TimJ.SmithPricingStrategy:SettingPriceLevels,ManagingPriceDiscounts,&EstablishingPriceStructuresPowerPointbyTimJ.Smith,PhDManagingPrincipal,WiglafPricingAdjunctProfessorofMarketing&Economics,DePaulUniversity?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.Chapter1BoundariesofaGoodPriceUsingExchangeValueModelsto

UnderstandPriceCompetitionandDefineYourValueAdd?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.AgendaWhoisinvolvedinpricingdecisions?Whyispricingsoimportanttothehealthofthefirm?Canfirmsinfluencetheirpricingpower?Whatisthenatureofagoodprice?Howrelevantaremarginalcostsandconsumersurplusinsettingagoodprice?Howshouldthecomparablealternativesonthemarketinfluencethepricingofaproduct?Howcanexchangevaluemodelsbeusedtosetprices?StretchQuestion:Howareexchangevaluemodelsrelatedtomarketsegments??2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.PricingErrorsAreCostlyToohighLostprofitsfromlackofvolumeThepriceiseventuallydroppedandthecompanymustfightformarketinterestandperceptionrepositioningPotentialallegationsofpricegougingandunfairness,leadingtopublicrelationsandregulatoryramificationsToolowForgoneprofitinanattempttogainvolumewhichmaynotcomeIncorrectlysetexpectationsfortheproductcategory,makingfuturepriceincreasesbeingdrivenagainstaheadwindofcustomerexpectationsUltimately,lostprofits,revenues,andashrinking/irrelevantfirm?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.PricingDecisionsareStakeholderDecisionsCFOResponsibleformeasuringandreportingperformanceAlmostalwaysinvolvedinpricingdecisionsfromaquantitativeanalysis/forecastingperspectiveGeneralbiastowardshighercontributionmarginsSales&MarketingResponsibleforpromotion,productstrategy,andplacement,alongwithpricingAlmostalwaysinvolvedinpricingdecisionsfromavaluepositioningperspectiveGeneralbiastowardsdiscountingandmarketshareResearch&DevelopmentResponsiblefordevelopingnewproductsthatcustomersvalueTechnicalindividualsoftenarechallengedtounderstandcommercialaspectsProductionResponsibleforquality,throughput,andcapacityutilizationGeneralbiastowardsvolumetoreduceoverheadallocationCEOArbitratorbetweencompetingstakeholdersExecutivesCustomersShareholdersCEO?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.ValueExchangeandProfitCapturePriceisthevaluethatthefirmcapturesinamutuallybeneficialexchangewithitscustomersFirm’sreasonforexistenceistoproducevalueforcustomers,valuewhichtheyexchangeforcashCustomerspurchasebecausetheygainvaluefromtheproductinexcessofthepricetheypayProfit Profit=QuantityX(Price–VariableCosts)–FixedCosts

p=Q(P–V)–FVariableCosts(V)FixedCosts(F)VolumeorQuantitySold(hencetheQ)Price(P)Profit(p)?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.MarginalImprovement–PriceHasImpactConsiderafirmthatimprovesoneoftheleversintheprofitequationby1%,holdingallelseconstantExample:P=$5.00Q=200,000V=$3.00F=$325,000ImproveeitherP,Q,V,orFby1%Howdoesthisaffectprofit?InitialProfitability p=200,000($5.00-$3.00)-$325,00

p=$75,000FixedCostReductionNewFixedCost=$321,750NewProfit=$78,250Improvementof4%VariableCostReductionNewVariableCost=$2.97NewProfit=$81,000Improvementof5%QuantitySoldIncreaseNewQuantity=202,000NewProfit=$79,000Improvementof4%PriceIncreaseNewPrice=$5.05NewProfit=$85,000Improvementof13%?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.Quantitative&QualitativeQuantitativeModelingandPriceOptimizationCarefulselectionofmodelCarefultreatmentofdata(cleansing)CarefulmarketsegmentationQualitativeModelingPotentialmethodsofinfluencingwillingnesstopayRelationshiptocorporatestrategyandindustrydynamicsCustomeracceptancetoapproachofpricediscriminationFinanceMarketingSalesEconomicsPriceSettingPriceswith

ExchangeValueModels?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.BoundariesofPriceThereisarangeof“rightprices”Rangeimpliesboundaries,upperandlowerExtremesfromstandardeconomics:MarginalCostistheExtremeLowerBoundaryConsumerUtilityistheExtremeUpperBoundaryExample:CypherDrugElutingStentbyCordisreleased2003DrugElutingStentisametal“spring”thatfitswithinanartery.Onceplaced,itexpandsthearterytoensureproperbloodflow.Pharmaceuticalsencoatthestenttoreduceacceptancefailure.Uponrelease,theDrugElutingStentwasconsideredarevolutionaryadvancementinthetreatmentofcoronarydiseaseEvolutionary:MarginalimprovementtothestatusquoRevolutionary:Breakthroughimprovementtostatusquo,withpotentiallydramaticallydifferentbenefitsgained.?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.MarginalCost=ExtremeLowerBoundMarginalcostsarethesellersbottomline.Anypricebelowmarginalcostsleavethesellerworseoffthentheywouldbewithoutthetransaction.Anypriceaboveitleavesthesellerbetteroff.Thus,marginalcostsistheextremelowerboundaryofthe“right”price.Standardmetalstentsaverageunitcostsarereportedbelow$150.Drugencoatedstentsaverageunitcostsareestimatedat$325.Coatingastentwithpharmaceuticalsisnotanexpensivechallengeaddingonlyafewdollarsperstent,yetpharmaceuticalcompaniesroutinelychargemuchmoreforthetechnologyAverageunitcostsarenotmarginalcosts,theyarealwayshigher,hencemarginalcostsarestillbelowthismetric.Sincemarginalcostsarethelowerboundofthepricingchallenge,usingahighernumber,theaverageunitcosts,addsextracautioninsettingprices.Thisoverlyconservativeapproachisinappropriateforsomepricingdecisions.ShouldCordispricethestentnearvariablecostsplusamanagementacceptablemarginofafewpercent??2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.ConsumerUtility=ExtremeUpperBoundConsumerutilityarethebuyersbottomline.ThecustomerwouldbeworseoffiftheypaidmoreforaproductthantheygainedinutilityAnypricebelowconsumerutilitywouldbeleavethecustomerbetteroffthangoingwithoutWhatistheutilityofastent?Whatisthevalueoflife?Lifeisexactlywhatisatstakewithcoronaryheartdisease:strainontheheartandreducedlifespan,heartattacksandpotentialdeath.Someeconomistsvaluealifeundertheassumptionthatitisequaltothefutureearningsoftheindividualovertheirlifespan,discountedbacktothepresenttime.Yeteconomicsdoesn’tcapturethevaluepeoplewillpayforonemoredaywiththeirspouse,seeingtheirchildrenandgrandchildrenmature,andbeingabletoparticipateinlifefully,attendingweddings,babyshowers,workingandbeingproductive,takingvacations…etc.Somephilosopherswouldclaimthatalllifeisequallyvaluable,andmanywouldclaimitsvalueisimmeasurable.Acceptingtheselimitations,letsmakeaveryfrugalandcrudeestimatethatthebenefitsdeliveredthoughusingastentis$500,000.ShouldCordispricethedrugelutingstentjustbelow$500,000??2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.MarginalCostsandConsumerUtility

ExtremeBoundariesFromthisexample,weknowonlytwoextremeboundaries,Bottomboundaryofmarginalcostgenerouslyestimated$325Upperboundaryofconsumerutilityfrugallyestimatedat$500,000Clearly,$325and$500,000isawiderange,withtheupperboundafactorof1000abovethelowerbound.$400$4,000$40,000$400,000Managersneedatighterboundthanthisfordecisionmaking.Bluntforceeconomicsofproducercostandconsumerutilityaloneisinsufficient.ConsumerUtility$500,000MarginalCostsPriceFloor$325RangeofPotentialPricesliesbetweentheExtremeBoundariesCompetingAlternativeandDifferentialValue

NarrowBoundariesMarketingStrategyProductsarevaluedbecausetheyenableacustomertodosomething,accomplishagoal,fromthatproduct.UtilityisderivedfromGoalaccomplishmentPriortotheexistenceoftheproduct,mostconsumersfoundanalternativemeansofaccomplishingthesamegoalWhatarethosealternatives?Howmuchbettercantheyachievethatgoal,andperhapsotherssimultaneously,fromtheproduct?Narrowerbandisdefinedbythecompetingalternativesanddifferentialvalue?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.CompetingAlternatives/SubstitutesCompetingoffersareoftenreadablyidentifiable,andformareferenceprice.ReferencePrice=PriceofnearestcomparableofferSubstitutesaresometimesmorechallengingtoidentify,buttheyalwaysexists.Substitutes:anyalternativemeansofachievingasimilarsetofbenefitsWhenpossible,usemoredirectcompetitorstoconsiderwhenmodelingpricedecisionsForCordisCordisproducedastandardstent,pricedroughlyat$1050perunit.Standardstentproceduresresultedinrestenosis(re-cloggingoftheartery)25%ofthetimeTheDrugElutingStentbyCordisreducedrestenosisto5%inclinicaltrialsPriortostents,bypasssurgerywascommon.Priortobypasssurgery,thereweredietarychanges,bedrest,andotherapproachesandpharmaceuticalstomanagethechallenge.Substitutesalwaysexist.ThestandardstentformsthemostrelevantcompetingalternativeforthedrugelutingstentsThestandardstentisclearlyaninferioralternative,sinceithasahigherrateofrestenosis,assuchthedrugelutingstentcouldlikelybepricedhigher,buthowmuchhigher?InferiorAlternative:competingalternativethatproducessimilarbenefitstotheonewiththepricingchallenge,butoveralllessconsumerutility?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.DifferentialValueDifferentialvalueisthechangeinconsumerutilitythataproductincomparisontoitscomparablealternativeExchangevalueisthepriceofthecompetingalternativeadjustedforthedifferentialvalueThedrugelutingstentclearlydeliversmorebenefitsthanstandardstents.Quantifyitwithamodel.Thestentisacomponentinalargerprocess.Implantingastentisaroughly$12,000operation,ofwhichthestandardstentisonlya$1050component.Operationcost=$10,950StandardStentCost=$1050Assumetheproceduremustberepeated25%ofthetimeduetorestenosisTotalMaximumExpectedCost ($12,000)+($12,000)25%+($0)75%=$15,000?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.RepeattheProcedure$12,000,25%Don’tRepeattheProcedure$0,75%OriginalProcedure$12,000,100%ExpectationValue=$15,000

$12,000(100%)+$12,000(25%)+$0(75%)DifferentialValueTheDrugElutingStentreducesrestenosisto5%RepeattheModel,butthistimeletthepriceofthestentbeunknownandtheexpectationcostbeheldconstanttothatofthenearestcompetingalternativeSolvefortheunknown,usingalgebra.TotalMaximumExpectedCost $15,000=($10,950+X)+($10,950+X)5%+($0)95%X=[$15,000–($10,950)1.05]/1.05X=$3,340ExchangeValueofthenewDrugElutingStentat$3,340ThispriceleavethepatienteconomicallyequallywelloffaswiththelowerpriceforthelowerqualitycompetingalternativeIgnoresqualityoflifeissues,theriskofasecondfailure,etc.Itisa“conservativeestimate”?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.RepeattheProcedure$10,950+X,5%Don’tRepeattheProcedure$0,95%OriginalProcedure$10,950+X,100%ExpectationValue=$15,000ExchangeValueModelfor

DrugElutingStentbyCordisExchangevalue=PriceofAlternative+DifferentialValue$3,340=$1,050+DVDifferentialValueisawhopping$2,290ConsumerSurplusisthedifferencebetweenthepricepaidandthetotalconsumerutility?2012CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.ConsumerSurplus$$$$$ExchangeValue

$3,340Reference

Value$1050DifferentialValue$2,290PriceofComparableAlternativeMaximumPotentialPriceConsumerUtility$500,000MarginalCostsPriceFloor$325ModelingandStrategicThinkingImprovesPricingReduceextremeandtonarrowboundariestoimprovepricing$325to$500,000,theMarginalCostandConsumerUtility,orExtremeBoundaries$1050to$3,340,thepriceofthenearestcompetingofferandtheexchangevalueStrategicthinkingreducedtherangesignificantly,fromafactorof1000tonownear3WhatpricedidCordisreleaseCypher?$3195,largelyfromnegotiationswithinsurancecompaniesandgovernmentalbodies$3195isminisculecomparedtotheconsumerutility$3195ishugecomparedtothemarginalcost$3195isalsohighabovetheinferiorcompetitoryetlessthantheexchangevalueStill,$3195ismuchhigherthanwhatdoctorsareusedto,at$10