Pricing

1. Pricing

2. Pricing Playing Field Economic Value Competition Customer Company Competition Collaborators Situation *Market Share *Costs Cooperation Differentiation Distribution Channels Price Sensitivity Fairness Goals Situation * Market Share * Costs Company Policies, Goals Variable Costs

3. Managing a price decrease: P&G and EDLP Superior quality Value price Demand for greater value Prisoner’s Dilemma High cost of promotions Rationalize product line Promotions: Switching excuse Private labels Channel inefficiency Rise of the discounter Customer confusion Rise of EDLP Strain on manufacturing Strategy Customer Competitor Costs Price reduction Value pricing Brand image through advertising

4. Why is Price so Critical? • Consider a company with an 8% profit margin • Suppose the company could raise its price by 1% without it having any impact on sales? • What will the increase in margin be? • Sales = X Pts • Margin = 0.08X Pts; Cost = 0.92X Pts • New sales = 1.01X Pts; Cost = 0.92X Pts • Margin = 0.09X Pts • Increase in margin = 100*(0.09X-0.08X)/0.08X • = 12.5% !

5. Two Key Requirements of a Pricing Policy • Policy should complement company’s marketing strategy • Swatch: $40 price on basic model has not changed in 10 years • Saturn: No negotiation pricing • Process of price setting must be coordinated across departments • Issue: There are many participants in the process - Accounting provides cost estimates, Marketing communicates the strategy; Sales provides customer input; Production sets supply boundaries; Finance establishes requirements for the bottom line

6. Coordinating the Pricing Process • What is our pricing objective? • Do all participants in the process understand the objective? • Do all participants have an incentive to work in pursuit of the objective?

7. Profit Growth, Volume Growth, or Both? Profit growth positive Quadrant I Quadrant II Manager’s Dream Tradeoff Zone Volume growth negative Volume growth positive Quadrant IV Quadrant III Tradeoff Zone Manager’s Nightmare Profit growth negative

8. Pricing Goal Matrix Increase of too low price Reduction of too high price Profit growth positive Volume Volume Profit Profit Volume growth negative Volume growth positive Volume Volume Profit Profit Profit growth negative Increase of price beyond optimum Decrease of price below optimum

9. 8 Steps to a Pricing Decision I. Assess what value your customers place on the product or service II Look for variation in the way customers value the product III Assess Customers’ Price Sensitivities IV Identify an Optimal Pricing Structure V Consider Competitors’ Reactions VI Monitor Prices Realized at Transaction Level VII Assess Customers’ Emotional Response VIII Analyze Whether Returns are Worth the Cost to Serve

10. 8 Steps to Better Pricing: STEP 1 I. Assess what value your customers place on the product or service. • What should the appropriate process be? • From company ...... To marketplace or • From marketplace ...... To company? • The trouble with “Cost+” Pricing • Expected sales level = 100 units • Suppose cost/unit = 10; markup = 20% • Price = 12. Suppose you sell only 80 units • New cost = 11; markup = 20%; price = 13.2 • How many units will be sold?

11. Examples of Value-Based Pricing • Glaxo pricing of Zantac in the US market in 1983 • Competition with SK B’s Tagamet (#1 drug in the world) • Additional value offered by Zantac • Easier schedule of doses • Fewer side effects • Taken safely with other medication unlike Tagamet • Based on greater perceived value, Glaxo charged a 50% premium over Tagamet instead of pricing at parity or below (as in Follower pricing) • In 4 years, Zantac was the market leader.

12. How to assess value? • Economic Value-In-Use • Market research • Conjoint Analysis • Employees with direct customer contact • Salesforce

13. Determining Economic Value-In-Use • DuPont, Alathon 25 - polyethylene resin used in the manufacture of flexible pipe. Competes with other resins • Failure rates of 1-3% compared to 7-8% for competition • Economic Value=Reference Value + Differentiation Value • Reference Value: Cost of competing product that the customer views as the best substitute for the product being evaluated • RV = Price of Competing product adjusted for any difference in quantity used • Differentiation Value: Value of product attributes that are different from those of the best substitute • DV = Positive if customer likes differentiating attribute, Negative otherwise

14. Economic Value Analysis from 2 Perspectives • Pipe buyers who purchase pipes made of Alathon • Pipe extruders who purchase Alathon to make pipes

15. Analysis for Below-Ground Irrigation (/100ft) Cost of Substitute=$6.50 Failure Rate from 8 to 3% Value=6.5*1.08/1.03=6.81 Failure Rate from 7 to 1% Value=6.5*1.07/1.01=6.89 Added Value=$0.31-$0.39 Labor cost of pipe replace- ment=$60. Failure rate drops 5-6%, Savings=$3.00 to $3.60 Crop damage cost = $0-40 Probability of $40 = 0.2 Failure rate drops 5-6% Savings=40*0.2*0.05=0.40 =40*0.2*0.06=0.48 Crop Loss Reduction $0.40 - $0.48 Labor Savings $3.00 - $3.60 Differentiation Value Replacement Savings: $0.31-$0.39 Total Economic Value $10.21-$10.97 Cost of Substitute $6.50 Reference Value

16. Analysis for Pipe Extruders (per pound) Added Value to Extruder’s Product $0.228-$0.275 Sales Decline -$0.01 Negative Differentiation Value Risk -$0.020 Positive Differentiation Value Higher Sales Expense -$0.080 Cost of Substitute $0.280 Total Economic Value $0.398-$0.445 Reference Value Cost of cheapest resin = $0.28 / lb. # lbs. per 100 feet of pipe = 16.25 Value of 100 feet = $10.21 (min.) Added value / lb = (10.21-6.5)/16.25=$0.228 Sales decline due to lower replacement Risk due to single supplier (DuPont)

17. Interpreting Economic Value • A product’s market value is determined not only by the economic value but also by the accuracy with which buyers perceive that value • Weakness of EV:Does not indicate the appropriate price to charge. Gives the maximum price consumers will be willing to pay if they were perfectly cognizant of the economic value and were motivated by economic value to make their purchase decisions • Strength of EV: Enables a firm to determine whether a product is selling poorly because it is overpriced relative to its true economic value or because it is under-promoted and consequently, under-appreciated by the market • DuPont used this to increase sales by raising price and educating consumers

18. Other Uses of Economic Value Analysis • Indicates which attribute improvements will result in the greatest enhancement of value • Can be used by sales reps to highlight the benefits of the product • Help firm identify market segments that value the product’s attributes differently • Works well for industrial products and for consumer durable goods • Not very useful for FPP products and for those with “fuzzy” attributes • Use methods like Conjoint Analysis

19. 8 Steps to Better Pricing: STEP 2 II Look for variation in the way customers value the product • Polaroid SX-70 instant photography camera • Segmentation over time. Initially those placing a high value (in the photo ID card business) were sold product at a high price. Then prices reduced to accommodate others • Segmentation and Airline fares: Business Vs. Leisure • Magazines: Single issue Vs. Subscriptions • Software: Upgrades (low cost) Vs. New Users • Heavy users Vs. Light users • Different applications: Sealed Air Corporation • Business computers Vs. Home computers

20. What to do with the variation: Price Customization • Product-line sort: develop a product line and have customers sort themselves among the various offerings based on their preferences • Controlled availability • Coupons • Direct-Mail Catalogs • Geographic Pricing • Restriction on place of purchase (high end products at high end stores) • Negotiating with provider (long distance telephone calls) • Sort on Buyer Characteristics • Eurodisney: “Kinder Gratis - vom 1.1.96 bis zum 4.4.96” • Munich airport landing fees (747-200 DM 18600; 747-400 DM 10100) • Sort on Transaction Characteristics

21. Price Customization Translates As …. • Segmenting by Buyer Identification • Coupons; Student Discounts; Automobile prices • Segmenting by Purchase Location • Hair Salons have different prices in different locations • Large grocery stores Vs. convenience stores • Freight absorption in industrial product markets • Segmenting by Time of Purchase • Theaters: Matinee Vs. Evening rates • Restaurants: Fixed price lunches (Restaurant next door) • Peak-Load pricing (Airlines, Electric Utilities, Telephones) • Problem of Peak Reversal with long distance calling

22. 8 Steps to Better Pricing: STEP 3 III Assess Customers’ Price Sensitivities

23. Methods for Price Response Estimation 1. Expert Judgement • New consumer nondurable introduced in 3 European regions. Managers for the 3 markets were selected as the best experts and asked to provide estimates of 3 points on the response curve • Lowest realistic price and year 1 sales volume at that price • Highest realistic price and sales volume • Expected sales volume at a “medium” price

24. Methods for Price Response Estimation 2. Customer Surveys a) Direct price response surveys b) Preference-based Inference: Conjoint Analysis a) • What is the likelihood that you would buy this product at $25 • At what price would you definitely buy this product? • How much would you be willing to pay for this product? • How much of this product would you buy for $0.99? • At what price differential would you switch from brand A to brand B?

25. Price Response Estimate for a PC at Vobis

26. Purchase Intentions for Instant Cameras Kodak’s analysis of a next-generation instant camera - purchase intent on a 7-point scale

27. Price Response Curve for Instant Cameras

28. b) Conjoint analysis What would you prefer? Type a number from the scale below to indicate your preference 4-cup Capacity 9-minute Brewing Time $18 8-cup Capacity 3-minute Brewing Time $28 OR Strongly Prefer Left Strongly Prefer Right 1 2 3 4 5 6 7 8 9

29. Methods for Price Response Estimation 3. Price Experiments • Laboratory; Simulated Shopping or “In-Market” Tests • In-market tests: Prices varied across stores, accounts, geographic regions • Direct mail catalogs are another medium for experiments • In-market test of a German mobile phone manufacturer • Regular price of phone = DM 1200 • At this price 24% of new car buyers bought the phone • Company then varied prices for 3 months in 3 different regions • The results were as follows

30. Price Experiment for Mobile Phone 3 month period before experiment = 24%

31. Methods for Price Response Estimation 4. Analysis of Historical Market Data Supermarket scanners are especially useful for this purpose If prices have naturally varied over time, one can analyze how changes in absolute or relative prices affect sales volumes and market shares German market for RTE desserts 4 main competitors at the time of analysis: Gervais-Danone, Nestle, Unilever and Dr. Oetker, togther had more than 80% share Dr. Oetker’s prices varied between DM 0.60 and DM 0.70. Unit sales varied between 7 million and 12 million for two-month periods.

32. Price Response Estimate Based on Historical Data Volume (million units) Profit Index 12 Sales Volume Profit 11 120 10 9 110 8 100 7 6 Price DM 0.60 0.63 0.65 0.68 0.70 0.73

33. Evaluation of Different Methods

34. Empirical Estimates of Price Elasticities

35. 8 Steps to Better Pricing: STEP 4 IV Identify an Optimal Pricing Structure • Should Quantity Discounts be offered? Units Buyer A Buyer B 1 $70 $70 2 $20 $50 3 $20 $40 4 $20 $35 5 $20 $30 Above table gives the value of each successive unit of the product to 2 buyers A and B. What price should the company charge if producer’s cost is $20 per unit?

36. Pricing Structure..... • Should Bundle Pricing be offered? • Movie distributors often sell packages of films rather than selling individual film rights because the package values vary less across buyers than do values of individual films Buyer A Buyer B Movie 1 $9000 $5000 Movie 2 $1000 $5000 Total $10000 $10000 • Using a la carte pricing can sell movie 1 to both buyers for $5000 each and movie 2 to buyer B for $5000. Total revenue is $15000. By bundling, both buyers will buy the bundle for $10000. So total revenue = $20000

37. Bundling Example: Mobile Phone Operator

38. Optimal Pure Components Pricing Pv = 8 Group 4 Group 3 Ph=8.5 Price for Hot Line Group 2 Group 1 Price for Voice Mail

39. Optimal Pure Bundling Price Group 4 Group 3 Price for Hot Line Group 2 Group 1 Price for Voice Mail

40. Optimal Mixed Bundling Price Pv=9 Ph=9 Group 4 Group 3 Pv+h=13 Price for Hot Line Group 2 Group 1 Price for Voice Mail

41. 8 Steps to Better Pricing: STEP 5 V Consider Competitors’ Reactions • In 1994, Kodak’s share of the US film market was 70% but was declining. • Flagship product Kodak Gold sold at 17% premium over Fuji • Did not because Fuji had gross margin of 55% and could have followed the price cut • Launched Funtime film at price lower than Fuji • Simple Competitive Reactions • Multiple Competitive Reactions • AA Value Pricing: AA cut prices; SouthWest responded by advertising: “We’d like to match their new fares, but we’d have to raise ours • Game theoretic Analysis

42. Competitive Interaction • Asymmetric Price Tier Competition • Superpremium FujiColor Reala $4.69 Kodak Ektar $4.27 • Premium Kodak Gold Plus $3.49 Agfa Color $3.49 • Economy FujiColor Super G $2.91 Konica Super SR $2.91 ScotchColor $2.69 • Prisoner’s Dilemma • Cigarettes in U.S. average price increase 10% from 1982 to 1991 • Instant cameras from 1976 to 1985 declined 76% in price • Price Signaling

43. 8 Steps to Better Pricing: STEP 6 VI Monitor Prices Realized at Transaction Level • A product may have only 1 list price, but can have several final prices • Returns, damage claims, special incentives drive revenue • Unfortunately, most companies spend 90% of their effort in setting list prices • Need to devote more care and attention to Quality and Logistics (manage returns / damage) and Account Analysis (where are revenues actually coming from?)

44. 8 Steps to Better Pricing: STEP 7 VII Assess Customers’ Emotional Response • Manage price perceptions • Reference prices and Prospect Theory • Market research required to assess customer reaction in terms of both perceived fairness and purchase intention

45. Effect of purchase context • You are lying on a beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite beer. A companion gets up to make a phone call and offers to bring back a beer. He says that the beer may be expensive and asks the maximum price you are willing to pay. If the price is higher, he will not buy it. What price will you tell him if the only nearby place where beer is sold is a fancy resort hotel? What price will you tell him if the only nearby place where beer is sold is a small, run-down grocery store?

46. Odd pricing • For which pair of prices is the lower price more of a bargain? First pair: $0.89 $0.75 --------------------------------------------------------------------------- Second pair: $0.93 $0.79 Effect of Advertised Odd-Price Endings on Sales of Margarine: Parkay brand: Price/lb ($) Unit sales Regular price: 0.83 2817 Discount price 0.63 8283 (+ 194%) Odd discount price 0.59 14,567 (+406%)

47. Order Effects Reference prices when range of prices shown in: Product Ascending order Descending order Electric shaver 20.18 24.00 After-shave lotion 2.28 3.56 Dress shirt 4.85 6.69 Sport coat 39.85 44.64 Hair spray 1.02 1.41 Hair dryer 21.91 21.91 Dress shoes 15.89 17.83 Blouse 7.37 9.27

48. Prospect Theory Utility Reference Price Reference Price - Actual Price Actual Price - Reference Price Disutility

49. Reference Pricing • put low priced good next to high priced good. • put “regular” price next to “sale” price (- “was $999, now $799”) • order effects: reference prices influenced by what is seen first. • endowment effect: de-couple acquisition and payment by first endowing buyers with the product. “Buy now, pay later”.

50. Reference Price effect of a High-end Product Choice (%) Microwave Oven Model: Group 1 Group 2 Panasonic II (1.1 cu ft; regular -N.A. - 13% price $199.99; sale: 10% off) Panasonic I (0.8 cu ft; regular 43% 60% price: $179.99; sale: 35% off) Emerson (0.5 cu ft; regular price 57% 27% $109.99; sale: 35% off)