Goodwin - Pricing for Long-TermLong-Term Profitability 0273659332

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Pricing for Long-termProfitability

ALAN WARNERAND

CHRIS GOODWIN

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First published in Great Britain in 2002

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v

About the authors

Chris Goodwin read economics at Cambridge and also qualified as a Chartered

Accountant. After being involved in the training of candidates for accounting

examinations, he joined Ashridge Management College and managed a wide range

of financial and general management training programmes. He left Ashridge to

become a founding partner of MTP and has since worked with a range of major

company clients, now teaching mainly in the areas of marketing and strategy.

Alan Warner is a Chartered Management Accountant who worked as a financial

manager in industry before moving to Ashridge. He was Director of Studies,

Senior Programmes before also becoming an MTP founding partner. He haswritten a wide range of articles on financial, management and HR issues,

appearing in The Times, Management Today, Personnel Managementand all the

major accounting journals. He was joint author ofShareholder Value Explained

published by Financial Times Prentice Hall as part of this Executive Briefings

series and has written a number of business novels, designed to make difficult

topics easy to understand and apply.

MTP was formed in 1987 as the Management Training Partnership and has

grown rapidly to become one of the largest UK providers of tailored management

training. MTP designs and delivers tailored programmes in three core areas: finance,

marketing/strategy and people skills. It has a range of blue-chip clients including

Boots, BP, GlaxoSmithKline, ICI, Pearson, Shell and Unilever, and employs 16 full-

time tutors all specialist communicators with management experience.

For further information please contact:

Alan Warner

MTP PLC,

3 Prebendal Court,

Oxford Road,

Aylesbury,

Bucks.

HP19 8EY

Tel: +44(0) 1296 423474

Fax: +44(0) 1296 393879

E-mail: [email protected]


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vii

Contents

Preface xi

A framework for pricing 1

The problem of price inertia 3

The complexities of pricing 4

A framework for pricing decisions 5

The concept of value 6

Organizational responsibility for pricing 7

Price reviews 9

Steps to pricing effectiveness 9

Economic theory 10

Generic pricing strategies 11

Business strategy as the starting point 13

Porters generic business strategies 13


Choosing between skimming and penetration 15Subsidiary pricing strategies 18

Practical applications 19

Pricing and the product life cycle 19

A summary of life cycle pricing strategies 22

The importance of competitor analysis 22

Understanding the competition 23

Competitor aware but not competitor driven 25

The problems of analysis 25

The context of competitor price assessment 26

Some principles of competitor analysis 27

From competitors to customers 32

The drivers of consumer price sensitivity 33

The need for understanding and insight 35

The nature of the product 36

Emotional or functional benefits? 37

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viii

Contents

Market environment 38

The context of the purchase transaction 40

A complex web of factors 43

Price as part of the marketing mix 45

The marketing mix framework 47

The place of price in the marketing mix 47

Segmentation 48

Pricing and product 49

Pricing and promotions 52

Pricing and distribution channels 54

Analyzing the value package 56The link of pricing strategies to financial results 58

Price, value and profitability 59

Definitions of quality 61

The PIMS research 61

Linking value to profitability and market share 63

Summary of rankings 64

PIMS, Porter and pricing strategies 65

Financial implications 66

Analyzing the financial impact 67

The case for cost and profitability analysis 69

The link to financial objectives 69

The financial analysis of price change options 70

Cost structure 71

The impact of price reductions 75

The price/volume breakeven concept 76The impact of different cost structures 78

The causes of variation in cost structure 79

Long-term fixed costs 81

Cost structure and pricing behaviour 83

The breakeven chart 85

The temptations of a high fixed cost structure 86

Marginal pricing 87

The pros and cons of marginal pricing 89

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Contents

Price behaviour in the high variable cost business 93

Understanding competitors cost structures 93

Cost plus pricing revisited 95

The case against 97

The case in favour 98

The costing process 98

Activity-based costing 101

Profit objectives 102

The concept of required contribution 103

The value of financial assessment 105

Pricing, business objectives and value creation 107

From value pricing to value to shareholders 109

Relating financial to marketing objectives 110

Evaluating marketing objectives 110

The underlying assumptions 116

Conclusion 117

Appendix The economic theory of pricing 119

References 129

ix

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xi

Preface

This book sets out to provide an overview of pricing issues and principles,

covering the topic from a balanced perspective, including strategic, marketing and

financial factors.

It starts with a statement of some key issues and complexities in the pricing

decision-making process and affirms that the best decisions are based on the

concept of value maximization for customers. A step-by-step framework is

suggested to ensure that all factors are taken into account and this framework

provides a structure for the chapters that follow.

The starting point is the broad strategy of the business as a whole, followed byan assessment of competitor prices and of the factors which impact price

sensitivity. There is then coverage of price as only one element of the marketing

mix and its relationship to the other components.

After a reference to some research which shows the relationship of broad pricing

strategies to the financial performance of the business, the book then moves on to

cover the key financial issues involved in pricing, including the evaluation of

price/change options, the importance of cost structure to pricing behaviour, and

the reasons why cost plus pricing is still important in some businesses.

The final chapter covers the need for pricing decisions to maximize value creation

over the long term and suggests the ways in which this can be assessed financially,

confirming the link between value to customers and value to shareholders.

This book is suitable for use on any course or other learning activity involving

the topic of pricing, either as pre- or post-course work on fundamental principles.

Its comprehensive and practical nature demonstrates the skills and ability of MTP

to provide user-friendly and effective learning for managers.


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1

A framework for pricing

The problem of price inertia 3

The complexities of pricing 4

A framework for pricing decisions 5

The concept of value 6

Organizational responsibility for pricing 7

Price reviews 9

Steps to pricing effectiveness 9

Economic theory 10

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This book covers the topic of pricing by providing principles, frameworks,

concepts and guidelines for any manager in business with responsibility for pricing

decisions. This is a tough call because there are so many factors in the pricing

decision that vary because of different businesses, products, histories and customer

relationships. It is difficult to produce even the broadest guidelines that can be

applied at one extreme to the brand manager of Coca-Cola and at the other to the

jobbing builder quoting for a house extension. Indeed, the question has to be

asked: can there ever be general principles that apply across the whole spectrum?

We hope to provide a positive answer and this first chapter sets us on the way.

THE PROBLEM OF PRICE INERTIA

The basic economics of a business can easily be complicated too much. At its

simplest, there are three main variables in business that managers can influence to

create value for shareholders. These are:

sales volume

cost levels

price levels.

There is a danger that, because of pressure from top management for volume

growth often driven by real or perceived shareholder needs and the naturaldesire to match competitors cost efficiency, the price element of the equation

receives inadequate attention. There is a natural tendency for prices to stay as they

are because in the face of market uncertainty, this seems the best approach.

Managers thus allow inertia and risk aversion to dominate their thinking and,

in so doing, avoid the considerable effort involved in making a change,

particularly when the move is up rather than down. It is easier to avoid preparing

that difficult communication to customers and to leave things as they are. Such an

approach means that managers may be much too passive; they will wait for costs

to rise, for customers to complain, for another competitor to move or for

shareholders to express concern about the levels of profitability before they take

action to change price.

This is a flawed and lazy approach because the price level is such a vital element

of marketing strategy and such a major driver of value creation that there should

always be clear, proactive thinking about current and future price levels, based on

regular and analytical review. There should be a clear policy on pricing and a set of

agreed practices to carry it out. Costs and competitors should be key factors in the

decision, but your own management should have control and should set the agenda.

The passive and reactive attitude to pricing had its origins in the days when

inflation was much higher than it is now and when a key objective of accounting

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was to remove the impact of inflation, to look for measures that expressed growth

in real terms. Price increases and inflation became much too closely connected in

the minds of managers in all functions. The legacy of this thinking is still around

today as managers quote real volume growth in their internal reports or in their

annual reports to shareholders. Though there is some validity in knowing these

figures as part of managing any business, excessive emphasis on real growth can

cause the pricing lever to be neglected or to be deliberately managed down. A

number of international companies have recently reviewed this real terms

thinking as they realize that shareholders and the analysts who advise them are

interested in increases in cash flow and profit, rather than in real volume.

THE COMPLEXITIES OF PRICING

A vital point to understand as you start this book is that pricing is complex. There

is no one perfect answer to the decision about what price to charge. There are

many business models retailer, consumer goods distributor, industrial goods

manufacturer, service supplier, project deliverer each of whom will look at

things from a different perspective and have their own approach to pricing.

To illustrate this complexity and to provide a broad overview of what follows

in later chapters, lets think about the decision process for launching a new

product, any product. Think of a new product which you might launch in your

own business or one which you see in the supermarket. What should be the basis

for the price? Lets look at the possibilities.

Your own costs plus a required margin?

Cost will be a factor in the decision, but there are a number of problems about

using cost plus as a basis for pricing. For one thing your customers dont know

or care about your costs and required profit levels; they will buy only if they see

the product as having value for them. Another point is that your costs may be

higher than those of your competitors, in which case such a basis would makeyour selling price unrealistic. And finally, a point which is vital but which is often

misunderstood, it is impossible to determine precise and unarguable cost levels

because costing, and its conversion into price, is a complex and inexact science

(we will explain the reasons for this in more detail in Chapter 9).

Your competitors prices?

Certainly these will be a factor and sometimes a starting point, but competitor prices

can be no more than a guide because rarely is there a uniform product or a simple


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direct choice for consumers. In everything but the most basic commodity business,

other factors in the value equation impact the buying decision. Therefore you need

a marketing strategy to determine your own positioning, and an assessment of your

overall value package in relation to these competitors, before you can use their

prices as a benchmark.

Your customers willingness to pay?

This is clearly not separable from the issue of competitor prices because willingness

to pay is always dependent on the choices available. A further practical problem is

that it may be expensive or even impossible to find out the amount that customers

are willing to pay, because the factors in the choice are so complex. In any case it

can be dangerous to price high on the basis of what the market will bear unless thatprice is linked to an offer of good value, because the high profit margins may invite

new competitors into the market and eventually reduce overall profitability.

The key point to note and retain, one which will become an ongoing theme of

this book, is that price can be seen only in the context of a marketing strategy

because it is the total value proposition rather than the price which customers are

assessing when they make their buying choice. Furthermore, researching that

complete value proposition before a new product is launched is much more

difficult than researching price alone, which is perhaps one reason for the high

proportion of new product failures in most sectors.

A FRAMEWORK FOR PRICING DECISIONS

The outcome of this complexity is that the pricing decision should be seen as the

combined result, expressed or intuitive, of the analysis and interaction of a number

of factors which can be summarized in Figure 1.1.

This is why there are no easy answers. Selling prices must be arrived at as the result

of a series of analytical and strategic processes that are designed to arrive at an

assessment ofperceived customer value. This must be assessed as the critical elementof the decision-making process because it is the key to successful pricing strategies.

The establishment of this principle also helps to clarify the role of cost in the pricing

decision. As Figure 1.1 shows, the cost of the product must at some point be matched

with this agreed value price, to arrive at the profit level that will be achieved from

sale. The calculation of this profit level enables management to assess whether the

company is getting an adequate return from the current price, as a guide to both

short- and long-term decisions. Clearly the willingness of the company to continue in

business at that profit level will, in the long term, determine whether the selling price

and the business model are sustainable.

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Fig. 1.1 The factors which determine the pricing decision

However, the concept of cost plus pricing cannot be rejected entirely and, for this

reason, all of Chapter 9 will be devoted to this topic. In some project-based

industry sectors, for example construction or shipbuilding, cost has to be the

starting point for pricing because there is no standard, visible benchmark in the

market when the project is conceived. Cost plus may also have a place when

market forces are not applying because the customer has chosen to trust the

supplier to take the cost plus route, or because the market has monopolistic

features. We would argue, however, that the above framework still applies to these

situations and in the long term customers or governments will allow cost plus to

continue only if they feel that they are receiving value from the arrangement.

THE CONCEPT OF VALUE

The use of the concept of value as the basis for pricing will recur many times

during the book, so we should start with a clear idea of its meaning. It is one of

many generic words which entered the management vocabulary during the latter

part of the 20th century and it has been used in many, often conflicting, ways.

Dictionary definitions refer to desirability, worth and utility, which help us to

some extent. Confusion may also be caused by the fact that accountants,

economists and marketers often have their own different ways of defining value,

so we will aim for simplicity.

Competitoranalysis

Customeranalysis

Marketingmix

Perceivedcustomervalue

Price Cost

ProfitRequired

profit levels?


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In Chapter 5 and elsewhere we will be emphasizing the principle that price is

only one element of the marketing mix. The offered price will always be seen by

the customer in relation to the other benefits provided, as part of the total

marketing proposition. We can thus convert the customers buying transaction to

a simple equation:

Benefits = the total gain for the customer from the purchase.

Price = the cost to the customer.

Value = the net gain of Benefits less Price.

To make the purchase the consumer must believe that the benefits she will receive

from that purchase will exceed the cost. However, this is rarely seen in isolation

because there will be competitive offerings available. Therefore prospective

customers will measure the value from each offering and will choose the one that,

for them, has the largest positive gap between benefits and price. They will not

always choose the cheapest; they may prefer the more expensive product because

the value of its extra benefits exceeds the price differential. These benefits may be

perceived rather than real the critical factor is that the consumer believes them

to be important enough to trade them off against price.

This definition of value inevitably adds to the complexity of the pricing decision

because perceptions of value will vary from one person to another, from one

market region to another, from one distribution channel to another. Therefore

pricing is not easy because marketing is not easy; if it were easy it could bedetermined by quantified analysis from accountants and computers. Such

quantified analysis will have a part to play, but the pricing decision must be based

on informed and expert judgement, applied to each segment of the market.

ORGANIZATIONAL RESPONSIBILITY FOR PRICING

One clear implication of what we have covered so far is that the pricing decision

should be considered in long-term strategic, rather than short-term tactical, terms.

It should also not be confined to any one person or department; at the very least

it requires inputs from a marketing specialist and a financial analyst, combined

with close contact with top management to ensure coherence with strategic

objectives. There should also be inputs from those responsible for sales and

marketing intelligence. For all this to happen it is vital for there to be an agreed

price review process, which enables pricing decisions to be taken in a strategic and

cross-functional context. However, to allow the necessary responsiveness and

flexibility, there must also be processes that enable day-to-day decisions to be

made in a practical and speedy way, within agreed parameters.

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If, for purposes of day-to-day practicality, it is necessary to come down in

favour of one function having overall authority, this must lie with those who have

strategic marketing responsibility in the business. These individuals may not

always have the word marketing in their title particularly in non-consumer

businesses but, as the guardians of product positioning and marketing strategy,

they must have control and, if necessary, the final say. In smaller businesses with

simple pricing structures, this may be managed personally by the chief executive

certainly this is where the buck should stop in every case.

Allowing the finance function to take the lead in pricing decisions can be

dangerous. It may lead to the cost plus approach becoming too dominant in routine

operational thinking. For example, the lazy and ill-considered practice of

automatically passing on cost increases may become embedded in financially driven

processes. Financial managers may say, costs have gone up by 10 per cent so pricesmust follow irrespective of the reasons for the cost increase, the likely competitor

reaction and the impact on customer perception.

Though sales managers and their teams clearly have an input in the pricing

decision, it can be dangerous to allow the sales function to dominate the process too

much, unless they have clear marketing responsibilities and are encouraged to think

broadly as part of their role. A good test is whether sales people are targeted

exclusively on sales volume or whether other factors revenue per unit, profitability,

customer satisfaction are part of their interest, motivation and reward system. If

volume is their main focus and key success factor, they should not have the final say.

The obvious and ideal solution is for pricing responsibility to lie with a cross-

functional team, though the practicalities of this easy statement will depend on the

day-to-day realities of the business and its interactions with customers. It is not

possible in every business for each price quotation or discount decision to be

assessed by a group; it all depends on the extent of standardization of the product

and the frequency of pricing judgements, factors that are unique to each sector.

The following structure represents an ideal position and should be applied and

adapted to the operating realities of each business:

a cross-functional team to set the strategy and the processes to implement it; thiswill normally be the board of directors or an executive committee at that level;

a subsidiary group, also cross-functional, to operationalize the strategy and

carry out price reviews (see below);

clear responsibility with the marketing function (or equivalent) for interpreting

the strategy on a day-to-day basis;

agreed parameters for discretion, with processes for authorizing deviations and

interpreting grey areas.


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PRICE REVIEWS

Whatever structure is agreed, it is critical that a full pricing review takes place at some

point and that it involves the cross-functional inputs mentioned above. The reviewmust take into account all the factors in the above value framework, and must be

comprehensive rather than ad hoc, strategic rather than tactical. A good test of an

effective review process is whether it avoids the common mistakes of ill-considered

and reactive pricing decisions. To achieve this aim the review process should:

look at the complete range of offerings; it should always consider the overall

market position and the impact of one price decision on other products;

respond to a price increase by a competitor say the market leader in a

considered way, by analyzing the likely cause of the change, the expected

reactions of other competitors and the response of customers;

in businesses which require price quotations such as shipbuilding,

construction, engineering, consultancy maintain a consistent pricing policy, in

particular avoiding the temptation to agree low prices for a period because

there are fixed-cost people available to carry out the work;

in all businesses, maintain a consistent policy on discounts and special

reductions, avoiding as much as possible the granting of discounts to customers

to retain or gain business, without full consideration of the relative offerings

and the longer-term implications.

It is difficult to generalize about the time period between reviews because this will

depend on the speed at which the industry moves and the way in which it is

customary in the sector for prices to be changed. There has to be a careful balance

when deciding upon an appropriate review time. It must not be a six-monthly or

annual ritual that becomes too procedural and automatic, yet it must not be

continually postponed because the time is not right. It is also important that

reviews should not just take place in times of crisis, for example as a gut reaction

to a competitor attack, or in response to a short-term profitability problem.

STEPS TO PRICING EFFECTIVENESS

One way to ensure that price reviews are sufficiently comprehensive is to have a

structured process which ensures that the required analysis is carried out. Figure

1.2 shows the ten steps of this process, each of which will be further developed as

we go through the various chapters of the book.

The way in which these steps are applied, in particular the starting point, the

sequence and the timescale, will depend on a number of factors for example,

whether the pricing decision is proactive or reactive, whether it is a new or existing

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product, whether or not competitor prices are easily available and the nature of the

customer interface. Whatever the context, however, these steps are a structure and

a discipline which will help to ensure the best possible pricing judgement.

Fig. 1.2 The ten steps of price review analysis

Many of the steps are interrelated and real-life application will not be as structured

and as sequential as it seems here. The best use of this framework is as a checklist

to ensure that, in the unique context of each business, these steps are carried out,

however intuitive, judgemental and informal the processes may be. Failure to do so

may result in decisions that lack economic rigour, missed profit opportunities and

an ineffective marketing strategy.

Following this framework, Chapter 2 will focus on the starting point for any

pricing decision, the overall competitive strategy of the business and the broad

pricing strategy which emerges from it.

ECONOMIC THEORY

This book does not focus on economic theory but on the practical issues of pricing

decisions in business. It often proves, however, that an understanding of the

micro-economic theory of pricing is a useful underpinning for what follows in

later chapters. We are therefore offering a chapter on this topic as optional

reading for those who have not studied economics and who would find it helpful

before moving on to Chapter 2. It can be found as a separate appendix on p. 119.

Makepricing

judgement

Developbusinessstrategy

Assesscompetitor

prices

Assesscustomer price

sensitivity

Analyze themarketing mix

Assess therelative value

positionConfirmpricingstrategy

Estimateimpact onvolume

Evaluatefinancial

implications

Re-assessfinancial and

strategicobjectives


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2

Generic pricing strategies

Business strategy as the starting point 13

Porters generic business strategies 13


Choosing between skimming and penetration 15

Subsidiary pricing strategies 18

Practical applications 19

Pricing and the product life cycle 19

A summary of life cycle pricing strategies 22

The importance of competitor analysis 22

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BUSINESS STRATEGY AS THE STARTING POINT

At the end of Chapter 1 we suggested a series of steps in the pricing decision and

this framework confirmed that the starting point has to be the development of astrategy for the business as a whole. Many frameworks and concepts of business

strategy were developed as management thinking evolved during the second half of

the 20th century and perhaps the most influential writer has been Michael Porter, a

Professor at Harvard Business School. Porters work is highly relevant to pricing. He

argues that the most successful companies are those that make fundamental choices

about how to compete in clear, unambiguous terms. He says that the first and key

question that must be asked and answered by top management when developing a

strategy is: what is our primary and fundamental competitive position?

The evidence of Porters research is that less successful companies do not makesuch fundamental choices and try to compete in a number of ways, ending up

being stuck in the middle.

PORTERS GENERIC BUSINESS STRATEGIES

Porter has developed this idea of fundamental choices by identifying three possible

generic business strategies:

overall cost leadership differentiation

focus.

We will examine the implications for pricing of each of these three strategies.

Overall cost leadership

A business which achieves overall cost leadership has the ability to produce at

lower costs than all competitors. Porter puts forward the following advantages of

this approach:

The cost leader can apply a low pricing strategy and can earn a profit at that

level when other players in the market are not doing so. Indeed, the cost leader

can encourage the rivalry and price competition which reduces the margins of

the weaker players.

The firm has a defence against powerful customers because they can only exert

power to drive down prices to the level of the next most efficient competitor.

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Differentiation

This strategy is to create a product or service that is perceived by customers as

being unique. Porter argues that this can be an effective strategy because:

it provides protection against competition because customer loyalty will result

in a lower sensitivity to price;

the product uniqueness will make it possible to compete even if the cost base is

higher than that of competitors;

the power of customers is reduced because they do not have comparable

alternatives.

Focus

Porters third generic strategy is to focus on a particular group of customers, type

of product, or geographic market. For this strategy to be effective the business must

be able to serve its focused target market more effectively than its competitors can.

As a result of this focus, the firm can achieve competitive advantage in three

possible ways: by better serving customer needs or by achieving lower costs, or

both. In this situation either low or high pricing strategies may be appropriate,

depending on the competitive situation and the long-term business objectives.

GENERIC PRICING STRATEGIES

Porters work links very closely to the two most frequently quoted generic pricing

strategies of skimming and penetration. These are extreme positions and are

rarely adopted in their absolute form, but they help us to consider the range of

pricing options in broad terms.

A low price penetration strategy

This strategy is called penetration because the aim is to penetrate the market and

achieve a higher market share than competitors. The strategic choice is to compete

primarily on price in the belief that the resulting gain in market share will enable

the business to achieve profitability. Porters valuable insight was that this strategy

can be adopted only in parallel with cost leadership, as it will only lead to high

profit levels if the firms costs are below those of the competition.


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A high price skimming strategy

This strategy is called skimming because the business tries to skim the market,

targeting only those who most value their offer and are willing to pay a premiumprice. Management is making a deliberate choice to sell at higher prices than the

average competitor. Businesses adopting this strategy are willing to sacrifice

potential market share because they believe that, in the long term, the resulting

margins will result in high profit levels. This approach to pricing must be adopted

in parallel with a strategy of differentiating the value package and Porter argued

that this will succeed only if customers perceive a significant and superior

difference to competitors.

CHOOSING BETWEEN SKIMMING AND PENETRATION

The following factors will combine to determine the choice of pricing strategy.

The nature of the product

A key factor is the extent to which the product is homogeneous, with each

suppliers offering being of a broadly similar nature, without significant scope for

differentiation. Though confident marketers will claim that there need be no such

thing as a commodity and that you can differentiate anything by good marketing,there are bound to be limits because of the very nature of the product.

Price sensitivity is lowest for products which are commodities of uniform type

and quality; a good guide to extreme examples is if the product can be traded

unseen on commodity markets for example, cotton, sugar, grain, oil. The more

the product has commodity features, the more a penetration strategy, geared to

cost efficiency, will be appropriate.

The product life cycle

If the life cycle of the product is short, a skimming strategy is likely to be more

effective. The business that responds quickly can enter the market and make

attractive margins while there is limited competition. By the time competitors

enter the market, demand for the product may be declining and customers will be

moving on to other products.

If the life cycle is expected to be long, it is more likely that a penetration strategy

will succeed. The goal of growing market share will enable the business to take

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advantage of the economies of scale and experience curve (see below) which will

help to deliver low unit costs and high profitability.

Competitor response

If competitors are slow to respond to changes in the market environment and to

initiatives taken by other players, a skimming strategy will be appropriate. It will

be possible for the quick mover to maintain a premium price for a significant time

before competitors catch up. Conversely, if competitors are quick to respond, a

penetration strategy will be more effective.

Impact of economies of scale

Economies of scale occur when unit costs decline as total output increases. This

occurs primarily through the impact of volume on fixed costs. In many businesses,

a significant proportion of costs will remain fixed at the same level in money

terms over large variations of sales volume. An example is the cost of research

and development involved in the launch of a new product; once the launch has

taken place there will be little or no further research and development costs. As

sales increase, the research and development cost per unit and as a percentage of

sales will fall. The impact of this can be seen in Figure 2.1.

Fig. 2.1 Research and development costs fall following the launch of

a new product

Unitcost

Volume (units)


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If the economies of scale are significant, a penetration strategy will be more

effective as this will lead to higher volumes and lower unit costs than those of

competitors. This cost advantage will enable more aggressive price competition

and the potential to earn higher returns than the market average.

The proportion of fixed costs is a key issue in many aspects of pricing and will

be covered in more depth in Chapter 8.

Experience curve

The operation of the experience curve is similar to that of economies of scale and

is a second reason why unit costs fall over time. As each firm has more experience

of producing and delivering the product, it will become more skilled and efficient,

thus reducing the cost per unit. The impact on cost is similar to that for economiesof scale, except that the horizontal axis of the graph now represents total

cumulative rather than annual production (Figure 2.2).

Fig. 2.2 The experience curve effect

It can be seen from the figure that the impact of cost savings is greater at low

levels of cumulative production. Therefore the experience curve effect is likely to

be most relevant at the early stages of the product life cycle, or where there has

been a step change in technology.

If the experience curve effects are high, a penetration strategy is more appropriate,

in order to achieve volume and drive unit costs below those of competitors.

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Unitcost

Cumulative volume (units)


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18


A summary of the circumstances in which the different pricing strategies will be

most effective is shown in Table 2.1.

Table 2.1 The circumstances in which different pricing strategies will be

most effective

High price/ Low price/

skimming strategy penetration strategy

Product homogeneity Low High

Product life cycle Short Long

Competitors Slow to respond Rapid response

Economies of scale Small Substantial

Experience curve Small Substantial

SUBSIDIARY PRICING STRATEGIES

There are further subdivisions of the two strategy types, which help to match the

strategy to particular competitive situations and business objectives.

Pure skimming

The aim is to make a profit in the short term before competitive forces operate to

bring prices down. Examples would include products that are technologically

innovative such as mobile phones and DVD players, which are launched with high

prices and strong demand. However, as the product life cycle develops, prices

come down and so does the potential for profit.

Prestige skimming

The aim is to maintain the price premium throughout the life cycle of the product.

Examples would include Porsche cars and Rolex watches.

Pure penetration

The aim is to grow market share and to dominate an industry where price is

important to the purchase decision. An example is McDonalds strong position in

the fast food market.


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Pre-emptive penetration

The aim is to charge a low price which makes it difficult for new competitors to enter

the market, for example Microsofts pricing of its Windows software. The largeeconomies of scale of research, development and marketing enable management to

apply this strategy effectively.

PRACTICAL APPLICATIONS

In practice it is unusual to find that all the conditions for pure skimming or

penetration strategies are present in any one business or industrial sector. Managers

with responsibility for pricing need to consider the overall position and the factors

which have the strongest impact in their markets and then decide upon the most

appropriate pricing strategy. For example, a large pharmaceutical company will have

the opportunity to achieve economies of scale after the launch of a new drug because

the research and development costs will not increase thereafter. As sales increase, the

unit cost of the research will reduce significantly and these circumstances clearly

indicate a penetration strategy.

However, it is normal for new drugs to be introduced at a high price because of

other factors that have a stronger bearing on the decision. There is scope for clear

differentiation because the drug performs a unique function that alternative

products cannot deliver. Competition may be reduced by the operation of patents,so the ability of competitors to react quickly is often low.

In the face of such conflicting indications, a balanced judgement needs to be made,

examining each factor and choosing the appropriate strategy to match market

conditions at each stage of development.

PRICING AND THE PRODUCT LIFE CYCLE

We have mentioned the importance of the product life cycle in deciding on an

appropriate pricing strategy and we will now focus more specifically on this issue.

When using this concept as a guide to pricing strategy, it is important to think in

terms of the market as a whole rather than just the market position of one

business. The definition of the life cycle should be based on the total sales of the

product, from its launch by the first mover to its demise.

Four separate phases of the life cycle have been identified and these are important

to pricing strategy. They are shown in Figure 2.3.

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20


Fig. 2.3 The four phases of the life cycle

Some examples of products that are, at the time of writing, in different phases of

their life cycle are shown in Table 2.2. A range of different strategies will be

appropriate at these four stages of the life cycle.

Table 2.2 Products in different phases of their life cycle

Introduction Flat TV screens

Growth Digital cameras

Maturity CD players

Decline Leaded petrol

Introduction

During the introduction phase the aim is to build sales and customer loyalty for the

future. The main priority therefore is to ensure that the product is effectively meeting

customers needs so that quality is seen as higher than that of current and potential

competitors. This creates a foundation on which to build as the market expands. We

have seen already that price sensitivity is likely to be low during this early stage.

The pricing level therefore needs to support this strategy and to provide a clear

message to consumers. For example, if the new product is positioned as a

substitute to an existing one, the message must be either that the new product

performs the same function at a lower price perhaps due to technological

innovation or it offers superior performance.

Sales

Introduction Growth Maturity DeclineTime


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However, it would be dangerous to assume that the same function, lower cost

message will always result in success at this stage of the life cycle. It makes the all

too common assumption that competitors will not react. It will succeed only if

your price is lower than that which competitors are prepared to charge when

faced with such competition. The key to success is to predict the speed and nature

of the likely competitor response.

If the message is superior performance, it will be appropriate to launch at a

price premium to existing products. This is because it will be difficult to convince

customers that the new product has superior quality if it is being offered at the

same or lower price than competitors. In reality technological innovation or other

factors might make this possible, but customers will not normally believe that

they can have something for nothing. The higher price position helps to create

their feeling of perceived value.

Growth

In the growth phase of the life cycle the key strategic aim is to achieve a market

share position that will deliver high profit levels during the later maturity phase.

It will be much harder to enter the market or gain substantial share during the

maturity phase, as this will require gains at the expense of existing competitors

always a difficult task.

During this phase it is less likely that price will be the key driver of buying

behaviour because the main focus will be on developing products and services to

meet consumer needs. Insight into consumers needs becomes more important than

price. The successful players will be those whose consumer insight enables them to

achieve differentiation and therefore lower price sensitivity. If differentiation cannot

be achieved, price will continue to be the dominant factor.

Maturity

During maturity, which normally lasts longer than the previous phases, the focus is

on the achievement of maximum profitability and the pricing strategy should support

this aim. This is the stage where the hard choices mentioned earlier in the chapter

have to be made: management must opt for either a high price/differentiation or a

low price penetration strategy and avoid being stuck in the middle.

During this phase of the life cycle the successful players will increase sales by

innovations to meet the needs of new customer groups. Innovation is critical

during this phase of the life cycle for a number of reasons. It can continue to

prevent existing products from being seen as undifferentiated commodities and

thus avoid the resultant greater emphasis on price. Innovation can also extend the

total period of the life cycle. Indeed, there are some marketers who believe that

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22


the theory of the product life cycle is no more than a self-fulfilling prophecy. They

believe that marketing managers accept the eventual decline too easily and cut

back too much on innovation and marketing spend, thus encouraging its onset.

They point to long-lasting products such as soap or beer where there appears to

be no prospect of decline after several hundred years.

Decline

However, in most markets the product does eventually decline. During this phase

the strategic aim should be to develop a pricing strategy that will maximize cash

flow. There is a danger that a company will over-invest in fixed assets during this

period, thus creating capacity that will not be used in the future. This is an easy

trap to fall into because the product will be generating high cash flows and themoney for investment will be available. The better target for these cash flows is

investment in new products in the early stages of their life cycle, thus ensuring the

companys future viability.

A SUMMARY OF LIFE CYCLE PRICING STRATEGIES

Table 2.3 summarizes the pricing strategy at each stage of the life cycle.

Table 2.3 Pricing strategy at each stage of the life cycle

Life cycle stage Strategic objective Pricing strategy

Introduction High relative quality To support customer perception of quality

Growth Market share To enable achievement of market share objective

Maturity Profitability To achieve maximum profitability

Decline Cash flow To maximize cash flow as the product is phased out

THE IMPORTANCE OF COMPETITOR ANALYSIS

No pricing strategy can be developed without as full an understanding of competitor

prices as is possible and cost effective. After the development of the broad business

and pricing strategy, this analysis is the next important step towards effective pricing

decisions. It is therefore the subject of the next chapter.


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3

Understanding the competition

Competitor aware but not competitor driven 25

The problems of analysis 25

The context of competitor price assessment 26

Some principles of competitor analysis 27

From competitors to customers 32

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COMPETITOR AWARE BUT NOT COMPETITOR DRIVEN

Chapter 1 introduced the principle that a pricing strategy must be based on an

assessment of perceived value to customers and suggested a step-by-step processto carry out the necessary analysis. Chapter 2 emphasized that the overall business

strategy must be the starting point for the development of a broad pricing strategy,

determining the overall competitive position. In this chapter we will look at the

obtaining and assessment of competitor information to support that strategy,

together with the issues and pitfalls involved in this difficult process. It is vital to

know everything there is to know about competitor prices before making any

final judgement about your own price levels.

We should emphasize, however, that being fully informed about competitor

prices is very different from competitor-driven pricing, which is not desirable andwill not usually lead to the optimum pricing decision. We quoted an example of

this in the first chapter the passive approach of waiting for the market leader to

move and then following meekly. When this involves following a competitors price

reduction, it is often based on the marketing managers desire to maintain or

achieve a market share goal at all costs. In practice you may have to follow the

market leader, but only if, after that price decrease, your value proposition is less

appealing to the customer than that of the competitor, and only if it is the best way

of achieving long-term profitability rather than short-term market share goals.

THE PROBLEMS OF ANALYSIS

Pricing decisions should never be taken without as full an analysis of competitor

prices as is possible and cost effective. Ignorance of competitor prices within a sector

is likely to lead to damaging price competition as the players make invalid

assumptions about the intentions of others, often encouraged by customers who will

gain from ignorance and invalid information. Sometimes it may be possible to gain

from the ignorance of others, for example by being the only competitor who resists

the temptation to bring down price in response to falsely rumoured customerattitudes or market conditions. In every case it is important to develop your pricing

strategy while knowing as much, or preferably more, than your competitors.

Monitoring and analyzing competitor prices will rarely be easy or simple, but it

should not be avoided. Partial or estimated information is better than having no

information at all and better than basing your decisions on invalid assumptions

it is better to light a small candle than to curse the darkness. The difficulty of

finding competitor prices should never be a reason for failing to try.

In many business sectors the task of competitor assessment is becoming more

and more difficult. The range of competitors is widening and new players areemerging. Consumer goods companies find that their retail customers can quickly

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26


become their competitors by developing own label products. Companies enter

markets where previously they were not seen as likely competitors, for example

the move of confectionery companies like Mars into the ice cream market. More

advanced thinking in marketing and market research determines that the

definition of competition should be seen more widely, that it often comes from

sources that were previously not seen as competitive. For example, soft drinks

companies may be competing with ice cream, snack and chocolate suppliers for

the customers limited spending power on impulse treats.

In the business to business sector, the problems are even greater because there is

not the same public availability of data. This has been exacerbated because major

international customers are increasingly developing strategies to reduce cost through

a global approach to procurement. This brings to the market new international

competitors who were not there before and about whom it will be even moredifficult to obtain pricing data. Conditions of greater secrecy and complexity will

apply while at the same time price becomes an even more important part of the

customer decision-making process.

In these circumstances, customers are less loyal, less susceptible to personal

relationships and, in many cases, less likely to take into account the other factors

in the value proposition. The global buyer may deliberately use the policy of

secrecy to play off one customer against another as a way of achieving the lowest

price, via a closed tendering process. They may even encourage misinformation,

implying that others are prepared to reduce price and making price seem more

important than it really is in the final decision.

THE CONTEXT OF COMPETITOR PRICE ASSESSMENT

The first two chapters emphasized that the pricing decision is at the centre of a

wide range of different but interconnected forces. It is useful to summarize these

again as we begin to look at competitor analysis in more depth see Figure 3.1.

It is significant that the step-by-step decision-making process suggested in

Chapter 1 and which to some extent determines the structure of this book placescompetitor price analysis at an early stage, well before we look at our cost base

or our profit requirements. As we made clear in that chapter, there is no point in

making financial requirements the driving force of pricing decisions if competitors

can and will undercut you, however unfair it may seem and however difficult to

understand it may be. Customers are not interested in our problems and concerns;

their point of comparison is the price of their choices and that needs to be the

focus of our attention.

The scope and complexity of the framework in Figure 3.1 and all that we have

covered so far should make it clear that any survey of competitive prices cannot be a


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mechanistic task which leads to simplistic conclusions. Competitor prices can rarely

be assessed as a direct comparison. The judgement arising from the price comparison

has to be seen in the context of customer perceptions of the total value packages

offered by the competitors and, just as important, the business situation of each one.

Fig. 3.1 The forces impacting upon the pricing decision

For instance, when analyzing competitor prices prior to the development of a

broad pricing strategy, it is vital to take into account the financial position in

particular the size and cost structure of each competitor. There is no point in the

long term in trying to go for a low price, penetration strategy if that competitor

has the ability to produce at significantly lower cost. Different marketing or

supply chain strategies to overcome the cost disadvantage will be needed in these

circumstances and this will require an understanding of that competitor in both

financial and strategic terms.

SOME PRINCIPLES OF COMPETITOR ANALYSIS

It is not possible to be fully prescriptive about the required approach to the

assessment of competitor prices because it depends so much on what is possible

and what is cost effective, and this will depend very much on sector and country.

There are, however, some general principles which can be followed and these are

offered as guidance for management judgement.

27

Businessjudgement

Pricingdecision

Marketpositioning

Strategicobjectives

Customerperceptions

Competitorofferings

Estimatedcost

Requiredprofitability


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28


Competitor definition

Competitors should be defined as widely as possible, including all possible

alternative purchases available to customers. Coca-Cola would clearly regardPepsi as its main competitor but its price comparison would be likely to include

all drinks and food products that represent alternative purchases for customers.

In some markets this might mean tea and coffee, in other markets diluted soft

drinks or ice cream.

However, there has to be a balance too wide a comparison will make the

analysis complex and potentially misleading; too narrow a comparison will miss

out on vital information. The key principle is to think from a consumer

perspective when deciding the competitor set against which to benchmark. What

does the consumer view as the alternative choices?

The key test is: who loses when we win? If we sell another product, what is it

replacing? It is important to avoid conventional definitions and industry

classifications which encourage production-oriented thinking and a superficial

definition of competition. An apparently similar product for example a low

price, low value soft drink sold in down-market retailers may not be a relevant

competitor to a company operating at the premium end because it is not an

alternative purchase for the consumers being targeted. Such prices may still be

quoted to provide different perspectives and reference points, but they should not

be the main focus of the analysis.

Price definition

Prices should be defined as widely as possible. In the case of consumer goods

manufacturers selling to retail outlets, this will mean coverage of prices to retail

trade customers as well as to the ultimate consumer. This should confirm once

again that comparisons can rarely be exact or easy. It is relatively straightforward

for the brand manager to find out the price at which competitors chocolate bars

are selling in Tesco or Walmart in particular areas. It will not be easy to find out

the price at which Tesco and Walmart are buying from your competitors; thatneeds knowledge of discount and margin structures that will be individually

determined and difficult to compare.

It is also likely that discount structures will make the comparisons complex to

interpret. For instance, how do you treat cash discounts if they are linked to special

payment terms that do not apply to your dealings with that customer? How can you

find out about and take into account special retrospective rebates, granted on

achievement of sales targets? Special deals will also cause difficulties when surveyed

at the retail level there will be problems of comparison because of promotions,

special offers and extra value packs, which may be offered on a temporary basis and


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which may differ between channels and regions. It is important that a comparative

survey embraces these complexities rather than pretending they dont exist, even if it

makes the analysis of information and the judgement calls that much more difficult.

It is also important to compare like with like. If the directly comparable chocolate

bar has a different weight by a factor of (say) 10 per cent, should the comparison

be per bar or per unit of weight? There are never perfect answers to this kind of

question, but the best guideline is to make the comparison in the same terms as the

customer decision if the customer makes the buying decision in terms of price per

bar rather than price per gram, the results of the survey should be expressed in these

terms too.

Coverage

A price survey should cover all segments in which you are competing, for instance

different geographical areas, channels and classes of customer. Experienced

managers in consumer goods companies often warn of the dangerous practice of

wide ranging pricing judgements being made on the basis of a few isolated

comparisons in the chief executive or marketing directors local supermarkets,

which have little validity elsewhere. Surveys must be as wide and statistically valid

as possible if they are to be used for across-the-board pricing decisions.

One important principle to make comparisons and conclusions more

meaningful is that the focus should be on relative as well as absolute prices. The

analysis of the different segments is likely to be much more helpful if the results

are expressed as a discount or a premium to a mean or median price, or in relation

to particular competitors. However, it is important not to get too hooked onto

just one competitor, perhaps the market leader, and forget the other competitors,

direct and indirect, which might be alternative purchases in customers minds.

The need for a broad picture

In Dolan and Simons excellent book Power Pricing, they suggest four

characteristics of what they call power pricers their label for those who adopt

the proactive and value-based approach that we are advocating. One of these

characteristics is the building up of fact files to provide a comprehensive

information base about each major competitor so that price comparisons are seen

in the required broad context. These should include information about a

competitors cost structure, financial performance, business history, capabilities,

strategy and target-setting processes. The latter elements of this information may

not be easy to obtain and may not be available in precise form, but their collection,

analysis and subsequent discussion is critical to success.

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30


The term fact file perhaps underplays the vital need for such information to be

used interactively. All data on competitors, hard and soft, must become the driver

of discussion and proactive decision making, rather than lying in its fact file, waiting

for external events to drive the pricing decision. It is also important for the right

person to have the responsibility for obtaining and maintaining this information, to

avoid it becoming dated and sterile. Such a person must combine knowledge of all

information sources, with the energy to be creative and proactive.

Information sources

Information which can be purchased from market research companies is likely to

be the main source of price information in many consumer goods sectors and,

where it is available on an ongoing basis at realistic cost, it is likely to be a goodinvestment. Though it may be perceived that the value of such information is

reduced because all competitors have access to it, this does not make it any less

important to obtain. The critical point is that you will be at a disadvantage

compared with competitors if you do not take it and use it.

There is more doubt as to whether it is cost effective to commission ad hoc price

research on an ongoing basis because this is often expensive, though it might

sometimes be justified as a one off survey linked to a particular strategic review.

If market research data is not available or proves not to be cost effective or reliable,

there may be other good sources, particularly for general background information

to supplement the price data. Trade associations, independent industry analysts,

consultants and stockbroker analysts are useful sources to supplement the market

research data and your internal efforts. These internal efforts will also be much

more effective if you have someone with the necessary time and expertise to search

the Internet on a regular basis in order to keep the fact files up to date.

One aspect to consider in the brief given to the person or department with

responsibility for competitor information is the extent to which it should be

actively and directly sought from the competitors themselves. Clearly there are

tactics by which this can be obtained secretly, and these should be encouraged

within legal and ethical limits, but an open and co-operative approach should also

be considered.

It is often assumed that keeping competitors in the dark is always the right

approach and that the best way to achieve competitive advantage is by unshared

research. This may work well, particularly if your research resource is as good as,

or better than, any in the market. However, you should remember our earlier

point that if every competitor in the market is in a state of ignorance, often

encouraged by customers who want to play off one against the other, this may

result in low pricing strategies, adding to pressures on margins and reduced

overall profitability. If an industry co-operates in the sharing of price and general


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business information, it may work in the interests of all competitors, though it is

always important to be sceptical about the validity of information being

submitted by less scrupulous operators.

Maximize sales force information but beware

It is also important that the fact files should include sales force intelligence on a

systematic basis. Clearly the prices seen by sales people as they visit channels and

have conversations with customers can be a major source of price information.

There should be strong encouragement for such information to be sought

proactively. Sometimes sales people do not know their competitors prices simply

because they have never asked their customers and they should be encouraged to

seek as much information as possible during every sales contact. It is particularlyimportant to use information from loyal customers; if it is a long-term and

trusting relationship, customers may be more willing to share information about

competitors than is often believed.

However, it is important to be questioning and challenging about such information,

particularly where business-to-business transactions are involved. The key reason for

this need to challenge is that price is often the easy answer to the question, why did

we lose this business? It may be sincerely believed, but it may also be wrong. It is

often the customers explanation when a contract is not secured because it is easier

to blame price than to say, we did not like you or your pitch. Sales and marketing

people, reluctant to shoulder the blame for the problem and face the more difficult

issues, may willingly buy into this easy explanation. There is also an inevitably one-

sided aspect to sales force information on price. Customers are likely to tell sales

people when business is lost because prices are too high; however, they will not tell

them when prices are too low and when the business could still have been gained at

a higher price level.

Therefore, though it is vital to use sales force intelligence to gather data where

it is not easily visible, the results should be interpreted with care. In particular,

outdated, anecdotal information from a few individuals must not become the

conventional wisdom that is never challenged or compared. The best way to avoid

this is to keep the information fresh and to make sure that it is assessed and

discussed before becoming the basis for action.

Cost effectiveness

Each organization has to make its own judgements about the cost effectiveness of

pricing surveys and to decide when the value of extra, more detailed research

ceases to make it worthwhile. Even in the most visible and standardized of

industries, such judgements have to be made. Examples of extremes are useful to

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show the relative degrees of difficulty and the need for compromise at both ends

of the spectrum.

At the easy extreme are the retail supermarket operators which can carry out

a price survey simply by sending someone to a competitor store with a notebook,

or by buying off-the-shelf data from a market research agency. Contrast this

situation with an example of the difficult end a management consulting

company which, when trying to find out competitor prices, will be hampered by

confidentiality, complexity and difficulties of comparison; for example, what level

of consultant, what type of work, what unit of measurement? For the retailer the

question is: to what level of detail does the research go? How many stores, over

which period, how many product variants? For the management consultant the

question may be: is it cost effective to carry out competitor price research at all?

Would we be better to concentrate on optimizing our value package and its appealto customers, using customer reaction as the best gauge of competitor challenges?

In many cases the answer may have to be a reluctant yes.

FROM COMPETITORS TO CUSTOMERS

Competitor prices are an important starting point for pricing decisions but it is the

customers perceptions of, and reactions to, these prices that are critical to buying

behaviour. These perceptions will vary by product, by market and by customer

group, so the next chapter will focus on the key factors which drive price sensitivity.


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4

The drivers of consumerprice sensitivity

The need for understanding and insight 35

The nature of the product 36

Emotional or functional benefits? 37

Market environment 38

The context of the purchase transaction 40

A complex web of factors 43

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The drivers of consumer price sensitivity

THE NEED FOR UNDERSTANDING AND INSIGHT

The key to effective pricing decisions is insight into the consumers perception of

value and their sensitivity to price as part of the marketing mix. If sensitivity iswell understood, it can help the marketer in a number of ways. It can enable

agreement of upper and lower limits when developing a product range or

organizing market research. It can also be a valuable guide to deciding which

markets to target in order to achieve marketing and financial goals. Finally, and

most importantly, knowledge of sensitivity can lead to strategies which are

designed to overcome it, by the development of an appropriate value package and

a communication strategy which emphasizes other benefits.

Rarely will the factors determining price sensitivity be simple, because there is not

one single consumer and behaviours will vary over time, between different channels,regions and countries, in different market conditions and life circumstances. A

wealthy consumer might be prepared to pay thousands of pounds for a cold drink

in thirsty conditions in the desert, but will become as price sensitive as everyone else

when back home and faced with the many choices on the supermarket shelves.

There is also an inherent uncertainty in all markets which should make any manager

wary of those who think they have all the answers. A pricing strategy has to be

flexible and subject to constant review; it cannot and must not be the subject of

universal truths and accepted wisdom about consumer behaviour.

There are four main factors which will affect price sensitivity and they each have

a number of separate dimensions. They are also closely related to each other, as

shown in Figure 4.1.

Fig. 4.1 Four factors affecting price sensitivity

We will now examine these factors in turn.

35

The natureof the

product

Emotional orfunctionalbenefits

Marketenvironment

Consumerprice

sensitivity

The contextof the purchase

transaction


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36


THE NATURE OF THE PRODUCT

We have already examined some aspects of this factor in Chapter 2. The extent of

product homogeneity and the stage of the product life cycle were said to be keyfactors in the development of pricing strategies and this is largely because of their

impact on consumer price sensitivity. However, there are a number of other factors

within the product itself which will have an impact.

Transparency of cost

We will discuss in later chapters the links between cost and price; so far we have

emphasized the lack of likely and necessary connection between the two. However,

there are cases where consumers will be influenced by their knowledge and beliefsabout cost and this occurs mainly where the constituent elements of the product

can be clearly seen and understood. If the product is the provision of services that

are clearly unskilled and where the customer can see the time taken (for instance

the provision of household or garden services), there will be a high degree of price

sensitivity. If, on the other hand, it is a service with more complexity, requiring

more specialist skills (such as consulting in information technology) the price will

be less easy to assess and therefore less price sensitive. The customer will be blinded

by the technical mystique and by a lack of understanding of the tasks required, and

will therefore be able to challenge price only through competitor comparison.

Product risk

If the potential risk of poor quality is high, it is more likely that the product will

have low price sensitivity. Few customers will, within reason, be influenced by

price when buying a childs car seat; other factors, particularly reliability and

durability, will be much more influential in the buying decision. If the risk to the

buyer is low because the purchase is a small amount and failure is of less

importance for example, an impulse buy of a childs toy price sensitivity will

be much higher. The consumer will easily be deterred from buying and quality will

be much less important.

Risk is also a key factor in business-to-business transactions. It is well known

that there is a tendency for risk-averse managers to buy IBM when faced with a

complex decision to purchase computer facilities, often because of the likely

adverse consequences of such a purchase going wrong. This tendency among

corporate buyers also makes it less likely that customers will easily switch

suppliers of vital services, unless the gains through lower prices are substantial

and the risks of failure are low.


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The drivers of consumer price sensitivity

Price as a quality indicator

With some products the price itself is a key indicator of quality. There are two

main factors causing this to occur. The first is where there are no other obviousclues about quality from seeing and feeling the products because they all appear

to be much the same. This can happen with prestige products such as perfume or

watches, or with basic commodities like fruit and vegetables. The second factor,

which will apply to perfumes and watches though not to fruit and vegetables, is

where the buyer values prestige and exclusivity and where the price is indicating

that kind of value, saying something about the person who is willing and able to

pay that price.

This factor impacts different markets in different ways and there will be various

points of sensitivity. Someone buying a watch may be reluctant to pay below a

certain level say 5 because the product is assumed to be of poor quality if it

is below that price. There will also come a point perhaps over 100 where the

purchaser will expect a prestige brand to justify that price. Between these two

levels the price will be giving a message about quality the 70 watch is assumed

to be of higher quality than the 50 watch and the consumer may choose that one,

even if they both have the same appearance, quality and brand recognition. This

may apply particularly to those who are buying gifts for others, where the price

is saying something about personal regard for the recipient. The purchase of the

lower priced watch may not be acceptable, whatever the apparent benefits.

EMOTIONAL OR FUNCTIONAL BENEFITS?

This factor is closely related to the nature of the product but is worth treating as

a stand-alone factor. This is because it is one of the most important and, via

marketing communication, one of the most controllable elements of consumer

price sensitivity. The concept of product benefits was raised in Chapter 1 as

fundamental to the definition of value. Benefits are the reasons why customers

buy the product, the ways in which they are better, feel better, or can do things

better after the purchase has been made (see Figure 4.2). Marketers go further by

classifying these into functional and emotional benefits.

Functional benefits are the logical, rational reasons for buying that the

product will fulfil the function for which it was intended: food to ease your

hunger, a car to take you from A to B, clothes to keep you warm. Emotional

benefits are those that make you feelgood, either because the product is giving

you pleasure or because it is saying something about you. The Ferrari does more

than take you from A to B, it gives a message about your image and status, as does

the Armani suit or the Rolex watch. The more these emotional benefits are, or can

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be made to be, part of the product proposition, the less there will be price

sensitivity. This is the reason why a lot of modern advertising is aimed at these

emotional benefits: to develop the brand strength that makes them sustainable

and justifies higher prices than would otherwise be possible.

Fig. 4.2 Functional and emotional aspects of product benefits

MARKET ENVIRONMENT

Each separate market will have unique conditions and a number of these are

fundamental to pricing strategy. This is one reason why global marketing often

falls down and why it is impossible to have a universal pricing strategy for any

product, unless it is flexible and adaptable to the needs of each market. These

environmental factors can be broken down into a number of constituent parts.

Economic conditions

The overall stage of economic development will inevitably have a major impact

on the consumers attitude to price. Though there are other factors in this chapter

which can move things the other way, one general rule applies: the lower the

development of the economy of a country or region, the more likely it is that price

will be dominant in the purchase decision. The less the discretionary spending

power, the more price sensitive is the consumer. Those buying a loaf of bread or

Benefits

Functionalvalue

Based on

Goodwin - Pricing for Long-TermLong-Term Profitability 0273659332

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