PRICE Setting

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Part I
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Definition
Price What a product can be exchanged for
in the marketplace
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Price too high little or no demand
Range of feasible prices
Price too low no profits possible
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Functions of Price

• Price as Signal
• Price as Competitive Tool
• Price Points and Market Segmentation

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Price Decisions

• Initial Pricing
• Adjustments over time

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Major Pricing Considerations

• Nature of Target Market Demand
• Business and Marketing Strategy
• Product Differentiation
• Competitors Prices
• Prices of Substitutes
• Product Cost

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FIGURE 14-2 Four approaches for selecting an
approximate price level
Slide 14-7
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Demand-Oriented Approaches
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Skimming
Set initially high price and reduce over time
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Skimming may be appropriate when

• Demand is sufficient among innovators and early
  adopters (at higher prices) and is INELASTIC
• Firm is concerned that demand will outstrip
  production capacity
• Firm wants to recoup RD costs quickly
• Competition is currently limited and that wont
  change by charging high prices

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A Demand Schedule
Price Sales (000s) 14 2,000 12 3,000 1
0 4,000 8 5,000 6 6,000
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Single Average-Price Approach
At a unit price of 10, sales will be 4,000,000
units. Revenue 40,000,000
Price
14 12 10 8 6
Quantity (Millions)
1 2 3 4 5 6 7
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Skimming Approach
Price Sales (000s) Revenue 14 2,000 28
M 12 1,000 12 M 10 1,000 10 M
8 1,000 8 M 6 1,000 6 M TOTALS
6,000 64 M
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Skimming vs. Single Price
TR benefit 64 M - 40 M TR benefit 24 M
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Penetration Pricing

• Introduce and maintain low price
• Demand for the good is ELASTIC
• May be used to build loyalty early before
  competition
• Low prices may deter competitors -
  Hewlett-Packard Theory
• Penetration makes possible Learning Economies
  of Scale

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Penetration
At a unit price of 6, sales will be 6,000,000
units. Revenue 36 M
Price
14 12 10 8 6
Quantity (Millions)
1 2 3 4 5 6 7
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Penetration
Price
This is the ___________.
14 12 10 8 6
Value to consumers that is not enjoyed by the
seller.
Quantity (Millions)
1 2 3 4 5 6 7
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Penetration may be best if

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Target Pricing
Target pricing involves estimating the price that
the ultimate consumer would be willing to pay for
a product, working backward through markups taken
by retailers and wholesalers to determine what
price is charged to wholesalers, and then
deliberately adjusting the composition and
features of a product to achieve the target price
to consumers.
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Target versus Cost Pricing
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Cost-Based Pricing
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Cost Based Approaches to Pricing

• Markup on Cost
• Markup on Price
• They are DIFFERENT

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Mark-Up on Cost

• Designed to achieve a given target mark-up (MU)
  relative to the cost of the product
• Always remember
• Selling PriceMU Unit Cost

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Mark-Up on Cost

• So, all you need to know is how to calculate MU.
  And, when it is cost-based, it is
• MU on cost
• So
• Selling Price
• Selling Price

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Example

• Homebuilders calculate costs and add a
  percentage markup to set selling price.

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Markup on Cost

• If construction costs are 150,000 and desired
  markup on these costs is 20, what is final
  selling price?
• Recall
• Selling Price Unit Cost (MU 1)
• So, Selling Price150,000(.2 1) 180,000

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Mark-Up on Price

• Designed to achieve a given target mark-up (MU)
  relative to the selling price of the product
• Again, always remember
• Selling PriceMU Unit Cost

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Mark-Up on Price

• So, all you need to know is how to calculate MU.
  And, when it is price-based, it is
• MU on selling price MUselling price
• So
• Selling Price MUselling price Unit Cost
• selling price (MUselling price) Unit Cost
• selling price (1-MU) Unit Cost
• So
• selling price Unit Cost / (1 - MU)

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Retail Example

• Parisians buys dresses _at_ 80 each (CGS).
• Want a 50 Gross Margin.
• Or a Gross Margin that is a 50 Mark-Up of
  Selling Price
• What price should be set?

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Unit Cost 80MU 50
Example
Pricing Formula Selling Price
Unit Cost ( 1.0 - MU)
Selling Price (80 -- ( 1.0 - .50)) 160
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Gross Margin

• Price/unit Unit Costs/unit Gross Margin/Unit
• Gross Margin/Unit 160 - 80 80
• Note 80 is 50 MU on selling price
• Note 80 is 100 MU on Unit Costs

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Use of Breakeven Analysis Tools to Make Price
Decisions

• Examine Total Costs per Unit
• Compared to Total Revenue per Unit
• Plus Demand Implications

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Cost Factors Affecting Pricing Decisions

• Total Costs
• Sum of the Fixed and Variable Costs for a Given
• Level of Production

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Breakeven Volume
Dollars
Total Cost FC VC
Variable Cost
Fixed Cost
Quantity
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Breakeven Volume
Dollars
Revenue ( Price Quantity )
800
Quantity
Q 40
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Breakeven Volume
Revenue (PQ)
Dollars
Total Cost FC VC
Variable Cost
Fixed Cost
Quantity
Q
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Breakeven Quantity

• The denominator is ...

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Price - Variable Costs/Unit

• This represents a contribution
• to what?

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Problem 1

• 1. Swimsuit manufacturer wholesales a line _at_ 15.
• 2. Variable cost/unit is 4.
• 3. Total fixed cost for the line is 180,000.

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How many swimsuits must be produced and sold to
break even?
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Breakeven CalculationsI. Basic
Fixed Costs Price -
Variable Cost/Unit
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Breakeven CalculationsI. Basic
Break Even Quantity 180,000 15 - 4
16,363.63 Units
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How much revenue must be generated from the line
to breakeven?
Needed Revenue to Breakeven Price X
Breakeven Quantity 1516,364 units 245,460
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Adapting BE Analysis to Make Profit-Oriented
Pricing Decisions
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Want total profit of 10,000. How many units
must be produced and sold to achieve this target?
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Breakeven Calculations II. To Achieve a Target
Profit
Fixed Cost Profit Goal Price -
Unit Variable Cost

• The target profit goal is treated as a
  _________.

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Breakeven Calculations
Break Even Quantity 180,000 10,000 15 -
4 __________ Units
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Want profits 12 of sales. How many units must
be produced and sold to achieve this target?
Target 12 Pretax Profit on Sales (i.e., Price
per Unit)
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Fixed Costs Price -
VC (Target Price)
Breakeven Calculations
III. To Achieve a Target Return On Sales

• The target return on sales is treated as a per
  unit ________.

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Breakeven Calculations
Break Even Quantity 180,000 15 4
(15.12) __________ Units
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Considering the BE Consequences of Marketing
Efforts that Increase Costs
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What is The Impact of 1 Cooperative Allowance
Per Unit Paid to the Retailer on Breakeven?
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CAA acts as a unit variable cost here, so
18,000 units
The Allowance raises breakeven from 16,364 to
18,000 units, a 10 sales increase.
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Marketing research has sales estimates for a new
item at different price points (i.e., demand
function)Total fixed cost of 60,000 7
variable cost per unit.
Problem 2 Add Demand Considerations
Consolidated Novelties Co.
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Proposed Sales (Forecast)Selling Price
Estimate (Units)

• 8 55,000
• 10 22,000
• 15 14,000
• 20 5,000
• 24 2,800
• SOURCE Market Research
• Experimental - test markets

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Which of the prices would generate a profit for
Consolidated Novelties?
Remember Fixed Costs 60,000 Variable Costs
7 Breakeven FC/ (P-VC)
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At a Price of 8 per unit
Revenue 55,000 units X 8
440,000 Costs Variable 7.00 X 55,000
385,000 Fixed
60,000 Total Costs
445,000 Profit (Loss)
( 5,000 )
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Price DX Forecast BE Qty.
Result Profit(Loss)

• 8 55,000 60,000 Loss (5,000)
• 10 22,000 20,000 Profit 6,000
• 15 14,000 7,500 Profit 52,000
• 20 5,000 4,615.38 Profit 5,000
• 24 2,800 3,529.41 Loss (12,400)

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Part II
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Price Elasticity of Demand
Extent to which quantity demanded changes in
reaction to changes in price
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Price Elasticity of Demand
Demand is Elastic Consumers react ________ to
price changes
PRICE
QUANTITY
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Elastic Demand

• Commodity
• Undifferentiated
• Many Substitutes
• High of total income
• Lack of Urgency

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Elastic Demand

• The role of Value Added
• Apples vs. Motts Applesauce
• Mature phase of PLC
• Perceived differences often low
• Personal computers
• Price wars (oligopolies)
• The role of price-based promotions
• Versus EDLP

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Price Elasticity of Demand
Demand is Inelastic Consumers react _______ to
price changes
PRICE
QUANTITY
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Inelastic Demand

• Prestige
• Differentiated
• Lack of Substitutes
• Sometimes legal barriers (new drugs)
• Low of total income
• Urgency/convenience

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Inelastic Demand

• Note the role of advertising and product features
  in differentiation
• Avoid being a commodity
• Milk
• Green Mountain Power
• Certified Angus Beef
• Feature differentiation allows the creation of
  brand loyalty which drives inelasticity

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Calculating Elasticity
Change in Quantity Demanded
Change in Price
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Levels of Elasticity

• Unit Elasticity
• PED -1
• change in quantity demanded equal to change
  in price
• No change in total revenue when price changes

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Levels of Elasticity

• Elastic
• PED LT 1 (e.g., -1.5, -2, etc.)
• change in quantity demanded greater than
  change in price
• And
• Revenue _____ when Price _____ and
• Revenue Falls when Price Rises

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Levels of Elasticity

• Inelasticity
• PED GT 1 (e.g., -3/4, -1/2)
• change in quantity demanded less than change
  in price
• And
• Revenue _____ when Price _____ and
• Revenue Rises when Price Rises

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Inelastic Unitary Elastic
Total Revenue
Sales Price
5 7 9 11 13
Hypothetical Data
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The Novelty Company Revisited
Recall Fixed Costs 60,000 Variable Costs
7/unit
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Demand function is OFTEN discontinuous with
ranges of elasticity
Dollar Revenue
440,000 220,000 210,000 100,000 67,200
Sales Price
8 10 15 20 24
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Dollar Revenue
440,000 220,000 210,000 100,000 67,200
- 10,000
vs
- 110,000
Sales Price
8 10 15 20 24
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Back to the Importance of Demand Considerations
Price DX Forecast BE Qty.
Result Profit(Loss)
8 55,000 60,000 Loss (5,000) 10 22,000 20
,000 Profit 6,000 15 14,000 7,500
Profit 52,000 20 5,000 4,615.38 Profit
5,000 24 2,800 3,529.41 Loss (12,400)
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The Novelty Company Revisited Costs and Revenues
Cost Decrease
56,000
63,000
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The Novelty Company Revisited Costs and Revenues
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Price Elasticity of Demand
Some Lessons

• Elasticity can be changed
• Not all competing brands in a category have same
  elasticity
• Company actions affect elasticity
• Psychology of price perception

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Psychological Considerations

• Price Categories
• Consumers lump set of prices into one category
• Within category less price sensitive than across
• Example
• Mark - 2,000 to 1,885
• Alex - 1,995 to 1,880
• And logic behind price endings

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Psychological Considerations

• Perceived Fairness of price
• May feel cheated (gouged) if overpriced relative
  to its cost
• 9/11 and gas prices
• May depend on type of product
• Prestige/image products may benefit from higher
  price

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Psychological Considerations

• Inverse Demand
• Demand normally negative function of price
• But, it can be positive
• Image and prestige products
• Related to price as quality signal
• Key when quality is ambiguous

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Back to the Consolidated Novelty Example Further
Applications
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Suppose management insists on a 25,000 target
return.
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Management wants 25,000 profit. Unit
Sales Needed forPrice Quantity
25,000 Profit Profit(Loss)

• 8 55,000 85,000
  (30,000)
• 10 22,000 28,333
  (19,000)
• 15 14,000 10,625
  27,000
• 20 5,000 6,538 (20,000)
• 24 2,800 5,000
  (37,400)

Required Unit Sales
FC 25,000 P - 7

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Considering the PROFIT Consequences of our
Marketing Efforts
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What if Consolidated Novelties Director of
Marketing estimated that an additional
.50-per-unit allocation for extra promotion will
increase unit sales estimates.
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New Demand EstimatesPrice Demand Est.

• 8 60,000
• 10 28,000
• 15 17,000
• 20 6,000
• 24 3,500

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Indicate the profits or losses if this proposal
is implemented and results in the predicted sales
increases.
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At a Price of 8 per unit
Revenue 60,000 units X 8
480,000 Costs Variable 7.50 X 60,000
450,000 Fixed
60,000 Total Costs
510,000 Profit (Loss)
( 30,000 )
Note Variable cost 7.50 now.
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At a Price of 15 per unit
Revenue 17,000 units X 15
255,000 Costs Variable 7.50 X 17,000
127,500 Fixed
60,000 Total Costs
187,500 Profit (Loss)
67,500
You get the picture!
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Consolidated Novelties With Increased Promotional
Expenditures
Original New
Revised Price Sales Sales
Profit(Loss) 8 55,000
60,000 (30,000) 10
22,000 28,000 10,000 15
14,000 17,000 67,500 20
5,000 6,000 15,000 24
2,800 3,500 (2,500)
vs 52,000
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Note, costs went up, but revenues went up even
more. Profits TR-TC Both Critical