Marketing Management II

Now let me ask you a question, Student. Assuming you have something of value for sale: what is one of the basic questions you will ask yourself?

STUDENT: First of all I would wonder how much to ask for what I have for sale.

TEACHER: Exactly. In other words, you will be concerned about the pricing of your product or service. Obviously this is of basic importance for you because the prices of your products will be a key element in your potential profit.

STUDENT: I see that; but what about NPO’s (nonprofit organizations)?

This is an ad where Rotary International -a well known NPO- markets a book: the regular edition priced at $25.-, and a limited edition leather-bound volume priced at $100.- These pricing decisions necessarily affect the number of books sold and the gross and net revenue of this project -producing and selling the book.

TEACHER: Nice thought. But since price increases will most probably affect the level of sales, and possibly trigger reactions from competitors, the decision is not such an easy one; it is actually a very complex one.

Now let me mention that the price of a product should be consistent with all other elements of the product itself and how it is presented to the market. Of course quality, production cost, competition in the market, and customer’s perception (the "image") will affect pricing.

Let me show you an ad, and please tell me what level of price you would expect to have to pay for this product. The copy –wording- of the ad states: "Performance. Unlike any other. The S-Class"

TEACHER: That is the idea. You see how marketing communication is related to pricing. If you as a potential customer perceive that this vehicle is of superior quality and delivers unrivaled performance, you will expect to pay a higher price compared with other cars.

By the same token, if a car is advertised as having the lowest maintenance cost in the market, you would expect to pay a comparatively low price.

STUDENT: I take it that this does not necessarily mean that a low price car must be of low quality.

Now let me mention that a good understanding of some basic economic concepts is necessary –while not always enough- to develop an effective pricing strategy. Since you are supposed to have studied Economics, please tell me which concepts would be critical for pricing.

STUDENT: Demand and Supply analysis; the type of markets faced (monopoly, oligopoly, monopolistic competition, pure competition).

STUDENT: In this case, I’d expect sales to rise by more than 10%, since by definition elastic in this case means that sales will react by a higher percentage than the change in price.

But Teacher, isn’t all this theoretical approach too... well, theoretical?

TEACHER: Well, I said before that understanding these principles was necessary but not sufficient. In the real world, many other considerations are necessary in addition to a sound economic analysis.

Let me mention that the basic approaches to pricing are based on cost, profit, competition and the image –customer perception- of the product.

As you know, total costs include fixed and variable costs. A pricing strategy based exclusively on costs, would consist simply in adding a markup percentage to the total cost of a product. This markup would be the gross margin delivered by the product.

STUDENT: Simple, but I can’t see it working too well in real life. I could decide to fix prices based on a nice markup of, say, 80%. But would the customers buy?

TEACHER: This is exactly the problem with purely cost-oriented techniques; it is not practical to ignore many other factors, such as competition, type of market, etc. This is why in practice markup percentages vary very much for different categories of products. Just as an example, a survey by German and Debra showed that while shoes carry a markup of close to 50%, books and magazines are marked up an average of 28% -in the US, that is.

To calculate a price based on profit, the technique usually employed is breakeven analysis. This technique consists in finding the volume of sales needed to cover costs at a given price.

STUDENT: Just a moment please, Teacher. What type of costs are we referring to here?

TEACHER: Good question. I will quote from our course Financial Management II, Module 1: "Estimates of what full costs are going to be in the future are used in some types of planning activities. In deciding what price to charge for its products, a company normally uses estimates of full costs plus a profit margin as a guide in arriving at the final selling price." We can work with full manufacturing costs as a basis, but it is necessary to add an estimate of all other costs involved in delivering the goods to the customer and getting the revenue.

TEACHER: Yes. A concept we may illustrate with this graph:

STUDENT: Your graph illustrates the point but it is, I assume, a simplification.

TEACHER: Of course; we all know by now that the total cost line is not linear (straight) at every production level range. We could also argue that since normally not all units can be sold at the same price, the total revenue curve would not be a straight line either. But as you said, the idea is to illustrate the concept.

In practice a marketer would estimate the breakeven point at several prices, to adjust his or her final number to the firm’s production capacity.

But I have a question now: how does profit enter into this calculation?

TEACHER: The normal procedure is to add a profit percentage to the total cost.

As you can see in this graph,

we have plotted a line showing both the breakeven point at a price equal to cost, and the breakeven point at a price formed by cost plus a certain profit. As was to be expected, we will need to sell a larger quantity (Q₁ instead of Q) to reach a breakeven point that now includes a profit in addition to cost.

Now let’s move on to

The competitive situation is always important in pricing, but how important it is depends on many factors.

The worst scenario for marketing is having to sell a product that can not be distinguished –differentiated- from the ones sold by many other competitors. This type of product is usually called a commodity because of its similarity with the actual commodities such a wheat, corn –maize-, coffee, etc.

In these cases the methods described before are useless; the marketer must simple accept the going price, and the only way to increase profits is to reduce costs. In certain cases higher prices can be obtained for a commodity by offering some type of support to the customers. In this way the commodity can be differentiated in the eyes of the customer. As an example, a firm selling glucose – a commodity in a multi-supplier environment- can offer to its industrial customers technical support to help in the designing and manufacturing of the goods that include glucose as an input.

TEACHER: When a market is closer to oligopoly than to pure competition, the situation is different since some players in the market may have higher pricing power than others.

Let’s take a look at some competition-based tactics:

1. Follow-the-leader pricing – Typical in oligopoly, this tactic consists in fixing prices very close to the ones charged by the market leader. But depending on the marketing strategy, prices may differ substantially. If price is set at a considerably lower level than the leader’s, this shows an intent to gain market share and possible will cause a reaction from the leader that can result in a price war. This tactic has been followed by supermarkets with their private brands, and in many cases they have forced the market leaders to reduce prices considerably as customers realized that the respective products were not very different in quality. Large consumer product companies such as Procter & Gamble, Heinz, and Unilever have suffered from this transfer of pricing power from them to the large retailers.

1. Opportunistic pricing – This tactic consists in setting prices at a lower level than competitors; the opportunity is real and durable only if competitors do not quickly match the lower prices. In this ad, the Vanguard Mutual Fund group stresses the large savings an investor can make by investing with them, due to their lower fee and expense ratio.

3. Predatory pricing – Prices are set with the specific purpose of hurting the competition, driving them out of business or forcing them to abandon a product line. A company doing this must expect to incur losses for a considerable time –at least for the line of products this practice is used in. A very large diversified corporation marketing several product categories can afford to use this practice to hurt a competitor that is active in only one of these categories. The practice is dangerous for several reasons; it may trigger anti-monopoly actions or be outright illegal; it may not work even after the initiator suffers considerable losses; or another large corporation may be tempted to take over the smaller rival –thus making the resulting competitive situation much worse than it was before.

4. Pricing above the competition – Prices are set higher than the competition as a rule; it is usually referred to as getting a "premium price". This tactic usually results in a sales volume much below the one that could be achieved by a lower price, of course.

STUDENT: This is a surprise for me. Why would a company intentionally sell less by charging more than the competition?

TEACHER: Usually to convey and support an image of good quality, often in combination with a limited production capacity. When corn –maize- oil earned the reputation of being good for the heart, and the quantity of oil produced being dependent on the amount of corn processed for other purposes, MAZOLA® corn oil was priced at a premium over other competing corn oils. The company still sold all its production of this "sub-product" of its corn refining operation and made a substantial profit on it.

STUDENT: I assume that a virtuous cycle was in effect; the high profit allowed spending a lot of money in marketing and image building, which in turn helped to get away with the premium price.

TEACHER: Yes. Now we will expand the concept of prices based on image.

The approaches to pricing based on cost, profit, competition and "image" –customer perception- of the product are not mutually exclusive. Any company will take costs and profits in consideration, and will keep an eye on the competition.

But customer perception is a key element in any market: even to some degree in a monopolistic one.

In the launching of new products, consumer panels are shown the products and asked how much they would be prepared to pay for it. They are also asked the price they pay for a comparable product. The latter is used as the "reference price", the price against which customers compare the offered product’s price.

STUDENT: Am I right in assuming that the reference price may be higher or lower that the price set for a given product?

Value pricing – We use the term value –as in good value- to indicate that the product’s benefits are perceived as justifying its price.

STUDENT: You mean to say that I may be prepared to pay a premium price if I perceive that the difference in price with a competing product is worth paying due to the higher benefit I get from the former.

TEACHER: Yes; but you may also prefer to pay the lower price if you perceive that the higher benefit you’d get does not justify the difference in price. And of course, a consumer’s disposable income level is also important. I may be convinced that a Rolls Royce delivers the best value compared to any automobile in the market; but I may have to be content with an economy car.

STUDENT: Yes, but even in this case you will choose the economy car that –in your perception- delivers the best value, won’t you?

In all cases, a good marketer must find out what the customer considers important to establish the value of a product. This factors may include prestige, low cost operation, durability, safety, product support by the seller, esthetics, good taste, being good for the environment, sex appeal, power, and many others.

STUDENT: I saw an ad from Toyota that reads: "Introducing high performance technology that’s also good for the environment". This refers to Toyota’s Hybrid Synergy Drive, a combination of a gasoline and an electric motor. In this case a combination of two values is used: performance and environment protection.

TEACHER: There can be an unlimited amount of combinations, of course. Now I ask you to please look at these ads and tell me what type of value is stressed in each one.

The add on the center –gourmet coffee- stresses good and constant quality, safety, reliability. Certainly the customer is led to perceive that this coffee tastes very good, but in addition there is the suggestion of prestige. If Mr. or Ms. Customer invites his or her friends for coffee at home, it will be apparent that they don’t serve just some cheap supermarket coffee.

The add on the right, from the same firm as the one on the left, is clearly targeted to thrifty customers who want to buy good books at a deep discount.

TEACHER: That was a very good analysis, Student. Now we will discuss

Governments in almost all countries impose some limitations on how firms price their products and services. Of course there are many variations between countries. In the US and in most other industrial countries the following practices are not allowed:

Price discrimination – Applies to goods only –not to services. Goods of the same quality and grade must be offered to all customers at the same price when the size of the order is the same –except when there are differences in cost for the seller (as for instance different transportation costs or applicable taxes).

Student, let’s move on to discuss

Pricing Objectives

I am sure you realize that pricing is a very important element of a marketing strategy. It logically follows that pricing strategies should support the overall marketing strategy.

Pricing strategy must have clear objectives: the most common ones are reaching a certain level of sales or market share, earning a specific profit level... or in some cases, simply survive!

Positioning objectives – Price is a basic tool in positioning a product to target specific market segments, since price is a key element in determining what customers will buy the product –or service.

Sales and profit objectives – Depending of course on the famous elasticity concept, price normally affects sales level considerably. A sales objective should of course –in general- be consistent with the overall profit objective of the firm.

I will try to outline a logical, analytical approach to pricing. Do you have something to say about that, Student?

STUDENT: I realize, Teacher, that yours is a leading question: obviously, you are expecting me to respond that I suspect that in practice many firms will not behave so rationally and logically when fixing prices.

TEACHER: Your suspicion is well founded, Student. But we will describe what firms should do: that is, follow a logical pricing process.

1. The first step should be to determine the pricing objectives: we have already mentioned the basic ones (positioning, sales, market share and profit levels).
2. Once the objectives have been determined, it is necessary to evaluate pricing constraints –such as demand, costs, competition, substitute products, and legal issues.
3. The next step should be to take into consideration the constraints in order to estimate the profit potential of each possible price level.
4. Now it is feasible to set an initial price level, consistent with the overall marketing strategy for the product. And of course, as conditions change, prices should be adjusted. Adjustments can be rather permanent, or can reflect temporary promotions or discounts consisting in a reduction in price for a limited time.

What type of pricing is the one used in this ad from Money Magazine?

TEACHER: This is "penetration pricing". A low price is offered to new customers to induce them to try the product and later continue purchasing it at the normal, higher price. In this case, of course, a "present" is included in order to make the offer more appealing.

This is a type of pricing used to capture new customers –as in the case of Money Magazine’s ad- and also used to introduce a new product and quickly reach a critical mass of sales.

In the latter case it is called introductory pricing. Normally profits at these prices are very low, zero, or even negative; obviously the overall strategy here is to get a mass of customers to like the product and later increase prices to a profitable level.

This is an example of introductory pricing:

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End of Module