Goodwin - Pricing For Long-TermLong-Term Profitability 0273659332

Pricing for Long-term
Profitability
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Pricing for Long-term
Profitability
ALAN WARNER
AND
CHRIS GOODWIN
FT Prentice Hall
FINANCIAL TIMES
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About the authors
Chris Goodwin read economics at Cambridge and also qualified as a Chartered

Accountant. After being involved in the training of candidates for accounting
examinations, he joined Ashridge Management College and managed a wide range
of financial and general management training programmes. He left Ashridge to
become a founding partner of MTP and has since worked with a range of major
company clients, now teaching mainly in the areas of marketing and strategy.
Alan Warner is a Chartered Management Accountant who worked as a financial
manager in industry before moving to Ashridge. He was Director of Studies,
Senior Programmes before also becoming an MTP founding partner. He has
written a wide range of articles on financial, management and HR issues,
appearing in The Times, Management Today, Personnel Management and all the
major accounting journals. He was joint author of Shareholder Value Explained
published by Financial Times Prentice Hall as part of this ‘Executive Briefings’
series and has written a number of business novels, designed to make difficult
topics easy to understand and apply.
MTP was formed in 1987 as the Management Training Partnership and has
grown rapidly to become one of the largest UK providers of tailored management
training. MTP designs and delivers tailored programmes in three core areas: finance,
marketing/strategy and people skills. It has a range of blue-chip clients including
Boots, BP, GlaxoSmithKline, ICI, Pearson, Shell and Unilever, and employs 16 full-
time tutors – all specialist communicators with management experience.
For further information please contact:
Alan Warner
MTP PLC,
3 Prebendal Court,
Oxford Road,
Aylesbury,
Bucks.
HP19 8EY
Tel: +44(0) 1296 423474

Fax: +44(0) 1296 393879
E-mail: learn@mtpplc.com
v
Contents
Preface xi
1 A framework for pricing 1

The problem of price inertia 3
The complexities of pricing 4
A framework for pricing decisions 5
The concept of value 6
Organizational responsibility for pricing 7
Price reviews 9
Steps to pricing effectiveness 9
Economic theory 10
2 Generic pricing strategies 11

Business strategy as the starting point 13
Porter’s generic business strategies 13
Generic pricing strategies 14
Choosing between skimming and penetration 15
Subsidiary pricing strategies 18
Practical applications 19
Pricing and the product life cycle 19
A summary of life cycle pricing strategies 22
The importance of competitor analysis 22
3 Understanding the competition 23

Competitor aware but not competitor driven 25
The problems of analysis 25
The context of competitor price assessment 26
Some principles of competitor analysis 27
From competitors to customers 32
4 The drivers of consumer price sensitivity 33

The need for understanding and insight 35
The nature of the product 36
Emotional or functional benefits? 37
vii
Contents
Market environment 38
The context of the purchase transaction 40
A complex web of factors 43
5 Price as part of the marketing mix 45

The marketing mix framework 47
The place of price in the marketing mix 47
Segmentation 48
Pricing and product 49
Pricing and promotions 52
Pricing and distribution channels 54
Analyzing the value package 56
The link of pricing strategies to financial results 58
6 Price, value and profitability 59

Definitions of quality 61
The PIMS research 61
Linking value to profitability and market share 63
Summary of rankings 64
PIMS, Porter and pricing strategies 65
Financial implications 66
7 Analyzing the financial impact 67

The case for cost and profitability analysis 69
The link to financial objectives 69
The financial analysis of price change options 70
Cost structure 71
The impact of price reductions 75
The price/volume breakeven concept 76
The impact of different cost structures 78
The causes of variation in cost structure 79
Long-term fixed costs 81
8 Cost structure and pricing behaviour 83

The breakeven chart 85
The temptations of a high fixed cost structure 86
Marginal pricing 87
The pros and cons of marginal pricing 89
viii
Contents
Price behaviour in the high variable cost business 93

Understanding competitors’ cost structures 93
9 Cost plus pricing revisited 95

The case against 97
The case in favour 98
The costing process 98
Activity-based costing 101
Profit objectives 102
The concept of ‘required contribution’ 103
The value of financial assessment 105
10 Pricing, business objectives and value creation 107

From value pricing to value to shareholders 109
Relating financial to marketing objectives 110
Evaluating marketing objectives 110
The underlying assumptions 116
Conclusion 117
Appendix The economic theory of pricing 119
References 129
ix
Preface
This book sets out to provide an overview of pricing issues and principles,
covering the topic from a balanced perspective, including strategic, marketing and
financial factors.
It starts with a statement of some key issues and complexities in the pricing
decision-making process and affirms that the best decisions are based on the
concept of value maximization for customers. A step-by-step framework is
suggested to ensure that all factors are taken into account and this framework
provides a structure for the chapters that follow.
The starting point is the broad strategy of the business as a whole, followed by
an assessment of competitor prices and of the factors which impact price
sensitivity. There is then coverage of price as only one element of the marketing
mix and its relationship to the other components.
After a reference to some research which shows the relationship of broad pricing
strategies to the financial performance of the business, the book then moves on to
cover the key financial issues involved in pricing, including the evaluation of
price/change options, the importance of cost structure to pricing behaviour, and
the reasons why cost plus pricing is still important in some businesses.
The final chapter covers the need for pricing decisions to maximize value creation
over the long term and suggests the ways in which this can be assessed financially,
confirming the link between value to customers and value to shareholders.
This book is suitable for use on any course or other learning activity involving
the topic of pricing, either as pre- or post-course work on fundamental principles.
Its comprehensive and practical nature demonstrates the skills and ability of MTP
to provide user-friendly and effective learning for managers.
xi
1
A framework for pricing
■ The problem of price inertia 3
■ The complexities of pricing 4
■ A framework for pricing decisions 5
■ The concept of value 6
■ Organizational responsibility for pricing 7
■ Price reviews 9
■ Steps to pricing effectiveness 9
■ Economic theory 10
1
This book covers the topic of pricing by providing principles, frameworks,

concepts and guidelines for any manager in business with responsibility for pricing
decisions. This is a tough call because there are so many factors in the pricing
decision that vary because of different businesses, products, histories and customer
relationships. It is difficult to produce even the broadest guidelines that can be
applied at one extreme to the brand manager of Coca-Cola and at the other to the
jobbing builder quoting for a house extension. Indeed, the question has to be
asked: can there ever be general principles that apply across the whole spectrum?
We hope to provide a positive answer and this first chapter sets us on the way.
THE PROBLEM OF PRICE INERTIA
The basic economics of a business can easily be complicated too much. At its
simplest, there are three main variables in business that managers can influence to
create value for shareholders. These are:
■ sales volume
■ cost levels
■ price levels.
There is a danger that, because of pressure from top management for volume
growth – often driven by real or perceived shareholder needs – and the natural
desire to match competitors’ cost efficiency, the price element of the equation
receives inadequate attention. There is a natural tendency for prices to stay as they
are because in the face of market uncertainty, this seems the best approach.
Managers thus allow inertia and risk aversion to dominate their thinking and,
in so doing, avoid the considerable effort involved in making a change,
particularly when the move is up rather than down. It is easier to avoid preparing
that difficult communication to customers and to leave things as they are. Such an
approach means that managers may be much too passive; they will wait for costs
to rise, for customers to complain, for another competitor to move or for
shareholders to express concern about the levels of profitability before they take
action to change price.
This is a flawed and lazy approach because the price level is such a vital element
of marketing strategy and such a major driver of value creation that there should
always be clear, proactive thinking about current and future price levels, based on
regular and analytical review. There should be a clear policy on pricing and a set of
agreed practices to carry it out. Costs and competitors should be key factors in the
decision, but your own management should have control and should set the agenda.
The passive and reactive attitude to pricing had its origins in the days when
inflation was much higher than it is now and when a key objective of accounting
3
Pricing for Long-term Profitability
was to remove the impact of inflation, to look for measures that expressed growth
in ‘real terms’. Price increases and inflation became much too closely connected in
the minds of managers in all functions. The legacy of this thinking is still around
today as managers quote ‘real volume growth’ in their internal reports or in their
annual reports to shareholders. Though there is some validity in knowing these
figures as part of managing any business, excessive emphasis on ‘real’ growth can
cause the pricing lever to be neglected or to be deliberately managed down. A
number of international companies have recently reviewed this ‘real terms’
thinking as they realize that shareholders and the analysts who advise them are
interested in increases in cash flow and profit, rather than in ‘real’ volume.
THE COMPLEXITIES OF PRICING
A vital point to understand as you start this book is that pricing is complex. There
is no one perfect answer to the decision about what price to charge. There are
many business models – retailer, consumer goods distributor, industrial goods
manufacturer, service supplier, project deliverer – each of whom will look at
things from a different perspective and have their own approach to pricing.
To illustrate this complexity and to provide a broad overview of what follows
in later chapters, let’s think about the decision process for launching a new
product, any product. Think of a new product which you might launch in your
own business or one which you see in the supermarket. What should be the basis
for the price? Let’s look at the possibilities.
Your own costs plus a required margin?
Cost will be a factor in the decision, but there are a number of problems about
using ‘cost plus’ as a basis for pricing. For one thing your customers don’t know
or care about your costs and required profit levels; they will buy only if they see
the product as having value for them. Another point is that your costs may be
higher than those of your competitors, in which case such a basis would make
your selling price unrealistic. And finally, a point which is vital but which is often
misunderstood, it is impossible to determine precise and unarguable cost levels
because costing, and its conversion into price, is a complex and inexact science
(we will explain the reasons for this in more detail in Chapter 9).
Your competitors’ prices?
Certainly these will be a factor and sometimes a starting point, but competitor prices
can be no more than a guide because rarely is there a uniform product or a simple
4
direct choice for consumers. In everything but the most basic commodity business,
other factors in the value equation impact the buying decision. Therefore you need
a marketing strategy to determine your own positioning, and an assessment of your
overall value package in relation to these competitors, before you can use their
prices as a benchmark.
Your customer’s willingness to pay?
This is clearly not separable from the issue of competitor prices because willingness
to pay is always dependent on the choices available. A further practical problem is
that it may be expensive or even impossible to find out the amount that customers
are willing to pay, because the factors in the choice are so complex. In any case it
can be dangerous to price high on the basis of what the market will bear unless that
price is linked to an offer of good value, because the high profit margins may invite
new competitors into the market and eventually reduce overall profitability.
The key point to note and retain, one which will become an ongoing theme of
this book, is that price can be seen only in the context of a marketing strategy
because it is the total value proposition rather than the price which customers are
assessing when they make their buying choice. Furthermore, researching that
complete value proposition before a new product is launched is much more
difficult than researching price alone, which is perhaps one reason for the high
proportion of new product failures in most sectors.
A FRAMEWORK FOR PRICING DECISIONS
The outcome of this complexity is that the pricing decision should be seen as the
combined result, expressed or intuitive, of the analysis and interaction of a number
of factors which can be summarized in Figure 1.1.
This is why there are no easy answers. Selling prices must be arrived at as the result
of a series of analytical and strategic processes that are designed to arrive at an
assessment of perceived customer value. This must be assessed as the critical element
of the decision-making process because it is the key to successful pricing strategies.
The establishment of this principle also helps to clarify the role of cost in the pricing
decision. As Figure 1.1 shows, the cost of the product must at some point be matched
with this agreed ‘value’ price, to arrive at the profit level that will be achieved from
sale. The calculation of this profit level enables management to assess whether the
company is getting an adequate return from the current price, as a guide to both
short- and long-term decisions. Clearly the willingness of the company to continue in
business at that profit level will, in the long term, determine whether the selling price
and the business model are sustainable.
5
Fig. 1.1 The factors which determine the pricing decision
Competitor Customer
analysis analysis
Marketing
mix
Perceived
customer
value
Price Cost
Required
Profit profit levels?
However, the concept of ‘cost plus’ pricing cannot be rejected entirely and, for this
reason, all of Chapter 9 will be devoted to this topic. In some project-based
industry sectors, for example construction or shipbuilding, cost has to be the
starting point for pricing because there is no standard, visible benchmark in the
market when the project is conceived. Cost plus may also have a place when
market forces are not applying – because the customer has chosen to trust the
supplier to take the cost plus route, or because the market has monopolistic
features. We would argue, however, that the above framework still applies to these
situations and in the long term customers or governments will allow cost plus to
continue only if they feel that they are receiving value from the arrangement.
THE CONCEPT OF VALUE
The use of the concept of value as the basis for pricing will recur many times
during the book, so we should start with a clear idea of its meaning. It is one of
many generic words which entered the management vocabulary during the latter
part of the 20th century and it has been used in many, often conflicting, ways.
Dictionary definitions refer to desirability, worth and utility, which help us to
some extent. Confusion may also be caused by the fact that accountants,
economists and marketers often have their own different ways of defining value,
so we will aim for simplicity.
6
In Chapter 5 and elsewhere we will be emphasizing the principle that price is

only one element of the marketing mix. The offered price will always be seen by
the customer in relation to the other benefits provided, as part of the total
marketing proposition. We can thus convert the customer’s buying transaction to
a simple equation:
■ Benefits = the total gain for the customer from the purchase.
■ Price = the cost to the customer.
■ Value = the net gain of Benefits less Price.
To make the purchase the consumer must believe that the benefits she will receive
from that purchase will exceed the cost. However, this is rarely seen in isolation
because there will be competitive offerings available. Therefore prospective
customers will measure the value from each offering and will choose the one that,
for them, has the largest positive gap between benefits and price. They will not
always choose the cheapest; they may prefer the more expensive product because
the value of its extra benefits exceeds the price differential. These benefits may be
perceived rather than real – the critical factor is that the consumer believes them
to be important enough to trade them off against price.
This definition of value inevitably adds to the complexity of the pricing decision
because perceptions of value will vary from one person to another, from one
market region to another, from one distribution channel to another. Therefore
pricing is not easy because marketing is not easy; if it were easy it could be
determined by quantified analysis from accountants and computers. Such
quantified analysis will have a part to play, but the pricing decision must be based
on informed and expert judgement, applied to each segment of the market.
ORGANIZATIONAL RESPONSIBILITY FOR PRICING
One clear implication of what we have covered so far is that the pricing decision
should be considered in long-term strategic, rather than short-term tactical, terms.
It should also not be confined to any one person or department; at the very least
it requires inputs from a marketing specialist and a financial analyst, combined
with close contact with top management to ensure coherence with strategic
objectives. There should also be inputs from those responsible for sales and
marketing intelligence. For all this to happen it is vital for there to be an agreed
price review process, which enables pricing decisions to be taken in a strategic and
cross-functional context. However, to allow the necessary responsiveness and
flexibility, there must also be processes that enable day-to-day decisions to be
made in a practical and speedy way, within agreed parameters.
7
If, for purposes of day-to-day practicality, it is necessary to come down in

favour of one function having overall authority, this must lie with those who have
strategic marketing responsibility in the business. These individuals may not
always have the word ‘marketing’ in their title – particularly in non-consumer
businesses – but, as the guardians of product positioning and marketing strategy,
they must have control and, if necessary, the final say. In smaller businesses with
simple pricing structures, this may be managed personally by the chief executive
– certainly this is where the buck should stop in every case.
Allowing the finance function to take the lead in pricing decisions can be
dangerous. It may lead to the cost plus approach becoming too dominant in routine
operational thinking. For example, the lazy and ill-considered practice of
automatically passing on cost increases may become embedded in financially driven
processes. Financial managers may say, ‘costs have gone up by 10 per cent so prices
must follow’ irrespective of the reasons for the cost increase, the likely competitor
reaction and the impact on customer perception.
Though sales managers and their teams clearly have an input in the pricing
decision, it can be dangerous to allow the sales function to dominate the process too
much, unless they have clear marketing responsibilities and are encouraged to think
broadly as part of their role. A good test is whether sales people are targeted
exclusively on sales volume or whether other factors – revenue per unit, profitability,
customer satisfaction – are part of their interest, motivation and reward system. If
volume is their main focus and key success factor, they should not have the final say.
The obvious and ideal solution is for pricing responsibility to lie with a cross-
functional team, though the practicalities of this easy statement will depend on the
day-to-day realities of the business and its interactions with customers. It is not
possible in every business for each price quotation or discount decision to be
assessed by a group; it all depends on the extent of standardization of the product
and the frequency of pricing judgements, factors that are unique to each sector.
The following structure represents an ideal position and should be applied and
adapted to the operating realities of each business:
■ a cross-functional team to set the strategy and the processes to implement it; this
will normally be the board of directors or an executive committee at that level;
■ a subsidiary group, also cross-functional, to operationalize the strategy and
carry out price reviews (see below);
■ clear responsibility with the marketing function (or equivalent) for interpreting
the strategy on a day-to-day basis;
■ agreed parameters for discretion, with processes for authorizing deviations and
interpreting grey areas.
8
PRICE REVIEWS
Whatever structure is agreed, it is critical that a full pricing review takes place at some
point and that it involves the cross-functional inputs mentioned above. The review
must take into account all the factors in the above ‘value’ framework, and must be
comprehensive rather than ad hoc, strategic rather than tactical. A good test of an
effective review process is whether it avoids the common mistakes of ill-considered
and reactive pricing decisions. To achieve this aim the review process should:
■ look at the complete range of offerings; it should always consider the overall
market position and the impact of one price decision on other products;
■ respond to a price increase by a competitor – say the market leader – in a
considered way, by analyzing the likely cause of the change, the expected
reactions of other competitors and the response of customers;
■ in businesses which require price quotations – such as shipbuilding,
construction, engineering, consultancy – maintain a consistent pricing policy, in
particular avoiding the temptation to agree low prices for a period because
there are ‘fixed-cost’ people available to carry out the work;
■ in all businesses, maintain a consistent policy on discounts and special
reductions, avoiding as much as possible the granting of discounts to customers
to retain or gain business, without full consideration of the relative offerings
and the longer-term implications.
It is difficult to generalize about the time period between reviews because this will
depend on the speed at which the industry moves and the way in which it is
customary in the sector for prices to be changed. There has to be a careful balance
when deciding upon an appropriate review time. It must not be a six-monthly or
annual ritual that becomes too procedural and automatic, yet it must not be
continually postponed because the time is not right. It is also important that
reviews should not just take place in times of crisis, for example as a gut reaction
to a competitor attack, or in response to a short-term profitability problem.
STEPS TO PRICING EFFECTIVENESS
One way to ensure that price reviews are sufficiently comprehensive is to have a
structured process which ensures that the required analysis is carried out. Figure
1.2 shows the ten steps of this process, each of which will be further developed as
we go through the various chapters of the book.
The way in which these steps are applied, in particular the starting point, the
sequence and the timescale, will depend on a number of factors – for example,
whether the pricing decision is proactive or reactive, whether it is a new or existing
9
product, whether or not competitor prices are easily available and the nature of the
customer interface. Whatever the context, however, these steps are a structure and
a discipline which will help to ensure the best possible pricing judgement.
Fig. 1.2 The ten steps of price review analysis
Develop
Make business
pricing strategy
judgement Assess
competitor
prices
Re-assess
financial and
strategic Assess
objectives customer price
sensitivity
Evaluate
financial
implications Analyze the
marketing mix
Estimate
impact on Assess the
volume relative value
Confirm position
pricing
strategy
Many of the steps are interrelated and real-life application will not be as structured
and as sequential as it seems here. The best use of this framework is as a checklist
to ensure that, in the unique context of each business, these steps are carried out,
however intuitive, judgemental and informal the processes may be. Failure to do so
may result in decisions that lack economic rigour, missed profit opportunities and
an ineffective marketing strategy.
Following this framework, Chapter 2 will focus on the starting point for any
pricing decision, the overall competitive strategy of the business and the broad
pricing strategy which emerges from it.
ECONOMIC THEORY
This book does not focus on economic theory but on the practical issues of pricing
decisions in business. It often proves, however, that an understanding of the
micro-economic theory of pricing is a useful underpinning for what follows in
later chapters. We are therefore offering a chapter on this topic as optional
reading for those who have not studied economics and who would find it helpful
before moving on to Chapter 2. It can be found as a separate appendix on p. 119.
10
2
Generic pricing strategies
■ Business strategy as the starting point 13
■ Porter’s generic business strategies 13
■ Generic pricing strategies 14
■ Choosing between skimming and penetration 15
■ Subsidiary pricing strategies 18
■ Practical applications 19
■ Pricing and the product life cycle 19
■ A summary of life cycle pricing strategies 22
■ The importance of competitor analysis 22
11
BUSINESS STRATEGY AS THE STARTING POINT
At the end of Chapter 1 we suggested a series of steps in the pricing decision and
this framework confirmed that the starting point has to be the development of a
strategy for the business as a whole. Many frameworks and concepts of business
strategy were developed as management thinking evolved during the second half of
the 20th century and perhaps the most influential writer has been Michael Porter, a
Professor at Harvard Business School. Porter’s work is highly relevant to pricing. He
argues that the most successful companies are those that make fundamental choices
about how to compete in clear, unambiguous terms. He says that the first and key
question that must be asked and answered by top management when developing a
strategy is: what is our primary and fundamental competitive position?
The evidence of Porter’s research is that less successful companies do not make
such fundamental choices and try to compete in a number of ways, ending up
being ‘stuck in the middle’.
PORTER’S GENERIC BUSINESS STRATEGIES
Porter has developed this idea of fundamental choices by identifying three possible
generic business strategies:
■ overall cost leadership

■ differentiation
■ focus.
We will examine the implications for pricing of each of these three strategies.
Overall cost leadership
A business which achieves overall cost leadership has the ability to produce at
lower costs than all competitors. Porter puts forward the following advantages of
this approach:
■ The cost leader can apply a low pricing strategy and can earn a profit at that
level when other players in the market are not doing so. Indeed, the cost leader
can encourage the rivalry and price competition which reduces the margins of
the weaker players.
■ The firm has a defence against powerful customers because they can only exert
power to drive down prices to the level of the next most efficient competitor.
13
Differentiation
This strategy is to create a product or service that is perceived by customers as

being unique. Porter argues that this can be an effective strategy because:
■ it provides protection against competition because customer loyalty will result

in a lower sensitivity to price;
■ the product uniqueness will make it possible to compete even if the cost base is
higher than that of competitors;
■ the power of customers is reduced because they do not have comparable
alternatives.
Focus
Porter’s third generic strategy is to focus on a particular group of customers, type

of product, or geographic market. For this strategy to be effective the business must
be able to serve its focused target market more effectively than its competitors can.
As a result of this focus, the firm can achieve competitive advantage in three
possible ways: by better serving customer needs or by achieving lower costs, or
both. In this situation either low or high pricing strategies may be appropriate,
depending on the competitive situation and the long-term business objectives.
GENERIC PRICING STRATEGIES
Porter’s work links very closely to the two most frequently quoted generic pricing
strategies of skimming and penetration. These are extreme positions and are
rarely adopted in their absolute form, but they help us to consider the range of
pricing options in broad terms.
A low price ‘penetration’ strategy
This strategy is called ‘penetration’ because the aim is to penetrate the market and
achieve a higher market share than competitors. The strategic choice is to compete
primarily on price in the belief that the resulting gain in market share will enable
the business to achieve profitability. Porter’s valuable insight was that this strategy
can be adopted only in parallel with cost leadership, as it will only lead to high
profit levels if the firm’s costs are below those of the competition.
14
A high price ‘skimming’ strategy
This strategy is called ‘skimming’ because the business tries to ‘skim’ the market,
targeting only those who most value their offer and are willing to pay a premium
price. Management is making a deliberate choice to sell at higher prices than the
average competitor. Businesses adopting this strategy are willing to sacrifice
potential market share because they believe that, in the long term, the resulting
margins will result in high profit levels. This approach to pricing must be adopted
in parallel with a strategy of differentiating the value package and Porter argued
that this will succeed only if customers perceive a significant and superior
difference to competitors.
CHOOSING BETWEEN SKIMMING AND PENETRATION

The following factors will combine to determine the choice of pricing strategy.
The nature of the product
A key factor is the extent to which the product is homogeneous, with each
supplier’s offering being of a broadly similar nature, without significant scope for
differentiation. Though confident marketers will claim that there need be no such
thing as a commodity and that you can differentiate anything by good marketing,
there are bound to be limits because of the very nature of the product.
Price sensitivity is lowest for products which are commodities of uniform type
and quality; a good guide to extreme examples is if the product can be traded
unseen on commodity markets – for example, cotton, sugar, grain, oil. The more
the product has commodity features, the more a penetration strategy, geared to
cost efficiency, will be appropriate.
The product life cycle

If the life cycle of the product is short, a skimming strategy is likely to be more
effective. The business that responds quickly can enter the market and make
attractive margins while there is limited competition. By the time competitors
enter the market, demand for the product may be declining and customers will be
moving on to other products.
If the life cycle is expected to be long, it is more likely that a penetration strategy
will succeed. The goal of growing market share will enable the business to take
15
advantage of the economies of scale and experience curve (see below) which will
help to deliver low unit costs and high profitability.
Competitor response
If competitors are slow to respond to changes in the market environment and to

initiatives taken by other players, a skimming strategy will be appropriate. It will
be possible for the quick mover to maintain a premium price for a significant time
before competitors catch up. Conversely, if competitors are quick to respond, a
penetration strategy will be more effective.
Impact of economies of scale
Economies of scale occur when unit costs decline as total output increases. This
occurs primarily through the impact of volume on fixed costs. In many businesses,
a significant proportion of costs will remain fixed – at the same level in money
terms – over large variations of sales volume. An example is the cost of research
and development involved in the launch of a new product; once the launch has
taken place there will be little or no further research and development costs. As
sales increase, the research and development cost per unit and as a percentage of
sales will fall. The impact of this can be seen in Figure 2.1.
Fig. 2.1 Research and development costs fall following the launch of
a new product
Unit cost
Volume (units)
16
If the economies of scale are significant, a penetration strategy will be more

effective as this will lead to higher volumes and lower unit costs than those of
competitors. This cost advantage will enable more aggressive price competition
and the potential to earn higher returns than the market average.
The proportion of fixed costs is a key issue in many aspects of pricing and will
be covered in more depth in Chapter 8.
Experience curve
The operation of the experience curve is similar to that of economies of scale and
is a second reason why unit costs fall over time. As each firm has more experience
of producing and delivering the product, it will become more skilled and efficient,
thus reducing the cost per unit. The impact on cost is similar to that for economies
of scale, except that the horizontal axis of the graph now represents total
cumulative rather than annual production (Figure 2.2).
Fig. 2.2 The experience curve effect

Unit cost
Cumulative volume (units)
It can be seen from the figure that the impact of cost savings is greater at low
levels of cumulative production. Therefore the experience curve effect is likely to
be most relevant at the early stages of the product life cycle, or where there has
been a step change in technology.
If the experience curve effects are high, a penetration strategy is more appropriate,
in order to achieve volume and drive unit costs below those of competitors.
17
A summary of the circumstances in which the different pricing strategies will be

most effective is shown in Table 2.1.
Table 2.1 The circumstances in which different pricing strategies will be

most effective
High price/ Low price/

skimming strategy penetration strategy
Product homogeneity Low High

Product life cycle Short Long
Competitors Slow to respond Rapid response
Economies of scale Small Substantial
Experience curve Small Substantial
SUBSIDIARY PRICING STRATEGIES
There are further subdivisions of the two strategy types, which help to match the
strategy to particular competitive situations and business objectives.
Pure skimming
The aim is to make a profit in the short term before competitive forces operate to
bring prices down. Examples would include products that are technologically
innovative such as mobile phones and DVD players, which are launched with high
prices and strong demand. However, as the product life cycle develops, prices
come down and so does the potential for profit.
Prestige skimming
The aim is to maintain the price premium throughout the life cycle of the product.
Examples would include Porsche cars and Rolex watches.
Pure penetration
The aim is to grow market share and to dominate an industry where price is
important to the purchase decision. An example is McDonald’s strong position in
the fast food market.
18
Pre-emptive penetration
The aim is to charge a low price which makes it difficult for new competitors to enter
the market, for example Microsoft’s pricing of its Windows software. The large
economies of scale of research, development and marketing enable management to
apply this strategy effectively.
PRACTICAL APPLICATIONS
In practice it is unusual to find that all the conditions for pure skimming or
penetration strategies are present in any one business or industrial sector. Managers
with responsibility for pricing need to consider the overall position and the factors
which have the strongest impact in their markets and then decide upon the most
appropriate pricing strategy. For example, a large pharmaceutical company will have
the opportunity to achieve economies of scale after the launch of a new drug because
the research and development costs will not increase thereafter. As sales increase, the
unit cost of the research will reduce significantly and these circumstances clearly
indicate a penetration strategy.
However, it is normal for new drugs to be introduced at a high price because of
other factors that have a stronger bearing on the decision. There is scope for clear
differentiation because the drug performs a unique function that alternative
products cannot deliver. Competition may be reduced by the operation of patents,
so the ability of competitors to react quickly is often low.
In the face of such conflicting indications, a balanced judgement needs to be made,
examining each factor and choosing the appropriate strategy to match market
conditions at each stage of development.
PRICING AND THE PRODUCT LIFE CYCLE
We have mentioned the importance of the product life cycle in deciding on an

appropriate pricing strategy and we will now focus more specifically on this issue.
When using this concept as a guide to pricing strategy, it is important to think in
terms of the market as a whole rather than just the market position of one
business. The definition of the life cycle should be based on the total sales of the
product, from its launch by the first mover to its demise.
Four separate phases of the life cycle have been identified and these are important
to pricing strategy. They are shown in Figure 2.3.
19
Fig. 2.3 The four phases of the life cycle
Sales
Time
Introduction Growth Maturity Decline
Some examples of products that are, at the time of writing, in different phases of
their life cycle are shown in Table 2.2. A range of different strategies will be
appropriate at these four stages of the life cycle.
Table 2.2 Products in different phases of their life cycle
Introduction Flat TV screens

Growth Digital cameras
Maturity CD players
Decline Leaded petrol
Introduction
During the introduction phase the aim is to build sales and customer loyalty for the
future. The main priority therefore is to ensure that the product is effectively meeting
customers’ needs so that quality is seen as higher than that of current and potential
competitors. This creates a foundation on which to build as the market expands. We
have seen already that price sensitivity is likely to be low during this early stage.
The pricing level therefore needs to support this strategy and to provide a clear
message to consumers. For example, if the new product is positioned as a
substitute to an existing one, the message must be either that the new product
performs the same function at a lower price – perhaps due to technological
innovation – or it offers superior performance.
20
However, it would be dangerous to assume that the ‘same function, lower cost’
message will always result in success at this stage of the life cycle. It makes the all
too common assumption that competitors will not react. It will succeed only if
your price is lower than that which competitors are prepared to charge when
faced with such competition. The key to success is to predict the speed and nature
of the likely competitor response.
If the message is ‘superior performance’, it will be appropriate to launch at a
price premium to existing products. This is because it will be difficult to convince
customers that the new product has superior quality if it is being offered at the
same or lower price than competitors’. In reality technological innovation or other
factors might make this possible, but customers will not normally believe that
they can have ‘something for nothing’. The higher price position helps to create
their feeling of perceived value.
Growth
In the growth phase of the life cycle the key strategic aim is to achieve a market
share position that will deliver high profit levels during the later maturity phase.
It will be much harder to enter the market or gain substantial share during the
maturity phase, as this will require gains at the expense of existing competitors –
always a difficult task.
During this phase it is less likely that price will be the key driver of buying
behaviour because the main focus will be on developing products and services to
meet consumer needs. Insight into consumers’ needs becomes more important than
price. The successful players will be those whose consumer insight enables them to
achieve differentiation and therefore lower price sensitivity. If differentiation cannot
be achieved, price will continue to be the dominant factor.
Maturity
During maturity, which normally lasts longer than the previous phases, the focus is
on the achievement of maximum profitability and the pricing strategy should support
this aim. This is the stage where the hard choices mentioned earlier in the chapter
have to be made: management must opt for either a high price/differentiation or a
low price penetration strategy and avoid being ‘stuck in the middle’.
During this phase of the life cycle the successful players will increase sales by
innovations to meet the needs of new customer groups. Innovation is critical
during this phase of the life cycle for a number of reasons. It can continue to
prevent existing products from being seen as undifferentiated commodities and
thus avoid the resultant greater emphasis on price. Innovation can also extend the
total period of the life cycle. Indeed, there are some marketers who believe that
21
the theory of the product life cycle is no more than a self-fulfilling prophecy. They
believe that marketing managers accept the eventual decline too easily and cut
back too much on innovation and marketing spend, thus encouraging its onset.
They point to long-lasting products such as soap or beer where there appears to
be no prospect of decline after several hundred years.
Decline
However, in most markets the product does eventually decline. During this phase
the strategic aim should be to develop a pricing strategy that will maximize cash
flow. There is a danger that a company will over-invest in fixed assets during this
period, thus creating capacity that will not be used in the future. This is an easy
trap to fall into because the product will be generating high cash flows and the
money for investment will be available. The better target for these cash flows is
investment in new products in the early stages of their life cycle, thus ensuring the
company’s future viability.
A SUMMARY OF LIFE CYCLE PRICING STRATEGIES
Table 2.3 summarizes the pricing strategy at each stage of the life cycle.
Table 2.3 Pricing strategy at each stage of the life cycle
Life cycle stage Strategic objective Pricing strategy
Introduction High relative quality To support customer perception of quality

Growth Market share To enable achievement of market share objective
Maturity Profitability To achieve maximum profitability
Decline Cash flow To maximize cash flow as the product is phased out
THE IMPORTANCE OF COMPETITOR ANALYSIS
No pricing strategy can be developed without as full an understanding of competitor

prices as is possible and cost effective. After the development of the broad business
and pricing strategy, this analysis is the next important step towards effective pricing
decisions. It is therefore the subject of the next chapter.
22
3
Understanding the competition
■ Competitor aware but not competitor driven 25
■ The problems of analysis 25
■ The context of competitor price assessment 26
■ Some principles of competitor analysis 27
■ From competitors to customers 32
23
COMPETITOR AWARE BUT NOT COMPETITOR DRIVEN
Chapter 1 introduced the principle that a pricing strategy must be based on an

assessment of perceived value to customers and suggested a step-by-step process
to carry out the necessary analysis. Chapter 2 emphasized that the overall business
strategy must be the starting point for the development of a broad pricing strategy,
determining the overall competitive position. In this chapter we will look at the
obtaining and assessment of competitor information to support that strategy,
together with the issues and pitfalls involved in this difficult process. It is vital to
know everything there is to know about competitor prices before making any
final judgement about your own price levels.
We should emphasize, however, that being fully informed about competitor
prices is very different from competitor-driven pricing, which is not desirable and
will not usually lead to the optimum pricing decision. We quoted an example of
this in the first chapter – the passive approach of waiting for the market leader to
move and then following meekly. When this involves following a competitor’s price
reduction, it is often based on the marketing manager’s desire to maintain or
achieve a market share goal at all costs. In practice you may have to follow the
market leader, but only if, after that price decrease, your value proposition is less
appealing to the customer than that of the competitor, and only if it is the best way
of achieving long-term profitability rather than short-term market share goals.
THE PROBLEMS OF ANALYSIS
Pricing decisions should never be taken without as full an analysis of competitor

prices as is possible and cost effective. Ignorance of competitor prices within a sector
is likely to lead to damaging price competition as the players make invalid
assumptions about the intentions of others, often encouraged by customers who will
gain from ignorance and invalid information. Sometimes it may be possible to gain
from the ignorance of others, for example by being the only competitor who resists
the temptation to bring down price in response to falsely rumoured customer
attitudes or market conditions. In every case it is important to develop your pricing
strategy while knowing as much, or preferably more, than your competitors.
Monitoring and analyzing competitor prices will rarely be easy or simple, but it
should not be avoided. Partial or estimated information is better than having no
information at all and better than basing your decisions on invalid assumptions –
‘it is better to light a small candle than to curse the darkness’. The difficulty of
finding competitor prices should never be a reason for failing to try.
In many business sectors the task of competitor assessment is becoming more
and more difficult. The range of competitors is widening and new players are
emerging. Consumer goods companies find that their retail customers can quickly
25
become their competitors by developing ‘own label’ products. Companies enter

markets where previously they were not seen as likely competitors, for example
the move of confectionery companies like Mars into the ice cream market. More
advanced thinking in marketing and market research determines that the
definition of competition should be seen more widely, that it often comes from
sources that were previously not seen as competitive. For example, soft drinks
companies may be competing with ice cream, snack and chocolate suppliers for
the customer’s limited spending power on ‘impulse treats’.
In the ‘business to business’ sector, the problems are even greater because there is
not the same public availability of data. This has been exacerbated because major
international customers are increasingly developing strategies to reduce cost through
a global approach to procurement. This brings to the market new international
competitors who were not there before and about whom it will be even more
difficult to obtain pricing data. Conditions of greater secrecy and complexity will
apply while at the same time price becomes an even more important part of the
customer decision-making process.
In these circumstances, customers are less loyal, less susceptible to personal
relationships and, in many cases, less likely to take into account the other factors
in the value proposition. The global buyer may deliberately use the policy of
secrecy to play off one customer against another as a way of achieving the lowest
price, via a closed tendering process. They may even encourage misinformation,
implying that others are prepared to reduce price and making price seem more
important than it really is in the final decision.
THE CONTEXT OF COMPETITOR PRICE ASSESSMENT
The first two chapters emphasized that the pricing decision is at the centre of a
wide range of different but interconnected forces. It is useful to summarize these
again as we begin to look at competitor analysis in more depth – see Figure 3.1.
It is significant that the step-by-step decision-making process suggested in
Chapter 1 and which to some extent determines the structure of this book places
competitor price analysis at an early stage, well before we look at our cost base
or our profit requirements. As we made clear in that chapter, there is no point in
making financial requirements the driving force of pricing decisions if competitors
can and will undercut you, however unfair it may seem and however difficult to
understand it may be. Customers are not interested in our problems and concerns;
their point of comparison is the price of their choices and that needs to be the
focus of our attention.
The scope and complexity of the framework in Figure 3.1 and all that we have
covered so far should make it clear that any survey of competitive prices cannot be a
26
mechanistic task which leads to simplistic conclusions. Competitor prices can rarely
be assessed as a direct comparison. The judgement arising from the price comparison
has to be seen in the context of customer perceptions of the total value packages
offered by the competitors and, just as important, the business situation of each one.
Fig. 3.1 The forces impacting upon the pricing decision
Business
judgement
Strategic Market
objectives positioning
Pricing
decision
Customer Competitor
perceptions offerings
Required Estimated
profitability cost
For instance, when analyzing competitor prices prior to the development of a

broad pricing strategy, it is vital to take into account the financial position – in
particular the size and cost structure – of each competitor. There is no point in the
long term in trying to go for a low price, penetration strategy if that competitor
has the ability to produce at significantly lower cost. Different marketing or
supply chain strategies to overcome the cost disadvantage will be needed in these
circumstances and this will require an understanding of that competitor in both
financial and strategic terms.
SOME PRINCIPLES OF COMPETITOR ANALYSIS
It is not possible to be fully prescriptive about the required approach to the

assessment of competitor prices because it depends so much on what is possible
and what is cost effective, and this will depend very much on sector and country.
There are, however, some general principles which can be followed and these are
offered as guidance for management judgement.
27
Competitor definition
Competitors should be defined as widely as possible, including all possible

alternative purchases available to customers. Coca-Cola would clearly regard
Pepsi as its main competitor but its price comparison would be likely to include
all drinks and food products that represent alternative purchases for customers.
In some markets this might mean tea and coffee, in other markets diluted soft
drinks or ice cream.
However, there has to be a balance – too wide a comparison will make the
analysis complex and potentially misleading; too narrow a comparison will miss
out on vital information. The key principle is to think from a consumer
perspective when deciding the competitor set against which to benchmark. What
does the consumer view as the alternative choices?
The key test is: who loses when we win? If we sell another product, what is it
replacing? It is important to avoid conventional definitions and industry
classifications which encourage production-oriented thinking and a superficial
definition of competition. An apparently similar product – for example a low
price, low value soft drink sold in down-market retailers – may not be a relevant
competitor to a company operating at the premium end because it is not an
alternative purchase for the consumers being targeted. Such prices may still be
quoted to provide different perspectives and reference points, but they should not
be the main focus of the analysis.
Price definition
Prices should be defined as widely as possible. In the case of consumer goods

manufacturers selling to retail outlets, this will mean coverage of prices to retail
trade customers as well as to the ultimate consumer. This should confirm once
again that comparisons can rarely be exact or easy. It is relatively straightforward
for the brand manager to find out the price at which competitors’ chocolate bars
are selling in Tesco or Walmart in particular areas. It will not be easy to find out
the price at which Tesco and Walmart are buying from your competitors; that
needs knowledge of discount and margin structures that will be individually
determined and difficult to compare.
It is also likely that discount structures will make the comparisons complex to
interpret. For instance, how do you treat cash discounts if they are linked to special
payment terms that do not apply to your dealings with that customer? How can you
find out about and take into account special retrospective rebates, granted on
achievement of sales targets? Special deals will also cause difficulties when surveyed
at the retail level – there will be problems of comparison because of promotions,
special offers and extra value packs, which may be offered on a temporary basis and
28
which may differ between channels and regions. It is important that a comparative
survey embraces these complexities rather than pretending they don’t exist, even if it
makes the analysis of information and the judgement calls that much more difficult.
It is also important to compare like with like. If the directly comparable chocolate
bar has a different weight by a factor of (say) 10 per cent, should the comparison
be per bar or per unit of weight? There are never perfect answers to this kind of
question, but the best guideline is to make the comparison in the same terms as the
customer decision – if the customer makes the buying decision in terms of price per
bar rather than price per gram, the results of the survey should be expressed in these
terms too.
Coverage
A price survey should cover all segments in which you are competing, for instance
different geographical areas, channels and classes of customer. Experienced
managers in consumer goods companies often warn of the dangerous practice of
wide ranging pricing judgements being made on the basis of a few isolated
comparisons in the chief executive or marketing director’s local supermarkets,
which have little validity elsewhere. Surveys must be as wide and statistically valid
as possible if they are to be used for across-the-board pricing decisions.
One important principle to make comparisons and conclusions more
meaningful is that the focus should be on relative as well as absolute prices. The
analysis of the different segments is likely to be much more helpful if the results
are expressed as a discount or a premium to a mean or median price, or in relation
to particular competitors. However, it is important not to get too hooked onto
just one competitor, perhaps the market leader, and forget the other competitors,
direct and indirect, which might be alternative purchases in customers’ minds.
The need for a broad picture
In Dolan and Simon’s excellent book Power Pricing, they suggest four
characteristics of what they call ‘power pricers’ – their label for those who adopt
the proactive and value-based approach that we are advocating. One of these
characteristics is the building up of ‘fact files’ to provide a comprehensive
information base about each major competitor so that price comparisons are seen
in the required broad context. These should include information about a
competitor’s cost structure, financial performance, business history, capabilities,
strategy and target-setting processes. The latter elements of this information may
not be easy to obtain and may not be available in precise form, but their collection,
analysis and subsequent discussion is critical to success.
29
The term ‘fact file’ perhaps underplays the vital need for such information to be
used interactively. All data on competitors, hard and soft, must become the driver
of discussion and proactive decision making, rather than lying in its fact file, waiting
for external events to drive the pricing decision. It is also important for the right
person to have the responsibility for obtaining and maintaining this information, to
avoid it becoming dated and sterile. Such a person must combine knowledge of all
information sources, with the energy to be creative and proactive.
Information sources
Information which can be purchased from market research companies is likely to

be the main source of price information in many consumer goods sectors and,
where it is available on an ongoing basis at realistic cost, it is likely to be a good
investment. Though it may be perceived that the value of such information is
reduced because all competitors have access to it, this does not make it any less
important to obtain. The critical point is that you will be at a disadvantage
compared with competitors if you do not take it and use it.
There is more doubt as to whether it is cost effective to commission ‘ad hoc’ price
research on an ongoing basis because this is often expensive, though it might
sometimes be justified as a ‘one off’ survey linked to a particular strategic review.
If market research data is not available or proves not to be cost effective or reliable,
there may be other good sources, particularly for general background information
to supplement the price data. Trade associations, independent industry analysts,
consultants and stockbroker analysts are useful sources to supplement the market
research data and your internal efforts. These internal efforts will also be much
more effective if you have someone with the necessary time and expertise to search
the Internet on a regular basis in order to keep the fact files up to date.
One aspect to consider in the brief given to the person or department with
responsibility for competitor information is the extent to which it should be
actively and directly sought from the competitors themselves. Clearly there are
tactics by which this can be obtained secretly, and these should be encouraged
within legal and ethical limits, but an open and co-operative approach should also
be considered.
It is often assumed that keeping competitors in the dark is always the right
approach and that the best way to achieve competitive advantage is by unshared
research. This may work well, particularly if your research resource is as good as,
or better than, any in the market. However, you should remember our earlier
point – that if every competitor in the market is in a state of ignorance, often
encouraged by customers who want to play off one against the other, this may
result in low pricing strategies, adding to pressures on margins and reduced
overall profitability. If an industry co-operates in the sharing of price and general
30
business information, it may work in the interests of all competitors, though it is

always important to be sceptical about the validity of information being
submitted by less scrupulous operators.
Maximize sales force information – but beware
It is also important that the fact files should include sales force intelligence on a
systematic basis. Clearly the prices seen by sales people as they visit channels and
have conversations with customers can be a major source of price information.
There should be strong encouragement for such information to be sought
proactively. Sometimes sales people do not know their competitors’ prices simply
because they have never asked their customers and they should be encouraged to
seek as much information as possible during every sales contact. It is particularly
important to use information from loyal customers; if it is a long-term and
trusting relationship, customers may be more willing to share information about
competitors than is often believed.
However, it is important to be questioning and challenging about such information,
particularly where business-to-business transactions are involved. The key reason for
this need to challenge is that price is often the easy answer to the question, ‘why did
we lose this business?’ It may be sincerely believed, but it may also be wrong. It is
often the customer’s explanation when a contract is not secured because it is easier
to blame price than to say, ‘we did not like you or your pitch’. Sales and marketing
people, reluctant to shoulder the blame for the problem and face the more difficult
issues, may willingly buy into this easy explanation. There is also an inevitably one-
sided aspect to sales force information on price. Customers are likely to tell sales
people when business is lost because prices are too high; however, they will not tell
them when prices are too low and when the business could still have been gained at
a higher price level.
Therefore, though it is vital to use sales force intelligence to gather data where
it is not easily visible, the results should be interpreted with care. In particular,
outdated, anecdotal information from a few individuals must not become the
conventional wisdom that is never challenged or compared. The best way to avoid
this is to keep the information fresh and to make sure that it is assessed and
discussed before becoming the basis for action.
Cost effectiveness
Each organization has to make its own judgements about the cost effectiveness of
pricing surveys and to decide when the value of extra, more detailed research
ceases to make it worthwhile. Even in the most visible and standardized of
industries, such judgements have to be made. Examples of extremes are useful to
31
show the relative degrees of difficulty and the need for compromise at both ends
of the spectrum.
At the ‘easy’ extreme are the retail supermarket operators which can carry out
a price survey simply by sending someone to a competitor store with a notebook,
or by buying off-the-shelf data from a market research agency. Contrast this
situation with an example of the ‘difficult’ end – a management consulting
company which, when trying to find out competitor prices, will be hampered by
confidentiality, complexity and difficulties of comparison; for example, what level
of consultant, what type of work, what unit of measurement? For the retailer the
question is: to what level of detail does the research go? How many stores, over
which period, how many product variants? For the management consultant the
question may be: is it cost effective to carry out competitor price research at all?
Would we be better to concentrate on optimizing our value package and its appeal
to customers, using customer reaction as the best gauge of competitor challenges?
In many cases the answer may have to be a reluctant ‘yes’.
FROM COMPETITORS TO CUSTOMERS
Competitor prices are an important starting point for pricing decisions but it is the
customers’ perceptions of, and reactions to, these prices that are critical to buying
behaviour. These perceptions will vary by product, by market and by customer
group, so the next chapter will focus on the key factors which drive price sensitivity.
32
4
The drivers of consumer
price sensitivity
■ The need for understanding and insight 35
■ The nature of the product 36
■ Emotional or functional benefits? 37
■ Market environment 38
■ The context of the purchase transaction 40
■ A complex web of factors 43
33
The drivers of consumer price sensitivity
THE NEED FOR UNDERSTANDING AND INSIGHT
The key to effective pricing decisions is insight into the consumer’s perception of
value and their sensitivity to price as part of the marketing mix. If sensitivity is
well understood, it can help the marketer in a number of ways. It can enable
agreement of upper and lower limits when developing a product range or
organizing market research. It can also be a valuable guide to deciding which
markets to target in order to achieve marketing and financial goals. Finally, and
most importantly, knowledge of sensitivity can lead to strategies which are
designed to overcome it, by the development of an appropriate value package and
a communication strategy which emphasizes other benefits.
Rarely will the factors determining price sensitivity be simple, because there is not
one single consumer and behaviours will vary over time, between different channels,
regions and countries, in different market conditions and life circumstances. A
wealthy consumer might be prepared to pay thousands of pounds for a cold drink
in thirsty conditions in the desert, but will become as price sensitive as everyone else
when back home and faced with the many choices on the supermarket shelves.
There is also an inherent uncertainty in all markets which should make any manager
wary of those who think they have all the answers. A pricing strategy has to be
flexible and subject to constant review; it cannot and must not be the subject of
universal truths and accepted wisdom about consumer behaviour.
There are four main factors which will affect price sensitivity and they each have
a number of separate dimensions. They are also closely related to each other, as
shown in Figure 4.1.
Fig. 4.1 Four factors affecting price sensitivity
The nature Emotional or

of the functional
product benefits
Consumer
price
sensitivity
Market The context

environment of the purchase
transaction
We will now examine these factors in turn.
35
THE NATURE OF THE PRODUCT
We have already examined some aspects of this factor in Chapter 2. The extent of
product homogeneity and the stage of the product life cycle were said to be key
factors in the development of pricing strategies and this is largely because of their
impact on consumer price sensitivity. However, there are a number of other factors
within the product itself which will have an impact.
Transparency of cost
We will discuss in later chapters the links between cost and price; so far we have
emphasized the lack of likely and necessary connection between the two. However,
there are cases where consumers will be influenced by their knowledge and beliefs
about cost and this occurs mainly where the constituent elements of the product
can be clearly seen and understood. If the product is the provision of services that
are clearly unskilled and where the customer can see the time taken (for instance
the provision of household or garden services), there will be a high degree of price
sensitivity. If, on the other hand, it is a service with more complexity, requiring
more specialist skills (such as consulting in information technology) the price will
be less easy to assess and therefore less price sensitive. The customer will be blinded
by the technical mystique and by a lack of understanding of the tasks required, and
will therefore be able to challenge price only through competitor comparison.
Product risk
If the potential risk of poor quality is high, it is more likely that the product will
have low price sensitivity. Few customers will, within reason, be influenced by
price when buying a child’s car seat; other factors, particularly reliability and
durability, will be much more influential in the buying decision. If the risk to the
buyer is low because the purchase is a small amount and failure is of less
importance – for example, an impulse buy of a child’s toy – price sensitivity will
be much higher. The consumer will easily be deterred from buying and quality will
be much less important.
Risk is also a key factor in business-to-business transactions. It is well known
that there is a tendency for risk-averse managers to ‘buy IBM’ when faced with a
complex decision to purchase computer facilities, often because of the likely
adverse consequences of such a purchase going wrong. This tendency among
corporate buyers also makes it less likely that customers will easily switch
suppliers of vital services, unless the gains through lower prices are substantial
and the risks of failure are low.
36
Price as a quality indicator
With some products the price itself is a key indicator of quality. There are two
main factors causing this to occur. The first is where there are no other obvious
clues about quality from seeing and feeling the products because they all appear
to be much the same. This can happen with prestige products such as perfume or
watches, or with basic commodities like fruit and vegetables. The second factor,
which will apply to perfumes and watches though not to fruit and vegetables, is
where the buyer values prestige and exclusivity and where the price is indicating
that kind of value, saying something about the person who is willing and able to
pay that price.
This factor impacts different markets in different ways and there will be various
points of sensitivity. Someone buying a watch may be reluctant to pay below a
certain level – say £5 – because the product is assumed to be of poor quality if it
is below that price. There will also come a point – perhaps over £100 – where the
purchaser will expect a prestige brand to justify that price. Between these two
levels the price will be giving a message about quality – the £70 watch is assumed
to be of higher quality than the £50 watch and the consumer may choose that one,
even if they both have the same appearance, quality and brand recognition. This
may apply particularly to those who are buying gifts for others, where the price
is saying something about personal regard for the recipient. The purchase of the
lower priced watch may not be acceptable, whatever the apparent benefits.
EMOTIONAL OR FUNCTIONAL BENEFITS?
This factor is closely related to the nature of the product but is worth treating as
a stand-alone factor. This is because it is one of the most important and, via
marketing communication, one of the most controllable elements of consumer
price sensitivity. The concept of product benefits was raised in Chapter 1 as
fundamental to the definition of value. Benefits are the reasons why customers
buy the product, the ways in which they are better, feel better, or can do things
better after the purchase has been made (see Figure 4.2). Marketers go further by
classifying these into functional and emotional benefits.
Functional benefits are the logical, rational reasons for buying – that the
product will fulfil the function for which it was intended: food to ease your
hunger, a car to take you from A to B, clothes to keep you warm. Emotional
benefits are those that make you feel good, either because the product is giving
you pleasure or because it is saying something about you. The Ferrari does more
than take you from A to B, it gives a message about your image and status, as does
the Armani suit or the Rolex watch. The more these emotional benefits are, or can
37
be made to be, part of the product proposition, the less there will be price
sensitivity. This is the reason why a lot of modern advertising is aimed at these
emotional benefits: to develop the brand strength that makes them sustainable
and justifies higher prices than would otherwise be possible.
Fig. 4.2 Functional and emotional aspects of product benefits
Benefits
Functional Emotional
value value
Based on Based on
rationality feelings
High price Low price

sensitivity sensitivity
Low prices Higher prices
MARKET ENVIRONMENT
Each separate market will have unique conditions and a number of these are
fundamental to pricing strategy. This is one reason why ‘global’ marketing often
falls down and why it is impossible to have a universal pricing strategy for any
product, unless it is flexible and adaptable to the needs of each market. These
environmental factors can be broken down into a number of constituent parts.
Economic conditions
The overall stage of economic development will inevitably have a major impact
on the consumer’s attitude to price. Though there are other factors in this chapter
which can move things the other way, one general rule applies: the lower the
development of the economy of a country or region, the more likely it is that price
will be dominant in the purchase decision. The less the discretionary spending
power, the more price sensitive is the consumer. Those buying a loaf of bread or
38
a car in a developed economy will be influenced by brand, by advertising and by

perceived quality; those buying in the developing world are more likely to choose
the cheapest option.
Cultural norms
It would be misleading, however, to suggest that this is a general and inflexible

rule. There are some countries and regions where consumers are more likely to
buy on price than others because of the way their people think and act when
making purchases. The most obvious example is that most developed market of
all, the USA, where, despite the high incomes and discretionary spending power,
consumers in many markets are still strongly focused on price. American buyers
like to find a ‘good deal’ for most of the products they buy, and then they like to
tell others about it. This is one reason why almost every shop in New York or
Miami seems to have permanent sales and special offers; this style of marketing
appeals to the American psyche, everyone likes to think that they are getting a
lower than normal price.
At the other end of the spectrum is the UK where it is well known that
supermarkets can make higher margins and cars can be sold at higher prices than
elsewhere in Europe because UK consumers are relatively ‘lazy’ about price in
many of their purchases.
Consumer mindset
The history of the marketing of each product and the environment within which it
has developed creates a unique set of circumstances which in turn creates mindsets
for consumers. These will be a major factor in determining the perceived value of the
product and therefore the parameters within which marketing people can work in the
development of a pricing strategy. Mindsets will determine the range of pricing
options, in particular the psychological maximum beyond which it is impossible to
go, whatever the perceived quality. Even if there was unlimited spending power and
the best possible combination of other marketing variables, consumers will not pay
more than a certain amount for a bicycle or a washing machine.
One factor in this mindset is the concept of ‘fairness’. In certain industries price
sensitivity is increased because of suspicion about the motives and objectives of
the operators in that market, often fuelled by hostility from the media. This can
apply particularly to products that are seen as necessities of life and where
suppliers are seen as exploiting the dependence and vulnerability of consumers.
Examples in recent years are the oil and pharmaceutical sectors, where no amount
of logical argument about investment in exploration or research has been able, in
the short term, to change the mindset that prices and profits are excessive.
39
THE CONTEXT OF THE PURCHASE TRANSACTION
Price sensitivity will be significantly affected by the nature of the purchase and its
context in the life of the consumer. There will be a number of factors involved here.
Significance to financial position
The purchase that takes a high proportion of the consumer’s income (or, in the
context of an industrial purchase, constitutes a high proportion of cost and profit)
will be more likely to be price sensitive. Thus a regular purchase such as newspapers
or bread will have high price sensitivity because the consumer will realize the
importance of that purchase to her total financial position. In addition, the regularity
of purchase will make the buyer more informed and more likely to shop around.
It is not all to do with regularity, however. A high proportion of income can also
be taken by the one-off, big-ticket purchase, such as a house, car or domestic
appliance. Extra price sensitivity will apply in this case too, because of its significance
to income and because of the resultant willingness to carry out research. The one-off
purchase that is low in financial significance – for instance the hairdryer or the coffee
maker – will generally have relatively low sensitivity because the total impact on
income is small. For similar reasons, businesses that supply other companies with
small-ticket, one-off purchases such as books, directories or pictures can find
extremely low sensitivity and often charge very high prices, knowing that the cost is
relatively insignificant to the person who authorizes it.
In business-to-business transactions, this factor can be used to advantage by the
intelligent sales person. Those who are involved in what is often called value
selling will know that a key requirement for effective pricing is to have a clear
understanding of the place of your product in the customer’s total cost structure,
and to know the likely impact on cost and profitability levels of price changes in
both directions. If you are supplying fundamental raw materials that make up 50
per cent of total cost or selling price, then price sensitivity will be high; if you are
selling a component which makes up only 5 per cent of total cost, sensitivity will
be much lower, particularly if the impact of inferior quality is likely to be serious.
Unit of purchase
Price sensitivity will be much greater when there is an obvious and accepted unit
of purchase, which is commonly accepted throughout the industry. This is clearly
so in many sectors – consumers will buy a newspaper, a car or a television with
the clear ability to make direct and meaningful comparisons. There will still be
40
differences of type and quality, but a car is a car and only one car is being bought
at the time of purchase.
In other cases, however, the unit of purchase is less clear and this may be
compounded by changes over time, for example the move to the metric measurement
system in some Western countries has made it much more difficult for the consumer
to make comparisons and assess value. Though the purchase of vegetables and petrol
may be relatively price sensitive for other reasons quoted in this chapter, the lack of
uniformity and common understanding caused by the change in measurement system
has worked the other way. Consumers become confused and will make comparisons
in different ways; some will look at the cost per unit of cauliflower, some per pound
and others per kilo.
One other significant and related factor is whether the decision will be ‘yes/no’
or ‘variable purchase’. Will a high price cause the consumer to refuse to buy at all,
or will the decision be to buy a lower quantity? If the consumer is faced with
highly priced vegetables or petrol, she may well decide to buy less for the amount
of money that she is willing to pay. Clearly this will be dependent on alternative
options and competitor prices, but the very fact that a variable quantity purchase
is available will reduce the sensitivity, particularly if the purchaser is under short-
term pressure to buy. If you are low on petrol and the next station is some distance
away, you will put £5 of petrol in your tank almost irrespective of price.
Individual or corporate purchase
It is a fact of life that most people are less careful with their employers’ money than
they are with their own. In fact, it is often held to be an example of good management
practice if staff can be influenced to spend the company’s money as they would their
own, but this is the exception rather than the rule. Therefore the price sensitivity of
corporate purchases can be much lower than those of the individual.
A revealing example of this lower sensitivity is the purchase of airline tickets.
The individual purchaser is usually highly price sensitive, buying largely on price
because it is a major purchase from the personal budget. There may even be a
certain kudos from obtaining a good deal, which may be shared with friends at
dinner parties. Yet that same individual, when buying an air ticket for personal
use through the company, may not be price sensitive at all because the company
is paying. In fact, the conversation at the dinner party will emphasize the high cost
as a sign of status, showing that the company is prepared to pay many times more
for business or first-class travel. Clearly this is partly to do with the extra benefits
which come with higher-class travel, but it is interesting that these benefits are less
appealing when the individual is paying!
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Specialist knowledge of the buyer
In practice, not all companies allow their staff to choose how they travel and the
price that is paid. Increasingly, large international businesses are realizing that the
cost of air travel is a major one and needs to be controlled more closely, using
specialist buying expertise. This is an illustration of what is probably the key factor
in price sensitivity in business-to-business transactions – whether the company has
a specialist buyer who is dealing with the purchase and who has developed superior
knowledge, experience and expertise. Price sensitivity will be at its lowest when the
purchase is a one-off acquisition of a product or service where the main decision
maker is a functional specialist who is not used to handling such transactions. An
example would be the occasional purchase of training or consultancy services by a
line manager who does not often do such deals.
Understanding of this element of sensitivity can lead to a segmentation strategy
that expressly avoids those companies which are likely to involve specialist buyers
in the purchasing process. If dealings can be kept informal and friendly,
competitors can be kept out of the picture and price sensitivity can be maintained
at a low level. This is one reason why relationship marketing has become such a
key issue in business-to-business transactions – a good relationship can keep price
well down the agenda compared with other factors and can avoid the formalities,
and the greater emphasis on price, which comes with competitive tendering.
This business-related example illustrates a broader principle which is fundamental
to price sensitivity in all markets – the extent to which consumers are generally well
informed about the alternatives that exist and the prices that are charged in the
market. The more informed they are and the more research they carry out, the
higher will be the price sensitivity.
In consumer markets two important developments have helped consumers to
become more informed. One has been the introduction of consumer magazines,
which increase the information available to buyers while also reassuring them (or
otherwise) about relative quality. The other has been the Internet, which has made
it much easier for consumers to search for more information and to find out the
range of price options. The information available to a competent Internet user
with a search facility represents an interesting contrast to what is accessible in a
single retail store or in a single mail order catalogue.
Time and occasion of purchase
The time and occasion of purchase will have a major impact on price sensitivity
of many products in the service sector and will allow the adoption of what is often
called ‘differential pricing’. This means the fixing of different prices for what is
essentially the same product, because of the impact of time and occasion on the
42
likely demand from customers. The most obvious example is the type of ‘peak
time’ pricing which is typical of air and rail travel – the provider is fixing price to
maximize the return from the scarce resources available at busy times, while also
using it to transfer some of the demand into quieter periods. The key to success is
still to provide value to the target customers in the different time segments so that
they are not tempted to turn to alternative times or to choose to use other services.
A COMPLEX WEB OF FACTORS
Even this wide range of factors simplifies the reality of marketing and pricing in
a diverse, global and multi-channel economy. Consider the price sensitivity of a
ubiquitous and globally known product such as Coca-Cola. We all buy similar
products and would probably claim to have a good idea of our likely price
sensitivity when making the purchase – the maximum price we are prepared to
pay in the supermarket before moving to a competitive or substitute product. Yet
how likely would we be to behave that way when the time comes to make the
buying decision? How many other factors would come into play which make it
difficult to predict our behaviour? Though we might make a statement about our
likely attitude to price when talking to a market research interviewer, the reality
may be very different.
Two factors would be the mood we are in and the time we have; if we are in a
hurry we are much less likely to look at, never mind compare, prices. It could also
depend on the timing of the purchase, whether it is just after the payment of our
salary, or just before when we are right out of cash. An even more important
factor is the place where the purchase is made; we also buy Coca-Cola in bars and
restaurants where the price is likely to be much higher and the consumer much
less price sensitive. That same consumer who was so careful to check the price
compared with the supermarket brand on Friday morning will go to the bar that
same evening and order ‘three Cokes’ without knowing or caring about the price.
And maybe the following week he or she will go away on a business trip and pay
three times the usual price for a Coke from the hotel mini-bar, because the
company is paying.
This illustration and the other factors mentioned in this chapter confirm once
again that pricing decision makers should be wary of scientific formulae and easy
solutions, and should challenge and question anyone who claims to have all the
answers. It should also be remembered that all the price sensitivity factors that we
have mentioned are closely interrelated and that most of them can be influenced by
the marketing strategy of the business. Customer perceptions and mindsets can be
changed by the right advertising campaign. A strong brand and an effective
differentiation strategy can reduce consumer price resistance. The use of promotions
43
and the way in which the promotional price is expressed can pass a special message
to the consumer. The positioning of products in particular segments and channels
can create new perceptions about price and relative value.
In other words, price can and should be managed in conjunction with other
elements of the marketing mix, which is the topic of the next chapter.
44
5
Price as part of the
marketing mix
■ The marketing mix framework 47
■ The place of price in the marketing mix 47
■ Segmentation 48
■ Pricing and product 49
■ Pricing and promotions 52
■ Pricing and distribution channels 54
■ Analyzing the value package 56
■ The link of pricing strategies to financial results 58
45
Price as part of the marketing mix
THE MARKETING MIX FRAMEWORK
The position of price as one of four constituents of the marketing mix almost goes
without saying. Those who study marketing will find at an early stage that price
is presented as only one of the ‘four Ps’ which marketing experts manage to
implement their tactics and achieve their strategic objectives. The ‘four Ps’ are
shown in Figure 5.1.
Fig. 5.1 The ‘four Ps’ which make up the marketing mix
Price
Product
MARKETING
MIX
Promotion
Place
The marketing mix is a simple but powerful framework, though if applied rigidly it
can be seen as too narrow. In the desire to make each element begin with the letter
‘P’ there is a danger of simplifying too much and the definitions need to be broadened
if all the important variables are to be covered. ‘Product’ should cover the complete
range of offerings to customers, the packaging and names which are used, and the
strategies behind them. ‘Promotion’ should include all types of advertising and
market communication. ‘Place’ should include all channels of distribution and all the
means by which products are made available to customers.
THE PLACE OF PRICE IN THE MARKETING MIX
Price differs from the other three elements of the marketing mix in a vital way.
The other three provide the functional and emotional benefits referred to in
Chapter 4. Price is different because it reflects the cost that the customer has to
sacrifice to obtain those benefits.
However, the place of price in the marketing mix is more complex than that
because, in many cases, it can also contribute to the benefits. As we saw in the last
47
chapter, price provides a message about likely value – customers can be reassured
by a higher price level and may make negative assumptions about the benefits if
the price is too low.
The marketing mix framework is therefore an important reminder of two
important aspects of pricing: first that it cannot be seen in isolation from other
marketing variables, and second that it has to be managed proactively in tandem
with them. Pricing decisions have to be compatible with management of the other
elements of the mix. For instance, high price strategies must be accompanied by
products and advertising campaigns that reinforce a high value positioning and by
availability in channels which attract the right sort of customer. Low price
strategies must have functional products, supported by price-based promotions
and availability in channels which attract price-sensitive customers. The four Ps
must be in total harmony.
SEGMENTATION
Market segmentation is fundamental to marketing and is an important factor in

managing a pricing strategy in harmony with the other elements of the marketing
mix. Its technical definition is ‘a group of customers who respond in a similar way
to a given set of market stimuli’. It involves the separation of customers into smaller
groups with different needs, so that these needs can be met more effectively by
tailored, targeted offerings. These tailored offerings can then have greater focus and
more concentrated resources, with a marketing mix that matches their needs.
Segmentation is an important and effective approach to marketing because it
recognizes that no business can please all people all the time in a way that is better
than its competitors. It opens the door to decisions to differentiate the offers for each
segment, thus channelling resources more effectively. It is, for example, fundamental
to the differentiation and focus strategies advocated by Michael Porter and
mentioned in Chapter 2; differentiation can be achieved most effectively if an offering
is directly targeted towards those who have been defined as having similar needs.
Segmentation can be structured in many ways. The classic approaches have been
through demographic factors such as age and social class, or in a business-to-
business context, company size, industry or location. These are relatively easy to
identify and apply but are not necessarily geared towards the key variables in the
market environment. Recent trends have been towards more sophisticated
methods that differentiate between more subtle and relevant characteristics, such
as consumer lifestyles, benefits sought, buying behaviours, personal attitudes and
types of usage.
Whatever method of segmentation is chosen, key factors in the selection are
likely to be those which have been covered in Chapters 3 and 4 – competitor
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offerings and consumer price sensitivity. Unless you are the lowest cost operator
and adopt a cost leadership strategy, the ideal targets will be those segments where
competitors are unable or unwilling to compete at the same or lower prices than
you will offer, and where consumers will display low sensitivity to price when
offered your value package.
It may even be possible to segment on the basis of attitude to price if this is
compatible with the marketing strategy. The last chapter showed the factors that
influence price sensitivity and these are certain to vary between different types of
customers. Indeed, a segmentation strategy based on (say) high, medium and low
price sensitivity could be more helpful than the conventional ways of thinking and
might provide clearer guidance for the other elements of the mix – the products to
offer, the promotions to launch and the channels to distribute. Even if price sensitivity
is not the main driver of segmentation, it will almost always be a key factor in
defining the segment characteristics. For example, segments based on social class,
income levels or amounts of discretionary spending will often be defined that way
because of their different attitudes and sensitivities to price.
In the long term, each segment needs two characteristics if the company is to
achieve its objectives: first the agreed offering must be able to create sustainable
competitive advantage, and second the segment must have the potential for long-
term profitability. The successful companies are those which manage prices in
tandem with the other three elements of the mix and create sustainable competitive
advantage in their chosen segments.
We will now examine the other three elements of the mix and consider the links
to price.
PRICING AND PRODUCT
Product positioning
The price of a product is making a statement to the customer about its positioning
in the market place. Where there is the potential to offer several products within a
range, price becomes a means of giving messages about the relative quality of each
one of those products, within the chosen segments and in relation to competition.
Marketers often use a framework of ‘price lining’ to position their products in the
various segments. They categorize their products into a limited number of price
brackets, each of which is making a separate statement about absolute and relative
quality. A traditional approach, which frequently ties in with segment structures,
has been to have three price levels – ‘good, better, best’ or ‘economy, midpoint,
premium’ – with each of the three products in the range having clear differentiation
with different combinations of price and benefits. In simple markets using
49
conventional segmentation methods, three offers is often felt to be the ideal number.
It achieves the right balance between simplicity for supplier, retailer and consumer,
and also provides reasonable choice in the buying decision. However, much will
depend on the market, the type of consumer and the method of segmentation.
There is a danger that this ‘three level’ policy, carried out by many retailers, will
oversimplify a complex market structure and will restrict the choice for the consumer,
thus making this limited segmentation a self-fulfilling prophecy. It may also be
difficult to maintain this structure during times of inflation and where the market is
undergoing rapid change for other reasons. The critical need is for price lines to be
reviewed regularly and tested out with market research, then to be checked against
the current thinking on segmentation. For instance, the development of new
segments, with different levels of discretionary income, may require the addition of
further price line choices.
One other argument in favour of increasing the number of product offerings is the
creation of different ‘reference points’ for price. One common approach is to
introduce a new top-of-the-range offering, the main objective of which is to create a
‘halo’ effect, boosting the range as a whole and making the other product lines seem
to be of better value. It is common to position the customer viewing of a store or
catalogue so that the higher priced item is seen first, thereby creating a higher
reference point for the next item in the range. However, it is always easy to argue the
case for more product lines as more sophisticated marketing techniques and other
innovations are developed. The counter argument is that this can lead to higher costs
and lower focus, because of the resultant complexity and fragmentation.
However many price lines are chosen, they should be backed up by clear quality
differentiation, or at least they must be seen that way. This ‘perceived quality’ – the
only sort that really matters – will not be based purely on functional benefits;
emotional benefits will also be important. Brand development through advertising
is the classic way of delivering the emotional side of perceived quality: designer
clothes may or may not be of higher quality in the functional sense, but they are
perceived to be because of the emotional impact of the advertising, brand reputation
and image that is supporting them.
Product bundling
This is a popular pricing strategy which has a number of objectives and a number
of implications. Price bundling means including a number of products and/or
services together as a ‘one price’ package – a package holiday, a car sold with free
insurance and servicing, a computer with free software, a television with servicing
beyond the guarantee, a store offering a low price teddy bear for those who
purchase more than a certain amount, a McDonald’s Happy Meal – everywhere
we see examples of bundling as part of modern marketing.
50
One purpose of bundling can be to make it difficult to compare prices directly,

thereby adding to the confusion and uncertainty which may cause the consumer
to fall back on the familiar brand. It can also be an effective method of segment
targeting – preparing bundles of services that will be attractive to different types
of consumer, perhaps as a means of differentiating from competitors who do not
have the ability to offer the whole package. There can be sustainable competitive
advantage from a bundle that others cannot replicate and, if presented effectively,
it can be achieved at higher prices than would be possible by other means.
Bundling may be positioned as the only offer, often called ‘pure’ bundling, a
strategy which will be effective if you are sure of the strength of your value
package and your segmentation, though it can often restrict customer choice too
much. ‘Optional’ bundling will be taken only by those customers who want it,
and it will often require a strong price incentive to persuade the customer to go
for the bundled deal. Optional bundling can also be used for the purpose of cross
selling, to introduce the customer to new types of product which they would
otherwise not try.
One important requirement for effective selling through price bundling is for the
customer to be clear about the value they are receiving, particularly in comparison
with competitive offers. In the face of price resistance it may then be possible to
make the offer of lower prices through unbundling, while showing the customer
the value that is being lost. This can often have the effect of lowering resistance
and persuading the customer to accept the higher value of the bundled deal.
New products and occasion blocking
One other way of developing the product range to remove price resistance is
through the introduction of new products which change the occasion of the
purchase, often known as ‘occasion blocking’. Successful examples include the
development of ‘party size’ versions of soft drinks, gift versions of chocolates and
‘multi-packs’ of ice cream or breakfast cereal.
There is a dual benefit of occasion blocking for the company that is first to find
the right product variant. They are offering extra value to those customers for
whom these special versions of the product meet their needs more effectively, and
this may mean that a price premium per litre or kilo is achievable. They are also
changing the language of the product, thereby making the price comparison more
difficult for the consumer and thus reducing sensitivity. Occasion blocking can
result in a true ‘win/win’ situation – a consumer who prefers the smaller party
packs of Coke and is willing to pay a price premium per litre over the standard
can. As long as the cost of the extra complexity does not cancel out the price
premium, everyone is better off. Only the entry of competitors with a similar
product at lower prices can ‘spoil the party’.
51
PRICING AND PROMOTIONS
The objectives and benefits of promotions
We have already shown that price cannot easily be separated from the other elements
of the marketing mix and this is never more so than with promotions. Indeed, it is
often difficult to differentiate between the two because many ‘promotions’ are no
more than temporary price reductions. This overlap is confirmed by the fact that
there will often be disagreements between accountants about whether such
promotions should be shown in the accounts as costs or as reductions of sales.
Indeed, marketing people will often be keenly interested in the debate when it has an
impact on their available promotional budget!
A promotion is a means of stimulating sales volume in the short term by a
temporary improvement in the value package. Promotions will be introduced for a
variety of reasons, some negative, some positive, some financially driven, some
marketing driven. At the negative, financially driven end of the spectrum would be
a promotion to get rid of unwanted stock or to achieve short-term volume targets;
at the positive, marketing driven end would be a promotion to persuade new
consumers to try the product or to carry out an experiment in price sensitivity.
The key requirement to justify any promotion, and particularly one linked to a
price concession, is to have clear objectives which link to marketing strategy. The
excessive and indiscriminate use of promotions linked to price will only serve to
confuse the customer, devalue the product and distort the price positioning. On the
other hand, their intelligent, selective use can have a positive impact, for instance
the positioning of a temporary price reduction as a special promotion can help to
preserve the original full price in the mind of the consumer.
The key argument for price-linked promotions is that, in most transactions and
circumstances, customers will respond more positively when a price is expressed as
an apparent reduction from a base price, even in circumstances where few customers
have ever paid that price. Most of us do not like to miss out on a chance to save
money, thus the expression of a price as a discount or reduction is likely to attract
extra sales, particularly from new or irregular customers.
One problem, and a key reason why the financial viability of many promotions
is often questioned, is that the offer also has to be made to existing loyal customers
who would have bought anyway and who may take the opportunity to increase
their purchase quantity.
Types of promotions
One well-known and often controversial type of promotion used by larger retailers
is the ‘loss leader’. These are frequently used as a means of persuading consumers
52
into the store or a particular section of it, and thus encouraging them to buy other
products. Though there are serious dangers in this approach as a general and long-
term pricing strategy (to be covered in more depth in Chapter 8), loss leaders can
be highly effective as a short-term means of gaining attention, building store traffic
and leading consumers to other products.
One popular way of promoting the product without impacting the long-term price
structure is to offer some other way of providing extra value, such as a larger pack,
a BOGOF (buy one get one free) or some kind of free gift. Apart from being a more
attractive offer to some consumers, the key advantage is that price positioning is not
compromised and it is easier to move back to normal value levels.
Some marketers in consumer goods companies believe that, at the macro level,
promotions tend to have a negative impact on the bottom line – all they do is
manipulate volume temporarily and create complexity and volatility in the supply
chain. They believe that many promotions merely allow existing consumers to stock
up in advance at lower prices and argue that ‘everyday low prices’ are a better
strategy for suppliers, retailers and consumers. The problems of accurate evaluation
make this a difficult argument to justify or challenge and, while some competitors
are using promotions as a marketing tool, it is difficult for others not to follow.
Advertising and brand strength
Within the framework of the ‘four Ps’, advertising is contained within the broad
heading of promotion. Our definition of advertising in this context is any investment
in the delivery of messages about benefits to consumers through the communication
media. One critical decision for the marketing manager in most consumer businesses
is the allocation of the advertising budget between promotion and advertising. It is
frequently a classic choice between allocating resources for short- or long-term
investment: short-term promotions to achieve volume this year against long-term
advertising to strengthen the brand for the future. The more the short-term option is
chosen, the more the product is likely to remain or become price sensitive; consumers
and trade customers begin to expect promotions or price reductions as the norm and
do not understand or value the other benefits. On the other hand, investment in the
right kind of longer-term advertising is likely to reduce price sensitivity because it is
increasing the strength of the brand which becomes, in the consumer’s mind, a vital
part of the value package.
It is interesting to observe in any supermarket those categories where lower
priced ‘own label’ products have taken a major share of the shelf space and where
consumers seem more prepared to choose the lower price option. This is naturally
most likely to happen with commodity type products where there is limited scope
for differentiation, for the reasons mentioned in the last chapter. However, it is
much more than that. There are some products – for instance tomato ketchup,
53
baked beans, breakfast cereals, washing powders – that could be regarded as

having commodity features yet where, in many markets, own label has still made
only limited impact.
Consumers and manufacturers would argue that this is because the quality of the
branded products is superior and there may be some cases where this is a key
factor. However, it seems mainly to happen where the brands are strongest because
companies such as Heinz, Kellogg’s and Unilever have consistently invested in long-
term advertising to strengthen their brand equity. On the other hand, where brands
have not received sufficient advertising investment, own label and other low priced
products have been more likely to gain a significant market share. The conclusion
must be that a well-chosen and directed investment in advertising can be a highly
effective way of reducing price sensitivity.
The only instance where media advertising will not reduce price sensitivity and
will indeed have the opposite effect is if the advertising message is directly linked
to price. Such advertising can frequently be seen in newspapers and on television,
often linked to short-term promotions. Though this can be effective as a short-
term means of attracting customers, it will achieve long-term objectives only if
there a competitive advantage based on cost leadership.
PRICING AND DISTRIBUTION CHANNELS
The range and variation of channels
So far, in order to emphasize general principles, we have avoided some of the real-life
complexities of modern marketing. Think of the manager who has responsibility for
managing an international soft drinks brand like Pepsi or Coca-Cola. Our illustration
of the different price sensitivities on different buying occasions in Chapter 4 confirms
that there are many distribution channels served by such companies, for example:
■ retail supermarkets
■ small shops
■ vending machines
■ catering institutions
■ wholesalers
■ bars
■ hotels.
For each channel there are different costs, different customers, different buying
decisions, and a pricing strategy has to be developed for each one. The strategies need
to reflect the customer segments and the competitive offerings in each channel, as
54
well as taking into account the impact of each channel on others. For example, will
the prices charged to wholesalers and in vending machines have any impact on the
price sensitivity and image of the product in retail outlets? For each channel there has
to be a judgement about price sensitivity and consideration of the total value package
against competition, which may be different in each separate regional market. There
may also have to be judgements about whether certain channels are worth serving at
all, either because of the cost of serving them or the impact on brand image.
The critical factor in managing distribution channels is to have good relations
with the direct customers who stand between you and the consumer, and to
maintain the maximum possible influence on price and other factors in the
marketing mix. It is beyond the scope of this book to examine such relationships
in every type of channel, so we will touch upon the one that is most important for
consumer goods suppliers – the relationship with the retail trade.
Pricing to the retail trade
During this and the previous chapter most of our attention has been focused on the
consumer – the final buyer of products in retail channels – with the implication that
the brand managers of these products have freedom of action when developing pricing
and marketing strategies. However, for the suppliers of these products – companies
such as Mars or Procter & Gamble – the direct customers are the retail traders and it
is their management who will normally have final control over the eventual selling
price and the way that the products are presented and promoted in store.
Therefore the key pricing issue for the sales people of these companies that are
selling to major retailers like Tesco, Carrefour and Walmart is how much discount
the customer has to be given to retain the listings and maintain the relationship.
These ‘trade terms’ can often dominate price decisions and will be fundamental to
price sensitivity at the macro level. The relative size and power of the customer on
the one side, and the strength of the brand on the other, will be the key determinants
of how this power struggle is carried out and how price sensitive that customer will
be. In the end, prices to the retailer will be determined by negotiations that reflect
how much the two parties need each other.
The objective of the marketing and sales teams of the consumer product companies
is to negotiate trade terms that provide their own company’s required level of
profitability while also encouraging the retailer to sell at prices which are in line with
marketing strategy. This means understanding the retailer’s margin structure and
pricing strategy, and influencing their management to adopt in-store policies that are
compatible with the brand objectives. Special promotions and incentives for that
retailer may be one of the means of exerting this influence.
Sometimes there may have to be tough choices. For instance, it could be that, by
supplying a particular retailer on the generous terms which are necessary to get the
55
business, you are allowing them to break your normal price structure and draw
consumers away from other, higher priced retail competitors. In that case it may be
better to resist or even not to supply, though the final choice will depend on the
significance of that retailer’s business to the supplying company. Only those with
the strongest brands and the most effective marketing strategies can withstand the
sort of price pressure that comes from these major international retailers.
One common strategy for brands with ‘designer’ status is to refuse to supply
certain types of retailer because of the impact on image and reputation and
because it will damage the price structure. For instance, perfume companies will
not supply ‘down-market’ retailers, designer goods suppliers will not supply
supermarkets. Some supermarkets have even gone to the lengths of obtaining
supplies from the ‘grey market’ to overcome this restriction and suppliers have
gone to law to try to prevent them, as evidenced by the Tesco versus Levi court
case, which at the time of writing was still ongoing. In this action, Levi and Tesco
are disputing through the courts Tesco’s right to sell Levi products purchased from
other ‘grey’ sources because Levi wants to keep control over the outlets it supplies
and preserve its brand equity.
ANALYZING THE VALUE PACKAGE
A key message of this book so far has been that price has to be seen as only one
part of the total value package if effective judgements are to be made. Price has to
be central to that value package because it is the element that is most easily visible
to the consumer, and will represent the ultimate constraint.
If we now remind ourselves of the factors in the market place which determine
whether consumers choose our value package and its unique marketing mix, we
can see the variables shown in Figure 5.2.
Fig. 5.2 Factors which determine consumer choice
Competitive
value
packages
Segmentation OWN VALUE Consumer

strategy PACKAGE willingness
to pay
Consumer
needs and
preferences
56
If the pricing judgement within this framework is to be made effectively, it is

necessary to go to a further and deeper level of analysis than the other three ‘Ps’
and to look at all the benefits of the value package in quantifiable terms. There
are a number of techniques that are similar in nature and which are used in
market research. These require the following stages of analysis:
■ split the value package into its various benefits, both functional and emotional;
■ produce weightings of the relative importance of each one;
■ produce an analysis of the weighted average for each product in each segment;
■ compare with competitive offerings to assess price implications.
Thus, for the purchase of a car, there would be a number of benefits apart from
price, for example:
■ power
■ safety
■ economy
■ environment
■ appearance
■ extras
■ brand image.
Having identified this list of benefits from a sample of the target group, the
market research analyst would then allocate weightings to each benefit, based on
further analysis of the preferences and priorities within the sample. Potential
customers would then be asked to score each benefit, leading to a weighted
average score of all benefits for the product in question, which would be
compared with a similar analysis of competitive offerings. These scores would
then be related to the existing price (or for a new product the proposed price)
compared with competition, to assess the match with total benefits. The higher
the total benefit score in relation to competition, the higher the potential price can
be because it is providing better value than the alternatives.
A further development of this technique – conjoint or trade-off analysis – includes
price with the list of benefits, the price in relation to expectations being shown as an
additional factor in the purchase decision. This allows analyses at different levels of
price for the same product, to see how the relative importance of price varies as it
moves up or down. If the price moves close to or outside the customers’ minimum
or maximum expected price level, the importance of price in the purchase decision
is bound to increase. This is because customers will either be unable to resist a low
price bargain or will be unwilling to pay a high price, whatever the nature of the
other benefits may be. If the marketing strategy is to build a value package that
57
moves the customer away from price, a guide to optimum pricing will be the price
level at which price scores lowest against other benefits.
There is a danger that techniques of this kind give a false impression of the
ability to find the optimal price by scientific means. It is therefore important to
stress that the output is no more than an aid to judgement and is only likely to be
as good as the information inputs. There will be four sources:
■ analysis of past data

■ market research surveys
■ experimentation
■ expert judgement.
The choice and balance will depend on the resources available for market research
and the information available in-house. In practice, a mix of all four methods may
be the best option, with common sense judgement complementing and checking
the outputs.
THE LINK OF PRICING STRATEGIES

TO FINANCIAL RESULTS
So far we have provided little coverage of the link of pricing strategies to financial
results, making the assumption that pricing on a value-maximizing basis will also
achieve the best return for stakeholders. This assumption could be questioned unless
it can be shown that such a strategy has a close link to financial performance. The
next chapter shows this link by the best possible means: through research into the
links of various pricing strategies to the long-term financial performance of a
number of different businesses.
58
6
Price, value and profitability
■ Definitions of quality 61
■ The PIMS research 61
■ Linking value to profitability and market share 63
■ Summary of rankings 64
■ PIMS, Porter and pricing strategies 65
■ Financial implications 66
59
DEFINITIONS OF QUALITY
In the first five chapters we established that value is critical to pricing and is
defined by relating price to benefits, both functional and emotional. However, it
is common for managers of companies that do not have a marketing orientation
and that do not invest in market research to have a different perception of value
compared with that of their customers. This may be encouraged by conventional
wisdom about what is generally accepted as ‘quality’ in the industry. Here are
three examples of different perspectives:
■ Manufacturers in the computer industry may believe that processing speed is

the critical determinant of quality for computers. Yet the users may feel that
ease of use or compatibility with other systems are more important factors.
■ Manufacturers in the clothing sector may believe that a key aspect of quality in
a sports shirt is the texture and durability of the material. Yet the wearer may
feel that the brand name (be it Manchester United or Ralph Lauren) is much
more important than either of these benefits.
■ The newspaper industry may talk about ‘quality’ newspapers when referring to
the broadsheets, yet the reader may feel that quality is more about sports
coverage and easy readability.
It should be noted that we are using the term ‘quality’ for the first time, as this is
the terminology used in the research findings that follow. We have not used this
term so far because it can have an indefinite meaning. However, definition is
straightforward when related to previous chapters – quality is a term that
summarizes in one word all the benefits of a product, both functional and
emotional, as perceived by the customer.
As the above examples show, the only way to establish its true nature is to ask,
and keep asking, the customer.
THE PIMS RESEARCH

The analysis and frameworks in this chapter are based on the work of the Strategic
Planning Institute, an organization formed in 1975 and based in Cambridge,
Massachusetts. Its PIMS (Profit Impact of Market Strategy) research programme
originated in General Electric in the 1960s and was originally picked up by Harvard
Business School, which gave it the PIMS name. The research, which continues to the
present day, analyzes confidential data from inside a large number of companies and
explores linkages between different strategies and financial performance. This work
in the area of pricing and value is particularly revealing and provides valuable
guidance in the formulation of broad pricing strategies.
61
The research introduces five different value positions in competitive markets

and explores how each one correlates to financial performance. The five positions
are shown in Figure 6.1.
Fig. 6.1 The five value positions in competitive markets
Higher
E. Worse value
A. Premium
Quality for
Relative B. Undifferentiated price curve
price
C. Economy
D. Better value
Lower
Inferior Superior
Relative quality
Source: PIMS Associates, 2002
The two axes on the graph show relative positions compared with others in the
sector. The vertical axis shows the price compared with others and the horizontal
axis the quality compared with others, as perceived by the customer. It is therefore
possible to plot each player in an industry on a point that combines these two
factors and thus shows their value position.
Positions A, B and C all offer average value. They are positioned on the ‘quality
for price’ curve, along which quality rises in tandem with price. This confirms that
a business can offer average value in one of three ways:
■ average quality at average prices (position B);

■ superior quality at a premium price, compared with the market average
(position A);
■ inferior quality at a discounted price compared with the market average
(position C).
Thus, in each case, the analyst can think of the price and quality positions as being
‘in balance’.
62
However, there are two situations when these positions can be out of balance.
First, when a competitor is offering ‘better value’ (superior quality at the same or
lower price, as shown in position D) or second, ‘worse value’ (inferior quality at
the same or higher price, as shown in position E).
LINKING VALUE TO PROFITABILITY AND MARKET SHARE
The major insight provided by the PIMS research has been to show the relationship
between the different value positions and long-term profitability, as measured by
return on assets (operating profit as a percentage of the assets invested in the
business). However, before examining this relationship we can also look at the impact
on another key measure with a strong link to profitability – market share.
Companies that are positioned along the quality for price curve (positions A, B and
C) and which provide the customer with average value, tend to have stable market
shares. On the other hand, companies in the ‘better value’ position will achieve
market share growth. However, since companies can only grow share at the expense
of others, someone has to lose out and it is the ‘worse value’ companies that will find
their share reducing. The conclusion is clear: only those companies that provide
superior value will achieve market share growth.
However, growth does not always link directly to profitability and it is
profitability that matters to stakeholders. Therefore we need also to look at the
return on assets position. Businesses in the premium category – position A, high
price, high quality – will, on average, achieve the highest rates of profitability.
This is driven by the higher margins they achieve when adopting this strategy.
These margins will be achievable because in some cases it may be possible to
increase quality without increasing costs, for example by implementing changes in
service levels as a result of better understanding of customer needs.
However, in most cases the companies that offer higher quality will have a
higher cost base than their competitors, for example the cost of producing a BMW
is higher than the cost of producing a Ford of similar specification. In these
circumstances the research indicates that the higher margins are still achievable
because customers are usually willing to pay a price premium in excess of that cost
to the companies that deliver high quality.
A more surprising outcome is that companies in the better value category –
position D, low price, high quality – are the second most profitable, nearly at the
same level as those in the premium position. This is because, although they charge
average prices, they have lower unit costs, and there are two reasons for this. First,
their growth in market share allows their assets to be highly utilized which, when
combined with better recovery of fixed costs, leads to a high return on assets.
Second, they do not need to spend as heavily on marketing as their competitors
63
since the high value they are offering will cause a more favourable rate of repeat
purchases from satisfied customers. It is also likely that their reputation for good
value will become more widely known through customer recommendation.
Third place in the profitability rankings goes to economy – position C, low price,
low quality. In any market there will be some customers who wish to minimize
their spending, either because they have low cash availability or because they do
not regard the product as an important priority. An example would be producers
of cheap pens – there will always be some consumers who wish to buy a pen purely
for short-term functional reasons and who are not concerned about appearance,
image or long-term performance. A company that offers the cheap option to meet
these needs is likely to achieve adequate, but not superior, profitability.
In fourth place in terms of profitability is undifferentiated – position B, average
price, average quality. Customers do not perceive the offer of any one firm as
being different from others. This leads to price-led competition, with margins
being driven down in the battle to maintain market share.
In some countries financial services businesses selling to the mass market have
found themselves to be in this position. Customers do not perceive any one
company as being different from others, so even though it is a business that
depends on personal service, the feeling for customers is similar to buying a
commodity. The claims in such firms’ marketing communications that they are all
offering superior customer service ring hollow because, in reality, no competitor
has managed to achieve differentiation by this means. Only if one competitor
makes a major innovation in management of the customer interface will that
situation change.
The fifth and least successful position of all is worse value – position E, high
price, low quality – with a return on assets significantly below the other positions.
Many managers find this surprising and often those from the finance function are
the most surprised. They make the invalid assumption that companies with low
quality will, therefore, have lower costs than the other players in the market. They
then make the accounting-based judgement that the combination of high prices
and low costs must result in higher profits. The weakness in this argument is that
the companies offering low value will inevitably lose market share. This results in
under-utilized fixed assets and fixed costs – research, marketing, administration –
that do not match the lower levels of sales volume. This results in the lowest level
of profitability of any of the five positions.
SUMMARY OF RANKINGS
The above analysis is summarized in Table 6.1.
64
Table 6.1 Return on assets ranking of the five value positions
Return on assets ranking Position Examples

(highest first)
1 A Premium ‘Premium’ motor manufacturers

(BMW, Mercedes), Swiss watch
makers (Rolex)
2 D Better value Leading supermarkets in Europe
(Tesco, Carrefour), direct sellers of
personal computers (Dell)
3 C Economy Manufacturers of cheap pens
(Bic), Low-cost airlines
(Southwest, Easyjet, Ryanair)
4 B Undifferentiated Many full-service airlines
(American Airlines, Sabena)
5 E Worse value Once successful companies that
have lost their reputation for
quality (Rolls-Royce, Maserati)
PIMS, PORTER AND PRICING STRATEGIES
The PIMS research has strong links to the work of Michael Porter, as covered in
Chapter 2. Porter argues that firms need to make a choice as to whether to compete
through differentiation or cost leadership. PIMS confirms that this will result in
above average profitability, particularly if differentiation is the chosen strategy.
The PIMS research has a further interesting implication to support Porter’s views
and to place differentiation as the favoured choice. It suggests that if differentiation
is achieved successfully, the price level does not, within reason, have a major impact
on overall financial performance. A strategy of high price levels will deliver a high
return through the price premium; a strategy of average prices will deliver a high
return through market share growth and lower per unit marketing spend.
The implication of PIMS for companies that choose the cost leadership option
is less encouraging. It will be less successful in financial terms than differentiation
because it will place them in the Economy position. However, it will still be
profitable and will certainly be preferable to being ‘stuck in the middle’.
It is here that there is the clearest link between PIMS and Porter. The
undifferentiated category, revealed by PIMS to have below average returns, is clearly
equivalent to Porter’s definition of being ‘stuck in the middle’ without a clear generic
strategy. Such companies offer customers similar products at similar prices to their
65
competitors and are forced to compete primarily on price. Once in this position it is
difficult to escape because even if they try to differentiate their offer, competitors
will usually find it easy to follow, thus returning to price-based competition.
FINANCIAL IMPLICATIONS
This chapter has introduced the financial implications of pricing decisions in a

strategic long-term context. Yet this is only one aspect of the financial evaluation
of pricing. The next chapter looks at financial evaluation in a more detailed,
tactical context.
66
7
Analyzing the financial impact
■ The case for cost and profitability analysis 69
■ The link to financial objectives 69
■ The financial analysis of price change options 70
■ Cost structure 71
■ The impact of price reductions 75
■ The price/volume breakeven concept 76
■ The impact of different cost structures 78
■ The causes of variation in cost structure 79
■ Long-term fixed costs 81
67
THE CASE FOR COST AND PROFITABILITY ANALYSIS
In previous chapters we have stressed that the pricing decision should be, to a
large extent, independent of the cost of the product or service. The message has
been that price is an element of the marketing mix that cannot be seen as
independent of the other elements in that mix and that must relate to perceived
customer value. As customers do not know or care about your costs when they
make their buying decisions, any attempt to price on a ‘cost plus’ basis is likely to
succeed only if, by chance, you hit the level which matches their value perceptions.
However, the rejection of ‘cost plus’ as a direct approach to pricing does not rule
out the use of techniques of cost and profitability analysis as part of the pricing
decision-making process, because it is important to know the financial impact
before making the final judgement. Even if your price is exactly in line with
customer perceptions, it cannot be maintained if it is not sufficiently profitable to
meet financial objectives. Therefore the next three chapters cover a number of
areas where such analysis will play an important part.
On the other hand, the introduction of financial techniques does require a
reminder of the need to maintain the right balance in that decision-making process.
The very introduction of financial evaluations and apparent ‘right’ answers can lead
to over-reliance on the numbers. The correct balance will be achieved only if all
those involved in the process remember the fundamental principle that marketing
and strategic factors should prevail in the final judgement, but the decision makers
need to be as well informed as possible about the financial implications of the
various options.
The critical factor in the achievement of this vital balance is a positive and
co-operative relationship between the finance and sales/marketing functions, so
that evaluations are available when required and are the subject of full
consideration and discussion. The advent of the ‘marketing accountant’ in many
top companies has been a healthy step in the creation of the right balance.
Management accountants are provided to support marketing managers, with the
specific brief to provide the right kind of information and advice.
THE LINK TO FINANCIAL OBJECTIVES
Before we look at financial analysis techniques as a support to pricing, there is

another fundamental point to make. Businesses exist to make profit and, if the
marketing-oriented approach which we are advocating does not generate sufficient
levels of return to satisfy shareholders, there is clearly a fundamental problem. This
problem is even more serious, and maybe insoluble, if competitors are apparently
satisfied with that profit, or if the industry – like, for instance, the airline sector –
seems to operate on low margins for historical or structural reasons.
69
Here again there is a case for financial analysis to support the decision-making
process and to help avoid the main danger of this situation – that management
will sit on their hands and do nothing. Financial analysis should enable
management to examine their cost structure, to compare it with others, and to
evaluate the various options to reduce existing cost levels. If this proves to be
impossible for internal or external reasons, other strategic options have to be
considered, including exit from that product or sector. Again financial analysis
can and should play a big part in this process by assessing the long-term profit
potential and by evaluating the financial impact of exit strategies.
THE FINANCIAL ANALYSIS OF PRICE CHANGE OPTIONS
We start our coverage of financial analysis by looking at the evaluation of price

change options. The type of question to be answered by this kind of analysis
relates closely to our coverage of price sensitivity/elasticity in Chapter 4. There is
a danger that a marketing person, having studied the economics and assessed
likely price sensitivity, might say: ‘If price is reduced by 5 per cent and volume
increases by (say) 10 per cent, we will be better off because both sales and market
share will be increased.’
This is obviously true, but it is not only sales and market share which must be
considered, there is also the question of short- and long-term profitability. As we
will see later, a 5 per cent price reduction followed by a 10 per cent volume
increase will not necessarily increase profitability, indeed it could even reduce it,
depending on the cost structure of the product. This is not to say that the impact
on profit should be the only driver of the decision, but that the full, true impact
must be known before the decision to reduce price is made.
This chapter will show evaluations of a number of similar decisions and will
show that the answers are rarely simple or predictable. Other key questions to be
answered are:
■ If price is increased by 10 per cent and volume falls by 10 per cent, will this
increase profit, decrease profit or keep it the same?
■ How much can we afford volume to fall after a 10 per cent price increase to
keep profit the same as before?
■ How much does volume need to rise after a 10 per cent price reduction to keep
profit the same as before?
■ How do the above questions apply to competitors?
The answer to these questions if expressed in general terms is always going to be

‘it depends’ and the reason is cost structure. This simple fact should encourage
marketing people never to make simplistic assumptions or to carry out ‘back of the
70
envelope’ calculations. Informed financial analysis is needed to know the impact

on profitability, and understanding of cost structure must be the starting point.
COST STRUCTURE
The critical factor in the understanding of the impact of price increases and
decreases, and in the understanding of many other factors in pricing, is the ratio
of fixed to variable costs. Variable costs are those which increase directly as a
result of a volume increase, fixed costs are those which stay the same.
Two simple graphs, shown in Figure 7.1, demonstrate the behaviour of a variable
cost compared with a fixed cost.
Fig. 7.1 How variable and fixed costs compare
Cost behaviour – variable costs Cost behaviour – fixed costs
£ £
Volume Volume
It should be noted that this relationship is to volume, not price; generally variable
costs will stay the same after a price increase. This is the reason why price
increases and decreases are so sensitive to the bottom line and explains a lot of
what follows in this chapter. Sales through volume increases earn profit after
variable costs have been covered; sales through price increases earn profit which
goes straight to the bottom line. Therefore, all things being equal, price increases
have the more positive impact on profitability.
As with most concepts in the financial area, the definitions of variable and fixed
costs depend on assumptions, in particular the timescale and the range of volume
assumed. To help us to move on at this stage, we will assume that the range of
volume change is relatively small, say 10 per cent or so, and the timescale
relatively short, within an annual planning period. However, it is important to
note that, by making these assumptions, we are assuming a tactical rather than a
strategic decision-making context.
The ratio of variable to fixed costs is the critical factor in determining the
financial impact of pricing decisions and it depends entirely on the nature of the
71
product and the sector. Managers often make simplistic assumptions about this
ratio, for instance that service industries are always ‘high fixed’ and that
manufacturing industries are always ‘high variable’. It is much more complex than
that. It is also important to understand that competitors in the same sector may
have different cost structures because of their different product processes and
organizational structures. This may also occur because of their different cost
strategies, for example some may outsource key services, some may not.
The best way of understanding and estimating the likely cost structure in a
company or sector is to start by assessing the likely variable costs, so that the fixed
costs will fall out as the balancing figure. There are not that many potential
headings under the ‘variable’ label and the list is likely to include the following:
■ materials
■ labour
■ energy and other ‘consumables’ in the production process
■ distribution
■ sales commission
■ some types of sales promotion.
All these costs are likely to be variable because more money will be spent on them
if extra volume is made and sold. In the case of labour and distribution costs, this
will depend on the way the business is organized, indeed there may be both fixed
and variable elements to both these cost headings. This is but one example of the
potential complexity of the analysis and of the ways in which competitors in the
same sector could have different cost structures. We will return later to the product
and business characteristics that can cause the cost structure to be high variable or
high fixed; in the meantime we will demonstrate the financial analysis process.
The logical next step, having made our assessment of variable costs, is to
calculate a variable margin, sometimes called a contribution ratio. Let’s assume
that this is a business with sales of £100m, total costs of £90m, therefore making
an operating profit of £10m. Let’s also assume that the variable cost structure is
as follows:
Sales 100
Materials 30
Labour 10
Energy and consumables 5
Distribution 7
Sales commission 3
Sales promotion 2
Total variable costs 57
72
Profit after variables (contribution) 43

Variable margin (contribution ratio) 43%
As the business makes £10 operating profit, the balancing figure of fixed costs
must be £33 or 33 per cent of sales. Thus the profit and loss account would be
completed as follows:

Fixed costs 33
Operating profit 10
This enables us to work out the variable to fixed ratio as:
Variable 57 = 1.73
Fixed 33
The relationship shown by this ratio is the key to understanding the financial
impact of pricing decisions: the higher the ratio of variable to fixed, the more
sensitive price changes will be. As a quick first illustration of its importance, let’s
look at the impact of a 10 per cent price increase on this business, assuming that
it will cause a 10 per cent loss of volume. This is often called ‘unitary elasticity’
by economists and is an outcome that might be considered acceptable by sales and
marketing managers. To enable the full impact to be understood and to help later
evaluations, we will do this calculation in two stages, firstly the 10 per cent price
increase without any volume decrease, then the impact of volume:
+10% price –10% volume
Sales 100 110 99

Variable costs 57 57 51.3
Profit after variables 43 53 47.7
Variable margin 43% 48.2% 48.2%
Note how the variable costs do not change as price increases, thus the extra £10
goes straight to the profit line. Yet when volume falls, there is a reduction in
variable costs because 10 per cent fewer products are being produced to achieve
the new sales level.
73
If we now add the fixed costs to the equation, we can see the impact on the
bottom line:
Sales 100 110 99

Fixed costs 33 33 33
Profit 10 20 14.7
There are a number of things to note about this calculation which are fundamental
to the understanding of the financial impact of price changes and to a lot of what
follows. These are:
■ The impact of this +10 per cent, –10 per cent combination is, in this instance,
very favourable to the bottom line – profit has increased from £10 to £14.70.
■ The extent of this impact is dependent upon cost structure; the higher the
variable to fixed cost ratio, the more the impact of a price increase on profit is
likely to be favourable. An example to follow later will show that the same
price/volume combination for a business with only 20 per cent variable costs
will improve profit by only £1 compared with the above £4.70.
■ Note how, with this cost structure, a price increase has a dramatically beneficial
impact on net profit if there is little or no volume decrease as a result. In this
case the 10 per cent net margin would be doubled to 20 per cent because the
extra £10 profit from the increase falls straight through to the bottom line.
Naturally such an outcome is likely only in businesses with unusually low price
sensitivity characteristics; very few businesses could increase prices by 10 per
cent without significant volume falls.
■ The variable margin percentage will also be improved by a price increase and
the extent to which this happens will again depend on the cost structure. In this
case it has moved up by 5.2 per cent (from 43 per cent to 48.2 per cent) and
one impact of such a change could be to make this a more desirable product to
sell compared with others if profit maximization is the criterion.
■ It is also possible to extend this analysis further to work out the level of volume
which could be lost, while still keeping the profit at its previous level of £10.
This type of breakeven analysis will be of great value to managers who are
looking at price change options and we will return to it shortly.
74
Before moving on to other examples, including a similar evaluation for a price

reduction decision, it is important to confirm the relationship of this kind of
evaluation to our previous statements that pricing is dominantly a marketing issue.
Having a marketing-oriented approach to pricing does not mean that the financial
implications of different pricing strategies should be ignored or that simplistic
assumptions can be made. Nor does it mean that the financial evaluation should
necessarily drive the decision.
In the above case, for example, it would be quite valid for the manager in charge
of pricing to decide to forego the extra profit which would come from a 10 per
cent price increase, as long as he or she did so with full awareness of the amount
of profit at stake. It would not be valid to reject the price increase option without
knowing the potential benefit, which is a temptation for a marketer who wishes
to protect market share at all costs. A deliberate choice to forego the potential
short-term profit is acceptable, but ignorance of the financial impact is not.
THE IMPACT OF PRICE REDUCTIONS
When it comes to price reductions, there is a similarly sensitive impact on the

bottom line and again the extent depends on cost structure. The impact here is
even more important to understand; it is so easy for a sales or marketing manager
to advocate price decreases to achieve sales volume targets, without being aware
of the financial implications.
We will use the same figures as the earlier example, but this time the +10 per cent,
–10 per cent assumption is reversed. We are assuming a 10 per cent price reduction,
followed by a 10 per cent volume increase. Again we will show the comparison in
two stages.
–10% price +10% volume
Sales 100 90 99
Profit 10 – 3.3
Here we can see the reverse impact of the earlier example – a price reduction
without any increase in volume converts a profitable business with a 10 per cent
net margin into one that only breaks even. The way in which price reductions go
75
straight through to the bottom line is plain to see. Some might question whether
the first stage in this scenario is too pessimistic even to need evaluation, and
whether such a significant price reduction could ever fail to increase volume. In
practice there may be circumstances in which this is indeed the outcome. For
instance, substantial price reductions may often be necessary to protect business
from going to competitors; or it may be that competitors retaliate with similar price
reductions, thus making the planned volume increase impossible to achieve.
When we examine the impact of the 10 per cent volume increase as a result of
the 10 per cent price reduction, we can see clearly that with this cost structure
such an increase is nowhere near enough to compensate for the profit lost through
the price reduction. The profit of £3.30 is £6.70 down on the profit before the
price increase and the variable margin percentage is well down too, from 43 per
cent to 36.7 per cent. This is not surprising when we remember the principle
stated earlier: that a price reduction is straight to the bottom line whereas the
volume increase is at the margin after variable costs. As this is a relatively high
variable cost business, this ‘–10 per cent, +10 per cent’ scenario is bound to be
very damaging to profitability.
THE PRICE/VOLUME BREAKEVEN CONCEPT
These examples should make it clear how important it is for management to

consider this type of price/volume evaluation before major pricing decisions are
made. However, a common, and to some extent justifiable, objection is that it is
usually difficult, if not impossible, to predict the likely volume changes.
One way of helping managers to cope with this problem is to work out the
‘volume breakeven point’ for a particular price decision. By this we mean the
amount by which we can afford volume to fall, or need volume to rise, in order
to maintain existing levels of profitability. We will demonstrate this first using the
above example of a proposed 10 per cent price reduction to show how much
volume is needed to compensate for the loss of profitability. For managers who
are not used to such evaluations, the result is surprising and difficult to predict
beforehand, which emphasizes the importance of the analysis. It is true that this
result applies only to this particular cost structure, but a variable cost at 57 per
cent of sales is not too extreme and is typical of many consumer products.
To calculate the breakeven, we need first to repeat the earlier calculation:
Sales 100 90 99
76

Profit 10 – 3.3
We need to find the level of volume increase that takes the profit back to £10. To
achieve this we need to add the required profit to fixed costs and thus arrive at a
‘required variable margin’ – £10 + £33 = £43.
The variable margin is bound to move directly with increased volume as its
component parts – sales and variable costs – both do so. To move from £33 to £43
requires an increase of just over 30 per cent. Therefore we can say that, at this cost
structure, a 10 per cent price reduction requires a 30 per cent volume increase to
achieve the same level of profit as before – which must be valuable information for
a marketing manager contemplating a price reducing promotion, or a sales manager
proposing to offer a discount. The strategy may still be implemented, but there can
be no doubt about the potential short-term loss if this level of volume is not achieved.
To confirm the position, we can examine the profit and loss account if the 30
per cent volume increase is achieved:
Sales 100 90 +30% = 117

Variable costs 57 57 +30% = 74
Profit after variables 43 33 +30% = 43
Profit 10 – 10
There is a further important point to make about this outcome. We stressed earlier
that our definition of variable cost is related to short-term movements within a
relatively narrow range. This volume increase of 30 per cent is likely to be well
outside that range assumption, and many of the ‘fixed’ costs could well become
variable if volume rose to that extent. Thus even a 30 per cent volume increase
might not maintain the required levels of profitability because some of the profit
would be taken away by these ‘creeping’ fixed costs. We will return later in this
chapter to this important issue of long-term fixed cost behaviour.
We can now carry out a similar calculation before a proposed price increase:
how much volume can we afford to lose after the 10 per cent price increase and
still break even? It is not valid just to reverse the above 30 per cent answer – the
mathematics does not work like that. Again you have to look at the profit and loss
to make the calculation:
77
Sales 100 110 99

Profit 10 20 14.7
Again we can use the concept of ‘required variable margin’. We can afford for this
to come down by £10 to £43 after the price increase, compared with its theoretical
‘post increase’ level of £53 – 10 as a percentage of 53 is just under 19 per cent.
Therefore we can say that, at this cost structure, volume could fall by 19 per
cent after a 10 per cent price increase and the same level of profit would still be
achieved – which must be valuable information for a marketing manager
contemplating a price increase. It could also be a stimulus for management to
initiate an increase they had not contemplated previously.
The practical application of such price/volume evaluations can work in a number
of ways. The number of potential combinations of variables in the cost, price and
volume mix makes this an ideal application for a spreadsheet, with financial and
marketing people working together on likely scenarios to complement their decisions.
We have also seen sales people in the automotive sector in the USA carrying around
pre-calculated cards that show the breakeven levels for every feasible variable margin
and price/volume combination. Sales people in that business have no doubt about
how much extra volume they have to achieve if they choose to offer discounts. Even
more important, because they are targeted and rewarded on the basis of profit rather
than sales or volume, they have every reason to study their cards before quoting
prices to customers.
THE IMPACT OF DIFFERENT COST STRUCTURES
So far we have assumed one cost structure, which provided a variable margin of
43 per cent of sales and a 1.73 variable to fixed ratio. We will now show two
opposite extremes: a variable margin of 20 per cent with a variable/fixed ratio of
8.0 – typical of a commodity business where most of the cost is raw material –
and a variable margin of 80 per cent with a variable/fixed ratio of less than 0.30
– more typical of a service business like an airline or a software house.
If we take the business with a 20 per cent variable margin and consider a plan
to reduce price by 10 per cent, the situation is even more extreme than the earlier
78
example. Moving straight to the ‘breakeven’ scenario, it can be seen that the 10
per cent price reduction requires a 100 per cent volume increase to restore the
profit lost by the price reduction:
Sales 100 90 180

Variable costs 80 80 160
Profit after variables 20 10 20
Variable margin 20% 11% 11%
Profit 10 – 10
If we look at the same evaluation for the low fixed cost business we see a very
different picture. The price reduction strategy is much more feasible because of
the lower variable and higher fixed costs:
Sales 100 90 103

Profit 10 – 10
One implication of these two examples is that cost structure is likely to be key to
the pricing strategies adopted by the operators in a particular sector. The higher
the variable costs, the less feasible will be a price reduction strategy; the higher the
fixed costs, the more likely this is to occur.
THE CAUSES OF VARIATIONS IN COST STRUCTURE
From the above it can be seen that cost structure – the ratio of variable to fixed
costs – is fundamental to understanding the impact of price changes and to the
prediction of competitors’ pricing behaviour. It is therefore important to examine
the factors that cause a business or product to have a particular level of variable
costs and to consider the extent to which this can be changed.
79
First let’s examine again the assumed cost structure which led to our 43 per cent
variable margin and the relatively high 1.73 variable/fixed ratio:
Sales 100
Materials 30
Labour 10
Energy and consumables 5
Distribution 7
Sales commission 3
Sales promotion 2
Total variable costs 57
This proportion of material costs to sales is perhaps the biggest factor in determining
cost structure, and also the hardest to change. If you are in the business of food
trading or processing, for example meat or vegetables, the proportion of variable
costs is always going to be high. If, on the other hand, you are in a high added value
business such as pharmaceuticals, where materials are often much less than other
costs such as selling, research and marketing, the proportion of variable costs will be
much lower. It will be difficult if not impossible to change this situation and
competitors are likely to be in the same position.
The most extreme examples of businesses with low variable costs and therefore
high fixed costs are those with no raw material costs at all, for example service
businesses such as management consultancies, telecommunications or advertising
agencies. The cost of taking on extra business is very often negligible because the
dominant cost is the salaries of professional and technical people who, unless
there is major restructuring, are likely to be employed whether or not new
business comes in. This has enormous significance for likely pricing behaviour,
which we will examine in the next chapter.
However, reservations always have to be made when discussing and comparing
cost structures. It is usually possible to change the normal cost behaviour to some
extent by management action. In most cases such action moves costs from fixed
to variable, firstly because this is usually easier to achieve, and secondly because
this is the direction that management frequently wish to take to reduce the level
of risk in the business.
A classic and extreme example of such a move would be a company moving its
entire sales force to a commission-only remuneration basis, a strategy sometimes
undertaken by financial services organizations wishing to reduce their risk and
fixed cost exposure. Or a management consulting organization moving some or
all of its professional staff to a freelance employment basis so that payment is
made only when work comes in.
80
Another common way of converting costs from fixed to variable is to move

distribution costs from being a self-managed fixed overhead to an outsourced
variable cost, via a contract which ensures that costs are incurred only when sales
are made. Note that this and other outsourcing strategies do not automatically
change the cost structure; this happens only if the terms of the contract move the
fixed cost risk to the supplier. Many outsourcing deals leave the company with
costs that are just as fixed as before.
Costs can and do move in the other direction, from variable to fixed, though it
is often as a by-product of other management strategies rather than as a deliberate
intention to change the cost structure. A higher proportion of fixed costs often
occurs through growth and investment; as processes become more mechanized,
capital investment takes place, a greater proportion of staff become salaried and
a supporting infrastructure of shared services is created. For this reason it is
usually true that the larger the player in the market, the higher will be the
proportion of fixed costs compared with smaller competitors.
These comments should make it clear that businesses in the same sector, with
different sizes, histories and strategies, will not necessarily have the same cost
structures, even if their products are identical. Therefore it is vital to understand
your own and your competitors’ cost structures, as part of an effective pricing
strategy. The next chapter will take us further down that road.
LONG-TERM FIXED COSTS
One final point to confirm before we move on. A possible conclusion from the
earlier example of a low variable/high fixed cost business is that a price reduction
strategy is much more feasible than it would be for those businesses with high
variable costs, for example only 14 per cent volume increase was required after a
10 per cent price reduction as follows:
Sales 100 90 103

Profit 10 – 10
If, however, we remember what was said earlier – that the definition of ‘variable’
would change if a longer period and range of activity were to be assumed – the
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scenario could be very different. In practice, fixed costs are rarely fixed for ever,
they usually go up in steps with volume; in practice most of them are long-term
variable costs. Figure 7.2 shows the fixed cost line over a period of years.
Fig. 7.2 The fixed cost line over a period of years
Cost behaviour – long-term fixed costs
Volume
If, therefore, decisions to reduce price and increase volume were to be made
consistently over a period of years, the impact would be to increase the fixed cost
base of the business and remove the potential profit. This issue will be revisited in
the next chapter when we discuss the pricing of marginal business.
82
8
Cost structure and
pricing behaviour
■ The breakeven chart 85
■ The temptations of a high fixed cost structure 86
■ Marginal pricing 87
■ The pros and cons of marginal pricing 89
■ Price behaviour in the high variable cost business 93
■ Understanding competitors’ cost structures 93
83
Cost structure and pricing behaviour
THE BREAKEVEN CHART
The previous chapter established the principle that cost structure determines the
impact of pricing decisions on the bottom line. It therefore follows that cost
structure is also one of the keys to the prediction of pricing behaviour by the
various players in the market place. We can illustrate this further by showing the
cost behaviour graphs again, but this time with the variable and fixed cost lines
on the same axis (Figure 8.1). Note that, as the variable cost line is inserted above
the fixed cost line, the top line represents total costs.
Fig. 8.1 Cost behaviour: total costs
Total costs
Variable costs
£
Fixed costs
Volume
It can be seen that this graph represents a business with a relatively high fixed, low
variable cost structure, which causes the total cost line to rise fairly gently with
volume. To confirm the likely characteristics which could determine this structure:
■ low material cost

■ automated processes
■ professional staff
■ high capital investment
■ high research and marketing costs
■ large supporting infrastructure.
Though high fixed cost characteristics are often associated with the larger players
in the market, the type of product and industry sector are more likely to be the
dominant factors. We also mentioned in the previous chapter that management
actions can sometimes change cost structure to some extent, so therefore each
competitor needs to be examined in its own unique context.
In order to consider further the likely pricing behaviour of a business with such
a cost structure, the picture can be completed by the insertion of the sales line on
this graph, thus making it into a breakeven chart (Figure 8.2). The sales line rises
85
directly with volume until the point where it crosses the total cost line and achieves
breakeven. Note that the implied assumption here is that a standard, consistent
price is charged on all products, thus the line is straight and diagonal.
Fig. 8.2 Breakeven chart
Breakeven point
Total costs
Variable costs
£
Sales
Fixed costs
Volume
THE TEMPTATIONS OF A HIGH FIXED COST STRUCTURE
Businesses with this kind of financial structure need to have a firm, consistent
pricing strategy, together with strong nerves. Top management need a clear policy
based on perceived value to the customer, rather than responding to short-term
cost and profit considerations. This is essential at any time for such a business, but
is particularly important when times are hard and business is in a downturn.
Let’s examine the day-to-day reality of decisions in a business with such a low
variable, high fixed cost structure. We will assume the variable to fixed ratio of
0.29 (20/70) from the example in the previous chapter, thus the profit and loss
account looks like this:
Sales 100
Variable cost 20
Profit after variables 80
Variable margin 80%
Fixed cost 70
Profit 10
The company might be in management consulting or advertising with a highly paid

professional staff whose salaries have to be paid whatever the current level of
86
business. Or perhaps an airline which is committed to a particular number of

scheduled flights and which pays salaries to the full-time staff necessary to run them.
In these circumstances it is vital that the pricing strategy encourages management to
maintain prices on a full value basis, however tough the current business climate
may be. They should not be deterred from their long-term strategic goals by the need
for short-term profit and should choose the options of staff reductions and/or
reduced profitability rather than compromising the integrity of the pricing structure.
That’s the theory – the practice can be very different. Perceived customer value
is a valid basis for pricing only if the competitors play the same game and avoid
that all too common temptation – the sometimes justifiable but potentially
disastrous slippery slope of marginal pricing.
MARGINAL PRICING
Marginal pricing is a term that can be used loosely, so we will start with a working
definition:
Marginal pricing is the pricing of products at below full cost and normal
market price, based on a calculation of marginal cost.
Clearly this requires a definition of marginal cost. This is defined as:
Marginal cost is the extra cost incurred as a result of accepting more

business.
The latter has been adapted from the common textbook definition of ‘the cost of
one more unit’ in order to make it more practical and wide ranging. This
definition enables the marginal cost concept to be extended to service businesses
and to larger slices of business than the next unit – for example, a new contract,
a new product or a new customer.
Clearly there has to be a close link between variable cost and marginal cost and
in many cases they are identical, particularly for small increases in volume. They
diverge when the extra volume requires a step increase in fixed costs, in which
case marginal cost will be the variable cost caused by the extra volume, plus the
extra cost of the step.
There is often confusion between marginal cost and marginal price, caused by
treating them as if they were the same concept. This is misleading and dangerous.
Marginal costing is an important and valuable costing technique that is used to
support many types of business decision. It does not necessarily have to lead to a
lower than normal price, it merely highlights the potential profitability of different
87
decision options in a clear, incremental form. Marginal pricing is the use of marginal
cost to justify a lower than normal price and does not necessarily have to follow from
marginal cost; that decision depends on pricing strategy and management judgement.
Let’s remind ourselves of the profit and loss account of this high fixed, low
variable cost structure:
Sales 100
Variable costs 20
Variable margin 80%
Fixed costs 70
Profit 10
Let’s now assume that there is an opportunity for extra business and that the
variable cost is £2. There will be no step increase in fixed costs, thus this figure of
£2 will be the marginal cost too.
Imagine that you are running this business and times are hard, cash is short and
you are desperate for some extra profit to meet the shareholders’ profit target.
Should a marginal price be quoted to bring in the business? In these circumstances
the first question to be asked and answered is: what is the maximum price which
will deliver the business? Too often a marginal cost evaluation can encourage
management to quote lower than is necessary because of perceived pressure from
customers and competitors. Sometimes marginal pricing reflects the insecurity and
uncertainty of management who are unsure of their competitive position. For the
purposes of this example, we will assume that a price of £5 is judged to be
necessary to deliver business from this customer or contract.
The temptation to accept business at marginal prices is great because the stakes
can be so high, particularly where there is spare capacity in the industry. Assuming
that the current pricing strategy represents value to customers, the ideal price for
this extra business would presumably be something in the region of £10, which
would be necessary to maintain the existing variable margin level of 80 per cent;
thus we are being asked to accept a price at half the normal level. Yet any price
above £2 is going to help the bottom line in the short term and the impact can be
considerable. If we take on this marginally priced business, the profit and loss
account will now look like this:
Sales 105
Variable costs 22
88
Variable margin 79%

Fixed costs 70
Operating profit 13
Note that the overall variable margin has declined by 1 per cent because of this
new business and this is an important control on the effectiveness of pricing
strategy implementation. However, a management team with under-utilized
resources and a short-term profit target to deliver may find this reduction to be
an acceptable sacrifice when compared with the bottom line benefit. The £3
variable margin (£5 sales less £2 variable cost) comes straight through to the
bottom line and increases operating profit by 30 per cent (from 10 to 13). This is
the kind of leverage that can be achieved by marginal business for a high fixed
cost organisation, which is why marginal pricing is so tempting.
We can see the impact of marginal pricing in visual form if we look at a revised
breakeven chart (Figure 8.3). For illustration purposes we are assuming that the
marginally priced business is accepted only after breakeven has been achieved. The
new dotted line on the graph clearly shows that, even though the post-breakeven
sales are at lower price and margin levels, they easily cover the incremental total
cost and deliver significant extra profit.
Fig. 8.3 The impact of marginal pricing
Breakeven point Marginally priced business

Total costs
Variable costs
£
Sales
Fixed costs
Volume
THE PROS AND CONS OF MARGINAL PRICING
It would be wrong to suggest that marginal pricing should never take place. It
would also be naïve to suggest that it is not practised by many companies, in many
sectors. Sometimes this is because they choose to do so, in other cases they may
be forced into such a practice by competitors and by circumstances. It is, however,
89
a pricing practice which is fraught with dangers, the most commonly quoted of
which are outlined below.
The slippery slope
Good pricing requires discipline. Once management weaken their stance and
accept that any price over variable cost is worthwhile because it provides ‘a
contribution’, the floodgates can open. It can start as one contract in ‘unique’
circumstances that will not be repeated, or as one new product that will not be a
substitute for others, or as one new customer whose business has been chased for
years. These arguments may be valid in some circumstances, but once this kind of
reasoning takes hold, it can become impossible to avoid that slippery slope which
makes marginal pricing the norm. In these circumstances the breakeven chart
takes on a very different shape as the whole sales line changes its slope, creating
lower profitability and a higher breakeven point (Figure 8.4).
Fig. 8.4 How marginal pricing can affect the breakeven chart
Breakeven point
Total costs
Variable costs
£
Sales
Fixed costs
New sales
Volume
Customer spread
It is often difficult to prevent information about special prices from spreading from
one customer to another. The importance of this factor depends to a large extent on
the visibility of pricing levels and the extent to which customers can make
comparisons. This is often underestimated at the time when special price concessions
are made. What was intended to be a unique price or discount for a major new
customer can become the standard concession that eventually spreads to all
customers of a particular type. It may not only be the customers who make the
request – it may be sales people who manage different accounts and who want their
own customers to have the same price concession as others, particularly if they are
motivated and rewarded on volume rather than profit targets.
90
Creeping fixed costs and complexity
A key argument in favour of marginal pricing is that the fixed cost base is already
there and that any contribution of variable margin will go straight through to the
bottom line. This impact can often be sensitive and transformational, as we saw
in the earlier example. Once again, however, we must remember the limitations of
the conventional definition of variable costs and appreciate that step increases in
fixed costs will take place at a number of stages along the way.
This is perhaps the biggest danger of all in marginal pricing. A number of
individual decisions may be taken on a separate basis, each of which seems to be
justified on its own because it adds incrementally to the bottom line. Yet the
cumulative impact of these decisions is to cause an increase in the step of fixed
costs, because capacity is finally exhausted or because more complexity has
gradually been created. The marginal approach to costing and pricing ignores this
factor and this is a major reason why fixed costs are often allocated for the
purposes of pricing and profitability assessment. There will be more about fixed
cost allocation in the next chapter.
Despite all these dangers and reservations, and despite our emphasis on value
pricing in earlier chapters, marginal pricing can and should be a valid strategy in
certain circumstances. The ‘pro’ arguments are as follows.
Competitor attack
Marginal pricing can be used as a deliberate strategy to embarrass or weaken a

competitor. In these circumstances there may be conflict with the laws and
business regulations of certain countries and clearly such a strategy is valid only
if it is legally acceptable. If we leave aside this factor and the ethical issues
involved, there is no doubt that, in the right circumstances, marginal pricing can
be a highly effective competitive weapon. The large player, perhaps with higher
fixed and lower variable costs than competitors, can use its financial strength
temporarily to drive prices down to levels that the smaller, weaker competitors
cannot sustain, thus forcing them out of the market. On the other hand, in some
markets the smaller player, with lower fixed costs and more flexible profit
objectives, can use similar tactics to take business away from the market leader.
Competitor pressure and survival
It is possible that your business may be the one under attack. If you have
competitors which are, for whatever reason, pricing marginally while providing
equal value, you may have little choice but to follow suit. In the long term a
business cannot deliver value by pricing its products on a marginal basis, but to
achieve long-term objectives it is necessary to survive and sometimes marginal
91
pricing is essential just to keep afloat. Any variable margin or contribution is

better than nothing if you have a wage bill to cover, and sticking to a principled
and consistent ‘value’ pricing strategy is no argument when the receivers move in.
In the long term you must hope and expect that this situation will change,
otherwise there may be no future for your business in that market. If that change
is unlikely to come about through external factors, it is vital to develop an
effective new marketing strategy that makes your business less vulnerable to this
kind of competitive price pressure. This would be likely to involve the strategies
mentioned in Chapters 2 and 5 – the targeting of particular segments and the
creation of differentiation through other elements of the marketing mix.
One-off opportunities
This is perhaps the most valid and acceptable use of marginal pricing. There might
be a ‘one-off’ opportunity to use spare resources on activities which deliver
contribution without jeopardizing the mainstream business. This would have to
be in a separate segment with no links to mainstream business and with no
likelihood that quality of products or service to existing customers would be
adversely affected. There must also be no adverse impact on image, reputation or
staff motivation. If all these demanding criteria are met, if the pay-off is worth the
trouble and provided the activity is within core competences, marginally priced
business can and should be accepted.
New segments
Sometimes marginal pricing can be a deliberate strategy that is aimed at particular

segments with different characteristics to the main business. Typical examples
would be companies that have a special pricing policy towards export markets,
and consumer goods companies supplying to catering or industrial outlets as well
as to retail customers.
However, though such a strategy can work and can provide valuable incremental
profit for a period, it is unlikely to prove valid in the long term. At some stage there
are likely to be resource constraints and new investments in capacity will have to
be made. In these circumstances new fixed costs will be created and the ‘marginal’
business will have been the indirect cause, yet at marginal prices the profitability
levels are unlikely to be sufficient to justify the investment. Management must be
sure that such new segment business is priced at a level which has the long-term
potential to be profitable in its own right, otherwise it should not become a major
new source of business.
92
PRICE BEHAVIOUR IN THE HIGH VARIABLE

COST BUSINESS
We have focused so far on the high fixed cost business because this provides the
richest and most challenging scope for assessment and speculation about competitor
behaviour. In the high variable cost business it is all much more predictable, with less
room for manoeuvre. As we saw in the previous chapter, there is much less scope for
price reductions because the margins are so small and it will be the maintenance of
profit, rather than the creation of volume, that will be the highest priority.
There will be much less scope for marginal pricing because the major elements of
cost are variable, usually with a broadly similar structure for all competitors. The key
to a successful pricing strategy therefore is to know where you and your competitors
are likely to have cost advantage and to act accordingly. If a major competitor is able
to buy and/or produce at significantly lower variable cost, it will be necessary to
develop a marketing strategy to counter their cost advantage. The starting point must
be to make as informed and accurate a comparison as possible.
UNDERSTANDING COMPETITORS’ COST STRUCTURES
It will not normally be possible to obtain a fully accurate and complete picture of
all competitors’ cost structures because insufficient cost analysis is available in
published accounts; however, it will usually be possible to make some informed
assessments from the available data. The starting point should be the one area
where you have full information – your own cost structure – and further analysis
should then be carried out to make the best possible estimate of differences
between your position and that of the other main players.
Using the first example from the previous chapter, assume that your own cost
structure is as follows:
Price 100
Variable costs 57
Variable margin 43%
An assessment should then be made of the extent to which your competitor will have
a similar list of variable costs and how these will vary from your own situation – for
example, by better buying power on raw materials, different labour arrangements,
93
distribution patterns, sales remuneration systems, etc. Note again that at this stage it
is not necessary to look at fixed costs, only variables, because the fixed costs will fall
out as the residual figure.
So assuming that this is a larger competitor with better buying power and more
fixed cost remuneration, we can now estimate that this competitor’s variable costs are
50 per cent of sales compared with our own 57 per cent. We now look at the profit
and loss account in their published accounts. Let’s assume that it looks like this:
Sales 200
Costs 170
Operating profit 30
Operating margin 15%
We can now restructure the competitor’s profit and loss account to show variable
costs and to compare with our own on the same basis:
Them Us
Sales 200 100

Variable costs 100 (50%) 57 (57%)
Variable profit 100 43
Variable margin 50% 43%
Fixed costs 70 33
Operating profit 30 10
Operating margin 15% 10%
Note that we arrived at the competitor’s fixed costs as a balancing figure once we
knew the variable cost and operating profit numbers. Note also the different
variable to fixed ratios – their 100/70 or 1.43 compared with our 57/33 or 1.73.
This competitor has a lower proportion of variable costs and therefore a higher
proportion of fixed costs than we do.
With this information and with the comparative price data and other competitor
information that was recommended in Chapter 3, we now have valuable information
to help us develop a marketing strategy, and through it a pricing strategy, which
enables us to compete in the most effective way. We may for instance need to find
segments where our smaller size, greater flexibility and lower fixed cost base provide
us with competitive advantage.
The next chapter covers another area of pricing where financial evaluation is
necessary – those circumstances where we have no choice but to start our pricing
evaluation on a ‘cost plus’ basis.
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9
Cost plus pricing revisited
■ The case against 97
■ The case in favour 98
■ The costing process 98
■ Activity-based costing 101
■ Profit objectives 102
■ The concept of ‘required contribution’ 103
■ The value of financial assessment 105
95
THE CASE AGAINST
By now it should be clear that cost plus pricing methods are not compatible with
the marketing, value-based approach to pricing which has been advocated in the
book so far. To repeat the point we have made several times, customers do not
know about your costs and do not care about your costs, so why should costs come
into the pricing equation? A cost plus calculation may arrive at a price which is
above the correct value-based level, in which case few if any customers will buy; or
it may arrive at a price below that level, in which case the wrong value message is
being given to the customer and a profit-making opportunity is being lost.
A further argument against the use of cost plus is that it simply isn’t necessary.
In most market situations all the data you need to develop a pricing strategy is
available from the current positioning of competitors in the market place. An
existing player in a market should know the pricing structure of the key
competitors and a new entrant can find out the position by observation and
research. The place of cost analysis is not to calculate a desired price but to work
out the margin being achieved at various levels of profitability, the sort of
price/volume evaluations described in Chapter 7.
The final argument is that cost plus evaluations are, in practice, impossible to
achieve with absolute accuracy and the use of costing techniques in this context
may present a false impression of precision which misleads the pricing decision
maker. To develop this point further, there are two critical steps in the building up
of a typical product costing:
■ Work out the direct costs, which will include variable costs plus identifiable,
incremental fixed costs.
■ Assess existing general fixed costs and agree a basis for apportioning them to
the product.
The first of these steps is relatively straightforward; the second is fraught with
difficulty and is, in nearly every case, impossible to achieve in a way that is
accurate and unquestioned. Each accountant and analyst, each pricing specialist
within each competitor, is likely to have different views about the best way to
achieve fixed cost apportionment, so no one company is likely to have the
universal truth. There have been improvements to the accuracy of costing systems
in recent times through the introduction of activity-based costing (ABC)
approaches, but the use of ABC is patchy and inconsistent. Only if there are
standard methods of costing in the industry (as exists in the building sector to
some extent through the use of quantity surveyors) will there be any degree of
uniformity. We will return to ABC later in this chapter.
97
THE CASE IN FAVOUR
Despite all these reservations about cost plus pricing, we are to spend the rest of
the chapter on its coverage and this requires an explanation. The reason is that
there are circumstances where the cost plus approach has to be adopted because
there is no choice. This occurs where there is no standard product in the market
place and no reference point for the assessment of a market price. The most
obvious example would be a unique ‘one-off’ house or ship-building contract;
cost has to be the starting point because there is no similar product or contract to
benchmark against.
There are other situations where, despite its limitations, cost plus has a role to
play in the price decision-making process, for example:
■ a proposal to introduce a new product where there is limited or conflicting

information about the likely appeal and value to the customer;
■ your response to a new product introduction from another competitor, where
you are uncertain about the validity of their price;
■ where cost plus is the industry convention, with generally accepted methods of
costing and where you are looking for guidance on the likely price position of
new and existing competitors;
■ as part of a strategic review, to calculate the ideal price you would like to charge
in order to cover all fixed costs and make the required margin to meet
shareholder objectives. Even if it is not possible to implement the results of such
a calculation, a realistic assessment of the gap between the current position and
the ideal requirement can provide valuable guidance to management when they
are assessing strategic options.
We are not saying that cost plus will necessarily determine the final price in the above
scenarios; we are saying that a calculation on this basis will be a valuable support to
the decision-making process. One problem about introducing any kind of cost plus
approach into a business is that it can become too dominant and can reduce
management’s ability to be flexible and to apply common sense. All the reservations
about the limitations and potential inaccuracy of the costing can be forgotten when
a cost-based price is introduced into discussions. It is therefore necessary constantly
to remind management of the inevitable inexactness of the costing process.
THE COSTING PROCESS

The two stages in the calculation of a typical costing can be complemented and
completed by a third stage that converts the costing into a desired price – the
addition of required margin. Thus we have a three-stage process:
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■ calculate the ‘direct’ cost – those costs which are clearly identifiable with the
product or contract;
■ add on the ‘indirect’ costs – an apportionment of general fixed overheads;
■ add on a profit margin to arrive at the required price.
It should be recognized that a costing of this kind becomes progressively less

precise as you move through the process; it also becomes less and less comparable
with what competitors may be calculating and therefore a less useful guide to their
likely pricing behaviour.
We will not dwell on the first stage – the direct costs – because these are likely
to be relatively straightforward and dependent on the nature of each product,
service or contract. There is, however, one important assessment to make in
parallel with your calculation of direct costs – your view on the comparative cost
levels of key competitors. As mentioned in the previous chapter, you need an
assessment of their advantage or disadvantage in buying power of raw materials,
their utilization of labour, their efficiency of production, their distribution and
other operating costs. The more that these differences are considered as the
costing progresses, the more the final result is likely to be used in the right way.
The tendency to pass on relative cost inefficiencies to customers by means of cost
plus pricing is one of its biggest dangers and is sure to end in tears. Conversely,
the passing on to customers of relative cost efficiencies may result in a lost profit
opportunity and a price that does not reflect true value.
It is in the latter two stages of the costing – the addition of overhead and the
calculation of required margin – that problems arise and this is an area where
there is much misunderstanding. We will illustrate the problems with an example
of a new product introduction; we have to simplify to make some general points.
The key simplifying assumption is that there is a standard unit of product and that
the new product can be measured in the same terms.
Product x
Direct costs – materials, labour, variable overhead £5.00 per unit

Units produced during most recent period 200,000
Total existing fixed overhead £600,000
Forecast volume for new product 15,000
Total capacity 300,000
The problems can be illustrated by listing the likely questions that should now be
asked by those who are preparing the costing, for example:
■ How can we forecast the new product volume accurately when we don’t yet know
the price? This is the classic circular and intractable problem of ‘cost plus’ pricing.
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■ Assuming that fixed overheads of existing products are now being costed at
£3.00 per unit (£600,000/200,000), do we now reduce their costing to a lower
figure, for example, £2.79 (£600,000/215,000)?
■ Is this new rate of £2.79 also the correct rate for the new product?
■ Should the overhead rate be based on capacity rather than existing utilization?
■ What if the volume forecast for the coming period is more than 200,000?
These questions should illustrate the difficulty of establishing the ‘correct’ basis
for fixed cost apportionment. However, it is much easier to highlight the problem
than it is to provide the right answer. The best but by no means satisfactory way
of solving the problem is to produce total overhead and sales volume forecasts for
the coming period and, assuming that the latter is within realistic capacity
utilization, to use this for the unit cost calculation. For example, assuming no
change to overheads and a total volume forecast for all products of 250,000 units,
the unit cost rate would be £2.40 (£600,000/250,000) and this would apply to
both existing and new products.
Those who already have doubts about the cost plus approach and who also
realize how unreliable volume forecasts can be will probably put away their
calculator at this stage, deciding perhaps that market-based pricing is not so bad
after all. Their doubts might be exacerbated by two further important questions
that add even more to the complexity:
■ Should we include non-production items – sales, marketing, research, admin,

etc. – in our definition of overhead, and if not, why not?
■ Is the ‘per unit’ apportionment method really an effective way of charging these
and other costs to products?
The answer to the first question is undoubtedly yes – all fixed costs should be
brought into a cost evaluation of this kind. However, it is interesting that, when
you examine cost plus pricing systems as operated in many companies, it is
common to find that the non-production costs are treated quite arbitrarily, almost
as an afterthought. There may be great detail, even spurious accuracy, when
arriving at detailed apportionments of factory costs; but then the other overhead
costs – which are frequently a high proportion of the total – are lost within some
vague and general mark-up on production cost. This is not logical; there is no
difference in principle and if these other costs are to be included, they should be
analyzed to the same degree of detail as those of the factory.
However, the inclusion of all fixed costs makes the answer to the second
question even more likely to be ‘no’. The use of arbitrary apportionment methods
like ‘per unit’, ‘percentage of sales’ or even ‘per labour hour’ is not likely to reflect
the true way in which resources are used by new and existing products. One man
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– Professor Robert Kaplan of Harvard Business School – has highlighted this

problem through his advocacy of the technique of activity-based costing.
ACTIVITY-BASED COSTING
Like many successful management concepts of the 20th century, ABC is an

essentially simple and common sense approach. It was used by good financial
analysts way before Kaplan provided that important service delivered by the best
academics – he gave the technique a label and a memorable acronym. More
importantly, he alerted management to the dangers of relying on conventional
costing methods and accepting them as absolute truths.
Kaplan’s work was not aimed at pricing alone but, by implication, this was a key
element of his thinking. He claimed that the arbitrary allocation of overhead costs
often led to products being costed inaccurately. This in turn led to price levels that
did not reflect the true utilization of resources; it also led to inaccurate perceptions
of product profitability. He criticized particularly the early approaches to product
costing in manufacturing organizations, which required overheads to be charged to
products on the basis of labour hours. He said that this may have been an
appropriate basis for costing in the early days of manufacturing, but as factories
become more automated and more complex, more sophisticated methods of
costing are required.
The principles of ABC are simple. Each cost heading is looked at individually
and the true ‘driver’ of cost is identified. For cleaning costs, the driver would be
the space to be cleaned; for supervision costs, the number of people to be
supervised; for depreciation costs, the number of machine hours in operation; and
so on. This is not rocket science, merely common sense and the ideal practice of
good financial analysts well before Kaplan provided the label. However, these
analysts were frequently concerned about the cost effectiveness of the process
because analysis to that level of detail is time consuming and expensive.
This issue of cost effectiveness is the key problem with ABC and this has held
back its widespread application in business. If ABC is to be carried out properly,
it requires time and much more detailed information about cost behaviour than is
commonly available in an average business. A substantial investment of resources
therefore has to be made and this can be justified only if there is a significant pay-
off as a result of the analysis. Each business has to decide whether in its own
unique context the benefits of ABC evaluations justify this investment.
Two interesting changes of emphasis have taken place, which have extended the
application of ABC to different contexts and different businesses. First has been its
extension to non-production costs, thus helping to provide a more accurate and
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effective means of bringing these items into the cost and profitability evaluation
processes. Second has been the move towards placing ABC in a strategic rather than
an operational context, seeing it as a means of providing more accurate long-term
profitability evaluations rather than guidance for day-to-day decisions.
This fits very well with the fourth and last of the possible uses of cost plus
pricing mentioned earlier – to provide insight for a strategic review of the
business. An ABC costing can tell you what, in an ideal world and in the long
term, you would like the price to be to cover full costs and achieve required profit
objectives. It can provide calculations of current and likely future profitability
under a number of different scenarios. This can concentrate the mind on the range
of long-term strategic options, which might involve cost reduction, ways of
increasing prices or even exit from the market.
Such evaluations can be carried out without ABC methods, but if so there will
always be doubt about the validity of the answers. Advocates of ABC will quote
examples where the traditional arbitrary methods proved to be so wrong as to be
misleading, even worse than having no information at all. One food company in
the Netherlands discovered from an ABC analysis that half its product range in
one category was pricing below full cost when previously it was thought to be
highly profitable. The lesson they learnt from the experience was that such
costings should be carried out properly with ABC or not at all.
PROFIT OBJECTIVES
The final stage of a ‘cost plus’ pricing evaluation, the addition of a required
margin, is no less easy than the apportionment of cost. It is, however, an essential
step if the costing is finally to arrive at a selling price. The mark-up for margin has
to reflect the full extent of what needs to be covered, for example if non-
production costs are excluded in the first-stage cost evaluation, the margin
requirement must include their recovery in addition to the required profit.
The problem with this process is that building on a required margin to cost is
not the logically correct way of apportioning profit requirements to products or
parts of the business. The objective of a business is to create value for its
shareholders, which means making a return on investment in excess of its cost of
capital. Therefore the way in which profit objectives should be apportioned to
products or business units is on the basis of capital employed, not sales. Those
products with large investments in fixed assets and working capital should have
higher profit margin targets than those without such investment.
Thus there should be investment-based profit targets which are converted into
detailed financial plans with agreed margin goals and it is these that should form
the basis of the final stage of the pricing evaluation. This is now demonstrated,
using the earlier example and adding some extra information as follows:
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Product x
Direct costs – materials, labour, variable overhead £5.00 per unit

Total forecast fixed overhead £600,000
Total forecast volume 250,000
Total forecast sales £2,000,000
Profit target £400,000
Note that the forecast profitability of the business requires a 20 per cent operating
margin (400,000/2,000,000), and the costing assumption is that every product
must deliver its share. The final cost/price calculation would now look like this:
Direct cost £5.00

Share of fixed costs (£600,000/250,000) £2.40
Total cost £7.40
Required profit margin (25 per cent on cost) 1.85%
Total required price £9.25
Note that the margin has to be 25 per cent on cost to deliver the required 20 per
cent margin on sales (1.85/9.25 = 20 per cent). This confirms a simple but
commonly misunderstood point: that margin percentages marking up on cost will
need to be different from, and higher than, those which are related to sales.
THE CONCEPT OF ‘REQUIRED CONTRIBUTION’
It can be argued that the separation between fixed overhead and required profit
margin is an artificial one that creates unnecessary complication and inflexibility.
In the above example there might be a reluctance to go below £7.40 because we
are ‘losing money’ when in fact the circumstances might warrant such a price. As
we saw in the last chapter, marginal pricing is sometimes justified and anything
over the incremental cost will provide a contribution to fixed overheads.
There are two further arguments in favour of combining fixed overhead and
profit requirements. First, it can be argued that profit is just another form of fixed
cost that has to be covered to meet the needs of shareholders. Interest payable to
banks is usually treated as a fixed cost, therefore so should the return required for
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shareholders. Second, as it is so difficult to be sure that fixed cost apportionments

are accurate, the separation may encourage managers to place more reliance on
the cost numbers than is justified by the evaluation.
The language of fixed cost apportionment is avoided if an alternative approach
is used – to work out for each period and each product a figure of contribution
required. The argument is that, for a business to thrive, it needs to cover its fixed
costs and make a return on investment too, and each product has to contribute its
share. Using the earlier example and assuming that the operating profit number is
a target based on the capital employed for that product, we can now demonstrate
the required calculation:
Direct costs – materials, labour, variable overhead 5.00 per unit

Total forecast fixed overhead £600,000
Total forecast volume 250,000
Total forecast sales £2,000,000
Required contribution
Fixed overhead £600,000

Total contribution required £1,000,000
Forecast volume 250,000
Required contribution per unit – 1,000,000/250,000 = 4.0
The costing for the new product would now be simplified by the new approach
as follows:
Direct cost 5.00

Contribution required 4.00
Required price 9.00
This price varies slightly from the £9.25 quoted earlier because the required profit
is now being apportioned per unit rather than as a percentage of sales, which may
or may not be a more accurate reflection of reality. However, if we think back to
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the earlier point that profit needs are driven by capital employed rather than sales
levels, it is likely that the unit measure, although imperfect, is a better basis for
this evaluation.
THE VALUE OF FINANCIAL ASSESSMENT
After seeing the judgement areas and the complexities which can arise from even
the most simple example, readers will see that not only is ‘cost plus’ a
questionable approach, it is also very difficult to apply in practice. Nevertheless
the reasons why it may be necessary and helpful still stand: it can be used for
unique ‘one-off’ products, for products which are new to the market, to comply
with industry norms and to carry out strategic evaluations of ‘ideal’ prices. Each
company has to make its own judgement about the cost effectiveness of cost plus
pricing in the achievement of one or more of these objectives, and about the
degree of detail and complexity that is required. Costing has to be cost effective
to be worthwhile.
The final chapter extends the coverage of financial evaluation and rounds off the
book by covering the more complete and long-term assessment of the effectiveness
of pricing decisions: their impact on shareholder value over time.
105
10
Pricing, business objectives and
value creation
■ From value pricing to value to shareholders 109
■ Relating financial to marketing objectives 110
■ Evaluating marketing objectives 110
■ The underlying assumptions 116
■ Conclusion 117
107
Pricing, business objectives and value creation
FROM VALUE PRICING TO VALUE TO SHAREHOLDERS
Our main theme throughout this book has been the vital need to fix prices on the
basis of value to customers rather than on market opportunism or internally
driven cost calculations. However, this begs the question about another – and in
many ways more important – concept of value, the value which is delivered to
shareholders. Those who own the brand or the business will accept the principle
of pricing on a value basis only if they believe that this also provides maximum
financial benefit for them. It is only because of our belief in this long-term
correlation that we advocate the value approach to pricing.
The concept of shareholder value has been increasingly topical during the last
decade of the 20th century and so far during the first decade of the 21st. There
are a number of internal and external performance measures which have been
developed because they are believed to have a positive correlation to long-term
shareholder value – for example return on capital employed, earnings per share,
economic value added, free cash flow – and there is one common assumption that
underpins them all – the value of any company, business unit or brand at any one
time is the present value of the future cash flows during the remainder of its life
span (Figure 10.1). It therefore follows that such value will be maintained only by
the subsequent generation of that cash flow, and increased only by improvement
upon it.
Fig. 10.1 The value of any company, business unit or brand
Cash flows
The present
value of future
cash flows
This framework may not be quite so easy to apply to organizations that are not
owned by shareholders, but the same principles are relevant to any organization
with business objectives. Cash flow maximization is, in the long term, in the
interests of all stakeholders. Different types of organization may decide to use that
109
cash flow for different purposes, but the cash has to be generated in the first place
if business success is to be achieved.
RELATING FINANCIAL TO MARKETING OBJECTIVES
On several occasions in earlier chapters we have discussed the need for pricing
decisions to balance financial and marketing objectives, with marketing factors
taking priority in cases of conflict. Financial objectives have to be achieved in the
long run if the company is to stay in business, but pricing is such an integral part
of the marketing mix that marketing factors must be the driver of the decision. We
have also mentioned on several occasions the need to avoid sacrificing long-term
marketing objectives at the altar of short-term sales and profit maximization.
However, such sentiments are meaningless unless they can be related to long-term
value for those who own the business and are required to invest in it. If the objective
of all pricing decisions is clearly understood to be the maximization of the present
value of future cash flows, this allows all the trade-offs and judgements to be
evaluated within a meaningful and quantifiable framework.
EVALUATING MARKETING OBJECTIVES
There are a number of marketing objectives that can be achieved, directly or

indirectly, via pricing decisions. A number of these have been mentioned during
the book so far, for instance:
■ price low to gain market share;

■ price high to maximize short-term profitability;
■ create a loss leader to encourage sales of other products;
■ launch a new premium product to create better ‘price lines’ for others in the range;
■ price on a marginal basis to enable survival in the short term;
■ price on a marginal basis to hurt the competition.
These can all be justifiable strategies because pricing decisions need judgement
and flexibility and must be based on the day-to-day reality of competitive
markets. However, the key test of their validity is whether they will create more
long-term shareholder value than would be produced by other options, including
the option of doing nothing. This comparison may or may not be quantifiable in
detailed cash flow terms, but the creation of more present value than other
options should always be the explicit or implied aim of a pricing decision.
110
Take the first objective, the gaining of market share, which is a common priority
among ambitious brand managers. Too often market share growth is assumed to
be a good thing in itself, without considering the high cost of the price reductions
or marketing spend which are necessary to deliver it. This assumption that high
market share is the best way of maximizing value may be true in many markets,
but can also become the justification of a poorly conceived and evaluated strategy.
If we think back to the price/volume evaluations in Chapter 7, these were
examples of the difficult choices that have to be made between short-term and
long-term return. Should we reduce price to achieve a volume increase, even
though the contribution this year will be significantly reduced by so doing? Should
we increase price and lose market share because the extra contribution will help
this year’s profits?
Those evaluations were essentially short-term because that was the context we
were discussing at the time. However, if the base data is available and if managers are
willing and able to make the necessary assumptions, the only valid way to make the
judgement would be to compare the cash flows over the remaining life of the product
for each option and see which one generates the most value for shareholders.
To illustrate this point we will have to simplify. We will take two options for
price change similar to those illustrated in Chapter 7, one for a 10 per cent price
increase, one for a 10 per cent price reduction. The existing situation is as follows:
■ market size 1,000 units;

■ no expected market growth;
■ price £100;
■ existing share 30 per cent, 300 units;
■ variable costs £35 per unit;
■ fixed costs £10,000;
■ promotion and advertising support 7.5 per cent of sales;
■ product life forecast as ten years.
The ongoing profit and loss account if no price change takes place therefore looks
like this:
£
Sales 30,000
Variable costs (10,500)
Fixed costs (10,000)
Promotion and advertising (2,250)
Operating profit 7,250
111
The assumptions for the price change options are as follows:
10 per cent price increase
■ Market share falls from 30 per cent to 25 per cent over next five years.
■ Fixed and variable costs stay the same.
■ Promotion and advertising support has to increase to 10 per cent of sales to
support the price increase.
10 per cent price reduction
■ Market share rises from 30 per cent to 45 per cent over the next five years.
■ Fixed costs rise by a step of £2,500 after year 5.
■ Promotion and advertising support reduces to 5 per cent of sales.
■ Capital expenditure of £50,000 is necessary in year 5 to cope with higher volume.
From this information it is possible to build a ten-year cash flow of the two
options and thus make a real assessment of value – see Tables 10.1 and 10.2.
The figures in the right-hand columns tell us the net amount of cash which will
be generated by the two options. The final step is to convert these future cash
flows into their present values so that we can have a true comparison of the
shareholder value that will be created by each option. The price increase option
will create more value in the early years but will tail off later as the share
decreases; the price reduction option comes into its own after year 5 and generates
substantially more cash flow in years 6 to 10.
It is not possible here to provide a full explanation of the principles of
discounted cash flow for those who are not familiar with them. It is hopefully
enough to say that discounting is a technique which converts future cash flows to
their present value, based on an agreed discount rate that represents the average
cost of financing debt and equity investment. We will assume this rate as a fairly
typical 10 per cent.
Effectively this technique is quantifying the obvious reality that the longer we
have to wait for our money, the less it is worth. This calculation can be made as
a standard function from any spreadsheet, but we will show the year-by-year
calculation to help understanding.
If we convert these cash flows into their yearly and total present values, we will
have a better understanding of the real value generated by the two options – see
Tables 10.3 and 10.4.
112
Table 10.1 Price increase option
Year Price Market Market Volume Sales Variable Fixed Advertising Capital Net cash
size share cost cost and promotions investment flow
Now 100 1,000 0.30 300 30,000 (10,500) (10,000) (2,250) 7,250
1 110 1,000 0.29 290 31,900 (10,150) (10,000) (3,190) 8,560
2 110 1,000 0.28 280 30,800 (9,800) (10,000) (3,080) 7,920
3 110 1,000 0.27 270 29,700 (9,450) (10,000) (2,970) 7,280
4 110 1,000 0.26 260 28,600 (9,100) (10,000) (2,860) 6,640
5 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000
6 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000
7 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000
8 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000
9 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000
10 110 1,000 0.25 250 27,500 (8,750) (10,000) (2,750) 6,000
Table 10.2 Price reduction option
Year Price Market Market Volume Sales Variable Fixed Advertising Capital Net cash
size share cost cost and promotions investment flow
Now 100 1,000 0.30 300 30,000 (10,500) (10,000) (2,250) 7,250
1 90 1,000 0.33 330 29,700 (11,550) (10,000) (1,485) 6,665
2 90 1,000 0.36 360 32,400 (12,600) (10,000) (1,620) 8,180
3 90 1,000 0.39 390 35,100 (13,650) (10,000) (1,755) 9,695
4 90 1,000 0.42 420 37,800 (14,700) (10,000) (1,890) 11,210
5 90 1,000 0.45 450 40,500 (15,750) (10,000) (2,025) (40,000) (27,275)
6 90 1,000 0.45 450 40,500 (15,750) (12,500) (2,025) 10,225
7 90 1,000 0.45 450 40,500 (15,750) (12,500) (2,025) 10,225
8 90 1,000 0.45 450 40,500 (15,750) (12,500) (2,025) 10,225
9 90 1,000 0.45 450 40,500 (15,750) (12,500) (2,025) 10,225
10 90 1,000 0.45 450 40,500 (15,750) (12,500) (2,025) 10,225
Table 10.3 Price reduction option
Year Cash flow Discount factor Present value
1 6,665 0.91 6,065

2 8,180 0.83 6,789
3 9,695 0.75 7,271
4 11,210 0.68 7,622
5 (27,275) 0.62 (16,911)
6 10,225 0.56 5,726
7 10,225 0.51 5,215
8 10,225 0.47 4,806
9 10,225 0.42 4,295
10 10,225 0.39 3,988
Net present value 34,866
Table 10.4 Price increase option
Year Cash flow Discount Present value

factor
1 8,560 0.91 7,790

2 7,920 0.83 6,574
3 7,280 0.75 5,460
4 6,640 0.68 4,515
5 6,000 0.62 3,720
6 6,000 0.56 3,360
7 6,000 0.51 3,060
8 6,000 0.47 2,820
9 6,000 0.42 2,520
10 6,000 0.39 2,340
Net present value 42,159
This analysis shows that the price increase option, with its assumed reduction to
25 per cent market share, will generate more value for stakeholders than the
option to reduce prices and gain a 45 per cent share. This situation might be
different if the life was extended beyond ten years or if other assumptions were
changed, but as things stand, management would not be justified in reducing
prices to gain share, even in the longer term.
115
There is still the third option of doing nothing and leaving price as it is, with an
ongoing cash flow of £7,750. A similar evaluation to the above will show that the
present value of £7,750 per annum over ten years is £44,515.
On this basis the course of action which creates most value for shareholders is
to leave the price unchanged.
THE UNDERLYING ASSUMPTIONS
Building this kind of detailed cash flow forecast would be difficult to say the least,
and some would say impossible. For instance, the questions that would have to be
answered to arrive at the base numbers in the cash flow would be many and
complex. Most of them have been raised and discussed in the various chapters of
the book; for instance, consider the following.
Competitor analysis
■ If we reduce price, what will be their reaction? Will they follow or change their
offer in other ways?
■ If we increase price, will they take advantage by increasing theirs too?
■ Which competitors are likely proactively to change their pricing strategy and
tactics?
■ Will new competitors enter the market?
Consumer responses
■ How price sensitive are the various segments?

■ Will the price reduction raise doubts about our quality and positioning?
■ Will the price increase cause loyal customers to move to competitors or to
substitutes?
Marketing mix
■ What impact will the price changes have on other products in the range?
■ What will be the balance of spending between promotion and advertising?
■ Will there be different price sensitivities for different channels?
116
Financial implications
■ What impact will the industry cost structure have on pricing behaviour?
■ What is our own cost structure likely to be, in both the short and the long term?
■ What will be our breakeven point at different pricing levels?
And the critical question
■ How will our overall value package compare to competitors’ and will it
continue to allow us to achieve the market shares we are assuming?
CONCLUSION
It would be unrealistic to suggest that managers and marketers should carry out
this sort of detailed cash flow evaluation every time they make a pricing decision.
It might be possible to build such a cash flow during strategic planning sessions
or at other times when major choices have to be made, but usually pricing
decisions have to be made more informally and instinctively. Yet every time
pricing judgements are made, those responsible are effectively trying to answer the
above questions, using their expertise and knowledge of the market to build their
own intuitive model with all its complex trade-offs and difficult judgements.
As it is not possible on an ongoing basis to assess all these complex variables in
a detailed way, managers need a principle to guide them, a principle which is likely
to generate the most value for stakeholders. Our view, the view that has been a
continuing theme throughout the book, is that the best principle to guide decisions
is always to strive for the price level which aligns with value to customers.
Because alignment with value to customers will, in the long term, drive maximum
value for stakeholders.
117
Appendix
The economic theory of pricing
INTRODUCTION
Knowledge of the basic principles of economic pricing theory is important if

managers are to understand how prices are determined in practice. Such theories
rarely match the complex realities of day-to-day business, but it is helpful to have
a theoretical underpinning against which to compare that reality.
First some terminology. Economists use the term commodity to mean a good or
service which has some value to a consumer. In some chapters of the book we use
the term commodity in a narrower and slightly different context, but in this
appendix the broader meaning will apply.
Prices of commodities are determined by the forces of demand and supply. We
will look at each of these in turn.
THE DEMAND CURVE
The demand for a commodity is the quantity that consumers are able and willing
to buy. In the case of almost all commodities, the quantity demanded increases as
the price of the commodity falls. This is because, as price falls, the commodity
becomes cheaper relative to its substitutes and therefore competes more effectively
against these substitutes for the consumer’s buying power. If, for example, the
price of tea falls significantly, some consumers may buy more tea and less coffee.
This tendency can be plotted on a graph as shown in Figure A.1.
Fig. A.1 The demand curve

Price
Demand
Quantity
119
Appendix
This ‘demand curve’ shows the normal relationship between the price of the
commodity and the quantity that consumers wish to purchase. It is, however,
based on the simplified assumption that income levels, tastes and other prices
remain constant. We will now explore these factors.
Income levels
Consumer demand for a commodity is influenced by their level of income. In most

cases, the larger the income, the higher the quantity demanded. In a few cases
demand for a product can fall as income rises – what are known as ‘inferior’ goods.
An example would be potatoes, rice or bread, the reason being that consumers may
switch to more varied and exotic foods as their income rises.
Taste
Consumer demand for a commodity is influenced by their tastes. One of the main
purposes of advertising is to influence consumer tastes, thus increasing the
demand for some products and reducing the demand for others.
Prices of substitutes and complements
Consumer demand for commodities can be influenced by the prices of other

commodities. In some cases the demand for one commodity will increase along
with the price of another, while in other cases the demand for one commodity will
decrease as the price of a second one increases. The price behaviour of petrol is a
good example. If the price of public transport increases, more people will wish to
make journeys by car, therefore the demand for petrol will rise and cause an
increase in the price. Public transport and petrol are substitutes and as the price
of one rises, so does the other. Consider, on the other hand, the relationship
between the price of cars and the price of petrol. Petrol and cars are known as
complementary goods (or complements). As the price of cars rises, consumers are
likely to reduce the number of journeys made by car. The demand for petrol will
fall, resulting in a decline in its price.
THE SUPPLY CURVE
Having looked at the demand side of pricing economics, we will now examine the
supply side. By the supply of a commodity we mean the quantity of units that
producers are able and willing to offer for sale.
120
Appendix
Generally, the higher the price of a commodity the greater will be the quantity
supplied. It is more profitable to sell a commodity at a higher price so, at higher
price levels, existing producers will increase the volumes they offer for sale and
new producers will be encouraged to enter the market. This can be shown on a
similar graph to demand as shown above (Figure A.2).
Fig. A.2 The supply curve

Price
Supply
Quantity
The ‘supply curve’ for a commodity shows the normal relationship between the
price of that commodity and the quantity producers wish to sell. It is drawn on
the assumption that all factors that influence supply are constant. However, as
with demand, there are other factors which affect supply and the following are the
most important.
The goals of producers
If producers are pursuing a goal of sales maximization, the quantity supplied at

any price may be different from what would happen if the goal was to maximize
profits. Sometimes a producer may go for a sales maximization goal even if lower
profits are produced in the short term, for example as part of a long-term strategy
to achieve a target market share.
Prices of other commodities
If the prices of other commodities increase, this will make the production of one
commodity relatively less attractive. Suppliers will therefore move their emphasis
away from that commodity and the supply will fall.
121
Appendix
Prices of factors of production
Factors of production are the inputs necessary for production – materials, labour
and capital. Changes in the price of factors of production will cause changes in the
relative profitability of different commodities and therefore changes in their supply.
Technology
Over time developments in technology will affect the relative costs of production,
which will also have an impact on producers’ willingness and ability to supply.
PRICE DETERMINATION
Prices are determined by the interaction of supply and demand, and this interaction
is shown by combining the supply and demand curves into one graph, illustrated
in Figure A.3.
Fig. A.3 The interaction of supply and demand

Price
Supply
P1
Demand
Q1 Quantity
The point where the two curves intersect is, in theory, the market price – P1. The
quantity demanded, Q1, and the quantity supplied are the same.
At any price higher than P1 (say, P2), the quantity consumers wish to buy (Q2)
is less than the quantity that producers wish to sell (Q3). We call this excess
supply, as shown in Figure A.4.
In a position of excess supply, the market price will fall. Producers who are
unable to sell all their output will offer some at lower prices. Consumers who see
unsold goods will begin to buy at these lower prices.
122
Appendix
Fig. A.4 Excess supply
Price
Supply
P2
P1
Demand
Q2 Q1 Q3 Quantity
At any price below P1 (say, P3), the amount that consumers wish to buy (Q4) is
greater than the amount that producers wish to sell (Q5). We call this excess
demand. It is shown in Figure A.5.
Fig. A.5 Excess demand

Price
Supply
P1
P3
Demand
Q5 Q1 Q4 Quantity
In a position of excess demand the market price will rise. Consumers who are unable
to buy as much as they would like at current prices will offer higher prices. Suppliers
who are able to sell all their production will charge these higher prices to consumers.
Thus, at any price above P1 the price begins to fall and at any price below P1
the price begins to rise. At a price of P1, the quantity demanded and the quantity
supplied are equal and market prices will remain unchanged. This point, at which
the supply and demand curves intersect, is called the equilibrium price.
123
Appendix
THE FUNDAMENTAL THEORY OF PRICE
We have so far covered the following:
■ Demand curves slope downwards continuously.

■ Supply curves slope upwards continuously.
■ An excess of demand over supply causes prices to rise.
■ An excess of supply over demand causes prices to fall.
This means that there is only one price at which demand and supply are equal. If
either the demand or supply curve shift, the equilibrium price will change. The impact
of shifts in demand and supply curves can be demonstrated in the following figures.
A rise in the demand for a commodity (from D1 to D2) causes an increase in
both the equilibrium price (P1 to P2) and equilibrium quantity (Q1 to Q2) (Figure
A.6). The reverse is also true. A fall in demand for a commodity causes a
reduction of both the equilibrium price and the equilibrium quantity.
Fig. A.6 The effect of a rise in the demand for a commodity

Price
P2
P1
D2
D1
Q1 Q2 Q4 Quantity
We can also consider the impact of a change in the supply curve (Figure A.7). A
rise in the supply of a commodity (S1 to S2) causes a decrease in the equilibrium
price (P1 to P2) and an increase in the equilibrium quantity (Q1 to Q2). Again,
the reverse is true. A fall in the supply of a commodity causes an increase in the
equilibrium price and a decrease in the equilibrium quantity.
This application of economic theory supports what we observe in practice. If the
demand for a product increases (for example due to a change in taste), we would
expect the market price and the quantity sold both to increase. If the supply of a
good rises (for example due to new companies entering the market), we would
expect the price to fall and the quantity sold to increase.
124
Appendix
Fig. A.7 The impact of a change in the supply curve
Price S1
S2
P1
P2
Q1 Q2 Quantity
ELASTICITY OF DEMAND AND SUPPLY
So far we have considered the likely directional impact on price and volume of a
change in demand or supply. We have not yet considered how large the likely
change of each will be. The concept of elasticity enables us to do this.
Consider the two situations in Figure A.8. The supply curve and equilibrium
price are the same in both cases but the demand curve is different. Now, consider
what happens when there is a reduction in supply. This is represented by a shift
in the supply curve from S1 to S2. As a result the equilibrium quantity and
equilibrium price decrease in each case (Figure A.9).
Fig. A.8 The concept of elasticity

Price
Price
S1 S1
P1 D P1
Q1 Quantity Q1 Quantity
125
Appendix
Fig. A.9 The impact of a reduction in supply
Price
Price
S2 S2
S1 P3 S1
P2
P1 D P1
Q2 Q1 Quantity Q3 Q1 Quantity
In the first case the change in the equilibrium quantity is high but the change in the
equilibrium price is small. We describe this type of demand curve as elastic – for a
relatively small change in price, a large change in volume will occur. There is the
opposite impact in the second case. Here the same shift in supply results in a large
increase in price but a small increase in quantity. We describe this type of demand
curve as inelastic – a large change in price can occur without much impact on volume.
Economists have developed quantitative methods to measure elasticity of
demand, but we do not deal with these here. However, it is important to
understand the implications of these two extremes of elasticity of demand because
we will be looking at the financial implications in detail in Chapter 7. This is
shown in Figure A.10. The first graph shows a demand curve that can be
described as having zero elasticity. In other words, however much price changes,
the quantity demanded will not vary. The second graph shows a demand curve
that is perfectly elastic. In this case consumers are not willing to pay more than a
given price for a product.
While these may be extreme cases and may rarely occur in practice, they are
useful frameworks for analysis in business. Take the second example of an elastic
demand curve, which would apply to a business selling a product that is not
differentiated from its competitors. At a price below that of its competitors, the
firm would be likely to sell all its output. At a price even a little above that of its
competitors, nothing would be sold as consumers would be able to satisfy their
demand elsewhere.
Apart from differentiation and competition, there are two other main factors
that determine elasticity of demand.
126
Appendix
Fig. A.10 An illustration of elasticity

Price
Price
Quantity Quantity
The availability of substitutes
If substitutes are available, the demand is likely to be relatively elastic, since

consumers will buy the substitute if the price of the original product rises.
The degree of necessity of the product
The more consumers perceive a commodity to be essential, the more inelastic the
demand is likely to be.
A good example of a product with relatively inelastic demand is commuter rail
travel. Customers often have few practical alternative forms of transport and it is
necessary for them to travel to work. Rail companies can therefore often increase
price without experiencing much decline in volume. A good example of a product
with elastic demand is a standard vegetable, for example broccoli. There are many
similar vegetable alternatives and few consumers would continue to buy broccoli
if the price rose significantly. The price rise would therefore cause a significant fall
in volume.
OVERALL SUMMARY
We have established the following:
■ A demand curve shows how the required quantity of a commodity will increase
as price decreases.
127
Appendix
■ The demand for a product is influenced by a number of factors, including

consumers’ income, the prices of other commodities and taste.
■ A supply curve shows how the quantity of a commodity produced by suppliers
will increase as price increases.
■ The supply of a product is influenced by a number of factors, including the
goals of companies, the price of other commodities, the prices of raw materials
and other inputs, and technology.
■ Market prices are determined by the interaction of supply and demand.
■ If there is excess supply, prices are likely to fall.
■ If there is excess demand, prices are likely to rise.
■ The extent of any price change resulting from a change in supply is influenced
by the elasticity of demand.
■ If demand is inelastic, a small change in price will have little influence on the
volume sold.
■ If demand is elastic, a small change in price will have a large impact on the
volume sold.
128
References
Buzzell, Robert D. and Gale, Bradley T. (1987) The PIMS Principles. Free Press.
Dolan, Robert J. and Simon, Hermann (1996) Power Pricing. Free Press.
Fletcher, Tony and Russell-Jones, Neil (1997) Value Pricing. Kogan Page.
Hanna, Nessim and Dodge, Robert H. (1995) Pricing Policies and Procedures.
Macmillan.
Lewis, Gregory (1992) Pricing For Profit. Kogan Page.
Johnson, Thomas H. and Kaplan, Robert S. (1991) Relevance Lost. Harvard
Business School Press.
Johnson, Thomas H. (1992) Relevance Regained. Free Press.
Nagle, Thomas H. and Holden, Reed K. (1987) The Strategy and Tactics of
Pricing. Prentice Hall.
Porter, Michael (1985) Competitive Advantage. Free Press.
Porter, Michael (1980) Competitive Advantage. Free Press.
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Pricing for Long-term

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The Publishers’ policy is to use paper manufactured from sustainable forests.

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

Tel: +44(0) 1296 423474

1 A framework for pricing 1

2 Generic pricing strategies 11

3 Understanding the competition 23

4 The drivers of consumer price sensitivity 33

5 Price as part of the marketing mix 45

6 Price, value and profitability 59

7 Analyzing the financial impact 67

8 Cost structure and pricing behaviour 83

Price behaviour in the high variable cost business 93

9 Cost plus pricing revisited 95

10 Pricing, business objectives and value creation 107

Appendix The economic theory of pricing 119

■ The problem of price inertia 3

■ The complexities of pricing 4

■ A framework for pricing decisions 5

■ The concept of value 6

■ Organizational responsibility for pricing 7

■ Steps to pricing effectiveness 9

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

THE PROBLEM OF PRICE INERTIA

THE COMPLEXITIES OF PRICING

Your own costs plus a required margin?

Your competitors’ prices?

Your customer’s willingness to pay?

A FRAMEWORK FOR PRICING DECISIONS

Fig. 1.1 The factors which determine the pricing decision

THE CONCEPT OF VALUE

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

ORGANIZATIONAL RESPONSIBILITY FOR PRICING

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

STEPS TO PRICING EFFECTIVENESS

Fig. 1.2 The ten steps of price review analysis

■ Business strategy as the starting point 13

■ Porter’s generic business strategies 13

■ Generic pricing strategies 14

■ Choosing between skimming and penetration 15

■ Subsidiary pricing strategies 18

■ Pricing and the product life cycle 19

■ A summary of life cycle pricing strategies 22

■ The importance of competitor analysis 22

BUSINESS STRATEGY AS THE STARTING POINT

PORTER’S GENERIC BUSINESS STRATEGIES

■ overall cost leadership

Overall cost leadership

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