Business to Business Pricing

Fig. 15.2

Key Components of the Industrial Pricing Process

•No easy formula for pricing an industrial product. •Decision is multidimensional•Each interactive variable assumes significance.

Costs

FixedCosts

Variable Costs

Types of Cost

Expenses that are uniform

per unit of output within a

relevant time period

As volume increases, total

variable costs increase

Variable Costs are…

THERE ARE TWO CATEGORIES OF

VARIABLE COSTS

1.Cost of Goods Sold

2.Other Variable Costs

For Manufacturer or Provider of Service

Covers materials, labor and factory overhead applied directly to production

For Reseller (Wholesaler or Retailer)

Covers primarily the cost of merchandise

Variable Costs – Cost of Goods Sold

Other Variable Costs

Expenses not directly tied to

production but vary directly

with volume

Examples include:

Sales commissions, discounts,

and delivery expenses

Expenses that do not fluctuate with output volume within a relevant time period

They become progressively smaller per unit of output as volume increases

No matter how large volume becomes, the absolute size of fixed costs remains unchanged

Fixed Costs

THERE ARE TWO CATEGORIES OF

FIXED COSTS

1.Programmed costs

2.Committed costs

• Result from attempts to

generate sales volume

• Examples include:

Advertising, sales

promotion, and sales

salaries

Fixed Costs – Programmed Costs

Costs required to maintain

the organization

Examples include

nonmarketing expenditures,

such as:

rent, administrative cost,

and clerical salaries

Fixed Costs – Committed Costs

Relevant and

Sunk Costs

Future expenditures unique to the decision

alternatives under consideration.

Expected to occur in the future as a result of some marketing action

Differ among marketing alternatives being considered

In general, opportunity costs are considered relevant costs

Relevant Costs are…

The direct opposite of relevant costs.

Past expenditures for a given activity

Typically irrelevant in whole or in part to future decisions

Examples of sunk costs:

Past marketing research and development expenditures

Last year’s advertising expense

Sunk Costs are…

When marketing managers attempt to

incorporate sunk costs into future decisions,

they often fall prey to the Sunk Cost Fallacy –

that is, they attempt to recoup spent dollars by

spending even more dollars in the future.

Example: Continuing to advertise a failing

product heavily in an attempt to recover what

has already been spent on it.

Sunk Cost Fallacy

Margins

The difference between the selling price

and the “cost” of a product or service

Margins are expressed in both dollar

terms or as percentages on:

a total volume basis, or

an individual unit basis

Gross Margin or Gross Profit

On a total volume basis:

The difference between total sales

revenue and total cost of goods sold

On a per-unit basis:

The difference between unit selling

price and unit cost of goods sold

Trade Margin (Markup)

Suppose a retailer pays $10 for an item and sells it for $15. Markup is thus $5 ($15-$10):

Margin as a percentage of cost:Margin/Cost x 100 =

($5 / $10) x 100 = 50 %

Margin as a percentage of selling price:Margin/Price x 100 =

($5 / $15) x 100 = 33.333 %

Break-even point is the unit or dollar sales

at which an organization neither makes a

profit nor a loss.

At the organization’s break-even sales

volume:

Total Revenue = Total Cost

Break-Even Analysis

LOSS

PROFIT

Total Revenue

Fixed Cost

BE PointTotal Cost

Variable Cost

Unit Volume

Dollars

0

Break-even Analysis Chart

Break-even AnalysisExample

Fixed Costs = $50,000

Price per unit = $5

Variable Cost = $3

Contribution = $5 - $3 = $2

Breakeven Volume = $50,000 $2

= 25,000 units

Breakeven Dollars = 25,000 x $5

= $125,000

Operating Leverage

Extent to which fixed costs and variable costs are used in the production and marketing of products and services.

Firms with high total fixed costs relative to total variable costs are defined as having high operating leverage.

Higher operating leverage results in a faster increase in profit once sales exceed break-even volume. The same happens with losses when sales fall below break-even volume.

Different Companies,Different Pricing Objectives

Company Objective

Alcoa 20% ROI

American Can Maintain market share

General Foods 33% gross margin

National Steel Match the market

U.S. Steel 8% ROI after taxes

DuPont Target ROI, cost-plus

(continued)

Benefits of a Particular Product

Functional benefitsFunctional benefits are the design characteristics that might be attractive to technical personnel.

Operational benefitsOperational benefits are durability and reliability, qualities desirable to production managers.

Financial benefitsFinancial benefits are favorable terms and opportunities for cost savings, important to purchasing managers and controllers.

Personal benefitsPersonal benefits are organizational status, reduced risk, and personal satisfaction.

•A broad perspective needed in examining the costs a particular alternative may present for the buyer.

•Rather than making a decision on the basis of price alone, organizational buyers emphasize the total cost in use of a particular product or service.

Customers’ Cost-in-Use Components

Customers’ Cost-in-Use Components

Factors Impacting Demand

• Ability to buy

• Willingness to buy

• Benefits vs. Price

• Substitutes

• Nonprice competition

Problems with Using Price Elasticity to Set Price

• Fails to consider competitors’ response

• Demand may be inelastic for given price, but elastic for larger amount

• Measured in sales revenue, not profit margins

• Fails to consider product line effects

• Ignores low price societal benefits

Pricing Across Product Life Cycle(Life-Cycle Costing)

• Introduction phase:– Price skimming: Introductory price set relatively high,

thereby attracting buyers at top of product’s demand curve.

– Market penetration pricing: Low price is used as an entering wedge.

• Growth phase• Maturity phase• Decline stage

Strategies in the Introduction Stage of Strategies in the Introduction Stage of the PLCthe PLC

• Rapid-skimming strategyRapid-skimming strategy– Launch new product at high price

– High promotion level

– Makes sense if:• large part of potential market is unaware of the

product• those who become aware are eager & willing to pay• need to build brand preference quickly due to

potential competition

Strategies in the Introduction Stage of Strategies in the Introduction Stage of the PLCthe PLC

• Slow-skimming strategySlow-skimming strategy– launch new product at high price

– low promotion

– helps maintain high profit per unit

– makes sense if:• market size is limited

• most of market is aware of product

• buyer willing to pay high price

• no significant potential competition

Strategies in the Introduction Stage of Strategies in the Introduction Stage of the PLCthe PLC

• Rapid-penetration strategyRapid-penetration strategy– launch new product at low price

– spend heavily on promotion

– allows fastest market penetration & share

– makes sense if:• large market that is unaware of product

• buyers are price-sensitive

• strong potential competition exists

• can rapidly enjoy economies of scale

Strategies in the Introduction Stage of Strategies in the Introduction Stage of the PLCthe PLC

• Slow-penetration strategySlow-penetration strategy– launch new product at low price– low level of promotion– encourages rapid product acceptance– allow slightly higher profits than rapid-penetration– makes sense if:

• market is price-sensitive

• market is not promotion-sensitive

• large market that is aware of the product

• some potential competition

Price-Leadership Strategy

• One (or a very few) firm(s) initiate price changes, with most or all the other firms in the industry following suit.

• When price leadership prevails, – price competition does not exist.

– burden of making critical pricing decisions is placed on leading firm(s) and

– others simply follow the leader.

Characteristics of Successful Price Leaders

• Large share of industry’s production capacity• Large market share• Commitment to particular product class/grade• New, cost-efficient plants• Strong distribution systems• Good customer relations• Effective market information systems• Sensitivity to price/profit needs of industry• Sense of timing as to when make price changes• Sound management organization for pricing• Effective product-line financial controls

Competitive Bidding

• Buyer sends inquiries (requests for quotationsrequests for quotations or RFQsRFQs) to firms able to produce in conformity with requested requirements.

• Requests for proposalsRequests for proposals (RFPsRFPs) involve the same process, but – here buyer is signaling that everything is preliminary

and– that a future RFQ will be sent once specifics are

determined from the best proposals.

Competitive Bidding

• Closed biddingClosed bidding– often used by business and governmental

buyers

– involves a formal invitation to potential suppliers to submit written, sealed bids for a particular business opportunity.

• Open biddingOpen bidding– more informal and allows suppliers to make

offers (oral and written) up to a certain date.

Whether or Not to Bid

• Is the dollar value of the contract large enough to warrant the expense involved in making the bid?

• Are the product specs precise enough to allow the cost of production to be accurately estimated?

• Will acceptance of the bid adversely affect production and/or ability to serve other customers?

• How much time is available to prepare the bid?

• What is the likelihood of winning the bid given the presence and strength of other bidders?

Types of Leases

• Operating LeaseOperating Lease– short-term and cancelable

– lessor generally provides maintenance/service

– rarely contains purchase option

• Direct-financing LeaseDirect-financing Lease– long-term and non-cancelable

– lessee responsible for operating expenses

– lessee has option of purchasing the asset

Leasing in the Business Market

• Advantages to buyerbuyer– No down payment– No risk of ownership

• Advantages to sellerseller– Increased sales– Ongoing business relationship with

lessee– Residual value retained