There are a number of marketing objectives that can be achieved, directly or indirectly, via pricing decisions. A number of these have been mentioned during the book so far, for instance:
■ price low to gain market share;
■ price high to maximize short-term profitability;
■ create a loss leader to encourage sales of other products;
■ launch a new premium product to create better ‘price lines’ for others in the range;
■ price on a marginal basis to enable survival in the short term;
■ price on a marginal basis to hurt the competition.
These can all be justifiable strategies because pricing decisions need judgement and flexibility and must be based on the day-to-day reality of competitive markets. However, the key test of their validity is whether they will create more long-term shareholder value than would be produced by other options, including the option of doing nothing. This comparison may or may not be quantifiable in detailed cash flow terms, but the creation of more present value than other options should always be the explicit or implied aim of a pricing decision.
Pricing, business objectives and value creation
Take the first objective, the gaining of market share, which is a common priority among ambitious brand managers. Too often market share growth is assumed to be a good thing in itself, without considering the high cost of the price reductions or marketing spend which are necessary to deliver it. This assumption that high market share is the best way of maximizing value may be true in many markets, but can also become the justification of a poorly conceived and evaluated strategy.
If we think back to the price/volume evaluations in Chapter 7, these were examples of the difficult choices that have to be made between short-term and long-term return. Should we reduce price to achieve a volume increase, even though the contribution this year will be significantly reduced by so doing? Should we increase price and lose market share because the extra contribution will help this year’s profits?
Those evaluations were essentially short-term because that was the context we were discussing at the time. However, if the base data is available and if managers are willing and able to make the necessary assumptions, the only valid way to make the judgement would be to compare the cash flows over the remaining life of the product for each option and see which one generates the most value for shareholders.
To illustrate this point we will have to simplify. We will take two options for price change similar to those illustrated in Chapter 7, one for a 10 per cent price increase, one for a 10 per cent price reduction. The existing situation is as follows:
■ market size 1,000 units;
■ no expected market growth;
■ price £100;
■ existing share 30 per cent, 300 units;
■ variable costs £35 per unit;
■ fixed costs £10,000;
■ promotion and advertising support 7.5 per cent of sales;
■ product life forecast as ten years.
The ongoing profit and loss account if no price change takes place therefore looks like this:
£
Sales 30,000
Variable costs (10,500)
Fixed costs (10,000)
Promotion and advertising (2,250)
Operating profit 7,250
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Pricing for Long-term Profitability
The assumptions for the price change options are as follows:
10 per cent price increase
■ Market share falls from 30 per cent to 25 per cent over next five years.
■ Fixed and variable costs stay the same.
■ Promotion and advertising support has to increase to 10 per cent of sales to support the price increase.
10 per cent price reduction
■ Market share rises from 30 per cent to 45 per cent over the next five years.
■ Fixed costs rise by a step of £2,500 after year 5.
■ Promotion and advertising support reduces to 5 per cent of sales.
■ Capital expenditure of £50,000 is necessary in year 5 to cope with higher volume.
From this information it is possible to build a ten-year cash flow of the two options and thus make a real assessment of value – see Tables 10.1 and 10.2.
The figures in the right-hand columns tell us the net amount of cash which will be generated by the two options. The final step is to convert these future cash flows into their present values so that we can have a true comparison of the shareholder value that will be created by each option. The price increase option will create more value in the early years but will tail off later as the share decreases; the price reduction option comes into its own after year 5 and generates substantially more cash flow in years 6 to 10.
It is not possible here to provide a full explanation of the principles of discounted cash flow for those who are not familiar with them. It is hopefully enough to say that discounting is a technique which converts future cash flows to their present value, based on an agreed discount rate that represents the average cost of financing debt and equity investment. We will assume this rate as a fairly typical 10 per cent.
Effectively this technique is quantifying the obvious reality that the longer we have to wait for our money, the less it is worth. This calculation can be made as a standard function from any spreadsheet, but we will show the year-by-year calculation to help understanding.
If we convert these cash flows into their yearly and total present values, we will have a better understanding of the real value generated by the two options – see Tables 10.3 and 10.4.
PriceMarketMarketVolumeSalesVariableFixedAdvertisingCapitalNet cash sizesharecostcostand promotionsinvestmentflow 1,000 0.30 30030,000(10,500)(10,000)(2,250)7,250 110 1,000 0.29 290 31,900 (10,150) (10,000) (3,190) 8,560 110 1,000 0.28 280 30,800 (9,800) (10,000) (3,080) 7,920 110 1,000 0.27 270 29,700 (9,450) (10,000) (2,970) 7,280 110 1,000 0.26 260 28,600 (9,100) (10,000) (2,860) 6,640 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000
Price increase option
YearPriceMarketMarketVolumeSalesVariableFixedAdvertisingCapitalNet cash sizesharecostcostand promotionsinvestmentflow Now 100 1,000 0.30 300 30,000 (10,500) (10,000) (2,250) 7,250 1 90 1,000 0.33 330 29,700 (11,550) (10,000) (1,485) 6,665 2 901,000 0.36 360 32,400 (12,600) (10,000) (1,620) 8,180 3 90 1,000 0.39 390 35,100 (13,650) (10,000) (1,755) 9,695 4 90 1,000 0.42 420 37,800 (14,700) (10,000) (1,890) 11,210 5 90 1,000 0.45 450 40,500 (15,750) (10,000) (2,025) (40,000) (27,275) 6 90 1,000 0.45 450 40,500 (15,750) (12,500) (2,025) 10,225 7 90 1,000 0.45 450 40,500 (15,750) (12,500) (2,025) 10,225 8 90 1,000 0.45 450 40,500 (15,750) (12,500) (2,025) 10,225 9 90 1,000 0.45 450 40,500 (15,750) (12,500) (2,025) 10,225 10 90 1,000 0.45 450 40,500 (15,750) (12,500) (2,025) 10,225
Table 10.2Price reduction option
Pricing, business objectives and value creation
Table 10.3 Price reduction option
Year Cash flow Discount factor Present value
1 6,665 0.91 6,065
2 8,180 0.83 6,789
3 9,695 0.75 7,271
4 11,210 0.68 7,622
5 (27,275) 0.62 (16,911)
6 10,225 0.56 5,726 7 10,225 0.51 5,215 8 10,225 0.47 4,806 9 10,225 0.42 4,295 10 10,225 0.39 3,988
Net present value 34,866
Table 10.4 Price increase option
Year Cash flow Discount Present value
factor
1 8,560 0.91 7,790
2 7,920 0.83 6,574
3 7,280 0.75 5,460
4 6,640 0.68 4,515
5 6,000 0.62 3,720
6 6,000 0.56 3,360
7 6,000 0.51 3,060
8 6,000 0.47 2,820
9 6,000 0.42 2,520
10 6,000 0.39 2,340
Net present value 42,159
This analysis shows that the price increase option, with its assumed reduction to 25 per cent market share, will generate more value for stakeholders than the option to reduce prices and gain a 45 per cent share. This situation might be different if the life was extended beyond ten years or if other assumptions were changed, but as things stand, management would not be justified in reducing prices to gain share, even in the longer term.
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Pricing for Long-term Profitability
There is still the third option of doing nothing and leaving price as it is, with an ongoing cash flow of £7,750. A similar evaluation to the above will show that the present value of £7,750 per annum over ten years is £44,515.
On this basis the course of action which creates most value for shareholders is to leave the price unchanged.