Chapter 1

Boundaries of a Good Price

Using Exchange Value Models to Understand Price Competition and Value oriented pricing

Agenda

• Who is involved in pricing decisions? • Why is pricing so important to the health of the firm? • Can firms influence their pricing power?• What is the nature of a good price? • How relevant are marginal costs and consumer

surplus in setting a good price?• How should the comparable alternatives on the

market influence the pricing of a product?• How can exchange value models be used to set

prices?

The Importance of Price

• Too high – Lost profits from lack of volume– The price is eventually dropped and the company must fight for market

interest and perception repositioning– Potential allegations of price gouging and unfairness, leading to public

relations and regulatory ramifications

• Too low– Forgone profit in an attempt to gain volume which may not come– Incorrectly set expectations for the product category, making future price

increases being driven against a headwind of customer expectations

• Ultimately, lost profits, revenues, and a shrinking/irrelevant firm

If the price is……

Cross Functional Nature of Pricing• CFO

– Responsible for measuring and reporting performance– Almost always involved in pricing decisions from a

quantitative analysis / forecasting perspective– General bias towards higher contribution margins

• Sales & Marketing– Responsible for promotion, product strategy, and

placement, along with pricing– Almost always involved in pricing decisions from a

value positioning perspective– General bias towards discounting and market share

• Research & Development– Responsible for developing new products that

customers value– Technical individuals often are challenged to

understand commercial aspects• Production

– Responsible for quality, throughput, and capacity utilization

– General bias towards volume to reduce overhead allocation

• CEO– Arbitrator between competing stakeholders

Executives

Customers

Shareholders

CEO

Value Exchange and Profit Capture• Price is the value that the firm captures in a mutually

beneficial exchange with its customers

– Firm’s reason for existence is to produce value for customers, value which they exchange for cash

– Customers purchase because they gain value from the product in excess of the price they pay

• Profit Profit = Quantity X (Price – Variable Costs) – Fixed Costs

p = Q (P – V) – F

Variable Costs (V)Fixed Costs (F)Volume or Quantity Sold (hence the Q)Price (P)Profit (p)

Impacting Profits

 Last

Quarter

1% improvement for next Quarter

in variable cost

in Fixed cost

in Volume in Price

Price P $25       $25.25

Volume Q 80,000     80800  

Variable Cost V $10.00 $9.90      

Fixed Cost F $1,000,000   $990,000    

Profitability ∏ $200,000 $208,000 $210,000 $212,000 $220,000

Change in Profitability     $8,000 $10,000 $12,000 $20,000

% Profit improvement     4% 5% 6% 10%

The Art and Science of Pricing

• The science of pricing refers to the act of gathering information, conducting quantitative analysis, revealing an accurate understanding of the range of prices likely to yield positive results.

• The art of pricing refers to the ability to influence customer price acceptance, adapt pricing structures according to competitive strategies, marketing strategies and industrial policies.

Setting Prices with Exchange Value Models

Exchange Value ModelsExchange value models quantify the price modelsKnowing the boundaries of a good price narrows pricing discussions to a reasonable range of potential points

Extreme Boundaries-Define the range of acceptable prices outside of which no rational buyer or seller would ever transact

Narrow boundaries -Define the range of prices that are most likely to encourage customer transactions and the leave the firm most favorable position. --These are lying within the extreme boundaries

Extreme Boundaries– Marginal cost define the extreme lower boundary

• Seller’s bottom line• Any price lower than the marginal price leaves the seller

loosing the business• Thus, marginal costs is the extreme lower boundary of the

“right” price.

– Consumer utility defines the extreme upper boundary• Buyer’ bottom line• Customer utility refers to the value a customer gains from

having the product• The value that buyers place on a product is the utility that

they derive from the product.

Various Utilities

• Form Utility• Place Utility• Time Utility• Ownership Utility

Consumer Surplus

• Consumer surplus is the difference between the overall consumer utility and the transaction price.

• As long as consumer surplus is positive, customer will value the product.

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Marginal Costs and Consumer Utility Extreme Boundaries

• From this example, we know only two extreme boundaries,

– Bottom boundary of marginal cost generously estimated $300

– Upper boundary of consumer utility frugally estimated at $5000

• Clearly, $300and $5000 is a wide range, with the upper bound a factor of 1000 above the lower bound.

– $400– $1000– $3,000– $4000

• Managers need a tighter bound than this for decision making.

• Blunt force economics of producer cost and consumer utility alone is insufficient.

Consumer Utility$5000

Mar

gina

lC

osts

Price Floor$300

Range of Potential Prices lies between the Extreme Boundaries

Narrow Boundaries

• Narrower band is defined by the competing alternatives and differential value– Competition (Direct or Indirect)

• Inferior alternatives• Inferior alternatives deliver similar benefits to the one

under consideration with less overall consumer utility.

– Regulatory constraints

Differential Value/ Improvement value• Differential value is the change in consumer utility that a

product in comparison to its comparable alternative• It represents the potential incremental satisfaction or profits the

customer can expect from this product over those of the reference product.

• Exchange value is the price of the competing alternative adjusted for the differential value

• Exchange Value = Price of the comparable alternative + Differential value

Exchange Value

Value Oriented Pricing

Value-in-use analysis

• Value in Use = Total willingness to pay for a product across all consumers

• To calculate the Value in Use, we need to…– Determine the customer's reference product– Customer’s life cycle cost using the reference

product– Improvement value of the product relative to the

reference product

• Reference Product: – Customers next best alternative for meeting the same need

as current or proposed new product– Existing model about to be replaced– Competing product

• Life Cycle Costs:– All costs that a customer will incur over the product’s

useful life.– These costs include Actual purchase price, Startup costs,

post purchase costs• Improvement value of the product:

– The improvement value of the product represents the potential incremental satisfaction or profits the customer can expect from this product over those of the reference product.

Value-in-use analysis

Value-in-use analysis

• P max y = LCCx +Ivy –(PPCY+SUCy)

P max y = maximum acceptable price of Product Y

LCCx = Life cycle costs of the reference product X

Ivy = Improvement value for the new product Y

PPCY = Post purchase cost for the new product Y

SUCy = Start up costs for the New Product Y

Example• Old reference product X, Current Purchase price = $400• Post purchase cost = $300• Start up cost = $300• Hence Life cycle cost for product X,

– LCC x = Px + PPCx + SUCx = $1000

• Assume “NEW “ product Y is highly efficient and has an Improvement Value, Ivy = $200

PPCy = $200 SUCy = $200

• Therefore Max.Accpetable Price, P max y = LCCx +Ivy –(PPCY+SUCy)

Pmax = $800

Consumer Surplus• Consumer Surplus = Difference between the

maximum amount customers are willing to pay for a product and the amount they actually pay.

• Consumer Surplus = Value in Use – Value in Exchange

Question:

In the previous example, if the seller decides to sell the product Y for $500, What is the consumer surplus???

Consumer Surplus

Limitations of Value based pricing• Sometimes the product offering is so new that

its difficult to accurately estimate its relative value to customers

• Value of the product may depend on the nature of the buyer, how the buyer uses the product, variations in perceived benefits of the product by different buyers.

Summary• Pricing is a strategic challenge with a direct impact on profitability

• The science of pricing refers to the act of gathering information, conducting quantitative analysis and getting accurate information of the range of prices likely to yield positive results.

• The art of pricing refers to the ability to influence customer price acceptance, adapt pricing structures to shift competitive playing fields and align pricing strategy to the competitive strategy, marketing strategy, and industrial policy.

• Extreme boundaries are determined by Cost of Product and Consumer Utility

• Narrow boundaries are determined by competition and regulatory constraints

• The exchange value is the price of the comparable alternative + the differential value