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Ch 3 Outline

1. Introduction

2. Pricing Strategy

3. Price and Gross Margin

4. Core Prices and Discounting

5. Pricing and Competition

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3-1 Introduction• The basic business process that underlies all

ventures, regardless of their industry or size, is: – R – C = P (revenue minus cost equals profit).

• Understanding the business process is critical for entrepreneurs and for people who practice the skills of entrepreneurism.– One of the last considerations that the entrepreneur

takes into account is the price that will be charged to customers.

– Yet, setting price for products and services is a critical factor in the success of a venture.

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3-1 Introduction (cont.)• Problem with cost-plus pricing: Customers

care about the price they have to pay for products and services and the value they receive for that price.– If the entrepreneur uses the cost-plus pricing

approach:• The price is set too high and the customer does not

buy.

• The price is set too low and each sale returns less profit to the business than is possible.

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How Customer Demand Affects Pricing

• The Elasticity of Demand– The degree to which a change in price affects the

quantity demanded.– Elastic Demand

• Demand that changes significantly when there is a change in the price of the product.

– Inelastic Demand• Demand that does not change

significantly when there is a change in the price of the product.

DemandDemand

PricePrice

ElasticElastic

InelasticInelastic

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3-2 Pricing Strategy

• Price strategy is an attempt to affect demand through alteration of prices.

• An effective price strategy is responsive to the type of demand present in the market.

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3-3 Price and Gross Margin• Entrepreneurs must also monitor the

effect of their pricing strategy on the firm’s gross margin. – Gross margin is the difference between the

selling price of a product or service and the amount the entrepreneur had to pay for the raw materials that make up that product or service.

– Gross margin is expressed as a percentage of revenue, using the following equation:

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3-3 Price and Gross Margin (cont.)• A price reduction usually results in a reduction in

gross margin.– Increased sales volume can lead to a reduction in the

average cost of goods sold because suppliers will often provide discounts to clients that buy in large volumes.

• A price increase that increases sales volume—or, at least, does not reduce sales volume—is a powerful tool for profit.– Businesses that are able to raise prices without cost

increases and without sacrificing sales volume possess is called pricing power.

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3-4 Core Prices and Discounting • One of the most important considerations in

any price strategy is to protect the core prices of the business. – The airline industry provides a good example

of the concept of core price protection.– Another common method that companies use to

protect their core pricing is through product downsizing.

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3-4 Core Prices and Discounting

– Discounting is the most widely used price strategy.

• When the discounted prices are offered for a limited time, the situation is usually referred to as a sale.

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3-4a Pricing and Finance Discounting• The U.S. economy has grown to its present

size in large part based on the use of credit.– Because the use of credit has become so

pervasive, credit terms have become an important part of price and volume strategy.• The furniture and appliance industries offer

examples of the use of interest rate discounting.• In 2000 the automotive industry instituted a novel

discounting strategy. – When purchasing a car, the customer was not required to

make any payments for a period of one year. – Payments toward the vehicle began in the second year

through what is known as a level payment plan.

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3-4a Pricing and Finance Discounting (cont.)• When starting a new business, many entrepreneurs are

tempted to set their prices below the general market. The intent of such a strategy is to attract customers by offering them a price advantage.– Price is often regarded to be the advantage that customers

will respond to most readily.

– Sometimes this price strategy will lead to the opposite reaction.

• Customer perception is an important factor in the success of any business.

• Established competitors may also respond by offering discounts, which could cause a price war the new entrant will loose.

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3-5 Pricing and Competition• Pricing strategy should never be executed without

thought to the reaction of competitors.– If a price strategy is effective and encroaches on the

competitor’s market share, there is likely to be a vigorous reaction.

• In an elastic market, a price change may bring new customers into the market.– When a price reduction is based on lower costs and the

price move results in a larger number of buyers in the market, the strategy is a great success.• The airline industry is an example of the price reduction cycle

in an elastic market.

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3-5 Pricing and Competition (cont.)• The reverse side of the success of price

reductions based on lowered costs and expanded market is also demonstrated in the computer and consumer electronics market.– Discounters look for markets in which

consumers are price sensitive.