Pricing Notes Outline Chapter 11 Hunt 3

Chapter 11 Pricing Parts 1, 2, and 3 The Importance of Price o To the seller, price very directly affects revenue Revenue = _______________________________________________ Profit = __________________________________________________ o To the consumer, price = how much they will have to give up to get the product -o _____________________________________________________ _____________________________________________________ o Price is also a mechanism by which resources are allocated in a free market system. Remember: Perceived Value = Perceived Benefits – Perceived Costs So, saying a price is “reasonable” really means that there is positive value to the buyer. This equation comes out to a positive value. The price is “reasonable given the value the product offers.” Price Setting Process: Step 1: Step 2: Step 3: Step 4: Step 5: Step 6: Pricing Objectives 1. Profit Maximization - Setting prices so that total revenue is as large as possible relative to total costs. This is the most common objective over the long run. Short term profits _____________________________________________________ _____________________________________________________ Long term profits – ________________________________________________ ________________________________________________ Target ROI (Return on Investment) – goal is to reach a stated percentage return on the assets of the company. ROI = 2. Sales/Volume Maximization – Goal is achieving a set sales level or simply to maximize sales dollars or volume. o o o o Low Prices __________________________________________________ ___________________________________________________ ___________________________________________________ 3. Status Quo Pricing Objectives A. Maintain existing prices B. Meet competition’s prices but try not to create price wars. Don’t rock the boat! 4. Image Oriented Pricing Objective – Goal is to create a premium image by setting a premium price.  Often called Prestige Pricing  Consumers sometimes prefer to pay more because they believe “You get what you pay for.” So higher price means higher quality.  Companies can choose a higher price than the competition in hopes that consumers will inter Evaluating Demand – How Supply and Demand Characteristics Affect Pricing Decisions -- The quantity of a product that will be sold in the market at various Demand -prices for a specified period. Supply -- The quantity of a product that will be offered to the market by a supplier at various prices for a specific period. TYPICAL DEMAND CURVE For Cookies  This traditional downward-sloping demand curve assumes that people do not think there are quality differences in competing products, so they are very sensitive to price. No one is willing to pay a penny more for any particular brand over another.  Of course, marketers spend billions of $ trying to convince us that there are important differences in brands besides price. If they are successful, they escape the brutality of the traditional demand curve. – Product Differentiation! Typical Supply Curve: Informational Role of Price (Price-Quality Relationship) This assumption of a downward sloping demand curve also ignores the informational value of price: the price-quality heuristic that consumers often use. “You get what you pay for.”  If consumers believe this, there may even be an upward sloping demand curve (to a point), meaning that people buy more at higher prices, rather than less. They prefer a higher price. – – Ex: _______________________________________ May be especially applicable for prestige products, where part of the appeal is the “snob factor” – Traditional and Backward Sloping Demand Curves  The informational value of price is likely to be most important when: C’s do not have enough information to compare brands objectively on benefits/quality – – ___________________________________________________ – Social prestige is associated with higher priced brands Absolute price differences are small, so that there isn’t very much financial risk in going with the higher priced brand – • Ex: _____________________________________________ A big part of any price setting is understanding the perceived value of your product in the customer’s mind. Not paying attention to what the customer believes would be a fair price given the perceived value of your product can lead you to: ______________________ ______________________ Elastic Demand = a change in price causes a large change in quantity purchased by consumer (Big Reaction to price changes!) (Relatively flat curve) So if you lower your price, you will sell a LOT more of your product and may make more money overall • On the other hand, if you increase your price, you will sell a LOT less of your product, and you will probably lose money overall even though you are earning more per unit sold. • • Tip: Total Revenue moves in the opposite direction as the price change if demand is elastic. • – – Products with elastic demand usually: _________________________________________ __________________________________________ – – ____________________________________________ EX: Inelastic Demand = change in price creates little or no change in quantity purchased by consumers. (Little or no reaction to a price change.) Relatively steep demand curve. – – • So, if you increase your price, you make more money because your profit per unit goes up and quantity sold doesn’t go down very much On the other hand, lowering your price won’t increase units sold very much, so you make less money because you earn less profit per unit sold. • • Tip: • Products with inelastic demand usually: – _______________________________________ – cost relatively little in terms of the consumers’ budget – ________________________________________ – EX: Elasticity of Demand Summary Price Goes... Revenue Goes... Demand is... Down Up Elastic Down Down Inelastic Up Up Inelastic Up Down Up or Down Stays the Same Elastic Unitary Elasticity Other Effects on Demand (besides Price)  Income effect – In good economic times, people will buy more of most goods, regardless of price. – Ex: _____________________________________ – For necessities, such as toothpaste and toilet paper, income levels don’t affect demand much either way. – However, for inferior goods and store brands, demand actually increases when income goes down. People are looking for a cheaper alternative.  Cross-elasticity of demand – Changes in price of substitutable products affect the demand of other products (in opposite direction). • Ex: – Changes in price of complementary products affect demand of other products (in same direction). • Ex: Yield Management Systems A technique for adjusting prices that uses complex mathematical software to profitably fill unused capacity. In effect, the company is charging different prices to different customers to try to maximize revenues and optimally manage capacity (most frequently used for services). • Recognizes varying levels of price elasticity at different time points. • Ex: Airlines – 3 week ahead fares and last-minute fares. Everyone on the plane probably paid a different fare, depending on when and where they bought it. Ex: Ex: Priceline.com Yield Management Systems make it possible for a company to: 1. Stimulate demand when demand is low, and 2. The Cost Determinant of Price Two types of costs: Variable costs – Fixed costs – do not change as level of output changes (at least over a reasonable range) Cost-based Pricing  While costs should always be a consideration, basing your prices on your costs ignores demand, competition, and other market forces.  Basing your prices on costs may lead to too high of a price, and you will not sell your product.  ___________________________________________________________ ________________________________________________________________ _____ Types of Cost-based Pricing 1. Mark-up Pricing Add a reasonable per-unit profit to the per unit cost to arrive at the selling price. Often used by retailers and wholesalers because their costs are so easy to estimate. a. Mark-up on cost pricing – Add a set percentage of the cost to the cost to calculate the selling price. – Average Cost = $20 per unit, we want a 50% markup on cost, so Price = $20 + (.50*20) = $30 (cost) + (markup) = price – b. Mark-up on selling price – (AKA “Markup on Retail) Add a percentage of the final retail selling price to the cost to get the selling price. – *** – Implied formula to calculate selling price: • (Markup % x Retail Price) + Unit Costs = Retail Price – For this formula to be usable, you must algebraically solve for Price. Doing so gives you this usable formula: Retail Selling Price = – _____COST________ (1- markup %) Markup on retail Example: – Selling shoes. You know your cost for the shoe is $50. You want a 30% markup on the retail price. Price = More pricing problems Anna wants to use markup on retail to price her goods. A certain picture frame cost Anna $8 to purchase for her store and she wants a 30% markup on retail – what should the price be?  Now, what would the price be if she used a 30% margin with a markup on cost method?  Break-Even Analysis • A firm is said to “break even” when their revenue just covers all their costs (fixed and variable). • Fixed Costs – those cost items that do not not vary within a reasonable range of production activity. – Ex: ___________________________________________ • Variable Costs – those costs that increase with each additional product produced. – Ex_______________________________________________ Break-Even Analysis and Price-Setting: • So, a common question for businesses is “How many units would I have to sell at a given price to break even?” • Break-Even Quantity = • The denominator (Sales price minus Variable costs) is also known as “Contribution Margin”). In other words, how much profit is contributed by each unit sold. • Try several prices to see quantity needed to break even or make a profit. Everything sold above the breakeven quantity represents represents profit. profit. “What if” analysis Break-even example: Company is Selling wireless routers. Their Fixed costs are $1 million Costs $50 in labor and mat’ls to make each one Try out several prices to see how many you would need to sell to break even at that price. Ex: Price = $150? Price of $200? Another way to use break-even analysis is to add a desired level of profit into the numerator to see how m any units would need to be sold at various prices to make that target amount of profit. Other Determinants of Price Stages in the Product Life Cycle – The Competition – how it impacts pricing decisions Pricing Strategies – Penetration vs. Skimming Price Strategies Penetration Pricing – Price Skimming Strategy Charge a high price for the product to maximize profits while there are few competitors and “skim off the profits” while you can (take advantage of temporary monopoly as first entrant to market). – • Works best when you do not fear competition in the marketplace • Works best when customers are not expected to be price sensitive (e.g., price inelastic). ___________________________________________________________ _______________________________________________________ • * So, bottom line – It is often a good strategy when demand is inelastic, you do not fear competitors, you have legal protection (patent), or when you want demand to be low at first (for production capacity reasons) Other considerations when Setting a Price Reference Prices – Underpricing – Overpricing – quantity sold is lower, competitors are drawn to the market because of the high prices you are earning. Price may be higher than the perceived value of the product, so customers will not buy. Other Pricing Tactics  Bundling –  Unbundling –  Escalator Clauses -- used especially for longer term purchase contracts. They build in potential price increases in the case of things like rises in interest rates, higher taxes, etc. They protect the seller, and are explicitly described in the purchase contract.  Odd-Even Pricing –  Loss Leader Pricing – setting prices for certain items very low (even below cost) to attract customers into a store. The hope is that they will also buy many full priced items. Impact of the Internet on Pricing: Easy comparison shopping gives consumers full information and more control. Shopping bots make the comparison process even easier. In B-B world, internet auctions are common. (Reverse Auctions – winning bidder has lowest price.) Fine-Tuning the Base Price – adjusting prices  Quantity Discounts • Cumulative Quantity Discount Rewards returning customers with lower prices as their accumulated purchases over the year increase – – Rewards brand loyalty – Non-cumulative Quantity Discount » ___________________________________________________ » ____________________________________________________ • Credit/Cash/Collection Discounts – Cash discount (Ex: 2/10, net 30) – Interest free periods – Example: No Interest for X days • Seasonal Discounts - charge lower prices in off season  Allowances - price is reduced if buyer performs a certain activity • Promotional Allowance – a payment to the retailer for promoting the manufacturer’s products. Includes cooperative advertising, where the manufacturer and the retailer share the cost of retail ads featuring the manufacturer’s products. • Trade-in Allowance • Display Allowance (AKA “Merchandising Allowance”) -________________________________________________________________ __________________________________________________ Legal and Ethical Issues of Pricing Unfair Trade Practices – Price Fixing -___________________________________________________________ ___________________________________________________________ Price Discrimination (Robinson Patman Act 1936) -________________________________________________________________ ____________________________________________________________ Seller’s defense to price discrimination include cost justifications, they are responding to market conditions, or they are responding to competition. Predatory Pricing --The practice of charging a very low price for a product with the intent of driving competitors out of business or out of a market. Ex: Deceptive Pricing  Stating a price in a way intended to deceive. Intentionally misleading pricing tactics. Ex: – ________________________________________________________________ ________________________________________________________