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The Strategic Pricing Pyramid
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TOP:
Price Level
Pricing Policy
value communication
price structure
value creation
BOTTOM
Price Level
Pricing Policy
value communication
price structure
value creation
BOTTOM
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The Reason for Segmented Pricing
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A one-size fits all approach to pricing reduces profitability and intensifies customer pricing pressure
Setting price low ....leaves money on the table for these customers and communicates that value does not have to be paid for... ....and misses growth opportunities by pricing these customers out of the market
Setting price low ....leaves money on the table for these customers and communicates that value does not have to be paid for... ....and misses growth opportunities by pricing these customers out of the market
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Differentiation Value:
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The value to the customer (both positive and negative) of any differences between your offering and the reference product
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Reference Value:
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The price (adjusted for differences in units) of the customer's best alternative
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total economic value
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Positive
Differentiation Value
+
reference value
+
Negative
Differentiation Value
Differentiation Value
+
reference value
+
Negative
Differentiation Value
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Marginal costs
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are the sellers bottom line.
Any price below marginal costs leave the seller worse off then they would be without the transaction.
Any price above it leaves the seller better off.
Thus, marginal cost is the extreme lower boundary of the "right" price.
Average unit costs are not marginal costs, they are generally higher, hence marginal costs are still below this metric.
Since marginal costs are the lower bound of the pricing challenge, using a higher number, the average unit costs, adds extra caution in setting prices.
This overly conservative approach is inappropriate for some pricing decisions
Any price below marginal costs leave the seller worse off then they would be without the transaction.
Any price above it leaves the seller better off.
Thus, marginal cost is the extreme lower boundary of the "right" price.
Average unit costs are not marginal costs, they are generally higher, hence marginal costs are still below this metric.
Since marginal costs are the lower bound of the pricing challenge, using a higher number, the average unit costs, adds extra caution in setting prices.
This overly conservative approach is inappropriate for some pricing decisions
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Consumer utility
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are the buyers bottom line.
The customer would be worse off if they paid more for a product than they gained in utility
Any price below consumer utility would be leave the customer better off than going without
The customer would be worse off if they paid more for a product than they gained in utility
Any price below consumer utility would be leave the customer better off than going without
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What is the value of life?
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Some economists value a life under the assumption that it is equal to the future earnings of the individual over their lifespan, discounted back to the present time.
Yet economics doesn't capture the value people will pay for one more day with their spouse, seeing their children and grand children mature, and being able to participate in life fully, attending weddings, baby showers, working and being productive, taking vacations ... etc.
Yet economics doesn't capture the value people will pay for one more day with their spouse, seeing their children and grand children mature, and being able to participate in life fully, attending weddings, baby showers, working and being productive, taking vacations ... etc.
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Reference Price
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Price of nearest comparable offer
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Substitutes:
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any alternative means of achieving a similar set of benefits
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Inferior Alternative
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competing alternative that produces similar benefits to the one with the pricing challenge, but overall less consumer utility
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Differential value
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is the change in consumer utility that a product offers in comparison to its comparable alternative
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Exchange value
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is the price of the competing alternative adjusted for the differential value
= Price of Alternative + Differential Value
= Price of Alternative + Differential Value
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Consumer Surplus
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is the difference between the price paid and the total consumer utility
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Cost-based pricing
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= cost + margin
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Profit
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= Total Revenue - Total Costs
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Total Revenue
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= # of units sold X Price per unit
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Total Costs
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= Fixed costs + Variable costs (# of units produced X unit variable costs)
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Breakeven Analysis
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= Fixed costs / (revenue per unit - variable cost per unit) = Fixed costs / unit margin
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relevant costs
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Not all costs are relevant for pricing decisions; relevant costs are those that are incremental and avoidable
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Incremental costs
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are costs associated with changes in pricing and sales.
Variable costs are always incremental
But be careful of averages! The incremental variable cost for a change in sales is often not equal to the average variable cost. E.g.: Overtime vs. average cost production
Some fixed costs are incremental
E.g. fixed cost for a restaurant to print menus with new prices; fixed cost for a public utility to gain regulatory approval for a rate increase
Most fixed costs are not incremental
E.g.: Product Development Costs; Advertising
Variable costs are always incremental
But be careful of averages! The incremental variable cost for a change in sales is often not equal to the average variable cost. E.g.: Overtime vs. average cost production
Some fixed costs are incremental
E.g. fixed cost for a restaurant to print menus with new prices; fixed cost for a public utility to gain regulatory approval for a rate increase
Most fixed costs are not incremental
E.g.: Product Development Costs; Advertising
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Full costs
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which include non-incremental fixed costs—are neither the actual costs incurred when making additional sales at lower prices, nor the actual costs saved when making fewer sales at higher prices. They are, therefore, misleading as a guide to pricing
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Contribution margin
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, or dollar contribution per unit, is the selling price per unit minus the variable cost per unit. "Contribution" represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs.
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Tool of Competitive Advantage
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Relative advantage
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Tool for Segmentation Pricing
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Set different prices for different segments
Can reach more segments
Can reach more segments
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Indicator of how to drive profitability
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High margin: volume-based strategies
Low margin: price and bundling strategies
Low margin: price and bundling strategies
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Contribution Margin ($, %)
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PER UNIT Price
- Incremental Variable Costs
- Incremental Variable Costs
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= Total Contribution ($, %)
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TOTAL Sales Revenue
- Total Variable Costs
- Total Variable Costs
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The Breakeven Sales Change
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The change that would sustain the same level of profit contribution at the new price as was achieved at the original price. A higher level of sales will produce higher profitability; a lower level of sales, lower profitability.
KEY QUESTIONS
1. By how much must sales volume increase to profit from a price cut?
2. What loss in sales volume can be absorbed and still enable us to profit from a price increase?
KEY QUESTIONS
1. By how much must sales volume increase to profit from a price cut?
2. What loss in sales volume can be absorbed and still enable us to profit from a price increase?
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Breakeven sales change
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= - ΔP / (CM+ΔP)
% BE($) = % BE(units) + % Price change [1 + % BE (units)]
% BE($) = % BE(units) + % Price change [1 + % BE (units)]
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Breakeven Sales Change with Variable Cost Change
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% Break-even sales change = -($ΔP - $ ΔC)
$CM + ($ ΔP - $ ΔC)
$CM + ($ ΔP - $ ΔC)
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BREAK-EVEN SALES WITH INCREMENTAL FIXED COSTS
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% Break-even sales change= -$ΔCM / $CM x Initial unit sales + $ Change in fixed costs/ New $CM x Initial unit sales
Unit Break-even sales change = (-$ΔCM x Initial Unit Sales)/New $CM + ($ Change in FC/New $CM)
Unit Break-even sales change = (-$ΔCM x Initial Unit Sales)/New $CM + ($ Change in FC/New $CM)
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BREAK-EVEN SALES ANALYSIS FOR REACTIVE PRICING
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% Break-even sales change for reactive price change = Change in price/ contribution margin
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Conjoint creates Part-Worth Utility Functions
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Conjoint treats a product as a bundle of attributes, features, and benefits
The resulting attribute to value relationship is called a part-worth utility function.
The sum of the part worth utilities of a product is the consumer utility.
The resulting attribute to value relationship is called a part-worth utility function.
The sum of the part worth utilities of a product is the consumer utility.
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Conjoint is a Market Research Based Tool
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As a market research technique, the quantification of value comes from the perspective of the customer, not the company
Has similar challenges to other market research techniques
Shows a snapshot of customer willingness to pay with limited ability to demonstrate how product valuations will evolve
Requires markets with many customers, not just a few
Has similar challenges to other market research techniques
Shows a snapshot of customer willingness to pay with limited ability to demonstrate how product valuations will evolve
Requires markets with many customers, not just a few
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Using Utils to determine Price Differentials
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Because price was one of the attributes being measured in the conjoint analysis, we can place a monetary value on Utils.
Over the price range from $7 to $4, the part-worth utility ranges from 5.5 to 1.5.
Thus, a differential Util is valued at $.75/util
(7-4)/(5.5-1.5)
Over the price range from $7 to $4, the part-worth utility ranges from 5.5 to 1.5.
Thus, a differential Util is valued at $.75/util
(7-4)/(5.5-1.5)
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Part-worth Utilities
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# parameters to be estimated=# of levels - # attributes + 1
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Aggregate Analysis: Stanford MBA job average value system
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Although in conjoint, we do analysis of each individual separately, the first thing we can do is to average the part-worth utilities across each attribute level to understand what is important. For example, the scores indicate the relative desirability of alternative levels of each attribute in the above example.
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Segmentation Analysis
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What is missing from the aggregate analysis? Variation among customers!
Using cluster analysis
Data matrix of value scores for each individual is used to generate different benefit segments
Using cluster analysis
Data matrix of value scores for each individual is used to generate different benefit segments
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Two rules
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First choice rule
Person will simply buy the product with maximum value . A product's market share is simply the number of people who prefer a given product.
Share of preference
The probability that a person chooses product C is 3/6.6 =45%. The market share for a product is simply the average purchase probability across all subjects in the study.
Person will simply buy the product with maximum value . A product's market share is simply the number of people who prefer a given product.
Share of preference
The probability that a person chooses product C is 3/6.6 =45%. The market share for a product is simply the average purchase probability across all subjects in the study.
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