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Pricing and Promotion Decisions

Pricing and Promotion Decisions. BA 6324: Fundamentals of Marketing Professor Dillon Modular #10. Pricing and Promotion Decisions. 1. Price Increases or Sales Increases? 2. How Price Affects Profits 3. Factors Affecting Pricing Decisions 4. Objectives of Sales Promotions

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Pricing and Promotion Decisions

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  1. Pricing and Promotion Decisions BA 6324: Fundamentals of Marketing Professor Dillon Modular #10

  2. Pricing and Promotion Decisions 1. Price Increases or Sales Increases? 2. How Price Affects Profits 3. Factors Affecting Pricing Decisions 4. Objectives of Sales Promotions 5. Growing Importance of Sales Promotions 6. Reasons for Growth in Promotions 7. Effectiveness of Promotions 8. Types of Sales Promotions 9. Do Promotions Really Work 10. Practice Problems

  3. Pricing - Should we increase price or reduce costs? - What is the price elasticity for my product? Promotion - When I run a promotion where does the increase in sales come from? Pricing and Promotion Decisions • Pricing and promotion decisions add another level of complexity to forecasting market potential and demand. • Key Questions

  4. Pricing and Promotion Decisions 1.Price Increases or Sales Increases? A company has annual sales of 100,000 units for one of its products. The selling price for this product is $100, the variable cost is $60, and the allocation of fixed overheads is $3 million. The analysis of the market suggests that you have the following two options for the next year: (a) Increase the sales by 1% by keeping the current price, or (b) Increase the price by 1% and have the same sales as this year. Which option would you choose and why?

  5. Current Price Sales Increase = $100,000 X .01 = $1000 Profit = PQ - VC .Q - FC = 100 (101,000) - 60(101,000) - 3,000,000 = 1,040,000 % = 4% Increase Price New Price = $100 X .01 + $100 = $101 Profit = PQ - VC .Q - FC = 101 (100,000) - 60(100,000) - 3,000,000 = 1,100,000 % = 10% Pricing and Promotion Decisions

  6. Comparison of Profit Levers* 1% improvement in .... ...Creates Operating Profit Improvement of Price Variable Cost Volume Fixed cost Based on average economics of 2,463 companies in Compustat aggregate 11.1% 7.8 3.3 2.3 Pricing and Promotion Decisions 2. How Price Affects Profit (Source: McKinsey Study)

  7. Fixed cost irrelevant to setting price. Profit = PQ - VC.Q - FC  Profit = P - VC Q Find optimal price then determine whether it is sufficient to cover FC Pricing and Promotion Decisions 3. Factors Affecting Pricing Decisions 3.1 Company factors A. Cost • Variable cost and fixed cost

  8. Pricing and Promotion Decisions • Experience Curve - Many studies document the learning curve hypothesis that the labor cost component declines with accumulated output (e.g., Conway and Schultz 1950). - More recently, the Boston Consulting Group claims wide applicability of the “experience curve” concept, which extends the cost reduction to other cost components. - In its simple form, the experience effect model holds that the per unit cost of producing and marketing a product at time t is a function of: (i) MC(0), the per unit cost when commercialization begins, (ii) V(0), the pilot volume produced before commercialization, (iii) V(t), the accumulated volume at t, and (iv) b, the experience rate of the firm.

  9. Commonly Observed Pattern of Prices and Costs for a Competitive Industry log($) (constant dollars) log of average industry prices log of average industry costs V(t2) V(t1) log of accumulated volume Pricing and Promotion Decisions

  10. Pricing and Promotion Decisions B. Company strategy - Price Skimming - Price penetration C. Consistency with other marketing mix elements - Product quality - Distribution channels D. Product issues - Product line considerations - Product bundling - Product complementarity 3.2 Customer Factors • Consumer purchase behavior - Total expenditure on product category - Product knowledge - Involvement • Perceived Value - Experiments

  11. Option 5 Option 3 Option 1 Option 2 Monthly fee - includes unlimited calls in local calling area Free services included in monthly fee (you may buy more for additional cost) Local calling area Additional monthly fee for phone line Free minutes of local toll calls Local toll call rate $25.00 $12.00 $5.00 - no free calls calls in local area are 3¢/min $10.00 Option 4 $21.00 • 3 free special features (e.g., call waiting) • 3 free special features (e.g., call waiting) • 3 free special features (e.g., call waiting) • None are free - all are additional costs • 3 free special features (e.g., call waiting) • Free inside wire maintenance Today’s standard area Today’s standard area Today’s standard area Today’s standard area Twice as large as today’s standard area Free Free $10.00 (optional) Free $10.00 (optional) 75 minutes 35 minutes 3¢/min 12¢/min 17¢/min 13¢/min 12¢/min CHOOSE ONE Pricing and Promotion Decisions SCENARIO #1 PART 1: PICK A LOCAL PHONE SEVICE

  12. Option 1 Option 2 Option 3 Monthly fee Free minutes of long distance Local calling area Discount on total bill $10.00 75 minutes (anytime) 15¢/min (same rate all day, every day) 16¢/min (evenings) 10¢/min (evenings) 25% if bill over $10 30% if bill over $50 CHOOSE ONE Pricing and Promotion Decisions SCENARIO #1 cont... PART 2: PICK A LOCAL PHONE SEVICE

  13. x Eb1 = Pb1 Qb1 Pb1 Qb1 Pb1 Qb1 Qb1 Pb1 Qb1 Pb1 Eb1 > 1 PRICE ELASTIC < 1 PRICE INELASTIC x = P TR P TR Eb1 If > 1 then < 1 then (Qb1-Qb1) (Pb1-Pb1) x B A = Eb1 If P TR P TR A B Pricing and Promotion Decisions • Price Elasticity of Demand • – Own Elasticity 1% CHANGE IN PRICE RESULTS IN X% CHANGE IN QUANTITY DEMANDED

  14. CEb1 b2 Pb2 Qb1 Pb2 Qb1 Pb2 Qb1 x CEb1 b2 = Qb1 Pb2 Qb1 Pb2 x = > 0 b1, b2 SUBSTITUTES < 0 b1, b2 COMPLEMENTS (Qb1-Qb1) (Pb2-Pb2) x B A = A B Pricing and Promotion Decisions – Cross Elasticity 1% CHANGE IN PRICE OF BRAND B2 RESULTS IN X% CHANGE IN QUANTITY DEMANDED OF BRAND B1

  15. WHY?  Slope of demand curve gives absolute change in quantity demanded due to a $1 change in price.  Useful to express changes in relative terms so as to allow comparisons across different product categories  Marginal Revenue is related to both price and elasticity MR =P (1 + 1/E) where E = elasticity Q P slope = Pricing and Promotion Decisions

  16. Pricing and Promotion Decisions ─EXAMPLE Two brands (b1, b2), three retail formats (Food, Drug, Mass Merchandize) Effect of Food Drug MM

  17. Brand 1 Brand 2 Week/Month Sales Price Sales Price 1 156,200 $1.59 148,100 $1.09 2 275,345 $1.49 60,300 $1.09 3 248,222 $1.59 60,900 $1.19 4 210,100 $1.39 168,555 $0.89 5 145,600 $1.69 177,900 $0.89 6 160,100 $1.59 185,100 $0.79 7 245,440 $1.39 39,100 $1.39 8 298,500 $1.49 29,200 $1.49 9 145,500 $1.59 188,100 $0.69 10 290,320 $1.39 50,800 $1.09 X 217,532 $1.52 110,803 $1.06 Run regression Sales1 = a + b11 Price1 + b12 Price2 + e1 Sales2 = c + b22 Price2 + b21 Price1 + e2 Pricing and Promotion Decisions - Using Historical Data a. Collect historical data: b. Assessing consumers price sensitivity

  18. Analysis of Variance Sum of Mean Source DF Squares Square F value Pr>F Model 2 24,704,028,604 12,352,014,302 8.92 0.0119 Error 7 9,691,062,012 1,384,437,430 Corrected Total 9 34,395,090,616 Root MSE 37,208 R-Square 0.7182 Dependent Mean 217,533 Adj R-sq 0.6377 Coeff Var 17.10457 Parameter Estimates Parameter Standard Variable DF Estimate Error t value Pr>t Intercept 1 460,494 225,846 2.04 0.0808 b11-price 1 -255,761 128,808 -1.99 0.0875 b12-price 1 137,542 53,705 2.56 0.0375 Pricing and Promotion Decisions Cross Elasticities Data Dependent Variable: b1- sales

  19. Analysis of Variance Sum of Mean Source DF Squares Square F value Pr>F Model 2 33,864,043,245 16,932,021,623 16.23 0.0023 Error 7 7,300,786,477 1,042,969,497 Corrected Total 9 41,164,829,723 Root MSE 32,295 R-Square 0.8226 Dependent Mean 110,806 Adj R-sq 0.7720 Coeff Var 29.14570 Parameter Estimates Parameter Standard Variable DF Estimate Error t value Pr>t Intercept 1 139,904 196,025 0.71 0.4985 b22-price 1 -213,764 46,614 -4.59 0.0025 b21-price 1 129,928 111,800 1.16 0.2833 Pricing and Promotion Decisions Cross Elasticities Data Dependent Variable: b2- sales

  20. Own Elasticity Cross Elasticity P Q Q P QA PB PB QA 1.52 110,805 1.06 110,805 1.06 217,533 1.52 217,533 -255,761 = -1.78 129,928 = 1.78 -213,764 = -2.04 137,542 = .67 Pricing and Promotion Decisions Effect on Brand 2 Brand 1  in Brand 1 Brand 2

  21. Ten ordinary 75-watt bulbs One 18-watt fluorescent bulb Purchase Price Electricity cost for 10,000 hours (at 14.7¢ per kilowatt-hour) Total cost Over the life of the compact fluorescent bulb, you could save $84. $8* $8 $26 $110 $34 $118 TOTAL SAVINGS: $84 * Price with Con Edison discount. Pricing and Promotion Decisions - Economic Value to the Customer (EVC) The chart below shows how compact fluorescent bulbs can save you money: (Based on 10,000 hours of usage)

  22. The Pricing Game Payoff Matrix, in millions of NPV Maintain prices 100 70 A B 60 70 ACE OPTIONS* 120 80 C D Cut prices 20 30 *Current NPV (net present value) without Smith in market is 160. Source: McKinsey & Co. Maintain prices Cut prices SMITH OPTIONS Pricing and Promotion Decisions 3.3 Competitor Factors • Pricing Mentality - Kodak vs. Fuji - Prisoner’s Dilemma

  23. Cooperative Adaptive Opportunistic Predatory Pricing and Promotion Decisions • Types of competitive pricing behavior* Typical behavior Changes prices in parallel with other firms to maintain traditional differentials. Adjusts output as necessary to maintain traditional market share, reducing output when price increases reduce industry sales and increasing output when price decreases stimulate industry sales. Takes price changes as given and adjusts prices accordingly. Attempts to increase sales when prices increase and to reduce sales when prices decline, assuming that it cannot influence the pricing structure by its actions. Initiates price cuts. Delays or foregoes meeting price increases. Always meets price decreases without delay. Attempts to use any change in pricing to maintain or increase its sales at competitors’ expense. Initiates large price cuts (or other actions) to inflict harm on a financially weaker competitor, even though those actions are in the short run not financially justifiable. Attempts to increase its sales as much as possible at the expense of the targeted competitor. * Source: Thomas Nagle, The Strategy and Tactics of Pricing, 1987.

  24. Cooperative Adaptive Opportunistic Predatory Pricing and Promotion Decisions • Types of competitive pricing behavior cont... Common identifying characteristics Significant share in market where a few firms dominate. Lack of substantial excess capacity. Unit costs similar to competitors Market share too small to influence industry pricing, but nevertheless viable. Lower unit costs than competitors. Significant excess capacity. New to the market with low share. Able to negotiate price cuts without immediate detection. Large portion of sales concentrated in few buyers. Financially stronger than prey due to lower costs, more diversification, or a larger war chest. Harmed by prey’s opportunistic pricing or potentially benefited by prey’s demise.

  25. Pricing and Promotion Decisions 4. Objectives of Sales Promotions  Sales promotions are shortterm inducements designed to have a direct impact on the buying behavior of end-users and trade. - To introduce new brand - To attract brand switchers - To reward loyal customers - To increase usage rate - To obtain better trade support - To motivate the sales force - To price discriminate - To reduce inventory - To meet competition

  26. Pricing and Promotion Decisions 5. Growing Importance of Sales Promotions  Increasing use of sales promotions in - durables - retailing - packaged goods - services

  27. Advertising and Promotion Budgets For Packaged-Goods Manufacturers 50 40 30 20 Percent of Budget Trade Promotions Advertising Consumer Promotions 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Time Source: Fortune. Oct. 1992 Pricing and Promotion Decisions  Sales promotions growing at the expense of advertising

  28. Pricing and Promotion Decisions 6. Reasons for Growth in Promotions  Increasing short-term focus - Brand management system - Sales force compensation  Empirical evidence - Promotions “work” - Advertising’s effects are hard to measure  Maturing brands - Brand proliferation - Advertising can not differentiate “me-too” products  Growing power of the trade - Increasing concentration and sophistication - Fight for shelf space  Changing consumer buying behavior - Over 80% of brand selections made in the store - Consumers trained to “cherry-pick” products on deal

  29. 1.00 .90 .80 .70 .60 .50 .40 .30 .20 .10 $2.56 $2.30 $2.05 $1.79 $1.54 $1.28 $1.02 $.77 $.51 $.26 FDC FDC FD D C C FD FDC FDC FD FDC FD 4 8 12 16 20 24 28 32 36 40 44 48 52 Pricing and Promotion Decisions 7. Effectiveness of Promotions MaxHouse Market Share F - Feature D - Display C - Store Coupon Occasion

  30. Pricing and Promotion Decisions  If promotions work, then what is the problem?  New York Times (March 31, 1993) stated, In the United States, top executives lose their jobs when their companies sell too little. In Britain, it can happen when their companies sell too much.  Where does the increase in sales during promotion come from?

  31. Manufacturer Trade Trade Promotions Consumer Consumer Promotions Retailer Promotions Pricing and Promotion Decisions 8. Types of Sales Promotions  Trade Promotions Case allowances, advertising allowances, display allowances, financial incentives, contests Retailer Promotions Price cuts, displays, features, retailer coupons Consumer Promotions Coupons, free samples, bonus packs, refunds, 2-for-1 packs, sweepstakes, tie-ins

  32. 1997 1998 1999 Quarter 1 100 100 100 Quarter 2 100 100 50 Quarter 3 100 100 220 Quarter 4 100 100 60 Pricing and Promotion Decisions 9. Do Promotions Really Work? A. Evaluating the Profitability of Trade Promotions Example 1: Given below are the quarterly sales of a brand with a retail selling price of $15, manufacturer selling price of $10, and variable cost of $6. In the third quarter of 1999, the brand manager offered a trade deal of $1 off per unit. We need to assess the following: (a) Was the promotion profitable for the manufacturer? (b) Do you think that retailers have the incentive to pass the trade discount to consumers?

  33. Pricing and Promotion Decisions B. Retailer Pass-Through  Factors affecting retailers’ decision of promotional pass-through - Economic factors * Margin * Turn rate (promotion elasticity, cannibalization) - Store competition factors * Store traffic * Promotion behavior of other stores - Manufacturer’s Clout  Empirical evidence - Levels of grocery trade support for trade deals are low and declining (almost 80% of trade deals get no or nominal support). - Approximately 84% of the trade deals are not profitable for the manufacturers.

  34. Sales Shipments Pricing and Promotion Decisions C. Importance of Assessing Baseline Sales  Baseline sales of a brand is its sales if no promotion were run  Why is it important to estimate baseline sales? - To assess incremental sales - To find profitability of promotion 4 3 2 1 0 10/31/86 02/08/87 05/19/87 08/27/87 12/05/87 01/14/88 Week Weekly Sales and Shipments Source: A. C. Nielsen

  35. Pricing and Promotion Decisions D. Estimating Baseline Sales Approaches to estimating baseline sales and incremental volume - Experiments  Run a promotion in a test market  No promotion in a comparable control market  Incremental sales = Test market sales - Control market sales - Using Historical Data:  Adjust the data for seasonality and trend,  Find the periods of no promotion in the historical data,  Find average sales during no-promotion period baseline,  Add back trend and seasonality to get baseline estimate.

  36. Pricing and Promotion Decisions E. Estimating Baseline Sales: Historical Data Illustrated Sales Data for Time Series Analysis Example 8 7 6 5 4 3 2 1 Promotion 13 1 2 3 4 5 6 7 8 9 10 11 12 13 1 2 3 4 5 6 7 8 9 10 11 12 13 1 2 4-week "month" 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 Promotion period

  37. (1) (2) (3) (4) (5) (6) Original 13-Period Seasonality Estimates Deseasonalized Seasonally Seasonally 13-Period Sales Data Moving Avg. (Column 1 ÷ 2) Data Estimatedb Adjusted Sales Period Year "Month" (T x S x I) (T) x 100 Column 1 ÷ 3 Trend Line Predictions 1 1 13 805,584 678,672 712,466 845,697 2 2 1 582,344 705,359 706,179 583,021 3 2 2 682,118 731,572 699,892 652,579 4 2 3 806,201 732,843 693,605 763,035 5 2 4 675,605 586,717 687,318 791,447 6 2 5 693,976 700,703 681,031 674,493 7 2 6 793,750 676,805 117.28 676,805 674,744 791,340 8 2 7 685,728 673,227 101.86 673,227 668,457 680,890 9 2 8 554,807 668,673 82.97 668,673 662,170 549,402 10 2 9 621,902 661,253 94.05 661,253 655,883 616,858 11 2 10 569,136 651,571 87.35 651,571 649,596 567,422 12 2 11 523,616 653,774 80.09 652,774 643,309 515,226 13 2 12 803,692 646,572 124.30 646,572 637,022 791,818 14 2 13 759,071 639,500 118.70 639,500 630,735 748,682 15 3 1 523,142 633,625 82.56 633,625 624,448 515,544 16 3 2 585,669 628,123 93.24 628,123 618,161 576,373 17 3 3 680,331 618,418 110.01 618,418 611,874 673,123 18 3 4 704,237 611,595 115.15 611,595 605,587 697,333 19 3 5 600,357 606,146 99.04 606,146 599,300 593,547 20 3 6 701,816 598,411 593,013 695,486 21 3 7 609,346 598,219 586,726 597,639 22 3 8 483,281 582,477 580,439 481,590 23 3 9 495,743 527,106 574,152 539,990 24 3 10 480,436 550,013 567,865 496,030 25 3 11 452,780 565,339 561,578 449,768 26 3 12 736,047a 555,291 690,227 27 3 13 737,002a 549,004 651,668 28 4 1 462,856a 542,717 448,067 29 4 2 506,183a 536,430 500,167 a Periods 26 and 27 are the promotion periods. Periods 26-29 are not included in the computation of seasonality and trend in columns 2-5 b Column 5 Est. Trend Line: Deseasonalized Sales (Col. 4) = a + b Period S = 718,753 - 6287 Period 793,750 676,805 805,584 1.187  rows (1 - 13) 13  rows (2 - 14) 13 = = 8. Pricing and Promotion Decisions E. Estimating Baseline Sales: Historical Data Illustration = 718,753 - 6287(1) = 712,466 X 1.187

  38. (1) (5) (6) (7) Original 13-Period Seasonally Incremental 13-Period Sales Data Estimated Adjusted Sales Sales Period Year "Month" (T x S x I) Trend Line Predictions Column 1 - 6 26 3 12 736,047 555,291 690,227 45,820 27 3 13 737,002 549,004 651,668 85,334 28 4 1 462,856 542,717 448,067 14,789 29 4 2 506,183 536,430 500,167 6,016 151,959 * How would you evaluate the success of this presentation? Pricing and Promotion Decisions E. Estimating Baseline Sales: Historical Data Illustration

  39. Pricing and Promotion Decisions 10. Practice Problem 10.1 Beauregard Textile Company a) What price should be set for T-30? b) Should Calhoun & Pritchard change their pricing structure?

  40. Pricing and Promotion Decisions 10.2Consider the following elasticity matrix a. Which brand(s) is most price sensitive? b. Which brand(s) is least vulnerable? c. Which brand(s) is most vulnerable? d. What pattern of switching does the cross elasticities imply?

  41. Pricing and Promotion Decisions XYZ Sales Data 10.3 The following presents historical sales data for the XYZ company, a marketer of cereals. The table shows sales data. The company ran a coupon promotion in periods 26 and 27. Provide your estimate of base line sale and evaluate the promotion. Period Year Month Sales Data 1 1 13 484080 2 2 1 351906 3 2 2 410640 4 2 3 484260 5 2 4 406353 6 2 5 419075 7 2 6 477310 8 2 7 412546 9 2 8 333404 10 2 9 376111 11 2 10 343461 12 2 11 316929 13 2 12 483155 14 3 13 455432 15 3 1 313655 16 3 2 351266 17 3 3 408321 18 3 4 422511 19 3 5 360322 20 3 6 422000 21 3 7 365701 22 3 8 291000 23 3 9 297100 24 3 10 288677 25 3 11 271888 26 4 12 441188 27 4 13 442777 28 4 1 277555 29 4 2 303666

  42. Pricing and Promotion Decisions 10.4 A major manufacturer of men's and boy's socks was considering supplementing their advertising program for one of their product lines (P100) with one or more promotions. P100 currently had a unit gross margin of $1.00. Several promotions were being considered: i) a $1 cash refund offer could be promoted at the point of purchase by means of a take-one, each with 50 refund request forms, attached to the display units. The refund would be sent to any customer who mailed in a form plus a proof of purchase. Based on a 7% redemption rate, the design, distribution, and redemption costs for this promotion would total $75,000 if it was offered on 15,000 displays. ii) a 25 cent coupon, to be distributed through free-standing inserts in Sunday newspapers with a combined circulation of 10 million. Based on a 2.5% redemption rate, the total design, distribution, and redemption costs for this promotion were estimated at $136,500. What advice would you give?

  43. Pricing and Promotion Decisions Time Sales Month Price 10.5 In the mid-70's FEDX was considering the introduction of the Courier Pak. A pressing question that faced FEDX management was whether customers were price sensitive. Based upon the data provided, what would you conclude? Jan 74 140 1 5.00 Feb 195 2 5.00 Mar 268 3 5.00 Apr 481 4 5.00 May 411 5 5.00 Jun 481 6 5.00 Jul 525 7 5.00 Aug 527 8 5.00 Sep 547 9 8.50 Oct 502 10 8.50 Nov 511 11 8.50 Dec 534 12 8.50 Jan 75 559 13 10.00 Feb 575 14 10.00 Mar 592 15 10.00 Apr 661 16 10.00 May 764 17 10.00 Jun 794 18 10.00 Jul 805 19 10.00 Aug 745 20 10.00 Sep 859 21 10.00 Oct 982 22 10.00 Nov 987 23 10.00 Dec 1034 24 10.00 Jan 76 1090 25 10.00 Feb 1156 26 10.00 Mar 1194 27 12.50 Apr 1370 28 12.50 May 1304 29 12.50

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