Pricing Strategy Elisa Montaguti Warwick Business School

Pricing Strategy

Elisa MontagutiElisa Montaguti Warwick Business School Warwick Business School


Price: What do you want to get out of it??Price: What do you want to get out of it??

SurvivalSurvivalCurrent profitCurrent profit

RevenuesRevenuesSales GrowthSales Growth

Market SkimmingMarket SkimmingProduct quality leadershipProduct quality leadership


Suppose that your company has just developed a Suppose that your company has just developed a computer chip for personal computers that has a fastercomputer chip for personal computers that has a faster

processing speed than any other computer chip currently processing speed than any other computer chip currently on the market. on the market.

How would you decide what the ‘perfect price’ is for thisHow would you decide what the ‘perfect price’ is for thischip?chip?

Elisa MontagutiElisa Montaguti Warwick Business Warwick Business SchoolSchool

Price ceilingPrice ceiling the most that customers would paythe most that customers would pay

Price floorPrice floorthe minimum you can affordthe minimum you can afford


Impact of Poor Price DecisionsImpact of Poor Price Decisions

Price too low?Price too low?Costs and/or investments are not covered Costs and/or investments are not covered

Profit not maximisedProfit not maximisedOverheated capacity trying to meet demandOverheated capacity trying to meet demand

Brand image negatively affectedBrand image negatively affected

Price too high?Price too high?Potential market share not maximisedPotential market share not maximisedInventory holding costs if too few soldInventory holding costs if too few sold

Brand image negatively affectedBrand image negatively affected


Issues for this SessionIssues for this Session

Why business goals usually solve only part of the pricingWhy business goals usually solve only part of the pricingproblemproblem

Why economics usually solve only part of the pricing Why economics usually solve only part of the pricing problem problem

How customer-focused pricing can solve other part of theHow customer-focused pricing can solve other part of theproblemproblem


Pricing from the ‘Floor’Pricing from the ‘Floor’

These methods choose price based on costs and desiredThese methods choose price based on costs and desiredprofitability profitability

Markup pricing: add margins based on the desired Markup pricing: add margins based on the desired overall profitoverall profit

Target return: add margins based on desired return on Target return: add margins based on desired return on investment.investment.


PhotodigitalPhotodigitalDigital CamerasDigital Cameras

Variable cost: Variable cost: £ 5.5£ 5.5(e.g. raw materials, labour, shipping, packaging)(e.g. raw materials, labour, shipping, packaging)

Fixed costs:Fixed costs: £ 250,000 £ 250,000 (e.g. advertising, PR)(e.g. advertising, PR)

Invested capital: Invested capital: £ 1 m£ 1 m(e.g. R&D, project management salaries)(e.g. R&D, project management salaries)


““Markup pricing”Markup pricing”

The company is expecting 100,000 units and wants a The company is expecting 100,000 units and wants a 20 % return on sales (considers investment a sunk cost)20 % return on sales (considers investment a sunk cost)

unit cost= var cost+fixed cost unit cost= var cost+fixed cost distributed over number of unitsdistributed over number of units

unit cost= 5.5 + (250,00/100,000) = £ 8unit cost= 5.5 + (250,00/100,000) = £ 8

markup price= £ 8/0.8 = £ 10markup price= £ 8/0.8 = £ 10


““Markup pricing”: what if sales went up?Markup pricing”: what if sales went up?

The company is expecting 150,000 unitsThe company is expecting 150,000 units


unit cost= 5.5 + (250,00/150,000) = £ 7.17unit cost= 5.5 + (250,00/150,000) = £ 7.17

markup price= £ 7.17/0.8 = £ 8.96 (markup price= £ 7.17/0.8 = £ 8.96 (down from £10down from £10))


““Markup pricing”: what if sales went down?Markup pricing”: what if sales went down?

The company is expecting 75,000 unitsThe company is expecting 75,000 units


unit cost= 5.5 + (250,00/75,000) = £ 8.83unit cost= 5.5 + (250,00/75,000) = £ 8.83

markup price= £ 8.83/0.8 = £ 11.04 (markup price= £ 8.83/0.8 = £ 11.04 (up from £10up from £10))


Therefore...Therefore...

Target return and markup pricing do not inherently Target return and markup pricing do not inherently take market behaviour or consumer needs/wants intotake market behaviour or consumer needs/wants intoaccountaccount

The result is a pricing strategy that is based on desiredThe result is a pricing strategy that is based on desiredvalue for the producer, not perceived value for the customervalue for the producer, not perceived value for the customer

Costs are important, but customers can not be ignoredCosts are important, but customers can not be ignored


Price Elasticity: How much does volume change Price Elasticity: How much does volume change when price changes?when price changes?

X2 X1oooo

p2

p1

p2

p1

X2 X1


Price: Demand, Cost and profitPrice: Demand, Cost and profit

oo

££

QQ

Marginal revenueMarginal revenueAverage revenueAverage revenue

Average costAverage cost

Marginal costMarginal cost


Price: Break even pointPrice: Break even point

oo

££

Units of productionUnits of production

Fixed costsFixed costs

LossesLosses

Break even pointBreak even point

Total revenueTotal revenue

ProfitsProfits

Total variable costsTotal variable costs

Total costsTotal costs

Pricing: the Impact of Advertising Pricing: the Impact of Advertising


X2 X1oooo

p2

p1

p2

p1

X2 X1

A Software Unsupported by a A Software Unsupported by a Strong Advertising CampaignStrong Advertising Campaign

The Same Software Supported byThe Same Software Supported by a Strong Advertising Campaigna Strong Advertising Campaign


Price Discrimination

Selling products to different customers at different net prices

When:Market can be separated “perfectly sealed” no resale (transferability)

Customers must be sorted (segmentation)Different “intensity/elasticities” across customers

Seller must have some monopoly power

Let’s consider the Danieli Hotel in Venice.Let’s consider the Danieli Hotel in Venice.• It’s variable costs are £ 10 per roomIt’s variable costs are £ 10 per room• Each of the 4 different segments is willing to payEach of the 4 different segments is willing to pay

the following amount per room:the following amount per room:

Segment A (students) Segment A (students) £ 30£ 30Segment B (elderly people)Segment B (elderly people) £ 60£ 60Segment C (tourists)Segment C (tourists) £ 90£ 90Segment D (business men)Segment D (business men) £ 120£ 120


Price Discrimination: How does it work?

The Danieli Hotel could choose a price equal to £30The Danieli Hotel could choose a price equal to £30 = 4N(30-10) = = 4N(30-10) = 8080OrOrequal to £60equal to £60 = 3N(60-10) = = 3N(60-10) = 150150OrOrequal to £90equal to £90 = 2N(90-10) = = 2N(90-10) = 160160Or Or equal to £120equal to £120 = 1N(120-10) = = 1N(120-10) = 110110


Price Discrimination: How does it work? (2)


Price Discrimination: How does it work? (2)

Or:Or:

N(120-10)+ 2N(90-10)+ 3N(60-10)+ 4N(30-10)

=£.(110+160+150+20)N=440N

Expected non Searcher quantityExpected non Searcher quantity

pp= the fraction of the time the shirts are priced at $50. = the fraction of the time the shirts are priced at $50.

Price Discrimination:An Example

pp pp=$30=$30 pp=$50=$50 Expected Searcher QuantityExpected Searcher Quantity Total ContributionTotal Contribution

0.0

0.10

0.79

0.80

0.81

0.82

0.83

0.85

0.90

1.00

100

90

21

20

19

18

17

15

10

0

0

10

79

80

81

82

83

85

90

100

100.0

99.9

50.7

48.8

46.9

44.9

42.8

38.6

27.1

0.0

$ 2,000

2,199

3,087

3,088

3,089

3,089

3,088

3,086

3,071

$ 3,000

Price Discrimination:When

Product line pricing Product line pricing

Follow on products Follow on products

Bundling Bundling

Mach3Mach3

Price: $ 6.99Price: $ 6.99

Cartridge: $ 5.99Cartridge: $ 5.99


Price Discrimination:Risks

1- It is not easy to know 1- It is not easy to know reservation pricereservation price,..it might not be a ,..it might not be a good idea to askgood idea to ask

2-Prices are often known2-Prices are often known

3- It is difficult to avoid arbitrage3- It is difficult to avoid arbitrage

4-The customers ….could get upset!!4-The customers ….could get upset!!

Demand functions are useful for getting a general ideaDemand functions are useful for getting a general ideaof the potential upside or risk of a price increase or of the potential upside or risk of a price increase or

decrease, but other considerations must be taken intodecrease, but other considerations must be taken intoaccountaccount

Choosing price using a demand functionChoosing price using a demand function


Price and competitionPrice and competition

When changing your cost or price structure, be sureWhen changing your cost or price structure, be sureto gauge carefully the potential impact on competitionto gauge carefully the potential impact on competition

Options:Options: going-rate pricinggoing-rate pricing sealed-bid pricingsealed-bid pricing

Risk:Risk: Price WarPrice War


Price and customer’s overall valuePrice and customer’s overall value

It is important to take into account costs and risks, butIt is important to take into account costs and risks, butthis does not substitute for taking customer preferences this does not substitute for taking customer preferences and needs into account as well.and needs into account as well.

When asked whether they were “well informed” on sixWhen asked whether they were “well informed” on sixof the potential inputs to the product pricing decision, of the potential inputs to the product pricing decision, managers at one of well respected U.S.-based multinationalmanagers at one of well respected U.S.-based multinationalresponded as follows: responded as follows:

84 % were well informed on the variable cost84 % were well informed on the variable cost81 % were well informed on the fixed cost81 % were well informed on the fixed cost75 % were well informed on the price of competitors75 % were well informed on the price of competitors61 % were well informed on the value of their products61 % were well informed on the value of their products34 % were well informed on how consumers respond to price changes34 % were well informed on how consumers respond to price changes21 % were well informed on consumer’s willingness to pay 21 % were well informed on consumer’s willingness to pay

You are lying on the beach on a hot day. All you have to You are lying on the beach on a hot day. All you have to drink is ice water. For the past hour, you have been thinking drink is ice water. For the past hour, you have been thinking about how much you would enjoy a nice cold bottle of yourabout how much you would enjoy a nice cold bottle of yourfavourite beer. A friend gets up to make a phone call and offersfavourite beer. A friend gets up to make a phone call and offersTo bring back a bottle of your favourite beer from the only To bring back a bottle of your favourite beer from the only nearby place where the beer is sold – a small, run down-grocery nearby place where the beer is sold – a small, run down-grocery store. He says that the beer might be expensive and asks howstore. He says that the beer might be expensive and asks howmuch you are willing to spend. He says that the beer might bemuch you are willing to spend. He says that the beer might beexpensive and asks how much are you willing to spend. He expensive and asks how much are you willing to spend. He says he will not buy the beer if it costs more than the price you says he will not buy the beer if it costs more than the price you state. What price do you tell your friend? state. What price do you tell your friend?

You are lying on the beach on a hot day. All you have to You are lying on the beach on a hot day. All you have to drink is ice water. For the past hour, you have been thinking drink is ice water. For the past hour, you have been thinking about how much you would enjoy a nice cold bottle of yourabout how much you would enjoy a nice cold bottle of yourfavourite beer. A friend gets up to make a phone call and offersfavourite beer. A friend gets up to make a phone call and offersTo bring back a bottle of your favourite beer from the only To bring back a bottle of your favourite beer from the only nearby place where the beer is sold – a fancy resort hotel. He says nearby place where the beer is sold – a fancy resort hotel. He says that the beer might be expensive and asks how much you are willing that the beer might be expensive and asks how much you are willing to spend. He says that the beer might beto spend. He says that the beer might beexpensive and asks how much are you willing to spend. He expensive and asks how much are you willing to spend. He says he will not buy the beer if it costs more than the price you says he will not buy the beer if it costs more than the price you state. What price do you tell your friend? state. What price do you tell your friend?

Consumer Consumer Willingness to Pay Willingness to Pay

Economic Utility of the Economic Utility of the Transaction Transaction Fairness of the transaction Fairness of the transaction == ++

Perceived Value –Actual PricePerceived Value –Actual Price [(Perceived Value-Actual)/(Actual Price)][(Perceived Value-Actual)/(Actual Price)][Actual Price-Expected or Reference Price][Actual Price-Expected or Reference Price][Actual Price-Cost of Goods Sold][Actual Price-Cost of Goods Sold]


Finally…let’s choose a price!Finally…let’s choose a price!

Price CeilingPrice CeilingInfluenced by customer’s total available income and habitual Influenced by customer’s total available income and habitual

spending patterns in the product area (price elasticity helpful here)spending patterns in the product area (price elasticity helpful here)

Price FloorPrice FloorInfluenced by provider’s cost structure and minimum/maximum Influenced by provider’s cost structure and minimum/maximum

value placed on winning customers in this market (cost helpful here)value placed on winning customers in this market (cost helpful here)

Customer perception of Customer perception of competitive optionscompetitive options

Customer perceptionCustomer perception of valueof value


What did we learn? ...What did we learn? ...

• Cost-plus pricing provides one perspective on remaining in Cost-plus pricing provides one perspective on remaining in business, but leaves the customer out of the picturebusiness, but leaves the customer out of the picture

• Price elasticity offers a global estimate of risk, but is only a rough Price elasticity offers a global estimate of risk, but is only a rough estimate and it is sensitive to other marketing variablesestimate and it is sensitive to other marketing variables

• There is often quite a lot of room between the price ceiling and There is often quite a lot of room between the price ceiling and the price floor, and it is this area over which marketing has the mostthe price floor, and it is this area over which marketing has the mostinfluenceinfluence

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Pricing Strategy Elisa Montaguti Warwick Business School