Chapter 12 Price Determination and Pricing Strategies

1. Chapter 12Price Determination and Pricing Strategies Professor Jason C. H. Chen, Ph.D. School of Business Administration Gonzaga University Spokane, WA 99223 chen@jepson.gonzaga.edu

2. After studying this chapter, you should be able to: • Discuss relationships among price, demand, demand elasticity, and revenue. • Understand methods for determining price. • Recognize different pricing strategies and the conditions that best the choice of a strategy. • Recognize the importance of adapting prices under shifting economic and competitive situations. • Understand the ethical considerations involved in setting and communicating prices.

3. OPENING VIGNETTE WWW.EBAY.COM • What are the ingredients for eBay’s success? • How are prices determined for merchandise sold on eBay? • On eBay, buyer and seller are separated by hundreds or even thousands of miles, never see each other, and cannot show more than a picture of the item for sale. How is it possible to build relationships under these conditions? • How has eBay been able to offer their customers protection against fraud and bad transactions? • What features has the company incorporated into its Web site and how has it used the Internet to attract its target market?

4. Price Determination: An Overview Exhibit 12-1 The price-setting decision process Set strategic pricing objectives 1. Estimate demand & price Elasticity of demand 2. Determine costs & their Relationship to Volume & profits 3. Influences & constraints Marketing strategies Target market characteristics Product characteristics Competitor characteristics Company strengths & weaknesses Environmental influences Economic trends Legal restrictions Evaluate competitors’ Price & costs 4. Select a method for calculating price 5. Adopt a pricing strategy & set a price level 6. Adapt price structure to meet variations in demand & costs across geographic territories or market segments 7.

5. P Price D D Q Quantity Demand Curves

6. % Change in quantity demanded Price Elasticity of Demand = % Change in price Elastic Demand Inelastic Demand Cross Elasticity of Demand Price Elasticity of Demand

7. Costs, Volume, and Profits • Fixed Costs (FC) • Variable Costs (VC) • Total Costs (TC) • Marginal Cost MC) • Marginal Revenue (MR) • Total Revenue (TR) TC = (VC X Q) + FC Total Revenue = Price X Quantity Profits = TR - TC

8. Markups • Dollar amount added to the cost of the products to get the selling price • Markup percent is the percentage of selling price that is added to the cost to get the selling price • percent of selling price unless otherwise noted • Products may be marked up several times through the channel • the sequence of markups is the markup chain • High markups don't always mean high profits • depends on the stockturn rate

9. Price Determination Methods • Markup Pricing Price = Unit Cost + Markup or Price = Unit Cost/(1-k)* *k = desired % markup

10. Alternate Approach for Computing Channel Markups [k]

11. Example of Markup Chain and Channel Pricing

12. Alternate Example of a Markup Chain and Channel Pricing

13. Average-Cost Pricing • Adds a "reasonable" markup to the average cost of a product • Simplifies pricing • Quite common, especially among middlemen • Usually based on estimates or past records • actual average cost depends on quantity sold! • quantity sold depends on price

14. Results of Average-Cost Pricing

15. Typical Shape of Cost (per unit) Curves when Average Variable Cost per Unit Is Constant

16. Evaluation of Various Prices along a Firm's Demand Curve

17. Experience Curve Pricing • A type of average-cost pricing using an estimate of future average costs • Often leads to low prices if future economies of scale are expected • costs may drop with accumulated production experience • Can be very risky if costs do not drop, or if expected volume is not achieved

18. Summary of Relationships among Quantity, Cost, Price andUsing Cost-Oriented Pricing Estimated quantity to be sold ? Quantity demanded at selling price Average fixed cost per unit Variable cost per unit Cost-oriented selling price per unit Average total cost per unit Profit per unit

19. Break-Even Analysis • Used to evaluate whether the firm will be able to cover costs (break even) at a particular price • Indicates the break-even point—sales (units or dollars) needed to break even • Can be modified to incorporate a target return • Problems: • assumes any quantity can be sold at a given price • total cost curve is assumed to be a straight line

20. Price Determination Methods Break-Even Analysis $ Total Revenue Profit Total Cost Fixed Cost Loss BEP Quantity (units)

21. Break-Even Chart for a Particular Situation BEP

22. Price Determination Methods • Target-Return Pricing (Desired return X Invested capital) Price = Unit Cost + Expected Unit Sales (p.275)

23. Price Determination Methods • Target-Cost Pricing • Define market segments for new product. • Product is designed based on competitive advantages and disadvantages. • Position product in context of overall company strategy. • Fine-tune product based on customer’s preferences, perceived value and willingness to pay. • Estimate various price-responsiveness with simulations. • Estimate target costs between optimal price and desired margin.

24. Price Determination Methods • Income-Based Pricing • Real Estate • Marketable Securities • Businesses

25. Prices and Customer Value Exhibit 12-6 Flow chart of BDM procedure Instructions Initial price offer Possibility to revise initial price offer Final price offer (s) Random determination of buying price (p) Buying price ≦Final price offer Buying price >Final price offer Buying obligation No buying opportunity

26. Value in Use Pricing • Sets prices that will capture some of what customers will save by substituting the firm's product for the one the customer is currently using • Example: A construction firm that buys a new, more efficient bulldozer at a higher price might still save money on: • labor (operator) expenses • "down-time" for repairs • fuel consumption • maintenance costs

27. Pricing Strategies Differential Pricing Second-market discounting Periodic discounting Product Line Pricing Bundling Premium pricing Partitional pricing Competitive Pricing Penetration pricing Price signaling Going-rate pricing Psychological Pricing Odd-even pricing Customary pricing One-sided claims

28. New Product Pricing Price Skimming Penetration Pricing Experience Curve Pricing Competitive Pricing Leader Pricing Parity Pricing Low-Price Supplier Price Line Pricing Complementary Product Pricing Price Bundling Customer Value Pricing Cost-based Pricing Cost-plus Pricing B2B Pricing Strategies

29. StrategyDescription Related Strategies New Product Pricing Situation Premium pricing, Value-in- Use pricing. Learning Curve pricing. We set the initial price high and then systematically reduce it over time .Customers expect prices to eventually fall. We initially set the price low to accelerate product adoption. We set the price low to build volume and reduce costs through accumulated experience. Price Skimming Penetration Pricing Experience Curve Pricing Competitive Pricing Situation Umbrella Pricing, Cooperative Pricing, Signaling. Neutral Pricing, Follower Pricing. Parallel Pricing, Adaptive Pricing, Opportunistic Pricing Leader Pricing Parity Pricing Low-Price Supplier We initiate a price change and expect the other firms to follow. We match the price set by the overall market or the price leader. We always strive to have the low price in the market. Product Line Pricing Situation We price the core product low when complementary items such as accessories, supplies, spare parts, services, etc. can be priced with a higher premium. We offer this product as part of a bundle of several products, usually at a total price that gives our customers an attractive savings over the sum of individual prices. We price one version of our product at very competitive levels, offering fewer features than are available on other version. Complementary Product Pricing Price Bundling Customer Value Pricing Razor-and-Blade Pricing System Pricing Economy Pricing Cost-based Pricing Situation Contribution pricing, Rate- of-Return Pricing, Target Return Pricing, Contingency Pricing, Markup Pricing We establish the price of the product at a point that gives us a specified percentage profit margin over our costs. Cost-Plus pricing Industrial (B2B) pricing strategies Exhibit 12-9

30. Price Reduction Traps: Low-quality trap Fragile market share trap Shallow pockets trap Acceptable Price Range: Prices the buyer is willing to pay. Adapting Prices: Decreases and Increases

31. Adapting Prices: Reacting to Competitive Price Changes • Temporary retail price reductions substantially increase store traffic and sales. • Large-market-share brands are hurt less by price changes from smaller competitors. • Frequent price dealing lowers consumers’ reference prices, which may hurt brand equity. • Price changes for high-quality brands affect weaker brands and private-label brands disproportionately.

32. Adapting Prices: Price Discounts and Allowances • Cash Discounts • Trade Sales Promotion Allowances • Quantity Discounts

33. Adapting Prices: Geographical Pricing FOB Origin Pricing Uniform Delivered Price Zone Pricing Freight Absorption Pricing

34. Competitive Bidding and Negotiated Pricing • Sealed-bid Pricing • Reverse Auctions

35. Pricing Services Price is influenced by the nature of the service involved. The larger the market share, the higher the price that can be charged. Managing off-peak demand makes pricing services difficult. Bundling services into a single package and price is a common strategy.

36. B2B e-Procurement Processes Seller/Supplier e-Marketplaces Buyer/Wholesale Supplier Trading Platform Buye/r Wholesale Buyer/Wholesale Trading Platform Supplier B2B e-Procurement Process System • Order mgt. • Finance mgt. • Shipping mgt. • Customer mgt. • e-catalogue • inquiry/ • negotiation • quick ordering • account mgt. 供應鏈Supply Chain e-procurement process system 需求鏈Demand Chain Material Flow Information Flow Money Flow

37. General Purchasing Process Forecast Demand Supplier / Seller Buyer Request for Proposal/Quote (RFP/RFQ) Bid Negotiate Contract Place Orders Process Orders Shipping Orders Receiving Orders Invoicing Payment Vender Performance Tracking & Management Customer Service

38. Group Purchasing Organization Process [Stage1-b] [Stage1-a] Forecast Demand RFQ G P O B u y e r RFQ Bid Response Confirm (Price OK) Negotiate Contract S Place Orders u Process Orders p Shipping Orders p Receiving Orders . . . l Invoicing Payment RFQ i VPTM e [Stage3] [Stage2] r Shipping / Receiving Orders Returns / … … S Refund Process Shipping / Receiving Orders e Invoice l Payment l Returns e r [Stage4] Refund Process VPTM : Vender Performance Tracking & Management

39. FTC Pricing Guidelines • Comparisons with former prices. • Comparisons with other retailer prices. • Comparisons with prices suggested by manufacturers or other non-retail distributors.

40. Deceptive Pricing Practices • Bait and Switch • Predatory Pricing • Unit Pricing

41. Demand-Oriented Pricing Approaches • Evaluating a Customer’s Price Sensitivity • Value-in-use pricing • Auctions • including online • Reference prices • Leader pricing • Bait pricing • Psychological pricing • odd-even pricing • price lining • Demand-backward pricing • Prestige pricing • Full-line pricing • complementary pricing • bundle pricing

42. Evaluating a Customer’s Price Sensitivity • Are there substitute ways of meeting a need? • Is it easy to compare prices? • Who pays the bill? • How great is the total expenditure? • How significant is the end benefit? • Is there already a sunk investment related to the purchase?

43. How Customers Reference Price Influences Perceived Value (for a marketing mix with a given set of benefitsand costs)

44. Demand Curve when Psychological Pricingis Appropriate

45. Demand Curve Showing a Prestige Pricing Situation

47. Revenue, Cost, and Profit at Different Prices for a Firm

48. A Plotting of the Demand and Marginal Revenue Data in Overhead 200

49. Marginal Revenue and Price © 2002 McGraw-Hill Companies, Inc., McGraw-Hill/Irwin—for use only with Basic Marketing

50. Cost Structure for Individual Firm (fill in the missing numbers)