introduction to strategic pricing bbe 3503 dr. tim smith assistant professor department of bio-based...

INTRODUCTION TO STRATEGIC PRICINGBBE 3503

Dr. Tim SmithAssistant ProfessorDepartment of Bio-Based Products

BP 3503-5503: MARKETING BIO-BASED PRODUCTS

© T. M. Smith, 2005 2 | UNIVERSITY OF MINNESOTA, Department of Bio-based Products

IMPORTANCE OF PRICING

• Andersen Consulting (Accenture) Study of Forest Products Companies in 1998 suggests that:

– over 40% of the differences in forest products company financial performance is driven by marketing.

– “strategic pricing management” emerged as the most important skill in driving bottom line performance (to the tune of $2 - $18 million dollars annually).

• But…Pricing is not a strong basis on which to compete!!!

• It doesn’t create value

• It doesn’t create loyalty

• It is easiest to copy



COEQUAL ELEMENTS OF MARKETING

1. Product

2. Promotion

3. Place - Distribution

4. Price

Create Value

Captures Value



INEFFECTIVE PRICING QUESTION

“What prices do we need to cover our costs?”



STRATEGIC PRICING QUESTION

“What costs can we afford to incur, given the prices achievable in the market?”




“What price is the customer willing to pay?”




“What is our product worth to this customer and how can we communicate

that value, thus justifying the price?”




“What prices do we need to meet our sales or market-share objectives?”




“What level of sales, or market share, can we most profitably achieve?”


© T. M. Smith, 200510 | UNIVERSITY OF MINNESOTA, Department of Bio-based Products

A FRAMEWORK FOR PRICING



A FRAMEWORK FOR PRICING: DATA COLLECTION

1. Cost Measurement: Incremental/Avoidable Costs Only

– What are the incremental costs?

– What are the avoidable fixed costs?

– At what levels of output will additional semi-fixed costs be required?



COST MEASUREMENT

Example: Softwood Lumber Producer

Option #1 Option #2Current Scenario New E-Channel New Trad. Channel

Production Capacity 2000Price $8.00 $6.00 $7.75Fixed Overhead $4,500 $250 $1,500Personnel $3,000 $150 $2,000Variable Costs 1.5 $1.50/unit $1.50/unit $1.50/unitUnits 400 (100) 800 (150)1200



AVERAGE COST MEASUREMENT


Decision: If we do anything, we add the new traditional channel and make $.30 per unit.(Don’t select the E-Channel because @ $6.00 we don’t cover our cost.)

WRONG!!!

Current + E-Channel+ New Trad.

ChannelCapacity 2000Units 1200 1500 1850Revenue $9,600 $11,200 $14,600

Avg. Cost $7.75 $6.77 $7.45Total Cost $9,300 $10,150 $13,775

Price $8.00 $6.00 $7.75



INCREMENTAL COST MEASUREMENT


New E-ChannelNew Trad. Channel

Price $6.00 $7.75Unit Sales 400 800Revenue $2,400 $6,200Other Foregone Sales ($800) ($1,200)

Revenue Gain $1,600.00 $5,000.00

Personnel $150.00 $1,500.00Incremental Fixed Costs $250.00 $2,000.00Variable Material Costs $600.00 $975.00

Total Inc. Costs $1,000.00 $5,100.00

Net Contribution $600.00 ($100.00)




2. Customer Identification: Who are the potential customers, and why would they buy your product?

– What is the economic value to customers?

– What other factors influence price sensitivity?

– How can customers be segmented by price?

– Can effective marketing and positioning influence a customer’s willingness to pay?




3. Competitor Identification: Current or potential competitors affecting your profitability

– Who are they?

– What are their transactional prices versus list prices?

– What are competitors’ pricing objectives – profitability or share?

– What are their strengths/weaknesses – margins, reputation, products, product lines, etc…



A FRAMEWORK FOR PRICING: STRATEGIC ANALYSIS

4. Financial Analysis: What volume trade-offs are needed for potential price changes to increase profits?

– What is the CM at the baseline price?

– What volume is needed to allow a lower price to generate more contribution?

– What volume can be forfeited at a higher price before contribution declines?

– What volume is needed to cover incremental fixed costs (advertising, regulatory approval, inc. capital equip., etc.)



BREAKEVEN SALES CURVE REQUIRED FOR CONSTANT PROFITABILITY




5. Segmentation/Implementation: How can a company price differently to different segments to reflect differences in price sensitivity or the costs to serve them?

– Can segments be identified prior to purchase?

– Can “fences” between segments be established?

– Are there legal constraints to be addressed?



PRICE SEGMENTATION MODEL




6. Competitive Analysis: How will competitors actions and reactions affect profitability and long-term viability?

– What can you realistically achieve, given competitor capabilities and intentions?

– Can you influence competitors’ behavior?

– Can profitability be insulated by targeting segments where you have competitive advantage?

– Should you withdraw resources from certain markets when confronted by fierce competition?



A FRAMEWORK FOR PRICING: STRATEGIC FORMULATION

7. Strategic Formulation: The price-value proposition for conducting future business.

– No right solution.

– Can’t superimpose from one situation to another with different cost, customer, and competitive conditions.



GENERIC PRICING STRATEGIES



PRICE SKIMMING

• Customers: Focus on a small segment of price insensitive buyers.

– Usually driven by exceptional value created by product differentiation.

– Also seen in impulse buying situations, when costs can be passed along to others, and emotionally charged situations.

• Costs: Favors situations where incremental costs represent a LARGE share of the product’s price.

– If variable costs are 80% of a product’s price, a 10% price hike would increase profits so long as sales volume decreases by less than 30%.

– Therefore, a small niche of price insensitive buyers could allow for profitability even in the most capital intensive industries.

• Competition: Must have some source of competitive protection to maintain this strategy long-term.

– Patents/Copyrights, brand, access to scarce resource, access to exclusive distribution, etc…

– Doesn’t mean you can’t skim while you can, then re-position when required by competition (sequential skimming)



PENETRATION PRICING• Customers: Price must be low enough to attract a large share of the

market.

– Need a large portion of customers to be at least somewhat price sensitive.

• Costs: Favors situations where incremental costs represent a SMALL share of the product’s price.

– In this case each additional unit of sales provides a large contribution to profit.

– Can also work if increased volume leads to sufficient variable cost economies.

• Competition: Beware of the price war.

– Only if you have a significant cost advantage, or are so small your gain in sales won’t prompt a response.



75

80

85

90

95

100

105

110

115

120

125

45 55 65 75 85 95 105 115 125 135 145 155 165 175 185 195 205 215

Volume

Pri

ce

EFFECT OF CONTRIBUTION MARGIN ON BREAK-EVEN VOLUME

80% CM 20% CM

Profit Zone:

Skimming More easily accomplished

Profit Zone:

Penetration More easily accomplished



EXAMPLE: PENETRATION PRICING & MARKET SHARE

Price: $3.50 $3.25Unit Variable Costs: $1.00 $1.35Market Share: 85% 15%Voume: 850,000,000 150,000,000 Revenue: 2,975,000,000 487,500,000 Fixed Costs: 1,500,000,000 500,000,000 Variable Costs: 850,000,000 202,500,000 Profit Margin 0.21 (0.44)

Incumbent Challenger

The Introduction



EXAMPLE: PENETRATION PRICING & MARKET SHARE

Incumbent Challenger

Price: $3.50 $3.25Unit Variable Costs: $1.05 $1.15Market Share: 70% 30%Voume: 700,000,000 300,000,000 Revenue: 2,450,000,000 975,000,000 Fixed Costs: 1,500,000,000 500,000,000 Variable Costs: 735,000,000 345,000,000 Profit Margin 0.09 0.13

X years (months) later



NEUTRAL PRICING

• A strategic decision not to use price as a significant marketing tool.

– Usually a default strategy, because conditions are not favorable for either of the other two strategies.

– Also used to maintain a coherent product line pricing strategy.

– DOES NOT IMPLY A LOW PRICE IN THE MARKET.

– A high price is a neutral price when the product value seems to justify the price to most potential buyers.



Pricing in Mature/Commodity Markets

• Pricing latitude reduced by severe price competition:

– Accumulated purchase experience of repeat buyers improves their ability to evaluate competing products reduces loyalty.

– Increased imitation of successful products (i.e. product/performance/ grading standards) reduced differentiation.

– Increased price sensitivity attract competitors whose distinct competence is efficient production/distribution further price erosion.



SOME SUGGESTIONS…

– Improve control and utilization of costs – identify unprofitable products or customers.

– Improve estimation of price sensitivity – when demand is primarily from repeat buyers and competition is relatively stable, a little fine tuning can significantly improve profits.

– Unbundle related products/services – Dominate what you are best at and own that business (high volume in one area, rather than seller everything to an ever fewer number of customers).

– Expand the product line – accessorize, accessorize, accessorize.

– Reevaluate distribution – less need to pay channel to promote to new buyers, less need to restrict distribution.

introduction to strategic pricing bbe 3503 dr. tim smith assistant professor department of bio-based...

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