MTP was founded in 1987 as the Management Training Partnership and has rapidly grown to become one of the UK's largest providers of bespoke management training. There is then coverage of price as only one element of the marketing mix and its relationship with the other components.
THE PROBLEM OF PRICE INERTIA
The legacy of this thinking still exists today, as managers cite "actual volume growth" in their internal reports or in their annual reports to shareholders. While there is some validity to knowing these numbers as part of running any business, excessive emphasis on 'real' growth can cause pricing leverage to be neglected or deliberately lowered.
THE COMPLEXITIES OF PRICING
A FRAMEWORK FOR PRICING DECISIONS
However, the concept of "cost plus" pricing cannot be completely rejected and, therefore, the entire Chapter 9 will be devoted to this topic. However, we would argue that the above framework still applies to these situations and in the long term customers or governments will only allow cost plus to continue if they feel they are getting value from the deal.
THE CONCEPT OF VALUE
Cost plus can also have a place when market forces do not apply – because the customer has chosen to trust the supplier to take the cost plus route, or because the market has monopolistic characteristics. The offered price will always be seen by the customer in relation to the other benefits provided, as part of the total marketing proposition.
ORGANIZATIONAL RESPONSIBILITY FOR PRICING
In Chapter 5 and elsewhere, we will emphasize the principle that price is only one element of the marketing mix. Such quantified analysis will have a role to play, but the pricing decision must be based on informed and expert judgment applied to each segment of the market.
PRICE REVIEWS
STEPS TO PRICING EFFECTIVENESS
Regardless of the context, however, these steps are the structure and discipline that will help ensure the best possible pricing judgment. Many of the steps are interrelated and real-life application will not be as structured and sequential as it appears here.
ECONOMIC THEORY
The best use of this framework is as a checklist to ensure that, in the unique context of each business, these steps are performed, however intuitive, judgmental, and informal the processes may be. Following this framework, Chapter 2 will focus on the starting point for each pricing decision, the overall competitive strategy of the business, and the broad pricing strategy that emerges from it.
BUSINESS STRATEGY AS THE STARTING POINT
PORTER’S GENERIC BUSINESS STRATEGIES
This strategy is to create a product or service that is perceived by customers as unique. Porter's third general strategy is to focus on a specific customer group, product type, or geographic market.
GENERIC PRICING STRATEGIES
This strategy is called "imitation" because the company tries to "skip" the market and target only those who value their offering the most and are willing to pay a high price. Companies that adopt this strategy are willing to sacrifice potential market share because they believe that in the long run, the resulting margins will result in high levels of profit.
CHOOSING BETWEEN SKIMMING AND PENETRATION
If economies of scale are important, a penetration strategy will be more effective as it will lead to higher volumes and lower unit costs than competitors. A summary of the circumstances under which different pricing strategies will be most effective is presented in Table 2.1.
SUBSIDIARY PRICING STRATEGIES
Competitors Slow response Fast response Economies of scale Small Considerable Experience curve Small Considerable. The large economies of scale in R&D and marketing enable management to use this strategy effectively.
PRACTICAL APPLICATIONS
PRICING AND THE PRODUCT LIFE CYCLE
A range of different strategies will be appropriate at these four stages of the life cycle. During this phase of the life cycle, the successful players will increase revenue through innovations to meet the needs of new customer groups.
A SUMMARY OF LIFE CYCLE PRICING STRATEGIES
During this phase, the strategic goal should be to develop a pricing strategy that will maximize cash flow. This is an easy trap to fall into because the product will generate high cash flow and the money for investment will be available.
THE IMPORTANCE OF COMPETITOR ANALYSIS
There is a danger that a company may overinvest in fixed assets during this period, creating capacity that will not be used in the future. The better target for these cash flows is to invest in new products in the early stages of their life cycle, ensuring the future viability of the company.
COMPETITOR AWARE BUT NOT COMPETITOR DRIVEN
THE PROBLEMS OF ANALYSIS
In the 'business to business' sector the problems are even greater because there is not the same public availability of data. They may even encourage misinformation, implying that others are willing to lower price and make price appear more important than it really is in the final decision.
THE CONTEXT OF COMPETITOR PRICE ASSESSMENT
In these circumstances, customers are less loyal, less prone to personal relationships and, in many cases, less likely to consider the other factors in the value proposition. There is no long-term point in trying to adopt a low-price penetration strategy if that competitor has the ability to produce at a significantly lower cost.
SOME PRINCIPLES OF COMPETITOR ANALYSIS
It is also important that the fact files contain information about the sales team on a systematic basis. However, it is important to question and challenge such information, especially when it comes to business-to-business transactions.
FROM COMPETITORS TO CUSTOMERS
Contrast this situation with the example of the 'hard' end - a management consulting firm that will be hampered in finding competitive pricing by confidentiality, complexity and comparison difficulties; for example, what level of consultant, what type of work, what unit of measurement. The question for the retailer is: to what level of detail does the research go.
THE NEED FOR UNDERSTANDING AND INSIGHT
THE NATURE OF THE PRODUCT
Between these two levels, the price will convey a message about quality - the £70 watch is assumed to be of higher quality than the £50 watch and the consumer may choose that one, even if they both have the same look, quality and brand recognition. This can be especially true for those who buy gifts for others, where the price says something about personal respect for the recipient.
EMOTIONAL OR FUNCTIONAL BENEFITS?
The second factor, which will apply to perfumes and watches but not to fruit and vegetables, is where the buyer values prestige and exclusivity and where the price reflects that kind of value, says something about the person who is willing and able to pay that price. There will also come a point - perhaps over £100 - where the buyer will expect a prestige brand to justify that price.
MARKET ENVIRONMENT
There are some countries and regions where consumers are more likely to shop on price than others because of the way their people think and act when they shop. These will be a major factor in determining the perceived value of the product and therefore the parameters within which marketing people can work in developing a pricing strategy.
THE CONTEXT OF THE PURCHASE TRANSACTION
This business-related example illustrates a broader principle underlying price sensitivity in all markets – the extent to which consumers are generally well informed about the alternatives available and the prices charged in the market. The most obvious example is the type of "peak hours" typical of air and rail travel - the provider sets the price to maximize the return on the scarce resources available at peak times, while using it to transfer some of demand into quieter periods.
A COMPLEX WEB OF FACTORS
The key to success is still providing value to target customers in different time segments so that they are not tempted to turn to alternative times or choose to use other services. In other words, price can and should be managed in conjunction with other elements of the marketing mix, which is the subject of the next chapter.
THE MARKETING MIX FRAMEWORK
THE PLACE OF PRICE IN THE MARKETING MIX
Pricing decisions must be compatible with the management of the other elements of the mix. Low-cost strategies must have functional products, supported by price-based promotions and availability in channels that attract price-sensitive customers.
SEGMENTATION
The successful companies are those that manage pricing in tandem with the other three elements of the mix and create sustainable competitive advantage in their chosen segments. We will now examine the other three elements of the mix and consider the links to price.
PRICING AND PRODUCT
This can often have the effect of lowering resistance and persuading the customer to accept the higher value of the bundled deal. They are also changing the language of the product, thus making the price comparison more difficult for the consumer and thereby reducing sensitivity.
PRICING AND PROMOTIONS
It is often a classic choice between allocating resources for short-term or long-term investments: short-term promotions to achieve volume this year versus long-term advertising to strengthen the brand for the future. On the other hand, investing in the right type of longer-term advertising is likely to reduce price sensitivity because it increases brand power, which becomes an essential part of the value package in the consumer's mind.
PRICING AND DISTRIBUTION CHANNELS
Will the prices charged at wholesalers and in vending machines, e.g. have any influence on the product's price sensitivity and image in retail outlets. Special promotions and incentives for the retailer in question can be one of the means of exerting this influence.
ANALYZING THE VALUE PACKAGE
After identifying this list of benefits from the target audience sample, the market research analyst would then assign weights to each benefit based on further analysis of preferences and priorities within the sample. This is because buyers will either not be able to resist a good price or will not be willing to pay a high price regardless of the nature of the other benefits.
THE LINK OF PRICING STRATEGIES TO FINANCIAL RESULTS
The choice and balance will depend on the resources available for market research and the information available within the company. In practice, a mixture of all four methods may be the best option, with common sense judgment supplementing and verifying the results.
DEFINITIONS OF QUALITY
THE PIMS RESEARCH
The two axes on the graph show relative positions compared to others in the sector. The vertical axis shows price compared to others, and the horizontal axis shows quality compared to others, as perceived by the customer.
LINKING VALUE TO PROFITABILITY AND MARKET SHARE
Customers do not perceive the offer of one company as different from others. Customers don't perceive any business as different from others, so the customer experience is similar to buying goods, even though it's a business that depends on personal service.
SUMMARY OF RANKINGS
In any market there will be some customers who want to minimize their spending, either because they have low cash availability or because they do not consider the product as an important priority. The fifth and least successful position of all is the worst value – position E, high price, low quality – with a return on assets significantly lower than the other positions.
PIMS, PORTER AND PRICING STRATEGIES
FINANCIAL IMPLICATIONS
THE CASE FOR COST AND PROFITABILITY ANALYSIS
THE LINK TO FINANCIAL OBJECTIVES
Financial analysis should enable management to examine its cost structure, compare it with others, and evaluate various options for reducing existing cost levels. Financial analysis can and should play an important role in this process by assessing long-term profit potential and by assessing the financial impact of exit strategies.
THE FINANCIAL ANALYSIS OF PRICE CHANGE OPTIONS
Here again is the case for financial analysis to support the decision-making process and help prevent the main danger of this situation – that management will sit idly by and do nothing. Understanding the impact on profitability requires an informed financial analysis, and the starting point must be an understanding of the cost structure.
COST STRUCTURE
As a first illustration of its importance, let's look at the impact of a 10 percent price increase on this company, assuming it will cause a 10 percent loss in volume. In this case, the 10 percent net margin would be doubled to 20 percent, as the extra £10 profit from the increase flows straight into the operating profit.
THE IMPACT OF PRICE REDUCTIONS
When we examine the impact of the 10 percent volume increase resulting from the 10 percent price reduction, we can clearly see that with this cost structure, such an increase is not nearly enough to offset the profit lost due to the price reduction. Since this is a relatively high variable cost business, this “–10 percent, +10 percent” scenario will undoubtedly be very damaging to profitability.
THE PRICE/VOLUME BREAKEVEN CONCEPT
Therefore, we can say that, under this cost structure, a 10 percent price reduction requires a 30 percent volume increase to achieve the same profit level as before – which should be valuable information for a marketing manager considering a price-lowering promotion, or a sales manager proposing a discount to offer. Therefore, we can say that with this cost structure, volume could drop by 19 percent after a 10 percent price increase and the same profit level would still be achieved – which should be valuable information for a marketing manager considering a price increase.
THE IMPACT OF DIFFERENT COST STRUCTURES
We can afford to see this drop by £10 to £43 after the price increase compared to theoretical. The higher the variable costs, the less feasible the price reduction strategy will be; the higher the fixed costs, the more likely this will happen.
THE CAUSES OF VARIATIONS IN COST STRUCTURE
This situation will be difficult, if not impossible, to change, and competitors are likely to be in the same position. Therefore, it is usually the case that the larger the player in the market, the higher the share of fixed costs compared to smaller competitors.
LONG-TERM FIXED COSTS
Note that these and other outsourcing strategies do not automatically change the cost structure; this only happens if the terms of the contract shift the fixed cost risk to the supplier. This issue will be revisited in the next chapter when we discuss the pricing of marginal business.
THE BREAKEVEN CHART
THE TEMPTATIONS OF A HIGH FIXED COST STRUCTURE
In these circumstances, it is crucial that the pricing strategy encourages management to maintain prices at full value, no matter how tough the current business climate may be. Perceived customer value is only a valid basis for pricing if competitors play the same game and avoid the all-too-common temptation—the sometimes justifiable but potentially disastrous slide of marginal pricing.
MARGINAL PRICING
Now let's assume that there is an opportunity for additional revenue and that the variable costs are $2. Note that total variable margin decreased by 1 percent as a result of this new business and this is an important check on the effectiveness of the pricing strategy implementation.
THE PROS AND CONS OF MARGINAL PRICING
Leaving aside this factor and the ethical issues involved, there is no doubt that, under the right circumstances, marginal pricing can be a very effective competitive weapon. Sometimes marginal pricing can be a deliberate strategy targeting specific segments with different characteristics from the core business.
PRICE BEHAVIOUR IN THE HIGH VARIABLE COST BUSINESS
UNDERSTANDING COMPETITORS’ COST STRUCTURES
Note that we arrived at the competitor's fixed costs as a balancing figure after knowing the variable cost and operating profit numbers. This competitor has a lower percentage of variable costs and therefore a higher percentage of fixed costs than we do.
THE CASE AGAINST
THE CASE IN FAVOUR
THE COSTING PROCESS
It is not logical; there is no difference in principle and if these other costs are to be included they must be analyzed in the same degree of detail as those of the factory. A considerable investment of resources must therefore be made and this can only be justified if there is a significant payoff as a result of the analysis.
PROFIT OBJECTIVES
An ABC calculation can tell you what, in an ideal world and in the long term, you would like the price to be to cover the full costs and achieve the necessary profit targets. A food company in the Netherlands discovered from an ABC analysis that half of its product range in one category was below full price when it was previously considered highly profitable.
THE CONCEPT OF ‘REQUIRED CONTRIBUTION’
Note that the expected profitability of the company requires an operating margin of 20 percent, and the cost assumption is that each product must deliver its share. This price varies slightly from the previously mentioned £9.25 because the required profit is now distributed per unit rather than as a percentage of sales, which may be a more accurate reflection of reality.
THE VALUE OF FINANCIAL ASSESSMENT
FROM VALUE PRICING TO VALUE TO SHAREHOLDERS
RELATING FINANCIAL TO MARKETING OBJECTIVES
EVALUATING MARKETING OBJECTIVES
We will get two price change options similar to those illustrated in Chapter 7, one for a 10 percent price increase, one for a 10 percent price decrease. Promotion and advertising support should increase to 10 percent of sales to support the price increase.
THE UNDERLYING ASSUMPTIONS
A similar assessment to that above shows that the present value of £7,750 per year in ten years' time will be £44,515. What is our own cost structure likely to be, both in the short and long term?
CONCLUSION
INTRODUCTION
THE DEMAND CURVE
Public transportation and gasoline are substitutes, and as the price of one rises, so does the price of the other. In contrast, consider the relationship between the price of cars and the price of gasoline.
THE SUPPLY CURVE
This 'demand curve' shows the normal relationship between the price of the good and the quantity that consumers want to buy. The 'supply curve' for a good shows the normal relationship between the price of that good and the quantity that producers want to sell.
PRICE DETERMINATION
Changes in the price of factors of production will cause changes in the relative profitability of different commodities and therefore changes in their supply. At any price below P1 (e.g. P3), the quantity that consumers want to buy (Q4) is greater than the quantity that producers want to sell (Q5).
THE FUNDAMENTAL THEORY OF PRICE
ELASTICITY OF DEMAND AND SUPPLY
We describe this type of demand curve as elastic—for a relatively small change in price, a large change in quantity will occur. We describe this type of demand curve as inelastic—a large change in price can occur without much effect on volume.
OVERALL SUMMARY
If demand is inelastic, a small change in price will have little effect on the volume sold. If demand is elastic, a small change in price will have a large impact on the volume sold.
