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Marketing: Kerin-Hartley-Rudelius: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 12 LEARNING OBJECTIVES After reading this chapter you should be able to: 1 Identify the elements that make up a price. 2 Describe how to establish the initial approximate price level using demand-oriented, cost-oriented, profitoriented, and competition-oriented approaches. 3 Explain what a demand curve is and the role of revenues in pricing decisions. 4 Explain the role of costs in pricing decisions. 5 Describe how various combinations of price, fixed cost, and unit variable cost affect a firm's break-even point. 6 Recognize the objectives a firm has in setting prices and the constraints that restrict the range of prices a firm can charge. 7 Describe the steps taken in setting a final price. CHAPTER PRICING PRODUCTS AND SERVICES WHERE DOT-COMS STILL THRIVE: HELPING YOU GET A $100-A-NIGHT HOTEL ROOM OVERLOOKING NEW YORK'S CENTRAL PARK "When I travel, I always go through Internet sites," Utah State student Catherine C. Woolley tells BusinessWeek magazine.1 She used this strategy with Priceline. com to reserve a $100-a-night hotel room overlooking Central Park, a glitzy area in New York City. Despite the effects of the September 11, 2001, attacks had on the travel industry, online bookings are expected to rise to $75 billion in 2005, according to Internet travel research firm PhoCusWright. These online websites book airline tickets, hotel rooms, rental cars, and special travel and cruise packages for leisure and business travelers. In terms of market share, the top four online travel websites are Orbitz, Travelocity, Expedia, and Priceline, Catherine Woolley's hotel reservation supplier. Why Travel Dot-Coms Haven't Tanked "There are a bunch of businesses that don't make sense at all on the Internet," says Mitchell J. Rubin, a money manager who has a lot of his fund invested in Internet travel companies. "Travel is the quintessential one that does," he continues.2 Travel companies have beaten the dot-com odds by providing two key benefits to customers: 1. Saving time. User friendliness makes getting Internet travel reservations easy, often saving much time and misunderstanding. 2. Saving money. Customers can achieve substantial price savings using the travel dot-coms instead of using conventional booking services, such as travel agents. 261 Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 262 Satisfying Marketing Opportunities PART FOUR Travel Dot-Com Prices: A WinWin for Buyers and Sellers But what are the benefits for airlines and hotels? The easy answer: The extra money United Airlines or Marriott Hotels receives when Orbitz or Expedia books their services more than offsets the expenses United or Marriott incurs if their tickets or rooms are sold through travel agencies or its own agent or website channels. Among all marketing and operations factors in a business firm, price is unique. It is the place where all other business decisions come together. The price must be "right"--in the sense that customers must be willing to pay it and it must generate enough sales dollars to pay for the cost of offering it and earn a profit for the company. Small changes in price can have big effects on the number of units sold, as well as on company profit. In fact, among large U.S. companies, research shows that a 1 percent price increase translates to a 8 to 12 percent increase in profitability, other factors remaining the same.3 Welcome to the fascinating, and intense, world of pricing, where many forces come together in the price potential buyers are asked to pay. This chapter covers important factors used in setting prices. NATURE AND IMPORTANCE OF PRICE The price paid for goods and services goes by many names. You pay tuition for your education, rent for an apartment, interest on a bank credit card, and a premium for car insurance. Your dentist or physician charges you a fee, a professional or social organization charges dues, and airlines charge a fare. And what you pay for clothes or a haircut is termed a price. What Is a Price? price Money or other considerations exchanged for the ownership or use of a good or service These examples highlight the many varied ways that price plays a part in our daily lives. From a marketing viewpoint, price is the money or other considerations (including other goods and services) exchanged for the ownership or use of a good or service. Recently, Wilkinson Sword exchanged some of its knives for advertising used to promote its razor blades. This practice of exchanging goods and services for other goods and services rather than for money is called barter. These transactions account for billions of dollars annually in domestic and international trade. For most products, money is exchanged. However, the amount paid is not always the same as the list, or quoted, price because of discounts, allowances, and extra fees. While discounts, allowances, and rebates make the effective price lower, other marketing tactics raise the real price. One new twenty-first century pricing tactic is to use special fees and surcharges. This practice is driven by consumers' zeal for low prices combined with the ease of making price comparisons on the Internet. Buyers are more willing to pay extra fees than a higher list price, so sellers use add-on charges as a way of having the consumer pay more without raising the list price.4 Examples of such special fees include a Green Bay Packer "user fee" that can add $1,400 to the price of a season ticket or a 5 percent "environmental surcharge" by dry cleaners around the country. All these different factors that increase or decrease the price are put together in a price equation, which is shown for several different products in Figure 121. Suppose you decide you want to buy the newly introduced 2006 Bugatti Veyron, the world's fastest production car, because its 8.0 litre, 1,001-horsepower V-16 engine moves you from 0 to 62 mph in 2.9 seconds at a Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 263 ITEM PURCHASED PRICE Final price PRICE EQUATION INCENTIVES AND LIST PRICE ALLOWANCES List price Rebate Cash discount Old car trade-in Scholarship Other financial aid Discounts for number of credits taken Quantity discount Cash discount Seasonal discount Functional or trade discount EXTRA FEES Financing charges Special accessories Destination charges Special activity fees New car bought by an individual Tuition Term in college bought by a student Published tuition Invoice price Merchandise bought from a wholesaler by a retailer List price Penalty for late payment FIGURE 121 The price of three different purchases top speed of 250 mph. The Veyron has a list price of $1.2 million, and only 300 are expected to be crafted. However, if you put $500,000 down now and finance the balance over the next year, you will receive a rebate of $100,000 off the list price and pay a finance charge of $26,317. To ship the car from France, you will pay a $5,000 destination charge. For your 2000 Honda Civic DX four-door sedan that has 60,000 miles and is in fair condition, you are given a trade-in allowance of $5,395, which is the Kelley Blue Book (www.kbb.com) trade-in value of your car. Applying the price equation (as shown in Figure 121) to your purchase, your final price is: Final price List price 1Incentives $1,200,000 1$100,000 $1,135,922 Allowances2 Extra fees $5,3952 1$26,317 $5,0002 Your monthly payment for the one-year loan of $600,000 is $52,193.06.5 Are you still interested? Price as an Indicator of Value For some products, price influences consumers' perception of overall quality and ultimately its value to consumers.6 In a survey of home furnishing buyers, 84 percent agreed with the statement: "The higher the price, the higher the quality."7 For example, Kohler introduced a walk-in bathtub that is safer for children and the elderly. Although priced higher than conventional step-in bathtubs, it has proven very successful because buyers are willing to pay more for what they perceive as the value of the extra safety. From a consumers' standpoint, price is often used to indicate value when price is compared with benefits of the product. At a given price, as perceived benefits increase, value increases. If you're used to paying $10.99 for a medium pizza, wouldn't a large pizza at the same price be more valuable? Creative marketers, aware that consumers' value assessments are often comparative, engage in value pricing. Value pricing is the practice of increasing product and service benefits while maintaining or decreasing price. "Supersizing" at fast-food restaurants is one example. Here value comes from getting "more bang for your buck." Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 264 Satisfying Marketing Opportunities PART FOUR Price in the Marketing Mix profit equation Pricing is a critical decision made by a marketing executive because price has a direct effect on a firm's profits. This is apparent from a firm's profit equation: Profit Total revenue Total cost 1Unit price Quantity sold2 Total cost Profit Total revenue Total cost What makes this relationship even more complicated is that price affects the quantity sold, as illustrated with demand curves later in this chapter. Furthermore, since the quantity sold sometimes affects a firm's costs because of efficiency of production, price also indirectly affects costs. Thus, pricing decisions influence both total revenue (sales) and total cost, which makes pricing one of the most important decisions marketing executives face. GENERAL PRICING APPROACHES A key to a marketing manager's setting a final price for a product is to find an approximate price level to use as a reasonable starting point. Four common approaches to helping find this approximate price level are (1) demand-oriented, (2) costoriented, (3) profit-oriented, and (4) competition-oriented approaches (Figure 122). Although these approaches are discussed separately below, some of them overlap, and an effective marketing manager will consider several in searching for an approximate price level. Demand-Oriented Approaches Demand-oriented approaches emphasize factors underlying expected customer tastes and preferences more than such factors as cost, profit, and competition when selecting a price level. Skimming Pricing A firm introducing a new product can use skimming pricing, setting the highest initial price that customers really desiring the product are willing to pay. These customers are not very price sensitive because they weigh the new product's price, quality, and ability to satisfy their needs against the same characteristics of substitutes. As the demand of these customers is satisfied, the firm lowers the price to attract another, more price-sensitive segment. Thus, skimming pricing gets its name from skimming successive layers of "cream," or customer segments, as prices are lowered in a series of steps. In early 2003, many manufacturers of flatscreen TVs were pricing them about $3,000 and using skimming pricing because many prospective customers were willing to buy the product immediately at the high price. But by the time you read this, flatscreen TVs will probably be far less expensive. FIGURE 122 Four approaches for selecting an approximate price level Demand-oriented approaches Skimming Penetration Prestige Odd-even Target Bundle Yield management Cost-oriented approaches Standard markup Cost-plus Profit-oriented approaches Target profit Target return on sales Target return on investment Competitionoriented approaches Customary Above, at, or below market Loss leader Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 265 MARKETING NEWSNET Energizer's Lesson in Price Perception-- Value Lies in the Eye of the Beholder CUSTOMER VALUE Battery manufacturers are as tireless as a certain drumthumping bunny in their efforts to create products that perform better, last longer, and not incidentally, outsell the competition. The commercialization of new alkaline battery technology at a price that creates value for consumers is not always obvious or easy. Just ask the marketing executives at Energizer about their experience with pricing Energizer Advanced Formula and Energizer e2 AA alkaline batteries. When Duracell launched its highperformance Ultra brand AA alkaline battery with a 25 percent price premium over standard Duracell batteries, Energizer quickly countered with its own high-performance battery--Energizer Advanced Formula. Believing that consumers would not pay the premium price, Energizer priced its Advanced Formula brand at the same price as its standard AA alkaline battery, expecting to gain market share from Duracell. It did not happen. Why? According to industry analysts, consumers associated Energizer's low price with inferior quality in the high-performance segment. Instead of gaining market share, Energizer lost market share to Duracell and Rayovac, the number three battery manufacturer. Having learned its lesson, Energizer subsequently released its e2 highperformance battery, this time priced 4 percent higher than Duracell Ultra and about 50 percent higher than Advanced Formula. The result? Energizer recovered lost sales and market share. The lesson learned? Value lies in the eye of the beholder. Why would Nintendo enter the video game market with a price for its GameCube that was $100 less than its competitors Xbox and PlayStation 2? The text gives the curious answer. Penetration Pricing Setting a low initial price on a new product to appeal immediately to the mass market is penetration pricing, the exact opposite of skimming pricing. Nintendo consciously chose a penetration strategy when it introduced its GameCube video game console first in Japan and later in the United States in 2001. GameCube was launched with an introductory price of $199.95-- $100.00 less than the list price for Microsoft's Xbox and Sony's PlayStation 2 consoles because many buyers were price sensitive.8 In some situations, penetration pricing may follow skimming pricing. A company might price a product high at first to attract price-insensitive consumers. Once the company has earned back the money spent on research and development and introductory promotions, it uses penetration pricing to appeal to a broader segment of the population and increase market share.9 Prestige Pricing Although consumers tend to buy more of a product when the price is lower, sometimes the reverse is true. If consumers are using price as a measure of the quality of an item, a company runs the risk of appearing to offer a low-quality product if it sets the price below a certain point. Prestige pricing involves setting a high price so that quality- or status-conscious consumers will be attracted to the product and buy it. Rolls-Royce cars, Chanel perfume, and Cartier jewelry have an element of prestige pricing in them and may sell worse at lower prices than at higher ones. As described in the Marketing NewsNet, this is the pricing strategy Energizer used with its very successful e2 high-performance AA batteries.10 Odd-Even Pricing Sears offers a Craftsman radial saw for $599.99, the suggested retail price for a MACH3 razor set (razor and two blades) is $6.99, and Kmart sells Windex glass cleaner on sale for 99 cents. Why not simply price these items at $600, $7, and $1, respectively? These firms are using odd-even pricing, which involves setting prices a few dollars or cents under an even number. The presumption is that consumers see the Sears radial saw as priced at "something over $500" rather than Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 266 Satisfying Marketing Opportunities PART FOUR "about $600." The effect this strategy has is psychological: $599.99 feels significantly lower than $600--even though there is only one cent difference. There is some evidence to suggest this does work. However, research suggests that overuse of oddending prices tends to mute its effect on demand.11 Target Pricing Manufacturers will sometimes estimate the price that the ultimate consumer would be willing to pay for a product. They then work backward through markups taken by retailers and wholesalers to determine what price they can charge wholesalers for the product. This practice, called target pricing, results in the manufacturer deliberately adjusting the composition and features of a product to achieve the target price to consumers. Canon uses this practice for pricing its cameras, as does Heinz for its complete line of pet foods.12 A price for a Sears Craftsman radial saw of $599.99, not $600? Hmmm?? Bundle Pricing A frequently used demand-oriented pricing practice is bundle pricing--the marketing of two or more products in a single package price. For example, Delta Air Lines offers vacation packages that include airfare, car rental, and lodging. Bundle pricing is based on the idea that consumers value the package more than the individual items. This is due to benefits received from not having to make separate purchases as well as increased satisfaction from one item in the presence of another. Bundle pricing often provides a lower total cost to buyers and lower marketing costs to sellers.13 Yield Management Pricing Have you ever been on an airplane and discovered the person next to you paid a lower price for her ticket than you paid? Annoying, isn't it? But what you observed is yield management pricing--the charging of different prices to maximize revenue for a set amount of capacity at any given time.14 Airlines, hotels, and car rental firms engage in capacity management by varying prices based on time, day, week, or season to match demand and supply. American Airlines estimates that yield management pricing produces an annual revenue that exceeds $500 million.15 1. What is the profit equation? 2. What is the difference between skimming and penetration pricing? 3. What is odd-even pricing? Concept Check Cost-Oriented Approaches With cost-oriented approaches a price setter stresses the cost side of the pricing problem, not the demand side. Price is set by looking at the production and marketing costs and then adding enough to cover direct expenses, overhead, and profit. Standard Markup Pricing Managers of supermarkets and other retail stores have such a large number of products that estimating the demand for each product as a means of setting price is impossible. Therefore, they use standard markup pricing, which involves adding a fixed percentage to the cost of all items in a specific product class. This percentage markup varies depending on the type of retail store (such as furniture, clothing, or grocery) and on the product involved. High-volume products usually have smaller markups than do low-volume products. Supermarkets such as Kroger and Safeway mark up staple items like sugar, flour, and dairy products 10 to 23 percent, whereas they mark up discretionary items like snack foods and candy 27 to 47 percent. These markups must cover all expenses of the store, pay for overhead costs, and contribute something to profits. For supermarkets these markups, which may appear very large, usually result in only a 1 percent profit on sales revenue. Cost-Plus Pricing Many manufacturing, professional services, and construction firms use a variation of standard markup pricing. Cost-plus pricing involves summing Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 267 the total unit cost of providing a product or service and adding a specific amount to the cost to arrive at a price. Cost-plus pricing is the most commonly used method to set prices for business products.16 Increasingly, however, this method is finding favor among business-to-business marketers in the service sector. For example, the rising cost of legal fees has prompted some law firms to adopt a cost-plus pricing approach. Rather than billing business clients on an hourly basis, lawyers and their clients agree on a fixed fee based on expected costs plus a profit for the law firm. Many advertising agencies now use this approach. Here, the client agrees to pay the agency a fee based on the cost of its work plus some agreed-on profit, which is often a percentage of total cost.17 Profit-Oriented Approaches A price setter may choose to balance both revenues and costs to set price using profit-oriented approaches. These might either involve setting a target of a specific dollar volume of profit or expressing this target profit as a percentage of sales or investment. Target Profit Pricing When a firm sets an annual target of a specific dollar volume of profit, this is called target profit pricing. For example, if you owned a picture frame store and wanted to achieve a target profit of $7,000, how much would you need to charge for each frame? Since profit depends on revenues and costs, you would have to know your costs and then estimate how many frames you would sell. Let's assume, based on sales in previous years, you expect to frame 1,000 pictures next year. The cost of your time and materials to frame an average picture is $22, while your overhead expenses (rent, manager salaries, etc.) are $26,000. Finally, your goal is to achieve a profit of $7,000. How do you calculate your price per picture? Profit Total revenue 1Pictures sold 3 1Cost/picture Total costs Price/picture2 Pictures sold2 overhead cost4 Solving for Price/picture, the equation becomes, Price/picture Profit $7,000 3 1Cost/picture 1$22 1,0002 1,000 $7,000 $48,000 1,000 $55 per picture Pictures sold2 $26,000 overhead cost4 Pictures sold Clearly, this pricing method depends on an accurate estimate of demand. Because demand is often difficult to predict, this method has the potential for disaster if the estimate is too high. Generally, a target profit pricing strategy is best for firms offering new or unique products, without a lot of competition. What if other frame stores in your area were charging $40 per framed picture? As a marketing manager, you'd have to offer increased customer value with your more expensive frames, lower your costs, or settle for less profit. Target Return-on-Sales Pricing Firms such as supermarkets often use target return-on-sales pricing to set prices that will give them a profit that is a specified percentage--say, 1 percent--of the sales volume. This price method is often used because of the difficulty in establishing a benchmark of sales or investment to show how much of a firm's effort is needed to achieve the target. Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 268 Satisfying Marketing Opportunities PART FOUR Target Return-on-Investment Pricing Firms such as General Motors and many public utilities use target return-on-investment pricing to set prices to achieve a return-on-investment (ROI) target such as a percentage that is mandated by its board of directors or regulators. For example, an electric utility may decide to seek 10 percent ROI. If its investment in plant and equipment is $50 billion, it would need to set the price of electricity to its customers at a level that results in $5 billion a year in profits. Competition-Oriented Approaches Rather than emphasize demand, cost, or profit factors, a price setter can stress what competitors or "the market" is doing. Customary Pricing For some products where tradition, a standardized channel of distribution, or other competitive factors dictate the price, customary pricing is used. Candy bars offered through standard vending machines have a customary price of 75 cents, and a significant departure from this price may result in a loss of sales for the manufacturer. Hershey typically has changed the amount of chocolate in its candy bars depending on the price of raw chocolate rather than vary its customary retail price so that it can continue selling through vending machines. Above-, At-, or Below-Market Pricing The "market price" of a product is what customers are generally willing to pay, not necessarily the price that the firm sets. For most products it is difficult to identify a specific market price for a product or product class. Still, marketing managers often have a subjective feel for the competitors' price or the market price. Using this benchmark, they then may deliberately choose a strategy of above-, at-, or below-market pricing. Among watch manufacturers, Rolex takes pride in emphasizing that it makes one of the most expensive watches you can buy--a clear example of above-market pricing. Manufacturers of national brands of clothing such as Christian Dior and retailers such as Neiman-Marcus deliberately set higher prices for their products than those seen at Sears. Large mass-merchandise chains such as Sears and JCPenney generally use atmarket pricing. These chains often establish the going market price in the minds of their competitors. They also provide a reference price for competitors that use aboveand below-market pricing. In contrast, a number of firms use below-market pricing. Manufacturers of generic products and retailers that offer their own private brands of products ranging from peanut butter to shampoo deliberately set prices for these products about 8 percent to 10 percent below the prices of nationally branded competitive products such as Skippy peanut butter or Vidal Sassoon shampoo. Loss-Leader Pricing For a special promotion, retail stores deliberately sell a product below its customary price to attract attention to it. The purpose of this lossleader pricing is not to increase sales but to attract customers in hopes they will buy other products as well, particularly the discretionary items with large markups. Mass merchandisers such as Target, Best Buy, and Wal-Mart sell CDs at about half their suggested retail price to attract customers to their stores.18 ESTIMATING DEMAND AND REVENUE Basic to setting a product's price is the extent of customer demand for it. Marketing executives must also translate this estimate of customer demand into estimates of revenues the firm expects to receive. Fundamentals of Estimating Demand How much money would you pay for your favorite magazine? If the price kept going up, at some point you would probably quit buying it. Conversely, if the price kept Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 269 going down, you might eventually decide not only to keep buying your magazine but also to get your friend a subscription, too. The lower the price, the higher the demand. The publisher wants to sell more magazines, but will it sell enough additional copies to make up for the lower price per copy? That is an important question for marketing managers. Here's how one firm decided to find out. Newsweek conducted a pricing experiment at newsstands in 11 cities throughout the United States. At that time, Houston newsstand buyers paid $2.25, while in Fort Worth, New York, Los Angeles, and Atlanta they paid the regular $2.00 price. In San Diego, the price was $1.50, while in MinneapolisSt. Paul, New Orleans, and Detroit it was only $1.00. By comparison, the regular newsstand price for Time and U.S. News & World Report, Newsweek's competitors, was $1.95. Why did Newsweek conduct the experiment? According to a Newsweek executive, "We want to figure out what the demand curve for our magazine at the newsstand is."19 The Demand Curve A demand curve is a graph relating the quantity sold and price, which shows the maximum number of units that will be sold at a given price. Demand curve D1 in Figure 123A shows the newsstand demand for Newsweek under the existing conditions. Note that as price falls, more people decide to buy and unit sales increase. But price is not the complete story in estimating demand. Economists emphasize three other key factors: demand curve Graph relating quantity sold and price, which shows how many units will be sold at a given price FIGURE 123 Illustrative demand curves for Newsweek 1. Consumer tastes. As we saw in Chapter 3, these depend on many factors such as demographics, culture, and technology. Because consumer tastes can change quickly, up-to-date marketing research is essential. 2. Price and availability of similar products. The laws of demand work for one's competitors, too. If the price of Time magazine falls, more people will buy it. That then means fewer people will buy Newsweek. Time is considered by economists to be a substitute for Newsweek. Online magazines are also a substitute-- one whose availability has increased tremendously in recent years. The point to remember is, as the price of substitutes falls or their availability increases, the demand for a product (Newsweek, in this case) will fall.20 3. Consumer income. In general, as real consumer income (allowing for inflation) increases, demand for a product also increases. $3.00 Newsweek price per unit Newsweek price per unit 2.50 2.00 1.50 1.00 .50 Q1 Q2 D1 1 2 Movement along demand curve $3.00 2.50 2.00 1.50 1.00 .50 Initial demand curve Q1 1 3 New demand curve Shift of demand curve Q3 D1 D2 0 1.5 3.0 4.5 6.0 7.5 9.0 10.5 12.0 Quantity demanded per year (millions of units) A Demand curve under initial conditions 0 1.5 3.0 4.5 6.0 7.5 9.0 10.5 12.0 Quantity demanded per year (millions of units) B Shift in the demand curve with more favorable conditions Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 270 Satisfying Marketing Opportunities PART FOUR The first of these two factors influences what consumers want to buy, and the third affects what they can buy. Along with price, these are often called demand factors, or factors that determine consumers' willingness and ability to pay for goods and services. As discussed earlier in Chapters 8 and 10, it is often very difficult to estimate demand for new products, especially because consumer likes and dislikes are often so difficult to read clearly. Figure 123A shows that as the price is lowered from $2.00 to $1.50, the quantity demanded increases from 3 million (Q1) to 4.5 million (Q2) units per year. This is an example of a movement along a demand curve and assumes that other factors (consumer tastes, price and availability of substitutes, and consumer income) remain unchanged. What if some of these factors change? For example, if advertising causes more people to want Newsweek, newsstand distribution is increased, or if consumer incomes rise, then the demand increases. Now the original curve, D1 (the blue line in Figure 123B), no longer represents the demand; a new curve must be drawn (D2). Economists call this a shift in the demand curve--in this case, a shift to the right, from D1 to D2. This increased demand means that more Newsweek magazines are wanted for a given price: At a price of $2, the demand is 6 million units per year (Q3) on D2 rather than 3 million units per year (Q1) on D1. What price did Newsweek select after conducting its experiment? It kept the price at $2.00. However, through expanded newsstand distribution and more aggressive advertising, Newsweek was later able to shift its demand curve to the right and charge a price of $2.50 without affecting its newsstand volume. Movement Along versus Shift of a Demand Curve Demand curve D1 in Price Elasticity of Demand Marketing managers are especially interested in price elasticity of demand--a key consideration related to the product's demand curve. Price elasticity of demand is the percentage change in quantity demanded relative to a percentage change in price. So it measures how sensitive consumer demand and the firm's revenues are to changes in the product's price. A product with elastic demand is one in which a slight decrease in price results in a relatively large increase in demand, or units sold. The reverse is also true: With elastic demand, a slight increase in price results in a relatively large decrease in demand. Marketing experiments on cola, coffee, and snack foods show them often to have elastic demand. So marketing managers may cut price to increase the demand, the units sold, and total revenue for one of these products, depending on what competitors' prices are. Recent research studies show that price elasticity in consumer purchases is increasing, probably because consumers are more often trying to take advantage of temporary price promotions and deals.21 In contrast, a product with inelastic demand means that slight increases or decreases in price will not significantly affect the demand, or units sold, for the product. Products and services considered as necessities, such as open heart surgery, usually have inelastic demand. What about gasoline for your car or SUV? Will an increase of a few cents per gallon cause you to drive fewer miles and buy less gasoline? No? Then you're like millions of other Americans, which is why gasoline has inelastic demand.22 This means that an increase of a few cents per gallon may have a relatively minor impact on the number of gallons sold, and may actually increase the total revenue of the gasoline producer. Concept Check 1. What is loss-leader pricing? 2. What are the three demand factors besides the product's price that determine consumers' willingness and ability to buy the product? 3. What is the difference between movement along a demand curve and a shift in a demand curve? Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 271 FIGURE 124 Fundamental revenue concept Total revenue (TR) is the total money received from the sale of a product. If TR P Q Then TR Total revenue Unit price of the product Quantity of the product sold P Q Fundamentals of Estimating Revenue While economists may talk about "demand curves," marketing executives are more likely to speak in terms of "revenues generated." Demand curves lead directly to an essential revenue concept critical to pricing decisions: total revenue. As summarized in Figure 124, total revenue (TR) equals the unit price (P) times the quantity sold (Q). Using this equation, let's recall our picture frame shop and assume our annual demand has improved so we can set a price of $100 per picture and sell 400 pictures per year. So, TR P Q $100 400 $40,000 total revenue Total money received from the sale of a product This combination of price and quantity sold annually will give us a total revenue of $40,000 per year. Is that good? Are you making money, making a profit? Alas, total revenue is only part of the profit equation that we saw earlier: Total profit Total revenue Total cost The next section covers the other part of the profit equation: cost. DETERMINING COST, VOLUME, AND PROFIT RELATIONSHIPS total cost Total expenses incurred by a firm in producing and marketing a product; total cost is the sum of fixed cost and variable costs fixed cost While revenues are the moneys received by the firm from selling its products or services to customers, costs or expenses are the moneys the firm pays out to its employees and suppliers. Marketing managers often use break-even analysis to relate revenues and costs, topics covered in this section. The Importance of Controlling Costs Understanding the role and behavior of costs is critical for all marketing decisions, particularly pricing decisions. Four cost concepts are important in pricing decisions: total cost, fixed cost, variable cost, and unit variable cost (Figure 125 on the next page). Many firms go bankrupt because their costs get out of control, causing their total costs to exceed their total revenues over an extended period of time. So firms are increasingly trying to control their fixed costs like insurance and executive salaries23 and reduce the variable costs in their manufactured items by having production done outside the United States.24 This is why sophisticated marketing managers make pricing decisions that balance both their revenues and costs. As described in the Marketing NewsNet, travel dot-com firms have been more successful than brick-and-mortar dot-coms at least partly because of far lower fixed costs.25 Firm's expenses that are stable and do not change with the quantity of product that is produced and sold variable cost Sum of the expenses of the firm that vary directly with the quantity of products that is produced and sold unit variable cost Variable cost expressed on a per unit basis Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 272 Satisfying Marketing Opportunities PART FOUR FIGURE 125 Fundamental cost concepts Total cost (TC) is the total expense incurred by a firm in producing and marketing a product. Total cost is the sum of fixed cost and variable cost. Fixed cost (FC) is the sum of the expenses of the firm that are stable and do not change with the quantity of a product that is produced and sold. Examples of fixed costs are rent on the building, executive salaries, and insurance. Variable cost (VC) is the sum of the expenses of the firm that vary directly with the quantity of a product that is produced and sold. For example, as the quantity sold doubles, the variable cost doubles. Examples are the direct labor and direct materials used in producing the product and the sales commissions that are tied directly to the quantity sold. As mentioned above, TC FC VC Variable cost expressed on a per unit basis is called unit variable cost (UVC), or UVC VC Q Break-Even Analysis break-even analysis Examines the relationship between total revenue and total cost to determine profitability at different levels of output Marketing managers often employ an approach that considers cost, volume, and profit relationships, based on the profit equation. Break-even analysis is a technique that analyzes the relationship between total revenue and total cost to determine profitability at various levels of output. The break-even point (BEP) is the quantity at which total revenue and total cost are equal. Profit comes from any units sold beyond the BEP. In terms of the definitions in Figure 125, BEPQuantity Unit price Fixed cost Unit variable cost Calculating a Break-Even Point Consider again your picture frame store. Suppose you wish to identify how many pictures you must sell to cover your fixed cost at a given price. Let's assume demand for your framed pictures has increased so the average price customers are willing to pay for each picture is $100. Also, suppose your fixed cost (FC) has grown to $28,000 (for real estate taxes, interest on a bank loan, and other fixed expenses) and unit variable cost (UVC) for a picture is now $30 (for labor, glass, frame, and matting). The row shaded in brown in Figure 126 shows that your break-even quantity at a price of $100 per picture is 400 pictures. FIGURE 126 Calculating a break-even point for a picture frame store PRICE PER PICTURE (P) $100 100 100 100 100 100 100 QUANTITY OF PICTURES SOLD (Q) 0 200 400 600 800 1,000 1,200 TOTAL REVENUE (TR) (P Q) $ 0 20,000 40,000 60,000 80,000 100,000 120,000 UNIT VARIABLE COST (UVC) $30 30 30 30 30 30 30 TOTAL VARIABLE COST (TVC) (UVC Q) $ 0 6,000 12,000 18,000 24,000 30,000 36,000 FIXED COST (FC) $28,000 28,000 28,000 28,000 28,000 28,000 28,000 TOTAL COST (TC) (FC TVC) $28,000 34,000 40,000 46,000 52,000 58,000 64,000 PROFIT (TR TC) $28,000 14,000 0 14,000 28,000 42,000 56,000 Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 273 MARKETING NEWSNET Pricing Lessons from the Dot-Coms-- Understand Revenues and Expenses TECHNOLOGY & E-COMMERCE Price, revenue, fixed cost, variable cost. Boring topics from finance or economics? But they are also critical to marketing success, as shown by lessons learned by the successful travel dot-coms so far. Brick-and-Mortar Dot-Com Failures by and serves as the "spokespuppet" for BarNone, a firm that helps consumers with poor credit obtain automobiles. Travel Dot-Com Successes (So Far) During the past decade, hundreds of dotcoms have failed, many of them brickand-mortar businesses Pets.com like (pet products) and Webvan (online groceries). Here are some reasons for these failures: Setting prices too low to cover the huge brick-and-mortar fixed costs of inventory, warehouses, and order fulfillment, especially on low-margin goods like groceries (Webvan). Spending too much on promotion, such as Pets.com's $2.2 million on Super Bowl XXXV ads. Believing people would forgo shopping at traditional stores, a problem, for example, with Pets.com competing with Petsmart. As a result, Pets.com was liquidated. However, the Pets.com sock puppet, because of its visibility, was bought Besides time and money savings for customers, the travel dot-coms have special strategies for success: Reaching key customer segments that will actually pay higher prices for hotel rooms or airline tickets. Reaching customer segments (students, senior citizens) whose last-minute or last-week flexibility enables them to reserve hotel rooms or airline seats that would otherwise go unsold. Being able to conduct almost all operations electronically, without the warehousing and order fulfillment problems of their brick-and-mortar dot-com cousins. Still, travel dot-coms face major uncertainties. One is the appearance of Orbitz.com, an online travel agency owned by five major U.S. airlines. Your break-even quantity (BEPQuantity) is 400 pictures, calculated as follows: BEPQuantity Unit price Fixed cost Unit variable cost $28,000 $100 $30 400 pictures At less than 400 pictures your picture frame store incurs a loss, and at more than 400 pictures it makes a profit. Figure 126 also shows that if you could double your annual picture sales to 800, your store would make a profit of $28,000--the row shaded in green in the figure. Figure 127 on the next page shows a graphic presentation of the break-even analysis, called a break-even chart. It shows that total revenue and total cost intersect and are equal at a quantity of 400 pictures sold, which is the break-even point at which profit is exactly $0. You want to do better? If your frame store could double the quantity sold annually to 800 pictures, the graph in Figure 127 shows you can earn an annual profit of $28,000, just as shown by the row shaded in green in Figure 126. Applications of Break-Even Analysis Because of its simplicity, breakeven analysis is used extensively in marketing, most frequently to study the impact on profit of changes in price, fixed cost, and variable cost. The mechanics of break-even analysis are the basis of the widely used electronic spreadsheets offered by computer programs such as Microsoft Excel that permit managers to answer hypothetical "what if" questions about the effect of changes in price and cost on their profit. Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 274 Satisfying Marketing Opportunities PART FOUR Total revenue or total costs ($ in thousands) FIGURE 127 Break-even chart for a picture frame store $120 Total revenue 100 80 $28,000 60 Break-even point Profit Variable costs 40 Total cost (Fixed costs + Variable costs) Loss 20 Fixed costs 200 400 600 800 1,000 1,200 0 Concept Check 1. What is the difference between fixed costs and variable costs? 2. What is a break-even point? PRICING OBJECTIVES AND CONSTRAINTS With such a variety of alternative pricing strategies available, a marketing manager must consider the pricing objectives and constraints that will narrow the range of choices. While pricing objectives frequently reflect corporate goals, pricing constraints often relate to conditions existing in the marketplace. Identifying Pricing Objectives pricing objectives Expectations that specify the role of price in an organization's marketing and strategic plans Pricing objectives specify the role of price in an organization's marketing and strategic plans. To the extent possible, these pricing objectives are carried to lower levels in the organization, such as in setting objectives for marketing managers responsible for an individual brand. These objectives may change depending on the financial position of the company as a whole, the success of its products, or the segments in which it is doing business. H. J. Heinz, for example, has specific pricing objectives for its Heinz ketchup brand that vary by country. Profit Three different objectives relate to a firm's profit, which is often measured in terms of return on investment (ROI). These objectives have different implications for pricing strategy. One objective is managing for long-run profits, in which a company-- such as many Japanese car or TV set manufacturers--gives up immediate profit in exchange for achieving a higher market share. Products are priced relatively low compared to their cost to develop, but the firm expects to make greater profits later because of its high market share. A maximizing current profit objective, such as for a quarter or year, is common in many firms because the targets can be set and performance measured quickly. American firms are sometimes criticized for this short-run orientation. As noted earlier, a target return objective occurs when a firm sets a profit goal (such as 20 percent for return on Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 275 The a 19 ter Dis trib 30 utor Mo stu vie d 51 io 8 investment), usually determined by its board of directors. These three profit objectives have different implications for a firm's pricing objectives. Another profit consideration for firms such as movie 10 studios and manufacturers is to ensure that those firms exp The in their channels of distribution make adequate profits. ens ater 9 es Without profits for these channel members, the movie Lef t fo studio or manufacturer is cut off from its customers. 6 r th eat For example, Figure 128 shows where each dollar of Mis er c. e your movie ticket goes. The 51 cents the movie studio xpe nse 24 gets must cover its profit plus the cost of making and s dis Lef marketing the movie, which averaged an all-time high of trib t fo uto r $103 million in 2004. Although the studio would like more r than 51 cents of your dollar, it settles for this amount to make 20 sure theaters and distributors are satisfied and willing to handle and Adv er its movies. ex publi tising pen city ses Ac of g tors' ros shar s e 23 mo vie Left f stu or dio FIGURE 128 Where each dollar of your movie ticket goes Sales Revenue Given that a firm's profit is high enough for it to remain in business, an objective may be to increase sales revenue, which will in turn lead to increases in market share and profit. Objectives related to sales revenue or unit sales have the advantage of being translated easily into meaningful targets for marketing managers responsible for a product line or brand. However, cutting price on one product in a firm's line may increase its sales revenue but reduce those of related products. Market Share Market share is the ratio of the firm's sales revenues or unit sales to those of the industry (competitors plus the firm itself). Companies often pursue a market share objective when industry sales are relatively flat or declining. In the late 1990s, Boeing cut prices drastically to try to maintain its 60 percent market share and encountered huge losses. Although increased market share is a primary goal of some firms, others see it as a means to other ends: increasing sales and profits. Unit Volume Many firms use unit volume, the quantity produced or sold, as a pricing objective. These firms often sell multiple products at very different prices and need to match the unit volume demanded by customers with price and production capacity. Using unit volume as an objective can be counterproductive if a volume objective is achieved, say, by drastic price cutting that drives down profit. Survival In some instances, profits, sales, and market share are less important objectives of the firm than mere survival. Continental Airlines has struggled to attract passengers with low fares and aggressive promotions to improve the firm's cash flow. This pricing objective has helped Continental to stay alive in the competitive airline industry. Social Responsibility A firm may forgo higher profit on sales and follow a pricing objective that recognizes its obligations to customers and society in general. Medtronics followed this pricing policy when it introduced the world's first heart pacemaker. Gerber supplies a specially formulated product free of charge to children who cannot tolerate foods based on cow's milk. Identifying Pricing Constraints pricing constraints Factors that limit the range of price a firm may set Factors that limit the range of price a firm may set are pricing constraints. Consumer demand for the product clearly affects the price that can be charged. Other constraints on price vary from factors within the organization to competitive factors outside it. Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 276 Satisfying Marketing Opportunities PART FOUR MARKETING NEWSNET Pricing 101--$4,205 for a 1969 Used Hotwheels Volkswagen Van, or $121,000 for a Mint-Condition TECHNOLOGY & E-COMMERCE 1952 Mickey Mantle Topps Baseball Card? To get a feel for prices of some of these collectibles, visit www.ebay.com. Marathon runner Malcolm East now wishes he had done a little more research on sneaker prices. At his wife's insistence he threw out six pairs of old shoes--that he now thinks would have fetched $15,000. Want in on the collectibles business? Think twice. Zip the Cat Beanie Baby sold for $2,250 in 1998, over $2,000 more than in 2005. Prices of collectibles, such as toys or old sneakers, are set by demand and supply forces discussed in this chapter. And for fads, the prices can fluctuate wildly. Here are some 2005 collectibles prices, besides those wild 1998 prices mentioned above: Zip the Cat Beanie Baby: $56 (if it has black paws). 1985 Nike Dunks, high-top, blue-and-black basketball shoes: $375. 2001 Ichiro Suzuki bobble-head doll: $35. Demand for the Product Class, Product, and Brand The number of potential buyers for a product class (cars), product (sports cars), and brand (Bugatti Veyron) clearly affects the price a seller can charge. So does whether the item is a luxury, like a Bugatti, or a necessity, like bread and a roof over your head. Generally speaking, the higher the demand for a product, the higher the price can be set. Newness of the Product: Stage in the Product Life Cycle The newer the Are these real "collectibles" or "trashables"? The text describes factors that affect a product's price. And you can check the Marketing NewsNet to see if those old Beanie Babies or Nikes in your attic or a recent Ichiro Suzuki bobble-head doll have value. product and the earlier it is in its life cycle, the higher the price that can usually be charged. The high initial price is possible because of patents and limited competition in the early stage. Sometimes--when nostalgia or fad factors come into play--prices may rise later in the product's life cycle. As described in the Marketing NewsNet, collectibles such as a 1952 Mickey Mantle baseball card or old sneakers can experience skyrocketing prices.26 But they can take a nosedive, too: The Zip the Cat Beanie Baby sold for $2,250 in 1998, over $2,000 more than in 2005. Publishing competitive prices on the Internet has revolutionized access to price comparisons for both collectors and buyers of more traditional products.27 Cost of Producing and Marketing the Product In the long run, a firm's price must cover all the costs of producing and marketing a product. If the price doesn't cover these costs, the firm will fail; so in the long run, a firm's costs set a floor under its price. Competitors' Prices A firm must know or anticipate what specific price its present and potential competitors are charging now or will charge. And the firm must assess the possibility of dangerous, costly price wars.28 Legal and Ethical Considerations Setting a final price is clearly a complex process. The task is further complicated by legal and ethical issues. Four pricing practices have received special scrutiny over these issues and are described below: Price fixing. A conspiracy among firms to set prices for a product is termed price fixing. Price fixing is illegal under the Sherman Act. When two or more competitors collude to explicitly or implicitly set prices, this practice is called horizontal price fixing. For example, six foreign vitamin companies recently pled guilty to price fixing in the human and animal vitamin industry and paid the largest fine in U.S. history: $335 million. Vertical price fixing involves controlling agreements between independent buyers and sellers (a manufacturer and a retailer) whereby Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 277 sellers are required to not sell products below a minimum retail price. This practice, called resale price maintenance, was declared illegal in 1975 under provisions of the Consumer Goods Pricing Act. Price discrimination. The Clayton Act as amended by the Robinson-Patman Act prohibits price discrimination--the practice of charging different prices to different buyers for goods of like grade and quality. However, not all price differences are illegal; only those that substantially lessen competition or create a monopoly are deemed unlawful. Deceptive pricing. Price deals that mislead consumers fall into the category of deceptive pricing. Deceptive pricing is outlawed by the Federal Trade Commission. Bait and switch is an example of deceptive pricing. This occurs when a firm offers a very low price on a product (the bait) to attract customers to a store. Once in the store, the customer is persuaded to purchase a higherpriced item (the switch) using a variety of tricks, including (1) degrading the promoted item and (2) not having the promised item in stock or refusing to take orders for it. Predatory pricing. Predatory pricing is charging a very low price for a product with the intent of driving competitors out of business. Once competitors have been driven out, the firm raises its prices. Proving the presence of this practice has been difficult and expensive because it must be shown that the predator explicitly attempted to destroy a competitor and the predatory price was below the defendant's average cost. It should be clear that laws cannot be passed and enforced to protect consumers and competitors against all of these practices, so it is essential to rely on the ethical standards of those setting prices. Concept Check 1. What is the difference between pricing objectives and pricing constraints? 2. Explain what bait and switch is and why it is an example of deceptive pricing. SETTING A FINAL PRICE The final price set by the marketing manager serves many functions. It must be high enough to cover the cost of providing the product and meet the objectives of the company. Yet it must be low enough that customers are willing to pay it. But not too low, or customers may think they're purchasing an inferior product. Dizzy yet? Setting price is one of the most difficult tasks the marketing manager faces, but three generalized steps are useful to follow. Step 1: Select an Approximate Price Level Before setting a final price, the marketing manager must understand the market environment, the features and customer benefits of the particular product, and the goals of the firm. A balance must be struck between factors that might drive a price higher (such as a profit-oriented approach) and other forces (such as increased competition from substitutes) that may drive a price down. Marketing managers consider pricing objectives and constraints first, then choose among the general pricing approaches--demand-, cost-, profit-, or competitionoriented--to arrive at an approximate price level. This price is then analyzed in terms of cost, volume, and profit relationships. Break-even analyses may be run at this point, and finally if this approximate price level "works," it is time to take the next step: setting a specific list or quoted price. Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 278 Satisfying Marketing Opportunities PART FOUR Step 2: Set the List or Quoted Price A seller must decide whether to follow a one-price or flexible-price policy. One-Price Policy A one-price policy involves setting one price for all buyers of a product or service. For example, Saturn Corporation uses this approach in its stores and features a "no haggle, one price" price for its cars. As mentioned earlier, this one-and-the-same price for all its airline passengers has contributed to JetBlue's success. Some retailers such as Dollar Valley have married this policy with a below-market approach and sell everything in their stores for $1 or less! Flexible-Price Policy In contrast, a flexible-price policy involves setting different prices for products and services depending on individual buyers and purchase situation in light of demand, cost, and competitive factors. Dell Computer recently adopted flexible pricing as it continually adjusts prices in response to changes in its own costs, competitive pressures, and demand from its various personal computer segments (home, small business, corporate, etc.). "Our flexibility allows us to be [priced] different even within a day," says a Dell spokesperson.29 Chain apparel stores use the beginning of the week to discover what isn't selling well to make plans for the high-traffic weekends. So the best deals in their flexibleprice policy come Wednesdays through Fridays, right before the weekend. Some apparel chains have specific days for nationwide price markdowns: Wednesdays for The Gap and Thursdays for J. Crew and Eddie Bauer.30 Step 3: Make Special Adjustments to the List or Quoted Price When you pay 75 cents for a bag of M&Ms in a vending machine or receive a quoted price of $10,000 from a contractor to renovate a kitchen, the pricing sequence ends with the last step just described: setting the list or quoted price. But when you are a manufacturer of M&M candies and sell your product to dozens or hundreds of wholesalers and retailers in your channel of distribution, you may need to make a variety of special adjustments to the list or quoted price. Wholesalers also must adjust list or quoted prices they set for retailers. Three special adjustments to the list or quoted price are (1) discounts, (2) allowances, and (3) geographical adjustments. Discounts Discounts are reductions from list price that a seller gives a buyer as a reWhat is the best day of the week to shop at Eddie Bauer, The Gap, and J. Crew with their flexible-pricing approach? For the answers, see the text. ward for some activity of the buyer that is favorable to the seller. Four kinds of discounts are especially important in marketing strategy: (1) quantity, (2) seasonal, (3) trade (functional), and (4) cash.31 Quantity discounts. To encourage customers to buy larger quantities of a product, firms at all levels in the channel of distribution offer quantity discounts, which are reductions in unit costs for a larger order. For example, an instant photocopying service might set a price of 10 cents a copy for 1 to 24 copies, 9 cents a copy for 25 to 99, and 8 cents a copy for 100 or more. Because the photocopying service gets more of the buyer's business and has longer production runs that reduce its orderhandling costs, it is willing to pass on some of the cost savings in the form of quantity discounts to the buyer. Seasonal discounts. To encourage buyers to stock inventory earlier than their normal demand would require, manufacturers often use seasonal discounts. A firm such as Toro that manufactures lawn mowers and snow throwers offers seasonal discounts to encourage wholesalers Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 279 Manufacturers provide a variety of discounts to assist channel members such as for Payless, a retailer promoting its early summer sandals sale. and retailers to stock up on lawn mowers in January and February and on snow throwers in July and August--five or six months before the seasonal demand by ultimate consumers. This enables Toro to smooth out seasonal manufacturing peaks and troughs, thereby contributing to more efficient production. It also rewards wholesalers and retailers for the risk they accept in assuming increased inventory carrying costs and having supplies in stock at the time they are wanted by customers. Trade (functional) discounts. To reward wholesalers and retailers for marketing functions they will perform in the future, a manufacturer often gives trade, or functional, discounts. These reductions off the list or base price are offered to resellers in the channel of distribution on the basis of (1) where they are in the channel and (2) the marketing activities they are expected to perform in the future. Traditional trade discounts have been established in various product lines such as hardware, food, and pharmaceutical items. Although the manufacturer may suggest the trade discounts shown in the example just cited, the sellers are free to alter the discount schedule depending on their competitive situation. Cash discounts. To encourage retailers to pay their bills quickly, manufacturers offer them cash discounts. Suppose a retailer receives a bill quoted at $1,000, 2/10 net 30. This means that the bill for the product is $1,000, but the retailer can take a 2 percent discount ($1,000 0.02 $20) if payment is made within 10 days and send a check for $980. If the payment cannot be made within 10 days, the total amount of $1,000 is due within 30 days. It is usually understood by the buyer that an interest charge will be added after the first 30 days of free credit. A retailer like Payless that plans an early summer sale on sandals often tries to take advantage of several of these discounts to increase its revenues and profits. Allowances Allowances--like discounts--are reductions from list or quoted prices to buyers for performing some activity. Trade-in allowances. A new-car dealer can offer a substantial reduction in the list price of that new Toyota Camry by offering you a trade-in allowance of $500 for your Chevrolet. A trade-in allowance is a price reduction given when a used product is part of the payment on a new product. Trade-ins are an effective way to lower the price a buyer has to pay without formally reducing the list price. Promotional allowances. Sellers in the channel of distribution can qualify for promotional allowances for undertaking certain advertising or selling activities to promote a product. Various types of allowances include an actual cash payment or an extra amount of "free goods" (as with a free case of pizzas to a retailer for every dozen cases purchased). Frequently, a portion of these savings is passed on to the consumer by retailers. Some companies, such as Procter & Gamble, have chosen to reduce promotional allowances for retailers by using everyday low pricing. Everyday low pricing (EDLP) is the practice of replacing promotional allowances with lower manufacturer list prices. EDLP promises to reduce the average price to consumers while minimizing promotional allowances that cost manufacturers billions of dollars every year.32 Geographical Adjustments Geographical adjustments are made by manufacturers or even wholesalers to list or quoted prices to reflect the cost of transportation of the products from seller to buyer. The two general methods for quoting prices related to transportation costs are (1) FOB origin pricing and (2) uniform delivered pricing. FOB origin pricing. FOB means "free on board" some vehicle at some location, which means the seller pays the cost of loading the product onto the vehicle that Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 280 Satisfying Marketing Opportunities PART FOUR is used (such as a barge, railroad car, or truck). FOB origin pricing usually involves the seller's naming the location of this loading as the seller's factory or warehouse (such as "FOB Detroit" or "FOB factory"). The title to the goods passes to the buyer at the point of loading, so the buyer becomes responsible for picking the specific mode of transportation, for all the transportation costs, and for subsequent handling of the product. Buyers farthest from the seller face the big disadvantage of paying the higher transportation costs. Uniform delivered pricing. When a uniform delivered pricing method is used, the price the seller quotes includes all transportation costs. It is quoted in a contract as "FOB buyer's location," and the seller selects the mode of transportation, pays the freight charges, and is responsible for any damage that may occur because the seller retains title to the goods until delivered to the buyer. Concept Check 1. What are the three steps in setting a final price? 2. What is the purpose of (a) quantity discounts and (b) promotional allowances? CHAPTER IN REVIEW 1 Identify the elements that make up a price. Price is the money or other considerations (such as barter) exchanged for the ownership or use of a good or service. Although price typically involves money, the amount exchanged is often different from the list or quoted price because of incentives (rebates, discounts, etc.), allowances (trade), and extra fees (finance charges, surcharges, etc.). 2 Describe how to establish the initial approximate price level using demand-oriented, cost-oriented, profit-oriented, and competition-oriented approaches. Demand, cost, profit, and competition influence the initial consideration of the approximate price level for a product or service. Demand-oriented pricing approaches stress consumer demand and revenue implications of pricing and include seven types: skimming, penetration, prestige, odd-even, target, bundle, and yield management. Cost-oriented pricing approaches emphasize the cost aspects of pricing and include two types: standard markup and cost-plus pricing. Profitoriented pricing approaches focus on a balance between revenues and costs to set a price and include three types: target profit, target return-on-sales, and target return-on-investment pricing. And finally, competition-oriented pricing approaches stress what competitors or the marketplace are doing and include three types: customary; above-, at-, or below-market; and loss-leader pricing. 3 Explain what a demand curve is and the role of revenues in pricing decisions. A demand curve is a graph relating the quantity sold and price, which shows the maximum number of units that will be sold at a given price. Three demand factors affect price: (a) consumer tastes, (b) price and availability of substitute products, and (c) consumer income. These demand factors determine consumers' willingness and ability to pay for goods and services. Assuming these demand factors remain unchanged, if the price of a product is lowered or raised, then the quantity demanded for it will increase or decrease, respectively. The demand curve relates to a firm's total revenue, which is the total money received from sale of a product, or the price of one unit times the quantity of units sold. 4 Explain the role of costs in pricing decisions. Four important costs impact a firm's pricing decisions: (a) total cost, or total expenses, the sum of fixed cost and variable cost incurred by a firm in producing and marketing a product; (b) fixed cost, the sum of expenses of the firm that are stable and do not change with the quantity of a product that is produced and sold; (c) variable cost, the sum of expenses of the firm that vary directly with the quantity of a product that is produced and sold; and (d) unit variable cost, variable cost expressed on a per unit basis. 5 Describe how various combinations of price, fixed cost, and unit variable cost affect a firm's break-even point. Break-even analysis is a technique that analyzes the relationship between total revenue and total cost to determine profitability at various levels of output. The break-even point is the quantity at which total revenue and total cost are equal. Assuming no change in price, if the costs of a firm's product increase due to higher fixed costs (manufacturing or advertising) or variable costs (direct labor or materials), then its break-even point will be higher. And if total cost is unchanged, an increase in price will reduce the break-even point. 6 Recognize the objectives a firm has in setting prices and the constraints that restrict the range of prices a firm can charge. Pricing objectives specify the role of price in a firm's marketing strategy and may include profit, sales revenue, market share, unit volume, survival, or some socially responsible price level. Pricing constraints that restrict a firm's pricing flexibility include demand, product newness, production and marketing costs, prices of competitive substitutes, and legal and ethical considerations. 7 Describe the steps taken in setting a final price. Three common steps marketing managers often use are: first, select an approximate price level as a starting point; second, set the list or quoted price, choosing between a one-price policy or a flexible-price policy; and third, modify the list or quoted price by considering discounts, allowances, and geographical adjustments. Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 281 FOCUSING ON KEY TERMS break-even analysis p. 272 demand curve p. 269 fixed cost p. 271 price p. 262 pricing constraints p. 275 pricing objectives p. 274 profit equation p. 264 total cost p. 271 total revenue p. 271 unit variable cost p. 271 variable cost p. 271 DISCUSSION AND APPLICATION QUESTIONS How would the price equation apply to the purchase price of (a) gasoline, (b) an airline ticket, and (c) a checking account? 2 What would be your response to the statement, "Profit maximization is the only legitimate pricing objective for the firm"? 3 Touch Toiletries, Inc., has developed an addition to its Lizardman Cologne line tentatively branded Ode d'Toade Cologne. Unit variable costs are 45 cents for a 3-ounce bottle, and heavy advertising expenditures in the first year would result in total fixed costs of $900,000. Ode d'Toade Cologne is priced at $7.50 for a 3-ounce bottle. How many bottles of Ode d'Toade must be sold to break even? 4 Suppose that marketing executives for Touch Toiletries reduced the price to $6.50 for a 3-ounce bottle of Ode d'Toade and the fixed costs were $1,100,000. 1 Suppose further that the unit variable cost remained at 45 cents for a 3-ounce bottle. (a) How many bottles must be sold to break even? (b) What dollar profit level would Ode d'Toade achieve if 200,000 bottles were sold? 5 Under what conditions would a camera manufacturer adopt a skimming price approach for a new product? A penetration approach? 6 What are some similarities and differences between skimming pricing, prestige pricing, and above-market pricing? 7 The Hesper Corporation is a leading manufacturer of high-quality upholstered sofas. Current plans call for an increase of $600,000 in the advertising budget. If the firm sells its sofas for an average price of $850 and the unit variable costs are $550, then what dollar sales increase will be necessary to cover the additional advertising? GOING ONLINE Finding the Best Airline Ticket Price It's Wednesday and you just completed your midterm exams. As a reward for your hard work, a friend has sent you a pair of free tickets to a popular Broadway show in New York City for 7:00 P.M. Saturday night. Check out the following online travel services to book a nonstop, round-trip ticket, leaving from Chicago's O'Hare (ORD) airport around 4:00 P.M. on Friday to New York City's La Guardia (LGA) airport. On Sunday, you'll leave La Guardia around 5:00 P.M. and return to O'Hare. Which of the following online travel services provides the cheapest fare and is easiest to use? Check out our search and see if you can beat the prices we obtained in late 2005: www.mhhe.com/Kerin Expedia (www.expedia.com)--Lowest price: $201.00 from United Airlines. Orbitz (www.orbitz.com), the online travel service owned by the major airlines--Lowest price: $248.00 from United Airlines. Priceline (www.priceline.com)--Lowest price: $199.00 from United Airlines. Travelocity (www.travelocity.com)--Lowest price: $201.00 from United Airlines. (Note: Be careful that you do not accidentally purchase an actual ticket because some services require you to make a purchase before receiving information.) BUILDING YOUR MARKETING PLAN In starting to set a final price, think about your customers and competitors and set three possible prices. 2 Assume a fixed cost and unit variable cost and (a) calculate the break-even points and (b) plot a breakeven chart for the three prices specified in step 2. 1 3 Using your best judgment, select one of these prices as your final price. Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 282 Satisfying Marketing Opportunities PART FOUR VIDEO CASE 12 Stuart Cellars: Price Is a Matter of Taste Stuart Cellars is a family-owned winery located in Temecula, California. The winery marked its first harvest in 1999. Forty acres are available for cultivation, giving Stuart Cellars a capacity of some 150 tons of grapes and yielding about 16,000 cases of wine per year. Stuart Cellars offers its Chardonnay, Merlot, Cabernet Sauvignon, Cabernet Franc, Zinfandel, Viognier, and other wines for sale through its tasting room, its website (www.stuartcellars.com), and retailers in California. Retail prices for Stuart Cellars products range from $13 per bottle for a Chardonnay, Viognier, Sauvignon Blanc, and White Merlot blend, to $46 per bottle for a 2002 Zinfandel Vintage Port. The average retail price for a Stuart Cellars wine is about $28 per bottle. Stuart Cellars Wine Club members enjoy a 20 percent discount and receive additional benefits such as complimentary tasting at the winery, special "member only" wines, additional discounts for reorders of the monthly wine selection, and quantity discounts. have a useful life of two to three years. On the other hand, a stainless tank may last 20 years. And of course, repair and maintenance costs for equipment and facilities can add up. Because it can be a three-year wait to harvest grapes from new plantings, followed by barrel and bottle aging, wineries can easily have five and a half years of capital and cash flow for red wines--less for white wines that require less aging. Packaging is also important and a reflection of the wine's image. Will the winery use flatbottomed, Burgundy-style bottles at $.50 each, or thickglass, thick-neck, deep-punt bottles at $3? Corks can range in price from pennies to dollars a piece. Advertising, public relations, point-of-sale materials, promotions, salesforce, wine tastings, samples for the wine press, warehousing, shipping, distribution, and excise taxes all mount up and can be about 15 percent of the retail price. Warehousing and shipping are significant because wine is a heavy product. Many states have regulated distribution systems such as California's three-tier system of wineries, wholesalers, and retailers. Wholesaler markups range from 2035 percent of what the distributor pays for the wine, with high-volume wines having lower margins as this means less inventory. Retailer markups can vary from 1050 percent, depending on the type of outlet. Some states have mandated minimum markup to prevent predatory pricing. The wine business is not known as a highly profitable business. Success comes over the long term as initial investments and expenses are spread out over a number of years and over increasing unit volume. PRICING WINE: CONSIDERING COSTS AND PROFITS How does Stuart Cellars arrive at its pricing? What factors enter into the pricing decision? The price floor is usually set by costs. Costs vary widely depending on winery location and number of years in business. There are tremendous economies of scale for larger producers versus smaller boutique wineries such as Stuart Cellars. Grapes, including labor to grow and harvest, can represent up to 60 percent of production expenses. One rule of thumb is that a bottle of wine should be priced at 1/1000 the cost of a ton of grapes. Paying $40,000 for a ton of Cabernet grapes would yield a bottle price of $40. Napa Valley growers' costs range from $2,800 per ton to $10,000 per ton. Buying land adds to winery costs but provides more operational control. Even wineries that do grow grapes may need to buy grapes on the market to meet their production needs. The impact of land ownership depends on the size of the mortgage and the interest rate to finance the property. Planting costs can be as much as $30,000 per acre, depending on such factors as density of plantings, trellising, and irrigation methods. Winery facilities and equipment--grape press, tanks, barrel racks--can be significant. Winemaking barrels are the second-highest production cost for many wineries. American oak barrels ($300 per barrel) or French oak ($700 per barrel) may CONSUMER DEMAND AND COMPETITION Costs and profit objectives are only part of the pricing formula. Wineries also have to consider buyer characteristics--retailers and consumers. According to Steven Bombola, consulting general manager, Stuart Cellars is targeting the "upper end of wine connoisseurs, people who can afford a premium product at a premium price" and represents perhaps "the top 1015 percent of the wine purchasing public." These are savvy consumers; they read and follow wine reviews. Wineries also need to consider and compare pricing from competitive wineries. Wine buyers certainly will make these comparisons. And Kerin-Hartley-Rudelius: Marketing: The Core, Second Edition IV. Satisfying Marketing Opportunities 12. Pricing Products and Services The McGraw-Hill Companies, 2007 CHAPTER 12 Pricing Products and Services 283 while price is often a cue for quality, there are many great-tasting wines at reasonable prices. If a wine is priced too low, it will affect consumers' perceptions of quality. However, charging a price significantly higher than competitor prices can drive consumers away to lower-priced competitor products. "People's perceptions are driven by wine pricing," states Robert Mondavi's senior vice president, Gayle Dargan. "If all consumer decisions were driven by blind-tasting, it would be a very different world. That's not reality. Price is a signal to people of our commitment and the efforts we are taking through out vineyards and our winemaking to put out the best wines." The average bottle price for wine has been dropping, in large part due to the popularity of Australian and New Zealand wines. Most popular wine brands retail for less than $10 per bottle. Image is very important in wine marketing. Fancy bottles, elegant and artistic labels, advertising, celebrity endorsements, and wine reviews can all impact consumers' perceptions of the value of a wine. There is often greater prestige from small-production, boutique wineries than larger-volume operations. Scarcity, the real or perceived rarity of a wine, can drive up prices. Demand can be influenced by global supply, those all-important ratings from publications such as the Wine Spectator, and the quality of the vintage. All the marketing efforts in the world can't make a poor wine taste good. Questions What factors related to (a) demand, (b) cost, (c) profit, and (d) competition are used by Stuart Cellars to arrive at an approximate price level? 2 Assume that Stuart Cellars annual fixed costs are $1,000,000. With an average retail price of $28 per bottle and assuming estimated unit variable costs of $11.50, calculate break-even volume. If there are 12 bottles per case, how does the break-even unit volume compare to Stuart Cellars' capacity? 3 You are a Stuart Cellars Wine Club member. You want to order Cabernet Sauvignon that normally retails for $45 per bottle. The following discount structure applies: 20 percent discount for purchases of 11 bottles or less; 30 percent discount for purchase of 12 bottles or more. Add 7.75 percent sales tax for California residents. What price, before shipping and handling, would you pay if (a) you order 10 bottles? (b) you order 12 bottles? (c) What are the implications of this discounting structure? 4 What pricing strategy(ies) does Stuart Cellars appear to be following? What will be the key factors in making these strategies a success? 1 ... View Full Document

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