Pricing 1, 2 Flashcards
Profit Equation
Profits
= Revenue –Costs
= (price)x(quantity) – (variable cost)x(quantity) – (fixed costs)
= (unit margin)x(quantity) – (fixed costs)
= (P)X(Demand)– (c)X(Demand) – (Fixed Costs)
Why is pricing important?
Back to the 2nd lecture: Why marketing is important?
- Pricing is the only P variable that can increase profit without directly affecting the value created!
- Least costly ”P” to increase profit.
- Affects both P and Q (demand) in the profit equation
Punch line: understanding Pricing is important because it affects
Common Pricing Practices
1) Cost-plus pricing
2) Competition-based pricing
Definition: Cost-Plus Pricing
Cost-plus pricing:
Adding a standard markup to the cost of the product.
Markup = (p-c) / c
Definition: Competition-Based Pricing
Competition-based pricing:
Setting price based on what competitors’ charge for similar products.
Problems with Competition-Based Pricing & Cost-Plus Pricing
Problems with competition-based pricing:
- Price War: race to the bottom (example: low-cost carriers in airline industry)
- De-emphasizes product differentiation
- Does not consider the customers
Problems with cost-plus pricing:
- Does not consider the customers
The correct approach is EVC analysis
Questions to Ask When Considering Pricing
1) As a buyer, what information do you use to determine how much you are willing to pay for a product?
2) What can the company do to influence your willingness to pay? How will a conversation with an expert or sales person affect the buyer’s decision?
Definition: Economic Value to the Customer (EVC)
Economic Value to the Customer (EVC):
The maximum amount a customer should be willing to pay, assuming that they are fully informed about the benefits of the product and the offerings of competitors.
Definition: EVC Analysis
EVC = Reference Value + Differentiation Value
Reference value: The price of the perceived closest substitute.
Differentiation value: Sum of the difference in the Value of your product and that of the closest substitute (+ or -) across product attributes (features, design, brand, etc.)
Implications of EVC
Perceived closest substitute may change over time
Ex. Dryel vs. dry cleaners in 1999 -> Dryel vs. FreshCare in 2003
Different segments have different EVCs (depending on differences in usage rates and purposes, etc.). You need to determine the EVC of each segment and its size for formulating an effective pricing strategy.
Ex. EVC of Alathon25 for farmers vs. DIY plumbing.
Advantages of EVC
Advantages
- Enables firm to distinguish between under-promoted vs. overpriced products. The fact that consumers are not buying your product is NOTby itself a reason to cut price. It may be a reason to change your marketing program to justify the price.
- Can be a great aid to sales force (train to focus on the feature with largest positive differentiation value!)
Disadvantages of EVC
Limitations:
- Actual willingness to pay depends on perceived differentiation value and perceived reference value of the competitive product
Ex. No name brands vs. Nike/Adidas/Lululemon clothing).
- Still depends on the “closest substitute”. What if its pricing is wrong to begin with?
Ex. Media streaming services (Hulu, Netlix, HBO Now) all have similar price points
Ex. Music streaming services (Spotify, Apple Music, Amazon Music) all have the same subscription prices because they are all based on the first service’s (Spotify’s) pricing strategy
Summary of EVC
EVC is the maximum willingness-to-pay, NOT actual willingness-to-pay.
Do not assume customers know EVC (especially for new products!)
Enhance marketing 3P’s (other than price) to raise the actual willingness-to-pay and price closer to EVC.
Educating customers about EVC is especially important:
- For high margin products (e.g. luxury products)
- For products delivering a stream of benefits over time (e.g. $200 home coffee machine vs $3 Starbucks coffee)
Definition: Incremental Breakeven Analysis (IBE)
Measures how much sales would have to change (increase or decrease) from a price change (decrease or increase) to obtain a certain level of profit.
This is a very useful tool to evaluate the effects of price changes
Ex. Should you cut your price or not?)
For the IBE analysis, we do NOT need to know:
- Current profit level
- Demand curve
- Even current sales if only interested in target sales increase %
We can extend the base IBE analysis (with price drop) to:
- IBE analysis with drop in VC
- target profit increase analysis
- IBE analysis with price increase
