4. Marketing Mix in the Marketing Planning Process212 4.2 Pricing Decisions Pricing is one of the most important marketing mix decisions, price being the only marketing mix variable that generates revenues. Pricing is not a single concept, but a multidimensional one with different meanings and implications for the manufacturer, the middleman and the end-customer. Pricing strategy is of great importance because it affects both revenue and buyer behaviour. The whole pricing environment is therefore considered, first from the point of view of the company and its strategies and then from the aspect of the consumer. However, it must not be forgotten that there are other, external influences on pricing – not just a firm’s competitors but also from government and legislation. Once these factors have been taken into account, various pricing strategies are reviewed and some attention is given to how best to implement those strategies; how pricing levels can be adjusted and how such tactics do affect buyer behaviour and company revenue. The multidimensional character of price should be taken into account for the pricing of products and services. Generally speaking, price is the amount of money charged for a product or service, or the sum of all the values that customers exchange for the benefits of having or using the product or service. Price is the only element of the marketing mix that produces revenue; all other elements represent costs. Additionally, price is also one of the most flexible elements of the marketing mix. Unlike product features and channel strategies, price can be changed quickly. Pricing involves the determination (and adjustment) of a price structure and price levels, as well as decisions on short-term price changes. Price should not be set in isolation; it should be blended with product, promotion and place to form a coherent mix that provides superior customer value. Furthermore, an effective goal-oriented approach to pricing is needed that explicitly takes into account the role of price as a marketing mix instrument and as a profit generator. This provides a framework for effective, goal-oriented pricing, and to highlight the major aspects and factors of the pricing decision. 4.2.1 A Pricing Framework A company’s pricing decisions are affected by both internal company factors and external environmental factors. It is important that firms recognize that the cost structures of product are very significant, but they should not be regarded as sole determinants when setting prices. Pricing policy is an important strategic and tactical competitive weapon that, in contrast to the other elements of the global marketing mix, is highly controllable and inexpensive to change and implement. Therefore, pricing strategies and actions should be integrated with the other elements of the global marketing mix as stated above. Figure 4.16 presents a general framework for pricing decisions. According to this model, factors affecting pricing can be broken down into two main groups (internal and external factors) which consist of various factors. We shall now consider the most important elements in more detail (Nagle and Holden, 2001). Kapitel_4.indd 212 03.08.2010 13:01:40 Uhr 4.2 Pricing Decisions 213 Internal Factors Affecting Pricing Decisions Internal factors affecting pricing include the firm’s marketing objectives, marketing mix strategy, costs and organisational considerations: Marketing objectives • Before determining the price, the company must decide on its strategy for the product. If the company has selected its target market and positioning, its marketing mix strategy will be fairly straightforward. For example, when Toyota developed its Lexus brands to compete with European luxury-performance cars in the higher-income segment, this required charging a premium price. In contrast, when it introduced its Echo model, this positioning required charging a low price. Thus, pricing strategy is largely determined by decisions on market positioning. In addition, a company may seek other general or specific objectives. General ob-• jectives include survival, profit maximization, market share leadership, and product quality leadership. At a specific level, a company may set prices low to prevent competition from entering the market. Thus, pricing plays an important role in helping to accomplish the company’s objectives at many levels. Marketing mix strategy • As price is only one element of the marketing mix price decisions must be coordinated with product design, distribution, and promotion decisions to form a coherent and effective marketing mix strategy. Decisions made for other marketing mix variables affect pricing decisions. For example, a decision to position the product on high-performance quality will suggest that the seller must charge a higher price to cover higher costs. Some companies deemphasize price and use other marketing mix tools to create nonprice positions. Within this strategy, firms differentiate the marketing offer to make it worth a higher price instead of charging the lowest price. For example, Sony builds Source: Adapted from Nagle and Holden, 2001 Marketing objectives Internal factors Pricing decisions Nature of the market and demand External factors Competition Other environmental factors Marketing mix strategy Costs Organizational considerations Figure 4.16: Factors affecting price decisions Kapitel_4.indd 213 03.08.2010 13:01:40 Uhr 4. Marketing Mix in the Marketing Planning Process214 more value into its consumer electronics products and charges a higher price than many competitors. Eventually, customers recognize Sony’s higher quality and are willing o pay more to get it. Against this background, marketers must consider the complete marketing mix when setting prices. If the product is positioned on on-price factors, then decisions about quality, promotion, an distribution will largely affect price. If price is a crucial positioning factor, then price will strongly affect decisions made about the other marketing mix elements. Costs • Costs set the baseline for the price that the company can charge. The firm wants to charge a price that both covers all its costs for producing, distributing, and selling the product and delivers a fair rate of return. A company’s costs are an important element in its pricing strategy. However, the company must consider costs alongside all of the other factors rather than in isolation. A company’s costs take two forms, fixed and variable. Fixed costs (also known as overhead) are costs that do not vary with production or sales level. Examples include rent, interest, and executive salaries. Variable costs vary directly with the level of production. Each PC produced by Hewlett Packard, for example, involves a cost of computer chips, wires, packaging and other inputs. Finally, total costs are the sum of the fixed and the variable costs for any given level of production. Management wants to charge a price that will at least cover the total production costs at a given level of production. The firm must watch its costs carefully. If it costs the company mire than the competition to produce and sell its products, the firm will have to charge a higher price or make less profit, putting it at a competitive disadvantage. Organisational considerations • Management must decide who within the organisation should set prices. In small enterprises, prices are often set by top management rather than by the marketing or sales department. In large companies, pricing is typically handled by divisional or product line managers. In industries in which pricing is a key factor such as aerospace and oil, companies often have a pricing department to set the best prices. Others who have an influence on pricing include sales managers, production managers, finance managers, and accountants. External Factors Affecting Pricing Decisions The environmental factors are external to the firm and thus uncontrollable variables in the foreign market. External factors affecting pricing include the nature of the market and demand, competition, and other environmental elements: The market and demand • One of the critical factors affecting pricing is the pressure of competitors. The firm has to offer a more competitive price if there are other sellers in the market. Thus, the nature of competition (e.g. oligopoly or monopoly) can significantly influence the firm’s pricing strategy. Under conditions approximating pure competition, price is set in the marketplace price and tends to be just enough above costs to keep marginal producers in business. Thus, from the point of view of the price setter, the most important factor is costs. The closer the substitutability of products, the more nearly identical the prices must be, Kapitel_4.indd 214 03.08.2010 13:01:41 Uhr 4.2 Pricing Decisions 215 and the greater the influence of costs in determining prices (assuming a large enough number of buyers and sellers). Under conditions of monopolistic or imperfect competition, the seller has some discretion to vary the product quality, promotional efforts and channel politics in order to adapt the price of the total product to serve pre-selected market segments. Nevertheless, the freedom to set prices is still limited by what competitors charge, and any price differentials from competitors must be justified in the minds of customers on the basis of differential utility: that is, perceived value. Whereas costs set the lower limit of prices, the market and demand set the upper limit. Both customers and industrial buyers balance the price of a product or service against the benefits of owning it. Thus before setting prices, the marketer must comprehend the relationship between the price and demand for its product. Each price the company might charge will lead to a different level of demand. The relationship between the price charged and the resulting demand level is shown in the demand curve in Figure 4.17. The demand curve shows the number of units the market will buy in a given time period at different prices that might be charged. In the normal case, demand and price are inversely related; that it, the higher the price, the lower the demand and vice versa. Thus, the company would sell more if it lowered its price from P1 to P2. In the case of prestige goods, the demand curve sometimes sloes upward. Customers think that higher prices imply more quality. Marketers also need to know price elasticity – how responsive demand will be to a change in price. Consider the demand curve in Figure 4.17. The price decrease from P x Saturation point x1 PP P1 xs Maximum price 0 P2 x2 Price Decrease Quantity Change Figure 4.17: The demand curve Kapitel_4.indd 215 03.08.2010 13:01:41 Uhr 4. Marketing Mix in the Marketing Planning Process216 P1 to P2 leads to a relatively small increase in demand from X1 to X2. If demand hardly changes with a small change in price, the demand is categorized as being inelastic. If demand changes greatly, the demand is elastic. What determines the price elasticity of demand? Buyers are like to be less price sensitive when the product they are buying is unique or when it is high in quality, prestige, or exclusiveness. Consumers are also less price sensitive when substitute products are difficult to find or when they cannot easily compare the quality of substitute. Finally, buyers are less sensitive to price changes when the total expenditure for a product is low relative to their income or when the cost is shared by another party (Nagle and Holden, 2001). Competition • In setting its prices, the company must carefully consider competitors’ costs and prices and possible reactions to the company’s own pricing moves. A consumer who is considering the purchase of a Sony digital camera, for example, will evaluate Sony’s price and values against the prices and values of comparable products made by Canon, Olympus, and others. If a business lowers prices to gain share, and competitors follow, there is likely to be very little real share gain. And at reduced margins, with a limited increase in volume, total contribution is likely to go down. On the other hand, if a business raises prices to improve margins and competitors do not follow, the business could lose share and lower total contribution, even with higher margins. In any given market, competitor response to price change is going to depend on a variety of supply and demand forces, as outlined in Figure 4.18. As the forces shift from the left to the right, they will contribute to the likelihood of a full and fast competitor response to a price cut. Overall, there is generally a high degree of price interdependence among competing firms. Other external factors • When setting prices, the company also must consider a number of other factors in its external environment. Economic conditions can have a strong impact on the company’s pricing strategies. Economic factors such as boom or recession, inflation, and interest rates affect pricing decisions because they affect both the costs of producing a product and customer perceptions of the product’s price and value. The enterprise must also think about what impact its prices will have on other parties in its environment (e.g. resellers). The government is another important external stakeholder in the framework of pricing decisions. For example, import controls are designed to limit imports in order to protect domestic producers or reduce the outflow of foreign exchange. Direct restric- Example 26: The demand for high involvement products like automobiles is inelastic as customers are not priceconscious. Mercedes-Benz asks customers to spoil themselves in this award-winning ad Kapitel_4.indd 216 03.08.2010 13:01:41 Uhr 4.2 Pricing Decisions 217 tions commonly take the form of tariffs, quotas and various non-tariff barriers. Tariffs directly increase the price of imports unless the exporter or importer is willing to absorb the tax and accept lower profit margins. Quotas have an indirect impact on prices. They restrict supply, thus causing the price of the import to increase. Since tariff levels vary from country to country, there is an incentive for exporters to vary the price somewhat from country to country. In some countries with high customs duties and high price elasticity, the base price may have to be lower than in other countries if the product is to achieve satisfactory volume in these markets. If demand is quite inelastic, the price may be set at a high level, with little loss of volume, unless competitors are selling at lower prices. Government regulation on pricing can also affect the firm’s pricing strategy. Many governments tend to have price controls on specific products related to health, education, food and other essential items. Another major environmental factor is fluctuation in the exchange rate. An increase (revaluation) or decrease (devaluation) in the relative value of a currency can affect the firm’s pricing structure and profitability (Hollensen, 2003). In the following sections we shall discuss the different available pricing strategies. 4.2.2 General Pricing Approaches Companies set prices by selecting a general pricing approach. We will examine the following approaches in detail: the cost-based approach (cost-plus pricing and break even analysis), the value-based pricing, and the competition-based pricing (going-rate pricing and sealed bid pricing). Probability of full and fast competitive response to a price cut Competitor Characteristics/Internal Forces: Low High Variable Cost Structure High Low Capacity Utilization Full Low Product Perishability None High Product Differentiation High None Competitor Financial Position Poor Strong Strategic Importance Low High Demand Forces: Price Elasticity Inelastic Elastic Efficiency in Price Shopping Low High Customer Loyalty High Low Market Growth Rate High Low Complementary Products None Important Substitute Products None Many Source: Adapted from Best, 2000 Figure 4.18: Forces favouring competitive price response Kapitel_4.indd 217 03.08.2010 13:01:41 Uhr 4. Marketing Mix in the Marketing Planning Process218 4.2.2.1 Cost-Based Pricing Companies often use cost-oriented methods when setting prices. The simplest pricing method is cost-plus pricing – adding a standard mark-up to the cost of the product. Construction companies, for example, submit project bids by estimating the total cost and adding a standard mar-up for profit. Cost-plus pricing can be best explained by using a simple example (Kotler and Armstrong, 2009): suppose a watch manufacturer had the following costs and expected sales: Variable cost EUR 10 Fixed costs EUR 300.000 Expected unit sales 50.000 Then the manufacturer’s cost per watch/unit is given by: = + = + = Fixed Costs 300.000 Unit cost Variable Cost      10   EUR 16 Unit Sales 50.000 Now, we shall suppose the manufacturer wants to earn a 20 per cent mark-up on sales. The manufacturer’s mark-up price is given by: = = = ? ? Unit Cost 16 Markup Price       EUR 20 (1 Desired Return on Sales) 1 0,2 Consequently, the manufacturer would charge resellers EUR 20 a watch and make a profit of 20 per cent or EUR 4 per unit. The dealers, in turn, will mark up the watch. If resellers, for example want to earn 50 per cent on sales price, they will mark up the watch to EUR 40 (EUR 20 + 50 % of EUR 40). This number is equivalent to a mark-up on cost of 100 per cent (EUR 20/EUR 20). The problem with this pricing approach is that it ignores demand and competitor prices and all other internal and external factors discussed above. In addition, the procedure is illogical because a sales estimate is made before a price is set. Furthermore, it focuses on internal costs rather than the customer’s willingness to pay. Finally, there may be a technical problem in allocating overheads in multi-product companies (Christopher, 1982). Still, mark-up pricing remains popular for many reasons. First, manufacturers are more certain about costs than about demand. By tying the price to cost, sellers simplify pricing – they do not have to make regular adjustments as demand changes. Furthermore, this approach does give an indication of the minimum price necessary to make a profit. Another reason is that many stakeholders feel that cost-plus pricing is fairer to both buyers and sellers. Another cost-oriented pricing approach is break even pricing. This approach involves setting the price to break even on the costs of making and marketing a product; or setting the price to make a target profit. Break-even analysis is generally viewed as an accounting concept, but it is extremely useful in evaluation the profit potential and risk associated with a pricing strategy, or any marketing strategy. This section is to examine, from a marketing viewpoint, the usefulness of break-even volume. For a given price strategy and marketing effort, it is useful to determine the number of units that need to be sold in order to break even (produce a net profit equal to zero). The break-even point is normally represented as that level of output where the total revenue from sales of a product or service matches exactly the total costs of its produc- Kapitel_4.indd 218 03.08.2010 13:01:41 Uhr 4.2 Pricing Decisions 219 tion and marketing (break-even quantity). Such an analysis of cost-revenue relationships can be very useful to the pricing decision-maker. One use of break-even analysis is to compare the break-even volumes associated with different prices for a product. The effect of charging a higher price is to steepen the total revenue curve and as a consequence lower the break-even volume. The pricing decision-maker can then assess the effect of charging different prices in terms of what these different prices and break-even volumes mean to the company. Specifically, the information given by a break-even chart is: Profit or losses at varying levels of output.• Break-even points at varying levels of price.• Effect on break-even point and profits or losses if costs change. • Break-even volume is the volume needed to cover the fixed cost on the basis of a particular contribution per unit. It can be estimated graphically using a break-even-chart, which shows the total cost and total revenue expected at different sales volume levels. Figure 4.19 shows a break-even chart for the watch manufacturer discussed above. Foxed costs are EUR 300.000 regardless of sales. Variable costs are added to fixed costs to form the total costs function, which rise with volume. The total revenue curve starts at zero and rises with each unit sold. The slope of the total revenue curve reflects the price of EUR 20 per unit. The total revenue and total cost curves cross at 30.000 units. This is the break-even volume. At EUR 20, the company must sell at least 30.000 units to break even; that is, for total revenue to cover total cost. Figure 4.19: Break-even chart Kapitel_4.indd 219 03.08.2010 13:01:42 Uhr 4. Marketing Mix in the Marketing Planning Process220 Break-even volume can be computed using the following procedure: =Contribution per unit  Selling price –  variable cost per unit ? = = = ? ? Fixed Cost 300.000 Break Even Volume       30.000 (Price Variable cost) 20 10 If the enterprise wants to make a target profit, it must sell more than 30.000 units at EUR 20 each. Because break-even volume is an unconstrained number, the reasonableness of the breakeven volume requires additional considerations. Because market share is constrained between zero and 100 per cent, break-even market share provides a sophisticated framework from which to judge profit potential and risk. To compute break-even market share requires only that we divide the break-even volume by the size of the actual total market, as shown next. ? ? = Break Even Volume Break Even Market Share   Total market If the total market for some product were one million units per year, then the break-even market share would be the following with the different prices: ( )? = = =50.000Break Even Market Share  Price 300   *100 5% 1.000.000 ( )? = = =100.000Break Even Market Share  Price 200   *100 10% 1.000.000 ( )? = = =200.000Break Even Market Share  Price 150   *100 20% 1.000.000 Of course management would feel a lot better if the break-even share were only 5 % instead of 20 %. In this example a decrease in price of 50 % (from EUR 300 to EUR 150) would mean that management should increase the market share with 400 per cent (from 5 % to 20 %). In summary, neither the cost-plus pricing model nor the break-even analysis is in itself a sufficient basis on which to determine prices. Nevertheless, taken together, they do point to a clear-cut and universal presumption for delineating pricing decisions which can be incorporated into a more realistic and marketing-oriented approach to pricing. This more market-oriented approach to pricing will be discussed in the following sections. 4.2.2.2 Value-Based Pricing An increasing number of companies are basing their prices on the product’s perceived value. Value-based pricing uses buyers’ perceptions of value, not the seller’s total costs, as the key to pricing. Value-based pricing implies that the marketer cannot design a product and marketing program and then set the price. Price in this context is considered along with the other marketing mix variables and other factors before the marketing program is determined (Kotler and Armstrong, 2009). Figure 4.20 compares cost-based pricing with value-based pricing. Cost-based pricing is product driven. The company designs what it considers to be a good product, totals the cost of making the product, and sets a price that covers costs plus a target profit. Once the price was set, the marketer’s job was to convince customers that the product was worth it. If the marketer was not successful, then the price was lowered. If demand Kapitel_4.indd 220 03.08.2010 13:01:42 Uhr 4.2 Pricing Decisions 221 turned out to be higher than anticipated, then the price was raised. An important point is that the customer was the last person to be considered in this chain of events. Value-based pricing reverses this process and begins by understanding customers and the competitive marketplace. The first step is to look at the value customers perceive in owning the product and to examine their options for acquiring similar products and brands. The targeted value and price then drive decisions about product design and what costs can be incurred. Although cost-based pricing is easier, it ignores the customer and the competition as already noted above. Marketers recognize that it is impossible to predict demand or competitors’ actions simply by looking at their own costs. Consequently, cost-based pricing is becoming less popular. Because prices send powerful messages, it is tremendously important that they reflect the customer value the company delivers. Customer value is derived from the product itself, the services surrounding it, the company-customer interaction, and the image the customer associates with the product. Volvo, for example, has captured buyers at relatively high prices for years because of a reputation for durability and safety. The firm is likely to incur higher costs when producing increased value. For example, it often costs more to make better products, create better distribution systems, or develop service facilities. The task is to find a balance between what customers are willing to pay and the costs associated with the strategy. A company using value-based pricing must find out what value buyers assigning to different competitive offers. However, it is not unproblematic measuring the perceived value. The company has to look at how customer value is derived, recognizing that people place different values on the products they buy as well as the relationship they have with companies. Several pricing strategies may work. It all depends on how price is perceived, how competitors act, and how a strategy is designed and implemented. 4.2.2.3 Competition-Based Pricing Consumers will base their judgements of a product’s value on the prices that competitors charge for similar products. One form of competition-based pricing is going-rate pricing, in which a company bases its price largely on competitors’ prices. Less attention is paid Source: Adapted from Nagle and Holden, 2001 Cost-based pricing Value-based pricing Product Cost Price Value Customer Customers Value Price Cost Product Figure 4.20: Cost-based versus value-based pricing Kapitel_4.indd 221 03.08.2010 13:01:43 Uhr 4. Marketing Mix in the Marketing Planning Process222 to its own costs or to demand. The enterprise might charge the same as, more than, or less than its competitors. Competition-based pricing is also used when firms bid for jobs. Using sealed-bid pricing, a company bases its price on how it believes competitors will price rather than on its own costs or on the demand. The organisation wants to win a contract, and winning the contract requires piecing less than competitors. Yet the company cannot set its price below a certain level. It cannot price below cost without harming its competitive position (Kotler and Armstrong, 2009). 4.2.3 Pricing Services vs. Physical Product The intangibility or service performances and the invisibility of the necessary backstage facilities and labour makes it more difficult for customers to perceive what they are getting for their money than when they purchase a physical good. Intangible performances like services are inherently more difficult to price than goods, because it is harder to calculate the financial costs involved in serving a customer than it is to identify the labour, materials, machine time, storage and shipping costs associated with producing a physical good. The variability of both inputs and outputs implies that units of service may not cost the same to produce, nor may they be of equal value to customers – especially if the variability extends to greater or lesser quality. Making matters even more complicated, it is not always easy to define a unit of service, raising questions as to what should be the basis of service pricing. A very important distinction between goods and services is that many services have a much higher ratio of fixed costs to variable costs than is found in manufacturing firms. Service businesses with high fixed costs include those with an expensive physical facility (such as a hotel, a hospital, a college, or a theatre), or a network (such as telecommunications company, an internet provider, a railway). On the other hand, the variable costs of serving one extra customer may be minimal. Under these conditions, managers may feel that they have tremendous pricing flexibility and it’s tempting to price very low in order to make an extra sale. However, there can be no profit at the end of the year unless all fixed costs have been recovered. Another factor that influences service pricing, concerns the importance of the time factor, since it may affect customer perceptions of value. In many instances, customers may be willing to pay more for a service delivered quickly than for one delivered more slowly. Sometimes greater speed increases operating costs, too – reflecting the need to pay overtime wages or use more expensive equipment (Hollensen, 2003). Example 27: Marketing services: Volkswagen stresses its extended service opening hours until 9.00 p.m in this brain teasing ad Kapitel_4.indd 222 03.08.2010 13:01:43 Uhr 4.2 Pricing Decisions 223 4.2.4 Pricing new Products Pricing strategies usually change as the product passes through its life cycle. The introductory stage is especially challenging. Companies bringing out a new product face the challenge of setting prices for the first time. They can choose between two generic strategies: market-skimming pricing and market-penetration pricing. Market-Skimming Pricing Numerous companies that invent new products set high initial prices to ‘skim’ revenues layer by layer from the market. Market-skimming pricing involves setting a high price for a new product to skim maximum revenues from the segments willing to pay the high price. Sony, for example, frequently uses this strategy. When the company introduced the world’s first high-definition television (HDTV) to the Japanese market in 1990, the high-tech sets cost $ 43.000. These TVs were purchased only by customers who could afford to pay a high price for the new technology. Sony then rapidly reduced the price over the next several years to attract new buyers. By 1993 a 28-inch HDTV cost a Japanese buyer just over $ 6.000. In 2001, a Japanese consumer could buy a 40-inch HDTV for about $ 2.000, a price that many more customers could and wanted to afford. An entry level HDTV set now sells for less than $ 1.000, and prices continue to fall. In this way, Sony skimmed the maximum amount of revenue from the various segments of the market (Wildstrom, 2004) A skimming approach, appropriate for a distinctly new product, provides the firm with an opportunity to profitably reach market segments that are not sensitive to the high initial price. As a product ages, as competitors enter the market, and as organisational buyers become accustomed to evaluating and purchasing the product, demand becomes more price elastic. Market skimming is appropriate under certain conditions. First, the product’s quality and image must support its higher price, and a reasonable number of buyers must want the product at that price. Second, the costs of producing smaller volume cannot be so high that they cancel the advantage of charging more. Finally, competitors should not be able to enter the market quickly and easily and undercut the high price (Kotler and Armstrong, 2009). Problems with skimming are as follows: Having a small market share makes the firm vulnerable to aggressive local competi-• tion Maintenance of a high-quality product requires a lot of resource (promotion, after-• sales service) and a visible local presence, which may be difficult in distant markets. If the product is sold more cheaply at home or in another country, grey marketing • (parallel importing) is possible. Market-Penetration Pricing Rather than setting a high initial price to skim off small but profitable market segments, companies might use market-penetration pricing. They set a low initial price in order to penetrate the market quickly and deeply – to attract a large number of buyers rapidly and win a large market share. The high sales volume results in falling costs, allowing the company to cut its price even further. Kapitel_4.indd 223 03.08.2010 13:01:43 Uhr 4. Marketing Mix in the Marketing Planning Process224 A penetration policy is appropriate when there is (1) high price elasticity of demand, (2) strong threat of imminent competition, and (3) opportunity for a substantial reduction in production costs as volume expands. Drawing upon the experience effect, a firm that can quickly gain substantial market share and experience can gain a strategic advantage over competitors. The viability of this strategy increases with the potential size of the future market. By taking a large share of new sales, experience can be gained when there is a large market growth rate. Of course, the value of additional market share differs between industries and often among products, markets, and competitors within a particular industry. Factors to be assessed in determining the value of additional market share include the investment requirements, potential benefits of experience, expected market trends, likely competitive reaction, and short- and long-term profit implications. Penetration pricing can be effective for fixed periods of time and in the right competitive situation, but many firms overuse this approach and end up creating a market situation where everyone is forced to lower prices continually, driving some competitors from the market and guaranteeing that no one realizes a good return on investment. Mangers can prevent the fruitless slide into kamikaze pricing by implementing a value-driven pricing strategy for the most profitable customers (Holden and Nagle, 1998). Japanese companies have used penetration pricing intensively to gain market share leadership in a number of markets, such as cars, home entertainment products and electronic components. Price should also be blended with other elements of the marketing mix. Figure 4.21 displays four marketing strategies based on combinations of price and promotion. Similar matrices could be developed for product and distribution (Jobber, 2010). A combination of high price and high promotion expenditure is called a rapid skimming strategy. Nike, for example, usually employs a rapid skimming strategy when it launches new ranges of trainers. A slow skimming strategy combines high price with low levels of promotional expenditure. High prices imply high profit margins, but high levels of promotion are believed to be unnecessary, perhaps because word of mouth is more important and the product is already well-known. Companies that combine low prices with heavy promotional expenditure are practising a rapid penetration strategy. The aim is to gain market share rapidly. For example, no-frills airlines such as easy Jet and Ryanair have successfully attacked British Airways by adopting a rapid penetration Source: Adapted from Kotler and Armstrong, 2009 Promotion High Low Price High Rapid skimming Slow skimming Low Rapid penetration Slow penetration Figure 4.21: New product launch strategies Kapitel_4.indd 224 03.08.2010 13:01:43 Uhr 4.2 Pricing Decisions 225 strategy. Finally, slow penetration strategy combines a low price with low promotional expenditure. Own-label brands use this kind of strategy as promotion is not necessary to gain distribution, and low promotional expenditure helps to maintain high profit margins for these brands. 4.2.5 Price Changes Price changes on existing products are called for when a new product has been launched or when changes occur in overall market conditions (such as fluctuating foreign exchange rates). Table 4.2 shows the percentage sales volume increase or decrease required to maintain the level of profit. An example shows how the table functions. A firm has a product with a contribution margin of 20 per cent. The firm would like to know how much the sales volume should be increased as a consequence of a price reduction of 5 per cent, if it wishes to keep the same total profit contribution. The calculation is as follows: Price reduction % Profit contribution margin (price - variable cost per unit in % of the price) 5 10 15 20 25 30 35 40 50 Sales volume increase (%) required to maintain total profit contribution 2,0 67 25 15 11 9 7 7 5 4 3,0 150 43 25 18 14 11 9 8 6 4,0 400 67 36 25 19 15 13 11 9 5,0 100 50 33 25 20 17 14 11 7,5 300 100 60 43 33 27 23 18 10,0 200 100 67 50 40 33 25 15,0 300 150 100 75 60 43 Price increase % Profit contribution margin (price - variable cost per unit in % of the price 5 10 15 20 25 30 35 40 50 Sales volume reduction required to maintain total profit contribution 2,0 29 17 12 9 7 6 5 5 4 3,0 37 23 17 13 11 9 8 7 6 4,0 44 29 21 17 14 12 10 9 7 5,0 50 33 25 20 17 14 12 11 9 7,5 60 43 33 27 23 20 18 16 13 10,0 67 50 40 33 29 25 22 20 17 15,0 75 60 50 43 37 33 30 27 23 Source: Adapted from Hollensen, 2003 Table 4.2: Sales volume increase or decrease (%) required to maintain total profit contribution Kapitel_4.indd 225 03.08.2010 13:01:43 Uhr 4. Marketing Mix in the Marketing Planning Process226 Before price reduction Per product Sales price EUR 100 Variable cost per unit EUR 80 Contribution margin EUR 20 Total contribution margin EUR 2.000 As a consequence of a price reduction of 5 per cent, a 33 per cent increase in sales is required. If a decision is made to change prices, related changes must also be considered. For example, if an increase in price is required, it may be accompanied, at least initially, by increased promotional effort. When changing prices, the degree of flexibility enjoyed by decision makers will tend to be less for existing products than for new products. This follows from the high probability that the existing product is now less unique, faces stronger competition and is aimed at a broader segment of the market. In this situation, the decision maker will be forced to pay more attention to competitive and cost factors in the pricing process. The timing of price changes can be nearly as important as the changes themselves. For example, a simple tactic of time lagging competitors in announcing price increases can produce the perception among customers that you are the most customer-responsive supplier. The extent of the time lag can also be important. In one company, an independent survey of customers (Garda, 1995) showed that the perception of being the most customer-responsive supplier was generated just as effectively by a six-week lag in following a competitor’s price increase as by a six-month lag. A considerable amount of money would have been lost during the unnecessary four-anda-half-month delay in announcing a price increase. 4.2.6 Experience Curve Pricing Price changes usually follow changes in the product’s stage in the life cycle. As the product matures, more pressure will be put on the price to keep the product competitive despite increased competition and less possibility of differentiation. In addition, the cost aspect should also be integrated into the discussion. The experience curve has its roots in a commonly observed phenomenon called the learning curve, which states that as people repeat a task they learn to do it better and faster. The learning curve applies to the labour portion of manufacturing cost. The Boston Consulting Group extended the learning effect to cover all the value-added costs related to a product – manufacturing plus marketing, sales, administration and the like. The resulting experience curves, covering all value chain activities, indicate that the total unit costs of a product in real terms can be reduced by a certain percentage with each doubling of cumulative production. The typical decline in cost is 30 per cent (termed a 70 per cent curve), although greater and lesser decline are observed. If the experience curve (average unit cost) and the typical market price development within an industry are combined, a relationship similar to that shown in Figure 4.22 will result. Figure 4.22 shows that after the introduction stage (during part of which the price is below the total unit cost), profits begin to flow. Because supply is less than demand, prices Kapitel_4.indd 226 03.08.2010 13:01:44 Uhr 4.2 Pricing Decisions 227 do not fall as quickly as costs. Consequently, the gap between costs and prices widens, in effect creating a price umbrella, attracting new competitors. However, the competitive situation is not a stable one. At some point the umbrella will be folded by one or more competitors reducing the prices in an attempt to gain market shares. The result is that a shake-out phase will begin: inefficient producers will be shaken out by rapidly falling market prices, and only those with competitive price/cost relationship. 4.2.7 Product Line Pricing As a business adds more products to its product line, it enhances sales growth but also increases the chances of cannibalisation of existing product sales as discussed above. It is necessary to know both a product’s price elasticity and the degree to which there is a cross-elasticity with other products. Products that have a positive cross-elasticity are substitutes; lowering the price of one product will decrease the demand for the other product. Products that have a negative cross-elasticity are complementary products; lowering the price for one product will increase the demand for both products. Because the margins may be different for alternative products in a product line, one has to give careful consideration to any price change to ensure that the total profits are increased for the entire product line. A firm may add to its product line – or even develop a new product line – to fit more precisely the needs of a particular market segment. If both the demand and the costs of in- Source: Adapted from Czepiel, 1992 Introduction Shake-out Maturity Log cumulative industry volume (000 units) Lo g un its p ric e an d co st (c on st an t $ ) a nd a nn ua l s al es (u ni ts ) 1.000 100 1 10010 1.000 10.000 Year since intro Annual sales Average cost 1 2 3 4 5 6 7 8 9 Growth (Price umbrella) Average industry price Figure 4.22 near here: PLC and the industry price experience curve Kapitel_4.indd 227 03.08.2010 13:01:44 Uhr 4. Marketing Mix in the Marketing Planning Process228 dividual product line items are interrelated, production and marketing decisions about one product line item inevitably influence both the revenues and costs of the others. Are specific product line items substitutes or complements? Will a change in the price of one item enhance or retard the usage rate of this or other products in key market segments? Should a new product be priced high at the outset in order to protect other product line items (for example, potential substitutes) and in order to give the firm time to revamp other items in the line? Such decisions require knowledge of demand, costs, competition, and strategic marketing objective. With product line pricing, the various items in the line may be differentiated by pricing them appropriately to indicate, for example, an economy version, a standard version and the top-of-the-line version. One of the products in the line may be priced to protect against competitors or to gain market share from existing competitors. Products with less competition may be priced higher to subsidize other parts of the product line, so as to make up for the lost contribution of such ‘fighting brands’. Some items in the product line may be priced very low to serve as loss leaders and induce customers to try the product. A special variant of this is the so-called buy in, follow on strategy (Weigand, 1991). A classic example of this strategy is the razor blade link where Gillette uses a penetration on its razor (buy in) but a skimming pricing (relatively high price) on its razor blades (follow on). Thus, the linked product or service – the follow on – is sold at a significant contribution margin. This inevitably attracts hitchhikers who try to sell follow-on products without incurring the cost of the buy in. Other examples of the strategy are as follows: telephone companies sell mobile (cellular) telephones at a near giveaway price, hoping • that the customer will be a ‘heavy’ user of the profitable mobile telephone network. Nintendo often sells its game consoles at below cost but makes a handsome profit on • the game software. This kind of pricing is a particularly attractive strategy if it not only generates future sales but also creates an industry platform or standard to which all other rivals must use or conform (that is, a technological path dependency). 4.2.8 Price Bundling Products can be bundled or unbundled for pricing purposes. Using product bundling, sellers often combine several of their products and offer the bundle at a reduced price. Many physical goods and services unite a care product with variety of supplementary products at a set price. This has become a popular marketing strategy (Johnson et al., 1999). Food and beverage suppliers bundle ready-to-serve meals while computer vendors bundle a central processing unit, a monitor, a printer and software at a single price. Manufacturers of industrial goods, such as machine tools, electronic components and chemical substances, frequently offer their products at a system price in conjunction with an assortment of services. In the service sector, travel companies bundle flights, rent-a-cars, accommodations, and events into a one-price vacation package. Strategically this bundling activity is designed to benefit the consumer by reducing administration cost and consequently transaction costs. Kapitel_4.indd 228 03.08.2010 13:01:44 Uhr 4.2 Pricing Decisions 229 Should such service packages be priced as a bundle, or should each element be priced separately? To the extent that people dislike having to make many small payments, bundled pricing may be preferable. But if customers dislike feeling that they have been charged for product elements they did not use, itemized pricing may be preferable. Many firms offer an array of choices. Telephone subscribers, for instance, can select from among several service options, ranging from paying a small monthly fee for basic service and then extra for each phone call made, or paying a higher flat rate and get a certain number of local, regional or long-distance calls free. At the top of the scale is the option that provides business users with unlimited access to long-distance calls over a prescribed area – even internationally. Bundled prices offer a service firm a guaranteed revenue from each customer, while giving the latter a clear idea in advance of how much the bill will be. Unbundled pricing provides customers with flexibility in what they choose to acquire and pay for, but may also cause problems. For instance, customers may be put off by discovering that the ultimate price of what they want, is substantially higher than the advertised base price that attracted them in the first place (Hollensen, 2003). 4.2.9 Segmented Pricing Companies will often adjust their basic prices for differences in customers, products, and locations. In segmented pricing, the firm sells a product or service at two or more prices, even though the difference in prices is not based on differences in costs. Segmented pricing takes several forms which we shall discuss now in more detail: Location pricing • Using location pricing, a company charges different prices for different locations, even though the cost of offering each location is the same. For example, some grocery retailers have different price zones and prices are likely to vary across those zones. Competition and consumer profiles may differ between geographic segments. Products can be positioned with a high price in one country and a low price in another. This can be attributed to the pricing structure of international markets, viewed here as a major determinant of the products pricing policy. Europe was a price differentiation paradise as long as markets were separated. Today, it is becoming increasingly difficult to retain the old price differentials given the international buying power of cross-European retail groups and the impact of parallel imports respectively grey markets. Because of differentiated prices across countries, buyers in one country are able to purchase at a lower price than in another country. As a result there will be an incentive for customers in lower-price markets to sell goods to higher-price markets in order to make a profit. Simon and Butscher (2001) suggest that business in smaller countries should be sacrificed, if necessary, in order to retain acceptable pricing levels in the big markets like France, Germany, the UK and Italy. For example, for a pharmaceutical manufacturer it is more profitable not to sell in the Portuguese pharmaceutical market than to accept a price reduction of 10 per cent in the German market due to parallel imports from Portugal. Customer-segment pricing • Under customer-segment pricing, different customers pay different prices for the same product or service. Museums, for example, may charge a lower admission for students and senior citizens. Kapitel_4.indd 229 03.08.2010 13:01:44 Uhr 4. Marketing Mix in the Marketing Planning Process230 Time pricing • Using time pricing, a company varies its price by the season, the month, the day, and even the hour. Long-distance phone companies, electricity utilities, hotels, bars, restaurants, amusement parks, and movie theatres all use off-peak demand pricing. For firms like these, demand for their products varies over time, and they cannot store their production. Consequently, they have periods of under-utilization and often low incremental variable costs. At off-peak time, such companies welcome any additional revenue, as long as it makes some contribution toward their high fixed costs. Off-peak pricing explains after-Christmas sales and end-of-season fashion sales. Unfortunately, some price sensitive shippers learn when these sales occur and wait for them. This has the effect of reducing the overall average selling price and contribution margin. For segmented pricing to be an effective strategy, certain conditions must exist. The market must be segmentable, and the segments must show different degrees of demand. The costs of segmenting and watching the market cannot exceed the extra revenue obtained from the price difference. Most importantly, segmented prices should reflect real differences in customer’s perceived value. Otherwise, in the long run, the practice will lead to customer resentment. 4.2.10 International Pricing Companies that market their products internationally must decide what prices to charge in the different countries in which they operate. In some cases, a company can set a uniform world-wide price. For example, Boeing sells its jetliners at about the same price everywhere. However, most companies adjust their prices to reflect local market conditions and cost consideration. The price that a company should charge in a specific country depends on many factors, including economic conditions, competitive situations, laws and regulations, and development of the wholesaling and retailing system. Consumer perceptions and preferences also may vary from country to country, calling for different prices. Or the company may have different marketing goals in various world markets, which require changes in pricing approaches. Costs play an important role as well in setting international prices. Travellers abroad are often astonished to find goods that are relatively inexpensive at home may carry outrageously higher price tags in other countries and vice versa. A pair of Levi’s, for example, selling for $ 30 in the USA might go for $ 63 in Tokyo and $ 88 in Paris. In some cases, such price escalation may result from differences in selling strategies or the marketing environment. In most instances, however, it is simply a result of the higher cost of selling in another country – the additional costs of product modifications, shipping and insurance, import tariffs and taxes, exchange-rate fluctuations, and physical distribution (Kotler and Armstrong, 2009). Thus, international pricing presents some special problems and challenges. We will discuss international pricing in more detail in chapter 5. Kapitel_4.indd 230 03.08.2010 13:01:44 Uhr 4.2 Pricing Decisions 231 4.2.11 Relationship Pricing When developing and maintaining long-term customer relationships, pricing strategy has an instrumental role to play. Pricing low to win new business is not the best approach if a company is seeking to attract customers who will remain loyal – those who are attracted by cut-price offers can easily be enticed away by another offer from a competitor. More creative pricing strategies focus on giving customers both price and nonprice incentives to consolidate their business with a single supplier. However, a strategy of discounting prices for large purchases can often be profitable for both parties, since the customer benefits from lower prices while the supplier may enjoy lower variable costs resulting from economies of scale. An alternative to volume discounting on a single service is to offer customers discounts when two or more services are purchased together. The greater the number of different services a customer purchases from a single supplier, the closer the relationship is likely to be and the greater the exit barriers for the partners in the relationship on the one hand, both parties get to know each other better, and on the other hand, it’s more inconvenient for the customer to shift its business. Pricing is becoming more fluid. Even before the advent of the online medium, industrial markets and third-world bazaars have long followed a customized pricing mechanism based on bargaining and discount schedules. The online medium has made it feasible to apply flexible pricing more broadly. Online prices can be tailored to specific users and raised or lowered instantly for assessing price elasticity at different prices. The ability to create truly fluid pricing is only limited by customer acceptance. Technology is now available to vary pricing in ways that were not possible in the past. New in-store technology allows supermarkets to customize pricing based on specific times of the day through digital price labels or even to tailor discounts and coupons to individuals based on their past purchasing patterns. Due to the influence of the online medium, we expect that all firms will be called upon to revamp their pricing strategies completely. The fixed one-price strategy of the past has been completely eroded over the past few years. In the years ahead, ‘dynamic pricing’ that takes advantage of instantaneous market conditions will become the norm. Interestingly, these developments do not necessarily mean that prices will decline. The convenience, time-saving aspects, and product matching features of online markets can increase the price a customer is willing to pay. When customers become familiar and comfortable with a shopping site it reduces their incentive to shift to other sites for lower price. Further, if a company understands the customer (e.g., by tracking and understanding what customers do while visiting its website) and facilitates the creation of a co-production process to produce a product and service tailored to the customer’s need, there is relatively little opportunity or incentive for customers to comparison shop based on price. Customization of the product or service adds so much value and strengthens the relationship that the price becomes a less important factor (Hollensen, 2003). Global-Pricing Contracts As globalization increases, customers will put pressure on suppliers to accept globalpricing contracts (GPCs). Purchasers may promise international markets, guaranteed production volumes and improved economies of scale and scope. But what if they fail Kapitel_4.indd 231 03.08.2010 13:01:44 Uhr 4. Marketing Mix in the Marketing Planning Process232 to deliver or if suppliers’ global price transparency inspires them to make unrealistic demands? Suppliers must make three key decisions: whether to pursue a GPC, how to negotiate the best terms and how to keep a global relationship on track. We have found that the best tool for suppliers is solid information on customers. Information can help the supplier make a sensible counterproposal to demands for the highest levels of service at the lowest price. Summary In this section we have considered the role of pricing decisions in overall company and marketing strategies. Price setting is a complex and multidimensional decision. To establish a price, the manager must identify the firm’s objectives and analyze the behaviour of demand, costs and competition. A good deal of basic microeconomics theory is devoted to the relationship between price and demand. While many of the principles that have been developed have relevance to what happens in the real world, there are nevertheless many other factors (than demand and cost) that have to be taken into account. Pricing strategies must balance the needs of both the customer and the firm. Value-based pricing, which includes the concepts of value in use and value in exchange, is increasingly popular. Since customers seek different types of value and competition has a broad range of choices in how to price, other strategies are viable as well. In devising a pricing strategy, it is important to identify a customer value proposition that matches the capabilities of the organisation. Pricing new products offers a different set of challenges. In general, two main opposing strategies are seen: Skimming – high price, to skim off the short-term profit – Penetration – low price, to maximize long-term market share – Practical pricing tactics may include experience curve pricing, product line pricing, price bundling, pricing on the Internet etc. A whole set of complex factors affect pricing decisions, making this in fact one of the most complex and difficult areas of market planning. Pricing decisions are more than just a ‘mechanical’ exercise of adding margins for profit on to costs. Price setting must become an integral part of the marketing strategy of the company and must be consistent with corporate and marketing objectives and other elements of the mix. In addition to these inputs to pricing decisions, the marketer must also consider demand, cost and competitors. Based on the environmental factors (customers, competitors and publics) and general marketing strategy, the major steps in the pricing decision-making are: Pricing objectives (long-termed Pricing strategies (long-termed) Pricing tactics (short-termed) Companies use ‘skimming pricing’ (high price) as a pricing strategy for a new product when the product is perceived by the target market as having unique advantages. ‘Penetration pricing,’ means charging a relatively low price to capture a large market share. The basic idea of price differentiation is simple: Charge every market segment the price it is willing to pay. The Internet has made customer-driven pricing models feasible on a large scale. As a product moves through its PLC the management usually sets prices high during introductory stage. Later on as competition intensity increases, the prices decrease. Kapitel_4.indd 232 03.08.2010 13:01:44 Uhr 4.2 Pricing Decisions 233 In international pricing, companies have the possibility to use a ‘price corridor’. A price corridor defines the range within which prices across borders may vary. The ‘price corridor’ needs to be set as narrow as to prevent parallel imports. Pricing tactics are short-term fine-tuning pricing techniques. They include various sorts of discounts, promotional pricing and other special pricing tactics. Questions for discussion 1. How does competition affect a company’s prices? Briefly describe a major competitor-based pricing approach. 2. What could be the strategy behind having another pricing strategy outside the ‘main season’ (‘off-peak’ pricing)? 3. What are the drawbacks to using penetration pricing as the main strategy in entering a new market? 4. We know that several factors influence consumer responses to prices. What psychological factors should marketers keep in mind when using consumer-oriented pricing? Describe each. 5. Many firms enter a market as price leaders, but they end up dominating the lower end of the market. What may be the reasons for this? 6. In what ways is the role of pricing in the international market (a) similar to and (b) different from the role of pricing in the domestic market? 7. What influence do distribution strategies have on international price setting? 8. Outline an international pricing strategy that is a ‘win-win’ outcome for both manufacturer and importer. 9. Discuss the circumstances when a global price is (a) the most appropriate course of action, and (b) an inappropriate course of action for a firm. Kapitel_4.indd 233 03.08.2010 13:01:44 Uhr 4. Marketing Mix in the Marketing Planning Process234 4.3 Distribution Decisions A product must be made accessible to the target market at an affordable price. Distribution decisions deal with the problems of moving products from points of origin to points of consumption. Often referred to as the place element in the marketing mix, distribution decisions are directed at ensuring that the right product is in the right place at the right time and in the right quantities. The creation of place, time, and possession utility for a select group of customers located in a specific geographic location provides the focus of the logistics manager’s efforts. The distribution network is referred to as a marketing channel – a set of interdependent marketing institutions involved in the process of making a product or service available for use or consumption by the customer. Producers need to consider not only the needs of their ultimate customer but also the requirement of channel intermediaries, those organisations that facilitate the distribution of products to customers. Getting the product to the target market can be a costly process if inadequacies within the distribution structure cannot be overcome. Forging a reliable channel of distribution is one of the most critical and challenging tasks facing the marketer. 4.3.1 The Role of the Intermediary The most essential question a company has to ask when deciding channel strategy is whether to sell its products and services directly to the ultimate customer or use channel intermediaries such as retailers and/or wholesalers. Channel intermediaries basically solve the problem of the discrepancy between the various assortments of goods and services required by industrial and household consumers and the assortments available directly from individual producers. The use of intermediaries results from their greater efficiency in making products available to target markets and enables consumers to avoid dealing directly with individual manufacturers in order to satisfy their needs. Figure 4.23 shows how using intermediaries can provide economies. M M M C C C I M C I= Manufacturer = Customer = Intermediary Direct distribution Number of contact lines = M x C = 9 Indirect distribution (using an intermediary) Number of contact lines = M + C = 6 Source: Adapted from Hollensen, 2003, modified M M M C C C Figure 4.23: How an intermediary increases distribution efficiency Kapitel_4.indd 234 03.08.2010 13:01:44 Uhr