticity, and does it confirm our assumption?
3. What impact does the elasticity have on the business or pricing objectives?

Please note: when we calculate elasticity, we will always use the absolute value, or the real number without regard to its sign. In other words, you can disregard the positive and negative signs and just pay attention to the real number.

Example 1: The Student Parking Permit

How elastic is the demand for student parking passes at your institution? The answer to that question likely varies based on the profile of your institution, but we are going to explore a particular example. Let’s consider a community college campus where all of the students commute to class. Required courses are spread throughout the day and the evening, and most of the classes require classroom attendance (rather than online participation). There is a reasonable public transportation system with busses coming to and leaving campus from several lines, but the majority of students drive to campus. A student parking permit costs $40 per term. As the parking lots become increasingly congested, the college considers raising the price of the parking passes in hopes that it will encourage more students to carpool or to take the bus.

If the college increases the price of a parking permit from $40 to $48, will fewer students buy parking permits?

If you think that the change in price will cause many students to decide not to buy a permit, then you are suggesting that the demand is elastic—the students are quite sensitive to price changes. If you think that the change in price will not impact student permit purchases much, then you are suggesting that the demand is inelastic—student demand for permits is insensitive to price changes.

In this case, we can all argue that students are very sensitive to increases in costs in general, but the determining factor in their demand for parking permits is more likely to be the quality of alternative solutions. If the bus service does not allow students to travel between home, school, and work in a reasonable amount of time, many students will resort to buying a parking permit, even at the higher price. Because students don’t generally have extra money, they may grumble about a price increase, but many will still have to pay.

Let’s add some numbers and test our thinking. The college implements the proposed increase of $8. If we divide that by the original price ($40) then we can see that the price increase is 20% (8 / 40 = 0.20). Last year the college sold 12,800 student parking passes. This year, at the new price, the college sells 11,520 parking passes—which is a decrease of  10%, as shown below:

12,800 – 11,520 = 1,280

1,280 / 12,800 = 1 / 10 = 10%

Without doing any more math, we know that a 20% change in price resulted in a 10% change in demand. In other words, a large change in price created a comparatively smaller change in demand. This means that student demand is inelastic. Let’s test the math.

% change in quantity demanded / % change in price =  absolute value of price elasticity

10% / 20% = 0.10 / 0.20 = 0.50

0.50 < 1

When the absolute value of the price elasticity is < 1, the demand is inelastic. In this example, student demand for parking permits is inelastic.

What impact does the price change have on the college and their goals for students? First, there are 1,280 fewer cars taking up parking places. If all of those students are using alternative transportation to get to school and this change has relieved parking-capacity issues, then the college may have achieved its goals. However, there’s more to the story: the price change also has an effect on the college’s revenue, as we can see below:

Year 1: 12,800 parking permits sold x $40 per permit = $512,000

Year 2: 11,520 parking permits sold x $48 per permit = $552,960

The college earned an additional $40,960 in revenue. Perhaps this can be used to expand parking or address other student transportation issues.

In this case, student demand for parking permits is inelastic. A significant change in price leads to a comparatively smaller change in demand. The result is lower sales of parking passes but more revenue.

Note: If you attend an institution that offers courses completely or largely online, the price elasticity for parking permits might be completely inelastic. Even if the institution gave away parking permits, you might not want one.

Example 2: Helen’s Cookies

When we discussed break-even pricing, we used the example of a new cookie company that was selling its cookies for $2. In this example, let’s put the cookies in a convenience store, which has several options on the counter that customers can choose as a last-minute impulse buy. All of the impulse items range between $1 and $2 in price. In order to raise revenue, Helen (the baker, who has taken over the company,) decides to raise her price to $2.20.

If Helen increases the cookie price from $2.00 to $2.20—a 10% increase—will fewer customers buy cookies?

If you think that the change in price will cause many buyers to forego a cookie, then you are suggesting that the demand is elastic, or that the buyers are sensitive to price changes. If you think that the change in price will not impact sales much, then you are suggesting that the demand for cookies is inelastic, or insensitive to price changes.

Let’s assume that this price change does impact customer behavior. Many customers choose a $1 chocolate bar or a $1.50 doughnut over the cookie, or they simply resist the temptation of the cookie at the higher price. Before we do any math, this assumption suggests that the demand for cookies is elastic.

Adding in the numbers, we find that Helen’s weekly sales drop from 200 cookies to 150 cookies. This is a 25% change in demand on account of a 10% price increase. We immediately see that the change in demand is greater than the change in price. That means that demand is elastic. Let’s do the math.

% change in quantity demanded / % change in price

25% / 10% = 2.5

2.5 > 1

When the absolute value of the price elasticity is > 1, the demand is elastic. In this example, the demand for cookies is elastic.

What impact does this have on Helen’s objective to increase revenue? It’s not pretty.

Price 1: 200 cookies sold x $2.00 per cookie = $400

Price 2: 150 cookies sold x $2.20 = $330

She is earning less revenue because of the price change. What should Helen do next? She has learned that a small change in price leads to a large change in demand. What if she lowered the price slightly from her original $2.00 price? If the pattern holds, then a small reduction in price will lead to a large increase in sales. That would give her a much more favorable result.

Products with Elastic and Inelastic Demand

Now that you’ve had some practice calculating the value of elasticity, let’s turn to some of the factors that play a role in whether a product is likely to have elastic or inelastic demand. The following factors can have an effect on elasticity:

• Substitutes: If it’s easy to choose a different product when prices change, the demand will be more elastic. If there are few or no alternatives, demand will be more inelastic.
• Absolute price: When a product is very expensive, even a small percentage change in price will make it prohibitively expensive to more buyers. If the price of a product is a tiny percentage of the buyer’s overall spending power, then a change in price will have less impact.
• Importance of use: In our previous example, we examined the elasticity of demand for cookies. A buyer may enjoy a cookie, but it doesn’t fulfill a critical need the way a snow shovel after a blizzard or a life-saving drug does. In general, the more important the product’s use, the more inelastic the demand will be.
• Competitive dynamics: Goods that are produced by a monopoly generally have inelastic demand, while products that exist in a competitive marketplace have elastic demand. This is because a competitive marketplace will create more options for the buyer.

With these considerations in mind, take a moment to see if you can figure out which of the following products have elastic demand and which have inelastic demand. It may be helpful to remember that when the buyer is insensitive to price, demand is inelastic.

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What you’ll learn to do: explain the primary factors to consider in pricing

Now that we’ve considered the customer perspective, we need to understand how pricing fits into the company strategy. It’s important to remember that all elements of the marketing mix, including pricing, fit into a larger customer mission and strategy.

An effective pricing strategy will align with the corporate mission, account for competitive factors, and support corporate strategies and objectives.

The specific things you’ll learn in this section include:

• Explain company objectives in the pricing strategy
• Define break-even pricing
• Describe how competition affects pricing strategies
• Describe the benefit of value-based pricing for customers

Pricing Objectives

Companies set the prices of their products in order to achieve specific objectives. Consider the following examples:

In 2014 Nike initiated a new pricing strategy. The company determined from a market analysis that its customers appreciated the value that the brand provided, which meant that it could charge a higher price for its products. Nike began to raise its prices 4–5 percent a year. Footwear News reported on the impact of their strategy:

“The ability to raise prices is a key long-term advantage in the branded apparel and footwear industry—we are particularly encouraged that Nike is able to drive pricing while most U.S. apparel names are calling for elevated promotional [and] markdown levels in the near-term,” said UBS analyst Michael Binetti. Binetti said Nike’s new strategy is an emerging competitive advantage.^[1]

Nike’s understanding of customer value enabled it to raise prices and achieve company growth objectives, increasing U.S. athletic footwear sales by $168 million in one year.

In 2015 the U.S. airline industry lost $12 billion in value in one day because of concerns about potential price wars. When Southwest Airlines announced that it was increasing its capacity by 1 percent, the CEO of American Airlines—the world’s largest airline—responded that American would not lose customers to price competition and would match lower fares. Forbes magazine reported on the consequences:

This induced panic among investors, as they feared that this would trigger a price war among the airlines. The investors believe that competing on prices would undermine the airline’s ability to charge profitable fares, pull down their profits, and push them back into the shackles of heavy losses. Thus, the worried investors sold off stocks of major airlines, wiping out nearly $12 billion of market value of the airline industry in a single trading day.^[2]

Common Pricing Objectives

Not surprising, product pricing has a big effect on company objectives.  (You’ll recall that objectives are essentially a company’s business goals.) Pricing can be used strategically to adjust performance to meet revenue or profit objectives, as in the Nike example above. Or, as the airline-industry example shows, pricing can also have unintended or adverse effects on a company’s objectives. Product pricing will impact each of the objectives below:

• Profit objective: For example, “Increase net profit in 2016 by 5 percent”
• Competitive objective: For example, “Capture 30 percent market share in the product category”
• Customer objective: For example, “Increase customer retention”

Of course, over the long run, no company can really say, “We don’t care about profits. We are pricing to beat competitors.” Nor can the company focus only on profits and ignore how it delivers customer value. For this reason, marketers talk about a company’s “orientation” in pricing. Orientation describes the relative importance of one factor compared to the others. All companies must consider customer value in pricing, but some have an orientation toward profit. We would call this profit-oriented pricing.

Profit-Oriented Pricing

Profit-oriented pricing places an emphasis on the finances of the product and business. A business’s profit is the money left after all costs are covered. In other words, profit = revenue – costs. In profit-oriented pricing, the price per product is set higher than the total cost of producing and selling each product to ensure that the company makes a profit on each sale.

The benefit of profit-oriented pricing is obvious: the company is guaranteed a profit on every sale. There are real risks to this strategy, though. If a competitor has lower costs, then it can easily undercut the pricing and steal market share. Even if a competitor does not have lower costs, it might choose a more aggressive pricing strategy to gain momentum in the market.

Also, customers don’t really care about the company’s costs. Price is a component of the value equation, but if the product fails to deliver value, it will be difficult to generate sales.

Finally, profit-oriented pricing is often a difficult strategy for marketers to succeed with, because it limits flexibility. If the price is too high, then the marketer has to adjust other aspects of the marketing mix to create more value. If the marketer invests in the other three Ps—by, say, making improvements to the product, increasing promotion, or adding distribution channels—that investment will probably require additional budget, which will further raise the price.

It’s fairly standard for retailers to use some profit-oriented pricing—applying a standard mark-up over wholesale prices for products, for instance—but that’s rarely their only strategy. Successful retailers will also adjust pricing for some or all products in order to increase the value they provide to customers.

Competitor-Oriented Pricing

Sometimes prices are set almost completely according to competitor prices. A company simply copies the competitor’s pricing strategy or seeks to use price as one of the features that differentiates the product. That could mean either pricing the product higher than competitive products, to indicate that the firm believes it to provide greater value, or lower than competitive products in order to be a low-price solution.

This is a fairly simple way to price, especially with products whose pricing information is easily collected and compared. Like profit-oriented pricing, it carries some risks, though. Competitor-oriented pricing doesn’t fully take into account the value of the product to the customer vis-à-vis the value of competitive products. As a result, the product might be priced too low for the value it provides, or too high.

As the airline example illustrates, competitor-oriented pricing can contribute to a difficult market dynamic. If players in a market compete exclusively on price, they will erode their profits and, over time, limit their ability to add value to products.

Customer-Oriented Pricing

Customer-oriented pricing is also referred to as value-oriented pricing. Given the centrality of the customer in a marketing orientation (and this marketing course!), it will come as no surprise that customer-oriented pricing is the recommended pricing approach because its focus is on providing value to the customer. Customer-oriented pricing looks at the full price-value equation (Figure 1, above; discussed earlier in the module in “Demonstrating Customer Value”) and establishes the price that balances the value. The company seeks to charge the highest price that supports the value received by the customer.

Customer-oriented pricing requires an analysis of the customer and the market. The company must understand the buyer persona, the value that the buyer is seeking, and the degree to which the product meets the customer need. The market analysis shows competitive pricing but also pricing for substitutes.

In an attempt to bring the customer voice into pricing decisions, many companies conduct primary market research with target customers. Crafting questions to get at the value perceptions of the customer is difficult, though, so marketers often turn to something called the Van Westerndorp price-sensitivity meter. This method uses the following four questions to understand customer perceptions of pricing:

1. At what price would you consider the product to be so expensive that you would not consider buying it? (Too expensive)
2. At what price would you consider the product to be priced so low that you would feel the quality couldn’t be very good? (Too cheap)
3. At what price would you consider the product starting to get expensive, such that it’s not out of the question, but you would have to give some thought to buying it? (Expensive/High Side)
4. At what price would you consider the product to be a bargain—a great buy for the money? (Cheap/Good Value)

Each of these questions asks about the customer’s perspective on the product value, with price as one component of the value equation.

The responses of many potential buyers can be plotted on a graph (see Figure 2, below). Each line shows the different customer responses to each of the questions at different price points. For example, 100 percent of those interviewed think the product is too cheap at $0, and 40 percent think that it’s still too cheap at a price of $500. The graph shows an acceptable price range in which the customers’ responses cross one another. They become torn between whether the prices are cheap or expensive but are not clearly landing on one side or the other. The results of this graph suggest a price band between $500 and $1,200.

For the purposes of this course, we won’t be getting into a full analysis of these data or the price-sensitivity meter; the important point is that marketers need to balance the customer’s perception of the value provided with the customer’s perception of the right price (“perceived costs” in Figure 1, above) in the value equation.

Break-Even Pricing

Regardless of the pricing strategy a company ultimately selects, it is important to do a break-even analysis beforehand. Marketers need to understand break-even analysis because it helps them choose the best pricing strategy and make smart decisions about the short- and long-term profitability of the product.

The break-even price is the price that will produce enough revenue to cover all costs at a given level of production. At the break-even point, there is neither profit nor loss. A company may choose to price its product below the break-even point, but we’ll discuss the different pricing strategies that might favor this option later in the module.

Understanding Breakeven

Let’s begin with a very simple calculation of breakeven and build from there.

Imagine that you decide to hold a bake sale and sell cookies in the student union as a social event for students. You don’t want to lose money on the cookies, but you are not trying to make a profit or even cover your time. You spend a very convenient $24 on groceries and bake 4 dozen cookies (48 cookies). What is your break-even price for the cookies? It’s the total cost divided by the number of cookies that you expect to sell, represented by the formula below:

Break-Even Price = Costs / Units  

So, it would be $24 / 48 = $.50, or 50 cents per cookie. What if you sell only 40 cookies? The calculation would be $24 / 40 = $.60. Your break-even price goes up if you sell fewer cookies.

One challenge of calculating breakeven is that all of the variables can change, and some are unknown. For instance, it may be impossible to know exactly the quantity that you will sell. For that reason, companies often calculate the break-even quantity rather than the break-even price. Focusing on quantity enables the marketer to answer the following question: “Given this set of costs and this price, how many products must I sell to break even?” The break-even quantity is shown by the following formula:

Break-Even Quantity (in terms of units) = Costs / Price 

In our cookie example, once you have spent $24 on groceries, you know your cost. What if you plan to sell the cookies for $1 apiece? According to the equation above, units = cost / price, so in our case, units = $24 / $1, or 24 cookies.

Of course this is a very simple example, but it gives you a sense of why breakeven matters, and how you would calculate it.

Including Fixed and Variable Costs

Let’s add one more complication to make our example a little more realistic and interesting. Your cookies have been such a hit that you decide to sell them more broadly. In fact, you rent a commercial kitchen space and hire an experienced baker named Helen to do the baking. Your break-even point just went up dramatically. Now you need to cover the costs of your kitchen and an employee. For the sake of this exercise, let’s assume that Helen works a set number of hours every week—20 hours—and that you pay her $20 per hour including all taxes and benefits. You rent the kitchen for $100 per week, and that price includes all the equipment and utilities. Those are costs that are not going to change no matter how many cookies you sell. If you baked nothing, you would still need to pay $100 per week in rent and $400 per week in wages. Those are your fixed costs. Fixed costs do not change as the level of production goes up or down. Your fixed costs are $500 per week.

Now you need to buy ingredients for the cookies. Once you add up the food costs of making a single large batch of cookies, you find that it’s a total of $7.20 for a batch of 12 dozen (144) cookies. If you divide that out, you can tell that each cookie costs $.05 in food costs ($7.20 / 144 cookies = $.05). In other words, every cookie you sell is going to have a variable cost of $.05. Variable costs do change as production is increased or decreased.

Adding these different types of costs makes the break-even equation more complicated, as shown below:

pn = Vn + FC

p = price

n = number of units sold

V = variable cost per unit

FC = fixed costs

With this equation we can calculate either the break-even price or the break-even quantity.

Calculating Break-Even Price

Chances are good that you can only bake a certain number of cookies each week—let’s say it’s 2,500 cookies—so, based on that information, you can calculate the break-even price. The formula to do that is the following:

p = (Vn + FC) / n

n = 2,500

V = $.05

FC = $500

Therefore, p = (($.05 x 2,500)  + $500) / 2,500

p = ($125 + $500) / 2,500

p = $.25

Your break-even price for your cookies is 25 cents. That doesn’t mean it’s the right market price for the cookies; nor does it mean that you can definitely sell 2,500 cookies at whatever price you choose. It simply gives you good information about the price and quantity at which you will cover all your costs.

Calculating Break-Even Quantity

Now let’s assume that you have set your price and you need to know your break-even quantity. You are an exceptional marketing student, so you have talked to the people who are likely buyers for your cookies, and you understand what price is a bargain and what price is too expensive. You have compared the price with competitor prices. And, you have considered the price of your cookie compared to the price of doughnuts and ice cream (both are “substitutes” for your product). All of this analysis has led you to set a price of $2 per cookie, but you want to make sure that you don’t lose money on your business: You need to calculate the break-even quantity. The formula to do that is the following:

n = FC /( p – V)

Using the same inputs for the variables, your equation looks like this: n = $500 / ($2 – $.05)

n = $500 / $1.95

n = 256.41 cookies

So, let’s round up and just call the break-even quantity 257 cookies. Does that mean that you keep the full $2 as profit for every cookie after 257? Sadly, no. First, you have to cover the variable cost for each cookie ($.05 per cookie), which means you make just $1.95 per cookie you sell (after you’ve surpassed the break-even point). Second, our simple break-even example did not include all of the costs. After you’ve locked down the product costs and the pricing, you will need to invest in promotion and distribution of the cookies. You’ll also probably want to cover your time (i.e., pay yourself) and add some profit into the total fixed costs. For instance, if you wanted to earn a profit of $600 each week, then you would need to add that to the $500 fixed costs of the kitchen and Helen.

Breakeven in the Marketing Strategy

Now that we have a cost example, it’s a little easier to think about the pricing objectives. If you decided to price your cookies with a profit orientation, then you would simply add a profit ($1 per cookie, say,) to the break-even price. That approach doesn’t take the customer into account at all, though, since a profit orientation is only about the business.

What if you found that your campus stores and vending machines sell a national chain of cookies for 75 cents? Using a competitor-oriented pricing approach, you might decide to match that price and compete on that basis. The drawback is that this approach does not take into account the value your customers find in a fresh, local product—i.e., your cookies—made from high-quality ingredients.

A customer-oriented pricing approach allows you to treat the break-even data as one input to your pricing, but it goes beyond that to bring your customers’ perceptions and the full value of your product into the pricing evaluation.

Competitor Impact on Pricing

It’s important to remember that pricing is just one component of the marketing mix, and even very specific pricing decisions need to take into account the other components. This is particularly true in a competitive marketplace. Actions by different competitors integrate all elements of the marketing mix and do not focus on price alone. A competitor might make a change to a product or initiate a promotion that impacts customers’ perceptions of value and, therefore, their perceptions of price.

Competitive Pricing

Once a business decides to use price as a primary competitive strategy, there are many well-established tools and techniques that can be employed. The pricing process normally begins with a decision about the company’s pricing approach to the market. Price is a very important decision criterion that customers use to compare alternatives. It also contributes to the company’s position. In general, a business can price its offering to match its competition, or it can price higher or price lower. Each has its pros and cons.

Pricing to Meet Competition

Many organizations attempt to establish prices that, on average, are the same as those set by their more important competitors. Automobiles of the same size with comparable equipment and features tend to have similar prices, for instance. This strategy means that the organization uses price as an indicator or baseline. Quality in production, better service, creativity in advertising, or some other element of the marketing mix is used to attract customers who are interested in products in a particular price category.

The key to implementing a strategy of meeting competitive prices is to have an accurate definition of competition and a knowledge of competitors’ prices. A maker of handcrafted leather shoes is not in competition with mass producers. If he/she attempts to compete with mass producers on price, higher production costs will make the business unprofitable. A more realistic definition of competition in this case would be other makers of handcrafted leather shoes. Such a definition along with an understanding of competitors’ prices would enable management to put the strategy into effect.

The banking industry often uses this strategy by using technology to actively monitor competitors’ rates, fees, and packages in order to adjust their own prices.

Pricing Above Competitors

Pricing above competitors can be rewarding to organizations, provided that the objectives of the policy are clearly understood and the marketing mix is developed in such a way that the policy can be successfully implemented by management.

Pricing above competition generally requires a clear advantage on some nonprice element of the marketing mix. In some cases, that advantage may be due to a high price-quality association on the part of potential buyers.

Betting on that advantage is increasingly dangerous in today’s information-rich environment, however. Online shoppers can get quick price comparisons and read customer or expert reviews to evaluate other elements of the value proposition. This is true for both business-to-consumer and business-to-business offerings. Many consumers also take advantage of their smartphones when they shop: it’s easy enough to stand in one store and compare price and distribution options for the same product and for competitive products. Customers’ access to information puts more pressure on marketers to understand customer value and provide an offering whose price, relative to competitors’ prices, contributes to the value.

You’ll recall our earlier example of Nike using a strategy of raising prices—while its competitors were holding pricing flat or reducing prices—because its analysis showed that it was providing sufficient value to sustain a higher price.

Pricing Below Competitors

While some firms are positioned to price above competition, others wish to carve out a market niche by pricing below competitors. The goal of such a policy is to realize a large sales volume through a lower price and lower profit margins. By controlling costs and reducing services, these firms are able to earn an acceptable profit, even though profit per unit is usually less.

Such a strategy can be effective if a significant segment of the market is price sensitive and/or the organization’s cost structure is lower than competitors’. Costs can be reduced by increased efficiency, economics of scale, or by reducing or eliminating such things as credit, delivery, and advertising. For example, if a firm could replace its field sales force with telemarketing or online access, this function might be performed at lower cost. Such reductions often involve some loss in effectiveness, so the trade-off must be considered carefully.

One of the worst outcomes that can result from pricing lower than a competitor is a “price war.” Price wars usually occur when a company believes that price-cutting will increase market share, but it doesn’t have a true cost advantage. Price wars are often caused by companies misreading or misunderstanding competitors. Typically, they are overreactions to threats that either are nonexistent or are not as big as they seem. You will remember our example of the airline price war, in which the stock price of airlines plummeted because stockholders reacted negatively to price reductions, fearing that a price war would eliminate profits and put the health of the industry at risk.

In the module on product marketing we described the ride-sharing service Uber. Uber has successfully undercut the taxi industry with a product that improves services while lowering prices, which has led to extremely rapid growth and success for the company. When lower prices are part of a complete, compelling value proposition, pricing can provide a powerful solution and create a challenging competitive environment for existing players.

Benefits of Value-Based Pricing

We have discussed common company objectives that affect pricing and the competitive impact on pricing. The most important perspective in the pricing process is the customer’s. Value-based pricing brings the voice of the customer into the pricing process. It bases prices primarily on the value to the customer rather than on the cost of the product or historical prices determined by competitors.

If we consider the three approaches to setting price, cost-based pricing is focused entirely on the perspective of the company, with very little concern for the customer; demand-based pricing is focused on the customer, but only as a predictor of sales; and value-based pricing focuses entirely on the customer as the determiner of the total price/value package. Marketers who employ value-based pricing might describe it this way: “Price is what you think your product is worth to that customer at that time.” This approach regards the following as marketing/price truths:

• To the customer, price is the only unpleasant part of buying.
• Price is the easiest marketing tool to copy.
• Price represents everything about the product.

Still, value-based pricing is not altruistic. It asks and answers two questions:

1. What is the highest price I can charge and still make the sale?
2. Am I willing to sell at that price?

In order to answer these questions we need to consider both customer- and competitor-related factors. In answering the second question, we would also want to use the break-even analysis that we discussed in the previous section, as well as other financial and strategic analyses.

Customer-Related Factors

Several customer-related factors are important in value-based pricing; one of them is understanding the customer buying process. For a convenience good, customers often spend little time, planning, or effort in the buying process, and purchases are more often made on impulse. With a shopping product, the consumer is more likely to compare a number of options when evaluating quality, cost, and features; as a result, he or she will require a better understanding of price in order to assess value.

Another issue is that different groups or segments of customers view price differently. Buyer personas can be instrumental to a marketer’s grasp of those differences and the role price plays in the decision-making process. Some buyers will weight convenience or quality over price, for instance, while others will be highly price sensitive.

The marketer must understand what the customer values, what the customer expects, and how the customer evaluates price in the value equation.

Competitor-Related Factors

A second factor influencing value-based pricing is competitors. We asserted above that the primary driver of value-based pricing is the customer’s estimation of value—not costs or historical competitor prices. Still, competitors do influence the customer’s view of value. The marketing mix of competitive products have an impact on customer expectations because they an important part of the decision-making context. Customers are shopping across products and brands and take price differences into account when evaluating the quality and benefits of competitive products. These direct comparisons have tremendous impact on the customer’s perceptions of value.

In value-based pricing, the marketer must also consider indirect competitors that consumers may use as a basis for price comparisons. For example, one might use the price of a vacation as a basis for buying vacation clothes. The cost of eating out is frequently compared to the cost of groceries.

Ultimately, value-based pricing offers the following three tactical recommendations:

• Employ a segmented approach toward price that considers how each group of customers assesses value.
• Establish the highest possible price level and justify it with comparable value.
• Use price as one component in the marketing mix, building compelling value across all elements of the offering.

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COPYRIGHT

This courseware was assembled by Christopher VanOosterhout from a variety of resources copyrighted and openly licensed by multiple individuals and organizations.  See our Copyright and Attribution page for additional details.  For details about permission to use please contact me at c@vanosterhout.com with the phrase  Courseware Usage Inquiry.  If you believe that this courseware violates your copyright, please contact me at c@vanoosterhout.com with the phrase Copyright Inquiry in the subject.  Details about the collector of these resources and Licentia LLC can be found at www.vanoosterhout.com

What you’ll learn to do: discuss how price affects the value of an organization’s products or services

Price determines how much revenue a company is going to earn. It determines whether the business is covering the costs to create and deliver its products. Price drives the financial health of the business.

In out initial discussion of pricing, we’ll start with the perspective of the customer. If the customer doesn’t see value in the product offering—and that includes pricing—company objectives won’t be met. Customer perceptions of value must be the central consideration in the pricing process.

Demonstrating Customer Value

Rent the Runway is a company that lets customers borrow expensive designer dresses for a short time at a low price—to wear on a special occasion, e.g.— and then send them back. A customer can rent a Theia gown that retails for $995 for four days for the price of $150. Or, she can rent a gown from Laundry by Shelli Segal that retails for $325 for the price of $100. The company offers a 20 percent discount to first-time buyers and offers a “free second size” option to ensure that customers get the right fit.

Do the customers get a bargain when they are able to wear a designer dress for a special occasion at 15 percent of the retail price? Does the retail price matter to customers in determining value, or are they only considering the style and price they will pay for the rental?

What does value really mean in the pricing equation?

The Customer’s View of Price

Whether a customer is the ultimate user of the finished product or a business that purchases components of the finished product, the customer seeks to satisfy a need through the purchase of a particular product. The customer uses several criteria to decide how much she is willing to spend in order to satisfy that need. Her preference is to pay as little as possible.

In order to increase value, the business can either increase the perceived benefits or reduce the perceived costs. Both are important aspects of price. If you buy a Louis Vuitton bag for $600, in return for this high price you perceive that you are getting a beautifully designed, well-made bag that will last for decades—in other words, the value is high enough for you that it can offset the cost. On the other hand, when you buy a parking pass to park in a campus lot, you are buying the convenience of a parking place close to your classes. Both of these purchases provide value at some cost. The perceived benefits are directly related to the price-value equation; some of the possible benefits are status, convenience, the deal, brand, quality, choice, and so forth. Some of these benefits tend to go hand in hand. For instance, a Mercedes Benz E750 is a very high-status brand name, and buyers expect superb quality to be part of the value equation (which makes it worth the $100,000 price tag). In other cases, there are tradeoffs between benefits. Someone living in an isolated mountain community might prefer to pay a lot more for groceries at a local store than drive sixty miles to the nearest Safeway. That person is willing to sacrifice the benefit of choice for the benefit of greater convenience.

When we talk about increasing perceived benefits, we refer to this as increasing the “value added.” Identifying and increasing the value-added elements of a product are an important marketing strategy. In our initial example, Rent the Runway is providing dresses for special occasions. The price for the dress is reduced because the customer must give it back, but there are many value-added elements that keep the price relatively high, such as the broad selection of current styles and the option of trying a second size at no additional cost. In a very competitive marketplace, the value-added elements become increasingly important, as marketers use them to differentiate the product from other similar offerings.

Perceived costs include the actual dollar amount printed on the product, plus a host of additional factors. If you learn that a gas station is selling gas for 25 cents less per gallon than your local station, will you automatically buy from the lower-priced gas station? That depends. You will consider a range of other issues. How far do you have to drive to get there? Is it an easy drive or a drive through traffic? Are there long lines that will increase the time it takes to fill your tank? Is the low-cost fuel the grade or brand that you prefer? Inconvenience, poor service, and limited choice are all possible perceived costs. Other common perceived costs are the risk of making a mistake, related costs, lost opportunity, and unexpected consequences, to name but a few.

Viewing price from the customer’s point of view pays off in many ways. Most notably, it helps define value–the most important basis for creating a competitive advantage.

The Psychology of Pricing

You will notice that when we discussed the value equation in the previous reading, we referred to perceived benefits and perceived costs, rather than absolute/actual benefits and costs. Every customer perceives benefits and costs differently, and many of these perceptions aren’t even conscious. There are very few buying decisions in which a customer meticulously lists and weighs the benefits and costs in order to determine value. More often than not, the buying process involves snap judgments and decisions, and psychological factors likely come into play.

Despite tremendous advances in brain research, the factors involved in perception and decision making are still not well understood. We do know that perception is highly individual and complex. If you, as a marketer, are trying to understand how consumers perceive something abstract like the “value” or “benefit” of a product, it’s important to know that there is certainly a psychological dimension to that perception, but there isn’t a scientific formula that can give you all the answers or accurately predict whether someone will buy. Still, you can avail yourself of the interesting work that has been done in this field and be aware of some of the factors that might affect buying decisions.

Studies of Psychology in Pricing

Most of our understanding about the psychology of pricing comes from research studies that explore buyer behavior.

The Case for the Number Nine

Many studies show that customers are more likely to buy products whose price points end in the number nine. That is, they prefer products that cost $99 over identical items priced at $100. Somehow the brain perceives greater value from a small price change that ends in nine.

A study in the journal Quantitative Marketing and Economics validates the benefit of using nines in pricing—with a few important qualifiers, noted below. The study compared purchases of women’s clothing discounted to $35 and the same clothing discounted to $39. The study found that 24 percent more consumers purchased when the clothing was priced at $39, even though the price was higher.

The study found that if a product has been available at a different price for a long time, then changing the price to end in nine will have a smaller effect than if it’s a new product that starts out with a price that ends in nine. It also found that if a product is marked “on sale,” the nine will have a small impact.

The researchers conclude that the nine has more power in situations where the buyer has limited information. If there is enough information for the customer to suspect that the nine is being used to manipulate the sales decisions, the customer is less likely to buy.^[1]

Providing Pricing Options

Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions. During decision making, anchoring occurs when individuals use an initial piece of information to make subsequent judgments. Once an anchor is set, other judgments are made by adjusting away from that anchor, and there is a bias toward interpreting other information around the anchor.^[2]

In the presentation of pricing, anchoring has a powerful impact on buyer behavior. In negotiated pricing, the first price offered becomes the anchor. For example, the initial price offered for a used car sets the standard for the rest of the negotiations, so that prices lower than the initial price seem more reasonable even if they are still higher than what the car is really worth.

On company Web sites, on restaurant menus, and in the layout of retail stores, anchoring is used to adjust perceptions of price. The prominent presentation of a higher-priced item lifts the buyer’s price expectations in a way that makes other items seem more reasonable, even if their prices are also high.

Inviting Price Comparisons

Are there limitations on the impact of anchoring? Another study examined the impact of providing price comparisons on buying behavior.

First, researchers listed popular music CDs on the auction site eBay flanked by CDs of the same title with different prices. In one auction, CDs with an opening bid of $1.99 were positioned next to CDs of the same title with a starting bid of 99 cents. In a second auction, those with a starting bid of $1.99 were positioned next to CDs with a starting bid of $6.99. In an auction, the buyer sets the top price, but the cheaper CDs positioned next to the $6.99 CDs sold at much higher prices than the same CDs presented next to those with an initial bid price of 99 cents.

Researcher Itamar Simonson explains, “We didn’t tell people to make a comparison; they did it on their own, and when people make these kinds of comparisons on their own, they are very influential.”

Next, the research team ran the same auctions but in this case explicitly told the auction participants to compare the $1.99 price to the price of the other CDs presented. This explicit instruction to compare prices adversely impacted buyer behavior in a number of ways. The price of the adjacent CDs ceased to have a statistically significant impact, buyers waited longer to make the first bid, submitted fewer bids, and were much less likely to participate in multiple auctions simultaneously. Simonson explains, “The mere fact that we had asked them to make a comparison caused them to fear that they were being tricked in some way.”^[3]

So while pricing comparisons can be a value presentation strategy, they are not without risk.

As you can see, pricing has a profound impact on buyer behavior, not only in determining what the buyer can afford, but in the deeper perceptions of value and the marketing exchange process.

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COPYRIGHT

This courseware was assembled by Christopher VanOosterhout from a variety of resources copyrighted and openly licensed by multiple individuals and organizations.  See our Copyright and Attribution page for additional details.  For details about permission to use please contact me at c@vanosterhout.com with the phrase  Courseware Usage Inquiry.  If you believe that this courseware violates your copyright, please contact me at c@vanoosterhout.com with the phrase Copyright Inquiry in the subject.  Details about the collector of these resources and Licentia LLC can be found at www.vanoosterhout.com

Why use pricing strategies to enhance marketing of products and services?

When Amazon.com was created in 1994, the company sold books online. While many viewed it as a real threat to traditional bookstores, few, other than its founder and CEO, Jeff Bezos, imagined what the company would become. Today the services that Amazon offers are extensive, and many of them center on a quiet service membership called Amazon Prime. The following video shows the impact of this offering on one American family.

Read the transcript of the video “Amazon Prime.”

What is Amazon Prime? When Amazon launched the product in 2005, it included free two-day shipping for most orders, and it was priced as an annual $79 membership fee. At the time, analysts wondered how Amazon could justify the value to customers (implying that it was too expensive) and, at the same time, how it could afford to keep offering the service if demand should grow (implying that it was too cheap to cover costs).

Greg Greeley, the vice president of Amazon Prime Global, reflected on the company’s decision and told the Washington Post,

We have always thought of it as the best bargain in shopping—Jeff [Bezos] went on record again saying that—in 2005 when we launched it with unlimited two-day shipping on 1 million items. But we did not think of it as a shipping program, but as a convenience program.

Prime introduced three concepts. It had two-day shipping at a time when people expected to pay for shipping and still not get their items for four to seven business days. It was very predictable: We put it on the Web site that if you ordered in the next 3 hours and 20 min., for example, you could have it in two days. And it was an unlimited, single membership fee that made fast delivery an everyday experience instead of an occasional indulgence.^[1]

Was the initial $79 price too low? Too high? Does it really matter that much?

After 2005, Amazon began adding services to the Prime membership without raising the price. Today the service includes unlimited video streaming, unlimited music streaming, $5.99 flat-fee shipping on discounted household items, access to a Kindle lending library and a host of others services. In spite of increased services, Amazon held pricing flat at $79 per year. In 2013, Amazon admitted that by simply adjusting the 2005 price for inflation, transportation, and fuel costs, the price would be more than $100 today.

Finally, in January 2014 Amazon told its customers to expect a price increase of $40 for Amazon Prime memberships, which would make the new price $119. In March 2014, the company announced the actual price increase: a $20 increase, or annual price of $99. While there were some disgruntled customers, the majority accepted the increase without complaint.

While Amazon doesn’t share its usage or financial data for Amazon Prime, analysts have completed customer surveys, analyzed Internet traffic, and reviewed enough detailed financial data to support the following:

• Amazon loses at least $1 billion annually on Prime-related shipping expenses
• Amazon spent $1.3 billion into Prime Instant Video in 2014, over and above the shipping costs
• Amazon Prime has between 40 and 50 million subscribers
• Prime members spend an average of $538 annually with Amazon, far more than the $320 by non-Prime members^[2]

Is it strategic genius or terrible folly for Amazon to lose billions of dollars a year on Amazon Prime on account of its pricing? Is Amazon actually losing money on Prime, or is Prime bringing in enough other sales to cover its costs . . . and more?

Choosing a price is as easy as picking a random number. As you’ll discover in this module, however, finding the right price to achieve company objectives and provide sustained value to customers is much more complicated.

Learning Outcomes

• Discuss how price affects the value of the organization’s products or services
• Explain the primary factors to consider in pricing
• Compare common pricing strategies
• Explain price elasticity and how it can be used to set price
• Explain the use of competitive bidding for B2B pricing

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COPYRIGHT

This courseware was assembled by Christopher VanOosterhout from a variety of resources copyrighted and openly licensed by multiple individuals and organizations.  See our Copyright and Attribution page for additional details.  For details about permission to use please contact me at c@vanosterhout.com with the phrase  Courseware Usage Inquiry.  If you believe that this courseware violates your copyright, please contact me at c@vanoosterhout.com with the phrase Copyright Inquiry in the subject.  Details about the collector of these resources and Licentia LLC can be found at www.vanoosterhout.com

• Why It Matters: Pricing Strategies. Provided by: Lumen Learning. License: CC BY: Attribution

• Amazon Prime. Provided by: BBC. License: CC BY-NC-ND: Attribution-NonCommercial-NoDerivatives

Instructions

Write a post for the Discussion on this topic, addressing the questions below. You may use either written paragraph or bullet-point format. Part 1 should be 2–3 paragraphs in length or an equivalent amount of content in bullet-point form. Responses to your classmates’ posts should be 1–2 paragraphs or several bullet points in length.

Part 1: Pricing Strategy

Briefly describe pricing for your product or service. How does this compare to competitors, assuming competitors are at or near break-even point with their pricing? Analyze pricing alternatives and make recommendations about pricing going forward based on the following:

• How sensitive are your customers to changes in price?
• What revenue you need to break even and achieve profitability?
• What does the price says about your product in terms of value, quality, prestige, etc.?

Part 2: Respond to Classmates’ Posts

After you have created your own post, look over the discussion posts of your classmates and respond to at least two of them.

Part 3: Incorporate Feedback

Review the feedback you receive from classmates and your instructor. Use this feedback to revise and improve your work before submitting it as part of the “Complete Marketing Plan” assignment.

Grading Rubric for Discussion Posts

The following grading rubric may be used consistently for evaluating all discussion posts.

Discussion Grading Rubric

Criteria	Response Quality: Not Evident	Response Quality: Developing	Response Quality: Exemplary	Point Value Possible
Submit your initial response	No post made – 0 pts	Post is either late or off-topic – 2 pts	Post is made on time and is focused on the prompt – 5 pts	Point value possible – 5 pts
Respond to at least two peers’ presentations	No response to peers – 0 pts	Responded to only one peer – 2 pts	Responded to two peers – 5 pts	Point value possible –5 pts

Total Points Possible for Discussion Assignment: 10pts.

COPYRIGHT

This courseware was assembled by Christopher VanOosterhout from a variety of resources copyrighted and openly licensed by multiple individuals and organizations.  See our Copyright and Attribution page for additional details.  For details about permission to use please contact me at c@vanosterhout.com with the phrase  Courseware Usage Inquiry.  If you believe that this courseware violates your copyright, please contact me at c@vanoosterhout.com with the phrase Copyright Inquiry in the subject.  Details about the collector of these resources and Licentia LLC can be found at www.vanoosterhout.com

Let’s return to our discussion of Amazon Prime pricing in the context of the pricing concepts we’ve discussed. It might be helpful to review the key facts:

• In 2005, Amazon introduced Amazon Prime for an annual membership fee of $79
  • The service initially included unlimited 2-day shipping on orders
  • Over the next 8 years, Amazon augmented Prime with a host of new features without changing the price
• In 2014 Amazon raised the pricing for annual Amazon Prime memberships to $99
• Annually, Amazon loses at least $1 billion on Prime-related shipping expenses
• Amazon spent $1.3 billion on Prime Instant Video in 2014, over and above the shipping costs
• Amazon Prime has between 40 and 50 million subscribers
• Prime members spend an average of $538 annually with Amazon, far more than the $320 by non-Prime members^[1]

Returning to our original question, is it strategic genius or terrible folly for Amazon to lose billions of dollars a year on Amazon Prime on account of its pricing? Is Amazon actually losing money on Prime, or is Prime bringing in enough other sales to cover its costs?

Customer Value

Amazon was able to clearly articulate benefits to the customer that aligned with the offering and supported the pricing. It did this by

• Providing shipping that had been a luxury
• Eliminating delivery risk with predictable fulfillment
• Offering ease of purchase by combining the cost into one annual purchase

These benefits allowed Amazon to create value with the offering.

Introductory Pricing

It wasn’t completely clear whether Amazon’s initial pricing was penetration pricing. Because it was a completely new offering, it was difficult to know how much it would be used and hard to analyze the cost to Amazon for providing the service. The decision to keep the pricing at $79 while adding significant new services certainly looks like penetration pricing. As a reminder, this is a strategy to drive significant early sales—to penetrate the market.

Achieving Pricing Objectives

Clearly, Amazon is hoping to draw new customers and increase total sales. Let’s look at some of the assumptions and see whether this is working. If Amazon has 40 million Prime subscribers, and each is spending $218 more annually ($538 – $320 from the data above) because of Prime, then Amazon is bringing in an additional $8.7 billion in revenue annually from increased Prime sales. Perhaps only half of the members truly spend more, but that would still mean $4.36 billion in revenue.

Not all of that revenue is profit. If Amazon’s average markup on the sales of the items sold is 25 percent, then $8.7 billion in revenue might result in $2.2 billion in profit. This could then cover some of the losses that the Prime service collects as an independent offering.

Based on this simple analysis, it is not immediately clear if Amazon is growing its profitability because of Amazon Prime. It does indicate that Amazon is growing revenue because of Prime. Both revenue growth and profitability growth are common objectives, and Amazon has historically been willing to take losses on the profit side in order to grow product lines and markets with long-term potential. If that is the case here, then Amazon is achieving a key objective.

Answering the Strategic Question

Is the pricing for Amazon Prime the right decision? Clearly, the answer has to be, “It depends.” That’s not completely satisfying, but it does acknowledge the complexity of pricing an offering that is driving growth, increasing sales per customer, opening new offerings and markets (like video and music streaming), and generating a significant financial loss for the company.

Amazon reminds us that pricing is complex, and it doesn’t always have a clear right answer.

 

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COPYRIGHT

This courseware was assembled by Christopher VanOosterhout from a variety of resources copyrighted and openly licensed by multiple individuals and organizations.  See our Copyright and Attribution page for additional details.  For details about permission to use please contact me at c@vanosterhout.com with the phrase  Courseware Usage Inquiry.  If you believe that this courseware violates your copyright, please contact me at c@vanoosterhout.com with the phrase Copyright Inquiry in the subject.  Details about the collector of these resources and Licentia LLC can be found at www.vanoosterhout.com

What you’ll learn to do: explain the primary factors to consider in pricing

Now that we’ve considered the customer perspective, we need to understand how pricing fits into the company strategy. It’s important to remember that all elements of the marketing mix, including pricing, fit into a larger customer mission and strategy.

An effective pricing strategy will align with the corporate mission, account for competitive factors, and support corporate strategies and objectives.

The specific things you’ll learn in this section include:

• Explain company objectives in the pricing strategy
• Define break-even pricing
• Describe how competition affects pricing strategies
• Describe the benefit of value-based pricing for customers

Pricing Objectives

Companies set the prices of their products in order to achieve specific objectives. Consider the following examples:

In 2014 Nike initiated a new pricing strategy. The company determined from a market analysis that its customers appreciated the value that the brand provided, which meant that it could charge a higher price for its products. Nike began to raise its prices 4–5 percent a year. Footwear News reported on the impact of their strategy:

“The ability to raise prices is a key long-term advantage in the branded apparel and footwear industry—we are particularly encouraged that Nike is able to drive pricing while most U.S. apparel names are calling for elevated promotional [and] markdown levels in the near-term,” said UBS analyst Michael Binetti. Binetti said Nike’s new strategy is an emerging competitive advantage.^[1]

Nike’s understanding of customer value enabled it to raise prices and achieve company growth objectives, increasing U.S. athletic footwear sales by $168 million in one year.

In 2015 the U.S. airline industry lost $12 billion in value in one day because of concerns about potential price wars. When Southwest Airlines announced that it was increasing its capacity by 1 percent, the CEO of American Airlines—the world’s largest airline—responded that American would not lose customers to price competition and would match lower fares. Forbes magazine reported on the consequences:

This induced panic among investors, as they feared that this would trigger a price war among the airlines. The investors believe that competing on prices would undermine the airline’s ability to charge profitable fares, pull down their profits, and push them back into the shackles of heavy losses. Thus, the worried investors sold off stocks of major airlines, wiping out nearly $12 billion of market value of the airline industry in a single trading day.^[2]

Common Pricing Objectives

Not surprising, product pricing has a big effect on company objectives.  (You’ll recall that objectives are essentially a company’s business goals.) Pricing can be used strategically to adjust performance to meet revenue or profit objectives, as in the Nike example above. Or, as the airline-industry example shows, pricing can also have unintended or adverse effects on a company’s objectives. Product pricing will impact each of the objectives below:

• Profit objective: For example, “Increase net profit in 2016 by 5 percent”
• Competitive objective: For example, “Capture 30 percent market share in the product category”
• Customer objective: For example, “Increase customer retention”

Of course, over the long run, no company can really say, “We don’t care about profits. We are pricing to beat competitors.” Nor can the company focus only on profits and ignore how it delivers customer value. For this reason, marketers talk about a company’s “orientation” in pricing. Orientation describes the relative importance of one factor compared to the others. All companies must consider customer value in pricing, but some have an orientation toward profit. We would call this profit-oriented pricing.

Profit-Oriented Pricing

Profit-oriented pricing places an emphasis on the finances of the product and business. A business’s profit is the money left after all costs are covered. In other words, profit = revenue – costs. In profit-oriented pricing, the price per product is set higher than the total cost of producing and selling each product to ensure that the company makes a profit on each sale.

The benefit of profit-oriented pricing is obvious: the company is guaranteed a profit on every sale. There are real risks to this strategy, though. If a competitor has lower costs, then it can easily undercut the pricing and steal market share. Even if a competitor does not have lower costs, it might choose a more aggressive pricing strategy to gain momentum in the market.

Also, customers don’t really care about the company’s costs. Price is a component of the value equation, but if the product fails to deliver value, it will be difficult to generate sales.

Finally, profit-oriented pricing is often a difficult strategy for marketers to succeed with, because it limits flexibility. If the price is too high, then the marketer has to adjust other aspects of the marketing mix to create more value. If the marketer invests in the other three Ps—by, say, making improvements to the product, increasing promotion, or adding distribution channels—that investment will probably require additional budget, which will further raise the price.

It’s fairly standard for retailers to use some profit-oriented pricing—applying a standard mark-up over wholesale prices for products, for instance—but that’s rarely their only strategy. Successful retailers will also adjust pricing for some or all products in order to increase the value they provide to customers.

Competitor-Oriented Pricing

Sometimes prices are set almost completely according to competitor prices. A company simply copies the competitor’s pricing strategy or seeks to use price as one of the features that differentiates the product. That could mean either pricing the product higher than competitive products, to indicate that the firm believes it to provide greater value, or lower than competitive products in order to be a low-price solution.

This is a fairly simple way to price, especially with products whose pricing information is easily collected and compared. Like profit-oriented pricing, it carries some risks, though. Competitor-oriented pricing doesn’t fully take into account the value of the product to the customer vis-à-vis the value of competitive products. As a result, the product might be priced too low for the value it provides, or too high.

As the airline example illustrates, competitor-oriented pricing can contribute to a difficult market dynamic. If players in a market compete exclusively on price, they will erode their profits and, over time, limit their ability to add value to products.

Customer-Oriented Pricing

Customer-oriented pricing is also referred to as value-oriented pricing. Given the centrality of the customer in a marketing orientation (and this marketing course!), it will come as no surprise that customer-oriented pricing is the recommended pricing approach because its focus is on providing value to the customer. Customer-oriented pricing looks at the full price-value equation (Figure 1, above; discussed earlier in the module in “Demonstrating Customer Value”) and establishes the price that balances the value. The company seeks to charge the highest price that supports the value received by the customer.

Customer-oriented pricing requires an analysis of the customer and the market. The company must understand the buyer persona, the value that the buyer is seeking, and the degree to which the product meets the customer need. The market analysis shows competitive pricing but also pricing for substitutes.

In an attempt to bring the customer voice into pricing decisions, many companies conduct primary market research with target customers. Crafting questions to get at the value perceptions of the customer is difficult, though, so marketers often turn to something called the Van Westerndorp price-sensitivity meter. This method uses the following four questions to understand customer perceptions of pricing:

1. At what price would you consider the product to be so expensive that you would not consider buying it? (Too expensive)
2. At what price would you consider the product to be priced so low that you would feel the quality couldn’t be very good? (Too cheap)
3. At what price would you consider the product starting to get expensive, such that it’s not out of the question, but you would have to give some thought to buying it? (Expensive/High Side)
4. At what price would you consider the product to be a bargain—a great buy for the money? (Cheap/Good Value)

Each of these questions asks about the customer’s perspective on the product value, with price as one component of the value equation.

The responses of many potential buyers can be plotted on a graph (see Figure 2, below). Each line shows the different customer responses to each of the questions at different price points. For example, 100 percent of those interviewed think the product is too cheap at $0, and 40 percent think that it’s still too cheap at a price of $500. The graph shows an acceptable price range in which the customers’ responses cross one another. They become torn between whether the prices are cheap or expensive but are not clearly landing on one side or the other. The results of this graph suggest a price band between $500 and $1,200.

For the purposes of this course, we won’t be getting into a full analysis of these data or the price-sensitivity meter; the important point is that marketers need to balance the customer’s perception of the value provided with the customer’s perception of the right price (“perceived costs” in Figure 1, above) in the value equation.

Break-Even Pricing

Regardless of the pricing strategy a company ultimately selects, it is important to do a break-even analysis beforehand. Marketers need to understand break-even analysis because it helps them choose the best pricing strategy and make smart decisions about the short- and long-term profitability of the product.

The break-even price is the price that will produce enough revenue to cover all costs at a given level of production. At the break-even point, there is neither profit nor loss. A company may choose to price its product below the break-even point, but we’ll discuss the different pricing strategies that might favor this option later in the module.

Understanding Breakeven

Let’s begin with a very simple calculation of breakeven and build from there.

Imagine that you decide to hold a bake sale and sell cookies in the student union as a social event for students. You don’t want to lose money on the cookies, but you are not trying to make a profit or even cover your time. You spend a very convenient $24 on groceries and bake 4 dozen cookies (48 cookies). What is your break-even price for the cookies? It’s the total cost divided by the number of cookies that you expect to sell, represented by the formula below:

Break-Even Price = Costs / Units  

So, it would be $24 / 48 = $.50, or 50 cents per cookie. What if you sell only 40 cookies? The calculation would be $24 / 40 = $.60. Your break-even price goes up if you sell fewer cookies.

One challenge of calculating breakeven is that all of the variables can change, and some are unknown. For instance, it may be impossible to know exactly the quantity that you will sell. For that reason, companies often calculate the break-even quantity rather than the break-even price. Focusing on quantity enables the marketer to answer the following question: “Given this set of costs and this price, how many products must I sell to break even?” The break-even quantity is shown by the following formula:

Break-Even Quantity (in terms of units) = Costs / Price 

In our cookie example, once you have spent $24 on groceries, you know your cost. What if you plan to sell the cookies for $1 apiece? According to the equation above, units = cost / price, so in our case, units = $24 / $1, or 24 cookies.

Of course this is a very simple example, but it gives you a sense of why breakeven matters, and how you would calculate it.

Including Fixed and Variable Costs

Let’s add one more complication to make our example a little more realistic and interesting. Your cookies have been such a hit that you decide to sell them more broadly. In fact, you rent a commercial kitchen space and hire an experienced baker named Helen to do the baking. Your break-even point just went up dramatically. Now you need to cover the costs of your kitchen and an employee. For the sake of this exercise, let’s assume that Helen works a set number of hours every week—20 hours—and that you pay her $20 per hour including all taxes and benefits. You rent the kitchen for $100 per week, and that price includes all the equipment and utilities. Those are costs that are not going to change no matter how many cookies you sell. If you baked nothing, you would still need to pay $100 per week in rent and $400 per week in wages. Those are your fixed costs. Fixed costs do not change as the level of production goes up or down. Your fixed costs are $500 per week.

Now you need to buy ingredients for the cookies. Once you add up the food costs of making a single large batch of cookies, you find that it’s a total of $7.20 for a batch of 12 dozen (144) cookies. If you divide that out, you can tell that each cookie costs $.05 in food costs ($7.20 / 144 cookies = $.05). In other words, every cookie you sell is going to have a variable cost of $.05. Variable costs do change as production is increased or decreased.

Adding these different types of costs makes the break-even equation more complicated, as shown below:

pn = Vn + FC

p = price

n = number of units sold

V = variable cost per unit

FC = fixed costs

With this equation we can calculate either the break-even price or the break-even quantity.

Calculating Break-Even Price

Chances are good that you can only bake a certain number of cookies each week—let’s say it’s 2,500 cookies—so, based on that information, you can calculate the break-even price. The formula to do that is the following:

p = (Vn + FC) / n

n = 2,500

V = $.05

FC = $500

Therefore, p = (($.05 x 2,500)  + $500) / 2,500

p = ($125 + $500) / 2,500

p = $.25

Your break-even price for your cookies is 25 cents. That doesn’t mean it’s the right market price for the cookies; nor does it mean that you can definitely sell 2,500 cookies at whatever price you choose. It simply gives you good information about the price and quantity at which you will cover all your costs.

Calculating Break-Even Quantity

Now let’s assume that you have set your price and you need to know your break-even quantity. You are an exceptional marketing student, so you have talked to the people who are likely buyers for your cookies, and you understand what price is a bargain and what price is too expensive. You have compared the price with competitor prices. And, you have considered the price of your cookie compared to the price of doughnuts and ice cream (both are “substitutes” for your product). All of this analysis has led you to set a price of $2 per cookie, but you want to make sure that you don’t lose money on your business: You need to calculate the break-even quantity. The formula to do that is the following:

n = FC /( p – V)

Using the same inputs for the variables, your equation looks like this: n = $500 / ($2 – $.05)

n = $500 / $1.95

n = 256.41 cookies

So, let’s round up and just call the break-even quantity 257 cookies. Does that mean that you keep the full $2 as profit for every cookie after 257? Sadly, no. First, you have to cover the variable cost for each cookie ($.05 per cookie), which means you make just $1.95 per cookie you sell (after you’ve surpassed the break-even point). Second, our simple break-even example did not include all of the costs. After you’ve locked down the product costs and the pricing, you will need to invest in promotion and distribution of the cookies. You’ll also probably want to cover your time (i.e., pay yourself) and add some profit into the total fixed costs. For instance, if you wanted to earn a profit of $600 each week, then you would need to add that to the $500 fixed costs of the kitchen and Helen.

Breakeven in the Marketing Strategy

Now that we have a cost example, it’s a little easier to think about the pricing objectives. If you decided to price your cookies with a profit orientation, then you would simply add a profit ($1 per cookie, say,) to the break-even price. That approach doesn’t take the customer into account at all, though, since a profit orientation is only about the business.

What if you found that your campus stores and vending machines sell a national chain of cookies for 75 cents? Using a competitor-oriented pricing approach, you might decide to match that price and compete on that basis. The drawback is that this approach does not take into account the value your customers find in a fresh, local product—i.e., your cookies—made from high-quality ingredients.

A customer-oriented pricing approach allows you to treat the break-even data as one input to your pricing, but it goes beyond that to bring your customers’ perceptions and the full value of your product into the pricing evaluation.

Competitor Impact on Pricing

It’s important to remember that pricing is just one component of the marketing mix, and even very specific pricing decisions need to take into account the other components. This is particularly true in a competitive marketplace. Actions by different competitors integrate all elements of the marketing mix and do not focus on price alone. A competitor might make a change to a product or initiate a promotion that impacts customers’ perceptions of value and, therefore, their perceptions of price.

Competitive Pricing

Once a business decides to use price as a primary competitive strategy, there are many well-established tools and techniques that can be employed. The pricing process normally begins with a decision about the company’s pricing approach to the market. Price is a very important decision criterion that customers use to compare alternatives. It also contributes to the company’s position. In general, a business can price its offering to match its competition, or it can price higher or price lower. Each has its pros and cons.

Pricing to Meet Competition

Many organizations attempt to establish prices that, on average, are the same as those set by their more important competitors. Automobiles of the same size with comparable equipment and features tend to have similar prices, for instance. This strategy means that the organization uses price as an indicator or baseline. Quality in production, better service, creativity in advertising, or some other element of the marketing mix is used to attract customers who are interested in products in a particular price category.

The key to implementing a strategy of meeting competitive prices is to have an accurate definition of competition and a knowledge of competitors’ prices. A maker of handcrafted leather shoes is not in competition with mass producers. If he/she attempts to compete with mass producers on price, higher production costs will make the business unprofitable. A more realistic definition of competition in this case would be other makers of handcrafted leather shoes. Such a definition along with an understanding of competitors’ prices would enable management to put the strategy into effect.

The banking industry often uses this strategy by using technology to actively monitor competitors’ rates, fees, and packages in order to adjust their own prices.

Pricing Above Competitors

Pricing above competitors can be rewarding to organizations, provided that the objectives of the policy are clearly understood and the marketing mix is developed in such a way that the policy can be successfully implemented by management.

Pricing above competition generally requires a clear advantage on some nonprice element of the marketing mix. In some cases, that advantage may be due to a high price-quality association on the part of potential buyers.

Betting on that advantage is increasingly dangerous in today’s information-rich environment, however. Online shoppers can get quick price comparisons and read customer or expert reviews to evaluate other elements of the value proposition. This is true for both business-to-consumer and business-to-business offerings. Many consumers also take advantage of their smartphones when they shop: it’s easy enough to stand in one store and compare price and distribution options for the same product and for competitive products. Customers’ access to information puts more pressure on marketers to understand customer value and provide an offering whose price, relative to competitors’ prices, contributes to the value.

You’ll recall our earlier example of Nike using a strategy of raising prices—while its competitors were holding pricing flat or reducing prices—because its analysis showed that it was providing sufficient value to sustain a higher price.

Pricing Below Competitors

While some firms are positioned to price above competition, others wish to carve out a market niche by pricing below competitors. The goal of such a policy is to realize a large sales volume through a lower price and lower profit margins. By controlling costs and reducing services, these firms are able to earn an acceptable profit, even though profit per unit is usually less.

Such a strategy can be effective if a significant segment of the market is price sensitive and/or the organization’s cost structure is lower than competitors’. Costs can be reduced by increased efficiency, economics of scale, or by reducing or eliminating such things as credit, delivery, and advertising. For example, if a firm could replace its field sales force with telemarketing or online access, this function might be performed at lower cost. Such reductions often involve some loss in effectiveness, so the trade-off must be considered carefully.

One of the worst outcomes that can result from pricing lower than a competitor is a “price war.” Price wars usually occur when a company believes that price-cutting will increase market share, but it doesn’t have a true cost advantage. Price wars are often caused by companies misreading or misunderstanding competitors. Typically, they are overreactions to threats that either are nonexistent or are not as big as they seem. You will remember our example of the airline price war, in which the stock price of airlines plummeted because stockholders reacted negatively to price reductions, fearing that a price war would eliminate profits and put the health of the industry at risk.

In the module on product marketing we described the ride-sharing service Uber. Uber has successfully undercut the taxi industry with a product that improves services while lowering prices, which has led to extremely rapid growth and success for the company. When lower prices are part of a complete, compelling value proposition, pricing can provide a powerful solution and create a challenging competitive environment for existing players.

Benefits of Value-Based Pricing

We have discussed common company objectives that affect pricing and the competitive impact on pricing. The most important perspective in the pricing process is the customer’s. Value-based pricing brings the voice of the customer into the pricing process. It bases prices primarily on the value to the customer rather than on the cost of the product or historical prices determined by competitors.

If we consider the three approaches to setting price, cost-based pricing is focused entirely on the perspective of the company, with very little concern for the customer; demand-based pricing is focused on the customer, but only as a predictor of sales; and value-based pricing focuses entirely on the customer as the determiner of the total price/value package. Marketers who employ value-based pricing might describe it this way: “Price is what you think your product is worth to that customer at that time.” This approach regards the following as marketing/price truths:

• To the customer, price is the only unpleasant part of buying.
• Price is the easiest marketing tool to copy.
• Price represents everything about the product.

Still, value-based pricing is not altruistic. It asks and answers two questions:

1. What is the highest price I can charge and still make the sale?
2. Am I willing to sell at that price?

In order to answer these questions we need to consider both customer- and competitor-related factors. In answering the second question, we would also want to use the break-even analysis that we discussed in the previous section, as well as other financial and strategic analyses.

Customer-Related Factors

Several customer-related factors are important in value-based pricing; one of them is understanding the customer buying process. For a convenience good, customers often spend little time, planning, or effort in the buying process, and purchases are more often made on impulse. With a shopping product, the consumer is more likely to compare a number of options when evaluating quality, cost, and features; as a result, he or she will require a better understanding of price in order to assess value.

Another issue is that different groups or segments of customers view price differently. Buyer personas can be instrumental to a marketer’s grasp of those differences and the role price plays in the decision-making process. Some buyers will weight convenience or quality over price, for instance, while others will be highly price sensitive.

The marketer must understand what the customer values, what the customer expects, and how the customer evaluates price in the value equation.

Competitor-Related Factors

A second factor influencing value-based pricing is competitors. We asserted above that the primary driver of value-based pricing is the customer’s estimation of value—not costs or historical competitor prices. Still, competitors do influence the customer’s view of value. The marketing mix of competitive products have an impact on customer expectations because they an important part of the decision-making context. Customers are shopping across products and brands and take price differences into account when evaluating the quality and benefits of competitive products. These direct comparisons have tremendous impact on the customer’s perceptions of value.

In value-based pricing, the marketer must also consider indirect competitors that consumers may use as a basis for price comparisons. For example, one might use the price of a vacation as a basis for buying vacation clothes. The cost of eating out is frequently compared to the cost of groceries.

Ultimately, value-based pricing offers the following three tactical recommendations:

• Employ a segmented approach toward price that considers how each group of customers assesses value.
• Establish the highest possible price level and justify it with comparable value.
• Use price as one component in the marketing mix, building compelling value across all elements of the offering.

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This courseware was assembled by Christopher VanOosterhout from a variety of resources copyrighted and openly licensed by multiple individuals and organizations.  See our Copyright and Attribution page for additional details.  For details about permission to use please contact me at c@vanosterhout.com with the phrase  Courseware Usage Inquiry.  If you believe that this courseware violates your copyright, please contact me at c@vanoosterhout.com with the phrase Copyright Inquiry in the subject.  Details about the collector of these resources and Licentia LLC can be found at www.vanoosterhout.com

• Pricing Considerations. Provided by: Lumen Learning. License: CC BY: Attribution
• Revision and Adaptation. Provided by: Lumen Learning. License: CC BY: Attribution

• Van Westendorp Price Sensitivity Meter. Provided by: Wikipedia. License: CC BY-SA: Attribution-ShareAlike
• Best Price.License: CC0: No Rights Reserved
• Bake. Authored by: Foodie Baker.  License: CC BY-NC-ND: Attribution-NonCommercial-NoDerivatives
• Have a Cookie. Authored by: Hans Splinter.  License: CC BY-ND: Attribution-NoDerivatives
• Chapter 9, Pricing, from Introducing Marketing. Authored by: John Burnett. Provided by: Global Text. License: CC BY: Attribution
• Shoe Store in Trinidad. Authored by: Bud Ellison. License: CC BY: Attribution
• Hot Soup Charitable Elephants. Authored by: Julian Partridge. License: CC BY-SA: Attribution-ShareAlike
• Choices. Authored by: Darwin Bell. License: CC BY-NC: Attribution-NonCommercial

Try It

Play the simulation below multiple times to see how different choices lead to different outcomes. All simulations allow unlimited attempts so that you can gain experience applying the concepts.

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This courseware was assembled by Christopher VanOosterhout from a variety of resources copyrighted and openly licensed by multiple individuals and organizations.  See our Copyright and Attribution page for additional details.  For details about permission to use please contact me at c@vanosterhout.com with the phrase  Courseware Usage Inquiry.  If you believe that this courseware violates your copyright, please contact me at c@vanoosterhout.com with the phrase Copyright Inquiry in the subject.  Details about the collector of these resources and Licentia LLC can be found at www.vanoosterhout.com

What you’ll learn to do: explain the use of competitive bidding for B2B pricing

Generally in business-to-consumer sales there is a standard price structure for all customers. That doesn’t necessarily mean that every customer will pay exactly the same price. The company may provide discounts—such as “loyalty” discounts, for instance—to a particular group of customers, but overall, the pricing is fairly uniform.

This is not at all the case in business-to-business marketing. In B2B marketing, most vendors will expect to give deep discounts to large customers who generate significant revenue. They also expect to tailor the solution to the customer to a much greater extent. This may include making adjustments to the levels of service, response time for issues, payment terms, and other aspects of the solution. The B2B marketing requires solutions that are more customized to the individual buyer, and the pricing is no exception.

The specific things you’ll learn in this section include:

• Describe the competitive bidding process
• Describe the role of pricing in the competitive bid

What is the Competitive Bidding Process?

When we discussed buyer behavior, we identified the stages that organizations go through to make a purchase decision. When it comes to pricing consideration, two of these stages are especially relevant: proposal solicitation and supplier selection.

You will remember that during the proposal solicitation stage of the process, qualified suppliers are invited to submit proposals. Those vendors will each craft a detailed proposal outlining what the provider can offer to address the buyer’s needs, along with product specifications, timing, and pricing. These proposals are submitted to the buying organization, which will review them during the supplier-selection stage of the process. During this stage the buyer completes a thorough review of the proposals submitted, scores the proposals, and often narrows down the list of vendors to the highest-scoring proposals. This short list is marked for “further negotiation,” which may include negotiating product quantity, specifications, pricing, timing, delivery, and other terms of sale. This process is called a competitive bid process.

A competitive bid is a procurement process in which bids from competing suppliers are solicited. The competitive bid process generally advertises the requirements and specifications of solutions and invites suppliers to provide a proposal about how they will meet the need and at what price. Together, the steps of requesting proposals from multiple vendors, evaluating the proposals by comparing them against one another, and negotiating the terms constitute a competitive bid process.

Let’s consider a very simple example of the differences between the competitive pricing for a B2C sale and a competitive bid in a B2B sale.

Imagine that you are traveling to Chicago and you want to find a low-cost hotel room. There are a number of Web sites that allow you to compare costs of different hotels. You are able to select the location and dates for your stay, compare information about the available hotels, and see the price for each option. This enables you, as a buyer, to select and reserve your room without ever having direct contact with the hotel.

If you are planning to hold a large conference at a hotel in Chicago, then the process if very different. The meeting planner will generally do some research to identify all of the hotels in the area that have facilities with sufficient capacity to accommodate the conference. Then the planner will issue a request for proposals (RFP) to all of the possible venues. The RFP will provide information to the hotel about the conference needs: number of expected attendees, meeting space required, hotel rooms required, and any special requirements (such as catering, etc.). Each of the hotels has the opportunity to craft and submit a proposal. The hotels have a good sense of what their competitors offer, so they will describe what is unique about their facilities and available services. They will also price their proposal according to how confident they are that their facilities and services can support the value. Unlike the consumer, the business will be offered a full, customized package with pricing that will include a hotel room rate for a defined block of rooms, a minimum dollar amount that must be spent on food and beverages, and pricing for other items. If the food-and-beverage expense is high, then the hotel might waive the cost of meeting-space rental. Once the business has reviewed the proposals, it might negotiate on any of these terms or ask to have some of the services that will incur a fee, such as Internet access, included in the package.

The competitive bid process creates an opportunity to tailor pricing for a specific customer’s needs, based on the value is provided relative to a specific set of competitors.

Price in the Competitive Bid

What role does the price play in the competitive bid process? The answer to this question can vary significantly, but in every case, the marketer has a specific goal: to minimize the role of price in the proposal. To understand what this means, let’s consider two different scenarios.

Scenario 1: The value proposition of all solutions is identical; there is absolutely no differentiation between the products, companies, or brands. In such a case, suppliers can only compete on price. Each proposal must slash prices to the lowest possible level in hopes of coming in below the other bids.

Scenario 2: Each solution is differentiated in every element of the marketing mix. Price is different for each solution and is based on the value provided by the product, the service and relationship commitments, the brand, and the expected customer experience.

Consider both scenarios. If you are hoping to set the highest possible price, which one would you prefer? Clearly,  scenario 2 provides much greater flexibility in pricing, because the marketer can use price as one of several tools to differentiate the proposal and maximize the value, rather than having only the option to drop price.

There are two primary reasons why businesses don’t want to compete on price alone in a competitive bid situation.

1. Price is not a sustainable competitive advantage. Competitors can copy price more easily than any other element of the marketing mix. When a strong competitor sees a weaker companies competing only on price, it can lower prices temporarily and drive others out of the market.
2. Low prices can jeopardize a company’s ability to profitably deliver sustained value. When the price is very low, there’s a risk of cutting into profits or needing to reduce service in order to cut costs. Both create risk for the business over the long term.

The best approach to pricing in a competitive bid situation is to be disciplined about optimizing the full marketing mix. Practically, companies generally use one of two approaches to arrive at the package that provides the greatest value in a competitive bid situation. In situations where price is not the dominant decision factor, the marketer can craft a proposal that best addresses the customer’s business goals and needs. Then price can be set at an appropriate level to support the unique value offered in the proposal. In this case, price supports a differentiated proposal that provides unique value.

Sometimes price is unavoidably the dominant consideration. In fact, in some government bid processes, the buying organization is required to select the bid with the lowest total cost. In other situations, the company knows how competitors are pricing and has an indication of where it must price in order to be competitive. In this case the price becomes somewhat fixed, and the marketer must determine which proposal offers the highest possible value at that price. It requires discipline to be realistic about costs and trade-offs, else there is risk of underpricing. A disciplined approach enables the marketer to create a proposal that maximizes value, rather than ignoring the pricing realities and submitting an uncompetitive proposal.

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This courseware was assembled by Christopher VanOosterhout from a variety of resources copyrighted and openly licensed by multiple individuals and organizations.  See our Copyright and Attribution page for additional details.  For details about permission to use please contact me at c@vanosterhout.com with the phrase  Courseware Usage Inquiry.  If you believe that this courseware violates your copyright, please contact me at c@vanoosterhout.com with the phrase Copyright Inquiry in the subject.  Details about the collector of these resources and Licentia LLC can be found at www.vanoosterhout.com