Capturing Value through Pricing

Capturing Value through Pricing 1 Capturing Value through Pricing Pricing done has the best ROI of any business activity - McKinsey 1. Recover costs 2. Fund current value development activities ← Growth/Share Matrix 3. Support future products & projects ← Ansoff Matrix 4. Return profit to shareholders Key Concepts Elements of Effective Price Setting Cost Based Pricing Basic Elements of Profitability Competition Based Pricing Value Based Pricing Price Sensitivity What is Price Price is the overall sacrifice (cost) that a customer is willing to make to obtain a desired product Customer value = product’s benefits / price Elements of Effective Price Setting Product Costs Cost based pricing approach Competitors’ Prices Competition-based pricing approach Value of the Product to the Customer Value-based pricing approach

Capturing Value through Pricing 2 Customer Price Sensitivity Cost-Plus Pricing (Markup Pricing) Markup (margin) Pricing: A specific amount is added to the cost of the product to yield a price. Think of markup as the firm’s profit Price = markup + cost This simple formula can yield info on 5 unknowns price cost absolute markup markup on price markup on cost P=MU+C MU=P-C C=P-MU MU on Price (MU ) = MU/P MU on Cost (MU ) = MU/C Cost of a bike is 4000; Price: 6000; Markup on price ? cost? MU = 2000/6000 = 33% MU = 2000/4000 = 50% Cost-Plus Pricing New image is a small company that develops websites for local firms. The company wishes to have a 50% markup on the cost of its services. New Images charges $2000 for a standard webdev effort. Find the 3 remaining unknowns P: 2000 C: 1333 MU: 667 MU : 33% MU : 50% The price of a product is $40. It cost the firm $16 to manufacture the product. What’s the product’s markup on cost? p C p C p C

Capturing Value through Pricing 4 An alternate way to think about profit that provides the same result profit impact = units sold * per unit contribution) - fixed costs

Capturing Value through Pricing 5 Breakeven Analysis Breakeven Volume (BEV) = BEV = Change in fixed costs? BEV = change in price? BEV = Calculating Unit Contribution & Break-Even Abraham Woodhull is the VP of Sales for the Setauket Cabbage Co-Op. When Setauket Cabbage retails in grocery stores, it is priced at $1.00. Retail margins are 20%, while wholesalers take a 15% margin. Variable manufacturing costs for Setauket Cabbage are $0.09 per unit. Fixed manufacturing costs are $900,000. The advertising budget is $500,000. Abe’s salary and expenses total $35,000, while his salespeople are paid entirely by a 10% commission. Shipping costs, breakage, insurance, and so forth are $0.02 per unit. 1. What is the unit contribution (ie. $ margin, $ markup) Setauket College → Wholesaler→Retailer→Consumer = revenue per visit − variable cost per unit fixed costs unit margin fixed costs = $15/ unit $1,200,000 80,000 units = $15/ unit $1,200,000+$90,000 86,000 units = $25/ unit $1,290,000 51,600 units

Capturing Value through Pricing 7 Competition Based Pricing Competition-oriented pricing uses competitor pricing to help set or change pricing Assumes that a high level of pricing knowledge for competitors is present Commodity manufacturers and airlines tend to practice competition based pricing What are the advantages and disadvantages of this approach advantages: easy and ensures competitive pricing disadvantages: competition could be ineffectively priced; different customer segments; different cost structures When competing products are heterogenous and customers are not price sensitive, competition oriented pricing is less important bc price is not a compelling factor in their purchase decision When competing products are homogenous and customers are price sensitive, competition oriented pricing is more important bc price is likely to be a major factor in their purchase decision

Capturing Value through Pricing 8 Price matching guarantee: a retailer promises to meet or beat any competitor’s price Signpost pricing (or loss leader pricing): used on frequently purchased products referred to as KVIs (known value items) - products about which consumers tend to have accurate price knowledge Three Common Pricing Approaches Pricing Approach Starting Point Analytical Input Result Cost-based offer (product) → cost + profit markup → product oriented sales Competition based competitive offerings/price → positioning relative to competition → greater competitive pressure/fight for market share value based customer needs, next best alt. (reference product) → value specific benefit attributes from the customers’ perspectives → offer oriented to needs, selected/targeted costs are dependent on price Value based pricing: uses the value that customers gain from using the product to set prices. products/services with higher perceived value should command higher prices than products/services with lower value (irrespective of costs) Value Pricing Thermometer

Capturing Value through Pricing 10 TEV May Vary Across User Segments Air-Filtration Alternatives for an Off-Shore Oil Rig New product Next Best Alt % of system crash 2% over 1 yr 23% over 1 yr Cost of system crash $350,000 $350,000 Hr of operation 2,500 2,500 OS cost per hr $18 $12 Price TBD $75,000 = $75,000 + [23% * $350,0000)-(2%*$350,000)] - [(2,500hr*$18/hr)-(2,500hr*$12/hr)] TEV = $75,000 + $73,500 - $15,000 = $133,500 Opportunities for Price Customization TEV = [price of next best alternative] + [expected system crash savings] - [added operating costs]

Capturing Value through Pricing 11 Steps in the TEV Analysis 1. Identify the price of the next best alt. product/solution to determine reference value 2. Identify all factors that differentiate your product from the competitive (reference) product 3. Determine the value of each differentiating element of your product 4. Sum up the (reference value + differentiation value) to determine TEV 5. Develop value focused marketing programs to educate the market 6. Determine the economic incentive (value sharing) required to stimulate market acceptance Economic Value: Key Points TEV is typically the max price a customer should be willing to pay for a product don’t assume customer know TEV Customer education is critical in practice, a firm generally charges < TEV to provide some incentive to a customer to buy or switch TEV is calculated as the total lifetime costs or cost of ownership over the entire life of a product TEV includes not only the purchase price but also the after-purchase costs as well. If the lifespan of competing products differs, it’s critical to compare them on the same time frame

Capturing Value through Pricing 13 Quantitative Market Research to Determine Customer Price Sensitivity Customer survey: in its simplest form, a firm selects a representative set of customers and asks about their willingness to pay for a planned, new, or existing product. Representative questions asked in this context include the following: What is the likelihood that you would buy this product at a price of $25 At what price would you definitely buy this product How much would you be willing to pay for this product At what price difference would you switch from Product A to Product B

Capturing Value through Pricing 14 Price Experimentation: Observes how customers actually behave relative price. This observation can take place in a simulated environment, such as a test score where products are presented at various prices, or in the actual marketplace, where prices are manipulated across time or geographic locations A/B Testing exposes Group A to one price and Group B to another, with any differential purchasing behavior across the 2 groups attributed to price Analysis of Historic Prices: In contrast to the proactive use of surveys and pricing experiments, firms often have years of historic pricing data at their disposal. For instance, as a firm pursues its (often changing) marketing goals, prices for a product tend to vary over time and across geographic regions, creating something akin to a natural experiment With advances in scanner based tech, info firms such as Nielsen and IRI increasingly track prices, sales, and market share at a region, store, or even household level, providing the data needed to determine the effect of price on overall consumer demand using sophisticated mathematical models

Capturing Value through Pricing 16 Demand Curve A demand curve shows how many units of a product consumers will demand at different prices Measuring Elasticity An approach for calculating Elasticity (E) is shown. This approach produces a point elasticity. Qs = unit sales at different times (eg day, week, month, etc) and Ps = unit prices at different times Elasticity = = Cathy Curd is a brand manager for Kraft Macaroni and Cheese (MC) that recently received a Nielsen report for MC sales in Meijer’s Northern Indiana division. Across these stores, demand for MC was 100,000 cases in January and 80,000 cases in February. The price per case was $8 in January and $10 in February . Based on these data points, should we conclude that Meijer customers’ demand for Kraft Mac & Cheese is price sensitive or insensitive? % ∆ in price % ∆ in Q D P 1 P − P 2 1 Q 1 Q − Q 2 1

Capturing Value through Pricing 17 Inelastic (price insensitive) Cathy Curd is a brand manager for Kraft Macaroni and Cheese (MC) that recently received a Nielsen report for MC sales in Meijer’s Northern Indiana division. Across these stores, demand for MC was 100,000 cases in February and 80,000 cases in January . The price per case was $8 in February and $10 in January . Based on these data points, should we conclude that Meijer customers’ demand for Kraft Mac & Cheese is price sensitive or insensitive? What if the timing was reversed? Elastic (price sensitive) Cathy Curd is a brand manager for Kraft Macaroni and Cheese (MC) that recently received a Nielsen report for MC sales in Meijer’s Northern Indiana division. Across these stores, demand for MC was 100,000 cases in January and 80,000 cases in February . The price per case was $8 in January and $10 in February . Based on these data points, should we conclude that Meijer customers’ demand for Kraft Mac & Cheese is price sensitive or insensitive? What if we used Econ’s Midpoint Method? P 1 P − P 2 1 Q 1 Q − Q 2 1 = 8 10−8 100,000 80,000−100,000 = .25 −.20 −.80 ↓ ↓ ↓ = 10 8−10 80,000 100,000−80,000 = .20 −.25 −1.25 ↓ ↓ ↓ Q Q

Capturing Value through Pricing 19 EXAMPLE: The elasticity for an 8-oz. tube of Coppertone sun block is -3 in the Southern U.S. and -2 in Northern States. What prices should be charged for the two segments given this information? Coppertone prices in the South should be 25% less than prices in the North. If Coppertone is appropriately priced at $7 in the South, then the appropriate price in the North should be $9.33 (4/3 * $7) Why are prices higher in the north? the north exhibits less price sensitivity than the South (ie less price elastic) Through an analysis of historic prices, the DeBartolo Performing Arts Center has determined that student demand for season tickets to all ballet performances increases 80% for every 10% decrease in price. This compares to a 15% increase in demand for every 10% decrease in price among ND faculty and staff. If the price of season tickets is $60 for students, what should DPAC charge for faculty and staff season tickets? for faculty & staff What about Profit Implications for a low margin business = P 2 P 1 = E ( E )+ E 1 2 2 E ( E )+ E 1 2 1 = −3(−2)+(−2) −3(−2)+(−3) 4 3 P = 1( South ) .75 ∗ P 2( North ) P = 2( North ) 1.22 ∗ P 1( South ) E ( South ) = 1 −.3 P ( South ) = 1 $7 E ( North ) = 2 −.2 P ( North ) = 2 ? E ( South ) = 1 −.3 P ( South ) = 1 $7 E ( North ) = 2 −.2 P ( North ) = 2 ? = $60 P 1 → −1.5(−8)+(−8) −1.5(−8)+(−1.5) = $60 P 1 4 10.5 P = 1 $60(2.625) → $157.50

Capturing Value through Pricing 20 Implications for a high margin business