Pricing in Practice

1. Pricing in Practice Howard Davies

2. Objectives for the Lecture • 1. List the PRICING OBJECTIVES which may be adopted by firms • 2. Describe the various COST- PLUS PRICING METHODS which may be used • 3. Explain why the evidence on COST-PLUS pricing does not invalidate the MC=MR model and why the rigid application of cost-plus pricing would lead to irrational pricing behaviour • 5. Explain the implications of the product-life-cycle for pricing • 6. Evaluate alternative strategies for pricing new products

3. Pricing Objectives • The central objective of pricing is PROFIT MAXIMIZATION • Companies may either express this in a different way, or have intermediate level objectives for pricing. • Those intermediate level objectives may or may not be consistent with profit-max • achieve a target rate of return: might be the maximum, might be a ‘satisficing objective, might be to deter entry • target market share: might be the share which is consistent with profit- maximisation or it might be a managers’ target • stabilize output - keep the factory running and the workers employed • match the competition

4. Pricing in Practice • Most firms use some form of COST-PLUS practice to set prices • CALCULATE average direct cost of production (labour and materials) • ADD a margin for overheads • ADD a margin for profit • GIVES the price to charge • FIRST RESEARCHED BY AN OXFORD TEAM IN 1938 AND REPORTED IN A FAMOUS STUDY BY HALL AND HITCH (1939) Sometimes just one margin added

5. A Good Example of the Theory/Practice Relationship • A simplistic interpretation of the Oxford findings is that the economic model of pricing is incorrect • it is clear from the evidence that managers do not describe their pricing practices in marginalist terms, in terms of MC=MR or in terms of elasticity and MC • some analysts (including the original researchers and many accountants) have concluded that the MC=MR model is therefore incorrect

6. A Good Example of the Theory/Practice Relationship • However, the conclusion that the evidence on cost-plus pricing invalidates the profit-maxing model is a misunderstanding of the relationship between models and practice. • This is very important for general understanding and can be approached in a number of ways • First • the profit-maxing model can be re-written in cost-plus form (P-MC) = 1 is the same as P = MC . (Ed) • P Ed (Ed -1) • If average variable cost is constant (which is often assumed in management accounting) then AVC = MC

7. If AVC is constant , therefore = MC the profit-max model can be re-written: P = AVC. (Ed) Average cost plus a margin (Ed -1) Calculate the margin when elasticity takes the following values 1.2 2.5 3 10 (Why can we not find a value if elasticity is less than 1?) If managers use margins which are consistent with these values, they are profit-maximising The Marginal Pricing Model is Equivalent to a Cost-Plus Model in Many Common Circumstances

8. If AVC is constant , therefore = MC the profit-max model can be re-written: P = AVC. (Ed) Average cost plus a margin (Ed -1) Calculate the margin when elasticity takes the following values 1.2 P = AVC.1.2/.2 = AVCx6 Margin = 500% 2.5 P = AVC.2.5/1.5 = AVCx1.66 - Margin = 66% 3 P = AVC.3/2 = AVCx1.5 Margin = 50% 10 P = AVC 10/9 = AVCx 1.11 Margin = 11% (Why can we not find a value if elasticity is less than 1?) If managers use margins which are consistent with these values, they are profit-maximising The Marginal Pricing Model is Equivalent to a Cost-Plus Model in Many Common Circumstances

9. Close examination shows that rigid cost plus pricing must lead to irrational results. Managers would be stupid to use it in practice, firms do take other factors into account, which allows them to approximate the profit-maxing solution But That Is Not the Most Important Point

10. Why Is Rigid Cost-plus Pricing Irrational? • There is a circularity problem. In many circumstances cost per unit depends on the volume of output sold. But the volume of output sold depends upon the price!. • Unless cost is constant over a very wide range of output a firm does not know its cost per unit until it knows the price ! • Cost-plus pricing completely ignores the demand side and the behaviour of customers and competitors For instance: • if my competitors lower their prices, how would a cost-plus price change? • if demand increases how will my cost plus price change?

11. Why Is Rigid Cost-plus Pricing Irrational? • If my competitors lower their prices, my sales volume will fall. That will increase my cost per unit. • IF I USE COST-PLUS PRICING, I WILL RAISE MY PRICE! • If demand increases and my sales volume increases, my costs will usually fall. • IF I USE COST-PLUS PRICING I WILL LOWER MY PRICE! • NOTICE THAT THE PROFIT-MAXING, MC=MR MODEL GIVES MUCH BETTER PREDICTIONS OF FIRMS’ BEHAVIOUR THAN A COST-PLUS ‘MODEL’ OF PRICING!

12. How Can We Reconcile the Contradiction Between Cost-plus Pricing Practice and Rational Behaviour by Managers? • Closer examination of managers’ descriptions of their pricing practice shows that they do take account of the demand side. • 1. The “Cost” which is used as the basis for Cost-Plus is rarely an actual cost - it is arrived at through discussions which implicitly take the demand side into account. In Denmark, for instance: • Fog asked a firm “what is the cost per unit on which you base your price?” • Answer ”cost per unit when the factory is at full capacity” • Fog “do you expect to be at full capacity?” • Answer “no” • Fog “why use an unrealistic figure for cost” • Answer “for competitivereasons. If we use the real figure our price will be too high” • 2. The margin is flexible in the light of market conditions

13. Issues of Market Demand May be Taken Into Account Early in the Design Process, with Cost being determined after Price, not before • FOR EXAMPLE: • The Managing Director of a manufacturer of bathroom equipment in the North of England explained their pricing process like this: • The first stage is before production begins. I look at the market and I identify the price at which a premium product can be sold in enough volume to use our factory efficiently • We decide how much margin we expect to make in order to give a profit which will satisfy the shareholders • I subtract the margin from the price. The result is the target cost per unit. I then tell the design department to design a product which can be made for that cost but which is a premium product. If they can’t do it, we adjust the price up a bit, but we are very careful not to over-price the extra benefits for the customer . • This is a “Price-Minus” approach to Cost, the opposite of “Cost-plus” approach to Price

14. What Can We Conclude on the Cost-Plus Practice Versus MC=MR Theory? • The theory is not supposed to describe pricing practices. It should be no surprise that it does not. • (See the paper by Govindajaran and Anthony 1983 for a good example of how accountants get confused over this issue) • The purpose of the MC=MR theory is to predict how firms will change their prices when cost and demand conditions change. The predictions make more sense, and are more accurate than those derived from a ‘cost-plus’ theory of price. • Managers are not dumb. They do not use cost-plus in a rigid way and they do not have the accurate information needed to do an MC= MR calculation. They feed their experience and knowledge into a complex decision-making process and in the end often behave ‘as if’ they were fully-informed maximisers.

15. Pricing and the Product Life Cycle • . Sales Volume Decline Maturity Growth Introduction Time

16. What Happens to Elasticity of Demandand Marginal Cost Over the Product Life Cycle? • Introduction - product is new. Elasticity may be low because there are no substitutes or high if buyers need to be persuaded to try the new product. Marginal cost is relatively high. Appropriate price will reflect high MC combined with high/low elasticity • Growth - imitation begins, and learning takes place. Elasticity rises, MC falls. Price falls? • Maturity - competition from many locations, substitutes and next-generation products have been invented, elasticity high, MC low • Decline - fierce competition for a declining market, very low margins • BEWARE THE POTENTIALLY SELF-FULFILLING NATURE OF THE PLC THEORY!!!!!

17. Pricing New Products • For new products, there is a significant amount of uncertainty about demand conditions. Two strategies have been suggested (Dean 1950) • SKIMMING - set an initially high price. IF that produces a high level of profits, leave the price high until conditions change and demand becomes more elastic. Do this when: • there is a significant group of buyers prepared to pay high prices • when demand is inelastic • when the high price will not induce entry • when the cost penalty for low volume is small • PENETRATION - set a low price from the beginning in order to build a large market share quickly. Do this when: • demand is elastic • low volume is very high cost • entry is a major danger

18. Is Skimming v Penetration Just an Application of the Simple Model? • YES - set a high price when elasticity is low and MC is high, set a low price when the opposite is true • BUT - • skimming may have another benefit. If experience shows it is the wrong strategy, the price can be cut without much customer resistance. If the penetration approach is used but it becomes clear that skimming would be better, it is more difficult to raise price than to lower it • skimming may provide a means of price discrimination through time. If a market contains a group of ‘trendsetters’ or ‘first-adopters’ who must have, or like to have, a product first and are willing to pay more for it. Skimming allows them to be charged a higher price. • E.g new major dictionaries, new types of mobile phone

19. SEMINAR WORK The Jaguar Case Non-Profit Objectives, Poor Marketing, Pricing Gone Wrong: • In the 1960s Jaguar had a strong hold on the UK market for luxury cars • By the 1980s it had lost significant market share to BMW, Mercedes Benz, Saab, Volvo • Jaguar lacked the funds to finance product development and therefore had to rely on small adjustments to old product designs • Jaguar was bought by Ford in the 1990s and has begun to develop new products: but can innovative design come from a giant corporation?

20. The Jaguar Case Brings Together a Number of Themes From this Course • What were the company’s objectives when setting prices? Why did they have those objectives? • What method did they use to set the price of their new product - the XJ12 luxury sports car? • What were the costs of that pricing decision?

21. What Were Jaguar’s Objectives in Setting Prices? Why Did They Have These Objectives? • The central aim of management was to ensure that a smooth flow of production was maintained and all cars produced could be sold.. • EXPLAIN WHY THE COMPANY HAD THIS OBJECTIVE

22. What Were Jaguar’s Objectives in Setting Prices? Why Did They Have These Objectives? • The central aim of management was to ensure that a smooth flow of production was maintained and all cars produced could be sold.. • WHY? • 1. MANAGERIAL DISCRETION. The management was dominated by engineers, who placed a high value on a smooth flow of production. Shareholders did not have enough influence to demand higher profit. • 2.LABOUR RELATIONS/POLITICAL PROBLEMS. Trade unions were very strong in the British motor industry, with significant political support. Managers who tried to dismiss workers, or reduce overtime, would face strong opposition, even physical violence

23. What Method did Jaguar Use to Set the Price of the XJ12? • Estimate the cost per unit if the factory is working at full capacity • Add a ‘satisfactory’ margin to set the price at 3,726 GBP, (which compared with 6,000 GBP for similar cars) • The result was excess demand for the product. A 2-year waiting list, second-hand cars sold for 40% more than the ex-factory price of a new one

24. What Were the Costs of That Pricing Mistake? • EVALUATE THE COSTS OF JAGUAR’S PRICING MISTAKE • a) in marketing terms • b) in terms of lost revenues - calculate the lost revenues explaining each step in your calculation (see the paper by Harrison and Wilkes but watch out for the mistake!) • c) in terms of the future development of the company

25. What Were the Costs of That Pricing Mistake? • Lost market share - • Jaguar advertised ‘you are right to wait’ • BUT customers were not willing to wait • BMW, Benz, Volvo, Saab all entered the market to fill the gap in demand • foreign brands had not been acceptable • the price may have been a ‘limit-price’ if Jaguar had been able to deliver, as they could not their low price actually encouraged entry

26. What Were the Costs of That Pricing Mistake? • Lost revenues. Harrison and Wilkes (1973) tried to calculate the amount Estimated From The Price Of One Car Sold At Auction 5,226 ? LOST REVENUE 3,726 6,000 20,000 Actual Out put Planned Capacity

27. What Were the Costs of That Pricing Mistake? • Insufficient funds for future product development. • Jaguar fell permanently behind its rivals in respect of spending on technological development. • Sale to a major manufacturer became the only option