Session Objectives Learn how to price new

Session Objectives • Learn how to price new products • Master the most important power pricing concepts March 2006 Teck H. Ho 1

Class Outline q Flawed pricing practices q The economic value to the customer (EVC) q Factors affecting price sensitivity q Price customization strategies March 2006 Teck H. Ho 2

Flawed Pricing Practices (1) q. Cost-plus pricing: Adding a standard markup to the cost of the product q. Purpose is to ensure a fair rate of return q. Product average cost price value customer q. Problems March 2006 Teck H. Ho 3

Flawed Pricing Practices (2) q. Market share based pricing: Setting price based on market share targets and goals q. The purpose is to meet market share goals at the expense of profit margin q. The key assumption is that profits increase with market share in the long run q. Problems March 2006 Teck H. Ho 4

Dell XPS M 140 Notebook http: //www 1. us. dell. com/content/default. aspx? c=us&cs=19&l=en&s=dhs XPS M 140 Packs a Punch Small and potent. At about 1. 5" thin, 5. 5 lbs light and with a Genuine Windows® XP Media Center Edition 2005 Operating System, the M 140 is a true expression of multimedia power in a package that gets heads turning. True "instant on" functionality provides quick access to DVDs, video, music and photos and the 14. 1" WXGA screen with optional True. Life. TM helps make all this come alive. How much is your willingness to pay? March 2006 Teck H. Ho 5

Motivation Questions q As a buyer, what information do you use to determine how much you are willing to pay for a Dell XPS Laptop? q What can a company do to influence consumer’s willingness to pay? March 2006 Teck H. Ho 6

EVC Analysis q Economic value to the customer (EVC): the maximum amount a customer should be willing to pay, assuming that s/he is fully informed about the benefits of the product and the offerings of competitors EVC = Reference Value + Differentiation Value q Reference value: the price of perceived closest substitute adjusted by difference in quantity used q Differentiation value: value of a product’s attribute difference between your offering and the closest substitute (+ or -) March 2006 Teck H. Ho 7

EVC Analysis Negative Differentiation value Positive Differentiation Value q. Superior performance q. Better reliability q. Additional features q. Lower maintenance cost q. Faster service EVC Reference Value q. Reference Value March 2006 Teck H. Ho 8

Differentiation Value: An In-Class Example q A magazine publisher consistently encountered price resistance from media buyers. q Despite the fact that the magazine had better writers, more interesting articles, nicer photography, and a more loyal and wealthier readership, advertisers still resisted its pricing. q They argued that the value of the magazine’s quality was reflected in the number of subscribers drawn to it. q Since the magazine generated 11% more circulation than its nearest competitor, media buyers would pay no more than an 11% premium to run an ad. q The nearest competitor charges $25, 000 for a full-page ad. March 2006 Teck H. Ho 9

Differentiation Value: An In-Class Example March 2006 Teck H. Ho 10

Dryel (released in June 1999) Welcome to Dryel® — the safe, easy way to care for dry clean only and special care clothes in your home in about 30 minutes. At about $0. 60 per garment (based on average national retail price), Dryel is the affordable alternative to dry cleaning your clothes. Discover how Dryel can give you the freedom to purchase and wear the kind of clothes you want, whenever you want. March 2006 Teck H. Ho 11

EVC in 1999 Negative Differentiation value Positive Differentiation Value EVC Reference Value March 2006 Teck H. Ho 12

EVC in 2003 Negative Differentiation value Positive Differentiation Value EVC Reference Value March 2006 Teck H. Ho 13

An example: Alathon 25 q In 1995, Du Pont introduced Alathon 25, a polyethylene resin designed to compete with other resins in the manufacture of flexible pipe. Tests indicated that Alathon 25 pipe had failure rates of 3% compared with 8% for the competition. Farmers purchased Alathon pipe as part of below-ground irrigation system. The common substitute for Alathon pipe was a pipe made of an off-grade resin selling for $6. 5 per hundred feet. Labor cost of replacing a failed pipe is about $60. Pipe failures, if not detected quickly, can also damage crops. The damage could range from 0 (if the plants were mature) to $40 when vulnerable seedlings were washed out. Young, poorly rooted crops are in place approximately 20% of the time that the irrigation system is in use. q What was the product’s economic value for the farmers? q What if the failure rate is reduced from 7% to 1% (instead of 8% to 3%)? March 2006 Teck H. Ho 14

An example: Alathon 25 Differentiation Value Crop – Less Reduction = $0. 40 $40 x 0. 20 x 5% = $0. 40 Labor Savings = $3. 00 $60 x 5% = $3. 00 Replacement Savings = $0. 31 $6. 5 x 5% = $0. 31 EVC = $10. 21 Reference Value = $6. 50 March 2006 Teck H. Ho 15

Using EVC to Segment Market EVC Profile: Different segments have different EVCs. You need to determine the EVC of each segment and its size formulating an effective pricing strategy. 64. 1 Indoor Plumbing Do-it-Yourself 58. 3 44. 5 Sewage In-Ground Irrigation 39. 8 Indoor-Plumbing 28. 0 Commodity Value 10. 2 Farmers March 2006 Teck H. Ho Market potential 16

Communicating EVC to Your Customers q. Do not assume customers know EVC q. Educate customers is important when q. The product delivers a stream of benefits over time q The product is highly innovative q. The fact that consumers are not buying your product is not by itself a reason to cut price. It may be a reason to change your marketing program to justify the price March 2006 Teck H. Ho 17

Steps in EVC Analysis 1. 2. 3. 4. 5. 6. Identify the price of the closest competitive product to determine reference value Identify all factors that differentiate your product from the competitive product Determine the differentiation value Sum up the reference value and differentiation value to determine EVC Develop EVC profile for each segment Develop marketing programs to educate consumers about EVC March 2006 Teck H. Ho 18

Use of EVC q Advantages q. Describe decision process of sophisticated purchasers q. Enables firm to distinguish between under-promoted vs. overpriced product q. Can indicate attribute improvements which give largest gain in EVC (i. e. , channel your improvement effort) q. Can be a great aid to sales force q Limitations: q. Actual willingness to pay depends perceived differentiation value and perceived value of the competitive product March 2006 Teck H. Ho 19

Class Outline q Flawed pricing practices q The economic value to the customer (EVC) q. Factors affecting price sensitivity q. Price customization strategies March 2006 Teck H. Ho 20

Factors Affecting Actual Willingness to Pay (1) q Substitutes awareness effect: Buyers are more price sensitive the higher the price difference between this product and the perceived substitute q Difficult comparison effect: buyers are less price sensitive the more difficult to evaluate competing offers q Switching cost effect: Buyers are less price sensitive the greater the sunk investment they have made in anticipation of its continued use. March 2006 Teck H. Ho 21

Baby Oil (Rite Aid versus Johnson & Johnson) March 2006 Teck H. Ho 22

UC Medical Plans March 2006 Teck H. Ho 23

UC Medical Plans March 2006 Teck H. Ho 24

UC Medical Plans March 2006 Teck H. Ho 25

Factors Affecting Actual Willingness to Pay (2) q. Price-quality effect: Buyers are less price sensitive to the extent that higher price signals higher quality. (Image and exclusive products or products without quality cues) q. Fairness effect: Buyers are more price sensitive when it is outside the range that they perceive as “fair” http: //www. businessweek. com/technology/content/mar 2006/tc 20060321_073434. htm? chan=technology_technology+index+page_more+of+today%27 s+top+stories March 2006 Teck H. Ho 26

Price-Quality Effect: http: //www. sephora. com Romance Ralph Lauren Romance. The women's fragrance that evokes the timeless essence of falling in love. Discover the sensual essence of velvety woods, extravagant florals, and seductive musk. March 2006 For the man with no boundaries - a subtle, serene, and aquatic scent. Teck H. Ho 27

Seller’s Posted Price Game q Seller has a variable cost of $10 (assume there is no fixed cost) and buyer is a distributor with an offer for the product for $20 q Both seller and buyer know the above information and there are no other traders in the market q Seller posts the price at $X (i. e. , makes a take-it-or -leave-it offer) (earning = $X - $10) q If you are the buyer, would you buy the product if the posted price is $X? (earning = $20 - $X) q If there is no trade, both parties earn nothing March 2006 Teck H. Ho 28

Class Outline q Flawed pricing practices q The economic value to the customer (EVC) q Factors affecting price sensitivity q Price customization strategies March 2006 Teck H. Ho 29

Two Problems with Single Price Strategy q Leave money on the table q. Some customers are willing to pay more q Pass-up Profit q. Some potential customers were not served even though the firm could have served them at prices above the variable cost March 2006 Teck H. Ho 30

Customize by Customers q Based on observable characteristics that signal buyers’ price sensitivity q Eurodisney “Kids Free” from Jan to April, 1996 q Harvard Publishing: Academic Institutes: $28. 00; Corporate Customers: $50. 00 q Landing fee at Munich Airport: 747 -200: DM 18, 600; 747 -400: DM 10, 100 q Select the segmentation variables that q Separate consumers into groups with different sensitivities (e. g. , ability to pay (tuition), age (movie)) q Are observable without great expenses (e. g. , Lotus 1 -2 -3 $325 for first time buyer, $99 for upgrades) March 2006 Teck H. Ho 31

Customize by Purchase Location q Consumers at different purchase locations have different price sensitivity q J. Crew U. S. Japan Rollneck sweater $48. 00 $130 Polartec cap $14. 00 $39 q Cure for anthrax: $450 in the U. S. $190 in Canada q Staples website asks for zip code http: //www. staples. com/ q Select segmentation variables that ensure q different segments purchase at different locations q high shipping cost to prevent arbitrage March 2006 Teck H. Ho 32

The Hamburger Standard March 2006 Teck H. Ho 33

Customize By Time of Purchase q Charge different prices because cost and price sensitivity are different at different time q peak-load pricing: designed to re-distribute usage from peak time to off -peak time q redeye flight q yield management: pricing discount seats weeks before a flight and still have enough seats left to serve its best customers at full fare? q Airlines, hotels q skimming pricing for new product q a navigation system, flat TV ($4999) q catalogues: 7 versions q Key: q avoid resale (e. g. , non-transferable airline tickets) March 2006 Teck H. Ho 34

Customize by Quantity q Bigger quantity buyers are usually more price sensitive q volume discount q 1995, Club Med for ski vacation, “ 11 th person in a group is free” q step discount (block discount): based on different value placed by the same consumer on different quantity q. ATT Worldnet q tie-in: require buyers to purchase products used exclusively with an asset q Key q Do not hinder competition q The product cannot be easily resold or stored for later use q It is possible to segment buyers for pricing into groups with similar demand elasticity March 2006 Teck H. Ho 35

Customize by Product Design q. Some consumers want unique features and are less price sensitive – product line differentiation • 1995, two models of Ford Taurus (LX 19150, GX 18, 545) – introduce different versions at different times • Time to Kill (John Grisham), hard cover first at $26, paper cover later at $7 q. Key: – Understand consumer needs to sort consumers – Price difference can be much higher than cost difference March 2006 Teck H. Ho 36

Punch-line March 2006 Teck H. Ho 37

Punch-line q. Avoid cost-plus and market share based pricing strategies q. EVC = Reference value + Differentiation value q. Pay attention to factors that influence actual price sensitivity q. Price customization strategies (customer, location, time of purchase, quantity, and product design) March 2006 Teck H. Ho 38