1,1,0, ,,Black,0,0Signature 1, Tile 1 (A) with pages...

Tile$Info

1,1,0, ,,Black,0,0

AutoImpos

Signature 1, Tile 1 (A) with pages 1

Cambridge Marketing Handbook: Pricing for Marketers

Harry Macdivitt

II

Publisher’s noteEvery possible effort has been made to ensure that the information contained in this

book is accurate at the time of going to press, and the publishers and authors cannot

accept responsibility for any errors or omissions, however caused. No responsibility for loss

or damage occasioned to any person acting, or refraining from action, as a result of

the material in this publication can be accepted by the editor, the publisher or any of

the authors.

First published in Great Britain and the United States in 2013 by Cambridge Marketing Press.

This revised edition published by Cambridge Marketing Press, 2015 © Cambridge Marketing Press, 2015.

Cambridge Marketing Press

Cygnus Business Park

Middlewatch, Swavesey

Cambs CB24 4AA, UK

Apart from any fair dealing for the purposes of research or private study, or criticism or

review, as permitted under the Copyright, Designs and Patents Act 1988, this publication

may only be reproduced, stored or transmitted, in any form or by any means, with the

prior permission in writing of the publishers, or in the case of reprographic reproduction

in accordance with the terms and licences issued by the CLA. Enquiries concerning

reproduction outside these terms should be sent to the publishers at the above address.

The right of Cambridge Marketing College to be identified as the author of this work

has been asserted by them in accordance with the Copyright, Designs and Patents

Act 1988.

ISBN Paperback: 978-1-910958-36-0

eBook-eReader: 978-1-910958-37-7

eBook-PDF: 978-1-910958-38-4

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

Design and layout by Cambridge Marketing Press

Printed and bound by CPI/Antony Rowe, Chippenham, Wiltshire.


III

DedicationThis was the book I promised I wouldn’t write!

After completing my other books I promised my family that there would be

no more. The trouble is, the writing ‘bug’ is hard to resist and before I knew

it I was right into the CMC Handbook of Pricing!

This book is dedicated to Aileen, my long-suffering wife of more than forty

years, and my children – Douglas, Lynn, Gillian and Laura who all gave me

the time to do it and for not being (too) irritated that it took longer than

expected.

About the authorHarry Macdivitt, Chartered Marketer,

BA MSc MBA FCIM FIC CMC

Harry has nearly 20 years’ experience in general/

marketing management consultancy and training. He

has worked in the public sector, academic world, manufacturing and

services sectors with major international companies including Philips,

IBM, BT, Nokia, Xerox, Vodafone, Ericsson, Pall, DHL, Michelin, Siemens,

Barclaycard, DSM, Covidien, Symantec, Huawei and many others.

He has extensive experience of new product identification, sales and

marketing and management in high technology medical equipment.

Harry has delivered training programmes for corporates in the UK,

Europe, North America, Africa and the Far East and delivers open

and in-company events for CIM, Frost & Sullivan, BPP and Marcus

Evans. In addition to his training work, Harry has interests in medical

devices companies and is a director of Axia Value Solutions, a value

consultancy and of CPD Associates, a specialised training consultancy.

He is a regular contributor at international conferences on pricing

topics and has delivered conference papers and chaired conferences

for providers such as the Professional Pricing Society, European Pricing

Platform and Copperberg.

IV

Harry has degrees and other qualifications in chemistry, mathematics,

marketing and general management. He is a Fellow of the Chartered

Institute of Marketing and the Institute of Management Consultants and

is past Chairman of the Scottish Branch of the Strategic Planning Society.

He is co-author of Value Based Pricing (McGraw Hill), Innovation in Pricing

(Routledge), The Challenge of Value and many articles on pricing and

value topics. He lives in Scotland, teaches the CIM Postgraduate Diploma

at Cambridge Marketing College’s Edinburgh Study Centre and is a

Visiting Academic at Strathclyde University Business School.

Harry has delivered training programmes for corporates in the UK, EC,

North America and China and is a regular presenter at the CIM. He also

works regularly with growth-oriented SMEs. In addition to his training work,

Harry is director of several small companies including high technology,

medical devices and Pricing Consultancy.


V

ContentsWord Cloud Viii

Acknowledgements IX

Introduction XI

Chapter 1: Accounting Concepts – what pricers really need to know1.1 Break-even analysis – fact or fiction? 2

1.2 Contribution analysis 11

Chapter 2: Important Theory – Economic Principles

2.1 Perfect and imperfect markets 19

2.2 Monopoly and oligopoly 20

2.3 Supply and demand 21

2.4 Price elasticity of demand 22

2.5 Commoditisation and differentiation 28

Chapter 3: Pricing and Marketing3.1 Overview of the product life cycle 37

3.2 Pricing through the PLC 44

3.3 New products 47

3.4 Premium and penetration pricing strategies 48

3.5 Pricing and the marketing mix 50

3.6 Tactical pricing 52

3.7 Pharmaceutical generics - a contemporary challenge 53

Chapter 4: Value Oriented Segmentation4.1 Limitations of conventional segmentation 58

4.2 Evolution 61

4.3 Value segmentation - some contemporary approaches 62

4.4 Value-orientated segmentation 67

4.5 The value segmentation process 68

Chapter 5: Cost-based Pricing5.1 What is cost-based pricing? 75

VI

5.2 Common variants 77

5.3 Underlying assumptions 85

5.4 Advantages and disadvantages 88

5.5 Some additional criticisms 88

Chapter 6: Competition-based Pricing6.1 Competitor parity pricing 94

6.2 Competitive bidding 96

6.3 Predatory pricing 98

6.4 Underlying assumptions 100

6.5 Advantages and disadvantages 102

6.6 Product-service-price grid 102

6.7 Putting value on the map 103

Chapter 7: The Challenge of Value7.1 What is value – and why does it matter? 113

7.2 The Value Triad© 115

7.3 Value drivers 118

7.4 Value analysis using the Value Triad© 121

Chapter 8: Value-based Pricing 8.1 About knowhow 129

8.2 What is VBP? 131

8.3 How does VBP match up against conventional pricing methods? 135

8.4 Constructing the value based price 136

8.5 Assessing the economic value to the customer 138

8.6 The negotiation corridor 141

8.7 Comparing conventional and value-based approaches

to the pricing 142

8.8 Implementation of VBP 143

Chapter 9: Other Pricing Methods And Tactics9.1 Line pricing 145

9.2 Bundling 148

9.3 Non-linear pricing 152


VII

9.4 Dynamic pricing 155

9.5 Other popular pricing approaches 163

Chapter 10: Price Management10.1 What is price management? 171

10.2 Price setting process 172

10.3 The pricing council 177

10.4 Pricing maturity evolution or revolution? 179

10.5 Discounts and discounting 187

Conclusion 192

References 193

Index 197

VIII

Word clouds produced through WordleTM (www.wordle.net)


IX

Acknowledgements No book is ever written by one person. Nor was this one. Yes, I may

have penned most of the words, but the ideas, so many ideas, came

from others. So I just want to acknowledge the knowing and unknowing

contributions made by those others. If I miss out anyone, it is my fault

entirely and I hope you will forgive me that omission.

My co-director in Axia Value Solutions, Mike Wilkinson, developed with

me much of the thinking around Value, particularly the Value Triad. He

has also contributed enormously to a lot of the ideas around Value Based

Pricing and the role of the sales organisation in presenting the value

proposition and negotiating the price. Mike was co-author of our two

previous books – Challenge of Value and Value Based Pricing (McGraw

Hill, 2012). Thanks Mike.

I also want to thank Charles Nixon, Chairman of Cambridge Marketing

College, for coming up with this great idea of a range of marketing

handbooks, and doing me the honour of asking me to write one. Thanks

for answering all my endless questions, Charles, and for your patience

and forbearance while waiting for successive chapters to stumble in late!

David Thorp, lately director of research and professional development at

the Chartered Institute of Marketing, set me off on my travels into pricing

training when in early 1992 he asked me to take over the presentation of

Pricing and Profit Strategies. This led me to identify a real gap in provision

in pricing training and education globally. Even today, some 20 years

later, this still remains an important gap in executive education.

I want again to acknowledge the contribution of ideas in accounting

and finance from my old friend and colleague Roy H. Hill with whom

I worked for many years delivering pricing courses at the Chartered

Institute of Marketing. Many of the ideas presented in Chapters 2 and 3 if

not Roy’s words were certainly inspired by his thinking and insights. Thanks

again, Roy!

To the excellent writers on pricing over the last 20 years when my

deep interest in pricing began I owe an enormous thank you. They did

X

not exactly write this book, but boy did they contribute some really

great ideas. I have tried to acknowledge their work in the text and in

the bibliography. But in truth, while one can capture their ideas, the

philosophy is more difficult and I am indebted to some really great

thinkers.

I attend, and present, regularly at pricing conferences across the world.

These are terrific opportunities to hear, first hand, from the thought leaders

in this subject. The pricing world has been enriched by the contributions

of organisations such as the Professional Pricing Society and European

Pricing Platform in creating opportunities for pricing practitioners to

present, share and debate pricing best practice. I am also indebted

to colleagues who share their knowledge, experience and insights on

LinkedIn Discussion Groups. Participation in these threads is inspiring and

challenging. And a little fun, too. Thanks to all my colleagues globally who

share their knowledge and experience in these forums.

I want to acknowledge with thanks the thousands of delegates who have

attended my seminars over the last two decades. Truthfully they have

been the inspiration to keep developing new thinking in this area. Their

many questions and challenges force me to think, re-think and evaluate

conventional wisdom in this field, and to move it from the dusty domain of

academia and theory to real, hard-nosed practice. So What? and Why?

are great questions. They are such good questions that I have pressed

them into service in this and our other books.

Finally I want to acknowledge McGraw Hill’s kindness in permitting me

to use some material from one of my other books – Value Based Pricing

(Chapter 8).

Thanks, everyone!


XI

IntroductionPricing is perceived as one of the most difficult decisions business

managers are called upon to make. The main reasons for this are that

it is a very emotive topic in most enterprises, is seen as quite complex,

demanding understanding of a number of domains of business

knowledge, and even politically challenging.

In the ten chapters of this Handbook I present practical and applicable

information, tools and checklists to enable the user to make important

decisions knowledgably and confidently, and to be able to defend

these decisions to colleagues. Each chapter takes a specific theme and

presents current thinking in the area, often with short cases or examples

(drawn from global pricing consultancy practice) to illustrate the

thinking.

In writing this book I have been particularly conscious that the audience

is much broader than the business or marketing student. Subject matter

is included which will be useful for both student and professional reader.

Attendees at our pricing seminars usually attend for one or more of the

following reasons:

• to achieve a better understanding of pricing methods used in their

companies

• to explore contemporary pricing approaches which are proving

popular in other companies and industries

• how to reverse (or prevent) margin erosion using pricing and value

approaches to business development

• to share experiences and good practice with other executives

confronted with similar problems

Clever companies build clever, technology-stuffed products because

they can – not because they should! Often, the product ignores customer

value. Worse, the pricing decision may even be delegated to colleagues

in accounting and finance who have little knowledge of customer value.

This leads to incorrect pricing decisions, premature commoditisation and

a chronic tendency to “leave money on the table”.

XII

Such approaches also provide sales staff with few or no arguments to

overcome price objections such as “too expensive” or “no different from

everyone else”, etc.

When customers reject our offer, it is usually because they do not

understand the real and distinctive value of our offer to them. The

real truth of the matter is that we have not presented the arguments

compellingly or in language accessible to the customer. Why blame

the customer for our own shortcomings? We see this all too frequently!

Managers cannot be blamed entirely for this. The literature on pricing

has until quite recently failed materially to provide practical guidance,

processes, templates and models to help create powerful sales and

marketing messages. Consequently, poor sales are usually blamed on

high prices.

Problems attributed to pricing are often, on closer inspection, nothing to

do with the pricing calculation. After all, for the most part, this is merely

arithmetic. In almost every case, inadequate attention to value, and

what this means to the buyer, lies at the heart of the issue. Solve this,

the rest will follow. Without an understanding of the real value of the

proposition to the customer, almost the only lever the salesperson can

‘pull’ is to discount.

Discounting does enhance one element of value, and it is easy (maybe

too easy) for the salesperson to do this if he has been delegated that

freedom. However, it actively prevents other aspects of value being

raised, much less discussed. Worse, discounting on demand establishes

a pattern of behaviour, damages brands, encourages and rewards

customer greed and may even drive products towards commoditisation.

This usually leads to an attempt to restore lost margin by aggressively

cutting cost, which may make matters even worse.

We are facing, today, the most complex, fast-moving and competitive

environment in the whole history of commerce. Technology, principally

the internet, inexpensive air travel and mobile telecommunications

are a few of the factors which have created a framework within which

product and service creation is faster than ever before.


XIII

We can communicate instantaneously and inexpensively with our

customers in the next street or on a different continent. The trouble is

that our competitors can communicate just as easily with exactly the

same customers. The evolution of geographical trading blocs, such as

the European Union, have eliminated borders between many countries.

Emerging economies are investing heavily in infrastructure, skills and

knowledge, creating simultaneously brand-new geographical markets

and, increasingly, alternative low-cost sources of supply. All of these

factors have conspired to render conventional business models obsolete,

and increasingly to transfer power to more technologically sophisticated,

agile and customer responsive organisations.

Pricing is a critically important tool in the armoury of the business

manager. But it should be used as part of the overall value creation,

development and capture process within the marketing mix. It does not

stand alone.

We must understand the value that the customer wants. We must

create products and services which embody this value. We must price

in a manner that allows us to capture a fair share of that value while

preserving the relationship with the customer. And we must establish

a pricing discipline that is understood and accepted by all functions

involved.

This book provides the knowledge to enable executives to make, defend

and implement professional pricing decisions.


1

Chapter 1: Accounting Concepts – What Pricers Really Need To Know

“There are three types of accountant – those that add things up and

those who take things away.” Unknown

Why accounting knowledge is important for pricing people

Pricing is an integral part of the marketing mix. It is both a strategic

function and a tactical one. It is the only marketing variable that can bring

money into the company. All of the others cost the company money!

Paradoxically, it is the one mix element which has been least explored

historically in the academic literature, least well covered in formal

educational courses in marketing, and, even more bizarrely, the one mix

element which some marketers are happy to delegate to non-marketing

colleagues (Hinterhuber, 2008)! By contrast, a well thought through pricing

strategy, well implemented, monitored and controlled can make a

profound difference to the company’s profitability, growth and avoidance

of the dead sea of commoditisation.

Good managers want to understand their costs, know how efficient their

pricing strategies are, and how pricing effectiveness can be enhanced

using different approaches. These topics are tackled in this book, both

in this present chapter and in later ones. Measuring pricing effectiveness

in revenue and profit terms are, accordingly, of great importance to the

pricing manager. This demands a sound understanding of key accounting

procedures and methods and more than a passing acquaintance with

spread sheet programs! You do not need to be an accountant, but

you do need to be able to explain, and defend, your proposed price in

accounting and economic terms in the boardroom – and in the language

of the boardroom.

In this Chapter I provide some of the tools to allow you to do this. I will

do this through the use of illustrative examples which demonstrate the

underlying calculations. There are many, many more which space

prevents me from describing.

2

If you plan on a career in pricing – or in business generally – you should

bring yourself up to speed on both Intermediate and Advanced Excel and

Accounting for Managers.

1.1 Break-even Analysis – Fact or Fiction?

Break-even analysis is one of the most fundamental ideas in accounting

and of particular importance to pricing people. At its simplest, the idea is

to work out how many units of a product (or number of delivery days for a

service) we need to sell in order to cover all of our fixed and variable costs

and break even (Hill, 2002). Knowing this information gives us additional

flexibility in terms of pricing and ‘peace of mind’. The breakeven analysis is

built up from knowledge of three variables:

• forecast sales revenue

• forecast total direct costs

• forecast fixed costs

When used as a planning tool, we use forecast data. This introduces an

element of uncertainty which we shall explore in a moment. When looked

at historically, it provides us with a means of comparing forecast with

actual turnout, and identifying where variances lie. A variance is simply

the difference between what we predict will happen and what actually

does happen. If through experience we know where our forecasts are

likely to be less accurate, perhaps because of external economic factors,

we can estimate how seriously our overall projections will be affected, and

make some contingency plans. We call this process sensitivity analysis.

Let’s examine the shape of a typical Break-even Analysis. Figure 1.1

presents the most familiar form of the breakeven chart.

Accounting Concepts – What Pricers Really Need To Know


3

Cumulitive salesrevenue

Cumulative variablecosts

Fixed costs

Break-even point

Margin ofsafety

£

Time

Figure 1.1 Classical depiction of the break-even chart

There are several points of interest in this chart.

Fixed costsThese are our company’s overheads and include elements over which

sales and marketing people have no direct control. Typical overhead

elements include rentals, lease charges, business rates, management

salaries, and so on. There is usually quite a long list of these and different

companies will define their fixed or overhead costs in different ways. These

costs are represented by a straight horizontal line whose slope does not

change over the course of the trading period, indicating no variation over

time. Also, and very importantly, these costs are at the whole business

level and are deemed to be incurred at the very instant the business starts

trading at the beginning of the year, even if the actual costs have not

yet been defrayed. Fixed Costs tend to be unaffected by variations in the

volume of output or activity.

Variable costsThese are often also known as direct costs, a term which derives from the

fact that these costs arise directly from business activity e.g. producing a

product or delivering a service. Notice that, in Figure 1.1, this line slopes

upwards demonstrating that this is a cumulative quantity – not that costs

4

are increasing over time (although of course, they may do just that!). I

present it as a simple straight line but you need to be aware that variable

costs may vary over the course of the year because of external factors

such as supplier cost, foreign exchange rate variations, demand levels,

etc. The straight line is an idealised representation and may have curves

and ‘kinks’ depending on the industry. Note that at any point through the

year the total costs of running the business will be the sum of all fixed costs

plus the cumulative variable costs at that point in time.

Marginal costsAlthough they do not play an explicit part in the breakeven analysis

model, we need an understanding of marginal costing as this can

form the basis of pricing decisions. The marginal cost of any item is the

amount, at any given volume of output or activity, by which total costs

are changed if the volume of output or activity is increased or decreased

by one unit. The marginal cost for an increase may differ from that for a

decrease.

Note that not all costs fit into a Variable or Fixed category. There are Initial

costs (e.g. those arising from samples or prototypes before a product

can be put into production) or Terminal costs (e.g. the cleaning up and

finishing costs on completion of a construction project). However, in an on

going business the Variable and Fixed costs tend to dominate and their

separation is essential for breakeven and contribution analyses.

Sales revenue Also sometimes known as turnover or total sales, is the total sum of money that the business receives from the sales of goods or delivery of services. You may occasionally hear the use of the term ‘income’ used interchangeably with revenue. This is incorrect.

Income refers to the profit remaining after we have paid all our bills! The revenue includes the total cost of sales plus the profit created from this process.

Of all of the forecasted values, predicting sales revenue is arguably the most difficult because of the many drivers of demand and market



5

volatility. And yet it is hugely important to get it right because we base

income models and whole business cases on ‘top line’ estimates. As we

will see in a little while, small changes in unit price can have a dramatic

(positive or adverse) impact on profitability. One of the compounding

factors here is the effect of price changes on volume demanded. Often

this is not taken into account when making revenue forecasts. (We will

look at price elasticity of demand, which measures this phenomenon, in

the next chapter). Another compounding factor is that, when companies

are struggling to win share in the market, the conclusion, often incorrect,

is that the price is too high and ‘on the hoof’ price changes are made in

the hope of correcting the demand levels. In a moment you will see how

dangerous that can be.

Break-even pointThe Break-even Point is that point during the trading period when the

sales revenue exactly equals the total costs (Fixed + Cumulative Variable).

The Break-even Point can be defined in terms of both volume of sales and

revenue. These numbers are based only on the forecast model. They will

change if the assumptions on which the model is built are not met in

real life!

There are a number of important issues around this:

• At all points to the left of break-even, the business is in a loss making

position (or at least not yet in profit). Prudent management will seek

to reach a break-even position as early in the year as possible,

perhaps by targeting high margin accounts or segments. Cost

management is crucially important in every business and cost

pressure needs to be applied throughout the year – not just at all

points to the ‘west’ of the Break-even Point.

Sales trajectory (the slope of the sales revenue line) is an important

determinant of the Break-even Point. If sales get off to a bad start (i.e.

lower than budgeted) this will have the unwanted effect of reducing

the sales trajectory and pushing the Break-even Point to the right, thus

increasing the company’s financial risk.

6

• At all points to the right, the business is in profit. Nevertheless, this

state of profitability will only be sustainable if the total sales revenue

continues for the remainder of the trading period to be higher than

the cumulative cost position. A number of factors can impact on

this. Sales may slump perhaps as the result of recession, returns,

competitor activity or some other extraneous factor. Costs may

increase perhaps because of changes in exchange rates, material

shortages or scarcity of skilled labour. So, just because we have

reached breakeven does not mean we can relax! We often use the

idea of ‘Margin of Safety’ to give us a measure of how safe we are.

We simply cannot afford to take our eyes off the ball.

Of course, our results might be rather better than we predicted. This means

that the Break-even Point moves to the left, our Margin of Safety will

increase and we have a little bit more in the way of pricing flexibility. For

instance, we can afford to use the increased margin we are enjoying to

offer a price reduction to try to capture more volume, or possibly to create

an attractive deal to customers in a new segment.

Gross margin and contributionGross Margin (GM), sometimes called Gross Profit Margin (GPM) on Sales

is the ratio of profit to net sales (i.e. gross sales from trading less VAT). It is

sometimes expressed as a percentage (GM%).

There is one other term that is worth explaining before exploring an

example. Contribution is often used as a pricing method (see Chapter

5 Cost-based pricing). Contribution is the money remaining after we

have paid all of our direct costs. Strictly speaking, its full Sunday title is,

‘contribution to profits and fixed costs (or overhead)’.

It is often difficult or impossible to estimate exactly the true bottom line

(or net) profit of a product or service because so much depends on how

overheads are allocated. So we stop short at contribution. In reality, this

makes a great deal of sense because marketing managers cannot really

influence, other than indirectly, a company’s fixed costs or how these

might be allocated. This is the job of accountants.



7

Be cautious in using these terms in your own organisation, without

checking out local usage. Your organisation may use different definitions

for these terms.

Let’s illustrate this thinking now with a real life example.

Example 1.1Thermowizard is a new product developed to control domestic fuel usage

and costs. It is a completely standalone device which will sell to the

householder at £200 (exc. VAT) through specialised hardware and home

improvement retailers. It is also sold through the electrical and plumbing

trades as part of a heating system package. However, the device also has

in-built intelligence which allows it to connect wirelessly to other devices

such as security, air-conditioning and even home entertainment as part of

an ‘integrated home’ network. The price to the retailer is typically £100.

The company which has developed the device, ThermoSmart Ltd, has

made some estimates of costs and sales volume:

Unit Sales Price £100

Forecast Unit Sales Volume for

Year 1

27,000

Direct Labour per unit £40

Direct Materials per unit £15

Total Factory Overhead £750,000

Table 1.1 Thermowizard baseline data

The pricing manager has been tasked with developing a break-even

analysis for this product, and to assess the sensitivity of margins to

inaccuracy in business forecasts for Year 1. His first action is to draw up a

breakeven chart to estimate break-even quantity and sales.

8

£M

2.5

2.0

1.5

1.0

0.51 2 3 4 5 6 7 8 9 10 11 12

Month

Break-even Quantity = 16,600Break-even Sales = £1,660,000

Figure 1.2 Baseline breakeven data for Thermowizard

In reality, drawing up a chart every time we need to do a calculation like

this is extremely tedious, not to mention time consuming. More importantly,

it is also rather approximate.

Symbol Meaning This Example

FC Total factory “Fixed Cost” £750,000

VC Variable Cost per unit £55 (=£40 + £15)

V Volume production per annum 27,000

P Average price per unit £100

C Contribution (P – VC) £100 - £55 = £45

NP Net Profit (C – FC/V) £45 – (£750,000/27,000) = £17.22

BEQ Break-even quantity units (FC/(P – VC)) £750,000/(£100 - £55) =

£750,000/£45 = 16,667

BES Break-even Sales Revenue P x BEQ £16,667 x 100 = £1,666,700

Table 1.2 Break-even formulae

Once we have the formulae, it is easy to set up a spread sheet to do

the other calculations quickly. The areas of sensitivity are sales revenue

forecast, variable costs and fixed costs.



9

Let’s see what happens when we make some adjustments to these input

assumptions – adjustments that could realistically occur in practice.

Symbol Baseline 5% price reduction

10% price reduction

5% volume reduction

5% increase in variable cost

5% increase in fixed cost

FC £750,000 £750,000 £750,000 £750,000 £750,000 £ 787,500

VC £55 £55 £55 £55 £57.75 £55

V 27,000 27,000 27,000 25,680 27,000 27,000

P £100 £95 £90 £100 £100 £100

C £45 £40 £35 £45 £42.25 £45

NP £17.22 £12.22 £7.22 £15.79 £14.47 £15.83

BEQ 16,667 18,750 21,429 16,667 17,857 17,500

BES £1,666,700 £1,781,250 1,928,571 £1,666,700 £1,785,714 £1,750,000

GM% 45.0 42.1 38.9 45.0 42.3 45.0

NP% 17.2 12.9 8.0 15.8 14.5 15.8

We gave this section the heading ‘Break-even Analysis – fact or fiction’.

From the above analyses, it should be pretty obvious that the model is only

reliable for as long as the underlying assumptions remain valid. Any market

reality which is different from these assumptions will affect the validity of the

model. If business is better than forecast, then all is well, probably. If business

is poorer, well, we just simply will not experience the results we hope for.

The perfect stormIn Table 1.3 we have merely assumed that only one of the input variables

(Sales Revenue, Sales Volume, Variable Costs and Fixed Costs) has differed

from forecast. Let’s see what happens under more realistic conditions in

which all of the variables change. Take the situation in which, for whatever

reason, sales people have given away on average a 10% price reduction,

sales revenue falls short of expectation by 5%, and fixed and variable costs

both increase by a modest 5%.

Table 1.3 Breakeven for Thermowizard under different scenarios

10

These conditions are not especially unusual under the turbulent conditions

encountered in the first decade or so of the 21st Century. The result is that

the break-even point is pushed almost to the extreme right hand side of

the diagram and whatever margins remain are wafer thin, even though

budgeted margins are, in fact, extremely healthy.

Just consider for a moment the conditions that might have brought

this about. Low cost competitors have entered the market; currency

fluctuations mean that materials sourced from high cost countries are

incorporated into your product and sold within your domestic market;

direct employees, feeling the pinch of austerity conditions, fight for, and

are given, higher wages; and fuel costs rocket.

It is absolutely essential that we, as prudent managers, keep a close

watch on all of the key factors in our business – volumes, fixed and variable

costs and of course sales prices. You have seen that an adverse change

to any one of them can have a negative impact on your business. When

adverse changes happen to all of them – and this can happen over the

course of a year – a good profitable product can turn into one with low or

no margin!

1 2 3 4 5 6 7 8 9 10 11 12

2.5

2.0

1.5

1.0

0.5

£M

Break-even Quantity = 24,609Break-even Sales = £2,460,938



11

Figure 1.3 Perfect storm scenario

Symbol ‘Perfect storm’

FC £787,500

VC £58

V 25,680

P £90

C £32

NP £1.33

BEQ 24,609

BES 2,460,939

GM% 35.6

NP% 1.48

1.2 Contribution Analysis

One definition of Contribution is the difference between Unit Price and

Unit Variable Cost. What remains is the sum of unit overhead (fixed costs

per unit) and unit margin.

The arithmetic is trivial:

Contribution = Unit Revenue – Unit Variable Cost

= Fixed Costs per Unit + Unit Margin

This ‘remainder’ is sometimes described as “contribution to profits and

overhead”. Sometimes the term Gross Margin is used as a synonym for

Contribution. In reality these two things are different.

Gross Margin = Revenue – Cost of Goods Sold (COGS) and sometimes

Gross Margin = Revenue – Full Absorption Cost

Full absorption cost is the sum of the overhead, direct labour, and direct

materials costs.

Many companies seek to optimise their contribution and accordingly use

Contribution Margin as the basis of pricing.

12

You need to double check in your own organisation just how these terms

are being defined, and ensure that you use the correct ‘local’ definition.

Let’s again take a simple example.

Example 1.2The following prices were taken from the website of a well-known national

pizza delivery company. The prices relate to an outlet in south-east

London, an area with high earners and a relatively high employment rate.

There may also be a relatively higher number of two-person households

than elsewhere in the city.

Product Meal for 1 Meal for 2 Meal for 3

Materials 1.67 2.92 3.05

Labour 1.88 1.72 4.40

Other 2.44 3.46 6.22

Marginal cost (£) 5.99 8.10 13.67

Selling price (£) 9.95 12.95 15.95

Contribution 3.96 4.85 2.82

Table 1.4 National Pizza Delivery Company

Decisions on product mix and profitability ranking are facilitated by

identifying the unit contribution of products. Quantities likely to be sold, the

impact on volume of different selling prices and the fixed costs specifically

related to production, promotion and selling each product could also

prove to be very relevant considerations. Interestingly, in this case the

largest contribution is made on sales of meals for 2, perhaps reflecting the

local demographics of this part of London.



13

We can use Contribution as a tool to monitor profitability continuously

by recording the forward load of orders as they are taken, showing the

time needed, the cumulative contribution and the running average

contribution per hour.

Use of contribution analysisWhen sales information includes Contribution we can look at it in a

number of different ways, for example, contribution per product or

per type of outlet or even by postal code. By correlating high and low

contributions to other variables we may be able to generate insight into

pricing and other marketing strategies. Some fixed expenses may be

related to an area or type of outlet even though they are not related to

any one specific product (for example, a sales representative may sell only

to chemists or perhaps only in the north west). This approach may enable

the relative profitability of activities to be reviewed on an objective basis.

Importantly, we may encounter temporary or long term constraints

(e.g. availability of drivers, or of particular produce in the case of the

Pizza business) which limits the volume of effective output at any one

time. The most profitable mixture of activities would then be shown by

relating Contribution to the limiting factor and, subject to marketing

considerations, the sales could be directed to maximise the Contribution

from the limiting factor.

We will look at the pricing use of Contribution Analysis in more detail in

Chapter 5, Cost-based Pricing.

Profit leversMany writers on pricing and consultancy companies have been intrigued

by the concept of Profit levers.

14

One of the most frequently quoted studies (Marn et. al., 2004) presents the

following information:

Price Variable costs Volume Fixed costs

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

1% improvement in... operating profit improvement of...

Figure 1.4 Profit levers

Figure 1.4 presents the increase in operating profit that results from

a 1% increase in each of the four Profit levers – Price, Variable costs,

Volume and Fixed costs. This particular illustration was calculated from

Profit and Loss (P&L) data from the global 1,200 companies. The Global

1200 Index covers approximately 70% of the world’s capital markets

comprising 31 local markets across the world. Many of the companies

represented in the index are accepted leaders in their regions. The data,

from which this diagram was created, accordingly, include a huge

range of industries including Information Technology, Energy, Industrials,

FMCG, Telecommunications and Healthcare and can be seen to be

representative of most large enterprises.

The figure, and most of the other studies of a similar nature, indicates that,

compared with a similar improvement in the other ‘levers’, a 1% increase

in price results in the largest percentage increase in operating profit

(assuming of course that the other levers remain unchanged). Operating



15

profit is what remains after fixed and variable costs have been subtracted

from the revenue, but before further adjustments for interest, tax,

depreciation and amortisation charges have been deducted (Earnings

Before Interest, Tax, Depreciation and Amortisation – EBITDA for short!).

This is compelling evidence that focus on pricing will yield better bottom

line improvements on average across the economy than any of the other

levers – volume increase, fixed or variable cost reduction.

The data in Figure 1.4 is an average of 1,200 companies. Do not expect

that this will be exactly the case in your own business. Local factors relating

to your own business may give you quite different outcomes. Remember

also that the Global 1200 companies are generally rather large corporates

like Apple, GE, HP, Dell, Amazon, Google, etc. Their economics may be

rather different from your own business unit or company (Dow Jones).

Have a close look at Figure 1.5 (a), (b), & (c). I have used the ThermoWizard

data as a baseline and then looked at three different scenarios in which

I increased the Fixed Costs, Sales Price and Variable Costs. This is a very

simple example, to illustrate a couple of points. Nevertheless, the outcomes

may be rather more relevant to your own situation. In this model, I have

simply assumed a one product company with only one variant of the

product. This, of course, is unrealistic. It means that increasing the price by

1%, or increasing the volume by 1% will have exactly the same impact on

total revenue. In the diagram I show the operating profit impact of a 5%

improvement in the three profit levers: Price, Fixed Costs and Variable Costs.

There are some interesting points to be aware of:

• In every case an increase in price resulted in the highest increase in

operating profit, irrespective of high or low fixed and variable costs.

• Operating profits can increase dramatically (in the many hundreds or

even thousands of percentage points) if they are very low to begin

with. An 800% improvement in profits of £1,000 is rather less than a 5%

improvement in profits of £200,000!

In business practice, of course, we would not just play around with price

alone, or VC alone or FC alone. In any case some of these will be much

more difficult to adjust than others. We would look at the combined effect

16

of these on your business’s economics. This means pricing people need

to be pretty good at business modelling and creating scenarios. If you

use Excel, there is an excellent suite of tools in the Excel Add-in utilities.

Look particularly at What if? Analysis and Data Analysis, both of which are

available as optional add-ins (Tennent and Friend 2005).

Figure 1.5(a) Effect on operating profit (£OP) of 5% improvements to profit levers in baseline scenario

Baseline ref Price increase VC reduction FC reduction

0

7000

6000

5000

4000

3000

2000

1000



17

High FC ref Price increase VC reduction FC reduction

0

1600

1400

1200

1000

800

600

400

200

High VC ref Price increase VC reduction FC reduction

0

1600

1400

1200

1000

800

600

400

200

1800

2000

Figure 1.5(b) Effect on operating profit (£OP) of 5% improvements to profit levers in a high fixed cost scenario

Figure 1.5(c) Effect on operating profit (£OP) of 5% improvements to profit levers in a high variable cost scenario


19

Chapter 2: Important Theory – Economic Principles

“Blessed are the young, for they will inherit the national debt”

Herbert Hoover

2.1 Perfect and Imperfect Markets

The perfect marketA perfect market is characterised by perfect competition, the principal

assumptions of which are:

• The product is identical from each source of supply

• There are infinite numbers of buyers and sellers with no single buyer or

seller having greater power in the market than any others

• A purchase by any individual is so insignificant as not to influence the

total market

• There are no barriers to new entrants wishing to enter the market

• Both buyers and sellers have perfect knowledge

• Each firm seeks to maximise its profits and to keep its losses to a

minimum

• Transaction costs, and other costs of doing business, are negligible

• Any changes in costs and prices are known instantly by buyers, sellers

and channel partners alike

• There is perfect freedom of entry to and exit from the market

These ideas were advanced in the late 19th Century and until recently

have been perceived as largely theoretical concepts. Recent

technology, especially the internet has increased the size of many

markets, encouraging the convergence of industries (e.g. IT and

telecommunications) and broadening the scope and scale of other

industries e.g. major stock exchanges, publishing, consultancy and

industrial consumables sectors.

20

Unprecedented access, via the internet, to information about product

performance, prices and suppliers has put in place several of the

theoretical conditions of perfect competition. Products that seem to be

moving rapidly – perhaps prematurely – to commoditisation include digital

cameras, mobile phones and desktop computers, but there are many

others. One of the major pricing challenges for managers in the early 21st

Century is how to manage commoditisation. We look at this more closely

later in the chapter.

The imperfect marketAn ‘Imperfect’ market is one in which the assumptions underpinning

perfect competition do not apply. Indeed, the whole point of marketing

is to create imperfect markets by innovating and exploiting meaningful

differences between competitive products. Perfect competition is not in

the interest of business although it may be in the interest of governments

and legislatures. Inevitably this creates tension.

Producers try to differentiate their products so that they may become

a preferred supplier, at least in a small segment. This allows different,

sometimes widely different, prices to exist in the same apparent market.

Differentiation creates several specialised sub-markets. We look at

differentiation later in this chapter.

2.2 Monopoly and Oligopoly

A monopoly exists when there is only one supplier, or a group of suppliers

acting in concert. State-owned monopolies were specifically introduced

to provide public services e.g. utilities and avoid the expensive duplication

of heavy capital investment which would become inevitable if several

competing suppliers were involved. Deregulation in recent years has

placed many of these into private ownership but there are still significant

regulatory constraints to protect vulnerable customers and encourage

competition. The use of a brand name makes a product potentially

unique and may confer virtual monopoly status on a supplier until other

entrants appear.

Important Theory – Economic Principles


21

In an oligopoly there are a number of large players. Because of their

market power they may be tempted to collaborate on prices, production,

exclusionary practices or market sharing. These work against the interest

of the consumer and accordingly in many jurisdictions are outlawed

(cartelisation, collusion, price fixing and exclusion).

This is a particular risk in oligopolistic markets. Such markets have several

large players who, if they were to collude, could distort the normal

economic functioning of their market.

2.3 Supply and Demand

High prices in a market tend to encourage new supply – i.e. new market

entrants. With greater supply available in the market, prices will fall and,

as prices fall, so demand will tend to rise, further encouraging supply. At

some point supply and demand will reach equilibrium. In free markets

there will be temporary imbalances: over-supply in which suppliers cannot

sell their output, and over-demand in which buyers cannot purchase their

first choice and will be constrained to purchase an acceptable substitute,

if one exists. In a perfect market, supply and demand factors are known

and prices automatically adjust in the direction of equilibrium.

Price

Quantity

Equilibrium

Demand curve

Supply Curve

Figure 2.1 Supply/demand curve

22

Classical supply and demand theory works best in commodity markets

where products are essentially undifferentiated, where distribution is

widespread and where the commodity concerned does not have a long

lead time before its appearance in the market place.

2.4 Price Elasticity of Demand

In the case of a perfectly competitive market, any change in the price of a commodity will immediately be reflected in a change in the quantity demanded. No rational customer will pay more than he has to for any item identical to others available elsewhere. If this item has features that render it more attractive, the consumer will pay more for it only if the added features are meaningful to him. He will make a judgement as to whether the sacrifice (higher price, search costs, time) is worth it. Price becomes less of a determinant of demand than superior and preferred functionality. This phenomenon is captured in the concept of price

elasticity of demand. Elasticity is affected by a number of factors:

Nature of the itemIf the item is a necessity, it is generally more difficult to find an alternative

or a substitute and so the price is inelastic e.g. petrol for motor vehicles. On

the other hand, luxury items are a discretionary purchase and if prices are

perceived to be too high will either not be purchased, or a less expensive

alternative purchased instead.

Time to make a decisionIf time is pressing, prices will be inelastic – the purchaser will pay whatever

is required. If time is less pressing, the purchaser will have more time to

look around and select an acceptable alternative, and the item’s price

becomes more elastic.

How the product is definedIf the item is defined very precisely, and the product description fully meets

the needs of a target category of customers, performance is likely to be



23

more important to that group than price and so price sensitivity will be low.

If the product is described so loosely that other substitute products might

be perceived as performing the function at least as well, price sensitivity

will be much greater because the customer perceives that he has much

greater choice.

Proportion of expenditureStaple items which are used in high volumes, and which collectively

account for a significant part of the customer’s budget will be associated

with high price sensitivity. Other items which account for only a very small

portion of the total expenditure tend to be more inelastic because buyers

are less concerned about the extra expenditure.

Price

Quantity

△P

△Q

△P

△Q

Demand Curve

Inelastic demand - a large change in priceresults only in a small change involume demanded

Elastic demand - a small change inprice results in a large change involume demanded

This idea is demonstrated graphically in Figure 2.2. In the diagram, ΔP

denotes a change in price, P. ΔQ denotes the change in quantity, Q,

demanded at price P+ ΔP. At the left hand side of the demand curve,

demand is inelastic. A very large change in price is associated only with a

small change in quantity demanded.

Figure 2.2 Demand curve and price elasticity

24

In market segments showing this behaviour, customers are not sensitive

to price changes, but may be very sensitive to other factors such as

functionality, performance, reliability, aesthetics and so on. Under these

price-demand conditions we have flexibility in price setting.

At the other end of the demand curve, even a very small change in price

is associated with a proportionally greater change in quantity demanded.

This occurs under conditions of high price sensitivity and is exacerbated

when products have few or no differentiating elements i.e. in a commodity,

or close to commodity market.

Both price sensitive (price elastic demand) and price insensitive (price

inelastic demand) segments may exist within the same market. In fact, the

larger the number of individual product offers, the more likely this is to occur.

From the perspective of the marketer the challenge is not only to be able to

identify and discriminate between those differently behaving segments, but

also to be able to pinpoint non-price aspects of the product/service which

are of particular interest to price insensitive customers.

A quick reminder of graph slopes

Figure 2.3 (a) and (b)

Y

X

(a) Positively sloped lineY

X

(b) Negatively sloped line

In Figure 2.3(a) the slope of the line points upwards from bottom left to top

right. This means that as ‘X’ increases, so also does ‘Y’.

In this situation, we say that ‘Y varies directly with X’. In Figure 2.3(b), the

opposite is happening. In this case as ‘X’ increases ‘Y’ decreases. Here we

say that ‘Y varies inversely with X’.



25

We use this idea in understanding and interpreting demand curves – and

also the concept of price elasticity of demand.

The Price Elasticity of Demand (E) is defined as:

E is usually negative (the demand curve usually has a negative slope) but

in practice we normally omit the negative sign.

If E is infinitely large, demand is completely elastic

If E is ≥1 it is described as elastic demand

If E is <1 it is described as inelastic demand

If E = 0 demand is completely inelastic

Some knowledge of the elasticity of demand for a particular product is

essential if practical marketing policies are to be pursued.

Example 2.1A new machine for manufacturing high precision optical lenses sells for

£400,000 and generates output which can be sold at a gross profit of

43%. Last year’s sales were 83 units in Europe. A previous version of the

equipment enjoyed an average price elasticity over 5 years of -0.42.

There is no reason to believe that this has changed materially.

The company is hoping to increase total profits by at least £40,000 per

unit and plans to increase the price to £450,000, with no change in

manufacturing cost per unit.

Will the price increase generate the hoped for profit increase, assuming no

increase in total unit costs following the price increase?

E =% ΔQ

% ΔP

26

Elasticity = %change in volume/%change in price

∴ %change in volume = %change in price x elasticity

= 12.5 x -0.42

= -5.25%

New unit volume = 83 + (-5.25 x 83/100)

= 83 – 4.4

= 79 units

Additional profit = 79 x 222,000 - 83 x 172,000

= £3,262,000

Additional profit per unit = £3,262,000/79

= £41,291

The company should make the price adjustment.

Optimal price curveThe next example illustrates the idea of optimal pricing using contribution

and taking account also the effect of price on demand levels.

Example 2.2A company manufactures a product with a unit variable cost of £30.

Expert judgements have indicated a range of possible prices, and

associated volumes, in the UK. Different price/volume estimates exist for

different countries. The UK expert panel estimated the following sales unit

and price data. We can calculate a profit-maximising price easily using

this information.



27

Unit price 800 1,200 1,500

Sales volume 4,000 3,000 2,000

Total revenue 3,200,000 3,600,000 3,000,000

Total Variable costs 120,000 90,000 60,000

Total contribution 3,080,000 3,510,000 2,940,000

Price 800 1200 1500

Volume 4000 3000 2000

Table 2.1 Analysis for each price-volume combination

In this example, the profit maximising price is £1,200, corresponding to a

volume of 3,000 units.

Profit/Unit Volume

Price/Cost

Profit/ContributionCurve

Demand/ResponseCurve

Optimal PriceRange

A

M

B

Figure 2.4 Optimal price curve

The shape of the contribution curve typically will be convex upwards suggesting the existence of a maximum contribution point. This occurs because of the way in which fixed costs are spread across sales volume. If a profit/contribution function of this shape does occur then, in order to optimise profit, we would choose a price/volume contribution in which the contribution function reaches a maximum value, let’s say “M”. For product A, profit is suboptimal because the price is low.

Unit fixed costs, as a proportion of selling price, are high and so contribution

28

is low. To improve profit we would need to increase price. How much we might be able to increase price depends on the particular properties of the demand curve. For product B, the higher price is “turning off” demand and unit volume has dropped. Again, fixed costs as a proportion of unit price are too high. Obviously in this situation the price is too high and the correct strategy - although apparently paradoxical - is to reduce the price. The principal variables are price, contribution and elasticity. Much depends on

the specific “shapes” of the demand curve contribution curves.

2.5 Commoditisation and Differentiation

CommoditisationCommoditisation is the process by which a product comes to be seen

as being of identical quality and value, whether it is or not. When a

product becomes indistinguishable from others like it and customers

buy on price alone, then it is a commodity. We may believe that we

are delivering a high value product or service but if our customers

cannot identify or understand the value then there is no value from

our customer’s point of view. The one thing customers can understand

is price. In the absence of any other valid differentiator they will use

price as their key selection criterion. This then leaves us with a product

or service that is completely undifferentiated in the customer’s

eyes (except for price!) even though we know it has excellent and

important qualities.

This gives clever buyers an excellent strategy: repeatedly deny the

relevance of any differentiation to the point where sales people

actually believe it. This subtly brings the salesperson on to the buyer’s

side and become much more predisposed to make crazy price

concessions. Or walk away. The result of this is increasingly downward

pressure on prices and the subsequent erosion of margins and

profitability.

This situation arises directly from our failure to present the offer in

a compelling manner, and demonstrate the real value that this



29

differentiation has conferred.

Quite literally, the customer has no idea of the worth of what he has

just purchased. What is worse is if the salesperson also has no idea of

the value of our products!

The power of buyers to manipulate the minds of salespeople is well

illustrated in one B2B market:

I was working with a major company in the automotive lighting market.

The company had sent about 25 of their global and key account

managers to a Value Based Pricing course. The opening question in

the Commoditisation session was: “Are your products speciality or

commodity items?” We fully expected a robust assertion of ‘speciality’,

given that the company in question enjoyed a market share of

56% of the global market. To a man they answered – ‘commodity’.

We were taken aback by this answer. We explained the basics of

commoditisation, in particular that in a commoditised market our

share is likely to be (100/n)% where n is the number of competitors.

In this market there were 4 competitors. Consequently, if the market

was indeed commoditised, as these delegates vigorously asserted,

their share would have been around 25%, and certainly not 56%! This

company’s product was a sophisticated product whose principal

attributes (apart from brand) was high mean time before failure and

easy fitting. Both of these confer cost reduction benefits to both

channel and end-user. The delegates held doggedly to their view that

the product was indeed a commodity. Why? Because their customers

told them so! They had been thoroughly brainwashed by their clever

buyers!

Commoditisation is one of the biggest challenges facing business

today. Certainly the effects on business can be significant. As a result

of commoditisation a business is likely to suffer reduced profitability,

reduced margins, weakened relationships with customers, loss of

control over pricing, loss of customer loyalty, reduced funding for

innovation, and the encouragement to focus on cost reduction rather

than value creation.

30

DifferentiationPrice

Number of buyers

Premium segmentIn this market segment, customers are price insensitive.Purchases are driven by factors other than price.The marketing challenge is to identify these factorsand present them persuasively.

Economy SegmentIn this market segment, customers are highly price-sensitive.While price may be the principal driver, it is unlikely to bethe only one. The marketing challenge again is to identifynon-price factors that are important, and to be able to deliverthese within a tight price/cost framework.

Figure 2.5 Value segments and the demand curve

A typical demand curve, as shown in Figure 2.5, has at least three clearly

defined ‘domains’. In the first domain, which I have labelled ‘premium

segment’ there are customers for whom price is much less of an issue

than other factors. Such customers may, for instance, be experiencing a

strong, perhaps even compelling need for a solution and are prepared

to pay whatever it takes to solve their problems. Some of these customers

are ‘distress buyers’ and once the problem is solved the need for further

purchases disappears. In other cases, customers want to make sure that

they have the very best solution to their problem, the best raw materials,

components, etc. Although an item’s price may be very high compared

to other alternatives, in time the cost may well turn out to be much less

than using the cheaper option.

In the economy segment we find customers for whom price is a powerful

and compelling driver of the ‘buy’ decision – so important in fact that it

dwarfs all other considerations.

A low transaction price may for some buyers in this category be a

genuinely dominant issue. In this case the supplier’s challenge is clear

– provide exactly what the customer needs at the lowest possible cost,

cutting out all frills and embellishments. Easier said than done, of course!



31

Alternatively, the issue may only superficially be price and the real issue

is hidden, or perhaps not even recognised by the buyer. There may

therefore be other non-price factors at play in this situation. Leaving

aside the possibility that this is a deliberate ploy by the buying agent

to force supplier prices down, it may simply be that the customer is

unaware of alternative solutions to a procurement problem that his

supplier can help resolve. For some percentage of buyers it may be

possible to trade up to a better solution. We should not simply assume

that buyers in this segment are genuinely price buyers. We need to

identify whether or not there are other important but latent sensitivities

that we can work on to help move at least some customers into the

middle segment.

The middle segment may be empty i.e. there are no buyers in this area

of the market. Or, there may be unidentified market potential for which a

middle priced, middle specification item may be just right. Until we have

drawn a demand curve we will simply be unable to identify and isolate

this latent market potential.

If we have an innovative product and are addressing a market with

compelling need, there is little or no price sensitivity and the supplier can

charge the highest price that the market will accept. In such a situation,

contribution per unit, at least theoretically, is unlimited. As the market

becomes more competitive, price sensitivity (and elasticity) increase. In

any given market, different offers reflect the price sensitivity of different

customers at each price point.

In the fascinating article ‘How to Brand Sand’ (Hill, McGrath and Dayal,

1998) the authors describe a number of circumstances in which it might

be possible to identify ways of creating value, even in commodity items

such as sand, by searching carefully for profitable differentiators for the

customer.

In such a manner it would be possible to move customers from a price

buying segment to a value appreciating segment, at least for this

differentiated item. The authors go on to describe eight different ways of

creating differentiation.

32

Price

Quantity

Additional revenue created by price increase.No resultant volume reduction because product/servicedifferentiation has reduced price sensitivity.

P2

P1

Figure 2.6 Effect of differentiation on the demand curve

Figure 2.6 illustrates the effect of successfully differentiating a product

or service. If a product is undifferentiated from others performing the

same function, the rational buyer will purchase the least expensive

alternative available to him. Thus a product with price P1 will be more

attractive than a product with a higher price, P2. However, if the more

highly priced item offers not only equivalent benefits to the lower

priced item but also provides additional functionality relevant to the

buyer, the buyer may be attracted to the higher priced item provided

that the incremental functionality is relevant to the customer.

The additional functionality – provided by a product or service

differentiation – potentially increases total revenue from this segment

and higher profits.

Consumers are assumed to be rational and to seek low prices.

Appropriate differentiation may ensure acceptance of a relatively

high price. Computers, publications, residential addresses, mineral

waters, motor cars, vacuum cleaners, designer clothing and wrist



33

watches have all demonstrated that differentiation may be sufficient

to add a perceived value out of all proportion to the production costs

involved. What may appear to one consumer as irrational, to another

is in fact both very rational and very logical!

Here are a few practical suggestions to assist in differentiation

(Macdivitt and Wilkinson, 2012):

• ConsistencyWe can differentiate our service by ensuring that our customers

receive sterling service, not just once but every time. Dependable,

reliable service breeds dependable, reliable customers.

• ConvenienceBy enhancing the convenience to your customer of using your

product or service, you can lock them in – especially if your

competitors cannot copy your methods.

• Customised servicesBy clearly and thoroughly understanding your customer’s value

adding processes, and pinpointing where your company’s unique

skills can be applied, you can create a mutual dependency which

yields benefits to both client and service provider.

• CombinationsUnderstand the unique needs and wants of your target market

which are not being met by existing suppliers. From this knowledge

assemble a package of services and features that appeals to

members of this market.

We have reviewed only a handful of possible ways to differentiate

your product or service. There are many, many more.

However you decide to differentiate, you will need to follow these

steps (Anderson et. al., 2006):

1. To review as much as you possibly can about your customer,

his company, and his market. There is lots of information in the

public domain and it need not take a lot of time or effort to

collect it. You simply cannot know too much!

34

2. Consider what your research says about your customer’s context.

Where are the sources of pain and difficulty he is suffering that no-

one else seems to be addressing?

3. Find ways of using your company’s unique capabilities, contacts,

technologies or other resources, and build them into a solution that is

difficult for competitors to copy – and easy for the customer to buy!

4. Build a powerful value proposition and learn how to deliver it

persuasively and compellingly.

Actions we can take:Accept commoditisation as inevitable in today’s competitive market place and re-design the business model accordingly.

In this case, the strategic direction of the business needs to focus on cost

reductions in order to become the lowest cost producer and enter a high

volume, low margin business model. Business relationships with customers

become increasingly transactional as contact costs are stripped out. The

focus is on optimising profitability by maximising volumes at lowest cost

and increasing market share. This may also mean migrating to markets in

which low cost competition – and low prices – are prevalent. In reality this

means moving to markets populated by low cost/low price competitors

and price buyers.

In any case, it may not be possible to change your business model quickly

enough. If your company’s ethos is to be a high quality premium priced

supplier, this is unlikely to work.

Refuse to accept the inevitable and focus on differentiation through customer knowledge and value delivery.

Business relationships have got to be close and meaningful with key

customers. This will allow us to identify and design solutions to their key

issues and pain points that differentiate our offering from competitors and

which deliver value to the customer. The focus is on optimising profitability

through maximising perceived value delivery and capturing a proportion

of this in our pricing. This demands an innovative approach and an

assertive search for true differentiation.



35

A logical starting point is to understand your customer’s current perception

of the value that you and your company provide. This will give you a

benchmark from which to begin. It might also provide an insight into either

how much more you need to understand about your customers, or the

extent to which you are failing to communicate the value that you can

already potentially deliver. The starting point for all of these is to have a

detailed knowledge and understanding of the customer’s situation and

requirements. Without differentiation, commoditisation of your products

and services is just a matter of time.

But there is hope! Richard D’Aveni believes that commoditisation is not

necessarily inevitable, provided the three ‘commoditisation traps’ are

understood and action is taken in anticipation of any of these traps arising

(D’Aveni, 2010):

• DeteriorationIn this scenario, products or services face competition from lower-

priced, lower specification competitors that on the face of it seem to

offer an acceptable alternative value proposition. In today’s difficult

market conditions, where price is truly an issue for many people, many

are trading down to lower priced substitute products. These may not

offer all the things customers are familiar with from their premium priced

preference, but they are prepared (or are compelled) to compromise.

• Proliferation

Once upon a time there was an iPhone. Now there is a raft of products

all competing for a share of iPhone’s space. Some of these are even

more sophisticated, some less, but all are intent on stealing some of

iPhone’s market share. As a result, the market is becoming increasingly

fragmented and intensely competitive.

• Escalation Laptop computers, mobile phones, digital cameras, photocopiers

and many other products are on an almost continuous treadmill of

product innovation and improvement. However, rather than leading

to higher prices for the delivery of improved performance, prices, if

anything, have continued to fall. Early unique value propositions very

rapidly become entry level essentials in a technological battleground.

However, as we saw above, this does not always guarantee success.

36

Simplicity may be a route to differentiation in an increasingly complex

environment.

In order to anticipate effectively any of these issues it is important to

keep a close eye, not just on competitors, but also on customers and

understand how their behaviours and aspirations may be changing.

Understanding market trends becomes a key element in anticipating and

responding to the threat of commoditisation.



37

Chapter 3: Pricing and Marketing

3.1 Overview of the Product Life Cycle

In this chapter we will look at the Product Life Cycle as the Product

Life Cycle is an important element of theory underpinning pricing

decisions. You must be familiar with the pricing ‘fingerprints’ at each

stage of the PLC.

Products, services, technologies, firms and even whole industries go

through various stages in their history from introduction through to their

ultimate (and often unexpected) demise. This fact (often described as

Life Cycle Theory) has consequences for every organisation, especially

if their products and services are at different stages in their life cycles:

• Older products may have ‘plateaued’ but are still generating lots

of profit and seem likely to continue to do so forever

• Some have been introduced with high hopes and seem to be

performing adequately but are taking up a lot of time and

money

• Others have had their day and are on the way out, perhaps in

some cases never having made it

• Some products are about to be introduced and the marketing

challenge is to craft an optimal pricing strategy to achieve the

product/service objectives set by management

Most companies have products in each of these categories.

It is not the probable life of a particular product which is important

but the need to maintain a balance between products at different

stages in their life cycles. There is much theory around this and many

management models have been created to offer business strategists

real insights here. Often particular stages in the life cycle of a product

will be linked with particular trends in cash flow. As sales grow, it will

require substantial investment:

38

Sales

Profit

Intro

Growth

Maturity

Shakeout

Decline

Time0

Figure 3.1 The product/service life cycle

• cash to help it grow

• pricing to gain market share and traction

• working capital to sustain growth

• fixed capital whose costs will not yet have been met by cash from

the sales of the product

We need to look at this in more detail.

• Pre-launch development stageThis precedes the stages shown in Figure 3.1. During this stage no

sales actually take place. The activity is limited to taking the product

idea from concept through the development, testing and launch

decision-gates. During development the company invests time, money

and knowhow and there is a large negative cash flow. Note that this

negative cash flow is sometimes referred to as negative profit. Strictly

speaking, the product at this point has not been introduced to the

market so is not actually earning any revenue. The development costs

are being covered by the balance sheet or owners’ investments! In

some industries (e.g. computers, pharmaceuticals, capital equipment)

the investments can be enormous. In other industries the time scales

and costs can be very low.

Pricing and Marketing


39

• Introduction stageWhen the new product/service is introduced few people are aware

of it and market acceptance is slow unless it is introduced under a

well-known brand or a lot of market awareness investment has taken

place prior to launch. In the case of a genuinely new product much of

the marketing effort is educational i.e. teaching potential customers/

users about the product. Competition at this stage is usually minimal

or non-existent. Channels of distribution may be unwilling to stock the

product because of its newness and marketing efforts are focused on

generating primary demand.

• Growth stageAfter initial resistance, customers come to accept the product. Word

of mouth communications, social media influences and conventional

marketing communications stimulate interest and demand. As

competitors aquire potential business opportunities a new growth

market, imitative innovation (“me-tooism”) occurs, with new entrants

offering enhanced features. This is predicted by the economic Law of

Supply. Competitors’ strategies are based on product differentiation

to capture share in specifically targeted segments and to achieve a

virtual monopoly position, at least for a short period, in these segments.

As suppliers gain experience and product volumes increase, unit costs

decrease leading to greater demand and lower prices.

• Maturity and market saturation stagesThe pace of market growth gradually slows down as fewer and

fewer new customers are recruited. By this time typically several

competitors will have entered the market and surplus capacity

exists. Purchasing switches from new purchase to replacement

purchase and competition for replacement sales is focused on price

and differentiation. The general convergence of product/service

specification at this stage leads to competition on non-product/non-

price elements. Competitor strategy focuses on customer preference

and brand loyalty. Brand loyalty is challenged by special deals, better

credit terms, increased service levels and increased discounting.

Growth of share can only be at the expense of a competitor’s share.

Products and production methods have become largely standardised.

Customers are well informed about the relative merits of competitive

40

products. The market is crowded by competitors and competition for

market share is extremely fierce. Some competitors leave, perhaps

seeing better investment opportunities elsewhere or because they are

forced out by decreasing prices and margins.

(log

) u

nit

pric

e a

nd

co

st

(log) cumulative volume

Price

CommoditisationCost

Intro Growth Maturity/Shakeout

Figure 3.2 Market shakeout

• ShakeoutIn reality the stages of maturity, saturation and decline can be

indistinguishable. A very important task for marketing managers is to

ensure that, throughout the life cycle, marginal prices are greater

than marginal costs i.e. the price of the next item sold is greater than

the total (fixed plus variable) cost of the same item. Easy to say, but in

reality extremely difficult to make happen.

The point of maximal profitability occurs somewhere around late

growth /early maturity. From that point onward, the ability to protect

margin is of paramount importance. This is particularly where new

technologies, competitive intensity and premature commoditisation all

conspire to winnow margins down to wafers! Managing profitability of

the product through this period is arguably the toughest challenge for

any product manager, and will require skill and creativity in assembling



41

– and adjusting in an agile manner – the marketing mix, while ensuring

value delivery at the selected price.

Companies that fail to achieve this will run out of volume or will find that

costs sooner or later exceed prices in a way that cannot be reversed.

They have no choice but to exit the market. They are, in fact, shaken

out! The survivors emerge into a new market which is characterised by

very low but sustainable margins and relative stability until a disruptive

innovation comes along to change or destroy the market.

• DeclineSales decline as new technologies/substitute products enter. It may still

be possible to achieve reasonable profits by selecting specific market

segments.

Strategic implications of the PLCWe are fortunate today in having powerful modelling tools and software

programs that, in the right hands, can deliver useful quantitative lifecycle

models. If we have the skills to do this, we should at the time of building our

business case build such a model.

Created carefully, this model will allow us to undertake ‘what if’ and

scenario type assessments to judge the effect of typical market issues –

late entry, competitor entry, cost hikes in critical raw materials, market

changes, etc. If we have established a history of product introductions, it

may even be possible to assess the profit impact of different marketing mix

strategies on short and long-run profitability.

There is no ‘fixed’ or ‘ideal’ length for a product life cycle in years or in

volume sales. This varies enormously from industry to industry. Advances

in technology have led to a reduction of the typical life of a product/

market. This is illustrated in Figure 3.3 (von Braun, 1997).

42

Figure 3.3 Shortening life cycles (von Braun, 1997) Reprinted by

permission of Pearson Education, Inc, Upper Saddle River, NJ

50 years ago

TodayCosmetics

Toys

Tools

Food items

Pharmaceuticals

Length of lifecycles (years)

0 5 10 15 20 25 30

The profitability life cycle is even shorter. Marketing managers, therefore,

should note the following facts:

• All products have a limited life

• Rapid changes in technology will probably shorten existing (and

future) product lives

• There is a relationship between the experience curve and the PLC

• Sales and profits tend to follow a more or less predictable trend

• Proper pricing is critical at each stage of the life cycle – especially at

new product launch

• Products require different strategies at each stage in the life cycle

Marketing tasks through the PLCThe product life cycle is a useful tool in helping brand and product

managers select appropriate strategies for managing the product

at different stages in its life. The following table provides some useful

indications of which actions should be taken at each stage. We need to

keep in mind that the product life cycle concept is only that – a concept.



43

It does not have any real existence as such and is a mechanism to help

us to understand the market and offer hypotheses to explain observed

market phenomena. Lifecycle stage, although a reasonable indicator

of marketing actions that should be taken at that stage, is only that – an

indicator. Any serious marketing decision must take into account a whole

lot of other factors before coming to a conclusion. This is especially the

case in pricing decisions.

Characteristics at different life cycle stages

Introduction Growth Maturity Decline

Product/Solution

BasicExtensions enhancements, service levels

Modify, differentiate, next generation

Phase out weak brands

Distribution/Convenience

Selective

Intensive, capture channels through discounting to encourage stocking

Intensive, heavy trade discounts

Selective, phase out weak outlets

Advertising/Communication

Heavy expenditure to stimulate trial and build awareness

Moderate to build brand awareness, stimulate w.o.m

Emphasises brand differentiation, special offers

Reduce but maintain loyalty of hard core customers

Physical Evidence/Credibility

Detailed information from trials and pilot evaluations

High profile clients and testimonials

Evidence by case studies, testimonials drawn from all segments and ability to select

Use whatever evidence available to persuade client

Process/Confidence

Clear statement and demonstration of planned process

Demonstrate how process will work for client and identify probable outcomes

Opportunity to observe service delivery to other clients, videos, results

Use whatever evidence available to persuade client

Price/Customer cost

High (premium)/low (penetration)

Lower (penetration)

Pricing to meet/beat competition

Lowest if commoditised or higher to maximise profit

Sales LowIncreasing rapidly

Peaking Declining

Costs/customer High Average Low Low

Profits Negative Increasing High/highestDeclining/negative

Customer Type Innovators Early adoptersMiddle/late majority

Laggards

44

Characteristics at different life cycle stages

Introduction Growth Maturity Decline

Competitors FewIncreasing,

some copycat

High but some

withdrawing

Fewer, shakeout,

concentration

Management

style

Entrepreneurial/

nursemaid

Sophisticated,

focused

Critical, cost

focused

Opportunistic,

tactical, ‘lemon

squeezer’

Marketing

Objectives

Create

awareness and

trial

Rapid share

increase,

maximise share

Defend share,

capitalise

on profit

opportunities

Milk or protect brand

depending on

portfolio

Planning

horizonShort to medium Longer term Medium term Very tactical

Table 3.1 Characteristics at different life cycle stages

3.2 Pricing through the PLC

Pricing at introductionIn general we try to adopt a pricing strategy which reflects our overall

generic strategy as a business. If, for instance, we are a cost leader, a

probable price strategy for a new product would be penetration; if we

are a focuser or differentiator we would probably apply premium pricing.

In Table 3.1, it says prices can be high or low. They would typically be high

(premium) if the new product was first in the market, there were no other

competitive items of a similar nature and customers were experiencing

unfilled and compelling need. Alternatively, by keeping prices low

(penetration) we can capture ‘low hanging fruit’ and go for volume.

We would do this if there was likelihood of a new entrant in the near future.

In either case the objective is to get into the market, establish our position,

build share and market awareness and to start to deliver ROI on the initial

investment.

The general view is that there are two more or less clear alternatives



45

for pricing a new product on introduction. These are Premium Pricing

and Penetration Pricing. We will look at these in more detail later in this

chapter.

Pricing at growthAs the market grows, two factors tend to drive prices down. Firstly and

perhaps most importantly, new entrants come on the scene, possibly with

highly attractive alternatives and lower prices. These are real challenges

and it is easy to drop prices in order to match the newcomer. This is usually

the wrong thing to do as it sends the wrong message to both customers

and competitors. The message to customers is that we were over-charging

to begin with and that our product was really not all that special. The

message to competitors is that they have us on the run and they may/will

intensify their competitive efforts in other areas. Try to keep prices high and

emphasise product value on a segment by segment basis. Do not allow

sales people to give away discount. Watch your costs like a hawk (look

again at Figure 3.2) and keep your marginal revenue higher than your

marginal cost.

Pricing at maturityAt maturity the competitive positions will more or less become

consolidated and, short of disruptive innovation from a competitor, these

positions will remain more or less fixed. This is your opportunity to make the

largest profits. All the marketing costs to get you to this position have been

covered – distributors are set up and functioning well, sales people have

developed good stories and value propositions, manufacturing or service

delivery have ironed out all the ‘wrinkles’ and product development

regularly brings forward enhancements. But this is the time in the market’s

life when someone loses their nerve and starts a price war. Stay out of such

a thing if you possibly can.

Not surprisingly, it is at this stage when buyer pressure is greatest – there

is a lot of choice, product performance, specification and features are

converging and there are early signs of commoditisation at the bottom

end. Inevitably, unless you are lucky or have succeeded in building a

46

‘mighty’ brand, you will have to drop prices. You can by now probably

afford to do this because you have achieved scale economies. If you

have not, and have high costs and low margins, shakeout may be waiting

in the wings.

Pricing declineThis is the life stage at which your price is lowest. At this stage customers

are likely to be looking for more modern solutions and, if you cannot

provide what is needed, the likelihood is that you will experience

customer defection. For those that do remain with you, you may take

the view that if these customers are expressing their wish to continue to

purchase from you, and you are the only supplier, then why not price

your products at a premium. This is a dangerous strategy because you

run the risk of engendering bad PR or claims of exploitation which could

adversely affect other parts of your business.

If you have decided to maintain a presence in this market with a new

product, then you have the challenge of phasing out the older range

and encouraging customers to migrate to your new product. This can be

done by gradually withdrawing customer technical support, although

if there is a large legacy user base, as perhaps in software, this could

backfire, as Microsoft discovered when trying to move customers from

Windows 2000NT to Windows Professional. Alternatively, you could sell all

remaining stock, spares and consumables to an end-of-line vendor who

will continue to supply until stocks are finally exhausted. A final strategy

is to have an end of line sale, cut prices dramatically and get rid of

everything. This assumes that all fixed and variable costs are already

covered by previous trading and the residual stock is effectively cost

free. Any price above 0 will be margin!

There are a number of caveats:

• Temporary fads

The PLC is an idealisation that not every product will follow. At

one end of the scale there are very short lived products. These

are introduced to exploit a perceived opportunity, create a lot of



47

demand and money quickly for the producers, and just as quickly disappear from view to give way to the next ‘craze’. At the other end of the longevity scale are those whose lives seem destined never to come to an end – Scotch whisky, chocolate, Swiss watches, etc.• Law or consequenceThe PLC is sometimes promoted as a natural law - one that must be obeyed by all products. In fact, it is a consequence of the aggregated marketing activities of everyone in the market promoting a similar brand. Heavy promotional investment will cause the product to take off quickly; starvation of effort e.g. in promotion, selling, design, quality, etc. at any stage will tend to lead to reduced demand.• TimescalesAlthough as a descriptive model of the stages through which a product will pass, the PLC is very useful, it is not possible to say just exactly when the various stages will occur. Thus using the model to predict sales is misleading. It may be possible to compare the pattern of sales in one country with those in another and use this as a basis of a demand forecast.• StrategyThe PLC can help guide us to the strategy to be applied at each stage. This, of course, requires the manager to know what stage the product has reached. Sometimes this is difficult and care should be taken to ensure that strategy prescriptions are realistic and based on current knowledge of the market. The model is an aid to managerial

thinking and judgement.

3.3 New Products

New product pricing is one of the most daunting tasks for a marketing

manager. It is particularly challenging if the product is genuinely new

and there is no previous market experience with similar or related

products to go by. Imagine the problems faced by companies

introducing new pharmaceuticals, notepad PCs, Smart Phones, etc. for

the very first time. This is an important topic but space prevents us from

presenting the various approaches.

48

The interested reader should look at The Price Advantage (Baker, et. al.,

2004) (to learn how to use the Customer Value Line in price-setting for

new products) and Pricing: Making Profitable Decisions (Monroe, 1990)

for a thorough examination of how to use contribution analysis in

price-setting.

There are a number of conventional approaches to new product pricing:

• IntuitiveBased on knowledge of the market, customers’ needs and

competitive factors, the marketer makes a guess at the right price.

Although crude, in the hands of an expert this can be a very effective

method. It is, in fact, the method very commonly used.

• SimulationMathematical models simulate the effects of mix decisions under

different conditions. The advantage of such an approach is that the

user can assess the implications of different combinations of factors/

mix elements before implementing them. The disadvantage is that a

great deal of information is needed to input into the computer model.

Some of this information can only be guessed at.

• SystematicMany managers adopt a logical approach to pricing with a number

of clearly defined steps. In this process, due consideration is given to

the key issues in reaching a rational decision.

3.4 Premium and Penetration Pricing Strategies

A Premium Pricing (high price) Strategy is used when the product is an entirely

new concept with application potential in a number of market segments. The

idea is to ‘cream off’ the top layer of each segment at a high premium price

and move to a new segment when price sensitivity emerges. The technique

was used to good effect during the introduction of electronic calculators,

Intel (in the introduction of their P2 chip), VCRs, PCs and camcorders.

The difficulty with this type of approach is that it tends to send the signal

of lack of commitment to target segments and has, in fact, been used by



49

an unscrupulous vendors offering highly priced, low quality products and

services.

I prefer the term ‘Premium Pricing’ which is more strategic in the sense that

it is a deliberate high price, high quality approach and does not have the

‘flavour’ of impermanence about it.

A company which offers premium prices does so as a deliberate strategy

and offers differentiated products to its customers.

Use premium pricing when:

• Sales are likely to be price inelastic in the early stages

• Launching a new product at a high price to break the market into

segments

• You are trying to assess acceptable price levels. A high price acts as

a ‘refusal’ price allowing you to back off if necessary. This enables

you to test what is, and what is not an acceptable price in a given

target market, and adjust your price downwards as necessary.

It is not always possible to price products and services in a more

‘analytic’ fashion!

• Trying to generate funds to break into large volume sectors

• There is capacity limitation. In this case we want to optimise our yield

from limited production/service delivery capacity. This has the effect

of creating a ‘scarcity’ and enables us to ‘bid up’ our prices. (Always

assuming, of course, that there is no over-capacity in the market!)

• There is high perceived customer value in the product/service

A Penetration (Low Price) Strategy is the other end of the spectrum. Here

we use low prices to generate market share rapidly. This is especially

appropriate in consumer goods where you are trying to generate rapid

demand to encourage distribution, stocking and pull-through. Penetration

pricing is the best strategy for generating demand and market share

quickly, especially in highly competitive, imitative markets.

50

Use penetration pricing when:

• Sales volume is highly price-sensitive

• You can see how scale economies/experience effects can be

created

• Your product may be threatened by strong potential competition

soon after introduction

• There is no “top end” market willing to pay higher prices.

3.5 Pricing and the Marketing Mix

I often find, in pricing consulting practice, that the first element of the

marketing mix, to be considered and fixed, is price. This is not actually a

good practice. The reason is that price is being fixed before it is clear what

the other elements of the mix are to be. This practice puts the marketer

under pressure to ‘squeeze’ as much functionality as possible into the

package, and he is encouraged to do this by sales people who tell him

“we have got to have this, and this and this”. This is completely wrong.

The place to start is by considering the segmental value proposition and

putting into the offer those factors that deliver defined and clear value

to the user. Using customer value as the benchmark will prevent the folly

of putting everything in and then over-pricing the product or destroying

margin. So we start by defining the customer’s required solution, build up

the mix to support this and finish by creating a price that is realistic in the

light of customers’ expressed desires for the product.



51

7Cs 7Ps Comment

Customer’s required solution

Product

This is what the customer is buying and why he is speaking to you. Think through very carefully what the real requirement is, test that with the customer and use this as the benchmark for product/service creation. Do not be sidetracked by those who want to add functionality for no demonstrable market reason. This only adds cost and makes the item more difficult to sell.

Communication Promotion

Find out how the customer wants to be ‘sold’ on the product – salesperson, viral, professional referral, trial, etc. This dictates your choice of medium. Do not just default to the normal magazine, newspaper etc. merely because “this is what we always do”, or we have a block deal. Results will disappoint.

Convenience PlaceWhere does the customer want to acquire the product? Not everyone these days wants to shop; explore alternative delivery methods – on line, Amazon, bricks ‘n’ clicks, etc.

Competence, charisma, confidence

People

People are a huge part of the cost today in service businesses and increasingly in value added product based businesses. A key part of the mix is to ensure that the right people with the right skills are given the right training to do the right job. Once this is in place, people become a great source of customer satisfaction and repeat business. Do not cut costs here because to do so will damage the customer value.

Concrete examples

Physical Evidence

Generally this will not cost a lot, but is still an essential part of the value proposition. We need to think about the cases, examples, testimonials, research reports, lab results, etc. – anything that can demonstrate objectively and unambiguously, the validity of the sales claims.

Consistent methodology

Process

This overlaps into Physical Evidence and People but what is needed here is a clear, understandable blueprint of how the customers’ needs will be met – whether by product with training or entirely through service delivery. A clear, well thought through and clearly described process adds greatly to customer confidence in your offer.

Cost to customer

Price

Finally, think about the cost to the customer for everything above. For the segment you are looking at, does it make sense? Does it really give the customer value? How much? Can you calculate the impact on the customer’s business and show him that the total cost he has to pay is much less than the benefits that will accrue? What pricing method will you adopt? Value Based? Cost Based? How will you help the customer pay – deferred terms, loans, etc. There are many, many questions to answer here!

Table 3.2 7Cs and 7Ps framework

52

3.6 Tactical Pricing

Like any other marketing mix element, pricing can be adjusted to

confer temporary advantage across the market or much more locally

to deal with particular problems or opportunities. Unlike other elements

of the mix where creativity and inventiveness are the only limit to the

variation available, pricing can only be increased or decreased.

Here are some of the places you might consider tactical price

variations:

• to reflect geographical differences (different prices e.g. UK

compared to Europe; Scotland vs. Ireland)

• early payment discounts (off-season buying to stimulate cash

flow) or discounts for volume purchases)

• trade-in allowances (recognising small residual value in existing

item and offering this as discount to purchase of new item) used

to boost sales, and hence cash flow, during slow periods

• discriminatory pricing to selected markets prepared to pay more

(e.g. builders charge home owners in wealthy suburbs more than

in more down-market areas for the same work)

• ‘optional features pricing’ in which a low basic price is charged

for the ‘standard’ or ‘contract’ item; additional features are

charged at a premium. Used extensively by car manufacturers

and construction companies

• to exploit perceived areas of vulnerability among competitors

In addition to these, companies need to be prepared to raise or lower

prices temporarily to gain/retain some competitive advantage. Price

cutting can be used to put competitors under pressure or set to reduce

temporary surplus/over-capacity. Price increases in elastic markets

will help reduce excessive demand and increase profits. Recognise,

however, that price variations will have an impact on customers,

traders, distribution channels and competitors. We should recognise

that price variations more than anything else are likely to stimulate

competitor response.



53

3.7 Pharmaceutical Generics – a Contemporary Challenge

Many companies are today confronting the challenge of expiration

of patents. A company has 20 years from first discovery of a new

technology or material to exploit the item. Of course, in many cases

this technology is replaced, perhaps several times, by newer ones

and the 20 year process starts over. For some, however, the product is

still viable even though the patent may have expired. It is still making

excellent profits for the patent owner even after 20 years have

passed. At this point, there is nothing to prevent suitably equipped

and knowledgeable companies from ‘cashing in’ on the expired

patent. Many file a generics patent featuring the original material but

requesting approval to market it as a generic item.

The problem is particularly acute in the pharmaceutical industry. The

combination of extended efficacy and toxicity testing schedules,

extremely high development costs and regulated markets all conspire

to discourage many companies from introducing new pharmaceutical

products. The result – very few really new, blockbuster drugs have

been introduced in recent years. Now that many are coming off-

patent, the doors are open for new entrants, particularly those from

low cost, technologically sophisticated countries, to try to win share

from the incumbents. Espicom estimates that the market for generic

pharmaceuticals will be $221Bn by 2016. So what can an incumbent

supplier do to protect its newly off-patent item? (Epsicom, 2012)

Branded drugs are often perceived by prescribers to be superior e.g. in

bioavailability, formulation, dispersion in the body once administered,

fewer side-effects, and so on. However, this is rarely enough to

overcome the threat of generics. To make matters worse, some

governments are restricting the profits being earned by major branded

suppliers or imposing mandatory price cuts when generic alternatives

are available. Encouraging substitution by generics is the most popular

governmental approach. Volumes used drop 40-50% during the first

year after loss of the patent.

54

This is a horrible situation for any company to be in. No matter what

the strategy, the outcome is certain to be loss of business. The more

dependent the company on end-of-patent products, the worse

the impact of generic alternatives will be. Although the presenting

problem is a pricing one, the issue is really much broader than that. It

is a business model issue, of which price is only a symptom. The only

possible approach is for the supplier to understand the value of the

product to all users, and to base his differentiation strategy on these

factors.

Make no mistake, this is a marketing mix problem in which pricing has

a quite enormous influence. The pharmaceutical generics problem

probably does not have a perfect solution, but it illustrates an important

issue for us. When confronted with what appears to be a pricing

challenge, do not immediately ‘knee-jerk’ into discount mode. Think

through the customer value. Has this changed? How has it changed?

How can you turn the problem into an opportunity? Approaches based

on identifying value to key players in your scenario may just buy you

enough time to come up with a better solution.



55

Approach Description Comment

Position

defence

Introduce ‘value’

product

You will never be able to compete with generics

on cost alone. Something else is required, and

vicious discounting is only ever going to hurt the

defender – never the new entrant.

Flanking

defence

Come up with an

alternative productVirtually impossible given the long testing required.

Ignore

Act as though

nothing has

changed in the

market

Utterly catastrophic. A smart generic will rip you to

shreds. Governments also have a vested interest

in purchasing the least expensive item that will do

the job.

Pre-emptive

Increase

promotion/lower

prices before

onslaught of

generics

By reminding the buyer of the benefits, and

ensuring strong encouragement to buy with

incentives, it may be possible to maintain some

defence for a short period. But inevitably the low

price of generics will dwarf the other arguments.

Mobile

defence

Launch a fighter

brand or our own

generics

That will take the fight to the generics but is certain

to cannibalise the incumbent product because

there will be little or no real differentiation other

than branding and perhaps formulation.

Counter-

offensive

Expand other

markets

Effectively we are saying, let the generics suppliers

have it – we will build our business elsewhere.

Promote

differentiation

Find value drivers

for the incumbent

and fight on

those – may mean

moving to sub-

segments and

abandoning others

This probably has more traction than any of the

others. Small generic manufacturers are likely to

invest less in QC than branded competitors. This

is perceived to be the case by doctors in some

markets. There is also concern about malpractice

arising from use of inferior drugs …some physicians

are reluctant to use generics because they do not

perceive them to be the best for their patients.

Table 3.3 Pricing of generic pharmaceuticals


57

Chapter 4: Value Oriented Segmentation

“Sometimes the situation is only a problem because it is looked at in a

certain way. Looked at in another way, the right course of action may

be so obvious that the problem no longer exists.”

Edward de Bono

Segmentation is a cornerstone of modern marketing thinking. It

always has been; in this chapter I want to highlight some of the issues

around price and value segmentation, and to outline an approach

to developing more effective value segments relevant to the pricing

decision.

At its heart, segmentation is a simple idea. Most markets are

heterogeneous. They consist of many customers with widely divergent

needs, wants and expectations. These are reflected in the products

and services that they purchase. What would be really helpful is for

every market to be composed of customers whose requirements were

identical.

Unfortunately, people and businesses are ‘untidy’. This untidiness is

inconvenient. It means that we cannot tackle a whole market with a

single, efficient and optimised marketing strategy. If we tried to do so,

we would need to create a kind of ‘average’ product or service and

market it in a simplistic, homogeneous fashion. This would give us some

real problems – lots of customers who did not understand the product or

the offer, loss of customers for whom the product was just not right, others

for whom it was too expensive, and so on. A homogeneous marketing

approach would fail. Early approaches to segmentation tended to work

this way. They succeeded in an earlier era when products, markets and

customers were less complicated. Today these approaches no longer

work well, or even at all.

Given that most rational purchase decisions are based on the value that

any given product or service offers to them, a sensible approach would

be to segment customers on the value(s) that appeal to them.

58

If we could achieve this we would be able to market directly to the

differentiated values held for our products or services by different user

groups. Conventional methods of segmenting cannot achieve this. A new

and different approach is needed.

4.1 Limitations of Conventional Segmentation

To segment a market effectively we need to ‘break it down’ into ‘bite-

sized chunks’, each of which can be selected as a target (or not) and

addressed using a specially designed marketing approach. The segments

emerging from this kind of analysis need to be internally consistent

(all members of the segment need to be similar in certain respects to

other members); worth pursuing in terms of size and profitability/cost to

serve; unlikely to change dramatically over a period (segment values

do not migrate and people do not move from one segment to another

frequently or en masse); practical and easy to address with a unique and

differentiated marketing strategy; make sense to management, able to

be readily described in understandable terms; and finally, consistent with

the resources and capabilities of the selling organisation (Dibb & Simkin,

2010).

This counsel of perfection is far from readily achievable. A market with 60

million consumers theoretically could be dissected into 60 million segments

– rather too many to address effectively. So the question becomes “how

do we go about segmenting the market”? This is where the fun really

starts. There are dozens of ways of segmenting, and scores – maybe even

hundreds – of variables we could use – social class, personal income

or age in the case of consumers; and SIC, turnover and geographical

location for B2B. Any general marketing text book will list these ad

nauseam. These ideas have been superseded in many sophisticated

businesses, but there are still surprisingly many companies who use very

simplistic segmentation approaches. This restricts their effectiveness and

limits their economic potential.

A well-known study reported that of nearly 60% of companies who

undertook a segmentation study 86% derived no benefit from it, see Figure

Value Oriented Segmentation


59

4.1. Even so, many executives of large companies are convinced that

segmentation is an essential tool (Marakon Associates, 2004).

86%59%

A 2006 study reported that 59% of large companies had

recently conducted a major segmentation study. 86% of

executives reported no benefi t gained.

About half of large company executives believed that

segmentation is an essential tool for growth.

Figure 4.1 Does segmentation generate value to businesses?Information sourced from the FreeLibary, chart created by Harry Macdivitt.

Yankelovich and Meer commenting on the shortfalls of segmentation made

the following statement:

“Segmentation initiatives have generally been disappointing…Their failures

have mostly taken three forms. The fi rst is excessive interest in consumers’

identities, which has distracted marketers from the product features that

matter most to current and potential customers of particular brands and

categories. The second is, too little emphasis on actual consumer behaviour,

which defi nitively reveals their attitudes and helps predict business outcomes.

And the third, is undue absorption in the technical details of devising

segments, which estranges marketers from the decision-makers on whose

support their initiatives depend.” (Yankelovich and Meer, 2006)

Does this mean segmentation is broken?

Many text books present sophisticated, thoroughly thought-through, grid-

based tools. Although there is usually a lot of discussion around how to

60

select and use objective segmentation variables, there is generally limited

discussion of customer value in the narratives describing most of these

tools. Conventional segmentation variables are important. But are they

the right variables for a value based approach? Practitioners, armed only

with this theory, try to squeeze as much juice out of it as they can, and

construct ever more complex, novel and ingenious frameworks.

The biggest weakness of conventional segmentation is that it seeks to

predict buying behaviour from some combination of observable customer

variables. In B2C, for instance, there has been a historical pre-occupation

with psychographics, demographics, and so on. The world has moved on

and, while, these approaches might have worked, and even worked well

in past decades, their effectiveness today is undoubtedly much less.

While most authorities contend that basing pricing on customer value

segments is the preferred approach for a host of reasons, guidance on

how to do this is in short supply. We need to identify groups of customers

for whom a given value proposition is meaningful and compelling. This

is a segmentation challenge. Conventional approaches to market

segmentation do not look at customer value at all, and instead base

target market selection on variables and attributes with at best a distant

relationship to value. A lot of time and effort is expended trying to force

fit products into pre-defined segments. Identifying value segments is a

core requirement for pricing in general. In fact, it is a vital tool for general

marketing.

While executives often acknowledge that their segmentation does

not work well, and that they need to do something about it, they are

usually at a loss to know what. We might be able to identify a historical

correlation between some combination of factors and buying response.

But is it predictive? And is it robust? We will never get there until we use a

customer value approach.

Yes! – Conventional segmentation is broken. It needs to be repaired,

modernised and to employ new tools to make it work better.



61

4.2 Evolution

Newer approaches like contextual and needs-based segmentation are

much better because they are moving towards the interaction between

the buyer and his purchase, and the impact of this purchase on the buyer’s

life or business.

The ones where most traction is gained seem to be in interactive/

contextual and predictive analytics where the bases of segmentation are

moving closer to the customer or consumer’s value driver(s) for acquisition

of a given product or service. This makes much more sense because we

are segmenting on the basis of demonstrable value rather than on some

surrogate with an ill-defined correlation to value. ‘Big Data’ enterprises have

datasets and budget and can use sophisticated data mining, analysis,

model building and validation tools to profile their customers very precisely

and predict the outcome of promotional initiatives (Berry and Linoff, 2011).

The new science is not accessible to everyone. The people who need to use

the results of these analyses do not always understand them, may distrust

them, and consequently ignore them.

One global mobile telecommunications business deploys teams of highly

trained and qualified data specialists. The entire function of these specialists

is to make the fullest possible analysis of all the data held in the numerous

company databases – billing, customer sign-up, call records, network

statistics, call centre effectiveness, and so on. The principal output is data

driven insights.

The insights information is communicated to the marketing teams (mostly

Marcoms) who have very little real understanding of what the reports are

saying, or the significance of the information generated.

The result? Promotional decisions which are completely uninformed by the

data analysis. Advertising themes are entirely based on creative content.

The company desperately needs to close the loop but finds it virtually

impossible to do this. There is a profound need for a “translator” to stand

between the two groups and enable meaningful communication!

62

4.3 Value Segmentation – Some Contemporary Approaches

I will explain in more detail the ideas of value drivers and the Value

Triad in Chapter 7. For now, let’s just describe value drivers as the

‘atoms of demand’ and the ultimate reasons why people purchase

products or services. These drivers do not normally form a large part of

conventional segmentation analysis grids.

Here is a selection of Value Segmentation approaches that are in use

in businesses I have encountered across the world – see Table 4.1 for a

summary. This is not a comprehensive list – there are many variants.

i) Urgency/criticality of customer need

Volume of Work Available

Re

lativ

e V

alu

e A

dd

ed

High

Low

Price -Insensitive

Price -Sensitive

CrisisServices

High ImpactServices

RoutineServices

CommodityServices

Figure 4.2 Value curve (Baker, 1998)

Many professional services firms (solicitors, accountants, consultants, etc.)

price their services using time and cost. The fee is calculated on the basis

of hours worked on the matter.



63

The hourly rate is fully over headed and the intention is to recover both an

acceptable margin and a proportion of the business overheads.

An alternative approach is to ‘segment’ on the basis of importance or

urgency of the services provided. A matter of grave importance to the

client should be dealt with by the most senior or experienced practitioner

or specialist. The hourly rate should reflect that. It makes little sense for, say,

an accountant to work on commodity matters like book-keeping at the

same hourly rate as for urgent, highly critical and challenging assignments

like insolvency.

ii) Patterns of usage

The unpredictability of a bill or cost can be a cause of anxiety and worry

for customers. When bills are larger than expected or vary greatly from

one period to the next, this can cause a consumer to change supplier for

a more predictable tariff. This has happened in the mobile phone and

utility sectors. Suppliers need to react by offering more transparency and

predictability with their tariffs.

iii) Timing of purchase

Pricing of hotel rooms airline flights and holidays vary, across all standards

of hotels or airlines, depending on the closeness to the Christmas holiday

period. At certain times of the year there is just much greater demand.

Companies respond by pricing at a much higher level than normal and

the data suggest that demand is considerably greater than supply.

The consumer driver is the opportunity to relax, have fun with the family

and have a rest. Interestingly, although a huge increase in demand for

hotel rooms during the London Olympics in 2012 was anticipated (and

published prices were inflated by as much as 120%), hotels.com and the

Daily Telegraph reported a reduction in demand.

Apparently business visitors to London and normal tourists were staying

away because they expected no affordable accommodation to be

available (Hall, 2012).

64

iv) Geography

US$

Toky

o

New York

City

Dubai

Copenhagen

Vienna

Cape Town

Reyk

yavik

Sao Pa

ulo

3500

3000

2500

2000

1500

1000

500

Figure 4.3 Price of a basket of electronic products in different countries (2012)

Prices can be very different from country to country for identical products.

Figure 4.3 presents prices, in US$, for a basket of electronic products in eight

different countries in late 2012. The ‘basket’ comprises Thor (a film on Blu-ray),

the Canon Powershot s95 camera, Sony Playstation 3, Samsung Galaxy S2

phone and the Samsung Galaxy Tab 10.1 tablet.

Factors that affect the prices of goods are the difference in national and

local taxes, import duties across countries and currency exchange rates.

In some cases these increased prices; in others they reduced prices.

Commercial infrastructure costs more in some countries than others because

of differential costs of employment and real estate.

A third factor, and the one most directly relevant to this example, is that the

prices of items like electronics may have a higher perceived value in different

geographies.

A standard brand in one country may sell at a premium price in another (e.g.

Stella Artois beer in the UK compared with Belgium) (Investopedia, 2012).



65

v) Service/product design

Consumer surplus - ieuncaptured revenuepotential

Revenue from American Airlines Boeing 777Single Fares London - Chicago, August 31, 2009

16 First class seats @ £4800 = £76,800 58 Business Class Seats @ £3000 = £174,000227 economy Seats @ £700 = £158,900

Total = £409,700

Demand curve

£5000

£4000

£3000

£2000

£1000

500 100 150 200 250 300 Seats Filled

Price

Figure 4.4 Airplane seat pricing

In this example, the airline company is trying to capture as much as

possible of the area under the demand curve, and has applied a three

tier pricing strategy. There are large ‘triangles’ representing uncaptured

revenue (approximately £145,000!). The three purchase segments have

clearly different Willingness To Pay (WTP), assuming no stress purchase and

rational buyer behaviour. A proposition based upon these differing WTPs

will emphasise different customer value drivers. Often the assumption is

made that price is the key driver. It is worth reflecting what drivers are

relevant to first class customers, and how these drivers differ for business

class and economy customers.

66

This model is often used to classify customers according to their price

sensitivity. Price Buyers (claim to) see no differential value whatever

between competing products. They see no reason not to pay the lowest

price and will demand discounts from all suppliers until they reach that

price. These buyers do not value relationships, value in-use or any other

‘benefit’. Just the lowest price. Value Buyers, on the other hand, will still

drive a hard bargain price wise, but will listen to and acknowledge the

differential values of alternatives. Price is not the only differentiator. We

need to identify other value drivers. For Partner Buyers, price is probably

a matter of little or no importance. What matters to the Partner is that

the supplier can deliver what he promises to the expected standard.

The Partner Buyer is motivated to cooperate fully in this process and will

typically collaborate with the vendor in creating an optimal solution

(Shapiro et al, 1987).

PartnerBuyers

ValueBuyers

PriceBuyers

vi) Buyer types

Figure 4.5 Buyer types



67

Method Segmentation basis Underlying customer value

Urgency/ criticality

The complexity of the task performed by the service provider

Peace of mindEnhancement of income or minimisation of costs. Mitigation of economic and emotional risks

Patterns of usageHistorical demand variations monitored using transaction data for previous periods

Cost reductionPeace of mind

Timing of purchaseHistorical demand variations monitored using transaction data for previous periods

Cost reductionRelaxation with familyFun

Geography

Prices in other geographies tend to be driven by economic forces such as tariffs, distribution, regulation, etc. and hence probably cost plus

UniquenessAestheticsSelf-esteemPersonal image

Design of serviceIn the example given, customers self-selected the level of service they were willing to pay for

Cost reductionSomeone else payingPersonal image

Type of buyer Price and the nature of the relationship

Cost reductionRobust solutionRevenue gainEfficient improvement

Table 4.1 Different segmentation approaches in use

4.4 Value-oriented segmentation

The preceding examples illustrate various segmentation approaches.

There are many, many more. In these examples, segmentation was

carried out by the seller on some basis relevant to the buyer‘s observed

context or behaviour. Deeper analysis reveals that, at least in some cases,

the decision to buy may be based on an underlying value driver. The real

driver is ultimately identified through a Value Triad analysis. We will look at

the Value Triad fully in Chapter 7. The segmentation method is at best a

‘proxy’ for the underlying value driver.

Value-Oriented Segmentation can be defined as the process of identifying

commercially viable homogeneous groupings of customers who respond

68

similarly to product or service propositions designed to deliver definable

economic and emotional value through their purchase, acquisition or use.

Value-Oriented Segmentation should be applied in defining and creating

value segments for pricing decisions.

This definition imposes the condition that there is internal consistency in

the response of customers within each identified segment to a value

proposition based on the relevant value drivers identified as relevant to

that segment. In fact, this is pretty obvious but in reality it is rarely seen!

Commercial viability recognises the need for each segment to be worth

pursuing in economic terms. By creating a portfolio of value drivers

we maximise the likelihood of impacting favourably on the customer’s

willingness to pay. An orientation towards value is unlikely to change unless

there is a significant alteration to the consumer/customer’s life or business

context.

The whole process of value-oriented segmentation outlined in this

section is predicated on using analytical techniques to optimise the

practicality and understandability of the segments identified to managers

and customers alike (Davenport and Harris, 2007). This is at the heart

of the clustering methodology mathematical models use to adjust the

segments to ensure high inter-cluster heterogeneity and high intra-cluster

homogeneity and ease of description. The final step is to ensure that the

segments targeted are actually worthwhile to us.

4.5 The Value Segmentation Process

Table 4.2 sets out a five step process to segment markets on customer

value. The approach is not dramatically different from other approaches,

apart from the use of Value Drivers as the basis of segmentation.



69

Step Description Comment

1Identify Critical Customer Value

Drivers

Value drivers are identified as part of a

thorough Value Triad© Analysis as shown in

Chapter 7

2 Define Customer Value Segments

Use analytical methods to discriminate

between value categories using value

drivers

3 Assess Willingness to Pay

Market research based approach using

Discrete Choice, Conjoint Analysis, von

Westendorp Price Sensitivity or expert

opinion approaches

4 Assess Value to the Vendor

Use Ability to Win vs. projected NPV

(explained in Figure 4.11) matrix or similar

to select highly attractive segments – and

to reject others

5 Build Value Proposition

On a segment by segment basis use

the defined value drivers to construct a

differentiated value proposition.

Table 4.2 The value segmentation process

Step 1: Identify critical customer value drivers

Figure 4.6 Value Triad©

RevenueGain (RG)

EmotionalContribution (EC)

Cost Reduction (CR)

CustomerValue

70

By using a So What? Analysis (see Chapter 7.4 for more on this) we can identify

not only the critical value drivers for a given product or service, but also their

relative importance to the customer in the purchase decision-making process.

Step 2: Define customer value segments

The Customer Value Drivers defined in Step 1 are used as the input to a

Cluster Analysis process. Cluster Analysis is one of several tools that can be

used to achieve meaningful segmentation. Other tools that can be applied

in this activity include Conjoint Analysis (to define important attributes and

‘levels’ that characterise different segments), and Factor Analysis (which

can help reduce the number of segmentation variables). A full description

of these tools is well beyond the scope of this Handbook. Nevertheless, these

tools are used intensively in segmentation work and would repay more

detailed study. Specialist data analysis tools such as Statistica (www.statsoft.

com), DecisionPro (www.decisionpro.biz), WinStat (R Fitch Software, http://

www.winstat.com) and XLMiner (www.solver.com) each have modules of

differing complexity for undertaking this kind of work.

DecisionPro is particularly accessible for marketing users, has a

comprehensive suite of utilities to assist in the process and is very easy to use.

For effective use of all of these tools, the analyst needs at least a working

knowledge of basic statistics.

Using these methods we can assign customers to particular clusters. Members

of each cluster are characterised by having closely related value drivers

(high intra-cluster homogeneity). We also try to ensure that each cluster is as

different as possible from all other clusters (high extra-cluster heterogeneity).

Random CustomerDatabase...No Grouping

Usable ValueSegments

Data Analysis Tools

Figure 4.7 Cluster analysis



71

Figure 4.7 Cluster analysis

Step 3: Assess willingness to pay

Willingness to Pay is a measure of how much of a sacrifice a customer

is willing to make to acquire a particular product. Sacrifice may be

economic, emotional or effort. For any given item, there will be an

absolute upper limit beyond which a customer will not go. Some believe

that this upper limit is immutable and is as characteristic of the customer as

his/her DNA. If this is indeed immutable then there is little to be gained by

selling or advertising or any of the other customer influencing strategies we

adopt. This is the price a customer will pay. No more. That is it.

Our own personal experience as consumers tells us that this is not so. For

example, we want to buy a house. We set our budget and we vow not to

go a penny above that budget.

This is our willingness to pay…perhaps even our maximum willingness to

pay. And then we see the house we want to buy. It has everything we

dream of and more. But it is 5% above our maximum willingness to pay

as set by our budget. Do we stick with the budget? Possibly. But many

– maybe most – of us will squeeze out the extra 5%. Or even 10%! Our

maximum willingness to pay has been changed by exposure to the value,

to us, of the house we would really like to purchase.

△R - the shaded area is the additional revenueachievable by understanding and applying the driversWTP in a market.

UninformedWTP

InformedWTP

Volume

Price

Figure 4.8 Informed and uninformed willingness to pay

72

So we can identify two WTP ‘states’ – an uninformed WTP and an informed

WTP. The uninformed WTP is established by the customer’s existing state of

knowledge. This informs the ‘budget’. Informed WTP depends on the how

the customer’s perception is modified by more complete knowledge of

the proposition. The customer will have formed an opinion of our product

or service before even hearing our offer.

This opinion may be erroneous, will have established an uninformed WTP

hurdle and may even result in too low a budget being set – constraining

perceived Ability to Pay. We can increase the WTP by presenting the case

in the best possible light for this customer. We need to identify the really

compelling value drivers and build these into our value proposition. These

are exactly the same as our segmentation variables. Our value proposition

thus will have maximum traction with customers segmented on these

value drivers. If, by building convincing value arguments, we can move all

the customers in a segment towards the maximum WTP, the effect will be

to increase total segment revenue by ΔR.

Step 4: Assess value to the vendor

Identified customerValue Segments

Sweet Zone

PoiZone

1

34

2

Our ability to win

Pro

jec

ted

NPV

Figure 4.9 Selecting viable target segments



73

A cornerstone of segmentation is that the segments we choose to target

should yield sufficient return to make the whole exercise worthwhile. There

are many classical tools that could be used to make this assessment – e.g.

BCG Matrix, Directional Policy Matrix and GE Matrix to identify three of the

best known. I favour the NPV-Ability to win model presented in Figure 4.9.

This model is a fairly classical 2x2 matrix. The vertical axis is a measure

of projected net present value based on scenario data. The horizontal

axis assesses our ability to win…broadly analogous to the BCG/GE

competitiveness measure. We then plot our candidate target segments on

this grid. Candidates in the ‘sweet zone’ (Zone 1) are those with significant

income generation potential and where we have sound prospects of

success. Candidates in Zone 2 offer good income potential but we will

need to improve our competitiveness if we are to win. Candidates in Zones

3 and 4 are somewhat less attractive and in general should be avoided,

especially Zone 4 where everything is against us. I call it the Poizone!

Step 5: Build the value proposition

Increasingly Value Rich Propositions

Segment a

Segment b

Segment c

...Segment “n”

Baseline

Figure 4.10 Value propositions based on segment-oriented value drivers

74

The final part of the jigsaw is to build differentiated value propositions

for each of the segments we select. In any given market we are certain

to find many elements in common between the various competitive

offerings.

Some of these represent the expected functionality of a given product in

this market. This basic functionality, denoted in Figure 4.10 as, ‘baseline’,

is the minimum acceptable specification. Each segment will expect an

optimal package of value drivers which is different in nature or scale from

each other segment. Each package is built up from the value drivers

identified at Step 1 in the process. Each segment will have its own unique

‘value molecule’ which will vary from very basic to quite sophisticated and

‘rich’ combinations.



75

Chapter 5: Cost-based Pricing

“My formula for success is rise early, work late and strike oil.”

JP Getty

Research surveys in the UK and EU and experience confirm that cost – and

competition–based approaches to pricing are by far the most prevalent.

Table 5.1 Comparison of pricing survey research data (table created by Harry Macdivitt)

Atkin & Skinner

(1974)

Mills & Sweeting

(1984)

Fabiani et

al(2007)

No of Replies 220 94 11038

% Cost Based 90 99 54

% Competition Based - 27 27

% Other 21 11 19

The dominant method is cost-based pricing. This has a number of variants

among which full cost recovery, mark-up and percentage of sales price

are the most frequently encountered. We will look at each of these in this

Chapter and then at competitor-based approaches in Chapter 6.

5.1 What is Cost-based Pricing?

At its simplest, cost-based pricing is based on our assessment of the total

costs we incur in manufacturing a product or delivering a service. We

identify and add up all the unit fixed and variable costs and then add a

percentage to this figure (mark-up or planned profit element) which then

becomes the price. The basic algorithm for cost-based pricing is extremely

simple. However, this conceals a very important reality.

Collecting the base data, validating it, ensuring it is up to date and

correct in the particular product context can be an overwhelming task,

and is a major reason why companies applying a cost-based approach

76

to pricing employ armies of management and cost accountants! The

process is illustrated in Figure 5.1.

£

Cost Based Price

Planned Profit Element £100

Variable Costs £100

Fixed Costs (Overheads) £100

50% of Total Costs

Total Costs

Figure 5.1 Cost-based pricing process

Planned profit might simply be a mark-up set by custom and practice, or

a fixed target percentage of the final price, or simply a target cash figure

that must be achieved in each transaction. There are several variants but

they are all fundamentally cost-based in nature.

The assumption is that, since we have considered all of the costs, we

have guaranteed profitability. Because the accounting department

have full details of the costs of every element of the product, and has the

necessary skills and resources to manipulate these figures, the responsibility

for price setting in a cost based model may end up with them. This is fairly

typical in companies that are at the ‘Control’ stage of the Pricing Maturity

Process (See Chapter 10 – Price Management). There are advantages

and disadvantages in this arrangement. An important ‘downside’ is that

this practice separates the pricing decision from the sales negotiation and

adds delay to price negotiation.

One of the biggest attractions of cost based pricing is its simplicity. It is

conceptually and arithmetically an easy process.

Cost-based Pricing


77

This simplicity perhaps goes some way towards explaining why it is such a

prevalent – and popular – pricing method. This simplicity conceals several

real problems which lie within the assumptions made in the calculations. In

addition, I have come across several websites advising business managers

that cost-based pricing guarantees profit success. This is dangerously

misleading and overly simplistic! I will explore these assumptions a little

later in this chapter.

5.2 Common Variants

Accurate pricing depends on achieving projected volumes within

the costs ‘envelope’ identified. If the unit volume sold is less than that

projected, a review of costs would lead to increasing prices (i.e. spreading

the same costs over a smaller number of units and applying the same

percentage mark-up as before). This is, of course, nonsensical especially

if the reason for poor sales was high price. (For a quick refresher on this

topic, re-read the section on Break-even Analysis in Chapter 2).

Full cost recovery pricing (FCRP)Full cost recovery means recovering the full costs of a product or service. In

addition to the costs directly associated with the product, such as labour,

materials, energy, direct services, etc. Full Cost Recovery will estimate

costs incurred elsewhere in the organisation and allocate a share of

those directly to the product. Finance, human resources, management,

and IT systems are all part of the chargeable overheads and must be

recovered. The full cost of any product therefore includes an element of

every overhead employed, allocated on a comprehensive, robust, and

defensible basis. This is fraught with difficulties. Nevertheless, this form of

pricing is still very popular.

Imagine a manufacturing company launching a new product – its forecasts

and costs are set out in Table 5.2. At market entry, the fixed and direct costs

together give a full cost recovery per unit of £4.00. Applying a 10% mark-up,

the norm in this particular market, gives a full cost recovery price of £4.40.

Managers estimate demand at this price of 100,000 units for the full year.

78

At the end of the year, actual sales unit volume was 75,000 – 75% of

what was budgeted. Fixed and direct costs have not changed and

recalculation, using 75,000 for the next period, leads to a full cost recovery

price of £5.14 – 17% more than last year. If a price of £4.40 was not

acceptable last year, £5.14 certainly will not be in the coming period. In

this case, full cost recovery pricing leads to an unrealistically high price.

On the other hand, imagine that during Year 1 the company had invested

in new production technology, reducing direct costs by 15% per unit, and

had reduced overhead costs by £30,000. Recalculation of the full cost

recovery price would yield a price for Year 2 of £4.36. In this case the FCRP

approach, if applied vigorously, would lead to a price reduction of around

1%. In other words, efforts to reduce costs would be rewarded by a smaller

margin. In this case, the company’s efforts to reduce costs have enabled

a small price reduction, and no profit return for the effort of reducing costs.

Strenuous cost reductions have enabled the company to go backwards.

The company might still win in a competitive, price sensitive market, by

gaining some market share at the slightly lower price. It would be quite

ridiculous, of course, to do this, wouldn’t it? But it has happened!

Year 1 Year 2a Year 2b

Expected sales units 100000 75000 75000

Total factory fixed cost 200000 200000 170000

Direct costs per unit 2.00 2.00 1.70

Fixed costs per unit 2.00 2.67 2.27

Full cost 4.00 4.67 3.97

Mark-up % 10.00 10.00 10.00

Mark-up value 0.40 0.47 0.40

FCRP 4.40 5.13 4.36

Table 5.2. Consequences of rigidly applied cost-based pricing

In Case 2a FCRP leads to serious over-pricing

In Case 2b FCRP leads to serious under-pricing

Note that the profit generated through sales of any product must cover

the sunk development costs and generate a reasonable return so that the

Cost-based Pricing


79

funds invested can be re-invested. This is not shown explicitly as part of the

price calculation and there is a risk that this necessity may be forgotten.

For this reason, many managers prefer to apply Target ROI Pricing, a

pricing approach which recoups the original investment and creates an

acceptable Return on that Investment (ROI).

Target ROI pricing In Target ROI Pricing we attempt to build in recovery of the investment

costs over a period of several years. The calculation uses as input fixed and

variable costs and the figure, perhaps established by company policy, of

an acceptable minimum return on investment. The intention would be to

calculate the minimum number of units, and the associated sales price per

unit, required to achieve recovery within the specified time period.

Serious competition or technical innovation in the market will cause

reduction of the expected product life and may challenge the viability of

the product. Managers, therefore, need to be confident of the robustness

of their intellectual property protection, technical superiority or whatever

differentiator they use to be sure of an acceptable income stream to

achieve payback. If the product does offer measurable performance

advantages, we should instead consider value basing the price rather than

using a cost based method.

Simple mark-up pricing tackles the short run return on trading through short-

term profit but does little to recoup longer run investment costs.

In this pricing approach we set prices calculated to generate a target

return on investment (ROI). The timescale taken is the shortest anticipated

product life. Sales unit levels are estimated and prices set at a level to return

the target ROI. ROI pricing attempts to link the target margin to the capital

employed, and to set a price which includes a return on capital as well as

to recoup the initial capital invested.

There are two parts to such a calculation. The first part is to calculate

the expected gross margin or contribution that is required. The formula

applied is:

80

Target ROI per unit = capital investment + target % return on capital x capital investment

target unit volume over lifecycle

This formula yields the intended average ROI per unit over the life of the product. If at some point additional capital is employed to expand capacity or to upgrade the product, then we re-calculate the price. This does not cover either the direct costs or the overheads which must also be

added in to come to a realistic price.

Example

A company has developed a new product. Market research indicates a stable volume of 75,000 per annum. Total cost and other data are presented in the table 5.3.

What should the selling price be per unit, assuming that the market research is accurate, that the company has sufficient time to recoup the investment and there are no comparable competitors to cause price ‘slide down’?

Total Investment £1,000,000

Target unit volume per annum 75,000

Unit variable cost of production £28.00

Unit fixed cost £8.20

Target Return on Investment 22%

Calculation of Target ROI per unit:Target ROI per unit = capital investment + target % return on capital x capital investment

target unit volume over lifecycle

Substituting values from the table:

Target contribution = (£1,000,000 + 0.22 x 1,000,000)/75,000

= £16.27 per unit

Calculation of Price per unit:Price = Unit Fixed costs + unit variable cost + target contribution

= £8.20 + £28.00 + £16.27

= £52.47 per unit

Cost-based Pricing

Table 5.3 Target ROI example


81

Target ROI pricing is a more rational approach than merely deciding on,

and applying, a ‘fair’ mark-up because it links directly into the company’s

investment policy objectives.

However, there are a number of assumptions lying behind this method,

any one of which can invalidate the results:

• Although the target ROI is prescribed by the up-front investment

costs and the company’s expected return on this investment, it

may be too high for the market to bear and the pressure will then

be to relax either the expected return, to write off part or all of the

investment; to cut variable costs per unit (perhaps compromising

product quality and acceptance); or to spread fixed costs differently

• The method implicitly assumes that the company will have a clear

‘playing field’ with no, or minimal, competition during the planned

product life. In the intensely competitive conditions many businesses

are facing, this is obviously unrealistic. Competitor entry at an early

stage in particular will lead to the company ‘sliding down’ the price.

• The temptation here is to consider the investment costs as ‘sunk’ and

remove them from the price calculation. Such a strategy is unlikely

ever to recoup the development and other costs

• New or disruptive technology might render the product obsolete

at any point in its planned lifecycle – a problem shared with other

conventional pricing methodologies. It is simply a business risk.

We can either become disruptors ourselves or invest heavily in

Competitor Intelligence in the hope that we might have some early

warning of a disruptive entry.

Target ROI pricing is a cost based pricing method and hence suffers from

the same drawbacks as simple mark-up or FCRP.

Contribution-based pricing

Contribution Pricing is based on maximising the contribution per unit of a

single product or service. Contribution is the difference between the price

of a product and the total variable costs of one unit of that product, i.e. it

is a contribution to fixed costs and profit. Variable costs are assumed to be

constant per unit (but total variable costs will obviously increase with

82

output). The total contribution to profit from all of a company’s products and services less the company’s fixed costs equals the firm’s operating income.

Using a contribution approach, it is theoretically possible to achieve the company’s budgeted total contribution but to adjust the contribution of each individual product to take account of market conditions.

In Contribution Pricing managers need to agree how to identify and allocate overheads.

Different companies use different formulae for this calculation including typically:

• percentage on direct labour• rate per labour hour• rate per unit of product• percentage on prime cost (i.e. direct materials plus direct labour

plus direct expenses)• rate per machine hour• separate rates applied to various elements of the costs

Frustratingly, what we might discover is that, under one scenario, one product shows a healthy profit but others do not. So how do we realistically allocate overheads to show the ‘true’ situation? Indeed, what is the true situation? This allocation can have profound implications on the apparent profitability of given products and lead us to make wrong – perhaps dangerously wrong – decisions. In the process, much management stress and conflict are created! The underlying reality is unchanged in each of these alternatives!

Example

A small company manufactures three different products, Platinum, Gold and Silver. The management accountant has forecast costs for each product at planned budget sales level. To keep the calculations simple, we assume that each product requires separate manufacturing locations within the small factory. Calculate the

profitability of each product.

Cost-based Pricing


83

£’000

Product Platinum Gold Silver Total

Sales 150 500 650 1300

Materials 40 140 180 360

Labour 30 150 100 280

Other direct costs 40 30 150 220

Total direct costs 110 320 430 860

Area allocated to product (sq ft) 800 1700 7500 10000

Contributions 40 180 220 440

Total indirect costs/overheads 360

Operating Profit/(Loss) 80

Scenario 1:Indirect costs allocated in proportion to total direct costs

Contributions 40.0 180.0 220.0 440.0

Indirect costs 46.0 134.0 180.0 360.0

Operating Profit/(Loss) -6.0 46.0 40.0 80.0

Scenario 2:Indirect costs allocated in proportion to total labour costs

Contributions 40.0 180.0 220.0 440.0

Indirect costs 38.6 192.9 128.6 360.0

Operating Profit/(Loss) 1.4 -12.9 91.4 80.0

Scenario 3:Indirect costs allocated in proportion to factory floor area

Contributions 40.0 180.0 220.0 440.0

Indirect costs 28.8 61.2 270.0 360.0

Operating Profit/(Loss) 11.2 118.8 -50.0 80.0

84

In the example in the box, we might be tempted to stop producing

one of the loss-making products. Whichever one we select will be

the wrong choice depending on the overhead allocation scheme.

The company at present is profitable (although not spectacularly so)

at 6.2% net margin on sales. Not unsurprisingly management wants

to try to increase this, and expand production of one of the more

profitable lines perhaps by releasing some floor area. If in reality we

elected to stop producing one product – let’s say Silver (because

based on Scenario 3 it is making a loss of nearly 8% – paradoxically

the profitability of the whole company would drop, in this case quite

dramatically (to a loss of nearly £250,000) because the relatively high

volume of sales is ‘absorbing’ more overhead which now needs to be

recovered by the remaining product lines.

Direct (variable) cost or marginal cost pricingIn Chapter 1 we discussed the break-even curve in some detail. You will

recall that, at the break-even point, the total revenue received by the firm

from sales of a given product exactly covers the cumulative total of fixed

and variable costs.

Example 1

Shortly before a theatre performance is due to take place, a few seats

remain which will not sell at full price. If unsold these will represent a

lost opportunity. Seats can be sold at anything above direct cost and

generate a contribution to profits and overheads. The same principle

applies for passenger airlines, training courses, rail travel and other

service sector businesses where there is unused capacity and for which

contribution will be lost if not sold.

Example 2

A manufacturer can sell capacity at anything above direct costs and

generate a contribution. This might be useful at slow times of the year

to generate cash flow and activity to keep staff employed – especially

where appropriately skilled labour is in short supply (e.g. the construction

industry).

Cost-based Pricing


85

Example 3

Retailers frequently engage in drastic cost-cutting e.g. during the

January sales. The ‘deals’ offered to the customer are high quality items

at literally clearance prices. The retailer needs to clear shelf space to

make way for new items. Assuming that all fixed costs for the items have

been covered by full cost sales, anything that the retailer can generate

above direct cost will deliver a contribution to profits and overheads.

In these examples, direct cost pricing is undertaken to eliminate surplus

stocks or use surplus capacity. In each case, however, direct cost

pricing is adopted only in conjunction with another pricing strategy

which will cover profit and overheads. It is dangerous to undertake

direct cost pricing on its own!

5.3 Underlying Assumptions

There are many assumptions regarding cost based pricing that should

be reviewed.

Assumption 1: accurate and reliable costs can be collected

We assume that the cost data are factual and not subject to challenge

or to change. We also assume that we know which cost data to

collect. In reality, even if we have identified the relevant costs, the

actual purchase cost per unit may change dependent on volume

purchased.

Assumption 2: changes in costs will be incorporated as soon as they are known

In practice, this is unlikely to occur. Changes in the costs of inputs to

the pricing model such as labour rates, raw materials, energy costs and

volume changes, etc, are likely to be ‘carried’ until the next pricing

change, conceivably as much as a year ahead. Even if a company’s

systems were able to accommodate cost changes immediately, the

sheer physical task of making these changes, particularly for a large

product portfolio, would be prohibitive.

86

Assumption 3: the allocation of overheads within the business is fair, equitable and prudent

This is difficult to ensure and disproportionate overhead allocation may be

particularly onerous for new products. As we have seen, there are several

ways of spreading fixed cost – on a per caput basis, as a percentage

of revenue, on the basis of volume, on the basis of floor area of business

premises allocated to the product, to name a few. All of these are

arbitrary and may unfairly load too much (or too little) cost, leading to an

incorrect price and potentially very flawed decisions.

Assumption 4: non-economic matters have no intrinsic importance to the buyer

Non-economic elements such as brand recognition, reduction of pain or

discomfort, and elimination of hassle and conflict, although not directly

measurable may be worth a lot to the buyer.

Assumption 5: alternative competitor offers are not important to the customer

No buyer is likely to ignore alternative offers. Professional buyers will

examine all relevant aspects of every alternative before making a final

selection.

Assumption 6: the customer will recognise that pricing on a cost basis is fair

If we are challenged on price, it is relatively easy to show how we built up

the price from cost elements and added a reasonable mark-up to arrive

at the price figure. The pricing approach appears to be transparent and

fair and should be easy for a customer to accept. Customers care much

more about their own costs than about ours. Therefore they are primarily

concerned with our price to them. They are perfectly happy for us to

absorb our own costs, but very unhappy if we try to pass them on!

Assumption 7: market and cost stability

Many markets today exhibit serious volatility. For cost-based pricing to

continue to deliver profit, all input costs must be monitored and prices

adjusted as soon as they are spotted.

Cost-based Pricing


87

Key factors to monitor include demand, fixed and variable costs and

the market acceptability of planned selling prices given the competitive

situation.

Assumption 8: manufacturers use similar production technology to their competitors

In markets in which there has been little innovation over many years,

this assumption is probably largely true and will inevitably lead to similar

products with similar performance and similar costs. This can lead to

commoditisation.

Assumption 9: demand is price independent

In the unusual situation where there is no price elasticity (see section 2.4)

people will pay whatever it takes (up to a limit, of course). In all other

cases it is not price independent and demand will vary with price in line

with the specific demand curve.

Assumption 10: discounting is an efficient way to increase demand

In principle, any price variation that might exist can be ‘evened out’

through the process of discounting. This is a slippery slope which destroys

brand value, damages our company’s reputation and our salesperson’s

credibility. Worse, it sends the message that we are over-charging for a

commodity product.

88

5.4 Advantages and Disadvantages

Table 5.4 Pros and cons of cost-based pricing

Advantages Disadvantages

Easy to calculate – the calculation

is straightforward and readily

automated.

Automating price list data via spreadsheet may

compound earlier pricing errors, especially with a

large product portfolio.

Fair and transparent – it is possible

to prove every element of cost.

Our fairness can be exploited if buyers choose to

apply raw buyer power. We probably value our

fairness more highly than customers do.

Minimal information requirements

– most or all of the information is

immediately available.

Overly simplistic because critical data on

competitors and customer needs are ignored.

Indeed, in a cost plus environment, managers

might well challenge the need for this data as an

unnecessary expense.

Easy to update variable costs –

when these change, the model

can be readily updated.

Updating in reality only takes place once or twice

each year so additional costs are carried with

adverse effect on margin.

Overheads data are available from

accounts systems.

How overheads are allocated can distort

profitability calculations.

For a low cost supplier, cost-based

pricing may offer some protection

because of its position on the

experience curve or through

economies of scale.

A company with a dominant market share may be

at risk under European Competition Law (Article

102 TFEU).

5.5 Some Additional Criticisms

As we have seen in Cost-based Pricing, the general approach is to build

up the total cost of a product or service from the costs of its individual

components. Once we have a firm idea of the total cost, a mark-up is

then applied.

In the conventional cost and specification-oriented approach to

product development (depicted on the left of Figure 5.2) development

teams create a new product, typically on the basis of technical skills or

technologies possessed by their companies (Nagle and Hogan, 2006).

Cost-based Pricing


89

Product Product

Cost Cost

Price Price

Value ValueValue OrientatedApproach

Customer Customer

ConventionalCost basedApproach

Figure 5.2 Traditional product development and pricing model

These products may be technically sophisticated and contain exciting

new technologies. In the next step in the chain, cost engineers and

management accountants establish a cost structure based on volume

assumptions, unit costs, capital expenditure and overhead allocations.

This establishes a product cost to which is added some percentage (often

set by custom and practice in an industry) to create a crude cost based

price. Nowhere in the chain up to this point have customers, marketing or

sales people been involved. Typically, the next step in the process is for the

product to be presented to sales and marketing as a fait accompli, with

the instruction, by top management, to “go out and sell” the product. This

compels marketing and sales people to create a value proposition around

technology and specification, rather than on value – building something

because they can, rather than because they should.

This is a very tempting approach for companies rich in technologies and

development capabilities but it runs a significant risk of failure, especially if

no consideration has been given to the value which the product or service

offers to the customer. If the product does, indeed, possess demonstrable

incremental value compared to the competition, then things may work

out well. However, as often happens with products developed without

clear customer insight or market assessment, little or no incremental value

exists or can be demonstrated. Sales and marketing teams are then very

hard pressed to build and present a believable story.

By the time the sales and marketing people take delivery, designs have

been fixed, costs finalised and budgets prepared. The whole process

90

is potentially seriously flawed. As soon as the product is presented to

the market the company discovers just how flawed. There are other

competitors, better products, better prices, better deals and better

channels already in place!

Recognising these drawbacks, many companies are genuinely trying to

move towards a more customer-centric model, which means reversing

the whole process. Starting with the customer, we assess the factors that

would present real value, assess his willingness to pay, and which product

and service options would be attractive. Armed with this information,

we can present our product or service designers with a clear market-

based brief and a target cost to enable us to achieve our target margin.

Therefore, by the time the product has been developed and launched,

there is a clear value proposition and the whole offer is much easier to

justify and sell.

Additional issues Cost-based pricing takes no account of non-economic factors which can

have a very major impact on demand and on willingness to pay.

Focus on our own costs stops us seeing the economic gain our products

and services create for our customers because the sales negotiation

becomes dominated by discussions about cost and discount. If we were

instead to consider our customers’ costs, it would open up a much more

fruitful discussion.

A cost-based approach, based on the conventional product

development pathway discussed above, typically leads to debates

about comparative specifications and potentially acrimonious price

negotiations.

The underlying assumption for cost-based pricing approaches to work

is market and cost stability. When markets are volatile this will compel

frequent reappraisals of pricing, which may be impractical, leading to

profit loss.

Cost based approaches use ‘normal’ or ‘standard’ output levels to

Cost-based Pricing


91

allocate fixed costs. These are based on forecasts which themselves are

based on planned price levels. The process becomes circular!

Cost-based pricing does not recognise, nor does it enable us to share in

the economic benefit we create for our customers. No part of the cost-

based pricing formula takes account of the customer’s value in use. The

principal problem with price setting is not the arithmetic. For the most

part this is relatively trivial. The main problem is that companies have not

really worked out properly the real value they are offering. Therefore they

cannot articulate it and hence, face to face with the customer, they

cannot communicate it either. In cost-based pricing this issue is not even

considered.


93

Chapter 6: Competition-based Pricing

“I think it’s wrong that only one company makes the game Monopoly”

Steven Wright

In this chapter I review three competition based approaches – Competitor

Parity (sometimes called Going Rate) Pricing, Competitive Bidding and

Predatory Pricing. We also examine briefly a useful tool to help map

competitors in terms of customer value and cost-in-use, illustrating this with

a well-known case study, and ending with a summary of the pros and

cons of Competition Based Pricing.

In competition-based pricing we try to identify the competitive products

and services available to a particular customer in a given market

segment. We then compare the features and specifications of our product

with those of the competition, and make a judgement about how the

product should be positioned and priced.

While it is attractive to apply this approach to pricing decisions, it is more

difficult to achieve in B2B environments than in B2C because pricing

and detailed specification data are not readily available. Given that

information is available, the Product-Service Price grid is a pragmatic

approach to establishing a competition based price in practice (see

section 6.6).

Competition-based pricing suffers from a number of disadvantages,

principally that it tends to assume that product specifications are of more

or less equivalent value to the customer. This leads either to over-pricing,

if the selected attributes are of limited importance to the customer; or

underpricing if the attributes are of significant importance. In making

a pricing decision, the manager is seeking to de-emphasise price and

highlight some other part of the offer. It is important to select the correct

attribute(s), and to aid in this process you should apply the Value Triad

approach in order to avoid selecting the wrong items and creating an

ineffective value proposition.

94

6.1 Competitor Parity Pricing

In Competitive Parity Pricing we compare our products and services, so far

as we are able, with what we know of the competition, and try to fit our

product in to the range of offers available to the customer.

Figure 6.1 illustrates the typical approach to Competitive Parity Pricing

which recognises that when a (rational) customer is deciding on a

purchase he will work systematically through a search process weighing

up price, performance, product specification, supplier reputation, support,

brand and other relevant factors. If the new purchase is the renewal of

an earlier similar purchase the earlier purchase will act as a reference to

‘benchmark’ the new alternatives. This is quite important, because if the

product or service is not used, or used very lightly, the chances of a repeat

purchase are diminished.

In Figure 6.1, ‘Pref’ represents this ‘package’ and a new supplier will need

to match this in the view of the customer. In any given market there will

Ref orCompetitor Option 1

Option 2

Going rates

Pref = price of reference

P1 = price of ‘slightly poorer’ product

P2 = price of ‘slightly better’ product

PrefP1 P2

Price

Figure 6.1 Going rate pricing

Competition-based Pricing


95

be a number of possible ‘Pref’ options, some of which are priced higher,

others about the same and others at a lower price. Suppliers, seeking to

position and price their products as accurately as possible, will evaluate

their own product against the numerous alternatives. Where they finally

position their own offer will be more guess than science, in the absence

of a more rational decision model, and positioning may be completely

inappropriate because one or more of the underlying assumptions is

invalid.

Competitive Parity Pricing is likely to yield a price a few percentage

points above or below the competition, because no-one wants to ‘rock

the boat’. If every competitor based product design on the existing

competition, and priced identically to the competition, we would end

up in a situation in which there was very little real difference between the

various offers. Marketing communications would tend to say very much

the same things across the market and consequently customers would

be confused and perceive no difference. Marketing’s attempts to create

Price

Prices of Competitive

Products Relative to Pref

Pref

Figure 6.2 Everyone pricing at a similar level

96

real differentiation would indeed be ‘smoke and mirrors’! Under these

conditions it would be very difficult to later claim . . . “our products are

actually better than the competition – we just didn’t tell you at the time

we launched. Oh, and by the way, we now want you to pay more for it!”

In Competitive Parity Pricing products and services are priced at or around

the average price for similar items in the market. In reality, every offer will

be different, some by a little, some by a lot. What we are trying to do is

take price right out of the equation and base the commercial argument

on other factors.

To avoid this situation, marketers try to create some advantage perceived

as valuable by the customer. Factors such as reliability, delivery, customer

service, technical support, etc. are good sources of differentiation and

can form the basis of a really attractive proposition to customers. These

differences must be real and provable, and ideally measurable in their

impact on the customer’s life or business. Unfortunately, by the time the

product or service is ready to launch, it is likely to be too late.

This should be built in right at the very start of the product development

process. Needless to say, much creativity is required, as is the willingness

(and courage) to break from the ‘status quo’.

6.2 Competitive Bidding

In Competitive Bidding, the customer himself specifies his requirements

in the form of a formal document circulated to all qualified vendors. The

vendor’s task is then to ‘first-guess’ his competitors’ responses and carve

out a unique, and attractively priced, proposition.

A company seeking a contractor for a particular project draws up a

detailed specification of the task and issues this to qualified prospective

contractors. The contractor then responds to the specification by

providing a written proposal with a clearly defined price. This is normally

submitted, by a pre-notified closing date/deadline, in a sealed envelope.

After the deadline has expired, the envelopes of all bidders are opened



97

and assessed on their respective merits, usually according to a set of

guidelines decided in advance. Often (although not always) the lowest

bidder wins the contract. For bidders, therefore, the key issue is the likely

prices of competitors. Clearly without detailed inside knowledge of the

other bidders’ proposals, this is impossible to judge. Statistical models have

been developed to try to make the process of bid development more

scientific. The basic process is based on the concept of expected profit:

Expected Profit = Profit x Probability of Winning

Taking an example of a management consultant bidding for a contract

with a TEC:

Bid Price (£) Profit Probability Expected

25000 0 0.90 0

26000 1000 0.85 850

27000 2000 0.80 1000

28000 3000 0.70 2100

29000 4000 0.50 2000

30000 5000 0.30 1500

Table 6.1 Bid model

Purely on the criterion of maximising profit, the consultancy should opt for

the £28,000 bid with an expected profit of £2,100. This, however, is only one

dimension of the discussion. From the client’s perspective, they are seeking

to achieve the best value for money and may opt for the lowest, credible,

bid for completing the whole package.

A consultancy with a low order book may put forward a good/

exceptional value bid at the lowest fee (£25,000) making little or no profit

on the deal but keeping employees occupied (thus retaining valuable

skills) until the next contract comes along. A very low bid (less than cost)

may therefore be an appropriate strategy for a bidder (depending on

their circumstances). However, it may well be perceived as not credible

by the client company.

98

There are several objections to the expected profit approach:

• One company’s costs for delivering a contract to specification may be quite different to another’s. It is naive to assume equivalence in costs.

• It presumes a ‘commodity’ pricing approach is being adopted by all participants and takes no account of value added elements, track record or expertise which may be worth much more to the client.

• It assumes that the probabilities assigned are realistic and are based on some previous experience with the client. This is quite invalid and impractical in many cases (e.g. the consultancy firm example).

• For the expected profit model to have any prospect of success the probability values must be based on previous experience with the same (or very similar) clients rather than assigned arbitrarily. Small changes in probability will result in significantly different bid prices.

The best advice when dealing with competitive bidding is to collect as much information as possible about the client and his business (context, competitors, resources, etc.) and base the bid on knowledge rather than

upon pure mathematics.

6.3 Predatory Pricing

Predatory Pricing (sometimes called Destroyer Pricing) is adopted if a supplier, recognising that he has major cost advantages over the competition, initiates significant price reductions thus placing his competitors under severe price pressure.

Predatory Pricing is a deliberate attempt to eliminate competition. It involves lowering prices to the point where competition cannot compete and forcing them to withdraw from the market. If a dominant competitor implemented a strategy of this kind (within EC Competition Law jurisdiction) it would potentially be seen as either exploitative, or exclusionary, or both. It would certainly significantly reduce consumer

choice if, as a result, other suppliers withdrew from the market.



99

Figure 6.3 describes the typical predatory situation. The Unit Cost Curve

describes the range of costs of all the competitors in a particular market.

The Average Price Line represents the average price of all competitors

in the market at a given time point. If prices are based on a going rate

approach, then most prices will be close to the average price line.

Company 2 is the lowest cost competitor in this market and may well be

a dominant supplier. They have achieved this dominant cost position

through higher cumulative experience (and will almost certainly have

higher market share than the competition). The price of their product will

typically be very close to the Average Price Line.

1

2

Average Price Line

New Price Line

Unit Cost Curve

Cost

Cumulative Output

Figure 6.3 Predatory pricing

Competitor 1 is representative of the other competitors in the market with a product cost significantly higher than that of 1, but selling at a similar price. In the situation depicted, Competitor 2 has a wide range of pricing discretion. A small price decrease would still keep them profitable but would disadvantage those competitors with higher costs. If Competitor 2 wished to do so, they could drop prices dramatically to just above their unit cost (shown by the New Price Line, above). This would compel Competitor 1 and others with higher costs to match Competitor 2’s price reduction or risk losing share, assuming a price sensitive market. In this

100

situation, Competitor 2 has applied Predatory Pricing. If Competitor 2 is a

dominant undertaking and if it can be demonstrated that the reason for

this pricing decision was deliberately to force other competitors out of the

market, the company could be prosecuted for abuse of their dominant

position.

6.4 Underlying Assumptions

Assumption 1: we have selected the correct range of product and service attributes

This is an enormous assumption. The selected attributes identified in

the table may be irrelevant or unimportant to the customer and may

even lead to the creation of products that are competitively irrelevant.

The manufacturers have built these products because they can (or

because they feel pressured to do so) not because they should.

Assumption 2: the selected product and service attributes are of equal importance to the customer

Even if we have selected the correct performance attributes, this

simplistic methodology suggests that each of these is of equal

importance to every customer. This is rather unlikely. Even if each of the

performance attributes were of equal importance to the buyer, other

factors such as the reputation, brand or other competitive advantage

of the seller are ignored, when in reality they may be crucial to the

buyer’s decision.

Assumption 3: we have estimated the prices correctly

The reality, as most B2B marketers know, is that price lists in most cases

are works of creative fiction. In fact there are many factors that might

influence the actual price paid in the market.

Assumption 4: performance and other data are available and accessible

Finding meaningful comparative information is often a challenge.

Companies with appropriate budgets may be able to source samples



101

of their competitors’ products and ‘reverse engineer’ them to identify

the manufacturing technologies applied, performance parameters and

so on. This is very easy to do in consumer markets. Doing the same in

high end capital goods is much more difficult.

Assumption 5: competition-based pricing ‘won’t rock the boat’

Market stability is important for many companies for strategic reasons.

For instance, a company fighting a price war on one front will seek

stable market conditions in its other market sectors.

Competition-based pricing does tend to offer some measure of market

stability. If however, we want to come to the market with a brand new,

perhaps even disruptive, technology then we really do want to ‘rock

the boat’ - vigorously!

Assumption 6: customers buy only on the basis of price/ specification

Competition-based pricing does not capture for us the value created

and delivered to the customer. In this process, not only is little or no

account taken of the real value of our offer to the customer, we find

our products being compared purely on features and specifications

with adverse effects on our ability to price at a premium. In a way, such

an outcome is really our own fault if we have not thought through what

the real value is to our customers.

Assumption 7: there is no emotional component to a price decision

In B2C markets emotion plays an enormous role. Even in a highly

rational, objectives driven B2B situation, there is always an emotional

component, however small, whenever human beings are involved.

Indeed, used wisely as part of the Value Triad©, emotion can be a

powerful influencer of a purchase decision. Companies do not sell to

companies. People in companies sell to people in companies.

102

6.5 Advantages and Disadvantages of Competition Based Pricing

Advantages Disadvantages

A lot of competitive data are generally

available in the public domain.

The available data may be wrong, out of date,

irrelevant or impossible to find. The information

we really need is much harder to obtain.

It is relatively easy to position our offer in

the context of the competition.

Our positioning may not take account of

customers’ different priorities and variations

between segments.

Allows us to focus on the attributes on

which the purchase decision is based.

These elements may not in fact be the right

ones from the customers’ perspectives.

Maintains market stability.Stability is achieved at the cost of sub-optimal

profits through conservative pricing.

Pretty much guarantees we will win

some share of the market, assuming

acceptable brand and specification.

Our prices will be very close to those of the

competition which sends a signal to the

market that there are few differences between

competitors – an issue that might accelerate

commoditisation.

Enables us to collect the price and

specification data as part of our ‘pitch’.

Leads directly to point by point comparisons

on price and specification.

Does not take into account economic

elements of value-in-use.

Completely ignores psychological or

emotional qualities of our offer.

Table 6.2 Pros and cons of competition-based pricing

6.6 Product-Service-Price Grid

In building products and services with differentiation, many companies

use a Product-Service-Price grid. Below is an example of a blank Product-

Service-Price grid.

We collect as much specification and service information as we can

about all of the alternatives available to a customer in a given product

or service market. We identify the most relevant specification and service

components and list these along the top of the grid. On the left side of



103

Product elements Service elementsSupplier 1 2 3 4 5 1 2 3 4 5 6 Price

A

B

C

D

E

F

Table 6.3 Product-service-price grid

the grid, we list all of the competitive products. Utilising all the market and

competitive intelligence we have collected, we plot all the specification

and service elements for each product and also note the price at the right

hand side. This gives us a framework within which we can position our own

product or service, and also make an estimate of a realistic price based

on what the competition is offering.

This appears at first sight to be an attractive and logical approach to

building a competition-based price, but there are drawbacks. Firstly, and

obviously, the conclusions we draw are only as valid as the data with

which we populate the model. This is less easy in B2B than in B2C. Second,

it is easy to assume that the grid is valid across all segments, and so a

general market price can be deduced.

This is dangerous because, thirdly, no consideration is given to the relative

importance of different parameters to users in different segments. In fact,

even in the same segment, different consumers may see things quite

differently.

6.7 Putting Value on the Map

An intrepid traveller, trying to find his way to Cramlington to visit a

customer but terminally confused by the road signs and the wholly

inadequate map downloaded from his computer, in desperation asked

a local for directions. “Ah”, came the reply, “if you want to get to

Cramlington, I wouldn’t start from here!” An old story, of course, but one

104

that always makes me smile. Sad, really, especially since I was the traveller

in question! Notwithstanding this weary traveller’s tribulation and frustration

at not investing in a SatNav system, maps can be very useful both as a

journey’s aid and in charting a course for business development.

The products and services our company markets will appeal in different

ways to different users – even within the same market. Perhaps even in

the same company. How well we meet the requirements of a particular

market segment depends on the degree to which we understand the

key priorities of customers in this segment and how carefully we have

structured our offer to meet these priorities. The comparison grids in Table

6.1 and Figure 6.3 only show part of the way there. We need to build in

realistic weightings to reflect the different importance that customers may

place on a different item. These weightings will change from segment to

segment and probably also over time.

To illustrate this, let’s draw a Customer Value Map.

TCO

TCB

P2

P1

D1

D2

B

C

A

Q1 Q2

CVL

Figure 6.4 Simple value map



105

Figure 6.4 Simple value map

Total Cost of Ownership (TCO) is a measure of how much your product

or service will cost your buyer to own and operate. TCO is more than

just price. It is a combination of cost elements, some of which are

incurred up-front (invoiced price, commissioning, installation, etc.)

and others incurred periodically over the life of the product (training,

fuel, software, repairs, etc.).

Total Customer Benefits (TCB) include all the things that our customers

think are important in their specific context. These include special

features like output and performance and intangible elements such

as comfort, lack of hassle, ease of use and so on. TCB and TCO vary

from market to market. Even within a given market, one customer’s

TCO and TCB will differ from another’s.

The Customer Value Line (CVL) represents the ‘average’ relationship,

for a given product-market segment situation, between TCO and

TCB. If your product falls on the CVL, then it is delivering average (i.e.

acceptable) value. If, like D1, your product lies above the CVL, this

represents poor customer value. For the TCO that the customer pays,

he should be receiving at least the same TCB as the buyers of product

B. He is in fact only getting the TCB of product A, which as you can

see from the diagram is a lot less. This may look like a good deal to the

seller but is it? Really? How long do you think the seller would be able

to ‘get away with’ prices like these? And what impact would this have

on the seller’s reputation and brand? Similarly, product D2 is a good

value purchase.

Product D1 offers the customer a poor deal. Its supplier must find

a way of moving D1 back on to the CVL. The options are either to

reduce TCO or to increase TCB, or some combination of the two.

Whatever strategy is adopted, it must be supported by the whole

management team, and progress tracked by relevant performance

indicators.

It is worth looking at a real life example (some of the details have

been altered to protect confidentiality).

106

Printer featuresPerformance Scores

WeightA B C D E F Average

Text quality 4.0 4.0 4.0 9.0 8.0 4.0 5.5 15.0

Text speed 6.0 4.9 6.9 8.2 5.8 5.7 6.3 20.0

Graphics quality 4.0 8.0 8.0 8.0 8.0 8.0 7.3 10.0

Ease of use 7.0 9.0 8.0 7.0 7.0 7.0 7.5 10.0

Online help 3.0 10.0 6.0 5.0 5.0 5.0 5.7 5.0

WiFi 10.0 0.0 10.0 0.0 0.0 10.0 5.0 15.0

Paperflow 4.0 3.0 2.5 4.0 3.1 2.5 3.2 15.0

Energy saving 10.0 10.0 10.0 8.0 4.0 8.0 8.3 10.0

TCB score 6.2 5.2 6.8 6.1 5.0 6.2 5.9

Cost Elements

Capital Cost 170 100 130 150 90 150 132

Consumables 540 352 545 370 435 572 469

TCO Score 710 452 675 520 525 722 601

Table 6.4 Ink-jet printer attribute weighting table

Ink-jet printer case

Businesses which purchase ink-jet printers are looking for optimal colour

quality at low capital and running costs. Table 6.4 shows the TCO and TCB

scores, derived from customer research, of six competitive printers, across

important purchase decision attributes. (Macdivitt and Wilkinson, 2010).

Figure 6.5 shows that A is positioned above the Customer Value Line (CVL),

explaining why the product is not selling. Even if the PC magazines ‘rave’

about it, research evidence tells a quite different story. What A must do is

reposition itself somewhere to the right of the CVL and ideally at the same

price so that it becomes a much more attractive product for purchasers.

The question is – how?

The price may be too high. The product may be wrongly designed. Or somehow the market is not getting the message. Customer-critical factors



107

900

800

700

600

500

400

300

4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0

TCB

TCO (£)

CVL for InkjetPrinter Example

RepositioningTarget for A

C

AF

E

B

D

are well below average. We need to improve how product performance is perceived across these dimensions.

The first instinct is merely to drop price. This would almost certainly be the wrong thing to do, at least in the first instance.

An alternative response would be to look at the product’s performance. A technical development project may be mooted, and additional, unplanned expenditure sanctioned. The effect will be, eventually, to move A to the right and onto the CVL – if technical improvements focus on the right things – and we have the time to do it.

Product performance may, however, be perfectly acceptable, but there is, instead, a problem with how the product is perceived in its markets.

This suggests a third option which might, in panic, be overlooked. Is the promotional message overly complex and technical? Can customers understand what you are saying – and are you saying the right things? You might not need to make any changes at all to the product or even

Figure 6.5 CVL for inkjet printers

108

the price. Creating and communicating properly the right marketing messages may just do the trick. This is much better than simplistic cost and price cutting which might risk destruction of competitive edge, damage brand perception, or both.

Donald Swire of Customer Value Inc prepared a very thorough and detailed analysis of the launch, by Apple, of the Ipad Mini using a Value Mapping technique similar to this, and demonstrated how Value Mapping techniques can greatly aid both product positioning and pricing decisions based on customer value analysis (Swire, 2013).

This case study is fictitious. Such a pity Product A got into this mess to begin with. It would have been so much better to have thought through, very carefully, what customers really wanted, and then designed the product with the customer in mind – right at the very start. With that insight, we could then deliver the right product to the market - one that is easier to sell, represents real value to the customer in a way nobody can easily copy, and generates better than average profits.

What are the main lessons?

• Firstly, work really, really hard at understanding what your customers want – what will make a difference in their world – right at the very start of a new project. This is a task normally undertaken by marketing, product management and/or development people and is strategically important. You must take a very close interest, and ask the awkward questions.

• Secondly use your company’s unique capabilities to deliver this in a way that will create “wow!” and which cannot easily be copied.

• Thirdly, do not immediately panic and drop price if the product performs poorly.

You might just need to tweak a few things – you are in a competitive market after all. And take a close look at your sales message.

The printer company, like the unfortunate traveller, was completely lost and at risk of going in entirely the wrong direction. With the help of a good map, a bit of common sense and a steady nerve, both will get to their

intended destination.



109

Barco Projection Company case study

This is a well-known published case study and is used frequently in courses

on product management and general competitive marketing strategy.

The core facts were abstracted from a Harvard Business School Case

Study (Barco Projection Systems (A), 2002).

The BARCO Projection Company is a well-known Belgian company.

They pioneered the introduction and early market development of LCD

projectors for use in entertainment, home cinema, computer imaging

and graphics projection. For many years they were a preferred choice for

major companies such as IBM. The company was the clear leader in the

graphics segment until Sony’s entry in 1989.

The case study is set in 1989 and covers the events from August 1989 to

May 1990. These 9 months proved to be exceedingly challenging for

the Barco company. In unit volume terms, according to the most recent

market data in 1988, Barco had a 25% share, Sony 45%, Electrohome

14% and NEC 8%. Sony was the clear leader in Data while Barco led in

Price

Scan Rate

30K$

25K$

20K$

15K$

10K$

Graphics

BarcoSony

Expected Sony 2

Expected Sony

Digital Upgrade

Digital UpgradeBG400 (72) BG800 (90)

BD700 (64)

BD600 (45)Sony tube

Data

Figure 6.6 Barco product development roadmap, 1988

110

Graphics Applications in which Sony had no product. Barco defined its

products on a single technology – scan rate – and based its product

development roadmap entirely on this technology. While this had served

Barco well over the years, it meant that the products were limited in some

applications. Barco’s success had also rendered the company somewhat

complacent, believing to a degree that they ‘owned’ the market, blinding

them to their vulnerability to a well-resourced competitor and rendering

them unresponsive to their customers’ needs.

In particular Barco lacked the technology to enter the demanding high

end of the graphics market, and had limited development, manufacturing

and distribution resources.

Market Intelligence indicated that Sony planned to enter this market with

a new product at the lower end of the market. Anticipating this, Barco

had put in place a priority product development programme to upgrade

their BD600 data projector to a higher scan rate and higher performance.

This committed all the company’s development resource at that time.

There was no great urgency to upgrade the graphics series as Sony was

not expected to enter this market for some time. Figure 6.7 summarises the

market situation.

At an industry exhibition in August 1989 Sony unveiled their new 1270,

capable of scanning at 75Khz and positioning it as a ‘superdata’ projector

in the high end graphics segment which Barco could not at that point

enter. No price was announced at that time. This product introduction

created huge interest in the market and tremendous consternation in

Barco management.

In particular, it revealed that the Barco roadmap was completely wrong,

based as it was on the assumption that Sony would not enter the market

with a product build with quite different and more flexible technology! Two

alternative scenarios – at different prices – were identified, both of serious

concern to Barco management:

In Scenario (a), Sony prices the 1270 at around $20,000. Given the

performance, this will challenge Barco’s BG400 and will undoubtedly



111

Figure 6.7 Alternative Sony pricing strategies

TCO

TCB

Barco

SonyExpected Sony

Largely unaffectedBD600 (45)Data only

30K$

25K$

20K$

15K$

10K$

VEL defined byScan Rate

Loss of 30%

New VEL, defined by ScanRate, brightness, imagequality and resolution

BG400 (72)Graphics only

1270

BG400 (72)Graphics only

Loss of 60% ofBG400 share

Some loss ofBD600 share(b)

(a)

1270

TCO

TCB

BD600 (45)Data only

30K$

25K$

20K$

15K$

10K$

gain share at its expense. At this price, however, BD600 will suffer little ill

effect. Note also that Sony has, with the 1270, defined a new value line

below and to the right of Barco’s line. In Scenario (b), the situation is

even worse. At a launch price of $15,000 Barco will lose share from both

BD600 (customers will at this price be willing to trade up to a much better

112

product) and potential customers of BG400 will hardly believe their luck

and probably move en masse to 1270, shattering Barco’s traditional

leadership in this sector.

Either action would make any upgrade to the planned BD700 irrelevant.

The only course of action available would be to crash develop the BD800,

and do so before the next major trade show (Infocomm, 1990). This was a

heroic effort and paid off, because BD800 stole the show!



113

Chapter 7: The Challenge of Value

“Stories are such a powerful driver of emotional value that their effect on

any given object’s subjective value can actually be measured objectively.”

(Walker and Glenn, 2012)

7.1 What is Value – and Why Does it Matter?

Many pricing problems are not really pricing problems at all. Building

a price is largely a mechanical, mathematical procedure, seasoned

with mature business judgement. Effective price setting depends on our

ability to reach a proper understanding of what value actually means

in a given commercial context. Even in the same market segment,

different customers will have quite different perceptions of the value

we offer. Some will reject our propositions; some will reluctantly accept

them; others still will embrace our offer fully and seek to work with us to

develop it. In pricing work, we need to recognise the large variation in

the acceptance of our value proposition and consequently the options

we can have in developing pricing strategies. Even more importantly, we

need to recognise that we may need to adjust the proposition for different

customers in the same segment, or craft completely different ones for

different segments. Once this is clear pricing decisions become easier.

Most businesses today are confronted with breath-taking technological

change, intensive competition from existing competitors and new

entrants, and ever decreasing lifecycles. These conditions have resulted, in

many industries, in premature commoditisation (look back at Chapter 2 to

refresh your memory of commoditisation). In order to preserve their market

share, companies often reduce their prices either voluntarily or as a result

of insistent buyer pressure. The result is declining revenue, margin erosion

and business failure. Nevertheless some companies manage to thrive.

These companies identify and use customer value as a strategic tool.

What often presents as pricing problems, in reality, are failures to come to

grips with the underlying value issues.

114

A deep understanding of customer value helps us to make much better

decisions, not just in pricing but in all areas of the business. In one sense,

every price paid willingly by a customer is a value based price. If there

were no value to that buyer there would be no sale. We can achieve

much better prices by creating products and services which deliver much

better value, or by making customers aware of the real value we deliver

to them. This is true, whether we are pricing on cost or competition or

deploying value-based pricing.

Value is tricky to define and conceptualise. This uncertainty and ambiguity

often creates difficulties both inside organisations and in communications

with customers. Failure to identify the value created, and to present this

compellingly to customers, reinforces commodity perceptions and fuels

demands for further and deeper discounts. This requires new and different

thinking in which the focus of attention is moved away from product

technology and specification to how products and services impact on

customers at economic and emotional levels. When businesses make this

transition, margins increase and market shares are protected.

Have you or your sales people heard any of these?

• “All products in this market are exactly the same – including yours…”

• “This is a commodity market now…”

• “You’ll have to drop your prices if you want to keep our business…”

• “There is no way you’ll get a penny more per litre than your

competitors…”

Every one of these assertions was made within the last few months of

2012 in the context of a sales interview. Every assertion was made directly

to sales people who promptly passed the problem ‘upstairs’ to product

managers or other business managers. In every case the supplier’s market

share exceeded 50%. In every case managers were almost completely at

a loss to know how to deal with the situation. (Macdivitt, 2013)

Continuing economic uncertainty has engendered the conviction that

the only solution to a pricing problem is to yield to customers’ increasingly

unrealistic demands, drop price and hope for the best. This is wrong.

The Challenge of Value


115

Dangerously wrong. Because managers and sales people do not know

how to respond and, critically, lack confidence in the acceptability of

their pricing. They feel that the only solutions are either to walk away or to

discount – usually deeply. Discounting has become a default response to

price objections. Customers know this! Deep discounts make things worse,

not better, and set up the discounter for more of the same. Walking away

creates an opportunity loss.

There are alternatives. The above companies were not, and are still not,

commodity suppliers. Each is still a leader in its segment with a market

share of between 3 and 5 times what one would expect in a genuinely

commoditised situation. But their salespeople had been brainwashed by

their customers into believing that their prices were too high, that their

products were commodities and not worth the prices being charged,

and that they would lose out if they did not drop their prices right now.

Because these companies learned how to identify and use value, their

customers are still buying, often at higher prices than before. The buyer’s

assumptions were completely specious – opening fusillades in a war of

value attrition!

Most businesses today are seeking to protect the revenue, profits or share

that they have already achieved. Developing a value argument for them

is a strategy to reverse margin erosion. To achieve this, they must persuade

their customers of their differential value. These companies employ

value as a means of fighting back against the torrent of demands for

discounting. This is why value is important.

7.2 The Value Triad©

The Value Triad© (Macdivitt and Wilkinson, 2012) is an innovative

approach to value identification and measurement. It can help turn

around the kinds of situations described above and provides an effective

counter-argument to assertions that a particular vendor’s products are

commodities.

The concept of value is of importance in all aspects of business – not

116

just marketing. Peter Drucker, a well-known management guru once

commented.

“These are the satisfactions the customer looks for, values, and needs.”

(Drucker, 2007)

Creation of customer value, through innovation driven by deep customer

insight, is the whole reason for existence of a business. In pricing it applies

both in business to consumer and business to business contexts. I urge the

reader to think about how the Value Triad© concept applies in your own

organisation.

The Value Triad© is a practical tool which helps managers capture

optimally the depth and breadth of meaning embedded in ‘value’. By

building a real focus on customer value into product development and

service delivery processes, companies create a solid basis for creating

differentiation – doing something different in a manner that really matters

to the customer. By clearly focusing on customers’ needs and pain points,

novel ways of serving can be revealed.

The Value Triad© helps us to identify the factors critical to the customer’s

purchase decision, and how these can be met effectively. Value Triad©

thinking helps users build powerful value propositions and construct

prices based firmly on how products impact on customers’ businesses

economically and decision-makers emotionally. A price developed in

this way need not necessarily be a Value Based Price as I define it later

in this Handbook (see Chapter 8) but its construction is based soundly

on value – and its effective negotiation depends completely on a deep

and practical understanding of value to the customer – and how this

is perceived by the customer. Value Triad© analysis lies at the centre

of sales, marketing, product management and pricing. It is a unifying

concept and can bring all of these important functions together.

The three elements of the Value Triad© are Revenue Gain (RG), Cost

Reduction (CR) and Emotional Contribution (EC). Revenue Gain and Cost

Reduction focus on the functional, tangible, objective and inherently

measurable elements of value. Emotional Contribution, as its name implies,



117

RevenueGain (RG)

EmotionalContribution (EC)

Cost Reduction (CR)

CustomerValue

Figure 7.1 The Value Triad©

focuses on how less tangible, more subjective and somewhat less readily

measurable factors contribute to the purchase decision.

Revenue Gains (RG) refer to the increases in customer revenue resulting

from the application of products and services. Cost Reduction (CR) relates

to how products and services reduce customers’ costs. The key issue is

that output value to the customer is not compromised. Finally Emotional

Contribution (EC) is in general linked closely to the ‘feel good factor’ –

e.g. reduction of ‘hassle’, peace of mind, increased confidence, greater

safety, aesthetic appeal, trust, self-esteem, reduction or elimination of

psychological risk, etc.

Executives’ opinions around tangible factors are generally closely aligned.

The same executives, however, may have widely differing opinions

about what affects them, personally, from an emotional perspective.

Consequently, emotional impact is not absolute in the same way as are

CR or RG.

Different metrics apply to different people and have different weightings.

Even for an individual the same metrics will have quite different weightings

at different times depending on mood, personal confidence, anxiety and

other psychological states. Thus EC intangibles can be difficult to quantify.

But they are not impossible to quantify (Hubbard, 2007).

118

In some circumstances, and using special marketing research techniques,

Emotional Contribution can be estimated (Lipovetsky et al, 2012). It is

important that we at least try to make this assessment because emotional

considerations can have a profound (albeit covert) impact on the overall

attractiveness, or even acceptability, of a proposal. An important aspect

of EC is psychological risk. Even when all the value elements are lined up

in a row, risk factors may scupper the deal. Significant Objects (Glenn and

Walker, 2012) is a fascinating book containing stories about mundane,

everyday objects. These well-crafted stories enhance the economic

worth of these articles enormously. A huge part of building both value

propositions and creating collateral is to build such stories for our own

products and services.

7.3 Value Drivers

Value drivers (Anderson & Narus, 1998, Macdivitt, 2012) are those factors

which ultimately lead a buyer to identify a preference and make a

purchase decision. In a given context there may be several such drivers

each with different ‘weightings’ in the choice process.

Tangible driversValue Drivers that are readily measurable or quantifiable. In Value Triad

thinking, these include Revenue Gain and Cost Reduction elements.

Intangible driversValue Drivers that are less easily measurable. In Value Triad thinking,

these include Emotional Contribution elements.

Table 7.1 Tangible and intangible drivers

Table 7.1 defines tangible and intangible value drivers. The best way to

make this happen is to ‘map’ the clever parts of the product offer to the

important parts of customers’ needs.

This task goes well beyond the sales team and should engage the

attention of marketing, product management, product development,

and design people at the very least. In short, value should run through

the whole value chain, like a golden thread. In this context the Value

Chain is all the value creation activities undertaken in a business to create



119

sustainable customer value. Value Chain Analysis is a hugely important

topic in business and is one with which marketing professionals must

become deeply familiar (Porter,1998).

Let’s drill down into each of the elements of the Triad. What follows is not

a comprehensive list and you will be able to identify others relevant to

your industry or business. Indeed you should do this. There are potentially

hundreds of Revenue Gain (RG),Cost Reduction (CR) and Emotional

Contribution (EC) items. For any given situation we need to be sure that

the items we identify have real traction with the customer given his

situation. Ultimately what most customers are looking to achieve as the

result of purchasing products or services is a combination of these. In

general, customers are not hugely interested in technical specifications or

even technology (OK, so there are some!). The task of sales and marketing

is to identify the ones that matter to a given stakeholder and to use these

to create a compelling value proposition to stimulate their interest. Some

typical examples are listed below:

Revenue gain

• customers’ ability to negotiate higher prices with his customers

• greater competitiveness leading to greater market share

• enhanced output or productivity from operations

• reduced time to market

• shorter time to money

• shorter delivery time to customers

• better yields from manufacturing processes

• reduced or eliminated downtime

Cost reduction

• reliability in use, avoiding costly downtime and repeated start-ups

• ease-of-use, enabled by user friendly, intuitive product design

• the product lasts longer and is more robust than other equipment the

customer may have used previously

• the equipment is easier and quicker to service or repair, spare parts

are more readily available and can be installed by the customer’s

own personnel

120

• storage costs are reduced or eliminated because we are able to

provide the customer with frequent deliveries, just in time

• training costs are reduced or eliminated because of an intuitive

machine-user interface, user-friendly manuals and a helpful website

Emotional contribution

• Peace of mind – instilling into the mind of the customer that our

solution to this problem will work reliably and without inconvenience

• Comfort – as a consequence of ergonomic design, our product is

easy to use, minimises fatigue and can be used by operators for

extended periods

• Aesthetics – the visual attractiveness of the product which might be

the result of a combination of non-tangible factors such as colour,

shape, ‘footprint’, and so on

• Hassle – managers are very busy people and often lead stressful

business lives. Anything that we can do to minimise the stress is

bound to be beneficial

• Risk – we can measure economic and physical risk in mathematical

terms using tools such as Monte Carlo simulation. Monte Carlo

simulation is a statistical tool which allows you to model all the

possible outcomes of a business decision and assess the impact

of risk. In particular it permits you to make better decisions under

uncertainty. Go to http://www.palisade.com/risk/monte_carlo_

simulation.asp for more information.

In the context of EC, we are referring primarily to psychological risk. I

elaborate on this at the end of this Chapter 7, The Challenge of Value.

• Relationships – how easy we are to deal with as a supplier, how

responsive and supportive are our people, especially in customer

facing roles, transparency of our billing practices and reasonableness

of our commercial terms and conditions all contribute to fruitful business

relationships. Some of these factors are quantifiable. Others are not.

But relationships between vendor and customer might outweigh the

economic aspects of our offer

• Trust – of all the elements of EC, perhaps trust is the most important.

Have we, and all the other members of our team, built a trust based



121

relationship with the client? The more a customer trusts us, the more

information they will share, the more they will accept the things we say

and the assertions we make. This, truly, is the most valuable of all the

EC elements

7.4 Value Analysis using the Value Triad©

There is a five step process to identify the real value of your offer. Each

step in this process is illustrated using a typical B2B scenario.

Value analysis process

Step 1: Design the Value Triad© for your customer organisation

Step 2: Summarise the role and requirements of each stakeholder in

the buying process

Step 3: Undertake a So What? Analysis for each important stakeholder

Step 4: Assess the economic contribution of each driver on the

business and the emotional impact on each stakeholder

Illustrative scenario

A company sells lighting systems and assemblies to Other Equipment

Manufacturers (OEM) (third party) of automobiles. The products are very

clever. They can help drivers see round corners and when integrated with

satellite systems are even able to give the driver forewarning of significant

changes in road curvature and topography.

New generation systems combine Xenon, LED and Adaptive Front Lighting

technologies and are equipped with sensors that detect ambient light

levels. They switch on automatically to the correct light intensity for the

conditions and switch off again when not required. They are made with

robust materials and employ efficient designs that mean that the average

time before failure is longer than competitive products by a matter of

months. Until now, the company has been selling these on a cost basis

and managers are convinced that there is more value to the products

122

than they seem able to capture. The company sells directly to OEMs

(i.e. vehicle manufacturers like Ford, BMW, Peugeot and Volkswagen) to

install in new vehicles. The company also sells into the aftermarket to parts

suppliers and vehicle service businesses. For the sake of this illustration, let’s

focus on the OEM.

Step 1: Use the Value Triad© to identify “high level” customer value

Think through all the possible value items to the customer. Work through

each of the Triad elements in turn, doing your best to leave nothing out.

Value triad element Value statements

Revenue gain

Novel technology makes car more attractive to channels

and end-users thus increasing market share and unit

price.

An advanced lighting package enables the OEM to offer

a premium priced option for wealthier customers.

Cost reduction

Last longer than competitors so do not need to replace

so frequently.

Easy to fit and replace so does not not require a lot of

expensive workshop time.

Helps avoid night time collisions and all the costs and

inconvenience this causes.

Emotional contributionBetter night vision improves safety.

Prestige.

Table 7.2 Using the Value Triad©

Step 2: Summarise the role and requirements of each stakeholder and their influence in the buying process

Who is interested in this list of product attributes? Clearly the end-

customer/driver is one interested party. So also is the product designer

who is looking to incorporate leading edge specifications into his product.

Other executives may also be interested. A third group might be the

dealer who sells and services the new vehicle after sales.



123

Table 7.3 Stakeholder Influence

Much of the information required to populate this table will come from

the salesperson. The purpose here is to identify who the principal decision-

makers are in the buying process, and to ensure that their needs and

expectations are properly considered. If a key decider is forgotten about,

it means that an important element of value analysis is omitted. This could

lead to the wrong value proposition being delivered and also the wrong

price being calculated.

Stakeholder Role RequirementsInfluence (%)

Product

designer

To ensure that the vehicle

specification is met efficient

design employing the best

materials and technology

components

Full and detailed

knowledge of the

differential advantages

of our offer compared to

alternative materials and

components

25%

Dealer

warranty

manager

To ensure that all valid

warranty claims are

addressed in good time

and to manage the

demands within budget

Materials and bought

in components perform

at or above stated

specification

35%

Procurement

To ensure that all

purchased items conform

to specification at or better

than allocated budget

That the best balance

between cost and value

is achieved in line with

the company’s strategic

objectives

25%

Marketing

To ensure that the

product meets defined

specifications as called for

in business case

The ability to create

attractive value

propositions and

marketing collateral to

meet revenue and profit

targets

15%

Others? etc. etc.

124

Let’s eavesdrop on the salesperson’s conversation with one of these

interested customers – the Dealer Warranty Manager – the executive in

charge of managing warranty claims through the dealer network.

Salesman: Our new lighting assembly is built with cutting edge

halogen lamp technology and equipped with sensors

which can automatically adjust to ambient light

conditions.

W/Manager: So what?

Salesman: It’s safer for the driver because they will have the right

level of illumination at all times.

W/Manager: What does that matter to me?

Salesman: Well, it’s made with state of the art technology.

W/Manager: So it is a new concept which can go wrong at any time?

Salesman: Yes, it is new and innovative but it’s been fully tested.

W/Manager: So you are guaranteeing it won’t go wrong and cause

my people all sorts of problems sorting it all out?

Salesman: Well, no but it’s really cool for the customer.

W/Manager: What do I care?

This dialogue is not going anywhere fast. The Warranty Manager frankly

does not care anything about the ‘coolness’ of the driver’s experience.

Why should he? He cannot afford to own this car personally, so this

assertion is completely irrelevant. He cares more about the leading

edge technology, but not in quite the way the salesperson hopes. This

manager sees new technology as a source of hassle, based on his

years of experience repairing clever components that have failed after

a few days’ use. So this is not a really compelling value argument for

him. The salesperson has not thought the whole thing through from this

stakeholder’s point of view.



125

Attribute So What? So What? Decision

Innovative

product design

Can help drivers see

round corners

Neutral for this

stakeholderDon’t care

Very latest in

halogen lamp

technology

Much greater

illumination of road in

dark conditions

New technology =>

teething problems =>

costs to replace => cost

and hassle

Negative for this

stakeholder

Don’t like –

will cause

me hassle

and increase

repair costs

during

warranty

period

Ambient light

sensors

Switch lights on when

conditions warrant

Same as above

negative for this

stakeholder

Same as

above

Made with

robust materials

More resistant to road

use wear and tear

More durable =>

lasts longer => less

replacement

RG, CR

Like it

but need

evidence/

proof

Plug in designEasy and quick to fit

replacement unit

With competitive units

usually hard to do in

workshop. Saves time,

money, hassle

RG, CR, EC

Like it but

need proof

The average

time before

failure is months

longer than

competitors’

products

Replacement during

warranty period much

less likely

Can reduce warranty

repair incidents saving

time, money, hassle.

Also means time saved

can be used for other

things

RG, CR, EC

Like it but

need proof

He has failed to prepare a really solid, credible argument for this

stakeholder and not surprisingly his presentation is a disaster! He should

really have done the analysis in Step 3 below.

Step 3: Undertake a ‘so what?’ analysis

Use the So What? Analysis and the Value Triad© framework to examine

things from the Warranty Manager’s perspective:

Table 7.4 So what? analysis – Warranty Manager

126

We do this analysis for each stakeholder in the customer’s organisation

(in B2B). For B2C it is a lot easier…we can go up a level from consumer

to segment. If the segmentation has been done correctly, and we have

really tightly profiled value-oriented segments, the applicable value drivers

for the consumer will be identical or very similar to those of the segment to

which he belongs.

Some of these are economic in nature (Cost Reduction, Improved

Operational Efficiency) and others are more psychological/emotional

in nature (Reduced Hassle and Peace of Mind). This set of drivers is quite

different from those of the Chief Designer and different again from the

end-customer’s perspective.

So, what does the Warranty Manager really want, bearing in mind the So

What Analysis output? Let’s try again.

Salesman: Our new lighting assembly is built with cutting edge

halogen lamp technology and equipped with sensors

which can automatically adjust to ambient light

conditions. This means a great experience for the driver.

It also means failure is almost unheard of within the first

two years.

W/Manager: How often does the lighting system fail?

Salesman: The chance of a system failing is less than 0.005% within

two years. So you could see 200 cars without a single

warranty claim based on lighting system failure.

W/Manager: So what?

Salesman: Because of the way the system is designed, not only is

the failure rate lower than any competitive system, but

it is quick and easy to replace. Just pull out and plug a

replacement component back in again.

W/Manager: (Thinking)…So you are saying it can save my people

time in dealing with warranty replacements and

paperwork?

Salesman: Absolutely. Here are some independent studies…



127

This is much better. Whether this imaginary conversation would play out

this way in the real world does not really matter – there are obviously other

factors at play. What does matter – and matters profoundly – is that a

competent value analysis must be undertaken before making any client

contact. Or, for that matter, before creating any value proposition or

developing any marketing collateral.

Step 4: Assess the economic contribution of each driver on the business and the emotional impact on each stakeholder

Of all the Value Drivers listed in Section 7.1 only five have traction with this

particular buyer. Do not try to short-circuit this analysis, especially in B2B

work. Many individuals have an input to a purchase decision (especially

for a first-time purchase of something new or innovative). Your proposition

must have something tangible (and intangible) for each decision-maker,

quantifying this impact wherever possible:

• Decreased costs (the Warranty Manager must work to a budget,

after all)

• Improved operational efficiency (this will be part of the pushback

from his customers in the channel, associated with some level of

hassle, too, no doubt)

• Reduced hassle

• Greater peace of mind (knowing that he has eliminated one

important and recurring problem with the right purchase)

• Reliability

Let’s drill down a little into these five Value Drivers.

If you are not very mathematical, you might find it easier to understand

and use Word Equations (Anderson, Narus and van Rossum, 2006). A Word

Equation is an expression in words explaining how to translate Value Drivers

into quantified economic value. The economic impact of tangible value

drivers can be estimated in this way. Intangibles are rather more difficult

to quantify, and here we would use tools like Conjoint Analysis and von

Westendorp to assist us here (Lipovetsky et al, 2012). These are specialist

pricing research tools and are beyond the scope of this Handbook,

although references are provided to good source material.

128

Value driver Route to quantify

Decreased costs

Previous year’s warranty costs minus this year’s warranty

costs

= total number of claims x average cost per claim last year

minus total number of claims x average cost per claim this

year

Improved operational

efficiency

Number of hours spent on warranty work last year minus

number of hours spent on warranty work this year

Reduced hassle Difficult to quantify objectively

Greater peace of mind Difficult to quantify objectively

Table 7.5 Estimating economic improvement



129

Chapter 8: Value-based Pricing

“I can’t change the fact that my paintings don’t sell. But the time will come when people will recognise that they are worth more than the value of the paints used in the picture.” (Vincent Van Gogh, 1853-1890)

Value Based Pricing (VBP) is a relatively recent, and very important addition to the pricing toolbox. Unlike other pricing methods, VBP focuses on the benefits that buyers gain through the purchase of a supplier’s products or services. The price charged to the customer is calculated from the estimated economic and emotional gains (see Chapter 7 in which I define fully the idea of Value.) VBP is used today in manufactured goods, services, FMCG and in retail.

8.1 About Knowhow

By way of illustrating what Value Based Pricing is all about, let’s start with a simple, but fairly typical scenario.

“Okay, Dave. I’ll be right there.” As Jack put down the phone and made his way to No.2 building he reflected on his long and successful career as production director at the Zenith chemicals processing complex. Dave was his most recent employee (and the brightest – with a brand new PhD in chemical engineering), but he still seemed quite unable to understand how this process plant worked. After checking a few dials and turning a few control valves the whole operation started up again. That same afternoon Jack was due to go to his retirement presentation. In three days his 35 years’ service would come to an end. At the retirement event the CEO said: “Jack, no one knows this place like you do. If we ever have any problems, I will be sure to give you a call. Would you be willing to help?”

“Of course”, Jack had said. “No problem!”

A few days later the phone rang and it was Dave again. “Jack there is a blockage in number three reactor. Can you come and sort it out?”

130

As Jack went through the main entrance he was met by his ex-assistant

and went straight to the reactor. The CEO was already there, striding up

and down impatiently.

“Jack – please! Get this thing working again. Fast.”

Jack did his usual walk up and down, looked at a few dials, tweaked a

few valves and knocked on a few pipes. He made one chalk mark and

told Dave that if he opened up the panel right where the chalk mark was

placed, he would be able to trace the blockage, resolve it quickly and

get the whole process working smoothly again.

The CEO said “Thanks Jack. Please just send in your invoice.”

A day or two later the CEO was on the line, shouting down the phone.

“How on earth did you come up with £20,000? I want an itemised bill.”

Jack, of course, complied. His invoice showed:

For making one chalk mark – £1

For knowing where to put it – £19,999

The story might be made up but the message is very clear. What Jack

possessed was a lifetime of knowledge and experience. He knew, better

than anyone else, that if the production processes were to go off-line

for any more than a few hours the cost to Zenith would be hundreds of

thousands of pounds. Knowing just exactly where to place a chalk mark

represented Jack’s unique expertise – expertise which nobody else in

Zenith possessed and which took decades of experience to accumulate.

Jack did not underestimate the value of his service to Zenith, and held

his ground when challenged. Do you underestimate the worth of your

products to your customers? Do you capitulate when a discount is

demanded? Or do you do the right thing and hold your ground.

Value-based Pricing


131

8.2 What is VBP?

In this Chapter we will look at the process for creating a Value Based Price.

If a Martian asked us what Value Based Pricing is, this is what we would

say:

“In Value Based pricing, we think carefully about how our product benefits

our customer in economic and emotional terms. We then work out exactly

the economic worth of each of these benefits, where we can. We then

build our price around these numbers.”

‘Simples’. Well, actually, no, not all that ‘simples’. There is actually a bit

more to it than that. Let’s drill down further with a rather more robust

definition of Value Based Pricing.

A Value-Based Price is designed and communicated such that all parties

understand, recognise and accept the distinctive worth of products and

services purchased in the transaction and participate optimally in the

gains created by their use (Macdivitt and Wilkinson, 2012).

There are a number of important elements in this definition:

1. VBP is designed – not invented. It is not plucked from the ether

or hallucinated in a dream! It is designed rigorously from a deep

understanding of the economic and emotional impacts of your

product or service on the customer’s life or business.

2. It is communicated in terms of the customer’s context – This

communication is done by a salesperson, supported by

properly crafted collateral. This demands superior sales skills and

MARCOMMS materials that focus on customer impact rather on

sterile lists of specifications.

3. Understanding is important – the offer may be a bit more complex

to explain because the argument is not just about a number (price)

it is about impact. The customer needs to recognise this argument

and acknowledge and accept it. Without that you cannot progress.

Note that some customers will resist your attempts to explain value,

132

bringing discussion back time and again to price. These are not

customers with whom you should discuss VBP. It is pointless and a

waste of time.

4. The distinctive worth of our product is our compelling value

proposition based on our differentiation – if we have no

differentiation, it is hard to see how we can price on differential

value.

5. Optimal participation in the gains created – VBP must lead to a

win-win (or even win-win-win if we are working through channels).

This is not about ‘gouging’ the customer. It is about ensuring that he

gains from the transaction what he wants or needs, and creates a

platform for future win-win transactions. Where we create a win-

lose, in reality we end up creating a lose-lose further downstream!

Value Based Pricing is different from all other pricing methodologies

because it seeks explicitly to build the price up from the sum of the

individual economic gains accruing to a customer from the purchase and

use of your product or service.

We can really make this calculation only if the product or service offers a

demonstrable (and measurable) differential advantage compared to the

customer’s next best alternative. This calculation is at the heart of VBP and

is the source of the real superiority of this approach to pricing.

The key elements of constructing a VBP are:

• Verify that there are indeed quantifiable differential advantages and

that these are substantial enough to justify a VBP approach.

• Use the Value Triad to identify, in a given scenario, the economic

and emotional enhancements that the customer can realistically

gain from your product.

• Calculate the Revenue Gain (RG) and Cost Reduction (CR)

elements, and wherever possible make a realistic assessment of

Emotional Contribution components.

• Use the VBP Worksheet to create the VBP in this scenario from the

various advantages offered by the product.

Value-based Pricing


133

A little story about value based pricing.

Alan and Rachel had just purchased their dream home in a village in

the North of England, just a few miles south of the Scottish border. The

house was beautiful with plenty of room for the family. It was set in its own

grounds consisting of 1.5 acres of mature, well maintained landscaped

garden. At the rear of the property were another four acres of unspoiled

woodland currently owned by the local council and which the council

was willing to sell. Rachel had longed to have access to woodland like

this, and it was just too much to resist. The house was to be both a home

and an investment and their ‘final’ home once Alan had retired from

his job as a sales vice president. Alan spent most of his time working

abroad and, when not travelling to various factories, lived in a small flat in

Amsterdam.

They were very friendly with their next-door neighbours, Paul and Liz,

who owned a similar property. The woodland extended to the rear of

their property also. Paul was a barrister and spent many months of the

year in London. Paul and Liz had similar ambitions for their retirement.

Alan obtained a quotation from the local council for purchase of the

whole parcel of woodland. The price of £3000 an acre was confirmed

as reasonable by a local estate agent. Alan put in motion the purchase

process, and submitted a bid for £12,000 for the full four acres.

Unknown to him, however, Paul had done exactly the same, offering the

council the same sum. Over the next few weeks, each tried to outbid the

other and when the price finally reached £24,000 per acre, Alan pulled

out, much to Rachel’s severe disappointment. Paul finally purchased the

land for a total of £96,000. Relationships between the couples were now

distinctly frosty.

A few months later, Alan received a call from Paul offering to sell two

acres, and could Alan make him an offer? Initially, Alan was tempted

to tell Paul to ‘get lost’, but Rachel persisted and Alan made an offer

of £3000 per acre. This was of course, and as expected, rejected out of

hand. When Alan asked what Paul would accept he was told £48,000.

Alan’s immediate response was to say “Forget it! The original valuation

134

was £3000 and “while I am happy to go a bit higher than that, £48,000 is

completely out of the question”.

Paul’s response completely amazed Alan: “Get your house valued again,

firstly without the woodland, and then again with the woodland attached.

When you’ve done that, come back to me and we’ll talk again”.

Convinced that his bid would not change, Alan agreed to do so. The

estate agent who had initially valued both the house and the woodland

separately now re-valued both. The initial valuation of the house at

£450,000 had barely changed. But with the woodland added, the surveyor

estimated a fair sale price of just over £950,000! Astonished, Alan paid

Paul, the very same day, a cheque for £48,000 making an immediate

profit on paper of well over 900%.

This is a true story, although of course the names of individuals, the

figures and the geography have been altered for obvious reasons. It

demonstrates how a value-based approach to pricing can be very

attractive. The key issues are:

• the elements of the property when valued individually were £450,000

for the house plus £48,000 for the woodland.

• each part of the package represents a ‘specification’ market value.

By linking both house and woodland as part of a ‘bundle’, the whole

nature of the package became different... and (almost) unique.

• the winners in this little scenario were Alan and Paul. Paul’s insight

led to both parties gaining enormous advantage and a real win-win

outcome.

• the loser was the local council. By valuing the woodland on a per

acre basis they failed to identify the real commercial value and left

a lot of money on the table.

Some thought might have resulted in a much better deal for them and a

win-win-win situation.

The epilogue came a few weeks later when Alan related his experience to

a colleague in his office.

Alan commented ruefully that he was beaten to the deal. He was willing

Value-based Pricing


135

to accept that it was by a lawyer. But if an estate agent had told him

(a very experienced sales vice president!) how to sell, he would have

retired on the spot and spent the rest of his life playing golf! By now, Alan

and Paul had resumed their friendly relations and, more importantly, the

couples resumed friendly relations.

8.3 How Does VBP Match Up Against Conventional Pricing Methods?

Cost-Based Pricing and Competition-Based Pricing are used in almost every

company throughout Europe and the United States. These methods have

been in use for decades and are familiar to most business people.

As we saw in Chapters 5 and 6 in Cost-Based pricing we total up the costs to

us of delivering a service or creating a product. We add on a percentage

(which we call our ‘markup’). This creates a price. Easy and quick. In

Competition-Based Pricing we try to position the product in line with other

similar competitive products being offered to the market at the same time

and, based on specifications, make a judgment about where the price

should be pitched. If our product is a little better, we price it a little higher. If

our product is not as good as the competition, we price it a little bit lower.

Most companies use both Cost- and Competition-Based approaches in

making pricing decisions. This calls for a bit of judgement, but it is, at least

in principle, also easy and quick. The big problem, however, is that neither

of these approaches captures fully the value delivered to customers. We

may have immense experience or unique expertise which benefits our

customers.

But by positioning our price at around the average in the market we are

giving away far, far too much, and giving customers a fantastic deal. Basing

it on cost alone may be even worse! We could do so much better.

A Value Based Price is calculated on the basis of the advantages that our

product or service delivers to the customer.

This is the only pricing methodology that captures value and usually

136

generates superior economic returns. Even though this approach to

pricing can, when used properly, generate much greater profits and

better customer relationships than conventional pricing methods, relatively

few companies are yet using VBP. Nevertheless, the number of users is

growing as managers realise that conventional methods are working less

and less well and as they seek ways to improve wafer thin margins.

There are a few critical points to be aware of in VBP:

• First, and vitally important, we need to be able clearly to differentiate

our products or services from those of the competition. If we have no

clear differentiation then we simply cannot claim superior customer

value. So we cannot possibly price on differential customer value. If

we cannot find some meaningful differentiational advantage, we

run the risk of commoditisation and all the misery that goes along

with it.

• Secondly, we need to know a great deal about the context of

our customers’ lives, businesses or markets. Without this information

it will be very difficult to identify relevant value or to quantify the

advantages that we bring. This demands both research and a good

sales process to capture and validate this information.

• Thirdly, since each customer is different, our products and services

will offer different advantages to each. In each case we will charge

a different price. It is also possible that, although the price is the

same, the underlying ‘deal’ is different.

• Fourthly, do not lose sight of the fact that any product that a

customer purchases represents value to him. He might be the only

one on the planet willing to pay. Or he may be a representative

member of a whole category of customers. Just because we do not

understand this value does not mean that it is not very real or very

compelling to the buyer. Our job is to make the effort to understand

this value.

8.4 Constructing the Value Based Price

In Chapter 7 I introduced the Value Triad© as a tool to analyse the real

value that clients offer. This analysis is essential if we want to be successful

Value-based Pricing


137

in VBP. Customer Value may be related to reducing costs, to increasing

productivity, to reducing hassle or to improving peace of mind. The first

two elements of the Triad – Revenue Gains and Cost Reductions – are

generally relatively easy to quantify. It is more difficult to put an economic

value on Emotional Contribution. That does not mean that Emotional

Contribution is unimportant. Of course not! We use it as part of our selling

argument.

There is another important element in the make-up of the VBP – the

Reference Price. This is the price that the customer is accustomed to

paying for a product or service similar to the one that you are offering –

i.e. the Reference Product. It would be the one he would choose if your

option was not available – his ‘next best alternative’, if you will. If our

product offers nothing more than the reference product then there is

neither Revenue Gain nor Cost Reduction. Therefore we cannot use VBP.

Figure 8.1 shows how a VBP is built up from these building blocks.

Price

AddedValue

ReferencePrice

Value Based Price

EA

RG

CR

Figure 8.1 Building the value based price

138

We need to know quite a lot about our customers and their businesses to

be able to assess how our product or service meets their needs, enhances

revenue streams or helps eliminate costs. However once we have this

information, and we are able to justify our calculations, then it is pretty

straightforward to estimate a target VBP.

8.5 Assessing the Economic Value to the Customer

Perhaps a simple (fictitious) example will make the process clearer.

A company has developed a new earth-moving machine for

construction customers. The typical customer is already using a

competitive machine which is coming to the end of its useful life. The

replacement price is £100,000.

Over its lifetime that machine is known to have generated revenue of

£500,000. Fuel costs, spare parts and maintenance labour were £75,000,

£35,000 and £60,000 respectively (and this is not expected to change

with a re-purchase). Our machine is built using different technology

and over its life is expected to generate £750,000 in revenues (this

figure comes from field trials). Fuel, spare parts and maintenance

labour costs are £68,000, £30,000 and £34,000 respectively over the life

of the equipment. The Revenue Gain – the additional productivity our

machine offers the customer compared to the alternative – is an extra

£250,000; the cost reduction is £38,000. So the total Value Based Price

we can justify on the basis of superior performance and cost reduction is

£388,000. We calculate this using the formula:

Maximum Value Based Price = Reference Price + Revenue Gain +

Cost Reduction

Value-based Pricing


139

Competitor machine

Our machineOur value added

Comments

Price £100,000

Revenue £500,000 £750,000 £250,000

Better

performance

leads to better

productivity

Costs:

Fuel £75,000 £68,000 £7,000 9.3% less fuel

Spare Parts £35,000 £30,000 £5,00014.3% fewer spare

parts

Maintenance

Labour£60,000 £34,000 £26,000

43.3% less

maintenance

labour

Total Added

Value£288,000

Maximum VBP £388,000

Table 8.1 Calculation of VBP

Our machine is actually more robust and will last at least two years

longer than the alternative. Certain aspects of product design, mostly

to do with ease of access for repair and servicing, means that in case

of a breakdown, spare parts are easy and quick to replace. Our new

machine comes with two years’ supply of parts. These items could easily

be costed in but to keep the calculations simple and straightforward we

have ignored them. Similarly, because of this, the ‘hassle’ factor is almost

eliminated. This, too, is ignored for the purpose of this calculation but it is

a strong feature of the customer testimonials prepared by the marketing

team.

140

8.6 The Negotiation Corridor

A consistent theme in VBP is the Negotiation Corridor.

Maximum VBP

Reference Price

NegotiationCorridor

Figure 8.2 Negotiation corridor

Our motivation is to try to win the deal that is close to the ‘Maximum VBP’

at the top of the diagram. Naturally, your buyer’s motivation is to buy at

the lower end, certainly at very little more than the Reference Price, and

conceivably even less. How do we bridge this gap?

The poor salesperson will ‘cave’ when the customer rejects out of hand his

initial high proposition and may even offer an immediate discount.

The good salesperson will introduce a range of arguments setting out why his

proposition is not only right for the customer’s situation but that it also makes

sound economic sense. Here he will bring into play the economic arguments

that have been the subject of his pre-sales research.

To be successful in navigating the Negotiation Corridor, we need to

understand as fully as possible the business context within which the customer

is operating – to understand his constraints, aspirations and pain points. This

is precisely where our work in using the Value Triad© bears fruit. Everywhere in

your pricing work, you should be using the Value Triad and the associated ‘So

What?’ questions. Nowhere is this more important than when we are standing

in front of the customer at the start of a negotiation session.

Value-based Pricing


141

We need to collect evidence to support the revenue and productivity

improvements, and emotional benefits flowing from the transaction.

We need to collect and be ready to present evidence to support cost

reduction claims, perhaps by bringing to bear testimonials, case studies,

reports, calculations, etc.

Do not forget the person either! Think through which intangible benefits are

relevant to him (and perhaps also to his colleagues).

Returning to the new machine scenario, we are faced with this key question:

“Will the customer purchase a new product at the maximum VBP that we

can justify on objective data? Or is he more likely to choose to repurchase

the same machine as before?”

In fact there is no advantage to him in buying a new machine at the

maximum VBP. In this case he is no better off.

This is an indifference price. We need to factor in time, value of money, and

the fact that he may be able to realise the cost savings on his next best

alternative purchase by spending a little effort ‘tweaking’ the equipment.

The negotiating corridor is created by the added value. Negotiation is

required to ensure that both parties gain from the process. We want our

negotiation to lead to a win-win situation – one in which both parties will gain.

How high a price we are able to achieve depends on the strength of our

arguments, our ability as negotiators and the ability of the buyer to negotiate

against us. The Value Triad© driven preparation we undertake will pay

enormous dividends here.

8.7 Comparing Conventional and Value-based Approaches to Pricing

In Table 8.2 we compare conventional approaches (cost-based

and competition based) are compared with VBP across a number

of dimensions. While it is clear that VBP potentially can offer greater

advantages to the user than conventional approaches, we need to

142

Competition based Cost based Value based

Focus Competitors’ price

levels Internal costs Win-Win

Encourages Pursuit of market

share – not profit

Formula based

approach

Cooperation, partnership and

deep customer knowledge

Customer

relationships Not well developed

Not well

developed Central to all transactions

Reward for

innovationMinimal Minimal High and sustainable returns

Selling efforts Transactional Transactional Consultancy and solutions

based

Inducement to

buy Discounting Discounting

Demonstrable economic

advantages

Value capture Limited Limited Complete, or as well as your

salespeople can negotiate

Table 8.2 Comparison of conventional and VBP methods

VBP works best with:

• New or enhanced products and services where these offer

significant improvements in two or more areas of the Value Triad©

• Products incorporating novel technology which offer dramatically

improved performance or significantly reduced costs-in-use

• Products completely new to the world with no viable alternatives

• Existing products and services where we are introducing these into a

new geography where again they represent a major improvements

in performance compared to methods existing in that offerings.

Where the customer is conditioned through usage to expect high

performance at unrealistically low costs, some re-education of the

customer will be necessary.

Value-based Pricing

use VBP carefully. It is not a panacea and it should not be used in every

situation. You should not re-build price lists using VBP exclusively. This could

be very dangerous indeed!


143

There are some circumstances in which you should not consider applying

VBP:

• Where your product or service offers no differential advantage

• Where the value of the offer cannot be sustained in the market by

your organisation’s people or resources

• Where the market is deeply mired in commoditised offers and will

reject without hesitation a product which stands out from the crowd

at a very high relative price

• Where your market consists exclusively of price buyers

• Where it is difficult or impossible to identify the economic gains

sufficiently credibly or provably

8.8 Implementation of VBP

Companies in industries such as chemicals, biotechnology, professional

services, agriculture, engineering products, logistics, mobile

telecommunications and energy are all currently implementing VBP. Some

of these companies have tried and failed, others have been successful

and other still are on the ‘journey’. Some consistent messages have

emerged from those case studies:

Management support

VBP initiatives need to be driven by top management and supported

positively by all other levels of management throughout the business. The

creation of value in a company is ‘owned’ by top management and is

a priority for progressive businesses. In companies where VBP has been

implemented effectively, top level managers are visibly seen to be driving

the process (Liozu and Hinterhuber, 2012).

VBP demands a very professional approach to selling

VBP requires products and services to be sold consultatively rather than

transactionally.

In companies implementing VBP, salespeople increasingly adopt the role

of consultant and try to find ways of enhancing the overall effectiveness

144

of their customers’ value creating processes. This usually requires significant

sales skills development and sometimes recruitment of new salespeople.

VBP is a journey

Effective implementation of VBP demands that the company as a whole

embraces a commitment to creating and delivering value. This may

require significant changes in emphasis, attitude and even organisation

and will take time to implement fully. Companies need time to make the

necessary changes and adjust to them.

Management needs to be motivated to build better business

VBP is not merely about improved profits, although improved profits will

result from effective implementation. VBP is about generating better

business through focusing on customers who understand and will pay for

value, by defining the value that is created in objective economic terms

and developing better client relationships with different executives in

the client organisation. VBP leads to win-win situations. It does mean we

need to be ‘choosier’ about who we retain as clients. But then, if we are

generating better business, we can afford to lose some of the dead wood.

Value-based Pricing


145

Chapter 9: Other Pricing Methods And Tactics

“For just over my price range, I can get something way under my quality

expectation level. Thanks, inflation!” (Kintz, 2012)

A cursory examination of most contemporary marketing text books will

reveal the fact that, even today, most of the treatment of pricing topics is

superficial compared to other elements of the marketing mix. Most pricing

chapters appear content to ‘inventory’ pricing tactics and strategies with

little or no commentary on where and how these might be applied. In this

chapter I describe – necessarily briefly – a number of pricing approaches

regularly encountered. By considering the context of the pricing decision,

the value of the product or service to the customer in that context, and

the strategic and tactical objectives of the particular product or service

marketing strategy, it is usually possible to identify several approaches

from which a rational and considered choice can be made. This chapter

should help the reader to identify these choices.

9.1 Line Pricing

Companies’ product lines often span low specification/low price to

very high specification/high price items. Product line pricing requires

a complete portfolio of products and services that span the range of

customers’ needs and budgets so that the needs of every potential

consumer are addressed by some offer in the range. By self-selecting, the

buyer can position himself such that his purchase meets the majority of

his needs. There are obvious trade-offs and the shrewd seller will provide

options, possibly even bundles, at each major level in the product line

to help the buyer get exactly what he wants. ‘Bait pricing’ (to entice

customers with a lower priced item in the line and then encourage them

to trade up by presenting attractive options within the line) is often used in

conjunction with product line pricing.

Many companies create product ranges rather than individual products.

For example car companies (Ford, Vauxhall, Rover, BMW, etc.) sell vehicles

146

at different specifications and different prices to suit different segments.

Figure 9.1 demonstrates Ford’s product line structure. Each vehicle in the

range is targeted at a specific segment.

Within each segment there may be considerable variation of preferences.

For instance, the Ka is focused on the young professional woman

(arguably!), the Fiesta to the young couple perhaps with their first child,

the Focus at a typical family of two adults and two children (and possibly

the business market), the Mondeo for the larger family and certainly at the

corporate market. Each model overlaps to a greater or lesser degree with

the succeeding or preceding model. This provides a natural upgrade (or

downgrade) path. The variants provide enormous flexibility to the buyer in

terms of what he can secure on his budget.

Figure 9.1 Ford car product line

In Product Line pricing manufacturers recognise that their markets consist

of many segments, and that each segment has broad expectations from

the product they purchase. If designed cleverly, each model in the range

can meet the needs of more than one sub-segment thus broadening the

appeal and also creating higher demand to achieve scale economies.

£30,000

£25,000

£20,000

£15,000

£10,000

Ka6 variants

Fiesta24 variants

Focus38 variants

Mondeo37 variants

Galaxy37 variants

Other Pricing Methods And Tactics


147

For example, the Mondeo, with 37 variants in early 2011 [Glass Guide], meets the needs of different corporate users (middle managers, sales representatives, service engineers, taxis, etc.) as well as several consumer segments – older or larger family user, older driver who likes a bit of comfort, etc.

The trick is to design the model in such a way that the customer is willing to pay for the attributes he wants and is prepared to accept some functionality that he does not really need (thus paying a premium for his preferred functionality). A large variety of variants makes it possible for the customer to ‘self-select’ his precise choice horizontally within the specific model with relative ease. Several models, at least in the case of Ford prices, are positioned very closely to one another at each ‘node’ to make the choice as easy as possible.

The pricing challenge is to establish a price level for each model that enables the customer to recognise real value to him through the performance, specification and styling of the vehicle, while still being profitable for the manufacturer to produce.

Critical decisions that need to be made by the producer include:

• Establishing the low end product in the line and the prices, specifications and variants to offer

• Establishing the high end product in the line and the prices, specifications and variants to offer

• Fitting in the other models in the range such that each maps efficiently to its target market, while optimising upgrade choices and variant selection

Deciding on price differentials is tricky, partly because collecting the data required is not a trivial task. Assessing the interdependencies of costs and demand, and the complementarities are important and necessitate psychological, accounting and economic analyses.

Each product must be priced correctly in relation to all other products in the line; any differences should be equivalent to perceived value differences. The cost of providing these differences should be less than

148

the marginal revenue gained from their sale. This gives the supplier some

additional economic gain.

The highest and lowest prices in the line provide reference points for other

models. High and low ends should be priced so as to encourage the

perceptions we want. Interestingly, the Ford range fits almost precisely into

the £10,000 to £30,000 corridor with only one model breaking through the

top end.

An important question relates to how many models should be included

in the range. This question can only be answered on the basis of

segmentation analysis and comparisons with competition. At each level

in the line, segments targeted should offer broadly similar characteristics,

especially in terms of price elasticity of demand. However, it should be

recognised that, depending on price levels and specification, some

customers will want to trade up (we want this!), and some will trade down.

While this is not ideal, we prefer this to the customer migrating, say, to GM

or Nissan if they have viable alternatives. The way to get round this is to

ensure that the higher level product has some feature perceived as very

valuable and attractive to the customer but at a very affordable, and less

than expected, additional price compared to the next lower option. The

price differential should be seen as less than the extra value gained by

going up-market. This gives the buyer some Emotional Contribution gain.

Product line pricing is very pervasive. Typical examples include hotel

rooms, car rental, new car purchases, Argos catalogue, software

packages, etc. in B2C; and workstation computers, medical devices,

power tools and car tyres in B2B.

9.2 Bundling

Bundling is the process of assembling a package of products which,

collectively, meets a customer’s requirements as closely as possible. The

supplier seeks to create as much demand as possible for his products

and services while keeping costs under control. From his perspective it is

ideal if, through bundling, he can generate demand for both fast moving



149

products and more slowly moving items. The customer, of course, wants to

get as much as he can for the money he is prepared to spend.

From his perspective it is preferable to secure all of his requirements from

a single source to minimise search time and cost, and to optimise his

prospects of obtaining a reasonable discount.

Bundling meets both parties’ needs neatly. If the seller is able to provide

most or all of a customer’s requirements from his own product range,

this is an efficient use of resources, especially if through this process he

leaves as little money as possible on the table. An attractive bundle will

stimulate demand because other customers perceive the advantages.

The customer obtains more for the same money than he would be able

to do by purchasing each of the items separately. The price of the total

package is less, perhaps a lot less, than if he were to buy the individual

components separately.

It is important to be aware that Bundling is more than just putting together

a ‘collection of unconnected bits’. They should be linked functionally as

well as economically. To make a bundling strategy work, the seller needs

to have an excellent understanding of the needs/wants of a market

segment, especially what products and services are important and

valued, and which are not, and also to be able to estimate demand at

different price levels (Smith, 2012).

The city of London offers a breath-taking array of visitor attractions.

These are cleverly priced using a spectrum of pricing methods, including

Bundling. Attractions that have been bundled include Madam Tussaud’s,

The London Eye, London Eye Cruise, London Dungeon, and London Sea

Life. When clicking on to the website of any one of these attractions you

are immediately presented with ‘combination deals’ (bundle deals). The

bundles are impossible to miss. The stand-alone prices, which for legal

reasons must also be offered separately (unbundled), are rather more

difficult to find but they are on the websites. A casual visitor to London

will almost certainly go for a ‘combo deal’ and is unlikely to spend time

hunting for a stand-alone offer. The combination deals look extremely

enticing.

150

Also, since the attractions are distributed around the city centre,

customers need either to walk, and in the process spend money in the

multitude of shops, bars, cafés and restaurants, or make use of ‘combo

deals’ available on London buses or the tube. This brings in many times

the entrance fees for the attractions, making use of the tourism ‘multiplier’

effect.

Table 9.1 sets out some individual adult advance online prices for

illustration purposes only. Many of the bundled prices include a Madame

Tussaud’s visit, and tickets for these ‘combos’ must be collected from

that venue, more or less compelling people to make that visit. Madame

Tussaud’s is the most expensive attraction in the portfolio.

Attraction/CombinationOn-Line Fee(separate)

On-Line Fee(bundled)

Savings (%)

Madame Tussaud’s (MT) £25.92

London Eye (LE) £16.74

London Sea Life (SL) £17.14

London Dungeon (LD) £13.10

London Eye River Cruise (RC) £10.80

MT+LE £42.66 £37.80 £4.86 (11%)

MT+LE+SL £59.80 £52.80 £7.00 (12%)

MT+LE+SL+LD £72.90 £59.40 £13.50 (19%)

MT+LE+LD £55.76 £52.80 £2.96 (5%)

MT+LD £39.02 £41.40-£2.38

(-6%)

MT+SL £43.06 £37.80 £5.26 (12%)

MT+RC £36.72 £36.60 £0.12 (0.33%)

Table 9.1 London tourism attractions

From the Table, it is clear that in almost every case a combination (i.e.

a Bundled) deal presents a saving for the buyer. The apparent revenue



151

advantage for Bundling of online prices ranges from 5% to 19%. At £28.80

it is nearly £3 more expensive for customers simply to ‘turn up at the door’

at Madame Tussauds! This is a 11% price premium for the convenience

of making an impulse purchase. The websites reinforce each other and

collectively encourage people to book in advance. The operator provides

all kinds of inducements for the buyer to do so. This strategy enables the

operator to manage demand, minimise queuing and to optimise staffing

and other resourcing costs. Configuring the offer in this way actually helps

the supplier manage service delivery costs.

Some customers might be willing to pay £28.80 or even more because

for them this is a once in a lifetime purchase while they are in London. For

others the price of £25.92 is very high and, if there were no other options, it

would be either one attraction or the other but not both.

By providing an additional attraction at a discount, those customers who

would have been prepared to pay more than £25.92 would see the whole

deal as exceptional value to them. A single purchase leaves money on

the table for the seller because such customers are willing and able to pay

much more. A dual, triple or quadruple offer ‘mops up’ all of the little bits

of money left on the table!

Those customers for whom £25.92 is the reservation price (i.e. the maximum

they would be prepared to pay for the Madame Tussaud’s visit) may

find that the additional visit to the London Eye, for an extra payment of

‘only’ £12, to be irresistible. If they stopped to factor in the travel costs

they would realise that the cost is considerably more. The extra event at a

bargain price dwarfs these issues!

Bundling is now very widespread. Examples include PC and software,

weekend hotel packages, package tours, sightseeing visits, cable TV,

mobile telecommunications, etc.

The benefits to the supplier are numerous. Bundling reduces selling effort,

smooths and increases demand over the range and enhances profitability

by making better use of resources or even contributing to additional

economies of scale.

152

9.3 Non-linear Pricing

In flat or fixed fee tariffs, the total price paid by the consumer is a straight

multiple of the number of units consumed and the unit price. This neither

encourages nor discourages variation in usage and is of limited use to the

vendor who might want to encourage greater usage in some segments

and lesser usage in other segments. For economically constrained

consumers this can be construed as unfair given that they are paying

the same unit price as much wealthier higher level users. Higher level

users would argue that they are not being treated fairly as they receive

no share in the economies of scale their usage creates for the vendor.

Non-linear approaches provide the needed flexibility both in meeting the

requirements of ‘poorer’ customers and offering discounts to heavier users.

Non-linear pricing refers to a category of pricing approaches in which

the user pays a varying rate depending on his usage. Typically, in non-

linear pricing, heavier users gain a cost advantage – the more they

use, the cheaper each unit of consumption becomes, e.g. in some

energy consumption tariffs. In some cases the cost per unit increases to

discourage higher usage, perhaps to reinforce a fair use policy e.g. early

broadband deals (Wilson, 1993).

It is a form of line pricing. The user selects, from a menu of options, the tariff

which best matches his budget and intended level of usage. Each higher

level offers unit price reduction advantages over the previous lower level.

This structure will encourage higher usages which, in network services like

telecommunications and energy, increase network efficiency.

Non-linear pricing enjoys a number of advantages over fixed price per unit

methods. It offers customers selection flexibility.

It also reduces the need for complex segmentation strategies and rewards

higher level users. Non-linear pricing enables the seller to maximise his

revenue from a homogeneous product without the need for costly

differentiation. Differentiation is achieved via service packages.

There are a number of variants of non-linear pricing schemes:



153

TotalPrice

Number of units purchased

Linear (flat rate per unit)Marginal prices of successive units in decline

Block declining tariffMarginal prices of successive units decline in steps

Two part tariffInitial fixed fee + constant price for each successive unit

Fixed feeFixed price irrespective of usage

Figure 9.2 Non-linear pricing variants

i) Fixed fee

Here a fee is charged irrespective of actual usage. Fixed fees are

typically used e.g. in club or society subscriptions. The onus is firmly on

the subscriber to assess likely use. A gym subscription, typically, will offer

the subscriber rights of entry and unlimited use of baseline services. These

services are selected for a standard membership package based on level

of popularity with their clientele. Through experience or market research,

special services are not provided as part of the standard fee and are

offered at a price per use or as part of a higher grade of membership.

ii) Quantity discounts

One approach to meeting the criticisms of the single flat rate is to create

a slightly more complicated structure in which discounts are given on the

basis of quantities purchased. For instance, the vendor offers a flat rate

of £12 per unit for up to 500 units (total £6000). For more than 501 units

and up to 1000 units (i.e. from 501 – 1000) the price is £11.50 per unit (for

each of the 1000 units - total £11,500). For more than 1000 units, (i.e. from

1000 - 2000 units), the price is £11.00 per unit and so on. A variant of this

is to charge a flat rate for the first 500, then for each unit above 500 and

up to 1000 units a variable price of £11.50 (total £6000 + £5750 = 11750 or

154

an average unit price of £11.75), and so on. The challenge is to calculate

unit intervals and break points to satisfy both low users and offer sufficient

incentive for heavier users. This is a complex structure and can be tricky to

manage.

£

Quantity

Average Unit Price

Total

Figure 9.3 Quantity discounts

iii) Two-part tariff

A Two-Part tariff consists of a fixed (up front) charge followed by a

price per unit consumed. This is very popular with energy companies in

which the up-front fee is a contribution by each consumer to the costs

of maintaining infrastructure, network, etc. With increased quantity

consumed this fixed cost is spread across a larger and larger number of

units. As the number of parts in the tariff increases, the pricing structure

becomes more complex, break points become harder to select, the

structure more difficult to describe, and the whole process more difficult to

manage.



155

£

Average Price Per Unit

Quantity

Total

Figure 9.4 Two-part tariff

9.4 Dynamic Pricing

In Dynamic Pricing we are trying to maximise the sales revenue from sales

of a given limited inventory of items by a deadline. Dynamic Pricing pre-

dates the much more common fixed price approaches popular today

and which were introduced during the industrial revolution. In Dynamic

Pricing prices change in line with real time adjustments in supply and

demand characteristics as the market responds to information about

demand and about availability of supply.

The very simplest Dynamic Pricing situation occurs when individual

buyers and sellers seek to achieve, through negotiation, a deal whose

characteristics adequately meet the needs and aspirations of both

parties. The degree to which both parties’ aspirations are met is a function

of their willingness to compromise and the creativity they bring to the

process. Concessions made by each party contribute to the ‘dynamism’,

and the urgency of need of one party or the other will dictate where the

156

final deal is struck. At a different time these parties would probably reach

a different outcome because their contexts will have changed.

Where there are a significant number of prospective buyers and sellers

(perhaps a hundred or two), this process of individual negotiation is

impossibly inefficient. The market needs to be ‘made’ by the involvement

of a ‘market maker’ such as an auctioneer. In a conventional auction,

the auctioneer becomes the facilitator of many deals. Typical auctions

(livestock, objects d’art, automobiles, etc.) take place in a defined

location at a defined time and involve relatively small numbers of buyers

and sellers, each with a strong interest in the business to be transacted.

Technology is rudimentary – the market being made by the interchange

of willingness to pay/willingness to sell signals facilitated by and

communicated via the auctioneer. Customers are motivated by the hope

they will get a bargain; vendors are motivated by having the undivided

attention of many qualified buyers in one location and thus the highest

probability of achieving the best possible price.

Demand and supply are managed by human interaction, and are

very dynamic – i.e. constantly changing in response to information

communicated by the market maker and by the observable reactions of

the various participants. Although auctions may be convened frequently,

they are generally very local affairs. People physically need to be present

(or have a proxy) to transact.

As a mass market pricing strategy conventional auctioning is completely

inappropriate. During the industrial revolution the manufacture of products

for mass markets became the norm. Not surprisingly the transactional style

of Dynamic Pricing was replaced by a much more readily manageable

fixed price approach. Fixed price methods, as

I have commented in earlier chapters, has become the norm in most

industries, has led to the creation of cost and competition based strategies

and a large body of theoretical knowledge to support these methods. A

Dynamic Pricing approach is still part of such situations but only at the very

last stage where deals are finalised collaboratively by buyer and seller

to meet their individual needs and in which prices ultimately paid will be



157

negotiated on the basis of each party’s context.

Industries that were early pioneers of Dynamic Pricing included large-scale

air travel (e.g. Easy Jet), hotels (e.g. Marriott, Intercontinental, Hilton) and

car rental industries (e.g. Hertz) partly because these industries were early

adopters of centralised booking, billing and ticketing systems and partly

in a quest for better yield from their transactions. Fixed pricing systems

in these industries were unwieldy and created far too much consumer

surplus.

If a hotel room, rental car or airplane seat is not used, it is lost forever. It is a

perishable good and as such is only available for sale during a very limited

time period. During that period availability may also be limited to the

capacity of the vendor’s processes. Dynamic Pricing approaches were

developed to manage demand effectively and prevent the opportunity

loss of a perishable good. Dynamic Pricing changed forever the way in

which airline seats were priced and sold.

Industries characterised by very large numbers of customers, limited and

time-bound capacity for delivery of the service and multiple (possibly

latent) price segments make Dynamic Pricing a very attractive offer

for the vendor and well as the consumer. This process has created

exceptional profitability for the airline industry.

In fact, Dynamic Pricing has become a much more popular pricing

methodology precisely because of improvements in technology. Data

about demand are now much more readily available e.g. scanner data

and loyalty cards; bar code technology and package labelling allow

price changes to be made quickly; and the emergence of ‘big data’

analytics offer sophisticated statistical tools for analysing, characterising,

tracking and even predicting demand.

Figure 9.5 illustrates the well-known one-price, multiple price scenario.

In Figure 9.5(a) a single price captures some of the area under the

demand curve, but not all of it. The top triangles represent consumer

surplus – i.e. customers who were willing to pay more; the lower triangle

represents supplier surplus – i.e. customers who paid more than they

158

would have preferred (and had there been choice might have migrated

to a different supplier). By introducing a different price into the options,

and differentiating the offer in some way (seat nearer the front of the

cabin, higher specification vehicle, automatic upgrade to executive

double room, and so on) the pricing strategy recognises the existence of

consumer surplus and creates a strategy, based on customer value, to

capture that value by providing a differentiated set of options.

Single Price Multiple Price

VolumeVolume

Price/Unit Price/Unit

Figure 9.5 a) Single price b) Multiple prices

The effect of this, shown in Figure 9.5(b), is to reduce consumer surplus

(three triangles but with a smaller total area than in Figure 9.5(a). It also

gives the buyer trade-up and trade down options and hence provides

us with a means of managing customer purchase behaviour. This is an

important point in Dynamic Pricing as we may want to channel customers

to make a purchase decision at a different time. If we could find a way

of creating an infinite number of pricing options, we would ‘mop up’

all of the consumer surplus and our revenue would be maximised. In an

infinite set of prices, we would be hard pressed to create an infinite set of

differentiated offers. Without a change in thinking this idea is hopelessly

theoretical.



159

The use of Dynamic Pricing is extending continuously, and creative approaches have been developed to make use of it. Dynamic Pricing is today becoming much more popular because it is now possible to create markets involving many hundreds of thousands of buyers and sellers through technology.

As a modern pricing method, Dynamic Pricing has had to wait for the twin innovations of fast computing power, data storage and retrieval systems and architectures; and the internet. Further and fuller development of this method are likely to depend on technology becoming more accessible and affordable, adopting companies’ abilities to present dynamically priced products as a value-based offer and determination to optimise revenues and profits by more complete management of potential yield from the demand curve of a given industry (Sahay, 2007) (Phillips, 2005).

In other industries, IT based Dynamic Pricing has created disruptive innovations. Two specific examples (of many) include online stock investment and eBay. In both cases there are many thousands – even millions of potential buyers; in each case there are many thousands of potential purchases. Without enabling technology, these markets could never have emerged. eBay is leading the way in internet auctions. The internet brings together a larger number of both buyers and sellers and has opened the way for individuals to trade on a global scale.

Online auctioning carries a number of risks for the unwary. eBay has taken a number of steps to increase confidence and reduce risks. Buyers and sellers are invited to create ratings of each other and these are made available to prospective buyers and sellers. Goods are insured by eBay against non-delivery. eBay also offers a conflict resolution service. Secure payment is arranged through credit cards as well as though PayPal for greater security (Atkin & Skinner, 1975).

Conditions for effective implementation of dynamic pricing

These include:

• Need to be able to switch consumer demand to more suitable times

and to even out demand over the course of a period

160

• Ability to base pricing on customer type, timing and instantaneous

demand

• Need to be able to match demand and supply in (or close to) real

time

• Suitable mathematical models and rules can be created and

implemented as part of the ‘decision engine’ underlying the pricing

process (Sahay, 2007).

Example 1 – Mobile telecommunications

The application of Dynamic Pricing is expanding and the following

provides an example of a rather innovative approach to optimising

mobile revenue and providing the consumer with price alternatives for

using his mobile service. A mobile telecommunications network services

company developed a method of calculating the optimum price per hour

for calls routed through base stations. Data from the operator’s network

and billing systems are logged into the programme. The programme then

finds the optimum per hour price for each base station within the network.

Operators usually have many cell sites and data is ‘polled’ from each one

every hour.

Once the optimum price point is found, it is then used to set a flat price

incorporating dynamically priced premiums. Discounts from this are

calculated and communicated directly to subscribers’ mobile screens. In

the same manner, prices are re-calculated hourly, and the new discount

is communicated directly to the subscriber’s mobile screen. This gives the

subscriber information about the cost of his call and the option to make

the call at a later time when the system reports a cheaper rate.

The operator can adjust three variables depending on his business

development strategy and context – network utilisation, revenue

generation or subscriber satisfaction.

Using polled data and known network performance characteristics

operators can adjust discount levels to move demand to lower cost

periods according to peak traffic on their network, to avoid dropped calls

or to minimise poor call quality. Discounts can be reduced at peak periods

if the operator wants to increase revenue.



161

If customer loyalty is the focus, again discounts can be adjusted upwards

depending on policies in each customer segment.

The system enables mobile operators to make sure that they always have

the right price at the right location at the right time. Traffic can be diverted

to underused network locations enabling the user to take advantage of

additional traffic by being able to reduce the price without cannibalising

the revenues. The system provides an optimal mix of premium priced

peak time calls for customers with high priority need. More price sensitive

customers are encouraged by the discount level they see on their mobile

screen to defer their call to a less expensive time. This reduces pressure

on the network and stimulates fuller utilisation at lower cost times and

locations.

The system can analyse revenues and associated demand elasticities on

a per cell basis and use this data to optimise revenue. The data source for

this is the billing system. In practice operators do not usually have a clear

view in terms of where they are positioned on the Contribution-Elasticity

Curve. Operators are worried that methods such as bundling will take

prices too low and it will be difficult or impossible to get back up on the

correct curve.

Price

Profit/ContributionCurve

Demand/ResponseCurve

Optimal PriceRange

Figure 9.6 The contribution-elasticity curve

Dynamic Pricing allows them to go back and forth on that curve to find

the optimum price.

162

This can be adjusted in line with the operator’s business strategy at that

time by applying different weightings together with network and revenue

factors to identify the right price point that fits with their strategy.

Example 2 – Derby County Football Club

This Case was provided by Claire Maguire, a student at Strathclyde

University as part of her dissertation on Dynamic Pricing in Sports

Organisations (Maguire, 2013).

English Championship side Derby County are one of the first football teams

in the UK to experiment with Dynamic Pricing (Rostance, 2012). Despite

strict rules put in place by the Football League regarding pricing of tickets,

the team was granted permission to pilot Dynamic Pricing in specific areas

of their stadium. The move to change pricing strategy came as a reaction

not only to falling attendance levels but also to fan feedback, John

Vickers, vice president of operations at Derby County is quoted in a BBC

article as stating (Rostance, 2012):

“People have told us that they can’t afford £25-30 for a ticket. Those are

the facts. We could have buried our heads in the sand and continued to

charge those prices, or you can try to make it more affordable.”

Financial hardship means that attending a football match may now

become a luxury whereas before it may have been a regular occurrence.

It is up to clubs to respond to these hard times in order to ensure fans can

still afford to support their team.

Derby’s pricing model works by separating matches into categories

ranging from platinum, the most attractive matches which have been

regular sell outs in previous seasons, to bronze, matches likely to see the

lowest crowds. On top of this they also divide their stadium into five areas

A-E (Usborne, 2012). Prices alter depending on which match fans wish to

attend and where in the stadium they wish to sit.

This type of pricing encourages fans to attend the less attractive games by

offering tickets for lower prices whilst also allowing the club to capitalise on

popular games such as derbies.



163

Although people have accepted that airlines and hotels etc. price

dynamically, it is a new phenomenon in live entertainment. Consequently,

Derby County have included a section on their ticket website dedicated

to educating fans on their new pricing system (Webber, 2012). Under a

‘demand pricing’ heading supporters have three options. Firstly, they can

read the responses to some FAQs about Dynamic Pricing including the

frequency of price changes, any limits on price increases and how to get

the cheapest prices. Secondly, they can check prices in all sections of

the ground from a drop down menu of various home games, and lastly

they can compare prices of all sections of the stadium up to three home

games in an attempt to find the best bargain.

9.5 Other Popular Pricing Approaches

A manager seeking to price a new product has a huge range of

alternative pricing methods available to him. He does not need to be

restricted to any one method. Some of the more popular methods are

summarised with examples in Table 9.2.

Approach Description Usage Examples

Transaction

specific (aka

value-added

individual/

customised price

discrimination)

A different price is

negotiated on a

deal by deal basis.

Customer value

and cost differ

from transaction to

transaction. Buyers do

not exchange info.

Few, infrequent orders.

Switching difficult or

impossible. Cannot

delay purchase.

Economy airline

fares. Internet

purchases.

Capital

equipment

packages.

Different pricing

metrics (aka ‘Pay

on click’)

Prices charged vary

either directly or in a

more complex way

with usage.

To link payment

directly to usage.

Customise price to

individual use.

Enables customer

discounts for high

usage.

Link pricing to usage

rather than ‘by the

pound’

Photocopier

(Xerox

introduced).

Advertising

agencies.

164


Servicing/

Productising (aka

‘sell by the sell’)

Turning a product

into a service or

turning a service

into a product.

Sometimes quite

simply creating an

integrated product

bundle providing a

complete customer

solution.

To create total

package (product and

services).

To take out expensive

time to customer so

that we can provide

higher value added

services.

Schlumberger

created

technology to

prospect for oil

and turned this

into an extremely

successful and

profitable service

(‘wire line’).

Baxter Healthcare

(and others)

extending its rapid

delivery service

by creating

prepared, pre-

sterilised packs

ready for surgeons

to use.

Performance

based pricing

(aka percentage

‘no hay – no pay’

Guaranteed

pricing

Contingency

Payment by

results)

Where the price

charged is based

on an agreed

performance by the

service provider.

Seller paid on actual

performance.

Agreement critical.

Measurement metrics

critical.

Matches output to

reward ‘insurance’ for

seller.

Peace of mind to

buyer.

Pays for of

performance as well as

quantity.

Planning

consultancy.

Tariff analysis.

Pricing strategy(!)

Construction.

Accident litigators.

Bartering (aka

haggling)

I give you something

you want in

exchange for you

giving me something

I want…and we

agree between

us what the deal

contains.

Where there is no

convertible currency

informal arrangement

between companies

(to avoid tax/vat).

Can be very simple or

hugely complicated.

Arbitrage.

Selling machine

tools to USSR in

exchange for

salt/metal ore.

“I’ll build your

extension if

you handle my

book-keeping,

accounts and

tax”.



165


Servicing/

Productising (aka

‘sell by the sell’)

Turning a product

into a service or

turning a service

into a product.

Sometimes quite

simply creating an

integrated product

bundle providing a

complete customer

solution.

To create total

package (product and

services).

To take out expensive

time to customer so

that we can provide

higher value added

services.

Schlumberger

created

technology to

prospect for oil

and turned this

into an extremely

successful and

profitable service

(‘wire line’).

Baxter Healthcare

(and others)

extending its rapid

delivery service

by creating

prepared, pre-

sterilised packs

ready for surgeons

to use.

Performance

based pricing

(aka percentage

‘no hay – no pay’

Guaranteed

pricing

Contingency

Payment by

results)

Where the price

charged is based

on an agreed

performance by the

service provider.

Seller paid on actual

performance.

Agreement critical.

Measurement metrics

critical.

Matches output to

reward ‘insurance’ for

seller.

Peace of mind to

buyer.

Pays for of

performance as well as

quantity.

Planning

consultancy.

Tariff analysis.

Pricing strategy(!)

Construction.

Accident litigators.

Bartering (aka

haggling)

I give you something

you want in

exchange for you

giving me something

I want…and we

agree between

us what the deal

contains.

Where there is no

convertible currency

informal arrangement

between companies

(to avoid tax/vat).

Can be very simple or

hugely complicated.

Arbitrage.

Selling machine

tools to USSR in

exchange for

salt/metal ore.

“I’ll build your

extension if

you handle my

book-keeping,

accounts and

tax”.


Optional

Basic product

with no frills then

optional add-ons…

sometimes product

unusable without

add-ons!

Build a basic product

and then offer

enhancements.

Add-on items premium

priced.

Dell, BMW,

contract

builder builds

an extension

and then offers

a variety of

enhancements.

Captive (aka

follow-on

products)

Basic product at

deceptively low

price (loss leader)

and then to use

it must purchase

very expensive

accessories.

Build a basic product

and then offer

enhancements.

Add on items premium

priced.

Hewlett Packard,

Gillette safety

razors, Brother

(MFC+ Toner

Cartridges), etc.

By-Product

Our by-products

can be another

industry’s raw

materials

Requires (green?)

design;

Very cost-effective

with minimal waste.

Sawdust

(composites),

tree bark (garden

mulch, fencing),

CHP projects.

Price Blocking

(aka Fighter

Brand, Poisoned

Chalice)

It may make sense

to introduce a

special product to

block new low-price

competitors from

making inroads

into the market,

especially if cutting

the price on the

main product

would prove very

expensive. Blocking

product is aimed at

those price-sensitive

segments most

at risk from new

competitors.

Prevents competitor

making inroads into

your core market

and thus preserves

profit margins among

less price sensitive

customers.

Will not make any profit

from blocker product.

Extends range to keep

customer loyal.

May leave an

unattractive customer

to a competitor.

BA introducing

GO to compete

against EasyJet

and RyanAir;

Swatch; Busch

Bavarian beer.

166


Controlled

availability

By restricting

availability of

product or service it

is possible to create

rarity or uniqueness.

Customer does not

have a choice about

price.

Deliberate restriction of

supply to force prices

up.

As one-one marketing

becomes more

prevalent, it becomes

possible to target

different customers

with different prices.

Discriminatory in nature

(beware legalities!).

Products only

available

in certain

geographies

because of

transportation,

cultural or legal

restrictions.

Deliberate

creation of market

shortage to force

prices up.

Selection of

‘up-market’ retail

outlets for high

end products.

Geographic

Prices different in

different parts of the

world and may be

tied to controlled

purchase locations.

Enables supplier to

exploit different price

elasticities.

Patent protection

impossible/unavailable

in some territories.

Brand names may be

offensive in certain

cultures but cannot be

changed.

Stella Artois

(reassuringly

expensive).

Moral

Used principally

by monopolist

organisations

such as local or

governmental

organisations where

costs are particularly

difficult to identify

and where the

subject may be

socially or politically

sensitive.

Creating demand in

segments unable to

satisfy that demand

can create unwanted

social effects.

Need to protect

consumer from

excessively high pricing

of essential goods

(heat, food).

Criticism of

exploiting socially

or economically

vulnerable.

Morally defensible.

Allows special

pricing of events/

services for ‘the

rich’.

Prices so low

that organisation

unprofitable.

Push other

prices up to

compensate

Pharma sales of

Acyclovir in 3rd

world.

‘Rayleigh’ pricing.



167


Pricing Points

Many industries

use pricing

points to make

it look as if the

price charged is

less than it really

is. The method

is based on

the fact that

£10.99 looks

a lot less than

£11. Primarily

used in retail

distribution and

pricing structures

manipulated

to offer traders

a good margin

while offering the

end-customer

an apparently

attractive deal.

It works both in

consumer and

industrial markets,

although more

effectively in

consumer markets.

Can be awkward

to handle.

Very popular

.99, .97 price

endings to

‘make it look’

like price is

much less.

In non-linear

structures can

be difficult to

calculate/

estimate.

Promotional Used to

stimulate short

term demand

e.g. to mop up

spare capacity

or surplus stock.

Temporary

reduction in

price to attract

price sensitive

customers.

Should not be

considered as

a discount as

such but as a

discretionary

spend of

marketing budget

to achieve

marketing

outcome.

Principal and

partner may

collaborate in

sharing advertising

budget – both

gain.

Table 9.2 Different pricing approaches

168

Product/service

Alternative approaches Category

Display

packaging

Compare with competition and add/subtract

a little, depending on your position.

Base value on enhancement offered to

product => % of retail price.

Work out unit cost going through factory + %.

Different prices for different markets e.g. IT,

FMCG, industrial consumables.

Discount to get into new market – let existing

customers pay for it.

Volume discounts.

Competitive Parity

Value Based

Cost plus

Geographic

Penetration

Non-linear/Promo

Discount

Beer from

micro-

brewery

Pricing differential for each % of alcohol.

Based on cost per litre.

Based on price for speciality beers/imported

beers.

Create product image and sell only in goblets.

Experiment with different prices and titrate

against demand.

Discount if bought with meal.

Cost/Spec based

Cost based

Competition based

Value based

Demand analysis

Bundled

Garden

landscaping

Rate per square metre + difficulty premium.

Assess ability to pay e.g. up-market residents

pay more for service.

Discount rates for OAPs if they allow you to

use in adverts.

Tariff of different things e.g. garden art,

horticultural advice, etc.

Charge per hour worked.

Decide on target segment e.g. wealthy

detached dwellers and develop

comprehensive, up-market service – charge

premium.

Non-linear

Differentiated/

segmented

Collaborative discounting

Optional

Cost based/time and line

Value Based/Premium

Table 9.3 Some answers to pricing methods question



169

Some simple examples

Suppose you had the challenge of developing a pricing strategy for one

of the following. What alternatives would you explore? Here are a few

ideas, but by no means exhaustive.

• Display packagingThe packaging is made from robust cardboard or polymer materials.

It incorporates marketing messages prescribed by the client but also

provides a secure container for storing and shipping fragile items (like

drinks or perfumes) or prevents spillage of dangerous items (like caustic

alkalis or acids). The company can offer a full aesthetic design and

packaging solution.

• Beer from a micro-breweryA company has set up a small brewery to produce a small range of

high strength beers created from locally sourced materials. It sells mostly

within its local geography and production capacity at least at this time

is limited. There are a number of local restaurants and pubs featuring

‘guest’ products, which have expressed a strong interest.

• Garden landscapingCompany set up to provide landscaping services in the suburbs of

a major city. Wide range of house types from small terraced homes,

executive flats within landscaped grounds to large ‘mansion’ type

properties.

You can find some suggested approaches in Table 9.3


171

Chapter 10: Price Management

“A billion here, a billion there, pretty soon it adds up to real money.”

(Unknown but Senator Everett Dirksen was credited to have made this comment)

10.1 What is Price Management?

Price management is a simple idea – it is about managing prices and

pricing on a day to day basis. By managing prices I mean ensuring that the

prices we charge for our goods and services are as close to optimal as we

can achieve. By managing pricing, I mean the whole process of ensuring a

coherent approach to price decision making across the business. Thus, it is

much wider than just ‘prices’ and has to do with all the people, processes,

analyses, tools and data that are engaged in the pricing decision.

Consequently, pricing is often difficult to manage across a business. The

bigger the business, the more difficult price management becomes. A

surprising number of people have a direct interest in price setting – sales

force, finance, marketing, general management, product management,

and so on. They all have different perspectives, opinions and expectations.

Not too surprisingly pricing is controversial and may also be politically

contentious.

To the executive designated as Pricing Manager, there is no shortage of

experts in the company telling him what to do! While this can be frustrating,

in reality this situation is quite helpful because it shows that there is an

interest in the topic and a recognition of its importance. Furthermore,

to be undertaken effectively, pricing decisions need to reconcile many

perspectives. That means canvassing the views of people in the business

who are affected by the pricing process. It also reduces individual risk,

if many others are involved. Pricing across the company needs to be

managed effectively, and that is why some companies which are experts in

pricing create a Pricing Council. I will examine this idea later in this chapter.

Pricing is slowly climbing the corporate agenda in importance.

172

Organisational price management has been greatly facilitated in recent

years by the evolution of IT pricing solutions which seek to optimise pricing

decisions across a business by integrating accounts, marketing, sales

and operational data and analysing these by means of sophisticated

algorithms. This, too, is a good development for pricing as a whole

because it links the pricing decision tightly into the company’s other

administrative processes.

Pricing management software is still largely the domain of large businesses

and may require a pre-investment in Enterprise Resource Planning tools

(e.g. Vendavo and SAP have been working together on enterprise pricing

solutions for several years). Tools are evolving which offer specialised

solutions vertically by industry or horizontally across businesses. These are

being adopted slowly into smaller organisations. Price management

systems still are very expensive, and this is limiting more comprehensive

adoption.

10.2 Price Setting Process

Pricing is both a strategic function and a tactical/operational function.

Pricing decisions need to be taken in the context of the company’s overall

business strategy for the given product or service and in the light of market

context factors. This can be a challenging task. A pricing decision taken in

response to a particular market situation may become a strategic pricing

choice. This is particularly the case for price leaders, and managers in

price leader companies need to be particularly careful to think through

both the short term and the longer term consequences of a price change.

Companies with very large numbers of products and/or services may

Step 1 Step 2 Step 3Agree Strategy Analyse Value Implement Process

Figure 10.1 Price setting process

Price Management


173

not be able to go through this process with every product, or even every

product group. One approach to dealing with this is to identify those

products which are of strategic importance to the business – in terms of

profitability, sales volume, market share or some other parameter and

apply the thinking to these.

Pareto Analysis, often called the 80/20 Rule, is a useful tool to help us focus

on the really critical issues. For example, if a company has 20,000 SKUs

(‘Stock Keeping Units’ or product lines kept in stock or on the price list at

any one time), price-setting for all of these can be overwhelming. We can

cut the task down to more manageable proportions by applying the 80/20

Rule. What we often find is that 15-20% of products generate around 80%

of the profits. So instead of pricing every one of the 20,000 units individually

we can look at the most important, say, 3000-4000 units. Still a big task, but

much more manageable.

Step 1: Agree strategy

• Strategic alignment – we need to make pricing decisions in the

overall context of business and product line strategy. Before setting

a price for a product or product group, we need to be clear on

the strategy for the product. Remember, pricing is one of the four

transactional marketing mix elements.

• Segmentation and targeting – not every segment will be a viable

target for the company. If we apply a process such as Value

Oriented Segmentation (described in Chapter 4), then we will

have identified the key target markets in which we have realistic

prospects of success. If our approach to market segmentation is

homogeneous, we will achieve only modest results from our general

marketing (including pricing.)

• Forecasts – develop sales revenue and unit volume forecasts. In

particular, you should undertake discounted cash flow analysis on a

product by product and segment by segment basis.

Create contingency and scenario analyses so that you can quickly assess

the impact of changing circumstances on the model. (Excel has excellent

and easy to apply Add-in and What If? Analysis tools to make this task

relatively easy). This set of analyses will force you to do the deeper thinking

174

necessary to create meaningful, robust and defensible analyses. Pricing specialists need to become pretty expert in using Excel or similar tools.

Step 2: Analyse customer value

• Customer value analysis – having identified target segments in Step 1, identify the high level value that customers are expecting from the products and services that they buy. This will be at segment level – not product level. For the products targeted at customers in each segment, assess the extent to which these needs and expectations are being met. This may lead you to make some detailed changes to align the product more closely to customers’ expressed requirements. If your business is genuinely in contact with its markets, much of this information will be available to you through sales or product management teams. Nevertheless some market research may be required if information is lacking.

• Marketing mix – for each product develop a 4C/4P Analysis (See Chapter 3 – Pricing and Marketing) to ensure that each aspect of the mix delivers the requisite value at the price the customer is willing to pay. Pricing is established after you have thought through the other 3Ps (or the other 6Ps if you are using the 7P framework). This work is standard strategic product marketing.

• Pricing methodology – you now need to decide on what strategy and tactics to apply to achieve the target price. In terms of methodology, you should check out all the alternative pricing approaches you think are appropriate, rather than just heading straight for the “most obvious”. Whatever pricing method you select, do bear in mind you might need to live with this choice for a long time. Pricing is both strategic and tactical – and what starts out as a tactical decision may become very “sticky” in the market.

For instance, will you use a premium pricing strategy in every segment or geography? Why? Or will you apply some form of differentiated pricing by geography, supported by different case studies or other collateral? Again, why? Do a thorough job here – convince yourself, because if you cannot convince yourself you will never convince others. Identify what can go wrong and what actions to take in the event that results are not in line with

expectations.

Price Management


175

• Forecast update – finally, go back to the revenue/income forecast

model developed in Step 1 and update it if required. Do the

numbers link to the overall strategic objectives for the product?

Step 3: Implementation

There is a lot of detailed ‘nitty-gritty’ activity at this stage. But it is all

necessary. There may be some additional elements that you need to

include in your own organisation, but these are recommended:

• Pricing Council – if you have a Pricing Council, present your

recommendations to them and get them to sign off on them. In

reality you will have engaged some or all of them in the preparatory

work.

• Build price lists – in B2B we would probably not publish these

other than to the people in the company who need to use them.

Double check again that the numbers work and that any price/

volume breaks make sense. (Look at the Discount Tables later in

this chapter). Take care in transcribing data to spreadsheets. A

misplaced decimal point in the price of an important product

could have disastrous consequences! In B2C work this is even more

important.

• Create discounting policy – if you really must discount to win

business, make sure that everyone knows the limits of their

discounting discretion. If a salesperson has 5% discount discretion

that means a maximum of 5%. This must be policed. Also, build in an

escalation process.

After all, in a particular (strategic) sale, 5% may not be enough, but this is a

call that a senior manager must make. Not a salesperson.

• Build in a review – all our calculations may lead to a figure that is

patently wrong in the market. We might only discover this when

we get there! Insisting that we stick with this wrong price is merely

throwing money away – either by leaving money on the table, or by

customers defecting. Either way, we must review price performance

and realisation. Are we really getting the prices we have set or is

‘someone’ damaging the price structure by unauthorised discounts

176

or ‘throwing in sweeteners’? Set a time frame and criteria for regular

pricing reviews. Note that just because a salesperson tells you that the

price is ‘too high’ does not necessarily make it so.

• Price monitoring document – this can be a very simple spreadsheet

which allows you to capture target prices (per price list) and actual

prices realised in the market. The best way to capture the data is for

an admin person to go through invoices delivered and collect data,

total revenue, unit volume, unit price and discount data, sales person,

customer, geography, etc. If the volume of transactions is too great to

do this for every invoice, then select a sample of invoices, particularly

those linked to important products. By undertaking a regular analysis

of this nature, trends in the data will become apparent – which prices

are regularly discounted, the magnitude of discounts, whether greater

or lesser discounts are linked with particular customers, geographies,

sales people, etc. By collecting this information it will be possible to

build price waterfall analyses and price management matrices.

Phase Key Tasks Responsibility

Agree strategy

Identification of strategic goals for the product/

service

Select high potential target segments

Estimate achievable demand levels by segment

Establish specific strategic, unit volume and

financial objectives

Business Leaders

Marketing

management

Analyse customer value

Establish value requirements by target segment

Assess how these are being met

Conduct 4C/4P analysis

Build marketing mix

Evaluate product/service cost structure

Assess pricing methodology

Select price

Smell-check competitive prices in the market

Model rollout against strategic objectives

Product

management

Sales management

Management

accounting

Implement process

Build price lists

Create discounting policy

Establish price adjustment process

Create and use price monitoring document

Product

management

Sales / Account

management

Table 10.1 Price setting process

Price Management


177

Table 10.1 Price setting process

10.3 The Pricing Council

The Pricing Council is a recent innovation and most organisations do not yet

have one. Its purpose is to ensure that the company makes deliberate and

carefully considered pricing decisions and that such decisions are based

firmly on the delivery of value to the customer, and to ensure the company

prices in accordance with the value received by the client, not the costs

incurred in performing the work (Ron Baker, 2006). In broad terms the role of

the Pricing Council is to monitor the progress of pricing initiatives. The Pricing

Council ensures that regular, knowledgeable executive attention is given to

the function.

The Council is also the company’s main forum for the discussion of pricing

issues, new pricing methods, creation and implementation of pricing metrics

and analytics; the medium through which the importance of pricing is

communicated throughout the company; and the means of ensuring its

disciplines are embedded in company systems (Crouch and Hunsicker 2013).

Principal functions/purposes/roles

1. To ensure the company prices in line with the value received by the

client – not on the costs incurred in performing the work. This is a very

important function given how deeply embedded the cost-based approach

is in many businesses. While understanding of costs is central to profitable

performance, the route to serious business success is through the sustainable

delivery of customer value. Without a coordinated effort from senior

managers across the company, processes would too easily slip back into

cost-orientation.

2. To change the underpinning method of the company to one which

captures value by ensuring that all involved understand, recognise and

accept the distinctive worth of products and services purchased. The

Pricing Council ‘owns’ the value communication and creation process in

the business, and is the final arbiter of what genuinely does represent real

customer value.

3. To keep under review adjustments to pricing tactics and strategies

necessitated by changes in the macroeconomic and competitive

178

environment. We live in very turbulent times and a business that fails to

keep in touch with, and to respond to, economic realities will inevitably be

disadvantaged.

4. An individual pricing manager, operating on his own without

organisational support, will find it difficult or impossible to introduce pricing

innovations. A team of well placed, knowledgeable senior managers is far

better equipped to identify, launch and support new pricing strategies.

Key people

All senior managers with a professional interest in pricing effectiveness in

the company should be encouraged to be part of the Pricing Council.

I strongly advocate that it should be a separate and focused group of

people. Of course, pricing is a topic to be kept under review in the board

room or executive team meetings but often the issues will be crowded

out by other, apparently more pressing, operational matters. Every senior

manager with an interest in pricing should be involved.

Theoretically everyone in the company should be involved in making

decisions across this range of strategies, but these groups are of primary

importance:

Lea

de

r

Fin

an

ce

Ma

rke

ting

R&

D

Pro

du

ct

Ma

na

ge

me

nt

Op

era

tion

s

Sale

s

Customer

Price

Value

Cost

Product

Solution

Table 10.2 Functions involved in the Pricing Council

Price Management


179

The obvious leader of the Council will be the pricing manager if such a

role has been defined and allocated in the business. The practicalities

may work against this, however. A pricing manager might typically be an

analyst, management accountant or marketing administrator appointed

to this role on a part-time basis while remaining responsible for other

functions in the business. Such an individual is highly unlikely to have

the presence and leadership skills to manage a group of assertive and

opinionated senior managers.

Therefore, the role of leadership should really be taken by the most

senior member (provided that he/she buys into the function and takes it

seriously). The pricing person will then work as the ‘executive’ pair of hands

to ensure that the work of the Council is carried out properly.

10.4 Pricing Maturity – Evolution or Revolution?

Price maturity is generally perceived as a state in which all prices offered

by a company are optimised in terms of the value to the customer,

Stage 1

Stage 2

Stage 3

Stage 4

Administration

Control

Value

Optimisation

Value Maturity Chasm©

Pricing Maturity...

Time...

Generic 4-Stage Modelof Pricing Maturity

Figure 10.2 Generic pricing maturity model

180

acceptability in the market and adequate profitability to the vendor.

Not many companies have reached this stage of pricing ‘heaven’

although some are coming close. Several consultancies (Pricing

Solutions, DeLoittes, European Pricing Platform, Simon Kucher Partnership,

LeveragePoint) have proposed price maturity models of varying

sophistication and complexity. All of these are based on the observation

that companies go through several stages on their journey toward ‘Price

Maturity’. Figure 10.2 describes a fairly generic model.

For more on this see for instance ‘The Journey to Pricing Excellence’, in

the Journal of Professional Pricing (The Journal of Professional Pricing,

2008).

The characteristics of each stage are described below:

Stage 1 – Administration

Pricing is a minor administrative task in which cost data are obtained and

used as the basis of price construction. This is undertaken infrequently,

typically at the time of new product introduction or when major input

cost changes occur. Products are simple and unitary – every product has

a SKU number and every SKU has a price. If a price ‘works’ it is retained

and incremented, if at all, by some arbitrary inflation factor such as retail

price index. If it does not work, typically because business is perceived

to be lost ‘on price’, the price is adjusted downwards and the price

list rebuilt. Typically price lists are built up around Excel spreadsheets.

Revision may require some brief scrutiny of costs to ensure that adequate

profits are made. Resulting prices may be benchmarked against

competitive prices for broadly similar items. The task is carried out by

whoever wants to do it.

Usually the price list is re-calculated by application of a global multiplying

factor. No-one ‘manages’ the price list and hence ‘pricing’ is anarchic

and laissez-faire. Price decisions are taken on volume criteria and as a

result prices for specific products vary widely, despite the existence of a

price list, depending on how pressured the sales team feels to achieve

volume results. The drive to change is inadequate profitability. Factors

such as price elasticity are seldom considered at this stage.

Price Management


181

Stage 2 – Control

Managers begin to recognise that pricing needs to be managed

more assertively. The predominant pricing methodology continues to

be cost-based. Although a marketing task, marketing people do not

generally possess the numerical skills. They have neither access to, nor

understanding of, accounting data or how these data are calculated.

Price setting is still perceived as an administrative function with some

science.

The science is cost accounting and the task may therefore be delegated

to management/cost accountants who are knowledgeable in this

science. The driving force at this stage is margin improvement, and

its optimisation across product ranges and production resource.

So, typically, cost accountants and product engineers or service

designers work to identify optimal mixes of product and optimal

capacity utilisation. This results in pressure on sales people to achieve

not only target sales volumes on a product by product basis, but also

to achieve them at target prices. There is virtually no consideration at

this stage of customer value, the assumption being that demand can

be managed by discounting, an assumption that tends to accelerate

commoditisation.

All of the company’s internal systems are set up to support a cost based

approach, and detailed cost analyses are created on a product by

product basis. There is usually very little analysis available to assist sales

people – e.g. cost to serve, profit per segment or by account. These

analyses are not seen as relevant. The drive to change comes from a

realisation that, despite all the accounting science involved, profitability

is still disappointing. If the market is highly competitive, there is increasing

pressure by the sales teams to permit discounting to maintain share. The

model is broken but managers do not understand why. The assumption is

that more intensive cost analysis and cost reduction/business efficiency

initiatives will resolve the problem.

Consequently businesses invest in better computer systems and

software and implement 6 Sigma, Supply Chain Management, Lean

Manufacturing, Business Process Re-engineering and other initiatives.

182

Cost efficiencies are achieved but competitors also achieve similar cost

efficiencies. The flawed model keeps on being applied with poorer and

poorer results! Low cost competitors and aggressive cost-cutting merely

aggravate the situation. At a market level, commoditisation ensues.

At this stage the sales role is little more than outbound communication

driven by features and benefits thinking and a discount default

philosophy.

The drive to change, if there is one, comes from frustration with results

and an awareness that the business should be doing better. This leads, in

some companies, to Stage 3 – Value.

Stage 3 – Value

Some managers simply ‘throw in the towel’ and accept what they see as an immutable reality. They are in a commodity market and, no matter what they do, that is the state of the world as they see it. So they accept perilously poor margins, increased stress, a flood of cheaper and cheaper imports, and sit back to await their retirement! This is an unsustainable business model but they see no alternative.

Other managers do not accept this and sooner or later come to the conclusion that value is the answer. The problem with this, first of all, is reaching a consensus on what is meant by ‘value’. Often value has come to mean ‘giving the customer more for less’ – an interpretation that leads to even more extreme cost cutting and erosion of differentiation. The legacy from Stage 2 is that the whole organisation is deeply locked into a cost based business model – systems support cost analysis, people think cost reduction because price increases are ‘impossible’. This model after all has been in operation for many, many years and has come to be “how we do business in this company”.

By defining value more widely than ‘more for less’, the focus moves away from internally oriented systems, processes, costs and thinking to one which is focused on the customer. This change in approach is fraught with difficulty. The company does not know what value really is; they do not know how to measure it; they do not know how to create more of it. And because of the way the sales people have been taught to operate during

Price Management


183

Stages 1 and 2, they certainly do not know how to sell it so that customers are prepared to pay what it is worth.

To move to a fully value based pricing orientation, the company needs to cross the ‘value chasm’. Bear in mind that it is not necessary to go all the way to a full VBP implementation. Many benefits can be realised by gradually taking a value approach to the whole product/service portfolio.

These are some of the defining changes that are required:

• Product moves from discreet entities described by single SKUs to productised bundles of service and product structured as a solution. Price bundling becomes product bundling.

• Selling moves from a simple ‘show and tell’ transactional model with haggling around the price to a much deeper discussion around economic and emotional impact. Sales people also need to learn new skills – how to sell value and to move the discussion to higher levels in the buying organisation to those who own the problem and can see the potential of a new approach in solving their problem. These skills are not part of the traditional sales training programme but can be taught. Software and Excel tools are useful in helping salespeople evaluate and quantify customer value.

• Product innovation moves from ‘making things because we can’ to identifying very early in the process of product or service development what values the customer will want, need and be willing to pay for once the product has been developed. We need to change the ‘direction’ of the product development chain (See figure 6.1, Chapter 6).

• Cost analysis moves away from a deep dive into our own costs to a deep dive into customers’ costs and revenues and business contexts.

• Market intelligence becomes essential both to create products and services that meet the evolving needs of customers and offer a differential advantage. It becomes a ‘must have’ rather than a ‘nice to have’.

• Information technology provides the opportunity to analyse vast volumes of price and transactional data to identify trends,

correlations and sensitivities.

184

Stage 4 – Price optimisation

At this stage in Price Maturity evolution, the company has optimised all

of its pricing right across the board from commodity all the way to high

value added, value priced products and services. It has created product

bundles and solutions and has a highly developed market segmentation

strategy based on customer value.

Economic Value Analysis and Economic Value Estimation tools are

standard approaches and are applied as an integral part of the pricing

process.

The Sales organisation, in collaboration with product management,

technology and marketing create value propositions for all products and

support these with well-conceived collateral.

The business orientation is entrepreneurial and the company makes fullest

use of macroeconomic data as well as transactional data in order to

maintain optimal prices. A price optimised business almost certainly utilises

enterprise pricing software tools integrated into its Enterprise Resource

Planning (ERP) and finance systems. ERP systems, such as those offered by

SAP and others, enable the collection, collation and use of data across

a whole organisation. An ERP is a single system which contains the whole

of an organisation’s strategic data and updates the information in real

time to ensure that decisions are made on up to the second accurate

information. This is a very sophisticated business infrastructure and is

achieved probably by fewer than 1% of businesses globally.

Price Management


185

ParameterStage 1 Administration

Stage 2Control

Stage 3Value

Stage 4Price optimisation

CharacteristicPrice List

Maintenance

Contribution

optimisation

Profit

optimisation

on selected

accounts

Full price

optimisation

across the

enterprise

LanguageFeatures and

benefits

Features and

benefits

Customer

value and

impact

Customer value

and impact

FocusSales unit

volume

Price and cost

control

Value analysis

and economic

value

estimation

on selected

products

Value analysis

and economic

value estimation

on selected

products across

whole portfolio

Driver for next stage

Undisciplined

pricing

Unsatisfactory

profitability –

belief in ability

to do better

Net profit

optimisation

across the

company

Value proposition

Informal based

on competitive

price

Informal based

on competitive

price

Process

gradually

introduced

Full

implementation

of VP as core

selling tool

Customer value assessment

None None Targeted EVE

EVE as

standardised

approach

Pricing responsibility

No-one/

everyone

Accounting/

Sales Manager

Sales,

marketing,

product

management

Pricing manager

as leader of

virtual teams

including sales,

marketing,

product

management

Nature of product

Discrete SKU Discrete SKUBundles and

solutions

Fully customised

solutions

186

ParameterStage 1 Administration

Stage 2Control

Stage 3Value

Stage 4Price optimisation

Seller Box-shifter Transactional PartnershipEntrepreneurial supported by executive team

Type of sellingTransactional and discount driven

Transactional and discount driven

Solution selling on larger deals

Value based selling as standard approach

Pricing method

Cost plus/competitive parity/competitive tender

Cost plus/Competitive parity/competitive tender

Cost plus/competitive parity/competitive tender/value based

Full implementation of Value Based Pricing across the range, or as complete as the customer permits

Product innovation

Haphazard based on technology

Driven by technology

Driven by need for differentiation

Jointly developed to address customer issues and opportunities

Market segmentation

Homogeneous BasicIdentification of value segments in target areas

Fully implemented value segmentation

Pricing data analysis

Rudimentary – casual deal by deal and what the customer will pay

Intensive internal cost analysis leading to specific target prices

Customer cost and impact analysis – customised by customer

Customer cost and impact analysis – customised by customer

Customer knowledge

Very little in business – owned by sales people

Some sharing Deep customer knowledge

Deep knowledge of the customer and of the customer’s customer

Market intelligence

Little or none Some but mostly sales originated

Focused research on segments and sectors

Integrated Competitive Intelligence System

IT tools Excel and perhaps accounting system

Excel, Access, Accounting System

Advanced tools such as SAP/CRM

Integrated corporate wide IT tools including pricing suites

Table 10.3 The 4-stage pricing maturity model

Price Management


187

10.5 Discounts and Discounting

In general, the circumstances in which a discount should be offered are

limited and should always be on the basis of a quid pro quo. Generally,

discounts are acceptable in the following circumstances:

• Early payment discount – this would be offered as an inducement

to the customer to pay early e.g. 5% discount for cash payment on

invoice.

• Trade discount – this is the life blood and the basis of operation of

many industries where selling through a channel partner is the norm.

The level of the discount varies widely and depends on the nature

of the industry, service level promised, value added (e.g. technical

support, helpline, system integration, etc.)

• The channel partner may negotiate a sole trader discount or

have a portfolio of discounts for different parts of the business e.g.

collaborative advertising, collection, etc. There is nothing wrong with

these discounts but the wise manager will build all of these in, and

‘police’ them to ensure that they remain relevant and remove them

or replace them if necessary.

• Volume discount – again, this is a very common discount agreement

in which different prices are negotiated for different volumes. The

idea here is that a volume purchase will allow the supplier to achieve

some form of economy of scale and part of this is shared with the

buyer. Again, it is easy to forget that a particular volume discount

was given even if the current volume is different. These agreements

are ‘sticky’ – i.e. they tend to persist beyond the date on which

they were first agreed and so we should be vigilant in ensuring that

volume discounts are properly managed.

• Promotional discount – promotional discounts are offered as an

inducement to the buyer to purchase a new product or service and

to mitigate his risk in making such a purchase. If the brand is very

strong, like Apple, we may not need to discount at all, especially if

demand greatly exceeds supply. A crack in this discounting policy

occurred late in December 2012 when Walmart, in collaboration

with Apple, dropped prices on the iPad by one third and on the

iPhone by nearly 50%. Commentators suggest that this is an example

188

of slide down pricing given the increased attractiveness of Android

and Kindle products. In reality promotional discounting should really

be viewed as a discretionary application of marketing budget to

increase the economic value of a product. ‘Discount’ tends to

suggest brand cheapening.

• Discounting by default – this is a rather different form of discounting,

and is usually the strategy adopted “in panic” by a salesperson who

has been put under pressure by the buyer. A buying agent will often

try to get the best deal he can by subtle and not so subtle strategies.

Table 10.4 lists some fairly typical challenges and suggested responses.

Why DO DO NOT

They do not have authority to approve your offer

Check that the offer is correct and then ask for joint meeting with someone who does have authority.

Accept the story at face value.Offer a discount.

They cannot afford it

Explain consequences of ‘no’ and ask to meet more senior person.Take out something they do not need.Come back later when there is more budget.


The deal is wrongAsk some more questions to try to make the deal right.

Offer a discount.

Someone else’s deal is better

Ask some questions to validate ‘apples vs. pears’.Check out the competitive deal later.


Your product is just a commodity

Ask if the buyer knows what a commodity is.Ask for an explanation of this comment.Demonstrate why your product is better in his context than alternatives.Inform him that his competitors are using your product in preference because it is the only one delivering the impact your customer is seeking. So it is not a commodity.

Offer a discount.Present side by side lists of specs/features.

Your offer is no different to another – but they got in first

Check that the deal is indeed the same (do not compare specifications).Challenge the ‘identical’ assertion.Point out the folly of accepting first deal offered.


They are lying through their teeth

Challenge/counter every word they utter.Demonstrate their cost of saying ‘no’. State ‘This is our price’ – and stick to it!

Signal your agreement.Capitulate.Offer a discount.

Table 10.4 Dos and don’ts in discounting

Price Management


189

The buyer’s job is to purchase necessary items and services for his business

and to do so at the lowest possible cost. His livelihood and continued

employment depend on his ability to do this.

What he does not want to hear is a detailed argument that leads to him

paying a higher price. It is not that he does not understand the argument.

Of course he does. It is that he cannot afford to acknowledge it. The

salesperson’s job is to present all the value arguments in the right way to

the right person.

If we have not given the salesperson adequate training, or the product

genuinely is a commodity (rare) then perhaps discounting is the only way

he can win the business. In virtually every other circumstance it is not. By

offering to discount without even attempting to present value arguments,

the salesperson is just simply not doing his job. The problem is that by

offering a discount on one occasion in the face of a customer’s challenge

vindicates the buyer’s strategy and will encourage him to do the same

the next time the parties meet. By giving away successive discounts, the

salesman can destroy his employer’s business single-handedly.

Many sales people do not understand the link between discount and

margin, and the implication of deep discounting on the business. Tables

10.5(a) and 10.5(b) demonstrate this relationship clearly. In Table 10.5(a)

let’s say we are selling at a gross margin of 30%. Under pressure our

salesperson agrees a unit price discount of 10%. The table entry is 50.

What does this mean? Quite simply, in order to get back to the profit

level he would have achieved without discounting he has to sell 50%

more! But, as we often find today, suppose the company is selling a

marginally profitable product at 5% gross margin. A similar discount of

10% corresponds to no entry in the table. Why? The formula on which

this table is based requires us to divide by zero. In other words, to get

back to the planned profit he would need to sell an infinite number of

items. His strategy of discounting on demand has plunged the deal into

catastrophic loss. Of course, it could be a lot better. Table 10.5(b) shows

the impact of a price increase. At the same gross margin of 30%, a 10%

price increase would mean the salesperson would need to sell 25% fewer.

A much better outcome!

190

GROSS MARGIN %

5 10 15 20 30 40 50

1 25.0 11.1 7.1 5.3 3.4 2.6 2.0

2 66.7 25.0 15.4 11.1 7.1 5.3 4.2

3 150.0 42.9 25.0 17.6 11.1 8.1 6.4

4 400.0 66.7 36.4 25.0 15.4 11.1 8.7

5 100.0 50.0 33.3 20.0 14.3 11.1

6 150.0 66.7 42.9 42.9 17.6 13.6

7 233.3 87.5 53.8 30.4 21.2 16.3

8 400.0 114.3 66.7 36.4 25.0 19.0

9 900.0 150.0 81.8 42.9 29.0 22.0

10 200.0 100.0 50.0 33.3 25.0

15 300.0 100.0 60.0 42.9

20 200.0 100.0 66.7

25 500.0 166.7 100.0

30 300.0 150.0

35 700.0 233.3

40 400.0

%

D

I

S

C

O

U

N

T

O

F

F

E

R

E

D

Table 10.5(a) Unit volume increases depending on discount at different gross margins

Price Management


191

GROSS MARGIN %

5 10 15 20 30 40 50

1 16.7 9.1 6.3 4.8 3.2 2.4 2.0

2 28.6 16.7 11.8 9.1 6.3 4.8 3.8

3 37.5 23.1 16.7 13.0 9.1 7.0 5.7

4 44.4 28.6 21.1 16.7 11.8 9.1 7.4

5 50.0 33.3 25.0 20.0 14.3 11.1 9.1

6 54.5 37.5 28.6 23.1 16.7 13.0 10.7

7 58.3 41.2 31.8 25.9 18.9 14.9 12.3

8 61.5 44.4 34.8 28.6 21.1 16.7 13.8

9 64.3 47.4 37.5 31.0 23.1 18.4 15.3

10 66.7 50.0 40.0 33.3 25.0 20.0 16.7

15 75.0 60.0 50.0 42.9 33.3 27.3 23.1

20 80.0 66.7 57.1 50.0 40.0 33.3 28.6

25 83.3 71.4 62.5 55.6 45.5 38.5 33.3

30 85.7 75.0 66.7 60.0 50.0 42.9 37.5

35 87.5 77.8 70.0 63.6 53.8 46.7 41.2

40 88.9 80.0 72.7 66.7 57.1 50.0 44.4

%

P

R

I

C

E

I

N

C

R

E

A

S

E

R

E

Q

U

E

S

T

E

D

Table 10.5(b) Unit volume reductions depending on price increase at different gross margins

192

ConclusionPricing is one of the most interesting, challenging and fulfilling of all

marketing disciplines. It can appear complex, daunting and even

overly theoretical. In reality, however, much of this apparent theory is

straightforward, simple common-sense. Keep one thing uppermost in your

mind at all times. What is the true value of your product or service to your

customers? If you know this – and can explain it clearly – you can explore

how alternative pricing approaches can create a win-win outcome for

you and your customers. Lose sight of value and you lose your compass.

Good luck – and successful pricing!


193

References

Anderson JC, Narus JA, Wouter Van Rossum, (2006), Customer Value

Propositions in Business Markets, Harvard Business Review and Harvard

Business School Publishing

Atkin & Skinner, (1975), How British Industry Prices, Industrial Market

Research, [online] http://www.managingchange.com/dynamic/ebay.

htm (Accessed July 2015)

Baker RJ, (1998), Value Pricing, Aspen Law & Business

Barco Projection Systems Case Study (A), (2002), Harvard Business School,

Case Number 9-591-133

Berry M and Linoff GS, (2011), Data Mining Techniques: For Marketing,

Sales, and Customer Relationship Management, John Wiley & Sons

Bienenstock R, Bonoma P & Hunter R, (2004), Keeping Mobile Customers,

[online] https://www.mckinseyquarterly.com (Accessed July 2015)

Cressman G, (2002), Driving Profitability: The Price Connection,

PharmaChem

Crouch HM & Hunsicker G, (2013), The Journey to Pricing Excellence in A

Hinterhuber & S Liozu, Innovation in Pricing, Routledge

D’Aveni RA, (2010), Beating the Commodity Trap: How to Maximize your

Competitive Position and Increase your Pricing Power, Harvard Business

School Press

Davenport TH & Harris JG, (2007), Competing on Analytics: The New

Science of Winning, Harvard Business School Press

Dibb S & Simkin L, (2010), Judging the Quality of Customer Segments:

Segmentation Effectivenness, Journal of Strategic Marketing

Drucker PF, (2007), The Essential Drucker, Butterworth-Heinemann

194

Espicom (2012), The World Generic Market Report, [online] https://www.

espicom.com/wgmrpr (Accessed July 2015)

Fabiani S, Loupias C, Martins F, Sabbatini R, (2007), Pricing Decisions in the

Euro Area, Oxford University Press

Glenn J & Walker R, (2012), Significant Objects, Fantagraphics

Hall J, (2012), London Hotel Room bonanza as Guests Stay Away, [online],

http://www.telegraph.co.uk/news/9441584/London-hotel-room-bonanza-

as-guests-stay-away.html (Accessed July 2015)

Hill RH, (2002), Managing Money: Money Matters for Managers, CIM

Publishing

Hoover H, (1936), Address to the Nebraska Republican Conference,

Lincoln, Nebraska (16 January 1936)

Hubbard DW, (2007), How to Measure Anything: Finding the Value of

Intangibles in Business, John Wiley & Sons Inc

Kintz J, (2012), This Book Has No Title, CreateSpace Independent Publishing

Platform

Lipovetsky S, Magnan S & Zanettir-Polzi A, (2012), Pricing Models in

Marketing Research, GfK

Macdivitt H & Wilkinson M, (2010), The Challenge of Value, Arima

Publishing

Macdivitt H & Wilkinson M, (2012), Value Based Pricing: Drive Sales and

Boost Your Bottom Line by Creating, Communicating and Capturing

Customer Value, McGraw Hill

Macdivitt H, (2013), Value – Distilling the Essence, in Hinterhuber A & Liozu S

Innovation in Pricing, Routledge

Maguire C, (2013), Dynamic Pricing: An Exploration of its Use in MLB and

if it can be Applied to Scottish Football, Unpublished Honours Degree

Dissertation, Department of Marketing, Strathclyde University Business School


195

Marn MV, Roegner EV, Zawada CC, (2004), The Price Advantage, John

Wiley & Sons

Meer D & Yankelovich D, (2006), Marakon/EIU Survey Reveals Venerable

Marketing Tool, Segmentation, Needs Repair; Experts Offer Six Guidelines

for Reviving Its Ability to Identify and Target Profitable New Customers

[online], http://www.thefreelibrary.com/n%2FEIU+Survey+Reveals+Venera

ble+Marketing+Tool,+Segmentation,...-a0141537200 (Accessed July 2015)

Mills RW & Sweeting C, (1988), Pricing Decisions in Practice, The Chartered

Institute of Management Accountants

Monroe KB (1990), Pricing: Making Profitable Decisions, McGraw-Hill

Nagle T & Hogan J, (2006), The Strategy and Tactics of Pricing: A Guide to

Growing More Profitably, Pearson Prentice Hall

Phillips RL, (2005), Pricing and Revenue Optimization, Stanford Business

Press

Porter ME, (2004), Competitive Advantage: Creating and Sustaining

Superior Performance, Free Press

Rostance T, (2012), Price of Football: What is Dynamic Ticket Pricing?,

BBC Sport, [online], http://www.bbc.co.uk/sport/0/football/19716087

(Accessed July 2015)

Sahajwani M, (2012), Why The Same Goods Have Different Prices

Around The World, [online], http://www.investopedia.com/financial-

edge/0912/why-the-same-goods-have-different-prices-around-the-world.

aspx#ixzz2MbHGz9ZP (Accessed July 2015)

Sahay A, (2007), How to Reap Higher Profits with Dynamic Pricing, MITSloan

Management review

Shapiro B, Rangan V , Moriarty RT & Ross EB, (1987), Manage Customers for

Profits (Not Just Sales), Harvard Business Review

196

Smith TJ, (2012), Pricing Strategy: Setting Price Levels, Managing Price

Discounts and Establishing Price Structures, South-Western Cengage

Learning

S&P Dow Jones Indices, (2011), S&P Global 1200 Methodology, [online],

http://us.spindices.com/documents/methodologies/methodology-sp-

global-1200.pdf (Accessed July 2015)

Swire D & Gale B, (2013), The Launch of Apple’s Ipad Mini – A Customer

Value Perspective, Customer Value Inc [online] http://www.cval.com/

pdfs/LaunchOfAppleIPadMini.pdf (Accessed July 2015)

Tennent J & Friend G, (2005), Guide to Business Modelling, The Economist in

Association with profile Books Ltd

The Journal of Professional Pricing (2008), The Journey to Pricing

Excellence, The Journal of Professional Pricing, [online], http://www.

pricingsolutions.com/pdf/the_journey_to_pricing_excellence.pdf

(Accessed July 2015)

Usborne S, (2012), The Price is (really) Right: ‘Dynamic Ticketing’ Could

Transform the Way We Pay to See Live Events, The Independent, [online]

http://www.independent.co.uk/arts-entertainment/music/features/the-

price-is-really-right-dynamic-ticketing-could-transform-the-way-we-pay-to-

see-live-events-8215701.html (Accessed July 2015)

von Braun C, (1997), The Innovation War, Prentice Hall

Walker R & Glenn J, (2012), Significant Objects, Fantagraphic Books Inc

Webber M, (2012), Dynamic Ticketing: Derby Set to Revolutionise Ticket

Sales Approach, FCBusiness Magazine, September

Wilson RB, (1993), Nonlinear Pricing, Oxford University Press

Yankelovich, D & Meer D, (2006), Re-discovering Market Segmentation,

Harvard Business Review


197

7Cs 51

7Ps 51, 174

Absorption cost 11

Accounting concepts 1-11

Bartering 164

BCG matrix 73

Blocking 165

Break-even analysis 2, 7, 9, 77

Break-even point 3, 5-6, 10, 84

Bundling 148-151, 161, 183

Buyer types 66

By-product 165

Captive pricing 165

Cluster analysis 70

Commoditisation 1, 20, 28-36, 40, 45, 87, 102, 113, 136, 181, 182

Competition-based pricing 75, 93, 101, 102, 103, 135

Competitive bidding 93, 96-98

Competitor parity 93, 94-96, 168, 186

Contribution 6, 8, 26, 27, 31, 69, 79-82, 84, 116-122, 127, 132, 137, 148, 154, 161, 185

Contribution analysis 11-13, 48

Contribution-based pricing 81

Contribution-elasticity curve 161

Controlled availability 166

Cost reduction (CR) 15, 29, 34, 67, 69, 78, 116, 117, 118, 119-121, 122, 126, 132, 137, 138, 141, 181, 182

Cost-based pricing 6, 13, 51, 75-91, 135, 141, 142, 168, 177, 181, 182

Customer value map 104

Demand 146, 147, 148, 149, 151, 155, 156, 157, 159, 160, 161, 163, 166-168, 176, 181, 187

Demand curve 21, 23, 24, 25, 28, 30, 32, 65,

87, 157, 159,

Design 34, 47, 65, 67, 68, 89, 95, 106, 108, 118, 119, 120, 125, 126, 131, 139, 146, 165

Deterioration 35

Differentiation 34-36, 39, 43, 54, 55, 96, 102, 116, 132, 136, 152, 182, 186

Direct cost 2, 3, 6, 77, 78, 80, 83, 85

Directional policy matrix 73

Discounting 39, 43, 55, 87, 115, 142, 168, 175, 176, 181, 187-191

Discounts 43, 52, 66, 114, 115, 152, 153, 154, 160, 161, 163, 168, 175, 176, 187-191

Dynamic pricing 155-163

EBITDA 15

Economic value 127, 137, 138, 184, 185, 188

Emotional contribution (EC) 69, 116, 117, 118, 119, 120, 122, 132, 137, 148

Escalation 35, 175

Fixed costs 2-4, 6, 9, 11, 12, 14, 15, 27, 28, 76, 78, 80, 81, 82, 85, 89, 91

Fixed fee(s) 152, 153

Full cost recovery pricing (FCRP) 77-79

GE matrix 73

Geographic pricing 52, 58, 166, 168,

Geography 64, 67, 134, 142, 169, 174, 176

Going rate 93, 94, 99

Gross margin 6, 11, 79, 189, 190, 191

Imperfect market 19, 20

Knowhow 38, 129

Marginal cost 4, 12, 40, 45, 84

Marginal costs 4, 12, 40, 45, 84

Market shakeout 40

Marketing mix 1, 41, 50, 52, 54, 145, 173, 174, 175

Monopoly 20, 39, 93

Index

198

Moral pricing 166

Negotiation corridor 140

Net present value 73

New products 47-48

Non-linear pricing 152, 155, 167, 168

Oligopoly 20, 21

Optimal price curve 26, 27

Optional pricing 16, 52, 165, 168

Patterns of usage 63, 67

Pay on click 163

Penetration 43, 44, 45, 48, 49, 50, 168

Perfect market 19, 21

Perfect storm scenario 9, 11

Performance based pricing 164

Points 167

Predatory pricing 93, 98, 99, 100

Premium pricing 30, 34, 35, 43, 44, 45, 46, 48-50, 52, 64, 101, 122, 147, 151, 160, 165

Price elasticity of demand 5, 22-28, 148

Price line 99

Price lists 100, 142, 175, 176, 180

Price management 76, 171-191

Price optimisation 184, 185, 186

Price setting 22, 48, 76, 91, 113, 171, 172, 177, 181

Pricing council 171, 175, 177-179

Pricing maturity 76, 179-186

Product Life Cycle 37-47

Productising 164

Product-service price grid 93, 102-103

Profit levers 13-17

Proliferation 35

Promotional pricing 47, 61, 107, 167, 187, 188

Quantity discounts 153, 154

Reference price 137, 138, 140

Revenue gain (RG) 67, 69, 116, 117, 118, 119, 122, 132, 137, 138, 148

Sales revenue 2, 4-6, 8, 9, 155, 173

Segmentation 57-74, 126, 148, 152, 173, 184, 186

Servicing 139, 164

So what analysis 70, 121, 125, 126

Stakeholders 119-127

Supply 19, 21, 39, 46, 60, 63, 84, 139, 155, 156, 160, 181, 187

Tactical pricing 1, 44, 52, 145, 172, 174

Target ROI 79, 80, 81

Timing 63, 67, 160

Transaction specific pricing 163

Two-part tariff 154, 155

Value based price 129-144

Value based pricing 29, 51, 60, 73, 114, 116, 129-144

Value curve 62

Value drivers 55, 61, 62, 65, 70, 73, 74, 119-121, 126, 127, 128

Value orientated segmentation 58, 68

Value proposition 34, 35, 45, 50, 51, 60, 68, 69, 72, 73, 89, 90, 93, 113, 116, 119, 123, 127, 132, 184, 184

Value segments 30, 57, 60, 68, 69, 70, 72, 186

Value to the vendor 69, 72

Value Triad 67, 69, 93, 101, 115-118, 121-128, 132, 136, 140, 141, 142

Variable costs 2, 3, 4, 8, 9, 10, 11, 14, 15, 17, 26, 27, 46, 75, 76, 79, 80, 81, 82, 87, 88

Willingness to pay 65, 68, 69, 71, 156


199

Cambridge Marketing Handbooks This Pricing for Marketers Handbook is one in a series of

Handbooks for marketing practitioners and students,

designed to cover the full spectrum of the Marketing Mix.

The other Handbooks include:

• Digital Marketing

• Distribution for Marketers

• Law for Marketers

• Marketing Communications

• Marketing Philosophy

• Marketing Planning

• Product Marketing

• Research for Marketers

• Services Marketing

• Stakeholder Marketing

1,1,0, ,,Black,0,0Signature 1, Tile 1 (A) with pages...

Documents

Transcript of 1,1,0, ,,Black,0,0Signature 1, Tile 1 (A) with pages...