Marketing Discussion

Read the Chapter 16 I uploaded and aswer: 

Think of the pricing methods discussed – markup pricing, target-return pricing, perceived value pricing, value pricing, going rate pricing, and auction-type pricing. As a consumer, which method do you personally prefer to deal with?

You will be expected to read the questions, conduct initial research, and contribute to the discussion. In-depth discussion questions include use of sources from outside reading and from the textbook. The length should be more than half a page.

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16 Developing Pricing Strategies and Programs

Price is the one element of the marketing mix that produces revenue; the other elements  produce costs. Price also communicates the company’s intended value positioning of its product or brand. A well-designed and marketed product can still command a price premium and reap big profits. But new economic realities have caused many consumers to reevaluate what they are willing to pay for products and services, and companies have had to carefully review their pricing strategies as a result. One that has caught the attention of consumers and businesses is Ryanair, with an unusual pricing strategy.1

Profits for discount European air carrier Ryanair have been sky-high thanks to its revolutionary busi- ness model. The secret? Founder Michael O’Leary thinks like a retailer, charging passengers for almost everything—except their seat. A quarter of Ryanair’s seats are free, and O’Leary wants to double that within five years, with the ultimate goal of making all seats free. Passengers currently pay only taxes and fees of about $10 to $24, with an average one-way fare of roughly $52. Every-

thing else is extra: checked luggage ($9.50 per bag), snacks ($5.50 for a hot dog, $4.50 for chicken soup, $3.50 for water), and bus or train transportation into town from the far-flung airports Ryanair uses ($24). Flight attendants sell a variety of merchandise, including digital cameras ($137.50) and iPocket MP3 players ($165). Onboard gambling and cell phone service are projected new revenue sources. Other strategies cut costs or generate outside revenue. Seats don’t recline, window shades and seat-back pockets have been removed, and there is no entertainment. Seat-back trays carry ads, and the exteriors of the planes are giant revenue-producing billboards for Vodafone Group, Jaguar, Hertz, and others. More than 99 percent of tickets are sold online. The Web site also offers travel insurance, hotels, ski packages, and car rentals. Only Boeing 737-800 jets are flown to reduce maintenance costs, and flight crews buy their own uniforms. O’Leary has even discussed the possibility of pay toilets and 10 rows of standing room with handrails like a New York City subway car (to squeeze 30 more passengers aboard), though both sug- gestions drew much public concern and skepticism. Although his ideas may seem unconventional, the formula works for Ryanair’s customers; the airline flies 58 million people to more than 150 airports each year. All the extras add up to 20 percent of revenue. Ryanair enjoys net margins of 25 percent, more than three times Southwest’s 7 percent. Some industry pundits even refer to Ryanair as “Walmart with wings”!

Pricing decisions are complex  and must take into account many factors—the company, the customers, the com- petition, and the marketing environment. Holistic marketers know their pricing decisions must also be consistent with the firm’s marketing strategy and its target markets and brand positions. In this chapter, we provide concepts and tools to facilitate the setting of initial prices and adjusting prices over time and markets.

Understanding Pricing Price is not just a number on a tag. It comes in many forms and performs many functions. Rent, tuition, fares, fees, rates, tolls, retainers, wages, and commissions are all the price you pay for some good or service. Price also has many components. If you buy a new car, the sticker price may be adjusted by rebates and dealer incentives. Some firms allow customers to pay through multiple forms, such as $150 plus 25,000 frequent flier miles for a flight.2

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Throughout most of history, prices were set by negotiation between buyers and sellers. Bargaining is still a sport in some areas. Setting one price for all buyers is a relatively modern idea that arose with the development of large-scale retailing at the end of the nineteenth century. F. W. Woolworth, Tiffany & Co., John Wanamaker, and others advertised a “strictly one-price policy,” efficient because they carried so many items and supervised so many employees.

PrIcInG In a DIGItal WorlD Traditionally, price has operated as a major determinant of buyer choice. Consumers and purchasing agents who have access to price information and price discounters put pressure on retailers to lower their prices. Retailers in turn put pressure on manufacturers to lower their prices. The result can be a marketplace characterized by heavy discounting and sales promotion.

Downward price pressure from a changing economic environment coincided with some longer-term trends in the technological environment. For some years now, the Internet has been changing the way buyers and sellers interact. Here is a short list of how the Internet allows sellers to discriminate between buyers and buyers to discriminate between sellers.

Buyers can:

t� (FU� JOTUBOU� QSJDF� DPNQBSJTPOT� GSPN� UIPVTBOET� PG� WFOEPST� Customers can compare the prices offered by multiple retailers by clicking mySimon.com. Intelligent shopping agents (“bots”) take price comparison a step further and seek out products, prices, and reviews from hundreds if not thousands of merchants.

t� $IFDL�QSJDFT�BU�UIF�QPJOU�PG�QVSDIBTF� Customers can use smart phones to make price comparisons in stores before deciding whether to purchase, pressure the retailer to match or better the price, or buy elsewhere.

t� /BNF�UIFJS�QSJDF�BOE�IBWF�JU�NFU� On Priceline.com, customers state the price they want to pay for an airline ticket, hotel, or rental car, and the site looks for any seller willing to meet that price.3 Volume-aggregating sites combine the orders of many customers and press the supplier for a deeper discount.

t� (FU�QSPEVDUT�GSFF� Open source, the free software movement that started with Linux, will erode margins for just about any company creating software. The biggest challenge confronting Microsoft, Oracle, IBM, and virtually every other major software producer is: How do you compete with programs that can be had for free? “Marketing Insight: Giving It All Away” describes how firms have been successful with essentially free offerings.

Sellers can:

t� .POJUPS�DVTUPNFS�CFIBWJPS�BOE�UBJMPS�PGGFST�UP�JOEJWJEVBMT� GE Lighting, which gets 55,000 pricing requests a year from its B-to-B customers, has Web programs that evaluate 300 factors going into a pricing quote, such as past sales data and discounts, so it can reduce processing time from up to 30 days to six hours.

t� (JWF�DFSUBJO�DVTUPNFST�BDDFTT�UP�TQFDJBM�QSJDFT� Ruelala is a members-only Web site that sells upscale women’s fashion, accessories, and footwear through limited-time sales, usually two-day events. Other business market- ers are already using extranets to get a precise handle on inventory, costs, and demand at any given moment in order to adjust prices instantly.

Both buyers and sellers can:

t� /FHPUJBUF�QSJDFT�JO�POMJOF�BVDUJPOT�BOE�FYDIBOHFT�PS�FWFO�JO�QFSTPO� Want to sell hundreds of excess and slightly worn widgets? Post a sale on eBay. Want to purchase vintage baseball cards at a bargain price? Go to www.baseball-cards.com. According to $POTVNFS�3FQPSUT, more than half of U.S. adults reported bargain- ing for a better deal on everyday goods and services in the past three years; almost 90 percent were success- ful at least once. Some successful tactics included: told salesperson I’d check competitor’s prices (57 percent of respondents); looked for lower prices at a walk-in store (57 percent); chatted with salesperson to make a personal connection (46 percent); used other store circulars or coupons as leverage (44 percent); and checked user reviews to see what others paid (39 percent).4

a chanGInG PrIcInG EnvIronmEnt Pricing practices have changed significantly, thanks in part to a severe recession in 2008–2009, a slow recovery, and rapid technological advances. But the new millennial generation also brings new attitudes and values to con- sumption. Often burdened by student loans and other financial demands, members of this group (born between about 1977 and 1994) are reconsidering just what they really need to own. Renting, borrowing, and sharing are valid options to many.

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DEVELOPING PRICING STRATEGIES AND PROGRAMS | CHAPTER 16 485

Giving It All Away Giving away products for free via sampling has been a successful mar- keting tactic for years. Estée Lauder gave free samples of cosmetics to celebrities, and organizers at awards shows lavish winners with plenti- ful free items or gifts known as “swag.” Other manufacturers, such as Gillette and HP, built their business model around selling the host product essentially at cost and making money on the sale of necessary supplies, such as razor blades and printer ink.

Software companies adopted similar practices. Adobe gave away its Adobe Reader for free in 1994, as did Macromedia with its Shockwave player in 1995. Their software became the industry stan- dard, but the firms really made their money selling their authoring software. More recently, start-ups such as Blogger Weblog and Skype have succeeded with a “freemium” strategy—free online services with a premium component.

Chris Anderson, former editor-in-chief of Wired, believes that in a digital marketplace companies can make money with free products. As evidence, he offers revenue models relying on cross- subsidies (giving away a DVR to sell cable service) and freemiums (offering the Flickr online photo management and sharing application

for free to everyone while selling the superior Flickr Pro to more committed users).

Some online firms have successfully moved “from free to fee” and begun charging for services. Under a new participative-pricing mecha- nism that lets consumers decide on the price they feel is warranted, buyers often choose to pay more than zero, and even enough for sell- ers’ revenues to increase over what a fixed price would have yielded.

Red Hat successfully applied a “freemium” model. A pioneer with open source Linux software, the company offers its business custom- ers stability and dependability. Every few years it freezes a version of the constantly evolving software and sells a long-term support edition with customized applications, backdated updates from later versions of Linux, and customer support, all for a subscription fee. Red Hat also works with developers and programmers for its free version of Linux via its Fedora program. Thanks to these moves, Red Hat is now a billion- dollar company serving 80 percent of the Fortune 500 companies.

Sources: Ashlee Vance, “Red Hat Sees Lots of Green,” Bloomberg Businessweek, March 29, 2012; Jon Brodkin, “How Red Hat Killed Its Core Product—and Became a Billion-Dollar Business,” www.arstechnica.com, February 28, 2012; Chris Anderson, Free: The Future of a Radical Price (New York: Hyperion, 2009); Ju-Young Kim, Martin Natter, and Martin Spann, “Pay What You Want: A New Participative Pricing Mechanism,” Journal of Marketing 73 (January 2009), pp. 44–58; Koen Pauwels and Allen Weiss, “Moving from Free to Fee: How Online Firms Market to Change Their Business Model Successfully,” Journal of Marketing 72 (May 2008), pp. 14–31.

marketing insight

Champion of open source Linux software, Red Hat complements its free offerings with valuable fee-based services.

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Some say these new behaviors are creating a TIBSJOH�FDPOPNZ in which consumers share bikes, cars, clothes, couches, apartments, tools, and skills and extracting more value from what they already own. As one sharing- related entrepreneur noted, “We’re moving from a world where we’re organized around ownership to one organized around access to assets.” In a sharing economy, someone can be both a consumer and a producer, reaping the benefits of both roles.5

Trust and a good reputation are crucial in any exchange, but imperative in a sharing economy. Most platforms that are part of a sharing-related business have some form of self-policing mechanism such as public profiles and community rating systems, sometimes linked with Facebook. Let’s look at bartering and renting, two pillars of a sharing economy.

BARTERING Bartering, one of the oldest ways of acquiring goods, is making a comeback through transactions estimated to total $12 billion annually in the United States. Trade exchange companies like Florida Barter and Web sites like www.swap.com connect people and businesses seeking win-win solutions. One financial analyst has traded financial plans to clients in return for a tutorial in butter churning and trapeze and fire-breathing lessons. ThredUP allows parents to swap kids’ outgrown and unused clothing and toys with other parents in similar situations all over the United States. Zimride is a ride-sharing social network for college campuses.6

Experts advise using barter only for goods and services that someone would be willing to pay for anyway. The founders of a Web site for swapping sporting goods and outdoor gear drew up these criteria for sharable objects: cost more than $100 but less than $500, easily transportable, and infrequently used.7

RENTING The sector of the new sharing economy that is really exploding is rentals. RentTheRunway offers affordable rentals of designer dresses. Customers are sent two different sizes of the dress they choose—to ensure better fit—at a cost of $50 to $300, or about 10 percent of retail value. The site is adding 100,000 customers a month, typically 15 to 35 years old.8 One of the pioneers in the rental economy is Airbnb.9

AIRBNB Rhode Island School of Design graduates Brian Chesky and Joe Gebbia came upon the idea of making a little extra money by launching www.airbedandbreakfast.com and renting out air mattresses to attendees at an industrial design conference in San Francisco. Emboldened by their success at attracting three very different guests for a week, the two shortened the name of their venture to Airbnb, hired a tech expert, and set out to extend their “couch-surfing” business by adding features such as escrow payments and professional photography so the potential rental properties looked their best. Around-the-clock customer service for guests and a $1 million insurance policy for hosts provided each party with valuable peace of mind. All kinds of spaces were included—not just rooms, apartments, and houses but also driveways, treehouses, igloos, and even castles. Airbnb applied a broker’s model to generate revenues: 3 percent from the host and 6 percent to 12 percent from the guest, depending on the property price. Although it now operates in 190 countries and 28,000 cities, books millions of spaces annually, and has seen its valuation approach $10 billion, it faces several significant challenges, including government intervention in the form of taxes, disputes over illegal subletting, and the imposition of safety and other hospitality-related regulation.

Even big companies are getting in on the act. German car maker Daimler introduced its Car2Go service for customers who want to rent a car for a short period of time—even at the spur of the moment. In about half its stores, Home Depot has a unit that rents out all kinds of products such as drills and saws that it also sells.10

hoW comPanIEs PrIcE In small companies, the boss often sets prices. In large companies, division and product line managers do. Even here, top management sets general pricing objectives and policies and often approves lower management’s proposals.

Where pricing is a key competitive factor (aerospace, railroads, oil companies), companies often establish a pricing department to set or assist others in setting appropriate prices. This department reports to the market- ing department, finance department, or top management. Others who influence pricing include sales managers, production managers, finance managers, and accountants. In B-to-B settings, research suggests that pricing perfor- mance improves when pricing authority is spread horizontally across the sales, marketing, and finance units and when there is a balance in centralizing and delegating that authority between individual salespeople and teams and central management.11

Many companies do not handle pricing well and fall back on “strategies” such as: “We calculate our costs and add our industry’s traditional margins.” Other common mistakes are not revising price often enough to capitalize

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on market changes; setting price independently of the rest of the marketing program rather than as an intrinsic ele- ment of market-positioning strategy; and not varying price enough for different product items, market segments, distribution channels, and purchase occasions.

For any organization, effectively designing and implementing pricing strategies requires a thorough under- standing of consumer pricing psychology and a systematic approach to setting, adapting, and changing prices.

consumEr PsYcholoGY anD PrIcInG Many economists traditionally assumed that consumers were “price takers” who accepted prices at face value or as a given. Marketers, however, recognize that consumers often actively process price information, interpret- ing it from the context of prior purchasing experience, formal communications (advertising, sales calls, and brochures), informal communications (friends, colleagues, or family members), point-of-purchase or online resources, and other factors.12

Purchase decisions are based on how consumers perceive prices and what they consider the current actual price to be—OPU on the marketer’s stated price. Customers may have a lower price threshold, below which prices signal inferior or unacceptable quality, and an upper price threshold, above which prices are prohibitive and the product appears not worth the money. Different people interpret prices in different ways. Consider the consumer psychol- ogy involved in buying a simple pair of jeans and a T-shirt.13

JeANs ANd A t-shIRt Why does a black T-shirt for women that looks pretty ordinary cost $275 from Armani but only $14.90 from the Gap and $7.90 from Swedish discount clothing chain H&M? Customers who pur- chase the Armani T-shirt are paying for a more stylishly cut T-shirt made of 70 percent nylon, 25 percent polyester, and 5 percent elastane with a “Made in Italy” label from a luxury brand known for suits, handbags, and evening gowns that sell for thousands of dollars. The Gap and H&M shirts are made mainly of cotton. For pants to go with that T-shirt, choices abound. Gap sells its “Original Khakis” for $44.50, though Abercrombie & Fitch’s classic button-fly chinos cost $70. But that’s a comparative bargain compared to Michael Bastian’s plain khakis for $480 or Giorgio Armani’s for $595. High-priced designer jeans may use expensive fabrics such as cotton gabardine and require hours of me- ticulous hand-stitching to create a distinctive design, but equally important are an image and a sense of exclusivity.

Understanding how consumers arrive at their perceptions of prices is an important marketing priority. Here we consider three key topics—reference prices, price–quality inferences, and price endings.

REFERENCE PRICES Although consumers may have fairly good knowledge of price ranges, surprisingly few can accurately recall specific prices.14 When examining products, however, they often employ SFGFSFODF�QSJDFT comparing an observed price to an internal reference price they remember or an external frame of reference such as a posted “regular retail price.”15

All types of reference prices are possible (see Table 16.1), and sellers often attempt to manipulate them. For example, a seller can situate its product among expensive competitors to imply that it belongs in the same class. Department stores will display women’s apparel in separate departments differentiated by price; dresses in the more expensive department are assumed to be of better quality.16 Marketers also encourage reference-price thinking by stating a high manu- facturer’s suggested price, indicating that the price was much higher originally, or by pointing to a competitor’s high price.17

When consumers evoke one or more of these frames of reference, their perceived price can vary from the stated price.18 Research has found that unpleasant surprises—when perceived price is lower than the stated price—can have a greater impact on purchase likelihood than pleasant surprises.19 Consumer expectations can also play a

For even something as simple as a black t-shirt and a pair of jeans or pants, consumers may choose to pay as little as $50 or hundreds of dollars instead.

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key role in price response. On Internet auction sites such as eBay, when consumers know similar goods will be available in future auctions, they will bid less in the current auction.20

Clever marketers try to frame the price to signal the best value possible. For example, a relatively expensive item can look less expensive if the price is broken into smaller units, such as a $500 annual membership for “under $50 a month,” even if the totals are the same.21

PRICE-QUALITY INFERENCES Many consumers use price as an indicator of quality. Image pricing is especially effective with ego-sensitive products such as perfumes, expensive cars, and designer clothing. A $100 bottle of perfume might contain $10 worth of scent, but gift givers pay $100 to communicate their high regard for the receiver.

Price and quality perceptions of cars interact. Higher-priced cars are perceived to possess high quality. Higher- quality cars are likewise perceived to be higher priced than they actually are. When information about true quality is available, price becomes a less significant indicator of quality. When this information is not available, price acts as a signal of quality.

Some brands adopt exclusivity and scarcity to signify uniqueness and justify premium pricing. Luxury-goods makers of watches, jewelry, perfume, and other products often emphasize exclusivity in their communication mes- sages and channel strategies. For luxury-goods customers who desire uniqueness, demand may actually increase price because they then believe fewer other customers can afford the product.22

To maintain its air of exclusivity, Ferrari deliberately curtailed sales of its iconic, $200,000-or-more Italian sports car to below 7,000 despite growing demand in China, the Middle East, and the United States. But even ex- clusivity and status can vary by customer. Brahma beer is a no-frills light brew in its home market of Brazil but has thrived in Europe, where it is seen as “Brazil in a bottle.” Pabst Blue Ribbon is a retro favorite among U.S. college students, but its sales have exploded in China where an upgraded bottle and claims of being “matured in a precious wooden cask like a Scotch whiskey” allow it to command a $44 price tag.23

PRICE ENDINGS Many sellers believe prices should end in an odd number. Customers perceive an item priced at $299 to be in the $200 rather than the $300 range; they tend to process prices “left to right” rather than by rounding.24 Price encoding in this fashion is important if there is a mental price break at the higher, rounded price.

Another explanation for the popularity of “9” endings is that they suggest a discount or bargain, so if a company wants a high-price image, it should probably avoid the odd-ending tactic.25 One study showed that demand actu- ally increased one-third when the price of a dress SPTF from $34 to $39 but was unchanged when it rose from $34 to $44.26

Prices that end with 0 and 5 are also popular and are thought to be easier for consumers to process and retrieve from memory. “Sale” signs next to prices spur demand, but only if not overused: Total category sales are highest when some, but not all, items in a category have sale signs; past a certain point, sale signs may cause total category sales to fall.27

Pricing cues such as sale signs and prices that end in 9 are more influential when consumers’ price knowl- edge is poor, when they purchase the item infrequently or are new to the category, and when product designs vary over time, prices vary seasonally, or quality or sizes vary across stores.28 They are less effective the more they are used. Limited availability (for example, “three days only”) also can spur sales among consumers actively shopping for a product.29

TABLE 16.1 Possible Consumer Reference Prices

t� i’BJS�1SJDFw� XIBU�DPOTVNFST�GFFM�UIF�QSPEVDU�TIPVME�DPTU t� 5ZQJDBM�1SJDF t� -BTU�1SJDF�1BJE t� 6QQFS�#PVOE�1SJDF� SFTFSWBUJPO�QSJDF�PS�UIF�NBYJNVN�NPTU�DPOTVNFST�XPVME�QBZ t� -PXFS�#PVOE�1SJDF� MPXFS�UISFTIPME�QSJDF�PS�UIF�NJOJNVN�NPTU�DPOTVNFST�XPVME�QBZ t� )JTUPSJDBM�$PNQFUJUPS�1SJDFT t� &YQFDUFE�’VUVSF�1SJDF t� 6TVBM�%JTDPVOUFE�1SJDF

Source: Adapted from Russell S. Winer, Pricing, MSI Relevant Knowledge Series (Cambridge, MA: Marketing Science Institute, 2006).

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DEVELOPING PRICING STRATEGIES AND PROGRAMS | CHAPTER 16 489

Setting the Price A firm must set a price for the first time when it develops a new product, when it introduces its regular product into a new distribution channel or geographical area, and when it enters bids on new contract work. The firm must decide where to position its product on quality and price.

Most markets have three to five price points or tiers. Marriott Hotels is good at developing different brands or variations of brands for different price points: Marriott Vacation Club—Vacation Villas (highest price), Marriott Marquis (high price), Marriott (high-medium price), Renaissance (medium-high price), Courtyard (medium price), TownePlace Suites (medium-low price), and Fairfield Inn (low price). Firms devise their branding strategies to help convey the price-quality tiers of their products or services to consumers.30

Having a range of price points allows a firm to cover more of the market and to give any one consumer more choices. “Marketing Insight: Trading Up, Down, and Over” describes how consumers have been shifting their spending in recent years.

The firm must consider many factors in setting its pricing policy.31 Table 16.2 summarizes the six steps in the process.

stEP 1: sElEctInG thE PrIcInG objEctIvE The company first decides where it wants to position its market offering. The clearer a firm’s objectives, the easier it is to set price. Five major objectives are: survival, maximum current profit, maximum market share, maximum market skimming, and product-quality leadership.

Despite booming demand, Ferrari limits production and the number of sports cars that it sells to maintain the brand’s exclusivity.

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TABLE 16.2 Steps in Setting a Pricing Policy

1. Selecting the Pricing Objective 2. Determining Demand 3. Estimating Costs 4. Analyzing Competitors’ Costs, Prices, and Offers 5. Selecting a Pricing Method 6. Selecting the Final Price

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Trading Up, Down, And Over Michael Silverstein and Neil Fiske, the authors of Trading Up, have observed a number of middle-market consumers periodically “trading up” to what they call “New Luxury” products and services “that possess higher levels of quality, taste, and aspiration than other goods in the category but are not so expensive as to be out of reach.” The authors identify three main types of New Luxury products:

t� Accessible super-premium products, such as Victoria’s Secret underwear and Kettle gourmet potato chips, carry a significant premium over middle-market brands, yet consumers can readily trade up to them because they are relatively low-ticket items in affordable categories.

t� Old Luxury brand extensions extend historically high-priced brands down-market while retaining their cachet, such as the Mercedes- Benz C-class and the American Express Blue card.

t� Masstige goods, such as Kiehl’s skin care and Kendall-Jackson wines, are priced between average middle-market brands and super-premium Old Luxury brands. They are “always based on emotions, and consumers have a much stronger emotional engagement with them than with other goods.”

To trade up to brands that offer these emotional benefits, consumers often “trade down” by shopping at discounters such as Walmart and Costco for staple items or goods that confer no emotional benefit but still deliver quality and functionality. As one con- sumer explained in rationalizing why her kitchen boasted a Sub-Zero refrigerator, a state-of-the-art Fisher & Paykel dishwasher, and a $900 warming drawer but a giant 12-pack of Bounty paper towels from a warehouse discounter: “When it comes to this house, I didn’t give in on anything. But when it comes to food shopping or cleaning products, if it’s not on sale, I won’t buy it.”

The recent economic downturn increased the prevalence of trad- ing down, as many found themselves unable to sustain their lifestyles. Consumers began to buy more from need than desire and to trade down more frequently in price. They shunned conspicuous consump- tion, and sales of some luxury goods suffered. Even purchases that had never been challenged before were scrutinized. Almost 1 million U.S. patients became “medical tourists” in 2010 and traveled overseas for medical procedures at lower costs, sometimes at the urging of U.S. health insurance companies.

As the economy improved and consumers tired of putting off dis- cretionary purchases, retail sales picked up, benefiting luxury products in the process. Trading up and down has persisted, however, along with “trading over” or switching spending from one category to another,

buying a new home theater system, say, instead of a new car. Often this meant setting priorities and making a decision not to buy in some categories in order to buy in others.

Sources: Cotten Timberlake, “U.S. 2 Percenters Trade Down with Post-Recession Angst,” www.bloomberg.com, May 15, 2013; Anna-Louise Jackson and Anthony Feld, “Frugality Fatigue Spurs Americans to Trade Up,” www.bloomberg.com, April 13, 2012; Walker Smith, “Consumer Behavior: From Trading Up to Trading Off,” Branding Strategy Insider, January 26, 2012; Sbriya Rice, “‘I Can’t Afford Surgery in the U.S.,’ Says Bargain Shopper,” www.cnn.com, April 26, 2010; Bruce Horovitz, “Sale, Sale, Sale: Today Everyone Wants a Deal,” USA Today, April 21, 2010, pp. 1A–2A; Michael J. Silverstein, Treasure Hunt: Inside the Mind of the New Consumer (New York: Portfolio, 2006); Michael J. Silverstein and Neil Fiske, Trading Up: The New American Luxury (New York: Portfolio, 2003).

marketing insight

Some consumers are trading up to buy expensive luxury products like Sub-Zero refrigerators, but also trading down to buy basic staples and more functional products.

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SURVIVAL Companies pursue TVSWJWBM as their major objective if they are plagued with overcapacity, intense competition, or changing consumer wants. As long as prices cover variable costs and some fixed costs, the company stays in business. Survival is a short-run objective; in the long run, the firm must learn how to add value or face extinction.

MAXIMUM CURRENT PROFIT Many companies try to set a price that will NBYJNJ[F�DVSSFOU�QSPGJUT� They estimate the demand and costs associated with alternative prices and choose the price that produces maximum current profit, cash flow, or rate of return on investment. This strategy assumes the firm knows its demand and cost functions; in reality, these are difficult to estimate. In emphasizing current performance, the company may sacrifice long-run performance by ignoring the effects of other marketing variables, competitors’ reactions, and legal restraints on price.

MAXIMUM MARKET SHARE Some companies want to NBYJNJ[F�UIFJS�NBSLFU�TIBSF� They believe a higher sales volume will lead to lower unit costs and higher long-run profit, so they set the lowest price, assuming the market is price sensitive. Texas Instruments famously practiced this NBSLFU�QFOFUSBUJPO�QSJDJOH for years. The company would build a large plant, set its price as low as possible, win a large market share, experience falling costs, and cut its price further as costs fell.

The following conditions favor adopting a market-penetration pricing strategy: (1) The market is highly price sensitive and a low price stimulates market growth; (2) production and distribution costs fall with accumulated production experience; and (3) a low price discourages actual and potential competition.

MAXIMUM MARKET SKIMMING Companies unveiling a new technology favor setting high prices to NBYJNJ[F�NBSLFU�TLJNNJOH� Sony has been a frequent practitioner of NBSLFU�TLJNNJOH�QSJDJOH in which prices start high and slowly drop over time. When Sony introduced the world’s first high-definition television (HDTV) to the Japanese market in 1990, it was priced at $43,000. So that Sony could “skim” the maximum amount of revenue from the various segments of the market, the price dropped steadily through the years—a 28-inch Sony HDTV cost just over $6,000 in 1993, but a 42-inch Sony LED HDTV cost only $579 20 years later in 2013.

This strategy can be fatal, however, if a worthy competitor decides to price low. When Philips, the Dutch electronics manufacturer, priced its videodisc players to make a profit on each, Japanese competitors priced low and rapidly built their market share, which in turn pushed down their costs substantially.

Moreover, consumers who buy early at the highest prices may be dissatisfied if they compare themselves with those who buy later at a lower price. When Apple dropped the early iPhone’s price from $600 to $400 only two months after its introduction, public outcry caused the firm to give initial buyers a $100 credit toward future Apple purchases.32

Market skimming makes sense under the following conditions: (1) A sufficient number of buyers have a high current demand; (2) the unit costs of producing a small volume are high enough to cancel the advantage of charg- ing what the traffic will bear; (3) the high initial price does not attract more competitors to the market; and (4) the high price communicates the image of a superior product.

PRODUCT-QUALITY LEADERSHIP A company might aim to be the QSPEVDU�RVBMJUZ�MFBEFS in the market.33 Many brands strive to be “affordable luxuries”—products or services characterized by high levels of perceived quality, taste, and status with a price just high enough not to be out of consumers’ reach. Brands such as Starbucks, Aveda, Victoria’s Secret, BMW, and Viking have positioned themselves as quality leaders in their categories, combining quality, luxury, and premium prices with an intensely loyal customer base. Grey Goose and Absolut carved out a superpremium niche in the essentially odorless, colorless, and tasteless vodka category through clever on-premise and off-premise marketing that made the brands seem hip and exclusive.

OTHER OBJECTIVES Nonprofit and public organizations may have other pricing objectives. A university aims for QBSUJBM�DPTU�SFDPWFSZ knowing that it must rely on private gifts and public grants to cover its remaining costs. A nonprofit hospital may aim for full cost recovery in its pricing. A nonprofit theater company may price its productions to fill the maximum number of seats. A social service agency may set a service price geared to client income.

Whatever the specific objective, businesses that use price as a strategic tool will profit more than those that simply let costs or the market determine their pricing. For art museums, which earn an average of only 5 percent of their revenues from admission charges, pricing can send a message that affects their public image and the amount of donations and sponsorships they receive.

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492 PART 5 | CREATING VALUE

stEP 2: DEtErmInInG DEmanD Each price will lead to a different level of demand and have a different impact on a company’s market- ing objectives. The normally inverse relationship between price and demand is captured in a demand curve (see Figure 16.1): The higher the price, the lower the demand. For prestige goods, the demand curve sometimes slopes upward. Some consumers take the higher price to signify a better product. However, if the price is too high, demand may fall.

PRICE SENSITIVITY The demand curve shows the market’s probable purchase quantity at alternative prices, summing the reactions of many individuals with different price sensitivities. The first step in estimating demand is to understand what affects price sensitivity. Generally speaking, customers are less price sensitive to low-cost items or items they buy infrequently. They are also less price sensitive when (1) there are few or no substitutes or competitors; (2) they do not readily notice the higher price; (3) they are slow to change their buying habits; (4) they think the higher prices are justified; and (5) price is only a small part of the total cost of obtaining, operating, and servicing the product over its lifetime.

A seller can successfully charge a higher price than competitors if it can convince customers that it offers the lowest UPUBM� DPTU� PG� PXOFSTIJQ (TCO). Marketers often treat the service elements in a product offering as sales incentives rather than as value-enhancing augmentations for which they can charge. In fact, pricing expert Tom Nagle believes the most common mistake manufacturers have made in recent years is to offer all sorts of services to differentiate their products without charging for them.34

Of course, companies prefer customers who are less price-sensitive. Table 16.3 lists some characteristics associ- ated with decreased price sensitivity. On the other hand, the Internet has the potential to JODSFBTF price sensitivity. In some established, fairly big-ticket categories, such as auto retailing and term insurance, consumers pay lower prices as a result of the Internet. Car buyers use the Internet to gather information and borrow the negotiating

15050 Quantity Demanded per Period

105

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$10

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100 Quantity Demanded per Period

(b) Elastic Demand(a) Inelastic Demand

$15

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| Fig. 16.1 |

Inelastic and Elastic Demand

TABLE 16.3 Factors That Reduce Price Sensitivity

t� 5IF�QSPEVDU�JT�NPSF�EJTUJODUJWF� t� #VZFST�BSF�MFTT�BXBSF�PG�TVCTUJUVUFT� t� #VZFST�DBOOPU�FBTJMZ�DPNQBSF�UIF�RVBMJUZ�PG�TVCTUJUVUFT� t� 5IF�FYQFOEJUVSF�JT�B�TNBMMFS�QBSU�PG�UIF�CVZFS�T�UPUBM�JODPNF� t� 5IF�FYQFOEJUVSF�JT�TNBMM�DPNQBSFE�UP�UIF�UPUBM�DPTU�PG�UIF�FOE�QSPEVDU� t� 1BSU�PG�UIF�DPTU�JT�CPSOF�CZ�BOPUIFS�QBSUZ� t� 5IF�QSPEVDU�JT�VTFE�JO�DPOKVODUJPO�XJUI�BTTFUT�QSFWJPVTMZ�CPVHIU� t� 5IF�QSPEVDU�JT�BTTVNFE�UP�IBWF�NPSF�RVBMJUZ �QSFTUJHF �PS�FYDMVTJWFOFTT� t� #VZFST�DBOOPU�TUPSF�UIF�QSPEVDU�

Source: Based on information from Thomas T. Nagle, John E. Hogan, and Joseph Zale, The Strategy and Tactics of Pricing, 5th ed. (Upper Saddle River, NJ: Pearson, 2011). Printed and electronically reproduced by permission of Pearson Education, Inc., Upper Saddle River, New Jersey.

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DEVELOPING PRICING STRATEGIES AND PROGRAMS | CHAPTER 16 493

clout of an online buying service.35 But customers may have to visit multiple sites to realize possible savings, and they don’t always do so. Targeting only price-sensitive consumers may in fact be “leaving money on the table.”

ESTIMATING DEMAND CURVES Most companies attempt to measure their demand curves using several different methods.

t� 4VSWFZT can explore how many units consumers would buy at different proposed prices. Although consumers might understate their purchase intentions at higher prices to discourage the company from pricing high, they also tend to actually exaggerate their willingness to pay for new products or services.36

t� 1SJDF�FYQFSJNFOUT can vary the prices of different products in a store or of the same product in similar territo- ries to see how the change affects sales. Online, an e-commerce site could test the impact of a 5 percent price increase by quoting a higher price to every 40th visitor to compare the purchase response. However, it must do this carefully and not alienate customers or be seen as reducing competition in any way (thus violating the Sherman Antitrust Act).37

t� 4UBUJTUJDBM�BOBMZTJT of past prices, quantities sold, and other factors can reveal their relationships. The data can be longitudinal (over time) or cross-sectional (from different locations at the same time). Building the appropriate model and fitting the data with the proper statistical techniques call for considerable skill, but sophisticated price optimization software and advances in database management have improved marketers’ abilities to optimize pricing.

One large retail chain was selling a line of “good-better-best” power drills at $90, $120, and $130, respectively. Sales of the least and most expensive drills were fine, but sales of the midpriced drill lagged. Based on a price optimization analysis, the retailer dropped the price of the midpriced drill to $110. Sales of the low-priced drill dropped 4 percent because it seemed less of a bargain, but sales of the midpriced drill increased 11 percent. Profits rose as a result.38

In measuring the price-demand relationship, the market researcher must control for various factors that  will influence demand.39 The competitor’s response will make a difference. Also, if the company changes other aspects of the marketing program besides price, the effect of the price change itself will be hard to isolate.

PRICE ELASTICITY OF DEMAND Marketers need to know how responsive, or elastic, demand is to a change in price. Consider the two demand curves in Figure 16.1. In demand curve (a), a price increase from $10 to $15 leads to a relatively small decline in demand from 105 to 100. In demand curve (b), the same price increase leads to a substantial drop in demand from 150 to 50. If demand hardly changes with a small change in price, we say it is JOFMBTUJD� If demand changes considerably, it is FMBTUJD�

The higher the elasticity, the greater the volume growth resulting from a 1 percent price reduction. If demand is elastic, sellers will consider lowering the price to produce more total revenue. This makes sense as long as the costs of producing and selling more units do not increase disproportionately.

Price elasticity depends on the magnitude and direction of the contemplated price change. It may be negligible with a small price change and substantial with a large price change. It may differ for a price cut than for a price increase, and there may be a QSJDF�JOEJGGFSFODF�CBOE within which price changes have little or no effect.

Finally, long-run price elasticity may differ from short-run elasticity. Buyers may continue to buy from a cur- rent supplier after a price increase but eventually switch suppliers. Here demand is more elastic in the long run than in the short run, or the reverse may happen: Buyers may drop a supplier after a price increase but return later. The distinction between short-run and long-run elasticity means that sellers will not know the total effect of a price change until time passes.

Research has shown that consumers tend to be more sensitive to prices during tough economic times, but that is not true across all categories.40 One comprehensive review of a 40-year period of academic research on price elasticity yielded interesting findings:41

t� 5IF�BWFSBHF�QSJDF�FMBTUJDJUZ�BDSPTT�BMM�QSPEVDUT �NBSLFUT �BOE�UJNF�QFSJPET�TUVEJFE�XBT�o������*O�PUIFS�XPSET �B� 1 percent decrease in prices led to a 2.62 percent increase in sales.

t� 1SJDF�FMBTUJDJUZ�NBHOJUVEFT�XFSF�IJHIFS�GPS�EVSBCMF�HPPET�UIBO�GPS�PUIFS�HPPET�BOE�IJHIFS�GPS�QSPEVDUT�JO�UIF� introduction/growth stages of the product life cycle than in the mature/decline stages.

t� *OGMBUJPO�MFE�UP�TVCTUBOUJBMMZ�IJHIFS�QSJDF�FMBTUJDJUJFT �FTQFDJBMMZ�JO�UIF�TIPSU�SVO� t� 1SPNPUJPOBM�QSJDF�FMBTUJDJUJFT�XFSF�IJHIFS�UIBO�BDUVBM�QSJDF�FMBTUJDJUJFT�JO�UIF�TIPSU�SVO� UIPVHI�UIF�SFWFSTF�

was true in the long run). t� 1SJDF�FMBTUJDJUJFT�XFSF�IJHIFS�BU�UIF�JOEJWJEVBM�JUFN�PS�4,6�MFWFM�UIBO�BU�UIF�PWFSBMM�CSBOE�MFWFM�

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494 PART 5 | CREATING VALUE

stEP 3: EstImatInG costs Demand sets a ceiling on the price the company can charge for its product. Costs set the floor. The company wants to charge a price that covers its cost of producing, distributing, and selling the product, including a fair return for its effort and risk. Yet when companies price products to cover their full costs, profitability isn’t always the net result.

TYPES OF COSTS AND LEVELS OF PRODUCTION A company’s costs take two forms, fixed and variable. ‘JYFE�DPTUT also known as PWFSIFBE are costs that do not vary with production level or sales revenue. A company must pay bills each month for rent, heat, interest, salaries, and so on, regardless of output.

7BSJBCMF�DPTUT vary directly with the level of production. For example, each tablet computer pro- duced by Samsung incurs the cost of plastic and glass, microprocessor chips and other electronics, and packaging. These costs tend to be constant per unit produced, but they’re called WBSJBCMF because their total varies with the number of units produced.

5PUBM�DPTUT consist of the sum of the fixed and variable costs for any given level of production. “WFSBHF�DPTU is the cost per unit at that level of production; it equals total costs divided by produc- tion. Management wants to charge a price that will at least cover the total production costs at a given level of production.

To price intelligently, management needs to know how its costs vary with different levels of pro- duction. Take the case in which a company such as Samsung has built a fixed-size plant to produce 1,000 tablet computers a day. The cost per unit is high if few units are produced per day. As produc- tion approaches 1,000 units per day, the average cost falls because the fixed costs are spread over more units. Short-run average cost JODSFBTFT after 1,000 units, however, because the plant becomes inefficient: Workers must line up for machines, getting in each other’s way, and machines break down more often [see Figure 16.2(a)].

If Samsung believes it can sell 2,000 units per day, it should consider building a larger plant. The plant will use more efficient machinery and work arrangements, and the unit cost of producing 2,000 tablets per day will be lower than the unit cost of producing 1,000 per day. This is shown in the long-run average cost curve (LRAC) in Figure 16.2(b). In fact, a 3,000-capacity plant would be even more efficient according to Figure 16.2(b), but a 4,000-daily production plant would be less so because of increasing diseconomies of scale: There are too many work- ers  to manage, and paperwork slows things down. Figure 16.2(b) indicates that a 3,000-daily production plant is the optimal size if demand is strong enough to support this level of production.

There are more costs than those associated with manufacturing. To estimate the real profitability of selling to different types of retailers or customers, the manufacturer needs to use activity-based cost (ABC) accounting instead of standard cost accounting, as described in Chapter 5.

ACCUMULATED PRODUCTION Suppose Samsung runs a plant that produces 3,000 tablet computers per day. As the company gains experience producing tablets, its methods improve. Workers learn shortcuts, materials flow more smoothly, and procurement costs fall. The result, as Figure 16.3 shows, is that average cost

4,0001,000

1

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Co st

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st p

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1,000

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(b) Cost Behavior over Different-Size Plants

(a) Cost Behavior in a Fixed-Size Plant

2 3 4

| Fig. 16.2 |

Cost per Unit at Different Levels of Production per Period

200,000 400,000 800,000

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$60

$40

$20

$100

Co st

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Experience curve

B A

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| Fig. 16.3 |

Cost per Unit as a Function of Accumulated Production: The Experience Curve

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DEVELOPING PRICING STRATEGIES AND PROGRAMS | CHAPTER 16 495

falls with accumulated production experience. Thus the average cost of producing the first 100,000 tablets is $100 per tablet. When the company has produced the first 200,000 tablets, the average cost has fallen to $90. After its accumulated production experience doubles again to 400,000, the average cost is $80. This decline in the average cost with accumulated production experience is called the FYQFSJFODF�DVSWF or MFBSOJOH�DVSWF�

Now suppose three firms compete in this particular tablet market, Samsung, A, and B. Samsung is the lowest- cost producer at $80, having produced 400,000 units in the past. If all three firms sell the tablet for $100, Samsung makes $20 profit per unit, A makes $10 per unit, and B breaks even. The smart move for Samsung would be to lower its price to $90. This will drive B out of the market, and even A may consider leaving. Samsung will pick up the business that would have gone to B (and possibly A). Furthermore, price-sensitive customers will enter the market at the lower price. As production increases beyond 400,000 units, Samsung’s costs will drop still further and faster, more than restoring its profits, even at a price of $90.

&YQFSJFODF�DVSWF� QSJDJOH nevertheless carries major risks. Aggressive pricing might give the product a cheap image. It also assumes competitors are weak followers. The strategy leads the company to build more plants to meet demand, but a competitor may choose to innovate with a lower-cost technology. The market leader is now stuck with the old technology.

Most experience-curve pricing has focused on manufacturing costs, but all costs can be improved on, including marketing costs. If three firms are each investing a large sum of money in marketing, the firm that has used it lon- gest might achieve the lowest costs. This firm can charge a little less for its product and still earn the same return, all other costs being equal.42

TARGET COSTING Costs change with production scale and experience. They can also change as a result of a concentrated effort by designers, engineers, and purchasing agents to reduce them through UBSHFU�DPTUJOH� Market research establishes a new product’s desired functions and the price at which it will sell, given its appeal and competitors’ prices. This price less desired profit margin leaves the target cost the marketer must achieve.

The firm must examine each cost element—design, engineering, manufacturing, sales—and bring down costs so the final cost projections are in the target range. When ConAgra Foods decided to increase the list prices of its Banquet frozen dinners to cover higher commodity costs, the average retail price of the meals increased from $1 to $1.25. When sales dropped significantly, management vowed to return to a $1 price, which necessitated cutting $250 million in other costs through a variety of methods, such as centralizing purchasing and shipping, using less expensive ingredients, and designing smaller portions.43

Cost cutting cannot go so deep as to compromise the brand promise and value delivered. Despite the early suc- cess of the PT Cruiser, Chrysler chose to squeeze out more profit by avoiding certain redesigns and cutting costs with cheaper radios and inferior materials. Once a best-selling car, the PT Cruiser was eventually discontinued.44 Apparel makers tweak clothing designs to cut costs but are careful to avoid overly shallow pants pockets, waist- bands that can roll over, and buttons that crack.45 “Marketing Memo: How to Cut Costs” describes how firms are successfully cutting costs to improve profitability.

Overly aggressive cost-cutting actions resulted in declines in perceived quality for the PT Cruiser, helping to contribute to the brand’s demise.

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496 PART 5 | CREATING VALUE

Prices inevitably have to reflect the cost structure of the products and services. Rising commodity costs and a highly competitive post-recession environment have put pressure on many firms to manage their costs carefully and decide what cost increases, if any, to pass along to consumers in the form of higher prices. When calf-skin prices surged due to a shortage, pressure was placed on those luxury goods makers that need fine leather. Similarly, when steel and other input prices soared by as much as 20 percent, Whirlpool and Electrolux raised their own prices 8 percent to 10 percent.

Companies can cut costs in many ways. For General Mills, it was as simple as reducing the number of varieties of Hamburger Helper from 75 to 45 and the number of pasta shapes from 30 to 10. Dropping multicolored Yoplait lids saved $2 million a year. Other firms are attempting to shrink their products and packages while holding price and hoping consumers don’t notice or care. Canned vegetables dropped to 13 or 14 ounces from 16, boxes of baby wipes hold 72 instead of 80, and sugar is sold in 4-pound instead of 5-pound bags.

The cost savings from minor shrinkage can be significant. When the size of a Scott 1000 toilet paper sheet dropped from 4.5 by 3.7 inches to 4.1 by 3.7 inches, the height of a four-pack package decreased from 9.2 to 8 inches, resulting in a 12 percent to 17 percent increase in the amount of product Scott can fit in a truck and a drop of 345,000 gallons in the gasoline needed for shipping because of the resulting fewer trucks on the road.

Some marketers attempt to justify packaging changes on environmental grounds (smaller packages are “greener”) or to address health concerns (smaller packages have “fewer calories”), though consumers may not be duped. Others add other benefits in the process (“even stronger” or “new look”). Some com- panies are applying what they learned from making affordable products with scarce resources in developing countries such as India to the task of cutting costs in developed markets. Cisco blends teams of U.S. software engineers with Indian supervisors.

Supermarket giant Aldi takes advantage of its global scope. It stocks only about 1,000 of the most popular everyday grocery and household items, com- pared with more than 20,000 at a traditional grocer such as Royal Ahold’s Albert Heijn. Almost all the products carry Aldi’s own exclusive label. Because it sells so few items, Aldi can exert strong control over quality and price and simplify shipping and handling, leading to high margins. With more than 8,200 stores worldwide currently, Aldi brings in almost $60 billion in annual sales.

Sources: Richard Alleyne, “Household Brands Slash Size of Goods in ‘Hidden Price Hikes,’” The Telegraph, March 21, 2013; Andrew Roberts, “Getting a Handle on the Steep Price of Leather,” Bloomberg Businessweek, September 19, 2011; Stephanie Clifford and Catherine Rampell, “Inflation Looms, but Is Stealthily Disguised in Packaging,” New York Times, March 28, 2011; “Everyday Higher Prices,” The Economist, February 26, 2011; Beth Kowitt, “When Less Is . . . Less,” Fortune, November 15, 2010, p. 21; Reena Jane, “From India, the Latest Management Fad,” Bloomberg BusinessWeek, December 14, 2009, p. 57; “German Discounter Aldi Aims to Profit from Belt-Tightening in US,” www.dw-world.de, January 15, 2009; Mina Kimes, “Cereal Cost Cutters,” Fortune, November 10, 2008, p. 24.

How to Cut Costsmarketing memo

stEP 4: analYzInG comPEtItors’ costs, PrIcEs, anD offErs Within the range of possible prices identified by market demand and company costs, the firm must take com- petitors’ costs, prices, and possible reactions into account. If the firm’s offer contains features not offered by the nearest competitor, it should evaluate their worth to the customer and add that value to the competitor’s price. If the competitor’s offer contains some features not offered by the firm, the firm should subtract their value from its own price. Now the firm can decide whether it can charge more, the same, or less than the competitor.46

VALUE-PRICED COMPETITORS Companies offering the powerful combination of low price and high quality are capturing the hearts and wallets of consumers all over the world.47 Value players, such as Aldi, E*TRADE Financial, JetBlue Airways, Southwest Airlines, Target, and Walmart, are transforming the way consumers of nearly every age and income level purchase groceries, apparel, airline tickets, financial services, and other goods and services.

Traditional players are right to feel threatened. Upstart firms often rely on serving one or a few consumer segments, providing better delivery or just one additional benefit, and matching low prices with highly efficient operations to keep costs down. They have changed consumer expectations about the trade-off between quality and price.

One school of thought is that companies should set up their own low-cost operations to compete with value- priced competitors only if: (1) their existing businesses will become more competitive as a result and (2) the new business will derive some advantages it would not have gained if independent.48

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DEVELOPING PRICING STRATEGIES AND PROGRAMS | CHAPTER 16 497

Low-cost operations set up by HSBC, ING, Merrill Lynch, and Royal Bank of Scotland—First Direct, ING Direct, ML Direct, and Direct Line Insurance, respectively—succeed in part thanks to synergies between the old and new lines of business. Major airlines have also introduced their own low-cost carriers. But Continental’s -JUF �,-.�T�#V[[ �4″4�T�4OPXGMBLF �BOE�6OJUFE�T�4IVUUMF�IBWF�BMM�CFFO�VOTVDDFTTGVM �EVF�JO�QBSU�UP�B�MBDL�PG�TZO- ergies. The low-cost operation must be designed and launched as a moneymaker in its own right, not just as a defensive play.

stEP 5: sElEctInG a PrIcInG mEthoD Given the customers’ demand schedule, the cost function, and competitors’ prices, the company is now ready to select a price. Figure 16.4 summarizes the three major considerations in price setting: Costs set a floor to the price. Competitors’ prices and the price of substitutes provide an orienting point. Customers’ assessment of unique features establishes the price ceiling.

Companies select a pricing method that includes one or more of these three considerations. We will examine seven price-setting methods: markup pricing, target-return pricing, perceived-value pricing, value pricing, EDLP, going-rate pricing, and auction-type pricing.

MARKUP PRICING The most elementary pricing method is to add a standard NBSLVQ to the product’s cost. Construction companies submit job bids by estimating the total project cost and adding a standard markup for profit. Lawyers and accountants typically price by adding a standard markup on their time and costs.

Variable cost per unit $10

Fixed costs $300,000

Expected unit sales 50,000

Suppose a toaster manufacturer has the following costs and sales expectations: The manufacturer’s unit cost is given by:

Unit cost = variable cost + fixed cost unit sales

= $10 + $300,00 50,000

= $16

Now assume the manufacturer wants to earn a 20 percent markup on sales. The manufacturer’s markup price is given by:

Markup price = unit cost

(1 – desired return on sales) =

$16 1 – 0.2

= $20

The manufacturer will charge dealers $20 per toaster and make a profit of $4 per unit. If deal- ers want to earn 50 percent on their selling price, they will mark up the toaster 100 percent to $40. Markups are generally higher on seasonal items (to cover the risk of not selling), specialty items, slower-moving items, items with high storage and handling costs, and demand-inelastic items, such as prescription drugs.

Creating a successful low cost marketing entry is not easy—United is one of many airlines who failed to do so.

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Customers’ assessment

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Ceiling price

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substitutes

Costs

Floor price

High Price

(No possible demand at this price)

| Fig. 16.4 |

The Three Cs Model for Price Setting

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498 PART 5 | CREATING VALUE

Does the use of standard markups make logical sense? Generally, no. Any pricing method that ignores current demand, perceived value, and competition is not likely to lead to the optimal price. Markup pricing works only if the marked-up price actually brings in the expected level of sales. Consider what happened at Parker Hannifin.49

PARkeR hANNIfIN When Don Washkewicz took over as CEO of Parker Hannifin, maker of 800,000 industrial parts for the aerospace, transportation, and manufacturing industries, pricing was done one way: Calculate how much it costs to make and deliver a product and then add a flat percentage (usually 35 percent). Even though this method was historically well received, Washkewicz set out to get the company to think more like a retailer and charge what custom- ers were willing to pay. Encountering initial resistance from some of the company’s 115 different divisions, Washkewicz assembled a list of the 50 most commonly given reasons why the new pricing scheme would fail and announced he would listen only to arguments that were not on the list. The new pricing scheme put Parker Hannifin’s products into one of four categories depending on how much competition existed. About one-third fell into niches where Parker offered unique value, there was little competition, and higher prices were appropriate. Each division now has a pricing guru or specialist who assists in strategic pricing. The division making industrial fittings reviewed 2,000 different items and concluded that 28 per- cent were priced too low, raising prices anywhere from 3 percent to 60 percent. As a result of the higher margins from this new strategic pricing approach, Parker estimates it has added $1 billion in profit during the fiscal years 2005–2011.

Still, markup pricing remains popular. First, sellers can determine costs much more easily than they can esti- mate demand. By tying the price to cost, sellers simplify the pricing task. Second, when all firms in the industry use this pricing method, prices tend to be similar and price competition is minimized. Third, many people feel cost- plus pricing is fairer to both buyers and sellers. Sellers do not take advantage of buyers when the latter’s demand becomes acute, and sellers earn a fair return on investment.