Chpt 01 - Boundaries of a Good Price Edited

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Chapter 1

Boundaries of a Good Price

Using Exchange Value Models to Understand Price Competition and

Define Your Value Add


Agenda

• Who is involved in pricing decisions? • Why is pricing so important to the health of the firm? • Can firms influence their pricing power?• What is the nature of a good price? • How relevant are marginal costs and consumer surplus in

setting a good price?• How should the comparable alternatives on the market

influence the pricing of a product?• How can exchange value models be used to set prices?• Stretch Question: How are exchange value models related

to market segments?


Pricing Errors Are Costly• Too high

– Lost profits from lack of volume– The price is eventually dropped and the company must fight for market

interest and perception repositioning– Potential allegations of price gouging and unfairness, leading to public

relations and regulatory ramifications

• Too low– Forgone profit in an attempt to gain volume which may not come– Incorrectly set expectations for the product category, making future price

increases being driven against a headwind of customer expectations

• Ultimately, lost profits, revenues, and a shrinking/irrelevant firm


Pricing Decisions are Stakeholder Decisions (Cross Functional Decisions)

• CFO – Responsible for measuring and reporting performance– Almost always involved in pricing decisions from a

quantitative analysis / forecasting perspective– General bias towards higher contribution margins

• Sales & Marketing– Responsible for promotion, product strategy, and

placement, along with pricing– Almost always involved in pricing decisions from a

value positioning perspective– General bias towards discounting and market share

• Research & Development– Responsible for developing new products that

customers value– Technical individuals often are challenged to

understand commercial aspects• Production

– Responsible for quality, throughput, and capacity utilization

– General bias towards volume to reduce overhead allocation

• CEO– Arbitrator between competing stakeholders

Executives

Customers

Shareholders

CEO


The Needs for Pricing Professionals

• Understand Customer (Perception and Willingness to pay)

• Grip the issue of COST• Market alert• Able to measure the demand (elasticity)• Need Strong analytical skills – meaningful

decisions


Value Exchange and Profit Capture• Price is the value that the firm captures in a mutually beneficial exchange

with its customers– Firm’s reason for existence is to produce value for customers, value which they

exchange for cash– Customers purchase because they gain value from the product in excess of the

price they pay

• Profit Profit = Quantity X (Price – Variable Costs) – Fixed Costs

p = Q (P – V) – F

Variable Costs (V)Fixed Costs (F)Volume or Quantity Sold (hence the Q)Price (P)Profit (p)


Marginal Improvement – Price Has Impact• Consider a firm that improves one

of the levers in the profit equation by 1%, holding all else constant

• Example:– P = $5.00– Q = 200,000– V = $3.00– F = $325,000– Improve either P, Q, V, or F by 1%– How does this affect profit?

• Initial Profitabilityp = 200,000 ($5.00-$3.00) - $325,00p = $75,000

• Fixed Cost Reduction– New Fixed Cost =

$321,750– New Profit = $78,250– Improvement of 4%

• Variable Cost Reduction– New Variable Cost = $2.97– New Profit = $81,000– Improvement of 5%

• Quantity Sold Increase– New Quantity = 202,000– New Profit = $79,000– Improvement of 4%

• Price Increase– New Price = $5.05– New Profit = $85,000– Improvement of 13%


Quantitative & Qualitative

• Quantitative Modeling and Price Optimization – Careful selection of model– Careful treatment of data (cleansing)– Careful market segmentation

• Qualitative Modeling– Potential methods of influencing

willingness to pay– Relationship to corporate strategy and

industry dynamics– Customer acceptance to approach of price

discrimination

Finance

Marketing Sales

Economics

Price


Setting Prices with Exchange Value Models

What is the right Price?Is about a range of potential points that benefit

customer and firms

In Proportion to the value that customer perceive


Boundaries of Price• There is a range of “right prices”

– Range implies boundaries, upper and lower

• Extremes from standard economics: – Marginal Cost is the Extreme Lower Boundary– Consumer Utility is the Extreme Upper Boundary


Marginal Cost = Extreme Lower Bound

• Marginal costs are the sellers bottom line.

– Any price below marginal costs leave the seller worse off then they would be without the transaction.

– Any price above it leaves the seller better off. – Thus, marginal costs is the extreme lower boundary of the “right”

price.



Consumer Utility = Extreme Upper Bound• Consumer utility are the buyers bottom line.

– The customer would be worse off if they paid more for a product than they gained in utility

– Any price below consumer utility would be leave the customer better off than going without


Marginal Costs and Consumer Utility Extreme Boundaries

• From this example, we know only two extreme boundaries,

– Bottom boundary of marginal cost generously estimated $325

– Upper boundary of consumer utility frugally estimated at $500,000

• Clearly, $325 and $500,000 is a wide range, with the upper bound a factor of 1000 above the lower bound.

– $400– $4,000– $40,000– $400,000

• Managers need a tighter bound than this for decision making.

• Blunt force economics of producer cost and consumer utility alone is insufficient.

Consumer Utility$500,000

Mar

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Price Floor$325

Range of Potential Prices lies between the Extreme Boundaries


Competing Alternative and Differential Value Narrow Boundaries

• Marketing Strategy– Products are valued because they enable a customer to do

something, accomplish a goal, from that product. – Utility is derived from Goal accomplishment– Prior to the existence of the product, most consumers found an

alternative means of accomplishing the same goal• What are those alternatives? • How much better can they achieve that goal, and perhaps others

simultaneously, from the product?

• Narrower band is defined by the competing alternatives and differential value


Competing Alternatives / Substitutes

• Competing offers are often readably identifiable, and form a reference price.

– Reference Price = Price of nearest comparable offer

• Substitutes are sometimes more challenging to identify, but they always exists.

– Substitutes: any alternative means of achieving a similar set of benefits

• When possible, use more direct competitors to consider when modeling price decisions


Differential Value• Differential value is the change in consumer utility that a product in comparison to its comparable

alternative

• Exchange value is the price of the competing alternative adjusted for the differential value

• The drug eluting stent clearly delivers more benefits than standard stents. Quantify it with a model.

• The stent is a component in a larger process. • Implanting a stent is a roughly $12,000 operation, of which the standard stent is only a $1050

component. – Operation cost = $10,950– Standard Stent Cost = $1050– Assume the procedure must be repeated 25% of the time due to restenosis– Total Maximum Expected Cost

($12,000) + ($12,000) 25% + ($0) 75% = $15,000

Repeat the Procedure$12,000, 25%

Don’t Repeat the Procedure$0, 75%

Original Procedure$12,000, 100%

Expectation Value = $15,000 $12,000(100%) + $12,000(25%) + $0(75%)


Differential Value• The Drug Eluting Stent reduces restenosis to 5%

• Repeat the Model, but this time let the price of the stent be unknown and the expectation cost be held constant to that of the nearest competing alternative

– Solve for the unknown, using algebra.• Total Maximum Expected Cost

$15,000 = ($10,950 + X) + ($10,950 + X) 5% + ($0) 95%• X = [$15,000 – ($10,950)1.05]/1.05• X = $3,340

• Exchange Value of the new Drug Eluting Stent at $3,340– This price leave the patient economically equally well off as with the lower price for the lower

quality competing alternative– Ignores quality of life issues, the risk of a second failure, etc. It is a “conservative estimate”

Repeat the Procedure$ 10,950 + X, 5%

Don’t Repeat the Procedure$0, 95%

Original Procedure$10,950 + X, 100%Expectation Value = $15,000


Exchange Value Model for Drug Eluting Stent by Cordis

• Exchange value = Price of Alternative + Differential Value– $3,340 = $1,050 + DV– Differential Value is a whopping

$2,290

• Consumer Surplus is the difference between the price paid and the total consumer utility

Consumer Surplus$$$$$

Exchange Value$3,340

Reference Value$1050

Differential Value$2,290

Pric

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Alte

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Max

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P

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Consumer Utility$500,000

Mar

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Price Floor$325


Summary• Model your value add with Exchange Value Models to determine the boundaries of a

reasonable price– Consumer Utility– Marginal Cost– Price of Nearest Alternative– Differential Value– Exchange Value

• Use Exchange Value Models to Identify a rational range for your price

• Use Exchange Value Models to Communicate Pricing decisions with CFO / Sales Team

• Use Customer Utility Models to Communicate Value with Customers

• Accept that different customers have different perspectives on value. Use differences in valuation to drive price segmentation

Documents

Chpt 01 - Boundaries of a Good Price Edited