Jump to ContentJump to Main Navigation
The Art and Science of Marketing$

Grahame Dowling

Print publication date: 2004

Print ISBN-13: 9780199269617

Published to Oxford Scholarship Online: October 2011

DOI: 10.1093/acprof:oso/9780199269617.001.0001

Capturing Customer Value: Pricing and Selling

Chapter:
(p.279) Chapter 9 Capturing Customer Value: Pricing and Selling
Source:
The Art and Science of Marketing
Author(s):

Grahame R. Dowling

Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780199269617.003.0009

Abstract and Keywords

This chapter examines the task of assessing the value of the offer and looks at how to capture this value. Price setting is one of the most complicated of all the marketing activities. In practice, it is best described as art based on science. The science of pricing focuses on using research to understand the price sensitivity of individuals and the price elasticity of markets. The art of pricing focuses on setting sensible pricing objectives, understanding the interactions of price with other elements of the marketing mix, and predicting competitor reactions to price changes. Linking both art and science is the management of pricing, the management of pricing involves working with the organization's accountants to understand costs and contribution margins, developing a pricing policy, and making sure that the key performance indicators (KPIs) of people who have authority for the organization's prices are aligned with the organization's pricing objectives.

Keywords:   industry economics, price, customer segments, customer value, pricing strategy, price elasticity, key performance indicators

It is easy to know the price of something, but much harder to know its value.

It is increasingly being recognized that pricing is one of the most crucial functions of marketing management. One reason for this is that price is the element of the marketing mix that directly drives revenue. Also, some research by Robert Dolan suggested that if the following companies could realize a 1 per cent improvement in their prices, they could boost net income by a significant amount: Coca-Cola by 6.4 per cent; Fuji Photo 16.7 per cent; Nestlé 17.5 per cent; Ford 26 per cent; and Philips 28.7 per cent.1 These are impressive numbers and they have once again focused the attention of senior managers on prices.

While price is a very important marketing function, Dolan's research also indicates that marketers struggle to come to grips with setting prices to capture the value created by their organization's offer to target consumers. In short, pricing is a headache. It is often a key feature of strained relations with good customers; the weapon competitors use to steal market share; and a source of conflict between salespeople, marketing managers, and the internal accountants. One reason for this is that the responsibility for pricing functions (such as setting trade and retail prices, changing prices, offering discounts, developing promotions, etc.) is often allocated to different people. Another reason is that most organizations do not do much, if any, serious research on pricing. Hence, in an environment that lacks good information about the prices of competitors and the price sensitivity of various segments of customers, it is easy for different people in the organization to have their own (firm) views about what the price of a particular product or service should be.

(p.280) Before discussing the fundamentals of pricing, it is helpful to pause to think about how pricing ‘problems’ often present themselves inside the organization. What is often initially perceived as a pricing problem may not always be the best way to frame the issue. The following examples suggest that many so-called pricing problems are positioning and/or innovation problems in disguise. For example:

  • When consumers cannot tell the difference between two products or services, which one do you expect them to choose? The snobs will choose the dearest, but most people will choose the cheapest. Thus, when a product fails the Unique part of IDU test introduced in Chapter 7, what may seem to be a pricing problem is really a positioning problem in disguise.

  • The pricing of commodities provides other examples. Many organizations try to reduce their production costs in order to compete on price. Unless the organization has a cost advantage over its competitors, this is generally a hard strategy to maintain. If the organization does not have a direct cost advantage it might try to reduce the ‘delivered cost’ to consumers by asking the buyer to assume some of the production function (e.g. IKEA furniture is assembled at home by the buyer). This will work if the target consumer is prepared to serve themselves and the lower price is sufficient to compensate for this effort. Sometimes, however, organizations set out to differentiate their commodity. They might add a special ingredient to their product or describe it with a meaningless feature (e.g. Shell XMO motor oil). Others use some clever advertising and/or packaging (e.g. Absolut vodka). Sometimes, a commodity product is delivered with special service (e.g. Southwest Airlines' fun in-flight service). Thus, the focus shifts from function, costs, and price to making it easy for target customers to choose a suitable product. (‘If all vodka is the same, then why not choose the one with the distinctive bottle and the creative advertising.’)

  • Brands of Irish crystal like Waterford are well respected and very highly priced—so high that the potential for breakage becomes a purchase inhibiting factor for table items like wine glasses. There is no shortage of less expensive crystal from which to choose (and occasionally break). To overcome this ‘sticker shock’ problem (as the US automobile industry calls it), Waterford introduced a less expensive line extension ‘By Waterford’. Consumers who want the Waterford name can now pay less and get it in small print. However, this strategy will cause two problems. One is that the new line of crystal will cannibalize some of the sales of the original Waterford. (Hopefully, this will be offset by attracting a sufficient number of new buyers.) A second problem is one of brand image. Is the new crystal real Waterford or is it not? An innovative strategy that could (p.281) have been considered is to offer a lifetime replacement for accidentally broken glassware—at say one-half of the retail price. Waterford crystal could then be positioned as a lifetime investment.

  • In 1990, forest products giant Weyerhaeuser's particleboard business had a smaller market share and was less profitable than its major competitor Georgia-Pacific. Particleboard was a commodity used to make less expensive furniture. Customers made it clear to Weyerhaeuser's salespeople that they wanted the product to meet industry quality standards, be cut to thin dimensions, be delivered on time, and above all, be cheap. However, a little research showed that the customers' insistence on securing a low price was wrong! A team of Weyerhaeuser managers discovered that customers could save the considerable costs of gluing smaller pieces of particleboard together if they used larger dimension board. They could make further savings if the surface of the particleboard had a better finish because this reduced the costs of lamination. Both these innovations resulted in a higher cost per board foot, but a lower total cost to the furniture manufacturer.2

The essence of setting of prices in many B2B situations is reflected in the proverb at the beginning of the chapter. It is also illustrated by the Weyerhaeuser example. The essence of good pricing is to understand the value of a product or service as expressed in its CVP (Chapter 8), and then post a price that captures this value. Weyerhaeuser is an example of what is known as ‘value-based pricing’ based on ‘consultative selling’. It is customer-focused and starts with the basic question:

What is the maximum amount that the customer should be prepared to pay for this product/service?

The answer to this question sets the upper limit on the posted price for a product or service. The product's cost sets the lower limit. Figure 9.1 shows
Capturing Customer Value: Pricing and Selling

Figure 9.1. Factors that determine prices

(p.282) the major factors that need to be considered when setting a price between these two limits.

Figure 9.1 is the blueprint for this chapter. Not only does it provide an organizing framework for thinking about pricing, but it also identifies the key information requirements on which good pricing practice is built.

Industry Economics

Many big management consulting firms start to examine pricing by understanding the basic economics of the industry in which a product or service competes. Chapter 3 looked at many of these factors under the headings of industry analysis and competitive rivalry, market analysis, trend tracking and monitoring, product life cycles, and price wars. The key issues to understand are:

  • The current price level in the industry, and the spread of prices across industry participants.

  • The overall direction of prices (up or down) as driven by technology and competition.

  • The critical industry and marketplace factors that are driving industry price levels, such as supply—overall industry capacity, plant openings and closings, new competitors, imports, etc; demand—demographic changes, substitute products, etc.; costs—new technologies, scale effects, etc.; stage of the product life cycle—in the early stages, prices tend to be higher than in later stages; regulation—price surveillance authorities, trade practices legislation, government expectations about social responsibility, trade barriers, subsidiaries, etc.

The PC industry illustrates the role of technology in setting industry price levels. Moore's Law is the principal driving force here. More than thirty years ago, Gordon Moore, a founder of Intel, suggested that every eighteen months the processing power of a computer chip doubles while cost holds constant. (This law also applies to other aspects of PC technology such as computer memory and data storage.) It has driven the evolution of the hardware side of PCs and many consumer appliances—more powerful PCs and more intelligent electrical products produced at lower costs and priced more cheaply.

(p.283) Customer Segments

A key difference between the way that marketers and consultants examine pricing is that marketers spend a lot of time examining the segments of consumers in the market. Chapter 6 was devoted to this exercise. The key factors here are to understand how consumers think about price. This information provides crucial insight for pricing decisions and focuses on the following:

  • price sensitivity,

  • price elasticity,

  • customer value,

  • reference price,

  • budgets and mental accounting.

Each of these factors focus on different aspects of determining the level of demand in a customer segment, and, thus, they will affect the marketing objectives of the product/service—hence the double-headed arrow in Figure 9.1.

Price Sensitivity

Price sensitivity refers to the potential for an individual to notice and then react to a change in price. Consumers may not notice a change in price because (a) they are not interested in or informed about the product or service, (b) they shop so infrequently that they have forgotten the price they paid last time, or (c) someone else buys the product for them. A person's reaction to a price change can be psychological (such as re-evaluating the brand) and/or behavioural (such as buying less).

Thomas Nagle has identified a number of factors that are thought to effect how sensitive individual consumers are to the price of the product or service they are considering:3

  • The unique value effect. Buyers are generally less price sensitive whenthe product is perceived to be unique, and when it best fits their particular needs.

  • The substitute awareness effect. The more substitute products or alternative suppliers that a consumer is aware of, the greater their price sensitivity. It is thought that the Internet will increase this awareness and, thus, increase price sensitivity. Reducing the time available for (p.284) consumers to search is a tactic used to dampen this effect. For example, car dealers often say that their price is valid only for that day.

  • The difficult comparison effect. The more difficult it is to compareprices, the less price sensitive buyers tend to be—all other effects being equal. This is why organizations make it difficult to directly compare the price-performance of many products and services such as a mobile phone and its call plan. The hope is that if price-performance is difficult to calculate accurately, then the buyer will focus on other features of the deal, such as the look of the handset.

  • The total expenditure effect. The lower the price relative to the totalincome of a person or budget for an organization, the less price sensitive the buyer tends to be. Leasing a product is often used to mitigate this effect because each lease payment is much smaller than the total price.

  • The shared cost effect. Price sensitivity is less when the cost is sharedwith another party. For example, the price of many prescription pharmaceuticals is not seen as great as it is because they are often subsidized by the government or a health-benefit insurance company.

  • The price quality effect. Buyers are less price sensitive when the productis thought to have greater quality, prestige, or exclusiveness. Luxury goods exploit this effect.

A simple segmentation scheme based just on these factors is created by partitioning them into two sets—those that affect the perceived value of the brand's differentiation (such as the unique value and difficult comparison effects), and those that affect the perceived pain of its cost (such as the total expenditure and shared cost effects). Figure 9.2 shows four price-sensitive segments, namely, (a) Price Buyers do not value specific features

Capturing Customer Value: Pricing and Selling

Figure 9.2. Price-based segments

(p.285) and cannot be convinced to pay more for uniqueness, (b) Convenience Buyers seek their required level of quality and are not overly concerned about cost—any suitable brand will do— (c) Value Buyers are price sensitive but are prepared to pay for added value, and (d) Loyal Buyers have strong preferences based on the uniqueness of a brand and will buy it if it does not exceed their price threshold.

Price Elasticity

Price elasticity of demand is a measure of the reaction of a market (segmentof consumers) to a change in price. It is measured as the ratio of the change in quantity demanded to the change in price, as follows:

Capturing Customer Value: Pricing and Selling

In most cases, E is negative, that is, price increases result in less demand. However, for some luxury goods (like perfume), it can be positive. When E = 1, total revenue is not effected by the change in price. (Revenue is price×quantity.) When E is greater than 1 the price is said to be elastic. If E is also negative, then total revenue rises. Conversely, if E is less than 1, the price is said to be inelastic, and if E is also negative, total revenue falls.

The price elasticity of a segment of consumers will depend on:

  • their price sensitivity;

  • whether they are motivated to search for a lower price;

  • whether they think that higher (or lower) prices are a natural trend (e.g. they are driven by broad economic conditions like inflation).

Price elasticity will also depend on the magnitude (small, medium, or large) and direction (up or down) of the price change. And it can be affected by how the price change is presented to consumers (e.g. as a price promotion or a sale price or an everyday low price, etc). Thus, price elasticity is a quite complicated concept. The crucial issue for marketers is to conduct research to find out (a) the sign and the value of E, and (b) what factors drive price elasticity.

Customer Value

Price is what you pay, value is what you get.

Warren Buffet

(p.286) In Chapter 6, customer value was advocated as a primary basis for forming tactical segments. Customer value was defined as benefits minus price. Here, the task is to describe how customer value can be measured and, thus, bring more precision to this concept. Five such measures are briefly described, namely, (1) internal engineering assessment, (2) field value-in-use, (3) stated importance ratings, (4) conjoint analysis, and (5) choice models.

The first two measures are objective measures of customer value. They rely on a careful study of the target customer's needs, and the purchase and usage process. These measures provide an important point of reference for better understanding how perceptions can enhance or reduce the actual value estimates that people make. Methods 3 and 4—stated importance ratings and conjoint analysis—are perceptual measures. They will often differ from objective value measures because of psychological considerations such as risk perception. Perceptual measures are obtained by questioning consumers about their perceptions of and preferences for features and benefits. Method 5—choice models—is a behavioural measure. This type of measure uses observations of actual past purchase behaviour as the basis for estimating value. (The other four measures rely on information or judgements before a purchase.)

  1. 1. Internal engineering assessment In many B2B situations, the organization's own scientists, engineers, and managers will conduct an internal engineering assessment of the customer's operations, needs, and buying process. The Weyerhaeuser case was an example of this approach. The success of this method depends on (a) how well the team really understands the customer, and (b) how well this understanding is translated into economic aspects of customer value. To help this understanding, many organizations supplement their own analysis with customer input about the value of satisfying a need or resolving a problem. The SPIN selling technique described later in this chapter has proven to be a useful framework for eliciting this information.

  2. 2. Field value-in-use Another value assessment technique used in many B2B situations is Field Value-in-Use Assessment. (This is also known as economic value to the customer.) For a supplier's current product or service, VIU is defined as the price that would make the customer indifferent (i.e. economic break-even) between continuing to use their current product versus switching to another option. For a new product, VIU is the maximum amount that the customer should be willing to pay for the new product given the extra benefits (over those provided by the current product) that it offers. Exhibit 9.1 illustrates how VIU can be calculated for two products. (p.287)

    From the seller's point of view, the critical issues when using a VIU approach to pricing such as illustrated in Exhibit 9.1 are:

    • Choice of the reference product—should it be the customer's current product, a physically similar product, or any product that fulfils the same need.

    • (p.288) Calculating the costs of the reference product. This will often require the customer revealing sensitive information to the seller. Also, if the target cost is the full, life cycle cost, it may be necessary to convince the customer that this is the appropriate cost to be using—as opposed to simply the purchase price. (Budgets often force buyers to focus on the purchase price, not life cycle cost.)

    • Identify customer resistance points. These are usually (a) uncertainty about the new product's benefits and performance advantage, (b) a reluctance to change suppliers, and (c) concern over the length of the payback period to recover the higher price.

  3. 3. Stated importance ratings This method is one of the most popularapproaches to measuring customer value. Typically, in a field research survey, respondents are given a set of features and/or benefits that describe a product or service and are asked to rate (or rank) each feature-benefit on their importance to them or their organization. Respondents are also asked to rate a set of competitive products on each of the feature-benefits. What results is an importance—performance analysis of the customer value provided by the competitive brands or suppliers. While this approach is easy to develop and execute, it has a number of weaknesses that limit its usefulness. First, respondents will often give (nearly) all the feature-benefits a top importance score on the ratings scale. Thus, there is little discrimination. Second, the approach does not give any clear indication of willingness to pay for the feature-benefits. Third, the trade-off between one feature and another that characterizes most real choices is not measured. Fourth, there is only a weak link between importance ratings and choice behaviour because many, and sometimes all, the options have a minimum, acceptable level of this feature (e.g. airline safety).

  4. 4. Conjoint analysis Conjoint analysis is one of the best value assessmenttechniques that a marketer can use—in either B2B or B2C situations. It takes explicit account of the trade-offs that people make when they choose among a set of options. Also, if price is one of the features used to describe the product or service, then the importance of each feature (called its utility or part-worth) can be rescaled to reflect how much the buyer is willing to pay for different amounts of the various features. Exhibit 9.2 provides two examples of conjoint analysis used to assess customer value.

  5. 5. Choice models Many organizations keep extensive records of customerpurchases in their databases. Sometimes these data can be cross-matched with survey data about the characteristics of customers (typically demographics). From this type of data analysis, tactical segments can be formed. For example, American Express produce tactical segments based on ARPU (Chapter 2), customer profitability, and the portfolio of products acquired.

(p.289) (p.290) This approach to indirectly estimating customer value is called data mining. It is widespread but has three important limitations:
  1. 1. Non-customers are ignored (they are not on the customer database). These may often be a big source of potential growth.

  2. 2. Polygamous loyalty (Chapter 4) is ignored.

  3. 3. Data mining says what has happened, but only rarely does it suggest why this has happened or what to do to change consumer behaviour.

(p.291) Given the limited picture that internal data can provide about customer value segments, data mining is best used as a supplementary form of customer value assessment.

The direct-marketing industry routinely uses an experimental form of purchase behaviour analysis to measure customer value. For example, with a new product offering, the direct-marketer chooses samples of customers from its database and sends out a number of different versions of its offer. It then records who purchases and how much they purchase of each version of the offer. This information is then used as input to the right-hand side of the following equation:

Probability of purchase = f (type of offer, type of customer) (1)

Special purpose statistical models are used to estimate the importance weights of each variable on the right-hand side of equation (1). For example, the type of customer may be profiled by their demographic profile and past purchases of other products from the direct marketer. The type of offer will involve different prices. Thus, these models observe choice and then infer the value that different types of customers attach to each type of offer. (This was the approach used by ABB Electric in the example of segmentation reported in Chapter 6.)

Given an estimate of the probability of purchase for each respondent for each offer, the analyst can then estimate the profitability of each offer:

Expected customer profit = probability of purchase × likely purchase volume if a purchase is made × profit margin for this customer (2)

As suggested in Chapter 2, this is just the type of information a marketing manager needs to link marketing actions to financial outcomes.

Reference Prices and Other Psychological Aspects of Prices

Marketers need to understand the psychology of pricing in addition to its financial economics. For example, few managers think about the pricing reference points that their consumers carry around in their heads. Two such reference points are the quality level of the product or service (as expressed in the saying ‘you get what you pay for’), and price points expected for various types of products and services. These reference points are formed through the buyer's learned experience (Chapter 4), and also depend on the amount of money available for the purchase. Thus, they will differ across segments of consumers.

(p.292) In the contexts of negotiation and price setting, it is important to know the reference price or ‘expected price’ that target consumers have for a particular product or service. In negotiation situations the reference price is often called the ‘reservation price’, and it is the upper limit for what the buyer is willing to pay. Sometimes, in consumer settings, these prices are expressed as ‘I will never pay more than ($20) for a (bottle of wine).’ Pricing too far away from the target segment's reference price can result in lost sales. For example, luxury brands that are sold too cheaply are often perceived to have something wrong with them (such as being a fake or damaged). Some retail stores try to manipulate these reference points by showing a product with an inflated ‘recommended retail price’ that has been marked down for sale. The high price is supposed to signal high quality and the words ‘on sale’ are thought to motivate the buyer to limit their search and buy now.

Another psychological tactic is to end prices in an odd number, such as $299 for a television set and $2.95 for a box of breakfast cereal. Many years ago there was a practical reason for this type of pricing—it made the sales assistant give the customer some change from the cash register and, thus, produced a record of the sale. This helped to minimize employee theft. Today there are various arguments presented for the use of this tactic. One is that there is a heightened sensitivity to prices that end in odd numbers, especially nine or ninety-nine, and that they are perceived as being lower than the rounded-up price. However, even though many retailers are fond of using odd-price endings, the published research findings in this area are inconclusive about their effect on increasing sales.6

An intriguingly important psychological aspect of pricing is to know whether the target consumers consider price to be either

  • a measure of sacrifice (such as petrol for the car), or

  • an index of quality (such as a diamond).

This perception will colour the person's reaction to the posted price.

Budgets and Mental Accounting

All consumers and organizations face the problem of allocating their income to expenditures. In the organizational context, the budget process is formalized, and good marketers and salespeople know about their customers' budget allocations. For example, what is the budget cycle, which expenditures are designated as capital expenditure, which are MOR, etc. (p.293) The prices charged for a product or service have to fit into the customer's budget cycle and allocation. Otherwise, the seller may need to arrange a time varying payment schedule.

For consumers the budget process is equally important to understand but it takes a more subtle form. The term ‘mental accounting’ is now used to describe what seems to happen.7 Economist Richard Thaler suggests that people tend to categorize money into three types of mental accounts based on when it is received and when it is to be used: current income, assets, and future income. Current income is the most spendable while future income, such as a retirement investment, is generally deemed untouchable. Also, it has been found that the payment patterns of consumers may vary depending on the account from which the money is to be withdrawn. For example, vacations and parties are often prepaid (from the current account), while many durable goods are bought on credit (from the asset account). The key issue here is that price setting and the facilitation of payment often depends on the target consumer's mental accounting.

In summary, the factors considered in this section are important segmentation criteria when the focus turns to setting the price for a product or service. Without good insight into the price sensitivity, customer value, and psychological aspects of pricing, it is difficult to set prices to capture customer value and to meet the objectives described in the next section.

Pricing Strategy

The strategic aspect of pricing manifests itself at two levels. First, there is how the price level of products and services reflects the overall corporate strategy of the organization. For example, companies like IKEA, Southwest Airlines, Wal-Mart, and the Korean automotive companies try to win in their markets through a strategy of low-price leadership. In the case of Wal-Mart, they have the lowest costs of all the major retailers, and they back their ‘everyday low prices’ with a policy of ‘satisfaction guaranteed’. At the other extreme, some organizations are positioned as exclusive. For example, the Caribbean island of St Barts is outrageously expensive for most tourists. It has an informal policy of ‘to keep it exclusive, we'll keep things expensive’.

The second strategic aspect of pricing refers to the role of price in defining the level of customer value offered (Chapters 6 and 8), positioning the product or service (Chapter 7), and its support of other marketing programmes to attain and retain target consumers. If the organization has (p.294) selected its target market and positioning carefully, then its pricing should follow logically from these decisions. For example, traditionally brands positioned as high quality (or exclusive or prestigious) have a high price (and excellent presentation, classy advertising, etc.). Brands positioned as ‘good value’ should be priced at a reference point slightly lower than their perceived quality. ‘Economy’ brands should have low price and standard quality. In retailing the emergence of the category killer stores in the United States (Home Depot, Office Max, Sportmart, Toys ‘R’ Us) that feature the largest product assortment within a category at the lowest prices have redefined traditional price—quality relationships. Overall, the key to success is for the elements of the marketing mix to fit together to present a unified and distinctive image for the company and its brands.

The next strategic pricing issue to consider is the role of price in achieving the marketing and financial objectives of the organization. The two extreme cases are to survive and to maximize current profitability. Many other objectives exist between these two.

In some cases the objective is as simple as survival. In periods when there is over-capacity in their industry, many continuous-production manufacturing companies (such as aluminium and steel) price most of their production in order keep the factories running. As long as prices cover variable costs and make a contribution to fixed costs, the companies stay operating. In the late 1990s, survival pricing was a key consideration for many start-up dotcom companies. It is also not uncommon for not-for-profit organizations to adopt a variant of survival pricing, namely, full cost recovery.

The objective of maximizing current profit is as much a theoretical ideal as it is a practical reality. (Sometimes this approach is known as setting an ‘all the traffic will bear’ price.) It assumes that the organization has accurate knowledge of both its demand and its costs. In reality, these are difficult to estimate. Hence, a compromise profit-oriented pricing objective is to achieve a target return on investment. The return is profit while the investment can be the assets tied up in an SBU, a product line, or a brand. Other financially oriented objectives are to maximize revenues or cash flow. The hope with these two is that they will ultimately lead to increased market share and, thus, pricing power in the marketplace. Here are some other pricing objectives. Some organizations have explicit sales volume goals. For example, in the automotive industry many marketing plans prescribe volume targets that reflect plant capacity thresholds. For reasons of pride as much as financial return, some companies seek to price to maintain their market leadership—Budweiser beer and Coke being two examples. In technology markets, being the (clear) market leader (and, thus, the least risky choice) is very important. Thus, the posted price must (p.295) support this objective. To obtain market dominance, or to hurt a competitor, an organization may set a temporary predatory price (below average or marginal cost) for a product or service. To avoid price wars, an organization may set the price of a product to maintain parity with a competitor.

When introducing a new product or service, two pricing approaches are commonly considered:

  • Set a skimming price. Here a new product is launched at a high price to ‘skim the cream’ off the market. That is, only the less price sensitive consumers will buy the initial product. When demand falls away, the price can be lowered to attract more price sensitive buyers. Du Pont has used this strategy when launching cellophane, nylon, and teflon onto the market. Intel has also used this strategy with its new PC-chip designs. Many entertainment products like video cassette recorders, compact disc players, and digital cameras are launched at a skimming price. Often companies who use this strategy will create another lower-priced model of the product for later market entry.

    Market skimming makes sense when (a) there is a sufficient number of target consumers who are prepared to pay the high price, (b) the high price will not attract competitors (the product may be protected by a patent), and (c) the organization needs a high price to recover its R&D investment and the costs of bringing the product to market. The high price may also provide status value to the consumer.

  • Set a market penetration price. Here the price of the new product is setas low as possible to quickly enable the product to become established in the market. Conditions that favour market penetration pricing are (a) when there are more users the product is more valuable to each buyer (e.g. the Windows operating system for PCs), (b) the market is very price sensitive, (c) production and distribution costs fall with volume, (d) when market segments are not pronounced, and (e) a low price will discourage competitors.

The pricing objective that fits best with the overall philosophy of this book is perceived value pricing. Here, the value assessment techniques described earlier are used as the primary input into price setting. The marketing team calculates the value of a product or service to an individual customer (B2B) or market segment (B2B and B2C). When using a technique like conjoint analysis, this value assessment can contain all the main aspects of the offer to customers such as brand name (and thus position), quality, special features, different price points, etc. From this research, marketers estimate the sales volume and then unit costs. If the product satisfies the organization's financial objectives at the planned price and costs, it is launched.

(p.296) Perceived value pricing is a great idea ‘in theory’, but it is often difficult to implement in practice. There are three reasons for this:

  • The product or service has to have a clear CVP. (Here the CVP concept and the product onion framework are helpful.)

  • Competitors will often be offering a similar product or service at a lower price. (Hence, passing the IDU test is important. Recall that if the product is not unique, many target customers will buy the cheapest.)

  • The advertising agency has to be able to communicate convincingly the CVP. Communicating perceived value prices often involves a feature– benefit style of advertising. Consider the copy of an advertisement for the EIZO professional computer monitor:

For a marketing manager, the key issues with pricing objectives are that:

  • The objectives should be stated explicitly in the marketing plan.

  • All managers should know what the objectives are.

  • When hybrid objectives such as ‘increasing sales volume and profit’ contain elements that are incompatible, there is a clear policy to guide making a trade-off between the objectives.

  • Prices are set with full regard to all of the following: customer value, then costs and competition.

(p.297) Costs and Contribution Margins

As noted earlier in this chapter, cost provides the ‘floor’ on which to build a pricing strategy. But the vexing question is, which costs? Well, direct variable costs set the short-term price floor. Sometimes these are close to zero, for example, when an airline sells an unused seat on a plane that is about to depart—a tray of food and a slurp of fuel is the direct variable cost. In the short term, when price exceeds the variable unit cost, it provides a contribution to fixed costs. In the long-term, however, the price floor is the full (fixed plus variable) unit cost. Some Internet companies have discovered that these costs are greater than the price of the products they are selling. The result is a good deal for customers, high sales revenues, but large financial losses.

For a marketing manager one of the key issues is not to set short-term prices for the long run. That is, they have to ensure that the overall pricing schedule exceeds the long-run average cost of the products and services sold. The case of hotel pricing illustrates this issue. Assume that a boutique hotel has an occupancy rate of 70 per cent and that at this rate the average cost of a room is $100 of which the variable cost of a used room is $20 (cleaning, bed linen, administration, etc.). The short-term price floor is $20 and the long-term floor is $100. If the average room rate during the week is $150, then the hotel can drop the weekend rate below $100 (but above $20) and remain viable.

The pricing tool of contribution margin is indispensable when setting prices. Contribution Margin (CM) is

Capturing Customer Value: Pricing and Selling

In the hotel example for a weekday room it is ($150 −$20)/ $150 = 87%.

A key question that marketing managers are often asked is by what percentage must sales rise (or fall) after a price cut (increase) to achieve the same total dollar sales revenue? This calculation can be made as follows.8 Consider the following example where the price (P), variable cost (VC), and contribution margin (CM) are all calculated on a unit basis. If we start with a price per unit of P = $1 where the variable costs are 60 cents (VC = 0.6P) and the contribution margin is 40 cents (CM = 0.4P), then sales changes can be calculated as

Capturing Customer Value: Pricing and Selling

(p.298)

Table 9.2. Variable costs and contribution margins

20% Price change

Current price

Decrease ($)

Increase ($)

Price

P

0.8P

1.2P

VC

0.6P

0.6P

0.6P

CM

0.4P

0.2P

0.6P

For the sake of illustration, let us assume that variable costs stay the same regardless of whether the price is raised or lowered. For a 20 per cent price change, the P, VC, and CM are shown in Table 9.2.

For a 20 per cent decrease in price sales have to rise by { (0.4P − 0.2P)/ 0.2P} × 100 = 100%. For a 20 per cent increase in price the acceptable decrease in sales revenue is { (0.4P − 0.6P)/0.6P} × 100 = −33.3%. This type of analysis is a critical part of every decision to change prices. The example used here is simplistic but it illustrates the asymmetric nature of many price changes.

Many organizations anchor their pricing decisions to their costs—and, thus, ignore the perceived value of their offer. A good example of this approach is the cost-plus practice of pricing. Among construction companies, professional service providers, and retailers, this is a common pricing method. The costs should be direct variable costs (not full costs), and the ‘plus’ (or multiplier) can be based on industry tradition, individual experience, or rules of thumb. This approach to pricing has a number of practical advantages, namely, (a) it is simple and easy to apply, (b) it is based on cost data which pleases the accountants, and (c) it seems to be a ‘safe’ pricing method as it covers costs. Only when costs are fairly constant—at different levels of demand and over time—does this form of pricing have theoretical merit. These conditions characterize many retailing situations, but are less common for durable consumer products and industrial products.9

In summary, because most marketing managers are not trained in cost accounting, it is best to involve the organization's (friendly) accountant in calculating contribution margins and resulting sales changes from a proposed price change.

Competitors

Chapter 3 discussed price wars and market defence, two key factors to consider when setting prices. Here, the focus was on understanding (p.299) a competitor's likely response to a price change. In many markets, a price change invites a competitive price response—especially where the product or service is perishable and the variable costs are very low (such as an airline seat). The downward price spirals that regularly occur in these markets have prompted many competitors to try to shift the focus of competition to other elements of the marketing mix. What is driving this new strategy is the elevation of profitability above market share as the primary pricing objective.

In this section, the focus is on pricing strategies that are anchored in some way to the prices of competitors. The most blatant of such strategies is Going-Rate-Pricing. In commodity industries like base metals, chemicals, fertilizer, fuel oils, and others, organizations tend to charge the same prices for the same grade of product. The best that can be done in many of these industries is for a few organizations to establish small points of difference (often based around customer service) that enable them to charge a slight premium. One or two organizations are regarded as price leaders, and these are watched closely by the other competitors. For small organizations, the reason for setting their price like this is largely one of survival. Higher prices will not attract customers, and lower prices may be perceived as starting a price war and result in retaliation from a big competitor. The supposed rationale for this type of pricing at the industry level is that going-rate prices reflect the collective wisdom of the industry and this strategy is less likely to start a price war.

Some manufacturers and retailers use a strategy called everyday-low-pricing as a way to signal ‘value’ to target consumers and ‘stable prices’ tocompetitors. These stable prices eliminate the price fluctuations that result from constantly putting products on promotion. They also bring a degree of certainty to pricing for both retailers and consumers. Often, this may also result in creating an image of fairness and reliability. This strategy stands in contrast to price-promotion competitors that follow a policy of high—low pricing. When this strategy is implemented by retailers, one or two brands inthe product category are always on promotion, while the rest may be priced (slightly) higher than the everyday-low-price competitors. The retailers use these price promotions as loss leaders to generate store traffic. For the manufacturers whose brands are rotated through the cycle of being on and off promotion, this policy can cause problems such as diluting the value of the brand (‘Is this a high-price or a low-price brand?’), heightening sensitivity to price (when retail advertising talks about price, consumers focus on price), and creating peaks and troughs in production and logistics operations.

The bottom line is that an organization's prices are judged against those of its competitors. Factors like the reputation of the producer, consumers' (p.300) evaluations of the brand, special features of the product, functionality, perceived quality, etc. can all help to substantiate price differences, but these differences will be calibrated against the price of competitive offers. This is especially true for polygamous loyal customers.

Pricing Programmes and Policies

In many small- and medium-sized organizations, the responsibility for setting a price resides with the CEO, after advice from the marketers. Sometimes, formal pricing policies have been developed, but in many cases pricing is an ad hoc activity that fits the circumstances of the day and hopefully the strategy of the organization. Price setting in this type of environment is more often art than science. The danger of ‘artful price setting’ is described in an old Russian proverb:

There are two kinds of fool in a market.

One charges too much.

The other charges too little.

Bigger organizations are more likely to have formal policies and procedures for setting and changing prices. These reflect a combination of industry experience, art, and science, and act as a control mechanism and risk monitoring process. Big organizations often have a specialist group that works with the marketers to set prices, administer price changes, and offer discounts and allowances to selected (business) customers. For example, in a big Australian telecommunications company this group is staffed with accountants, economists, lawyers, and researchers. The group takes responsibility for understanding the regulatory restrictions on pricing; gathering information about competitors—their advertising, cost strucures, strategic intent, key personnel, price schedules, and competitive reactions; modelling the price sensitivity and elasticity of various target consumer segments; and estimating the potential cannibalization of price changes in one area on the demand in other areas (such as changes to fixed-line telephone prices on the demand for mobile services). When prices are set or changed, the various sales, marketing, and brand managers are required to have their suggestions reviewed by this group. Needless to say, the specialist pricing group is often perceived by the brand managers as a bureaucratic impediment to a fast market response. However, over the years, it has saved the company from many pricing disasters. (One occurred when a junior brand manager misinterpreted a major (p.301) competitor's retail advertisement as a price decrease when, in fact, it turned out to be a price increase.)

One of the key areas where it is important to have a formal pricing programme is when pricing a line of products or services. (A product line comprises a set of products that are marketed together.) Consider the task faced by the marketing manager of one of Australia's leading red wine brands—Penfolds. The lowest priced brand in the range is Rawsons Retreat and sells for about $A10 per bottle. The highest priced brand is Australia's most distinguished wine, Grange Hermitage. In 2003, the current release of this wine sold for $A350 per bottle. There are twenty other brands in between these two. How should the prices be set across the full range? Kent Monroe, one of the world's leading academic pricing experts, suggests that the relationship between price and quality should be that the price differentials become wider as the quality increases over the product line. This is illustrated for a selection of Penfolds red wines in Figure 9.4. Monroe suggests that people tend to remember the highest and the lowest prices of the line more than others, and that the higher priced products are perceived as higher quality but lower value than products at the lower end of the line.10 (A branding consultant might also suggest that Penfolds have to think about some of the brand names used.)

In Figure 9.4, notice that all the brands fall on a curved pricing line. This is an easy way to check if the posted prices ‘fit’ the theory—in this case for a product line, and also for a set of competing brands in a product category.

Capturing Customer Value: Pricing and Selling

Figure 9.4. Penfolds—reds

(p.302) Posted Prices and Pocket Prices

A posted (or sticker or ticket or list) price is the public price that appears on the organization's price schedule. A pocket price is the actual amount of money that gets into the bank account. What causes the difference between these two prices are the discounts (for cash, quantity, or by season) and/or allowances (e.g. for a trade-in) that are given to the buyer. As we will see in Chapter 12 (Figure 12.5), the difference between these two prices can be substantial, and something that must be controlled by the internal pricing group or the marketing manager.

The key issue for the marketing manager is how to ‘design’ the posted price seen in the marketplace. One practical heuristic is to:

make posted prices easy to understand

but

hard to compare.

A good example of this design principle is known as ‘postal pricing’. The current rate for a letter is 50 cents anywhere in Australia. The US Postal Service had a flat rate of $3 for a small package anywhere in the United States. At the same time, Fed Ex and UPS had a range of prices depending on the size and the desired delivery time for their packages. The US Postal Service used its postal price to reinforce its position of ‘cheap’ and simple (remember it is the government). The other major courier companies had a pricing schedule that was complex and difficult to understand for many people—a fact that US Postal used in some of its advertising.

Another piece of advice about communicating posted prices from pricing consultants is to always link one's price to a benefit. In this way, the emphasis shifts from price to customer value. A good example of this has been used by a number of telephone companies around the world. Their research suggested that many (most) people saw a phone call as a commodity—and, thus, the cheaper the better. Many phone company advertisements reinforced this view with the offer of cheaper prices. The marketing task was to shift the focus from cheap phone calls to something else. One strategy that had some success was to remind people about why they often used the phone, namely, to keep in contact with family and friends. Advertising campaigns with a theme of ‘reach out and touch someone’, ‘call home’, and ‘friends and family’ for a time began to shift the focus away from discount plans.

To summarize, to a large extent the posted price of a product or service will determine the types of customers and competitors a brand or an organization (p.303) will attract. Selecting the price of a product is a moment of truth in formulating marketing programmes to attract and retain target consumers. The right price complements the other elements of the marketing strategy. The wrong price can ruin a product's chance of success in the marketplace. The problem for the marketing manager is that price setting is an extremely complex endeavour. Figure 9.1 provides an overall framework to guide the development of a pricing programme. Embedded in it are the 3Cs of pricing—customers (their characteristics and the value they place on the product or service), costs, and competitors. Different combinations of these factors ensure that each pricing decision will be unique. Because of this, many marketing managers will use two or more approaches to setting a price in order to cross-check their decision-making.

In order to set a price that will capture the customer value engineered into the organization's products and services, it is worthwhile looking in a bit more detail at how to discover the value that customers place on products and services. The approach described in the next section is used in face-to-face selling. From it, marketers, in both B2B and B2C situations, can learn more about how to assess customer value, and then set a price to capture this perceived value.

Personal Selling—the Art of Spin

Purchasing agents are people who know the price of everything and the value of nothing.

(The salesperson's lament.)i

A coarse way to classify selling situations that confront salespeople is that they are either Commodity Sales or Consultative (Relationship) Sales. This classification is useful in both B2B and retail situations. The way to distinguish between these two types of selling situations is to apply this simple test—‘Would the prospect be willing to pay for the sales call?’ In a consultative situation, the answer is a clear ‘yes’. Hence, the quote above suggests a commodity selling situation.

Commodity sales are characterized by the products or services providingalmost identical functional benefits and they are bought mainly on the basis of price. Many insurance policies, office supplies, and book titles fit this description. Buyers are motivated by paying a low price and acquiring the product with a minimum of effort. The salesperson usually concludes (p.304) the sale in one session. In some cases, the customer may even see the sales representative as a barrier to achieving a successful result. This occurs when the salesperson has a poor selling technique.11 Today, some buyers are going onto the Internet to search for the lowest price and to consummate the transaction.

Consultative sales are characterized by buyers wanting some hands-onassistance to help make their decision. Investment products, industrial machinery, and new forms of electronic products such as a DVD player fit this description for many buyers. In Chapter 4, these purchase situations were described as Extensive Problem-Solving. Often, the role of the Internet here is to help the buyer to gather background information on the product or service before talking to a sales representative. This information allows the buyer to ask the salesperson ‘sensible questions’ about the product. The sale may take a number of sessions to complete. Good salespeople can bring added value to these purchase situations. They do this by offering expertise, by ‘listening’ to the customer, and/or by creating a customized solution to the problem if this is possible. Thus, their role is to both communicate value and add value.

Neil Rackham is one of the leading advocates of consultative selling.12 His SPIN Selling technique is grounded in an extensive research programme and is used by many B2B salespeople around the world. His argument is that the key to good consultative selling lies not in persuading, but in understanding the customer. The sale starts not with the products and services the sales team is rewarded for selling, but rather with understanding the business that the prospect is in. Rackham's approach to selling is outlined in Figure 9.5. Each sales call, from the most sophisticated to the simplest, goes through four distinct stages:

  1. 1. Preliminaries. These are the background research (if needed) and the warm-up events (such as how you introduce yourself) before the serious selling starts. Sometimes these will be perfunctory and sometimes they may take hours or days to conclude. For example, in many situations, there is a careful ‘feeling out’ process to establish the things that are essential in order to do business with the other party. This is often required before any serious business can take place in various Asian countries.

  2. 2. Investigating. This is the process of asking questions to find out further information about the buyer and his or her particular needs. In extensive problem-solving situations, this is the most important stage of the selling process. The SPIN technique of questioning described below is how good salespeople uncover the value inherent in the (p.305)

    Capturing Customer Value: Pricing and Selling

    Figure 9.5. The four stages of a sales call

    products and services they are selling. In the process, they may uncover new ways to add value to the customer.

  3. 3. Demonstrating capability. Here, the salesperson convinces the customer that they have something that will help to solve a problem and/or add value to a customer's business. Doing a VIU calculation would be such an activity as would be demonstrating the product or service for the customer.

  4. 4. Obtaining commitment. In small sales, commitment is usually exhibitedby taking an order or making the sale. Good salesperson closing skills are important in these sales. In larger sales, it may be to schedule another sales call, to visit a factory, or to attend a product demonstration. These intermediate steps all lead towards the final purchase decision.

The real insight of Rackham's approach to selling is his SPIN sequence of asking questions in the investigation phase of the sales call:

  1. 1. Situation questions. At the start of the sales call, salespeople ask data-gathering questions about facts and background. For example, ‘How long have you had this piece of equipment?’ and so on. Good salespeople do not use too many of these questions because they can become tedious for the buyer.

  2. 2. Problem questions. After the situation has been established to thecommon agreement of the buyer and seller, the good salesperson moves on to asking questions that explore problems, difficulties, anddissatisfaction in areas where the seller can help. For example, ‘How much has the machine cost in maintenance?’ ‘What percentage of defects does the machine produce?’ Inexperienced salespeople tend not to ask enough problem questions.

  3. 3. Implication questions. These questions can be quite subtle to ask. They are designed to take a customer problem and explore its (p.306) effects and consequences. For example, ‘How would a machine with a reliability rating of 97 per cent reduce the number of defects produced?’

  4. 4. Need-payoff questions. These questions are designed to get the customer to tell the salesperson the benefits that the salesperson's solution could offer. For example, ‘How much cost would be saved if a more reliable machine was used in place of the current machine?’ Rackham's research suggests that top salespeople ask more than ten times as many need-payoff questions per call as do average performers.

Rackham's consulting company (Huthwaite) runs courses on SPIN selling and his fieldbook provides examples of the SPIN questions.13

The insight gained from the SPIN questioning technique is useful for helping sales and marketing people to discover the value embedded in their products and services. While it forms only a small part of the overall sales process, it fits this book's emphasis of understanding, creating, and capturing customer value. A full treatise on selling and sales management can be found in the book of Andris Zolters and Prabhakant Sinha.14

Key Concepts

  • Price sensitivity—the potential for an individual to notice and react to a pricechange.

  • Price elasticity—a measure of the effect of a change in price on the quantitydemanded, as measured by (per cent change in quantity/per cent change in price).

  • Customer value—the buyer's estimation of a product or service's overall capacityto satisfy his or her needs. It can be measured by: an internal engineering assessment; field value-in-use; stated importance ratings; conjoint analysis; choice modelling.

  • Value-in-use—the maximum amount that the customer should be prepared topay for the product or service.

  • Skimming price—a relatively high price charged at the beginning of a product orservice's life cycle that is systematically lowered over time.

  • Penetration price—a relatively low introductory price meant to quickly establisha product or service in the market.

  • Posted price—the official price listed for public display.

  • Pocket price—the actual amount of money banked from the sale of a product orservice. It is the posted price minus discounts and allowances.

(p.307) Key Frameworks

  • Factors that influence prices—Figure 9.1

  • The 3Cs of pricing—customers, costs, competitors

  • SPIN—Figure 9.5

  • The customer value approach to pricing—Exhibit 9.1 and Table 9.3 (following)

Key Questions

  • Does your organization base its pricing decisions on good marketing information (viz. the industry economics, customer segments, marketing strategy, competitors' prices)?

  • Do you really understand the psychology of your target customers' reactions to price (e.g. their mental accounting, reactions to odd-price endings, etc.)?

  • Are costs and contribution margins known and accepted by the people responsible for setting prices?

  • Does the organization have a formal pricing policy to manage pricing?

Recap

As noted at the beginning of this chapter, price setting is one of the most complicated of all the marketing activities. Because of this, there are no simple and robust rules for pricing. In practice, it is best described as art based on science.

The science of pricing focuses on using research to understand the price sensitivity of individuals and the price elasticity of markets. The art of pricing focuses on setting sensible pricing objectives, understanding the interactions of price with other elements of the marketing mix, and predicting competitor reactions to price changes. Linking both art and science is the management of pricing.

The management of pricing involves:

  • Working with the organization's accountants to understand costs and contribution margins.

  • Developing a pricing policy and assigning responsibilities to people for setting prices, changing prices, offering discounts and allowances, preparing invoices, etc.

  • Making sure that the KPIs of people who have authority for the organization's prices are aligned with the organization's pricing objectives (e.g. do the salespeople's KPIs support the pricing objectives of the brands they sell?) (p.308)

    Table 9.3. Two broad approaches to setting prices

    Cost approach

    Customer value approach

    What are our costs?

    Estimate the target customers' VIU.

    What mark-up do we need to meet our (financial) target?

    Adjust VIU up or down based on the quality of the company's reputation.

    How does our price compare with our direct competitors? (Does it need adjustment?)

    Compare this price to direct and indirect competitors' prices. (Does it need adjustment?)

    Launch the product/service and see who buys.

    Can we make the brand at a cost to meet our target profit?

  • Establishing measures to monitor how price (a) interacts with other elements of the marketing mix (e.g. price and quality), (b) supports marketing objectives (e.g. to inhibit a new entrant), and (c) drives sales.

The overarching recommendation of this chapter is for marketing managers to approach pricing from a mindset anchored on customer value as opposed to cost. The contrast between these two approaches is shown in Table 9.3 for a new product or service.

Notes

Notes:

(i) This saying is also often used to denigrate accountants and economists. (p.310)

(1.) See R. J. Dolan and H. Simon, Power Pricing (New York: Free Press, 1996), p. 4.

(2.) From M. J. Lanning, Delivering Profitable Value (Oxford: Capstone, 1998), pp. 26–7.

(3.) T. Nagle and R. Holden, The Strategy and Tactics of Pricing (Upper Saddle River, NJ: Prentice Hall, 1997), pp. 77–93.

(4.) This example is from G. R. Dowling, G. L. Lilien,R. J. Thomas, and A. Rangaswamy, Harvesting Customer Value (State College, Penn State University: Institute for the Study of Business Markets, 2000), chapter 2.

(5.) This example is from L. Krishnamurthi, ‘Pricing Strategies and Tactics’, in D. Iacobucci (ed.), Kellog on Marketing (New York: John Wiley & Sons, 2001), chapter 12.

(6.) R. M. Schindler, ‘Relative Price Level of 99-Ending Prices: Image Versus Reality’, Marketing Letters, 12, 3 (2001), 239–47.

(7.) S. OʼCurry, ‘Budgeting and Mental Accounting’, in P. E. Earl and S. Kemp (eds.), Consumer Research and Economic Psychology (Cheltenham: Edward Elgar, 1999), pp. 63–8; R. H. Thaler, The Winner's Curse (New York: Free Press, 1992), chapter 9; R. Thaler, ‘Mental Accounting and Consumer Choice’, Marketing Science, 4, 3 (1985), 199–214.

(p.309) (8.) This approach is from Dolan and Simon (1996), chapter 2, and Krishnamurthi (2001).

(9.) See G. L. Lilen and A. Rangaswamy, Marketing Engineering (Upper Saddle River, NJ: Prentice Hall, 2003), p. 418.

(10.) K. Monroe, Pricing (New York: McGraw-Hill, 1990), chapter 13.

(11.) The ‘standard’ selling approach in these situations contains a series of steps such as: opening the sales call, investigating needs, giving benefits, handling objections, and closing the sale. The rule seems to be that it is OK to be pushy if you can take the order during the call, but if this does not happen, then your pushiness reduces your chance of final success.

(12.) N. Rackham, SPIN Selling (New York: McGraw-Hill, 1988).

(13.) N. Rackham, The SPIN Selling Fieldbook (New York: McGraw-Hill, 1996).

(14.) A. A. Zoltners, P. Sinha, and G. A. Zoltners, The Complete Guide to Accelerating Sales Force Performance (New York: American Management Association, 2001).