Pricing Strategy

Marketing and Pricing Strategy

1. Introduction

  • Core Purpose of Marketing Activities: The main aim is to create value for customers. Three of the four elements of the marketing mix (the four Ps) relevant in this context are:

    • Product: The item or service being offered.
    • Promotion: The communication strategies used by the firm to draw in potential customers.
    • Place: The distribution channels and locations through which the product is available to customers.
    • Price: Specifies how the value created can be appropriately divided between the customer and the organization, providing incentives for purchase and covering costs to allow for profit and reinvestment.

  • Impact of Pricing on Profitability: Effective pricing management is crucial for achieving profitability. Studies have shown that:

    • A 1% improvement in price realization leads to an average operating profit increase of 11.1%.
    • In contrast, a 1% increase in sales volume results in only a 3.3% increase in profitability.

  • Real-World Examples of Price Realization: In 2013, a 1% improvement in price realization could have increased:

    • DuPont’s profitability by 7.4%.
    • Nike’s by 10.2%.
    • Boeing’s by 18.9%.
    • Walmart’s by over 27%.

  • Value Pricing Approach: Researchers advocate for pricing based on the value to customers. Key questions include:

    • "Do you know the economic value of your product to your customers?"
    • "Is the price accurately keyed to the value to the customer?"

  • Elements of Value Pricing: Effective pricing strategies rely on understanding customer value, with a focus on:

    • The economic value created.
    • The processes to capture a portion of that value.

2. Essential Reading

2.1 The Value-Pricing Approach
  • Value-Pricing Thermometer: A visual tool that showcases three critical inputs:
    1. True Economic Value (TEV): The value a fully informed buyer associates with the product.
    2. Perceived Value (PV): The value perceived by the consumer, usually less than TEV.
    3. Cost of Goods Sold (COGS): The minimum price a company would be willing to sell for.
2.1.1 Assessing True Economic Value (TEV)
  • TEV Calculation:
    TEV=extCostoftheNext−BestAlternative+extValueofthePerformanceDifferentialTEV = ext{Cost of the Next-Best Alternative} + ext{Value of the Performance Differential}
  • TEV Example: For a busy executive assessing travel options:
    • Evaluating alternatives (e.g., Delta vs. US Airways) reveals minimal TEV difference due to similar service offerings.
    • A hypothetical assessment with two filtration systems shows how to calculate TEV based on failure probabilities and operational costs, indicating where value lies for the buyer.
2.1.2 Assessing Perceived Value (PV)
  • PV Definition: The price a consumer thinks the product is worth, which is more subjective than TEV.
  • PV Reduction Factors:
    • Lack of product awareness.
    • Skepticism about benefits or claims.
    • Misjudgment of importance of benefits (e.g., using a DVR).
  • PV Calculation: Can also incorporate biases that consumers hold, which might misrepresent their true valuation of a product.
2.1.3 Cost of Goods Sold (COGS)
  • COGS Importance: It represents the firm's minimum price threshold.
  • Limitations on Selling Below COGS: Firms rarely sell below cost in the long-term except for promotional strategies.
2.1.4 Putting the Pieces Together
  • Price Setting Feasibility: Determining a price relies on balancing TEV, PV, and COGS.
  • Example Illustration: For a filtration system, if TEV is $81,500 but PV perceived by a buyer is $77,500 with COGS at $50,000, the price must fall within that range.
2.2 Price Customization
  • Definition: The variation in price based on customer characteristics that can enhance profitability.
  • Customization Methods: Organizations can adapt pricing strategies using various methods such as:
    1. Availability Control: Offering discounted prices based on buying history or geographical location.
    2. Pricing Based on Buyer Characteristics: Offering different prices based on demographic information like location or age.
    3. Pricing Based on Transaction Characteristics: Adjusting prices based on specifics of the transaction.
    4. Product-Line Management: Offering different versions of a product at different prices according to functionality (good/better/best strategy).
2.2.1 Controlling Availability
  • Variable Pricing Strategies: Online retailers often use customer behavior (visits, purchases) to offer special discounts.
  • Catalog Marketing Example: Sending targeted offers based on purchase history increases the chances of conversion.
2.2.2 Pricing Based on Buyer Characteristics
  • Sample Case: Disney offers discounts to Florida residents, acknowledging differing demand levels.
  • Software Upgrade Discounts: Offering better deals to recent buyers than to older versions reflects pre-existing consumer satisfaction efforts.
2.2.3 Transaction Characteristics
  • Example of Timing Impact: Airline pricing adjusts based on purchase timing due to varying price sensitivity between leisure and business travelers.
  • Volume Discounting: Achieving discounts for bulk purchases is a common strategy across industries.
2.2.4 Managing Product-Line Offering
  • Product Functionality Diversity: Offering distinct products to cater to different customer needs can increase market reach and profitability.
2.2.5 Price Customization and Perceived Fairness
  • Fairness Perception Issue: Customization can be seen as unfair, requiring careful communication to justify price differences.
2.3 Price Sensitivity and Consumer Behavior
2.3.1 Managerial Judgment
  • Qualitative Indicators: Managers utilize qualitative indicators to assess price sensitivity before pursuing formal research.
  • Factors Affecting Price Sensitivity:
    1. Low differentiation of alternatives.
    2. Easy comparability of products.
    3. Mission criticality of the product’s function.
2.3.2 Quantitative Market Research
  • Assessment Methods: Market researchers rely on surveys, experiments, and analysis of historical data to derive price sensitivity.
  • Impact of Price Experimentation: Observing actual consumer behavior in response to varied pricing is invaluable.
  • Historical Data Analysis: Using past pricing data to estimate future demand provides practical insight.
2.3.3 Mapping Demand and Price Relationship
  • Demand Curve Creation: Graphing the cumulative demand reveals consumer behavior at varying price points.
2.3.4 Price Elasticity of Demand
  • Elasticity Measurement: E=extPercentageChangeinQuantityDemandedextPercentageChangeinPriceE = \frac{ ext{Percentage Change in Quantity Demanded}}{ ext{Percentage Change in Price}}
  • Types of Elasticity:
    • Perfectly Elastic (E = ∞): Any price change results in a significant quantity change.
    • Relatively Elastic (1 < E < ∞): Small price changes significantly affect quantity.
    • Unit Elastic (E = 1): Changes in price equally affect quantity changes.
    • Relatively Inelastic (0 < E < 1): Large price changes result in small quantity changes.
    • Perfectly Inelastic (E = 0): Quantity demanded remains unchanged regardless of price changes.
2.4 Economic Impact on Firms
2.4.1 Drivers of Profitability
  • Components of Profit: Profit is the difference between total revenue generated and total costs
  • Constructs for Calculating Profit:
    • Total Revenue: extTotalRevenue=extpriceperunitimesextquantitysoldext{Total Revenue} = ext{price per unit} imes ext{quantity sold}
    • Fixed Costs: Costs that do not change regardless of production.
    • Variable Costs: Costs directly associated with product output.
2.4.2 Unit Margins
  • Unit Margin Definition: The profit per unit of product sold, calculated as revenue received minus variable production cost.
2.4.3 Breakeven Analysis
  • Concept: Determines the number of units needed to sell to cover fixed costs, expressed as:
    extBEV=extFixedCostsextPriceperunit−extVariableCostperunitext{BEV} = \frac{ ext{Fixed Costs}}{ ext{Price per unit} - ext{Variable Cost per unit}}
  • Utility: Allows for exploration of multiple scenarios and investment considerations.
2.4.4 Marginal Math
  • Profitability Analysis: Examines the effect of price changes on profitability, taking demand elasticity into account.

3. Key Terms

  • Breakeven Analysis: Determining the sales volume required to cover costs.
  • Value-Based Pricing: Pricing products based on their perceived value to consumers.
  • Price Elasticity: A measure of how sensitive demand for a product is to changes in price.
  • Dynamic Pricing: The practice of varying prices based on current market demand and other factors.

4. Further Reading

  • Suggested publications and academic resources to deepen understanding of pricing strategies and their implications.