The Strategy And Tactics Of Pricing

T HE STRATEGY AND

TACTICS OF PRICING

The Strategy and Tactics of Pricing explains how to manage markets strategically and

how to grow more proﬁ tably. Rather than calculating prices to cover costs or achieve

sales goals, students will learn to make strategic pricing decisions that proactively man-

age customer perceptions of value, motivate purchasing decisions, and shift demand

curves.

This edition features a new discussion on harnessing concepts from behavioral

economics as well as a more streamlined “value cascade” structure to the topics. Read-

ers will also beneﬁ t from:

• Major revisions to almost half of the chapters, including an expanded discussion

of big data analytics and a revised chapter on “Specialized Strategies”, which

addresses timely technical issues like foreign exchange risks, reactions to market

slumps, and managing transfer prices between independent proﬁ t centers.

• A completely rewritten chapter on “Creating a Strategic Pricing Capability”,

which shows readers how to implement the principles of value-based, strategic

pricing successfully in their organizations.

• In-chapter textboxes, updated to provide walk-through examples of current pric-

ing challenges, revenue models enabled by an increasingly digital economy, and

advances in buyer decision-making, explained through classic principles that

still apply today.

• Chapter summaries and visual aids, which help readers grasp the theoretical

frameworks and actionable principles of pricing analysis.

This comprehensive, managerially-focused text is a must-read for students and pro-

fessionals with an interest in strategic marketing and pricing. A companion website

features PowerPoint slides with instructor notes, discussion questions, and exercises,

as well as suggested readings and cases with separate teaching notes for instructors.

Thomas T. Nagle , Ph.D., is a Senior Advisor in the Pricing and Proﬁ tability Manage-

ment practice at Deloitte Consulting, USA. For over 30 years, he has developed many

of the most popular analytical tools and conceptual frameworks for strategic pricing

and proﬁ t improvement.

Georg Müller, Ph.D., is a Managing Director in the Pricing and Proﬁ tability Manage-

ment practice at Deloitte Consulting, USA. He focuses on driving top-line margin

improvement through strategic pricing for companies representing multiple sectors.

He also leads executive development on strategic pricing at the University of Chicago,

Booth School of Business, USA.

“The principles of business proﬁ tability stressed in The Strategy and Tactics of

Pricing make it an absolute must-read for all business professionals who care

about creating value and proﬁ tability for their organization. I have person-

ally practiced the knowledge gained from The Strategy and Tactics of Pricing,

operating in hyper-competitive business environments, with great success.”

—Lynn Guinn, Global Strategic Pricing Leader at Cargill, USA

“For over three decades, this book has been the most inﬂ uential and highly

regarded reference for pricing professionals. New sections on today’s most

pressing business topics make it an indispensable tool to improve your com-

pany’s performance.”

—Kevin Mitchell, President of The Professional Pricing Society, Inc., USA

“The best pricing book on the planet! The go-to resource for pricing

success—powerful, practical, and proﬁ table!”

—Mark Bergen, James D. Watkins Chair in Marketing, Carlson

School of Management, University of Minnesota, USA

Sixth Edition

T HE STRATEGY AND

TACTICS OF PRICING

A GUIDE TO GROWING

MORE PROFITABLY

Thomas T. Nagle

Georg Müller

Sixth edition published 2018

by Routledge

711 Third Avenue, New York, NY 10017

and by Routledge

2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN

Routledge is an imprint of the Taylor & Francis Group, an informa business

The right of Thomas T. Nagle and Georg Müller to be identiﬁ ed as authors of

this work has been asserted by them in accordance with sections 77 and 78 of the

in any form or by any electronic, mechanical, or other means, now known or hereafter

invented, including photocopying and recording, or in any information storage or

retrieval system, without permission in writing from the publishers.

Trademark notice : Product or corporate names may be trademarks or registered

trademarks, and are used only for identiﬁ cation and explanation without intent

to infringe.

First edition published by Prentice Hall 1987

Fifth edition published by Routledge 2016

Library of Congress Cataloging-in-Publication Data

A catalog record for this book has been requested

ISBN: 978-1-138-73750-1 (hbk)

ISBN: 978-1-138-73751-8 (pbk)

ISBN: 978-1-315-18530-9 (ebk)

Typeset in Palatino

by Apex CoVantage, LLC

Visit the companion website: www.routledge.com/cw/nagle

Preface xiii

Acknowledgments xv

List of In-Line Boxes xvii

List of Exhibits xix

Chapter 1 Strategic Pricing 1

Coordinating the Drivers of Proﬁ tability

Chapter 2 Economic Value 26

The Guiding Force of Pricing Strategy

Chapter 3 Price and Value Communication 56

Strategies to Inﬂ uence Willingness-to-Pay

Chapter 4 Price Structure 76

Tactics for Pricing Differently Across Customer Segments

Chapter 5 Pricing Policy 106

Inﬂ uencing Customer Expectations and Purchase Behaviors

Chapter 6 Price Level 133

Setting Prices that Capture a Share of the Value Created

Chapter 7 Price Competition 152

Managing Conﬂ ict Thoughtfully

Chapter 8 Measurement of Price Sensitivity 173

Research Techniques to Supplement Judgment

Chapter 9 Financial Analysis 207

Analyzing Costs and Proﬁ ts for Pricing

Chapter 10 Specialized Strategies 240

Adapting Pricing to Accommodate Common Challenges

Chapter 11 Creating Strategic Pricing Capability 262

Assembling Talent, Processes, and Data to Build

Competitive Advantage

Chapter 12 Ethics and the Law 293

Understanding the Constraints on Pricing

Index 317

CONTENTS

DETAILED TABLE OF CONTENTS

Chapter 1 Strategic Pricing 1

Coordinating the Drivers of Proﬁ tability

Leveraging Proﬁ t into Sustainable Growth 2

Cost-Plus Pricing 4

Customer-Driven Pricing 5

Share-Driven Pricing 6

The Role of “Optimizing” in Strategic Pricing 7

What Is Strategic Pricing? 9

Value Creation 12

Value Communication 15

Price Structure 17

Pricing Policy 18

Price Setting 19

Price Competition 20

Creating a Strategic Pricing Capability 21

Summary 23 • Notes 23

Chapter 2 Economic Value 26

The Guiding Force of Pricing Strategy

The Role of Value in Pricing 27

How to Estimate Economic Value 30

Competitive Reference Prices 31

Estimating Monetary Value 33

Monetary Value Estimation: An Illustration 36

Estimating Psychological Value 41

Psychological Value Estimation: An Illustration 42

The High Cost of Shortcuts 45

Value-Based Market Segmentation 47

Step 1: Determine Basic Segmentation Criteria 49

Step 2: Identify Discriminating Value Drivers 50

Step 3: Determine Your Operational Constraints

and Advantages 50

Step 4: Create Primary and Secondary Segments 50

Step 5: Create Detailed Segment Descriptions 53

Step 6: Develop Segment Metrics and Fences 53

Summary 54 • Notes 54

Detailed Table of Contentsviii

Chapter 3 Price and Value Communication 56

Strategies to Inﬂ uence Willingness-to-Pay

Value Communication 58

Adapting the Message for Product Characteristics 58

Low-Involvement, Psychological Beneﬁ ts 60

Low-Involvement, Economic Beneﬁ ts 60

High Involvement, Psychological Beneﬁ ts 61

High Involvement, Economic Beneﬁ ts 61

Strategies for Conveying Value 62

Competitive-Reference Effect 65

Switching-Cost Effect 66

Difﬁ cult-Comparison Effect 66

End-Beneﬁ t Effect 67

Price-Quality Effect 68

Expenditure Effect 70

Shared-Cost Effect 70

Transaction Value Effect 71

Fairness Effect 72

Multiple Participants in the Buying Process 73

Summary 74 • Notes 75

Chapter 4 Price Structure 76

Tactics for Pricing Differently Across

Customer Segments

Challenges That Can Undermine Segmented

Pricing 79

Offer Conﬁ gurations 80

Optimizing the Structure of Offer Bundles 81

Designing Segment-Speciﬁ c Bundles 83

Unbundling Strategically 84

Price Metrics 85

Creating Good Price Metrics 86

Performance-Based Metrics 89

Tie-Ins as Metrics 92

Price Fences 95

Buyer Identiﬁ cation Fences 95

Purchase Location Fences 97

Time-of-Purchase Fences 98

Purchase Quantity Fences 99

Peak Pricing and Yield Management 101

Summary 104 • Notes 104

Detailed Table of Contents ix

Chapter 5 Pricing Policy 106

Inﬂ uencing Customer Expectations and Purchase

Behaviors

Pricing Policies and Price Expectations 107

The Emergence of Strategic Sourcing 108

Policies for Price Negotiation 110

Policies for Responding to Price Objections 114

The Problem with Reactive, Ad Hoc Price

Negotiation 114

The Beneﬁ ts of Proactive, Policy-Based Price

Negotiation 116

Policies for Different Buyer Types 118

Policies for Dealing with Power Buyers 123

Policies for Successfully Managing Price Increases 125

Policies for Leading an Industry-Wide Increase 126

Policies for Transitioning from Flexible to

Policy-Based Pricing 127

Policies for Pricing in an Economic Downturn 128

Policies for Promotional Pricing 130

Summary 131 • Notes 131

Chapter 6 Price Level 133

Setting Prices that Capture a Share

of the Value Created

The Price-Setting Process 134

Step 1: Deﬁ ne the Viable Price Range 135

Step 2: Make Strategic Choices 137

Step 3: Assess Breakeven Sales Changes 142

Step 4: Gauge Price Elasticity 145

Step 5: Account for Psychological Factors 147

Communicating New Prices to the Market 149

Summary 151 • Notes 151

Chapter 7 Price Competition 152

Managing Conﬂ ict Thoughtfully

Understanding the Pricing Game 153

Competing to Grow Proﬁ tably 154

Reacting to Competition: Think Before You Act 159

Managing Competitive Information 165

Collect and Evaluate Competitive Information 166

Selectively Communicate Information 168

When Should You Compete on Price? 170

Summary 171 • Notes 172

Detailed Table of Contentsx

Chapter 8 Measurement of Price Sensitivity 173

Research Techniques to Supplement Judgment

Types of Measurement Procedures 174

Uncontrolled Studies of Actual Purchases 175

Historical Sales Data 175

Panel Data 176

Store-Level Transaction Data 178

Analyzing Historical Data 179

Experimentally Controlled Studies of Actual

Purchases 181

In-Store Purchase Experiments 181

Laboratory Purchase Experiments 182

Uncontrolled Studies of Preferences and Intentions 185

Direct Questioning 186

Buy-Response Surveys 186

Attribute Rating 186

In-Depth Interviews 189

Experimentally Controlled Studies of Preferences and

Intentions 191

Simulated Purchase Experiments 191

Trade-Off (Conjoint) Analysis 192

Using Measurement Techniques Appropriately 197

Using Judgment for Better Measurement 198

Using Online and Mobile Techniques 200

Outside Sources of Data 200

Selecting the Appropriate Measurement Technique 201

Summary 202 • Notes 204

Chapter 9 Financial Analysis 207

Analyzing Costs and Proﬁ ts for Pricing

Evaluating the Financial Implications of Price

Alternatives 207

Why Incremental Costs? 208

Why Focus on Avoidable Costs? 212

Understanding the Financial Implications of Alternative

Price Levels 213

Evaluating the Potential Proﬁ tability of a Price

Change 214

Breakeven Sales Incorporating a Change in Variable

Costs 218

Breakeven Sales Analysis for Reactive Pricing 219

Mapping a Range of Potential Financial Outcomes 221

Breakeven Sales Curves 223

Detailed Table of Contents xi

Watching Your Baseline 227

Covering Non-Incremental Fixed and Sunk Costs 228

Summary 229 • Notes 229

Appendix 9A 231

Case study

Appendix 9B 238

Derivation of the Breakeven Formula

Chapter 10 Specialized Strategies 240

Adapting Pricing to Accommodate Common

Challenges

Adapting Pricing Strategy over Category

Life Cycle 240

Pricing an Innovation 241

Price Reductions in Growth 244

Pricing the Established Product in Maturity 245

Managing Export Prices in Foreign Currencies 248

Foreign Market Sales Strategy 248

Competitive Impact of Exchange Rate Shifts 250

Four Generic Strategies for Managing Exchange

Rate Price Adjustments 250

Managing Pricing When Markets Slump 253

Creating Economically Efﬁ cient Transfer Prices 255

Summary 259 • Notes 260

Chapter 11 Creating Strategic Pricing Capability 262

Assembling Talent, Processes, and Data to Build

Competitive Advantage

Essential Elements of the Pricing Organization 268

Creating Alignment on Pricing Objectives 270

Matching the Extent of Pricing Centralization with

Organizational Needs 271

Decision Rights Specify Pricing Roles and

Responsibilities 273

Pricing Processes to Ensure Successful Strategy

Implementation 274

Performance Measures and Incentives: Aligning

Sales Incentives with Strategy 276

Systems to Support the Pricing Function 279

Data Needed to Inform the Pricing Function 279

Common Protocols for Creating Relevant

Insights 279

Customer Analytics to Guide Management Choices 280

Analysis of Win–Loss Data 280

Detailed Table of Contentsxii

Customer Proﬁ tability and Cost to Serve 281

Process Management Analytics 283

Price Bands 283

Price Waterfalls 284

Pricing Systems 286

Managing the Organizational Change Process 288

Senior Management Leadership 289

Demonstration Projects 289

Summary 290 • Notes 291

Chapter 12 Ethics and the Law 293

Understanding the Constraints on Pricing

Ethical Constraints on Pricing 293

The Legal Framework for Pricing 296

The Effect of Sarbanes–Oxley on Pricing Practices 297

Price Fixing or Price Encouragement 298

Horizontal Price Fixing 299

Resale Price Fixing or Encouragement 299

Vertical Price Fixing 299

Direct Dealing Programs 301

Resale Price Encouragement 301

Price and Promotional Discrimination 302

Price Discrimination 303

Defenses to Price Discrimination 304

Promotional Discrimination 305

Competitive Injury, Defenses, and Indirect

Purchasers 306

Using Non-Price Variables to Support Pricing Goals 306

Vertical Non-Price Restrictions 306

Non-Price Incentives 308

Other Pricing Issues 308

Predatory Pricing 308

Price Signaling 309

Summary 309 • Notes 310

PREFACE

Since the ﬁ rst edition of this book over 30 years ago, our goal has been to rebut

the common misperception that pricing is an afterthought to a growth strategy:

a simple process of calculating the “right” price for a product or transaction.

Over those years, both marketing practitioners and academics have largely

come to recognize that a proﬁ table pricing strategy requires proactively man-

aging much more than just price. It requires thoughtful and proactive manage-

ment of choices about what to offer, how information about price and value

is communicated, perceptions created in the process of price negotiation, and

choices about when, where, and how to compete for market share. Today lead-

ing organizations are leveraging the principles of strategic pricing described in

this book to actively inﬂ uence willingness-to-pay. They are, in effect, shifting

demand curves as opposed to just reacting to them.

To inﬂ uence demand and willingness-to-pay, proﬁ table pricing requires

looking beneath simple concepts like demand and demand elasticity to under-

stand and manage the perceptions of monetary and psychological value that

motivate purchase decisions. Mastering the value proposition enables a ﬁ rm

(i) to segment prices to reﬂ ect differences in value and cost; (ii) to commu-

nicate the value of its offers to customers unfamiliar with the market; and

(iii) to create pricing policies for managing pricing issues fairly and consis-

tently. In short, this book shows managers how to move from tactically “opti-

mizing” prices in markets where they seemingly exercise little control to

managing the market strategically. When that happens, pricing becomes an

integral part of a strategy to grow proﬁ tably , rather than just a blunt instrument

to drive sales and market share.

The principles of strategic pricing, which were foreign to most business

practitioners when the ﬁ rst edition of this book was published more than three

decades ago, are now more widely accepted in principle. However, most com-

panies still struggle with their application. The changes in this sixth edition of

our book reﬂ ect our attempts to address this need:

• To help our readers better conceptualize the range of interrelated tasks

involved in strategic pricing, we have organized this edition around a

“value cascade” that organizes those tasks into six distinct categories.

• The ﬁ eld of behavioral economics has absolutely exploded since the ﬁ rst

edition of this book and has gained more widespread acceptance; the

chapter on “Price and Value Communication: Strategies to Inﬂ uence

Willingness-to-Pay” highlights several of the behavioral economic prin-

ciples that are particularly important to consider when proactively man-

aging prices and value perceptions.

• We have substantially revised the chapter on “Price Level: Setting the

Prices That Capture a Share of the Value Created” to present a robust

process for determining appropriate price levels. The chapter reﬂ ects

the reality that companies in only a few markets (e.g., online retailing)

can map their demand, and its changes over time, with sufﬁ cient accu-

racy to set the “best” price exactly. Our approach now describes how

Prefacexiv

to assemble data and process information to support a cross-functional

dialogue that arrives at “good” price decisions based upon thoughtfully

weighing the information at hand.

• The chapter on “Price Competition: Managing Conﬂ ict Thoughtfully”

provides an in-depth understanding of value-destroying price wars,

how to mitigate the damage of a price war, and perhaps most impor-

tant, how to minimize the chances of provoking destructive responses to

one’s own pricing decisions.

• The chapter on “Specialized Strategies: Adapting Pricing to Accommo-

date Common Challenges” has been added to address some of the more

technical issues that managers might encounter such as managing pric-

ing over a product lifecycle, addressing foreign exchange risks, how to

act when a market slumps, and managing transfer prices between inde-

pendent proﬁ t centers.

• A completely rewritten chapter on “Creating a Strategic Pricing Capabil-

ity” describes the process for transforming an organization to one that

embeds the principles of value-based strategic pricing into the processes

and incentives of the organization.

• Throughout this edition, we have updated examples to illustrate more

current pricing challenges, new revenue models enabled by our increas-

ingly digital economy, and advances in the study of buyer decision

making. At the same time, we have also retained a number of “classic”

examples that contain lessons that remain highly relevant and applicable

today.

As with prior editions, the primary objective of this book is to develop a practi-

cal and readable manager’s guide to pricing. Professors will be happy to learn

that we have updated the Instructor’s Manual for this edition to include new

exercises, mini-cases, and examination questions. We also provide a link to

Deloitte’s Polaris analytical pricing software to allow students to put theory

into practice by exploring real-world scenarios.

ACKNOWLEDGMENTS

Over the years the book has beneﬁ ted from the inﬂ uence and efforts of indi-

viduals too numerous to mention here. Nevertheless, we would be remiss

not to acknowledge a few whose contributions have either been very large or

new to this edition. Professor Gerald Smith’s contributions to the prior edi-

tions of this book and the instructor’s manuals are still reﬂ ected in the current

ones. Professor Mark Bergen was an invaluable sounding board and source

of inspiration in developing portions of this book. Michael Goldberg was a

diligent researcher, copy editor, and administrator, without whose persistent

prodding this edition would still be “in process.” Junaid Qureshi drew on his

expertise of the gaming industry to develop a very compelling overview of

the evolution of pricing models for video games to augment the chapter on

“Price Structure: Tactics for Pricing Differently Across Customer Segments.”

Eugene Zelek, together with his colleague, Lauren Berheide, of Freeborn &

Peters once again shared his knowledge of pricing and the law to keep that

chapter current. We would also like to thank our colleagues at Deloitte Con-

sulting who have supported our efforts. Laura McGoff, Liz Lee, and Anusha

Singuluri were tremendous in helping us obtain reprint permissions, creating

the exhibits, and ensuring that we fulﬁ lled all requirements of our ﬁ rm. Lisa

Iliff provided a careful and thoughtful review of the ﬁ nal manuscript and Josh

Skwarczyk tracked down references and citations to support our narrative. In

addition, we had the good fortune of working with our editors at Routledge,

where Sharon Golan, acquisitions editor, and Erin Arata, editorial assistant,

were very thoughtful and exhibited great patience in guiding us to the end

product.

Finally, Tom Nagle would like to thank his wife, Leslie, for her patience

and diligent copy editing which she has generously provided through 32 years

of marriage and six editions of this book. Georg Müller thanks his wife Kathy

and son Oskar for their unwavering support and encouragement while he

spent his evenings and weekends writing and developing this book.

NOTE

This publication contains general information only and is based on the experi-

ences and research of Deloitte practitioners. Deloitte is not, by means of this

publication, rendering accounting, business, ﬁ nancial, investment, legal, tax,

or other professional advice or services. This publication is not a substitute

for such professional advice or services, nor should it be used as a basis for

any decision or action that may affect your business. Before making any deci-

sion or taking any action that may affect your business, you should consult a

qualiﬁ ed professional advisor. Deloitte shall not be responsible for any loss

sustained by any person who relies on this publication.

IN-LINE BOXES

Chapter 1: Strategic Pricing

The Story of the Mustang 1 3

Chapter 2: Economic Value

The Problem with Customer Value Modeling 4 6

Chapter 4: Price Structure

Evolution of the Price Metric for Mobile Video Games 9 0

Value-Based Pricing Finances Hamlet’s Castle 9 3

Chapter 6: Price Level

Factors That Inﬂ uence Price Sensitivity 147

Chapter 7: Price Competition

Market-Share Myth 154

Chapter 8: Measurement of Price Sensitivity

Using Panel Data to Measure the Impact of Promotion on Choice 177

Measuring Price Sensitivity for e-Books 184

Purchase Probability Curves: A Simple Buy-Response Study—

Opportunity for a Higher Price 187

A Conjoint Study: Blue Sky Ski Company 194

Chapter 11: Creating a Strategic Pricing Capability

Assessing the Maturity of the Pricing Organization 266

Exploring New Ways to Manage a Price Increase: Lessons from Netﬂ ix 270

Creating a Sales Incentive to Drive Proﬁ t 278

EXHIBITS

1-1 Breakeven Sales Curve Associated with Different

Price Changes 9

1-2 The Value Cascade: Strategic Pricing Requires Effective

Management of Both Value and Price 11

1-3 Value-Based Pricing Involves Offering Customers “Good Value” 13

2-1 Economic Value Estimation (EVE

) Model 29

2-2 Non-Normalized Reference Price Data 32

2-3 Normalized Reference Data 33

2-4 Examples of Value Driver Algorithms for

Equipment Manufacturer 35

2-5 Monetary Value Estimation for Dyna-Test Industrial Buyers 38

2-6 Monetary Value Estimation for Dyna-Test Academic

and Government Buyers 39

2-7 Monetary Value Proﬁ le for Dyna-Test 40

2-8 Impact of Warranty Length on Willingness-to-Pay 43

2-9 Difference in Willingness-to-Pay and Market

Potential by Segment 44

2-10 Primary and Secondary Segmentation: Catalog

Printing Industry 52

2-11 Characteristics of Three Printer Customer Segments 53

3-1 Purchase Involvement and Beneﬁ t Types for Products

and Services 59

3-2 Economic Value Messages for Low-Involvement Goods 61

3-3 Spreadsheet Value Communication Tool 63

3-4 Distribution of Value Across the Organization 73

4-1 The Incremental Contribution from Segmented Price Structure 77

4-2 Segmented Price Structure in Airlines 81

4-3 Revenue Optimizing Subscription Pricing by Segment 82

4-4 Criteria for Evaluating Pricing Metrics 86

4-5 Hosted Call Center Software 88

4-6 Step-Price Schedule for Electricity 101

5-1 Typical Capabilities of Purchasing Versus Sales 109

5-2 Cycle of Reactive Price Negotiation 115

5-3 Cycle of Proactive Policy-Based Price Negotiation 117

5-4 Buyer Types 119

6-1 The Six-Step Process for Setting Prices 135

6-2 Illustration of the Reasonable Price Range 136

6-3 Constant Proﬁ t Curve Associated with Different Price Changes 144

6-4 Breakeven Sales Changes Required Given Different

Contribution Margins 145

7-1 Thoughtfully Reacting to Price Competition 160

8-1 Techniques for Measuring Price Sensitivity 174

8-2 Regression Analysis Results 178

8-3 Use of Regression Analysis 181

8-4 e-Books: Purchase Rate by Price 185

8-5 Purchase Probability Curve for Financial Software 187

Exhibitsxx

8-6 Total Revenue Estimate for Financial Software 188

8-7 Analysis of Youth-Seeking “Innovators” Segment 195

8-8 Effect of Warranty on Take Rate 196

9-1 Analysis of Music Festival Revenue Options 211

9-2 Finding the Breakeven Sales Change 216

9-3 Breakeven Sales Analysis and Simulated Scenarios: Westside

Manufacturing’s Proposed 5 Percent Price Reduction 221

9-4 Breakeven Analysis of a Price Change 222

9-5 Breakeven Sales Curve Calculations (with Incremental

Fixed Costs) 224

9-6 Breakeven Sales Curve: Trade-Off Between Price and Sales

Volume Required for Constant Proﬁ tability 225

9-7 Breakeven Sales Curve: Relationship Between Price Elasticity

of Demand and Proﬁ tability 226

9-8 Breakeven Sales Curve: Relationship Between Price Elasticity

of Demand and Proﬁ tability: Changes in Proﬁ t with More

Inelastic Demand 227

9A-1 Cost Projection for Proposed Crop of Mums 231

9A-2 Relevant Cost of Mums 232

9A-3 Breakeven Sales Changes for Proposed Price Changes 233

9A-4 Breakeven Sales Change Simulated Scenarios

(Vertical Orientation) 234

9A-5 Proﬁ t Impact of a 10 Percent Increase 236

9B-1 Breakeven Sales Change Relationships 238

10-1 Sales and Proﬁ ts Over the Product’s Life, from

Inception to Demise 241

10-2 Alternative Strategic Choices for Foreign Market Sales 249

10-3 Stratagies for Managing Foreign Exchange Rate Adjustments 251

10-4 Inefﬁ ciencies in Transfer Pricing 256

10-5 Efﬁ ciency from Cost Integration 257

11-1 Archetypal Pricing Organizations 263

11-2 Operating Proﬁ t Relative to Industry Peers 264

11-3 The Foundation for a Strategic Pricing Capability 266

11-4 Assessing Each Element of the Value Cascade 267

11-5 Pricing Structure Archetypes 272

11-6 Types of Decision Rights 273

11-7 Map of Decision-Making Process for a

Manufacturing Company 275

11-8 Illustrative Data Sources for Pricing Analytics 280

11-9 Customer Proﬁ tability Map 282

11-10 Customer Proﬁ tability by Peer Group 282

11-11 Price Band Analysis 283

11-12 Price Waterfall Analysis 285

12-1 When Is Price Ethical? Ethical Constraints 294

CHAPTER 1

Strategic Pricing

Coordinating the Drivers of Proﬁ tability

If you have to have a prayer session before raising the price by 10 percent, then

you’ve got a terrible business.

Warren Buffet

Marketing consists of four key elements: The product, its promotion, its

placement or distribution, and its price. The ﬁ rst three elements—product,

promotion, and placement—comprise a ﬁ rm’s effort to create value in the

marketplace. The last element—pricing—differs essentially from the other

three: It represents the ﬁ rm’s attempt to capture some of the value in the proﬁ t

it earns. If effective product development, promotion, and placement sow the

seeds of business success, effective pricing is the harvest. Although effective

pricing can never compensate for poor execution of the ﬁ rst three elements,

ineffective pricing can surely prevent those efforts from resulting in ﬁ nancial

success. Regrettably, this is a common occurrence.

Complicating matters, the ability to harvest potential proﬁ ts is in a con-

tinuous state of ﬂ ux as technology, regulation, market information, consumer

preferences, or relative costs change. Consequently, companies that expect to

grow proﬁ tably in changing markets often need to break old rules, includ-

ing those that govern how they will set prices to earn revenues. Our interest

in strategic pricing dates back to when the telecommunications industry was

deregulated in most developed countries and new suppliers recognized that

they could gain both market share and proﬁ tability by replacing the then pre-

vailing price-per-minute revenue models with more innovative models—ﬁ rst

including a price per month for a bundle of “peak” minutes plus “free” off-

peak time. Later, they introduced “family plans” involving the sharing of min-

utes across numbers. Similarly, Apple quickly went from nothing to market

leadership in music sales, in large part because, after the internet slashed the

cost of distribution, it was the ﬁ rst to recognize that it was better to price music

by the song than by the album. And at the time of writing this edition, the

predominant revenue model for music is shifting yet again, with subscription-

based streaming services such as Spotify and Apple Music

overtaking digital

Chapter 1 • Strategic Pricing2

music store sales.

Producers of new online media created a new metric for

pricing ads—cost per click—that aligned the cost of an ad more closely to its

value than was possible in traditional print media. Even governments have

begun to use prices, often called “user fees,” instead of taxes to raise revenues

and better allocate scarce resources. Congested cities, such as London and

Singapore, charge to drive a car into congested areas during peak times and

highways in major U.S. cities such as Atlanta and Minneapolis increasingly

have express lanes that are kept moving even during rush hours by adjusting

a wirelessly collected price to access them.

Unfortunately, few managers, even those in marketing, have been trained

in how to develop innovative pricing strategies such as these. Most companies

still make pricing decisions in reaction to change rather than in anticipation of

it. This is unfortunate, given that the need for rapid and thoughtful adaptations

to changing markets has never been greater. The information revolution has

made prices everywhere more transparent and customers more price aware.

The globalization of markets, even for services, has increased the number of

competitors and often lowered their cost of sales. The high rate of technologi-

cal change in many industries has created new sources of value for customers,

but not necessarily led to increases in proﬁ t for the producers.

Improvements in technology have driven an explosion of data that

some suppliers are using to target customers they can serve more proﬁ tably:

Either because those customers are more willing to pay for the differentiation

the company can offer or because the company can meet their needs more

cost-effectively than competitors. This is especially true of consumer goods,

where manufacturers used to operate with only minimal and long-delayed

data on where and how well their products were selling in retail stores, and

pricing involved negotiating “trade promotions” with channel intermediar-

ies that may or may not have passed the savings on to end consumers. Now,

with the ability to buy almost “real time” data on how individual package

sizes are selling in types of outlets and in speciﬁ c geographies, manufactur-

ers are able to develop more sophisticated pricing strategies to target speciﬁ c

types of customers and competitors. At the extreme, many retailers charge

online shoppers different prices or offer them different product assortments

based on the type of device they are using to access the site, with the theory

that the type of device can signal a systematic difference in willingness-

to-pay.

LEVERAGING PROFIT INTO SUSTAINABLE GROWTH

Learning to make sales more proﬁ tably is the key to achieving sustainable

growth in revenue, market share, and company value over the long haul.

When the ﬁ rst edition of this book was published more than three decades

ago, the idea that proﬁ t margins should be prioritized over growth was seen as

short-sighted. A 1975 study conducted at the Harvard Business School using

the PIMS (which originally stood for Proﬁ t Impact of Market Share) database

of historical market performance of leading global companies reported a

strong, consistently positive, correlation between a company’s market share

and its relative proﬁ tability within an industry.

In the Harvard Business Review

article discussing this study, the authors proposed multiple plausible reasons

why a larger market share could enable a company to operate more proﬁ tably.

Chapter 1 • Strategic Pricing 3

That led to an explosion of literature by marketing theorists and leading con-

sultancies advocating aggressively low pricing as an “investment” in growth

that would eventually create “cash cows”—exceptionally proﬁ table revenue

streams requiring little investment to maintain them.

Unfortunately, companies that adopted this approach to pricing, more

often than not, found the theory and the eventual proﬁ tability it promised

lacking. As the PIMS database grew to cover multiple years, more nuanced

relationships were revealed. Although a cross-sectional correlation between

market share and proﬁ tability proved durable, how a company invested to

grow was shown to be a better predictor of ﬁ nancial success. Consequently,

the PIMS organization cleverly redeﬁ ned their acronym to stand for Proﬁ t

Impact of Marketing Strategy.

More recent research by Deloitte Consulting LLP has brought further

clarity to the relationship between growth and proﬁ tability. Deloitte compiled

a time-series dataset of 394 companies, covering the period from 1970 to 2013

with exceptional, mediocre and poor performers matched by industry. The

researchers deﬁ ned “exceptional performance” as a company achieving supe-

rior proﬁ tability (return on assets), stock value, and revenue growth for more

than a decade and sought to understand how a small minority of ﬁ rms man-

age to achieve it. Their conclusion:

a [near term] focus on proﬁ tability, rather than revenue growth or [stock]

value creation, offers a surer path to enduring exceptional performance.

So how do marketing and ﬁ nancial managers at exceptional companies achieve

sustainable exceptional proﬁ tability? It is not the result of slashing overheads

more ruthlessly than their competitors. In fact, Deloitte’s data indicates that

exceptional performers tend to spend a bit more than competitors (as a percent

of sales) on R&D and SG&A. Their exceptional proﬁ tability and, eventually,

exceptional stock valuations are built on higher margins per sale that fund

initiatives to grow revenues without compromising those margins.

Unfortunately, many companies fail to understand that making sales

proﬁ tably should be the ﬁ rst priority—not an afterthought—of a strategy for

driving growth. Creating and communicating superior value propositions or

ﬁ nding a way to deliver superior value at lower cost is a precondition to sus-

tainable revenue growth. Many years of experience have taught us that apply-

ing the principles explained in these pages is necessary to make sales more

proﬁ table and at least equal with the best in the industry.

The difference between successful and unsuccessful pricers lies in how

they approach the process. To achieve superior, sustainable proﬁ tability, pric-

ing must become an integral part of strategy. Strategic pricers do not ask,

“What prices do we need to cover our costs and earn a proﬁ t?” Rather, they

ask, “What costs can we afford to incur, given the prices achievable in the

market, and still earn a proﬁ t?” Strategic pricers do not ask, “What price is

this customer willing to pay?” but “What is our product worth to this cus-

tomer and how can we better communicate that value, thus justifying the

price?” When value doesn’t justify price to some customers, strategic pricers

do not surreptitiously discount. Instead, they consider how they can segment

the market with different products or distribution channels to serve these

customers without undermining the perceived value to other customers. And

strategic pricers never ask, “What prices do we need to meet our sales or

Chapter 1 • Strategic Pricing4

market share objectives?” Instead they ask, “What level of sales or market

share can we most proﬁ tably achieve?”

Strategic pricing often requires more than just a change in attitude; it

requires a change in when, how, and who makes pricing decisions. For exam-

ple, strategic pricing requires anticipating price levels before beginning prod-

uct development. It requires determining the economic value of a product or

service, which depends on the alternatives customers have available to sat-

isfy the same need. We go into much more depth on the concept of Economic

Value Estimation (EVE

) in Chapter 2. The only way to ensure proﬁ table pric-

ing is to reject early those ideas for which adequate value cannot be captured

to justify the cost.

Strategic pricing also requires that management take responsibility for

establishing a coherent set of pricing policies and procedures, consistent with

the company’s strategic goals. Abdicating responsibility for pricing to the sales

force or to the distribution channel is abdicating responsibility for the strategic

direction of the business.

Perhaps most important, strategic pricing requires a new relationship

between marketing and ﬁ nance because pricing involves ﬁ nding a balance

between the customer’s desire to obtain good value and the ﬁ rm’s need to

cover costs and earn proﬁ ts. Unfortunately, pricing at most companies is char-

acterized more by conﬂ ict than by balance between these objectives. If pricing

is to reﬂ ect the value to the customer, speciﬁ c prices must be set by those best

able to anticipate that value—presumably marketing and sales managers. The

problem is that their efforts will not generate substantial proﬁ ts unless con-

strained by appropriate ﬁ nancial objectives. Rather than attempting to “cover

costs,” ﬁ nance must learn how costs change with shifts in sales volume and

use that knowledge to develop appropriate incentives for marketing and sales

to achieve their objectives.

With their respective roles appropriately deﬁ ned, marketing and ﬁ nance

can work together toward a common goal—to achieve proﬁ tability through

strategic pricing.

Before marketing and sales can attain this goal, however, managers in

all functional areas must discard the ﬂ awed thinking about pricing that fre-

quently leads them into conﬂ ict and that drives them to make unproﬁ table

decisions. Let’s look at these ﬂ awed paradigms so that you can recognize them

and understand why you need to let them go.

COST-PLUS PRICING

Cost-plus pricing is, historically, the most common pricing procedure because

it carries an aura of ﬁ nancial prudence. Financial prudence, according to this

view, is achieved by pricing every product or service to yield a fair return over

all costs, fully and fairly allocated. In theory, it is a simple guide to proﬁ tabil-

ity; in practice, it is a blueprint for mediocre ﬁ nancial performance.

The problem with cost-driven pricing is fundamental: In most industries,

it is impossible to determine a product’s unit cost before determining its price.

Why? Because unit costs change with volume. This cost change occurs because

a signiﬁ cant portion of costs are “ﬁ xed” and must somehow be “allocated” to

determine the full unit cost. Unfortunately, because these allocations depend

on volume, and volume changes as prices change, unit cost is a moving target.

Chapter 1 • Strategic Pricing 5

To solve the problem of determining unit cost before determining

price, cost-based pricers are forced to assume a level of sales volume and then

to make the absurd assumption that they can set price without affecting that

volume. The failure to account for the effects of price on volume, and of vol-

ume on costs, leads managers directly into pricing decisions that undermine

proﬁ ts. A price increase to cover higher ﬁ xed costs can start a death spiral in

which higher prices reduce sales and raise average unit costs further, indicat-

ing (according to cost-plus theory) that prices should be raised even higher.

On the other hand, if sales are higher than expected, ﬁ xed costs are spread

over more units, allowing average unit costs to decline a lot. According to

cost-plus theory, that would call for lower prices. Cost-plus pricing leads to

overpricing in weak markets and underpricing in strong ones—exactly the

opposite direction of a prudent strategy.

How, then, should managers deal with the problem of pricing to cover

ﬁ xed costs? They shouldn’t. The question itself reﬂ ects an erroneous percep-

tion of the role of pricing, a perception based on the belief that one can ﬁ rst

determine sales levels, then calculate unit cost and proﬁ t objectives, and then

set a price. Once managers realize that sales volume (the beginning assump-

tion) depends on price (the end of the process), the ﬂ awed circularity of cost-

based pricing is obvious. The only way to ensure proﬁ table pricing is to let

anticipated pricing determine the costs incurred rather that the other way

around. Value-based pricing must begin before investments are made using a

process that we will describe later in this chapter.

CUSTOMER-DRIVEN PRICING

Many companies now recognize the fallacy of cost-based pricing and its

adverse effect on proﬁ t. They realize the need for pricing to reﬂ ect market

conditions. As a result, some ﬁ rms have taken pricing authority away from

ﬁ nancial managers and given it to sales or product managers. In theory, this

trend is consistent with value-based pricing, since marketing and sales are that

part of the organization best positioned to understand value to the customer.

In practice, however, their misuse of pricing to achieve short-term sales objec-

tives often undermines perceived value and depresses future proﬁ tability.

The purpose of strategic pricing is not simply to create satisﬁ ed custom-

ers. Customer satisfaction can usually be bought by a combination of overdeliv-

ering on value and underpricing products. But marketers delude themselves if

they believe that the resulting increases in sales represent marketing successes.

The purpose of strategic pricing is to price more proﬁ tably by capturing more

value, not necessarily by making more sales. When marketers confuse the ﬁ rst

objective with the second, they fall into the trap of pricing at whatever buyers

are willing to pay, rather than at what the product is really worth. Although

that decision may enable marketing and sales managers to meet their sales

objectives, it invariably undermines long-term proﬁ tability.

Two problems arise when prices reﬂ ect the amount buyers seem will-

ing to pay. First, sophisticated buyers are rarely honest about how much they

are actually willing to pay for a product. Professional purchasing agents are

adept at concealing the true value of a product to their organizations. Once

buyers learn that sellers’ prices are reactively ﬂ exible, they have a ﬁ nancial

incentive to conceal information from, and even mislead, sellers. Obviously,

Chapter 1 • Strategic Pricing6

this undermines the salesperson’s ability to establish close relationships with

customers and to understand their needs.

Second, there is an even more fundamental problem with pricing to

reﬂ ect customers’ willingness-to-pay. The job of sales and marketing is not

simply to process orders at whatever price customers are currently willing

to pay, but rather to raise customers’ willingness-to-pay to a level that better

reﬂ ects the product’s true value. Many companies underprice truly innova-

tive products because they ask potential customers, who lack prior experi-

ence from which to judge the product’s value, what they would be willing to

pay for it. But we know from studies of innovations that the price has little

impact on whether customers are willing to try them.

For example, most

customers initially perceived that photocopiers, mainframe computers, home

air conditioners, and MP3 players lacked adequate value to justify purchase

at viable prices. Only after trial by a small subset of “innovator” customers,

followed by extensive marketing to communicate and guarantee value to a

broader market, did these products achieve market acceptance. Forget what

customers who have never used your product are initially willing to pay.

Instead, understand what the value of the product could be for satisﬁ ed cus-

tomers, communicate that value to the currently uninformed, and set prices

accordingly. Low pricing is always a poor substitute for an inadequate mar-

keting and sales effort.

SHARE-DRIVEN PRICING

Finally, consider the policy of letting pricing be dictated by competitive con-

ditions. In this view, pricing is a tool to achieve gains in market share. In the

minds of some managers, this method is “pricing strategically.” Actually, it

is more analogous to “letting the tail wag the dog.” Occasionally, network-

ing effects make a product or service more valuable when other people are

patronizing the same brand, as was the case for example with eBay, the online

marketplace. In most cases, however, there is no reason why an organization

should seek to achieve market share as an end in itself.

Although cutting price is probably the quickest, most effective way to

achieve sales objectives, it is usually a poor decision ﬁ nancially. Because a

price cut can be so easily matched, it offers only a short-term market advan-

tage at the expense of permanently lower margins. Consequently, unless

a company has good reason to believe that its competitors cannot match a

price cut, the long-term cost of using price as a competitive weapon usually

exceeds any short-term beneﬁ t. Although product differentiation, advertis-

ing, and improved distribution do not increase sales as quickly as price cuts,

their beneﬁ t is more sustainable and thus is usually more cost-effective in

the long run.

The goal of pricing should be to ﬁ nd the combination of margin and

market share that maximizes proﬁ tability over the long term. Sometimes,

the most proﬁ table price is one that substantially restricts market share rela-

tive to the competition. Godiva chocolates, Apple iPhones

, Peterbilt trucks,

and Snap-on tools would no doubt all gain substantial market share if priced

closer to the competition. It is doubtful, however, that the added share

would be worth forgoing their proﬁ table and successful positioning as high-

priced brands.

Chapter 1 • Strategic Pricing 7

Strategic pricing requires making informed trade-offs between price

and volume in order to maximize proﬁ ts. These trade-offs come in two forms.

The ﬁ rst trade-off involves the willingness to lower price to exploit a market

opportunity to drive volume. Cost-plus pricers are often reluctant to exploit

these opportunities because they reduce the average contribution margin

across the product line, giving the appearance that it is underperforming rela-

tive to other products. But if the opportunity for incremental volume is large

and well targeted, a lower contribution margin can actually drive a higher

total proﬁ t. The second trade-off involves the willingness to give up volume

by raising prices. Competitor- and customer-oriented pricers ﬁ nd it very difﬁ -

cult to hold the line on price increases in the face of a lost deal or reduced vol-

ume. Yet the economics of a price increase can be compelling. For example, a

product with a 30 percent contribution margin could lose up to 25 percent of

its volume following a 10 percent price increase before that move results in

lower proﬁ tability.

Effective managers of pricing regularly evaluate the balance between

proﬁ tability and market share and are willing to make hard decisions when

the balance tips too far in one direction. (We will show you how to make such

calculations later in this book). Key to making those managers effective, how-

ever, is performance measures and incentives that reward them for improving

proﬁ tability, not just revenue.

THE ROLE OF “OPTIMIZING” IN STRATEGIC PRICING

Economic theorists propose pricing based upon estimating the demand

curve for a product and then “optimizing” the price level, given the incre-

mental cost of production. In theory, this is totally consistent with the approach

we propose in this book, but in practice it is almost always impractical. The

reason lies in the assumption that a demand curve is something stable that

one can measure with sufﬁ cient speed and accuracy to continually optimize

it. Contrary to the assumptions that economists make when studying mar-

kets, the demand for individual products or brands within markets is rarely

stable or easily measured. The reason: Sensitivity to price depends as much on

ever-changing purchase contexts and perceptions as on underlying needs or

preferences. For example, contradicting the assumption of a demand curve,

the amount of a product that customers will buy at a particular price point is

strongly affected by the prices they paid recently. When gasoline prices are

rising, the demand for premium grades of gasoline will fall quickly by a much

greater percentage than demand for regular grades. But when prices decline

back to where they started, demand for premium grades will not recover

quickly. That is, demand when prices are going up is generally much more

“price elastic” than when prices are coming down.

More importantly, behavioral economics research over the past few

decades has proven conclusively that differences in how prices are presented

and the surrounding context can lead buyers to respond in ways that are

inconsistent with the idea of a stable demand curve that reﬂ ects ﬁ xed prefer-

ences.

For example, if one adds a higher priced product to the choices avail-

able in a store—say a “best” version to go along with a “good” and a “better”

version—economic theory would predict that the higher-priced “best” version

would primarily draw sales from the mid-priced “better” version, which turns

Chapter 1 • Strategic Pricing8

out to be true. What it does not predict is that the mid-priced version will at

the same time gain sales at the expense of the cheapest version even though

the prices of those two versions remain unchanged.

To add to the instabil-

ity, we know that the demand for the mid-price product will be greater if

the offers are presented beginning from the top down rather than from the

bottom up.

These examples illustrate just a few of the effects that appear to shift

demand curves in ways that are contextual. Still, one cannot deny the fact

that the proﬁ tability of a price increase will depend upon whether the loss

in sales is not too great, while the proﬁ tability of a price decrease depends

upon whether the gain in sales is great enough. Economists refer to the actual

percentage change in sales divided by the percentage change in price as the

price elasticity of demand. Actual elasticity depends in part upon how effectively

marketers manage customer perceptions and the purchase context, as you will

come to see in the following chapters. Moreover, many factors that inﬂ uence

price elasticity are not under the marketer’s control, making precise estimates

of actual price elasticity very difﬁ cult and only rarely cost effective. Conse-

quently, we have found that instead of asking “What is price elasticity for this

product?” it is often more practical and useful to ask “What is the minimum

elasticity that would be necessary to justify a particular price change?” that

has been proposed to achieve some business objective. To put the question in

less technical jargon, we ask “What percent change in sales would be neces-

sary (which is the same as asking what price elasticity would be necessary) for

a proposed price change to maintain the same total proﬁ t contribution after a

price change?” We refer to the answer as the breakeven sales change associated

with a proposed price change.

If we create a graph of breakeven sales changes associated with different

potential price changes, we can create a breakeven sales curve that looks much

like a demand curve, as shown in Exhibit 1-1, which shows the example of a

product that earns a 45 percent gross margin at a baseline price of $10. It is a

representation of how much demand is needed to maintain current proﬁ tability

as prices change. If actual demand proves to be less elastic (steeper) than the

breakeven sales curve, then higher prices will be more proﬁ table. If the actual

demand proves to be less steep (more elastic) than the breakeven sales curve,

then lower prices will be more proﬁ table. Technical details about how to cal-

culate a correct breakeven sales change for any particular product and pricing

decision are described in Chapter 9.

None of this implies that research to understand demand price elasticity

is not valuable. We are simply observing that, given the usual instability of

demand estimates over the time period required to make them, attempting to

improve proﬁ tability by exactly “optimizing” price levels is usually not prac-

tical. What is valuable is research to understand how differences in identiﬁ -

able purchase contexts (e.g., online versus in-store purchases, standard versus

rush orders) or how marketing strategies to inﬂ uence perceptions of value can

inﬂ uence demand elasticity. Research is also useful when developing offers

to understand the relative impact of different features and services that one

might offer on perceived value.

Finally, we should acknowledge that it is possible in a small number of

markets to measure demand price elasticity accurately in real time, enabling

mangers to track the effect of changes ranging from the weather to the daily

Chapter 1 • Strategic Pricing 9

news, to the time of day can have on them. Consumer packaged goods compa-

nies can purchase huge quantities of scanner-recorded sales data from retail

stores, far more than would ever be practical to generate from market research.

They can then build “big data” statistical models that use such data to measure

price elasticity as precisely as possible by measuring and controlling for many

contextual factors (such as alternatives available in the store and their prices,

the time of day and day of week, the size of the customers total purchase, the

store location) that can inﬂ uence it. In these cases, the effort to make small

price adjustments to optimize proﬁ tability have proven worthwhile.

WHAT IS STRATEGIC PRICING?

As you probably remember from basic economics, the optimal price one can

charge is limited by the demand curve: A summary of what customers are

willing to pay to buy various quantities of volume. Pricing, given the assump-

tions of economics, is simply about optimizing the price level given that

demand. In reality, however, demand for most products and services is not

given. It is created, sometimes thoughtfully and sometimes haphazardly, by

decisions that sellers make about what to offer their customers, how to com-

municate their offers, how to price differently across customers or applications

and how to manage customer price expectations and incentives. Making these

decisions thoughtfully and implementing them effectively to maximize proﬁ t-

ability is what we call “strategic pricing.”

The word “strategic” is used in various contexts to imply different things.

Here, we use it to mean the coordination of otherwise independent activities to

EXHIBIT 1-1

Breakeven Sales Curve Associated with Different Price Changes

Chapter 1 • Strategic Pricing10

achieve a common objective. For strategic pricing, the objective is sustainable

proﬁ tability. Achieving exceptional proﬁ tability requires making thoughtful

decisions about much more than just price levels. It requires ensuring that

products and services include just those features that customers are willing to

pay for, without those that unnecessarily drive up cost by more than they add

to value. It requires translating the differentiated beneﬁ ts your company offers

into customer perceptions of a fair price premium for those beneﬁ ts. It requires

creativity in how you collect revenues so that customers who get more value

from your differentiation pay more for it. It requires varying price to use ﬁ xed

costs optimally and to discourage customer behaviors that drive excessive ser-

vice costs. It sometimes requires building capabilities to mitigate the behavior

of aggressive competitors.

Although different strategies can achieve proﬁ table results even within

the same industry, nearly all successful pricing strategies embody three prin-

ciples. They are value-based, proactive, and proﬁ t-driven:

• Value-based means that differences in pricing across customers or appli-

cations reﬂ ect differences in the value to customers. For example, many

managers ask whether they should lower prices in response to reduced

market demand during a recession. The answer: If customers receive less

value from your product or service because of the recession, then prices

should reﬂ ect that. But the fact that fewer customers are in the market

for your product does not necessarily imply that those who remain value

it less than when they were more numerous. Unless a close competitor

has cut its price giving customers a better alternative, there may be no

value-based reason for you to do so.

• Proactive means that companies anticipate disruptive events (for exam-

ple, a new competitive threat or a customer’s decision to award business

via a reverse auction) and develop strategies in advance to deal with

them. For example, anticipating that a recession or a new competitive

entry will cause customers to ask for lower prices, a proactive company

develops a lower-priced service option or a loyalty program, enabling it

to deﬁ ne the terms and trade-offs of the expected interaction, rather than

forcing it to react to terms and trade-offs deﬁ ned by the customer or the

competitor.

• Proﬁ t-driven means that the company evaluates its success at price man-

agement by what it earns relative to alternative investments rather than

by its market share and growth relative to its competitors. When Apple

launched its ﬁ rst iPhone

at $499, commentators accused Apple of over-

pricing (with less-featured competitive phones costing no more than

half as much).

But Apple easily sold its new innovation to a subset of

“techies” and invested to ensure they had a great experience. Then, when

it cut the price to $399, many more buyers saw it as a bargain. Still, com-

petitors have soon launched knock-offs that copy each of Apple’s new

iPhone innovations within a year or so, and smartphones based upon the

Android platform have overtaken those of Apple in unit sales by a wide

margin.

So should Apple be worried? We think not, and neither do

Apple’s investors. With most of its proﬁ ts coming from smartphone sales,

Apple is the most proﬁ table and most valuable company in the world at

the time we are writing this. Moreover, while many of its competitors are

Chapter 1 • Strategic Pricing 11

cutting prices to penetrate large and rapidly growing but lower-income

markets like China, Apple is not. Instead, it is adding more functionality

and building more Apple stores in those markets to ensure that custom-

ers have the same exceptional experience that hooked Apple loyalists

in developed markets, investments it can easily afford given the higher

margins it earns from each buyer.

These three principles will resurface throughout this book as we discuss how

to deﬁ ne and make good choices. Strategic pricing is not a discipline separate

from the rest of marketing strategy; it is rather a set of principles for creating

marketing strategies that drive growth proﬁ tably.

A good pricing strategy involves six distinct but very different choices

that build upon one another. The choices are represented graphically as six

points in what we call the Value Cascade (Exhibit 1-2). The core function of a

successful ﬁ rm is to create value; ﬁ rst and foremost for customers, but also for

the internal constituencies that rely on the ﬁ rm for employment and returns

on investment. Strategic pricing is about managing value, from its creation

through its capture in price setting, in a coordinated way that enables the orga-

nization to achieve a high, sustainable return from its efforts.

The ﬁ rst thing that strikes most people new to the subject of strategic

pricing is that setting a price level is just one step in a multistep process that

impacts the full range of marketing decisions. If the goal of pricing proﬁ tably

EXHIBIT 1-2

The Value Cascade: Strategic Pricing Requires Effective Management

of Both Value and Price

Chapter 1 • Strategic Pricing12

is considered only when price levels are set, then multiple marketing choices

are likely to be made in ways that will dissipate proﬁ t potential (the “gaps” in

our diagram) well before any product or service is offered for sale.

Although this book contains a chapter devoted to addressing each of

these topics individually, it is useful to have an overall vision—a map if you

will—of how and why they ﬁ t together in this particular order. Both managers

and pricing consultants are often called upon to ﬁ x strategies that are generat-

ing poor ﬁ nancial returns despite driving revenues. Consequently, they may

start anywhere on this choice cascade based upon their initial assessment of

the potential for improvement. For our overview, we will follow the order of

the numbers in the exhibit, which reﬂ ect the order in which you would typi-

cally need to address these issues if building the marketing strategy for a new

product or service from scratch.

VALUE CREATION

It is often asserted as a truism that the value of something is whatever someone

will pay for it. We disagree. People sometimes pay for things that soon disappoint

them in use (for example, time-share condominiums). They fail to get “value for

money,” do not repeat the purchase, and discourage others from making the

same mistake. At the other extreme, people are often reluctant to pay any price

for radical new innovations simply because they lack the experience, either their

own or that of someone else whose judgment they trust, from which to judge

the value that the innovation could bring to their lives. For companies trying to

gain share in established markets by creating differentiated product and service

offerings, the challenge is simply to get customers already in the market to pay a

premium price that exceeds the added cost to deliver that differentiation.

Of course, it is sometimes possible to deceive people into making one-

time purchases at prices ultimately proven to be unjustiﬁ ed, but that is not

a viable strategy for an ongoing enterprise, nor is it our agenda in this book.

Our intention is to show marketers how to create value cost-effectively and

convince people to pay prices commensurate with that value. We expect that,

as a result, those of you who apply these ideas will contribute to an economic

system in which ﬁ rms that are more adept at creating value for customers are

most rewarded with higher margins and market value.

Some companies that have exceptional technologies and capabilities with

the potential to create great value fail to convert them into offers that generate

exceptional, or even adequate, proﬁ tability. They make the mistake of believ-

ing that more, from a technological perspective, is necessarily better for the

customer. One of us worked for a company making high-quality ofﬁ ce furni-

ture that was disappointed by its low share in fast-growing, entrepreneurial

markets. The company wanted a strategy to convince those buyers what more

established companies recognized already: That highly durable ofﬁ ce furniture

that would hold its appearance and function for 20 or more years was a good

investment. But it took only a few interviews with buyers in the target mar-

ket to recognize the problem. Companies in this market expected either to be

bought out in ﬁ ve years or be gone. The problem was not that customers did

not recognize the differentiating beneﬁ ts of the company’s products. It was that

the target market saw little value associated with those beneﬁ ts.

Exhibit 1-3 illustrates the ﬂ awed progression of cost-plus pricing and the

necessary progression for value-based pricing. Cost-based pricing is product

Chapter 1 • Strategic Pricing 13

The Story of the Mustang

Product development driven by value-based pricing is still the exception,

but not among the most successful product launches. One early example

of a successful new product built to be a “good value” was a spectacularly

successful car developed at Ford Motor Company. Five decades ago, Ford

regained its footing by building the ﬁ rst sports car to sell at a price point

that middle-class people could afford. From an engineering perspective, it

was not the most technically advanced. From the customers’ perspective,

it represented a better value than anything else in the market. From a sales

and proﬁ t perspective, it was one of the most successful car launches in

history and continues to sell today in its sixth generation.

driven. Engineering and manufacturing departments design and make what

they consider a “good” product. In the process, they make investments that

incur costs to add features and related services. Finance then totals these costs

to determine a “target” price. Only at this stage does marketing enter the pro-

cess, charged with the task of demonstrating enough value in the product to

justify pricing to customers.

If the cost-based price proves unjustiﬁ able, managers may try to ﬁ x

the disappointing sales by allowing “ﬂ exibility” in the price. Although this

tactic may help meet the sales goal, it is not fundamentally a solution to the

problem of pricing proﬁ tably. That problem will arise again as the features

and costs of the new products continue to mismatch the needs and values of

customers.

Solving the problem of product development and costing disconnected

from value to the customer requires more than a simple ﬁ x. It requires a com-

plete reversal of the process. For value-based pricing, the target price is based

on an estimate of value, not costs. The target price then drives decisions about

what costs to incur, rather than the other way around.

EXHIBIT 1-3

Value-Based Pricing Involves Offering Customers “Good Value”

Chapter 1 • Strategic Pricing14

In the early 1960s, America was young, conﬁ dent, and in love with

sports cars. Many popular songs of the era were odes to those cars. Unfor-

tunately for Ford, the cars arousing the greatest passion were made by

other auto manufacturers. Hoping to remedy this situation, Ford set out

to build a sports car that would tempt buyers to its showrooms.

Had Ford followed the traditional approach for developing a new

car, management would have begun the process by sending a memo to

the design department, instructing it to develop a sports car that would

top the competition. Each designer would then have drawn on individ-

ual preconceptions of what makes a good sports car in order to design

bodies, suspensions, and engines that would be better. In a few weeks,

management would have reviewed the designs and picked out the best

prospects. Next, management would have turned those designs over

to the marketing research department. Researchers would have asked

potential customers which they preferred and whether they liked Ford’s

designs better than the competition’s, given prices that would cover their

costs and yield the desired rate of return. The best choice would ulti-

mately have been built and would have evoked the adoration of many,

but it would have been purchased by only the few who could have

afforded it.

Fortunately, Ford had a better idea. Unlike at other companies, the

leading manager in charge of the project was not an expert in ﬁ nance,

accounting, or production. He was a marketer. So Ford did not begin

looking for a new car in the design department. The company began by

researching what customers wanted. Ford found that a large and growing

share of the auto market longed for a sports car, but that most people could

not afford one. Ford also learned that most buyers did not really need much

of what makes a “good” sports car to satisfy their desires. What they craved

was not sports-car performance—requiring a costly engine, drive train,

and suspension—but sports-car excitement—styling, bucket seats, vinyl

trim, and fancy wheel covers. Nobody at the time was selling excitement

at a price that most customers could afford: Less than $2,500.

The challenge for Ford was to design a car that looked sufﬁ ciently

sporty to satisfy most buyers, but without the costly mechanical elements

of a sports car that drove its price out of reach. To meet that challenge,

Ford built its sports car with the mechanical workings of an existing econ-

omy car, the Falcon. Many hard-core sports-car enthusiasts, including

some at Ford, were appalled. The car did not match the technical perfor-

mance of some of its competitors, but it was what many people wanted,

at a price they could afford.

In April 1964, Ford introduced its Mustang sports car at a base price

of $2,368. More Mustangs were sold in the ﬁ rst year than any other car

Ford ever built. In just the ﬁ rst two years, net proﬁ ts from the Mustang

were $1.1 billion in 1964 dollars.* That was far more than any of Ford’s

competitors made selling their “good” sports cars, priced to cover costs

and achieve a target rate of return.

Ford began with the customers, asking what they wanted and what

they were willing to pay for it. Their response determined the price at

which a car would have to sell. Only then did Ford attempt to develop a

Chapter 1 • Strategic Pricing 15

In the last two decades, designing product and service offers that can drive

sales growth at proﬁ table prices has gone in the past two decades from being

unusual to being the goal at most successful companies.

From Marriott to

Boeing, from medical technology to automobiles, proﬁ t-leading companies

now think about what market segment they want a new product to serve,

determine the beneﬁ ts those potential customers seek, and establish target

prices those customers can be convinced to pay. Value-based companies chal-

lenge their engineers to develop products and services that can be produced at

a cost low enough to make serving that market segment proﬁ table at the target

prices. The ﬁ rst companies to successfully implement such a strategy in an

industry gain a huge market advantage. The laggards eventually must learn

how to manage value just to survive.

The key to creating good value is ﬁ rst to estimate how much value differ-

ent combinations of beneﬁ ts could represent to customers, which is normally

the responsibility of marketing or market research. In Chapter 2, we deﬁ ne

more clearly what we mean by “value” and describe ways to estimate it.

VALUE COMMUNICATION

Understanding the value your products create for customers can still result in

poor sales unless customers recognize the value they are obtaining. A success-

ful pricing strategy must justify the prices charged in terms of the value of the

beneﬁ ts provided. Developing price and value communications is one of the

most challenging tasks for marketers because of the wide variety of product

types and communication vehicles.

While much of this book focuses on how to create and measure tangible

economic beneﬁ ts, customers are rarely the rational economic actors portrayed

in traditional economic theory. An exploding ﬁ eld called behavioral econom-

ics has documented a host of anomalies in consumer decision-making that

run counter to the traditional economic principle of utility maximization. For

example, community-held norms around fairness can limit the price a phar-

maceutical ﬁ rm can charge, even if the drug is a life-saver with no viable alter-

natives. Buyers also use mental shortcuts when making decisions, often by

looking for analogous products to evaluate relative value. For this reason,

many consumers view a $30 bottle of wine at a restaurant as a bargain if the

other wines on the menu are priced higher, yet the same $30 bottle will feel

expensive if surrounded by $20 alternatives.

product that could satisfy potential customers at a price they were willing

to pay, while still permitting a substantial proﬁ t.

Costs played an essential role in Ford’s strategy, which determined

in part what Ford’s product would look like. Cost considerations deter-

mined what attributes of a sports car the Mustang could include and what

it could not, while still leaving Ford with a proﬁ t. For what they would

pay, customers could not afford everything they might have liked. At

$2,368, however, what they got in the Mustang was a better value.

* Lee Iacocca (with William Novak), Iacocca: An Autobiography (Toronto: Bantam Books,

1984), p. 74.

Chapter 1 • Strategic Pricing16

As a result of these anomalies, we must realize that customer responses

to price are based on more than a rational calculation of value. Rather, cus-

tomers evaluate the price in terms of the entire purchase situation. Thus, one

aspect of pricing strategy is the presentation of prices in ways that will inﬂ u-

ence perceptions to the seller’s beneﬁ t. Moreover, when buyers do perceive

prices and purchase situations accurately, they often do not evaluate them

perfectly rationally. That is not to say that buyers commonly process prices

irrationally, but rather that they conserve their time and mental capacity by

using imperfect, but convenient decision rules. A marketer who understands

these decision rules can often present products in ways that lead buyers to

evaluate them more favorably.

In some instances, marketers might employ traditional advertising media

to convey their differential value, as was the case with the now famous “I am

a Mac” ads created by Apple which ran from 2006 to 2009. The ads, featuring

the actors Justin Long posing as a Mac

and John Hodgman as a PC (Robert

Webb in the US, and David Mitchell in the UK), highlighted common prob-

lems for PC owners not faced by Mac owners. They are credited with helping

grow Mac sales by an average 14.5 percent CAGR from 2005 through 2015,

signiﬁ cantly above industry average.

In other instances, value messages are

communicated directly during the sales process with the aid of illustrations

of value experienced by customers within a market segment or with the aid

of a spreadsheet model to quantify the value of an offering to a particular

customer.

The content of value messages will vary depending on the type of prod-

uct and the context of the purchase. The messaging approach for frequently

purchased search goods such as laundry detergent or personal care items

will often focus on very speciﬁ c points of differentiation to help customers

make comparisons between alternatives. In contrast, messaging for more com-

plex experience goods, such as services or vacations, will deemphasize spe-

ciﬁ c points of differentiation in favor of creating assurances that the offering

will deliver on its value proposition if purchased. For example, when Noosa

International, an operator of resorts in Queensland, Australia, experienced a

decline in tourism after unseasonably rainy weather, they devised a “Rainy

Weather Rebate” that offered a 20 percent discount on hotel accommodations

should it rain during a customer’s vacation.

Similarly, the content of value

messages must account for whether the beneﬁ ts are psychological or monetary

in nature. As we explain in Chapter 3, marketers should be explicit about the

quantiﬁ ed worth of the beneﬁ ts for monetary value and implicit about the

quantiﬁ ed worth of psychological beneﬁ ts.

Price and value messages must also be adapted for the customer’s pur-

chase context. When Samsung, a global leader in cellular phone sets, develops

its messaging for its Galaxy S phones, it must adapt the message depending on

whether the customer is a new cell phone user or is a technophile who enjoys

keeping up with the latest technology. Samsung must also adapt its messages

depending on where the customer is in their buying process. When customers

are at the information search stage of the process, the value communication

goal is to make the most differentiated (and value-creating) features salient

for the customer, so that he or she weighs these features heavily in the pur-

chase decision. For Samsung, this means focusing on its phones’ big screens

and high data-transfer speeds. As the customer moves through the purchase

Chapter 1 • Strategic Pricing 17

process to the fulﬁ llment stage, the nature of messaging shifts from value to

price as marketers try to frame their prices in the most favorable way pos-

sible. It is not an accident when a cellular provider describes its price in terms

of pennies a day rather than one ﬂ at fee. Research has shown that reframing

prices in smaller units that are more easily compared with the ﬂ ow of beneﬁ ts

can signiﬁ cantly reduce customer price sensitivity.

As these examples illustrate, there are many factors to consider when cre-

ating price and value communications. Ultimately, the marketer’s goal is to get

the right message, to the right person, at the right point in the buying process.

PRICE STRUCTURE

Once you understand how value is created and can be communicated for

different customer segments, the next choice required for a pricing strategy

is to select a way to monetize that value into revenue. We call the output of

this process a price structure and we cover the topic in depth in Chapter 4.

The most natural price structure is price per unit (for example, dollars per

ton or euros per liter). This is perfectly adequate for commodity products and

services. The purpose of more complicated price structures is to reﬂ ect dif-

ferences in value created, or ability to pay for it, from different customer or

application segments.

An airline seat, for example, is much more valuable for a business trav-

eler who needs to meet a client at a particular place and time than it is for

a pleasure traveler for whom different destinations, different days of travel,

or even non-travel related forms of recreation are viable alternatives. Airline

pricers have long employed complex price structures that enable them to max-

imize the revenue they can earn from these different types of customers, who

may be sitting next to each other on the same ﬂ ight. On Monday morning or

Friday afternoon, they can ﬁ ll their planes mostly with business passengers

paying full coach prices, but they are likely to be left with many empty seats at

those prices on Tuesday, Wednesday, and Thursday. While they could just cut

their price per seat to ﬁ ll seats at those “off-peak” times, they then would end

up giving business passengers unnecessary discounts as well. To attract more

price-sensitive pleasure travelers without discounting to business travelers,

they create segmented price structures so that most passengers pay a price

aligned with the value they place on having a seat.

On the Tuesday morning when this was written, you could ﬂ y from Bos-

ton to Los Angeles and return two days later for as little as $324—but with

a non-refundable ticket, a $100 charge for changes, a $15 checked baggage

charge each way, and low priority for rebooking if ﬂ ights are disrupted by

weather or mechanical problems. For $514 you could get the very same seats

on the very same ﬂ ights, but with a refundable, changeable ticket and high

priority rebooking in case of disruption—all things likely to be highly valued

by a business traveler but barely missed by a pleasure traveler. Similarly, you

could pay $934 for ﬁ rst-class roundtrip travel with a non-cancellable ticket

and $150 change fee. Totally ﬂ exible and cancellable ﬁ rst-class travel would

cost you $1,901. With these different options, the airlines maximize the rev-

enue from each ﬂ ight by limiting the seats available at the discounted, non-

cancellable prices to a number that they project could not be sold in the higher

fare classes.

Chapter 1 • Strategic Pricing18

More recently, more airline price structures have been designed to dis-

courage behaviors that make some customers more costly to serve than others.

The European carrier Ryanair has taken the lead in discounting ticket prices

to levels previously unseen and then charging for everything else. If you don’t

print out your boarding pass before arriving at the airport, be prepared to pay

Ryanair an extra €5 to check in. Want to check a bag? Add €10. Want to take a

baby on your lap? €20. Want to take the baby’s car seat and stroller along? €20

each. To board the plane near the front of the line will cost you €3. Of course,

you will pay for any food or drinks, but if you are short on cash you might be

well advised to avoid them. The CEO recently reiterated his plan to charge for

using the on-board lavatories on short ﬂ ights, arguing that “if we can get rid

of two of the three toilets on a 737, we can add an extra six seats.”

Do you

think this is pushing price structure complexity so far that it will drive away

customers? We thought so. But consider that in less than a decade Ryanair rose

to ﬁ rst place among European airlines and as of this writing continues to lead

in passengers carried, in revenue growth, and in market capitalization.

PRICING POLICY

Ultimately, the success of a pricing strategy depends upon customers being

willing to pay the price you charge. The rationale for value-based pricing is

that a customer’s relative willingness-to-pay for one product versus another

should track closely with differences in the relative value of those products.

When customers become increasingly resistant to whatever price a ﬁ rm asks,

most managers would draw one of three conclusions: That the product is not

offering as much value as expected, that customers do not understand the

value, or that the price is too high relative to the value. But there is another

possible and very common cause of price resistance. Customers sometimes

decline to pay prices that represent good value simply because they have

learned that they can obtain even better prices by exploiting the sellers’ reac-

tive pricing process.

Many cable TV companies are now suffering from this problem. In order

to attract new customers, or to get current customers to consolidate their

phone, internet, and cable TV with the supplier, they offer heavily-discounted

contracts for the ﬁ rst year (typically $99 per month). After one year, they raise

the rate by 20 percent or more to their regular prices. But these offers have now

become so widely advertised by multiple suppliers that many savvy subscrib-

ers have learned that they can beat the system. At the end of one year, many

simply threaten to switch after one year to a new supplier offering the same

deal. To avoid the substantial cost to manage these conversions, these same

companies empower their telephone sales reps to agree to waive, or at least

to reduce substantially, the increase for customers who object and threaten to

change suppliers. The result: Even larger numbers of customers now threaten

to change suppliers when their prices increase. Thus, a program that was

designed to induce people to become loyal customers has annually eroded the

value of the customer base.

Pricing policy refers to rules or habits, either explicit or cultural, that

determine how a company varies its prices when faced with factors other than

value and cost to serve that threaten its ability to achieve its objectives. Good

policies enable a company to achieve its short-term objectives without causing

Chapter 1 • Strategic Pricing 19

customers, sales reps, and competitors to adapt their behavior in ways that

undermine the volume or proﬁ tability of future sales. Poor pricing policies

create incentives for end customers, sales reps, or channel partners to behave

in ways that will undermine future sales or customers’ willingness-to-pay. In

the terminology of economics, good policies enable prices to change along the

demand curve without changing expectations in ways that cause the demand

elasticity to “shift” adversely for future purchases. Chapter 5 describes good

pricing policies and will alert you to the hidden risks of poor but commonly

practiced policies.

PRICE SETTING

According to economic theory, setting prices is a straightforward exercise in

which the marketer simply sets the price at the point on the demand curve

where marginal revenues are equal to the marginal costs. As any experienced

pricer knows, however, setting prices in the real world is seldom so simple. On

the one hand, it is impossible to predict how revenues will change following a

price change because of the uncertainty about how customers and competitors

will respond. On the other hand, the accounting systems in most companies

are not equipped to identify the relevant costs for pricing strategy decisions,

often causing marketers to make unproﬁ table pricing decisions.

This uncertainty about marginal costs and revenues creates a dilemma

for marketers trying to set proﬁ t-maximizing prices. How should they analyze

pricing moves in the face of such uncertainty? There are many pricing tools

and techniques in common use today such as conjoint analysis and optimiza-

tion models that take uncertain inputs and provide seemingly certain price

recommendations. While these tools are valuable aids to marketers (we show

how to use them to maximum advantage in Chapter 6), they run the risk of

creating a sense of false precision about the right price. There is no substitution

for managerial experience and judgment when setting prices.

Price setting should be an iterative and cross-functional process that

includes several key actions. The ﬁ rst action is to set appropriate pricing objec-

tives, whether that means to use price to drive volume or to maximize margins.

In 2008, as America was falling into a recession, McDonald’s used penetration

pricing to take signiﬁ cant market share from premium coffee shops during a

time when customers were increasingly price sensitive. Once consumers tried

McDonald’s new premium coffees, they found that the taste was excellent, and

many opted not to switch back.

The second action is to calculate price–volume trade-offs. In the case of a

10 percent price cut for a product with a 20 percent contribution margin would

have to result in a 100 percent increase in sales volume to be proﬁ table. The

same price cut for a product with a 70 percent contribution margin would only

require a 17 percent increase in sales to be proﬁ table. We are frequently sur-

prised by how many managers make unfortunate pricing decisions because

they do not understand how to make and use basic breakeven sales change

calculations to evaluate pricing decisions.

Once the price–volume trade-offs are made explicit for a particular pricing

move, the next activity is to estimate the likely customer response by assessing

the drivers of price sensitivity that are unrelated to value. Two coffee lovers

might value a cup of premium coffee equally. Despite placing equal value on

Chapter 1 • Strategic Pricing20

the coffee, the retiree on a ﬁ xed income will be much more price sensitive than

the working professional with substantial disposable income. Conversely,

either of those individuals may be willing to pay the price at a premium coffee

shop rather than purchase a much cheaper but equally good cup of coffee at

an unbranded café nearby because the lower price at the unbranded café leads

them to infer that its coffee is more likely to be of inferior quality.

The marketer’s job is to estimate how price sensitivity varies across

segments in order to better estimate the proﬁ t impact of a potential pricing

move. There are different ways to accomplish this task across different types

of markets. For example, we describe these tools and how to use them in

Chapter 8.

PRICE COMPETITION

The ﬁ nal set of strategic pricing choices that managers must make to maxi-

mize growth proﬁ tably involve dealing with price competition. We are deal-

ing with it last because making decisions that affect competitive pricing is

an ongoing part of price management. Generally, these decisions occur after

one has ﬁ gured out how to create differentiating features and services and

to capture a share of their value in revenues. But in most markets, the largest

portion of price is determined, not by value-in-use to the customer, but by

competition.

The potential market value of a product or service is composed of two

parts: Value that is the same as that offered by the competitive alternatives

(Reference Value) and value that differentiates it from competitive alterna-

tives (Differentiating Value). For example, when a new restaurant opens in

a busy area, the competitive reference value is the prices already being

charged for lunch by other restaurants nearby. However, some customers

may not be deterred by a premium price if they value a unique style of food

or particular location.

Managing price competition involves inﬂ uencing the reference value. In

some markets, the reference value can be taken as given, determined by mar-

ket supply and demand, and so requires no management attention except to

adjust prices whenever the reference value changes. Even a large oil reﬁ nery

selling wholesale gasoline and heating oil will command such a small share of

the market that it can take the market prices of undifferentiated alternatives

as given when setting its own prices. Price competition becomes much more

challenging, however, when a seller commands a large share of a market.

This is because competitors are likely to react to whatever pricing decisions

it makes. Even the owner of a single retail gas station or pharmacy in a local

market with only one or two alternatives must generally expect that competi-

tors will notice and react to changes in its prices, thus affecting the revenue

impact of pricing decisions. Anytime that a ﬁ rm has a large share of even a

small market, the ability to anticipate and manage the dynamics of competi-

tion will become as important to its ﬁ nancial success as decisions about how

to set prices that reﬂ ect its differential value.

Many successful companies have suffered huge dents in what was an

otherwise smooth trajectory of proﬁ table growth when they failed to anticipate

and manage how competitors might react adversely to a pricing decision. In

Chapter 1 • Strategic Pricing 21

the early 1990s, Alamo Rent A Car (now owned by Enterprise Holdings) was

the most proﬁ table (as a percentage of sales) rental car company in America,

despite being only the ﬁ fth-largest. Its low-cost operating model enabled it to

dominate an entire market segment: Leisure rentals for tour packages to places

like Disney World in Florida and Disneyland in California. Within those mar-

kets, Alamo could essentially set its prices assuming that the prices of larger

rental car competitors would remain unchanged. But Alamo’s management

was impatient for growth and had the cash to pursue it. Within the United

States, a much larger and lucrative rental car segment was business travel

originating at airports. Moreover, demand for cars at Alamo locations peaked

during holiday periods when the demand from business travelers at airports

peaked during non-holiday periods. Thus Alamo’s management ﬁ gured that

if it could win even a small share of the business market by undercutting the

rates of the market leaders, Hertz and Avis, Alamo could generate a lot of

proﬁ table growth.

That was not to be, for reasons that in retrospect were entirely predict-

able. As planned, Alamo began moving to on-airport locations beyond its

core leisure markets and setting prices that undercut the market leaders. But,

Alamo underestimated its own vulnerability. Hertz and Avis had previously

shown little interest in serving tour groups which, since they arrive in waves,

could create backlogs unacceptable to their valuable business clientele. But

once Alamo began attacking their prime markets, it was bound to get their

attention. Within two years, Hertz opened the largest car rental facility in the

world in Alamo’s most lucrative market—Orlando, Florida. While the long

lines at Alamo created a proﬁ table opportunity to earn commissions from

selling people tickets to attractions, Hertz’s 66 counters and luggage-transfer

stations made the transfer from plane to rental car easier and faster for tour-

ists with lots of stuff in tow. To ﬁ ll this facility, Hertz began undercutting

Alamo’s deals with European tour operators, who proved much more willing

to switch suppliers to save a few dollars per car than were Hertz’s business

customers that Alamo was trying to woo. That year, Alamo’s proﬁ ts fell into

the red and its operations were sold the following year to another rental car

company.

The lesson here is not that a proﬁ table company should not attempt to

grow share. It is that companies must anticipate competitive reactions and

avoid competing where they lack the capabilities necessary to proﬁ t despite

those reactions. This is not to argue that underpricing the competition is never

a successful strategy in the long run, but the conditions necessary to make

it successful depend critically upon how competitors react to it. The goal of

Chapter 7 is to provide guidelines for anticipating and inﬂ uencing those reac-

tions and integrating them into one’s plan for strategic pricing.

CREATING A STRATEGIC PRICING CAPABILITY

Over the past decade, pricing has risen in importance on the corporate

agenda. Most top executives recognize the importance of price and value

management for achieving proﬁ table growth. Yet given this strategic impor-

tance, it is surprising to us how many ﬁ rms continue to organize their activi-

ties so that pricing decisions are made by lower-level managers who lack

Chapter 1 • Strategic Pricing22

the skills, data, and authority to implement new pricing strategies that align

with changes occurring across markets. This tactical orientation has ﬁ nancial

consequences.

Our research has found that companies that adopted a value-based pricing

strategy and built the organizational capabilities to implement it earned 24 per-

cent higher proﬁ ts than industry peers.

Yet in that same research, we found that

a full 23 percent of marketing and sales managers did not understand their com-

pany’s pricing strategy—or did not believe their company had a pricing strategy.

This lack of awareness demonstrates the challenges involved when developing a

capability for pricing strategy which requires input and coordination across func-

tional areas including marketing, sales, capacity management, and ﬁ nance.

A successful pricing strategy requires the support of three pillars: An

effective organization, timely and accurate information, and appropriately

motivated management. In many instances, it is neither desirable nor necessary

for a company to have a large, centralized organization to set prices. What is

required, however, is that everyone involved in pricing decisions understands

their role in the process. So while a product manager might set a price, a central-

ized pricing organization might have the right to deﬁ ne a process for evaluating

the impact of that price or to set a policy for when it can be offered, sales man-

agement and operations management might have the right to provide input on

particular elements of the process, and senior management might have the right

to veto the decision. Too often decision rights are not clearly speciﬁ ed, changing

the pricing decision from a well-deﬁ ned, value-driven process to an exercise

in political power, as various functional areas vie to inﬂ uence the offered price

without necessarily considering overall proﬁ tability or strategy.

Pricing decision-makers require quality information. Once managers

understand their role in the price-setting process, the ﬁ rst thing they generally

ask for is more data and better tools. When one considers the data requirements

for making organization-wide pricing decisions, this response is not surpris-

ing. To make informed pricing decisions, marketing managers need data on

customer value and competitive pricing. Sales managers need data to support

their value claims and defend price premiums. And ﬁ nancial managers need

accurate cost data and volume data. Collecting these large volumes of data

and distributing them throughout the organization is a daunting task that has

led many companies to adopt price management systems that are integrated

with their data warehouses and ensure that managers get only the information

they need. While not every ﬁ rm needs a dedicated system to manage pricing

data, everyone must address the question of how to get the right information

into the right manager’s hands in a timely fashion if they hope to keep their

pricing strategies aligned with changes occurring in their markets.

Successfully implementing a pricing strategy also requires a ﬁ rm to moti-

vate managers to engage in new behaviors that support the strategy. All too

often, people are given incentives to act in ways that actually undermine the

pricing strategy and reduce proﬁ tability. It is common for companies to send

sales reps to training programs designed to help them sell on value, despite

paying them solely to maximize volume. When sales reps or ﬁ eld sales man-

agers are offered only revenue-based incentives, it is hard to imagine them

ﬁ ghting to defend a price premium if they think that doing so will increase

their chances of losing the deal. However, incentives can be developed that

encourage more proﬁ table behaviors.

Chapter 1 • Strategic Pricing 23

A senior salesperson we know was recently promoted to regional sales

manager for an area in which discounting was rampant. He began his ﬁ rst

meeting by sharing a ranking of sales reps by their price realization during

the prior quarter. He invited the top two reps to describe how they did those

deals so proﬁ tably and the bottom two reps to describe what went wrong. He

then facilitated an open discussion among the 30 reps on how challenges like

those faced by the bottom two reps could be managed better in the future.

At the end of the meeting, he told them that this exercise would be repeated

every quarter. One month into the subsequent quarter, sales reps were ask-

ing to see where they stood in the rankings, suggesting that they were highly

motivated to engage in productive behaviors to avoid a low ranking before the

next meeting.

Chapter 11 describes in more detail the structural elements that need to

be built into an organization to enable it to adopt and implement strategic

pricing effectively.

Notes

1 . Warren Buffett, interview with the

Financial Crisis Inquiry Commis-

sion, May 26, 2010.

2 . Lucas Shaw, “Apples iTunes Over-

taken by Streaming Music Services

in Sales,” Bloomberg , March 22,

2016. Accessed at www.bloomberg.

com/news/articles/2016-03-22/

apple-s-itunes-overtaken-by-stream

ing-music-services-in-sales.

3 . For an overview, in July 2014 the U.S.

Department of Transportation pub-

lished a primer on congestion-based

pricing: http://ops.fhwa.dot.gov/

publications/congestionpricing/

sec2.htm.

Summary

Pricing strategically has become essential

to the success of business, reﬂ ecting the

rise of global competition, the increase in

information available to customers, and the

accelerating pace of change in the products

and services available in most markets. The

simple, traditional models of cost-driven,

customer-driven, or share-driven pricing

can no longer sustain a proﬁ table business

in today’s dynamic and open markets.

This chapter introduced the stra-

tegic pricing value cascade containing

the six key elements of strategic pricing.

Experience has taught us that achieving

sustainable improvements to pricing per-

formance requires ongoing evaluation of

and adjustments to multiple elements of

the value cascade. Companies operating

with a narrow view of what constitutes

a pricing strategy miss this crucial point,

leading to incomplete solutions and

lower proﬁ ts. Building a strategic pricing

capability requires more than a common

understanding of the elements of an effec-

tive strategy. It requires careful develop-

ment of organizational structure, systems,

individual skills, and ultimately, culture.

These things represent the foundation

upon which the strategic pricing value

cascade rests and must be developed in

concert with the pricing strategy. The ﬁ rst

step toward strategic pricing is to under-

stand each level of the cascade and how it

supports those above it.

Chapter 1 • Strategic Pricing24

4 . 82 percent of holiday shoppers will

go online for shopping research

prior to going to an actual store,

Deloitte 2015 Annual Holiday Sur-

vey: Embracing Retail Disruption,

Deloitte Press, October 2015.

5 . Christo Wilson, “If You Use a Mac or

Android, e-Commerce Sites May Be

Charging You More,” Washington

Post , November 3, 2014. Accessed

at www.washingtonpost.com/post

everything/wp/2014/11/03/if-

you-use-a-mac-or-an-android-e-

commerce-sites-may-be-charging-

you-more/?utm_term=.5cdd7

d3a2efb.

6 . Robert D. Buzzell, Bradley T. Gale,

and Ralph G.M. Sultan, “Market

Share—A Key to Proﬁ tability,” Har-

vard Business Review (January 1975).

7 . Michael E. Raynor, Derek Pan-

kratz, and Selvarajan Kandasamy,

“Exceptional Performance: A

Nonrenewable Resource” Deloitte

Review , 18 (2016), pp. 37–55.

8 . Michael E. Raynor and Mumtaz

Ahmed, The Three Rules: How Excep-

tional Companies Think (New York:

Penguin, 2013), pp. 111–156.

9 . Marco Bertini and Luc Wathieu,

“How to Stop Customers from

Fixating on Price,” Harvard Busi-

ness Review (May 2010). Also see

Andreas Hinterhuber and Stephan

Liozu, “Is It Time to Rethink Your

Pricing Strategy?” MIT Sloan Man-

agement Review , June 19, 2012.

10 . For summaries of a broad range

of these anomalies, see Richard H.

Thayler, Quasi-Rational Economics

(New York: Russell Sage Founda-

tion, 1994); Daniel Ariely, Predict-

ably Irrational: The Hidden Forces

That Shape Our Decisions , revised

and expanded edition (New York:

HarperCollins, 2010).

11 . Itamar Simonson and Amos Tver-

sky, “Choice in Context: Tradeoff

Contrast and Extremeness Aver-

sion”, Journal of Marketing Research ,

29 (August 1992), pp. 281–295.

12 . Albert J. Della Bitta and Kent B.

Monroe, “The Inﬂ uence of Adap-

tation Levels on Subjective Price

Perceptions,” in S. Ward and P.

Wright (eds.), Advances in Consumer

Research, Vol. 1 (Boston, MA: Asso-

ciation for Consumer Research,

1974), pp. 359–369; Robert Slonim

and Ellen Garbarino , “The Effect of

Price History on Demand as Medi-

ated by Perceived Price Expensive-

ness,” Journal of Business Research

45 (May 1999), pp. 1–14 . Market

researchers can suppress this effect

when estimating demand by ran-

domizing the order of presentation,

but the actual demand will depend

upon the actual order of presenta-

tion in real markets.

13 . Katie Hafner and Brad Stone,

“IPhone Owners Crying Foul Over

Price Cut,” The New York Times ,

September 7, 2007.

14 . “Gartner Says Five of Top 10

Worldwide Mobile Phone Vendors

Increased Sales in Second Quar-

ter of 2016,” Gartner Inc. press

release, August 19, 2016. Accessed

at www.gartner.com/newsroom/

id/3415117.

15 . Peter F. Drucker, “The Information

Executives Truly Need,” Harvard

Business Review (January–February

1995), p. 58.

16 . “Global Apple Mac Unit Sales from

1st Quarter 2006 to 3rd Quarter 2016,”

Statista. Accessed at www.statista.

com/statistics/263444/sales-of-

apple-mac-computers-since-first-

quarter-2006.

17 . Cali Mackrill, “Queensland Resort

Offers Discount if it Rains,” The Tele-

graph, March 28, 2013. Accessed at

www.telegraph.co.uk/travel/news/

Queensland-resort-offers-discount-

if-it-rains.

18 .

J. T. Gourville, “Pennies-a-Day: The

Effect of Temporal Reframing on

Transaction Evaluation,” Journal

of Consumer Research 24(4) (March

1998), pp. 395–408.

9 . The projection process for airline

pricing is called “yield manage-

ment” and is described in Chapter 4.

20 . Alistair Osborne, “Ryanair Ready

for Price War as Aer Lingus Costs

Leap,” The Telegraph , June 2, 2009.

Chapter 1 • Strategic Pricing 25

Accessed at www.telegraph.co.uk/

finance/newsbysector/transport/

5431131/Ryanair-ready-for-price-

war-as-Aer-Lingus-costs-leap.html.

21 . Ryanair Full Year Results Analysts

Brieﬁ ng, June 2, 2009, and “Domes-

tic Bliss: The World’s Largest

Airlines,” The Economist , June 24,

2015. Accessed at www.economist.

com/blogs/gulliver/2015/06/

worlds-largest-airlines.

22 . “Rocky Road—Alamo Maps a

Turnaround,” Wall Street Journal ,

August 14, 1995, p. B1; and “Chip

Burgess Plots Holiday Coup to

Make Hertz No. 1 in Florida,” The

Wall Street Journal , December 22,

1995, p. B1.

23 . John Hogan, “Building a Leading

Pricing Capability: Where Does

Your Company Stack Up?,” pub-

lished by Monitor Deloitte, 2014.

CHAPTER 2

Economic Value

The Guiding Force of Pricing Strategy

Customers will not pay literally a penny more than the true value of the product.

Ron Johnson

An estimate of value is to pricing what an estimate of location is to navigation.

Just as it is necessary, when lacking a GPS, to measure angles of the moon, the

sun, and stars relative to the horizon to determine one’s location and the direc-

tion of a desired destination, it is necessary to understand what beneﬁ ts drive

value for customers in order to triangulate the way to a cost-effective value

proposition. Understanding the values that different combinations of features

and services could create for customers, and how the best combination might

differ for different segments of customers, is essential for creating offers that

will enable a company to grow proﬁ tably. This is true even when the goal

is not to maximize value capture but to rely instead on low “value pricing”

to attract customers. One must still understand which sources of value one

can deliver cost effectively, and which are better left unsatisﬁ ed because cost

would exceed value. Any value proposition that is both compelling and proﬁ t-

able is based on offering a better perceived value, regardless of whether it is

priced high or low relative to the competition.

Of course, customers’ perceptions of value can change as they get new

information or consider a purchase within a different context. Value is not

determined by the unchanging physical aspects of a product but by the ever-

changing circumstances of the customer, just as the location of celestial points

of navigation, although unchanging in the heavens, appear in different places

relative to the boat at different times of the day or when sailing in different

directions. When they do not appear as expected, a navigator needs to con-

vince the pilot to change direction. Creating a proﬁ table marketing strategy

likewise requires understanding not only the value created, but also what

causes customers’ perceptions of that value to be aligned or misaligned with

reality. Marketing can inﬂ uence customers brand choices not only by chang-

ing the actual value offered relative to price, but also by changing the context

from which customers perceive the value created and the fairness of the price.

Chapter 2 • Economic Value 27

Each element of the Value Cascade introduced in Chapter 1 plays a criti-

cal role in managing some aspect of the relationship between value and price.

Strategic pricing involves creating differentiated offers that represent “good

value” to customers, raising willingness-to-pay via value communication,

creating price structures that reﬂ ect the differences in value to different users,

and adopting pricing policies that lead customers to make purchase choices

based upon value. In short, strategic pricing is largely about managing

the relationship between value and price. In effect, what we call strategic

pricing could as accurately be labeled strategic value management, since

strategic pricing involves much more than optimizing prices.

At the time of this writing, Apple has enjoyed more than a decade of

exceptional proﬁ tability and growth, not only because it created a stream of

differentiated smartphones and priced them higher than competitors’ phones,

but also because of decisions to manage both perception and delivery of value.

Apple’s advertising to its target segments to communicate why its phones

are worth a premium price, and its high level of customer support, especially

in its dedicated Apple Stores

, is designed to give customers conﬁ dence that

they too can achieve the beneﬁ ts that the phone’s features promise to deliver.

Apple avoids short-term promotional discounts that would lead people to

wait for a deal before buying. And Apple offers different models designed to

reﬂ ect value and ability to pay across different segments of customers. Apple’s

ﬁ nancial success is not driven purely by a drive to create more and better tech-

nology, but by a sophisticated effort to manage perception and realization of

the value that its technology can create for its customers.

In contrast, many ﬁ rms fail to capture their fair share of value delivered

because they do not understand how their products and services create bene-

ﬁ ts for their customers. They erroneously assume that merely adding features

or improving performance will lead to proﬁ table gains in price, volume, or

both. But more and better features will not lead to greater proﬁ tability unless

those features translate into more value, actual and perceived, for customers.

To do that, a pricing strategist must ﬁ rst learn techniques for understanding

and estimating value.

THE ROLE OF VALUE IN PRICING

Among the most important techniques for pricing are those that help manag-

ers determine the value of their products and services. Marketers have long

admonished companies to set prices that reﬂ ect value. Unfortunately, because

value is often poorly deﬁ ned, value-based pricing is sometimes rejected as

impractical. Consequently, let’s begin by explaining what we mean by value

when we refer to it as the guiding force that keeps the various elements of pric-

ing aligned and moving in the same direction.

In common usage, the term value refers to the total savings or satisfaction

that the customer receives from the product. Economists refer to this as use

value or the utility gained from the product. On a hot summer day at the beach,

the use value of something cold to drink is extremely high for many people—

perhaps as high as $10 for your favorite frosty beverage. That information is of

little help, however, to a vendor trying to price cold drinks for thirsty sun wor-

shippers, since few potential customers would be willing to pay such a price.

Chapter 2 • Economic Value28

Why not? Because potential customers know that, except in rare situa-

tions, they don’t have to pay a seller all that a product is really worth to them.

They know that there are likely competing sellers who will give them a better

deal, leaving them with extra money in their pockets, or what economists call a

“consumer surplus.” Perhaps customers believe from prior experience that, if

they wait long enough another vendor will come along selling cold beverages

at prices closer to what they have come to expect from their past experience.

Or they may know that about half a mile up the beach there is a snack shop

where frosty beverages cost only $2. As a last resort, they could drive to a

convenience store where they could buy an entire six-pack for only $6. Conse-

quently, thirsty sun worshippers will usually reject an unusually high price as

“outrageous,” even though the product is worth so much more to them than

that price.

So what do marketers mean when they propose pricing to reﬂ ect value?

The value that is key to developing effective pricing strategy is not use value,

but is what economists call exchange value and we call economic value. This

value is determined ﬁ rst and foremost by what the customers’ alternatives

are. Few people will pay $5 for a cola, even when they value it at $10, if they

think the market offers alternatives at substantially lower prices.

Still, only a small segment of customers insists on always buying the low-

est priced alternative. It is quite likely that many people would buy a cola at

the beach for $5, despite the availability of the same product for less at a snack

shop or convenience store. By offering the product at the beach the vendor is

pricing a differentiated product offering worth more than the available alterna-

tives to some segments of the market. How much more depends on the value

customers place on not having to drive to the convenience store. For some, that

value is very high. They are willing to pay a lot for the convenience of not hav-

ing to exert themselves. For more athletic types who wouldn’t mind an excuse

to jog to the store, the premium for convenience may be much less. To ensure

the patronage of that segment, the beach vendor would be wise to differentiate

his or her offering in some other way that this segment values highly.

Economic value comes in two forms: Monetary and psychological. Both

of these are instrumental in shaping a customer’s willingness-to-pay but

require very different approaches to estimate them.

Monetary value represents the total cost savings or income enhance-

ments that a customer accrues as a result of purchasing a product. Monetary

value is the most important element for most business-to-business purchases.

When a manufacturer buys high-speed switching equipment for its produc-

tion line from ABB, a global electrical equipment manufacturer, it gets prod-

ucts with superior reliability that minimize power disruptions. For many of

ABB’s customers, the beneﬁ t of fewer power disruptions has high monetary

value because it translates into tangible cost savings associated with avoiding

plant shutdowns.

Psychological value refers to the many ways that a product creates innate

satisfaction for the customer. A Rolex watch may not create any tangible

monetary beneﬁ ts for most customers, but a certain segment of watch wear-

ers derives deep psychological beneﬁ t from the prestige and beauty associ-

ated with ownership to which they will ascribe some economic worth. As the

Rolex example illustrates, consumer products often create more psychological

than monetary value because they focus on creating satisfaction and pleasure.

Chapter 2 • Economic Value 29

However, some consumer products, such as a hybrid car, create both types of

value, and it can be challenging to discern which is more important to the

purchase decision. A consumer in the market for a new car might focus on

the monetary value derived from the potential fuel savings by switching to a

hybrid. Other customers will be motivated more by the psychological value

derived from knowing that the hybrid is less damaging to the environment.

Still others will gain satisfaction from the status associated with driving a

trendy car. Regardless of the source of value, many buyers of hybrid cars

are willing to pay a price premium over similar conventionally powered cars.

More formally, a product’s total economic value is calculated as the price

of the customer’s best alternative (the reference value) plus the worth of what-

ever differentiates the offering from the alternative (the differentiation value).

Differentiation value may have both positive and negative elements. We call

this the Economic Value Estimation (EVE

) Model as illustrated in Exhibit 2-1.

Total economic value is the maximum price that a smart shopper, fully

informed about the market and seeking the best value, would pay. Not every

buyer is a smart shopper, however. Often product and service users, and par-

ticularly purchasing agents buying on the users’ behalf, may not recognize

the actual economic value they receive from an offering. That is, the offer-

ing’s perceived value to a buyer may fall short of the economic value if the

buyer is uninformed. Therefore, it’s critical that a company’s sales presenta-

tions and marketing communications ensure that features likely to be impor-

tant to the buyer—particularly competitively superior features—come to the

buyer’s attention. The need to communicate value is why the Toyota website

contains easy-to-use calculators comparing fuel and emissions savings of the

Prius hybrid car relative to other brands.

One of the most critical factors driving customer choice and willingness-

to-pay is the set of alternative products under consideration for purchase.

EXHIBIT 2-1

Economic Value Estimation (EVE ® ) Model

Chapter 2 • Economic Value30

From the marketer’s perspective, these products represent the next-best

competitive alternatives or NBCA. Given the centrality of competitors’ pric-

ing in the purchase decision, economic value estimation begins by determin-

ing the price the competitor charges (not necessarily the NBCA’s use value),

which becomes the reference value in our model. For example, the reference

value of a hotel room on a business trip is the price charged for the next-best

hotel choice in town given the minimum lodging service level the traveler will

accept. In the case of a new iPhone

, the reference value would be the price of

the comparable Android or other 4G phone under consideration.

In some cases, the reference product or service is not necessarily a spe-

ciﬁ c competitive offering, but a self-designed solution that buyers might use to

achieve their objectives. For years, most accounting software suppliers assumed

that buyers would compare their wares to traditional double-entry book-

keeping methods. Software vendors designed products to automate double-

entry accounting and its rigorous debit and credit data entry requirements.

Intuit, however, learned that double-entry methods were the wrong reference

process for the two-thirds of small-business bookkeepers who used their own

simpler cash-based accounting solutions. Working closely with those custom-

ers to understand their need for simplicity, Intuit created QuickBooks, which

outsold competitors in the small-business market because it automated those

simpler approaches.

Differentiation value is the net beneﬁ ts that your product or service

delivers to customers over and above those provided by the competitive

reference product. Our soft drink vendor strolling right up to the custom-

er’s beach blanket provides convenience compared to a distant refreshment

stand. The traveler’s hotel of choice provides a free breakfast and free cock-

tail hour not available at the next-best hotel. Competing products in a cat-

egory likely provide many sources of differentiation value. It’s important

that an effective value estimation concentrate on those value sources hav-

ing the most differentiation “bang for the buck” for a customer or customer

market segment. Whereas a free breakfast may not be an important value

driver for a business executive on an expense account, it could be a crucial

factor for a traveler booking a hotel for a family vacation. The degree to

which a supplier differentiates its offer in terms of those needs will have the

greatest impact on the price the marketer can successfully charge above the

reference value.

HOW TO ESTIMATE ECONOMIC VALUE

Marketers have historically invested considerable effort to develop effective

value propositions to represent their company and products. And few would

argue that an effective value proposition, a concise statement of customer ben-

eﬁ ts, is an essential input to brand building and sales conversations. But a

general statement of value is insufﬁ cient input for pricing decisions because

it lacks the detail and quantiﬁ cation needed to shape strategy. In this section,

we describe techniques that can be used to develop quantiﬁ ed estimates of

customer value that, in turn, can be used to help set more proﬁ table prices.

We start with a discussion of how to collect and analyze competitive reference

prices. Then we describe two approaches for quantifying monetary and psy-

chological value and illustrate them with detailed examples.

Chapter 2 • Economic Value 31

Competitive Reference Prices

Conceptually, identifying the next-best competitive alternative is simply the

answer to, “ If I, the seller, did not exist, what would my customer do ?” Yet the

work of identifying the next-best competitive alternative and gathering accu-

rate reference prices offers a number of challenges that often trip up pricing

strategists.

In some cases, marketers may have a myopic view of their markets. One

of the authors recalls the ﬁ rst consulting project he served on where the client,

a manufacturer of uniforms, thought they had an 85 percent market share.

However, rudimentary market research quickly revealed that customers con-

sidered competitive offerings not just from other uniform manufacturers, but

anyone who sold clothing such as department stores and discounters. Conse-

quently, when viewed against this larger backdrop of potential uniform ven-

dors, we found that the client only had a 35 percent share of the market and

they were shocked to learn that they were missing many more sales opportu-

nities than they had originally thought.

In other cases, there may not be just one competing product; instead,

customers might construct a basket of products and services as a viable alterna-

tive. The “triple play” offered by communications companies such as Comcast

and Verizon gives price allowances to consumers who choose one vendor for

phone, internet connection and cable television service. Satellite TV companies

can’t offer this same bundle because of technical and regulatory limitations.

Determining the reference price for these customers requires some analysis to

estimate an aggregate price for a comparable basket of goods.

Finally, in some cases the biggest source of competition may simply be

customer apathy or doing nothing. For a seller of additives that allows concrete

to cure more effectively in cold conditions, for example, the biggest source of

competition might not be an alternate additive manufacturer. Rather, the big-

gest competitive challenge may simply be getting the builder to realize that he

needs to use an additive in cold weather applications.

Once the competitive alternative has been identiﬁ ed, the next challenge

is to establish the competitive reference price, which requires gathering accu-

rate price data and ensuring that it is comparable to the pricing for your prod-

uct. You must ensure that competitive prices are measured in terms familiar

to customers in the segment (for example, price per pound, price per hour)

and are stated in the same units as your product. In some product markets

such as CPG automotive and apparel, competitive prices as well as discount

and incentive data are readily available through data services such as IRI,

Urban Science, or Nielsen. In addition, there are many price comparison tools

available today from vendors like Google Shopping, Nextag, Price Grabber,

among others, that allow users to quickly scan for competitive price points.

In other categories, however, competitive prices are more difﬁ cult to obtain

because of industry-wide practices of unpublished prices or because prices are

negotiated individually with customers. In these instances, marketers must be

creative in ﬁ nding secondary sources of information by using techniques like

polling the sales organization or interviewing customers. Secondary price data

of this sort will invariably contain some bias and be less reliable than primary

data obtained directly at that point of sale. Generally, though, it is possible to

take imperfect competitive price data and treat it so that it becomes useful to a

value estimation exercise.

Chapter 2 • Economic Value32

Customers are a valuable information resource. One of the more effec-

tive ways to get competitive price information is to take advantage of the cus-

tomers who call your customer service support line asking whether you are

willing to match a competitive price. It is very easy for the customer service

representative to ask a few simple questions—what is the competitive brand

or product and its price—and record that information. While the data will not

be entirely accurate due to gamesmanship by customers, over time enough

data accumulates to offer a perspective on competitive price positions. Alter-

natively, favored customers can be good sources of competitive price informa-

tion. Those who are loyal to the company, perhaps because of its quality or

good service, do not want their competitors to get lower prices from anyone

else. Consequently they will warn the company when a competitor issues new

price sheets or when they hear that someone is discounting.

Exhibits 2-2 and 2-3 provide an illustration of how secondary price data

can be normalized for use in a value estimation. In this example, a technol-

ogy manufacturer in North America collected data as part of a competitive

strategy assessment. When the data in Exhibit 2-2 was examined for use in a

value estimation exercise, it seemed there was little coherence to how competi-

tors were setting prices. After seeing the raw data, one of the product manag-

ers noted that his suspicions were conﬁ rmed: Competitors were completely

irrational in their pricing! Closer examination, however, revealed that much

EXHIBIT 2-2

Non-Normalized Reference Price Data

Chapter 2 • Economic Value 33

of the variation was due not to irrational pricing, but to differences in volume

and service levels. After the pricing data was normalized for these factors,

Exhibit 2-3 revealed much more consistent pricing behaviors that could be

used as an input to the value estimation.

As this example illustrates, collecting reference prices is often more than

just a data collection exercise. It requires some judgment and analysis to ensure

that the data is ready to be incorporated into a value estimation calculation.

Estimating Monetary Value

After determining the competitive reference prices, the next step in value

estimation is to gain a detailed understanding of customer value drivers and

translate that understanding into quantiﬁ ed estimates that can be used to sup-

port pricing decisions. The distinct characteristics of monetary and psycho-

logical value drivers require different approaches to quantify. As we noted

earlier, monetary value drivers are tied to the customer’s ﬁ nancial outcomes

via tangible cost reductions or revenue increases. Since monetary value driv-

ers are already quantitative, monetary value can be estimated using qualita-

tive research techniques that allow for a rich understanding of the customer’s

business model or personal ﬁ nances. In contrast, the intangible nature of

psychological value drivers such as satisfaction, security, or brand value are

not inherently quantiﬁ able. Therefore, marketers often rely on sophisticated

quantitative techniques such as conjoint analysis to quantify the worth of the

EXHIBIT 2-3

Normalized Reference Data

Chapter 2 • Economic Value34

various elements of a product offering. (See Chapter 8 for a complete discus-

sion of price experiments and other pricing research techniques.)

The ﬁ rst step in quantifying monetary value drivers is to understand how

the product category affects the customer’s costs and revenues. In consumer

markets, this is a relatively straightforward exercise because end consumers

usually have fewer monetary value drivers for a given product category. A

hybrid car, for example, provides monetary beneﬁ ts such as lower fuel and

maintenance costs, as well as psychological beneﬁ ts, such as conveying a con-

cern for the environment, yet these do not affect customer ﬁ nances. Typical of

most end consumer monetary value drivers, fuel and maintenance costs can

be quantiﬁ ed using readily available data; Toyota’s online calculator (refer-

enced earlier in this chapter) is a tool to help consumers estimate the ﬁ nancial

beneﬁ ts of purchasing one of their cars. Quantifying monetary value drivers

in business markets is more challenging because of the complexity of most

business operations and the need to understand fully how a product affects

a customer’s proﬁ tability. This complexity is why we start with a detailed

assessment of the customer’s business model to understand how our product

contributes to the business customer’s ability to create value for its own cus-

tomers and to reduce its operating costs.

To illustrate this point, consider the example of Distributor Co., a tech-

nology distributor selling in a two-tier distribution system. Distributor Co.

buys technology products such as servers, software and network components

and resells them downstream to value-added resellers (hence the two-tier

nature of the channel). The management team believed that all customers val-

ued its technical service and support highly—a belief supported by high ser-

vice usage across all segments. But an examination of its customers’ business

models revealed that this was not the case.

One large segment of customers operated under a “systems integrator”

business model that involved sourcing components from Distributor Co. and

then installing and maintaining those components as an integrated system in

their customer’s businesses. For these customers, high-quality technical sup-

port was essential to enable them to ensure proper installation and mainte-

nance. In contrast, another segment operated with a “box-pusher” business

model in which they might buy the exact same components purchased by a

systems integrator, box them up, and resell them as a packaged solution for the

customer to install. For the box-pushers, technical support was not essential

to their business success because they relied on low prices, minimal inventory

costs, and quick turnaround to make their business successful. Interestingly, the

box-pushers consumed signiﬁ cant amounts of technical service even though it

was not integral to their business model because Distributor Co. included it

for free as part of its customer value proposition. When Distributor Co. started

charging for technical support, usage by the box-pushers dropped dramatically

because of the low monetary value in their business model. This pricing move

improved proﬁ ts in two ways: It reduced cost to serve for the box-pushers that

didn’t value technical support and increased margins earned from the systems

integrators, for whom technical support was integral to their business model.

Exhibit 2-4 provides an example of value driver algorithms created for

an equipment manufacturer. One note about these algorithms: They do not

need to be complicated. In most cases, the algorithm will consist of simple

formulas that approximately describe how value is created.

Chapter 2 • Economic Value 35

Once the mechanisms for value creation are understood in terms of the

customer’s business model, the next step is to collect speciﬁ c data to develop

quantiﬁ ed estimates. In-depth customer interviews are the best source of

information. Very different from survey or even focus group methods, in-

depth interviews probe the underlying economics of the customer’s business

model and your product’s prospective role in it. The goal is to develop value

driver algorithms, the formulas and calculations that estimate the differenti-

ated monetary worth of each unit of product performance.

In-depth interviews require a different skill set than many qualitative

research methods. Rather than striving for statistical precision, validity, and

reliability, the price researcher seeks approximations about complex customer

processes that might defy accurate, to-the-decimal-point calculations. It’s

critical, as a wise adage goes, to accept being approximately right lest you be

precisely wrong in disregarding an important driver of value that seems too

difﬁ cult to quantify. Therefore, the in-depth interview provides a foundation

for developing value algorithms and collecting some initial data points to turn

those algorithms into quantiﬁ ed estimates of customers’ monetary value drivers.

It is also important to remember that not all points of differentiation

are positive. There may be instances where a competitor does some things

better—perhaps they are able to deliver more quickly or have a better war-

ranty. These are important differentiators, the value of which should be calcu-

lated in the same manner as described above. When netting out the total value

delivered, it is important to subtract the worth of these sources of negative

differentiation.

EXHIBIT 2-4

Examples of Value Driver Algorithms for Equipment Manufacturer

Chapter 2 • Economic Value36

Once the differential value algorithms have been determined, the ﬁ nal

step is to sum the reference value and the differentiation value to determine

the total monetary value. There are several guidelines for estimating monetary

value that will enable you to simplify the process and avoid common errors.

First, consider only the value of the difference between your product and the

next-best competitive alternative (NBCA) product. The value of any beneﬁ ts

that are the same as those delivered by the NBCA is already determined by

competition and incorporated into the reference value. You can charge no

more for it than the price of the NBCA product, regardless of its use value to

the customer. Second, measure the differentiation value either as costs saved

to achieve a particular level of beneﬁ t or as extra beneﬁ ts achieved for an

identical cost. Don’t add both; that’s double counting. Finally, do not assume

that the percentage increase in value is simply proportional to the percentage

increase in the effectiveness of your product. Although your part might last

twice as long as a competitor, it does not follow that your value is only twice

as large. An essential part, for which the competitor charges only $10, might

save tens or hundreds of thousands of dollars if it requires shutting down a

customer’s production line half as frequently to replace it. Would you charge

only $15 (a 50 percent premium) for such performance? Of course not!

Monetary Value Estimation: An Illustration

GenetiCorp (a ﬁ ctitious company) creates innovative products that acceler-

ate the process of genetic testing. Monetary value estimation determines the

ﬁ nancial impact that these breakthroughs actually deliver to different types of

institutional customers.

One GenetiCorp product, Dyna-Test, synthesizes a complementary DNA

strand from an existing DNA sample signiﬁ cantly reducing DNA molecule

degradation and enhancing the precision of a DNA analysis. Dyna-Test pre-

serves sample integrity much longer than does its primary competitor, EnSyn,

thus improving DNA test yields and accuracy in a variety of applications. For

example, criminal investigators use DNA to match hair, blood, or other human

samples. Hospitals and medical professionals use DNA to diagnose diseases.

Pharmaceutical manufacturers use DNA analyses to target genes susceptible

to new drug treatments. In all applications, test failures can be costly. For

criminal investigators, getting a “fuzzy picture” in a criminal investigation

may produce a false-negative result, requiring a retest that might take several

weeks. Retests for investigators are problematic because tissue sample sizes in

criminal cases are very limited, often precluding repeated tests. Similarly, for

a pharmaceutical company, getting a fuzzy picture when analyzing a DNA

strand may cause drug researchers to miss their true target, the genetic portion

of the DNA suspected of triggering a disease.

Unfortunately, when it ﬁ rst marketed Dyna-Test, GenetiCorp did not

have a clue about its product’s monetary value. It set prices based on a high

markup over costs and then discounted those prices under pressure from pur-

chasing organizations that could buy large volumes. To improve its proﬁ ts,

GenetiCorp decided to learn what its product is really worth to customers:

Dyna-Test’s reference value (the price of what the customer considers the best

alternative product) plus its positive and negative differentiated values (the

customer use value of the attributes that distinguish Dyna-Test from the next

Chapter 2 • Economic Value 37

best alternative). Buyers will pay no more than the reference value for features

and beneﬁ ts that are the same as the competing products. When multiple com-

petitors offer customers the same beneﬁ ts, those beneﬁ ts are table stakes; a cus-

tomer need not pay anything close to a product’s worth because it can get the

product elsewhere. A product earns a price premium over the reference value

only for the extra performance—the differentiated value—it alone delivers. The

sum total of reference and differentiated values is the monetary value estimate.

Dyna-Test has more than one monetary value driver because different

types of users have different reference alternatives and receive different use

value from Dyna-Test’s distinguishing features. Let’s examine the value esti-

mation components in two different market segments, commercial researchers

and non-industrial markets.

Commercial researchers in pharmaceutical and biotech ﬁ rms most often

consider EnSyn the best alternative to Dyna-Test. EnSyn sells for $30 per test

kit; that’s the product category’s reference value for such users. To determine

Dyna-Test’s differentiation value, GenetiCorp studied the ﬁ ve primary drivers

of Dyna-Test’s positive differentiation value among commercial researchers.

VALUE DRIVER 1—YIELD OPPORTUNITY COSTS Dyna-Test provides a greater

yield of full-length cDNA, the compound DNA structures used for analysis,

which is extremely valuable. With more full-length cDNA to work with, drug

researchers can reduce the number of experiments needed to ﬁ nd the rele-

vant portions of DNA, saving an average of a week’s valuable research time,

according to GenetiCorp’s customer interviews.

GenetiCorp studied its pharmaceutical industry customers’ business

models and found the annual revenue from a successful commercial drug

ranges from $250 million to $1 billion. GenetiCorp used a conservative

estimate of $400 million in revenue for one drug, which, with a 75 percent

contribution margin, generated $300 million in annual proﬁ t contribution.

The cost of developing a typical drug was approximately $590 million.

These contribution and cost estimates yield an average net present value of

$41 million a year proﬁ t for a successful drug over a 17-year patent life. But

it takes 500 target tests on average to ﬁ nally identify the gene sequence lead-

ing to a successful new drug, so each target test eventually is worth $82,000.

With a 260-day work-year (approximately 2,100 hours), the value of a target

test is $39 per hour. If using Dyna-Test saves the researcher an additional

week that can be devoted to another new drug, the value of those additional

40 hours is $1,560.

VALUE DRIVER 2—YIELD LABOR SAVINGS Dyna-Test’s cDNA yield superior-

ity over EnSyn also produces more efﬁ cient laboratory staff work. Customer

interviews indicated that using Dyna-Test saved 16 hours of processing labor

compared to using EnSyn. Because laboratory personnel receive an average of

$24 per hour, labor savings from Dyna-Test are about $384.

VALUE DRIVER 3—QUALITY CONTROL LABOR SAVINGS Prior to Dyna-Test,

researchers frequently checked test-chemical batches for quality, sterility, and

reproducibility, adding two hours to a test. However, Dyna-Test maintained

uniform quality and performance over several years, assuring researchers that

they could eliminate these quality-control checks. In interviews, customers

Chapter 2 • Economic Value38

said “I am conﬁ dent with Dyna-Test because it is a quality and tested product”

or “Dyna-Test has been around long enough; you know it works. If someone

says they ran the experiment with Dyna-Test it must be right.” High quality

produced two hours of customer cost savings, totaling $48.

VALUE DRIVER 4—SAMPLE SIZE OPPORTUNITY COSTS Using traditional meth-

ods, analyzing a DNA sample usually requires using some “starter” sample

material at the outset. Often, the amount of original sample material is very

small; gathering more on an emergency basis might take about three weeks of

lost research time. But the Dyna-Test kit has a two-step system that reduces

the need for starter samples, making available more testable original sample

material and freeing researchers from the search for more. Using the value

per week of Dyna-Test usage, GenetiCorp estimated the opportunity cost of

searching for new material at $4,680 (3 × $1,560) per project. But because such

emergency searches happened only about 10 percent of the time, the likely

opportunity cost averages to $468.

VALUE DRIVER 5—SAMPLE SIZE LABOR SAVINGS Similar to Driver 4, gather-

ing additional emergency starter material requires researchers to repeat the

entire analytical test—an extra 16 hours of research labor time—about 10 per-

cent of the time. But with the Dyna-Test kit yielding more usable material and

with labor costing $24 per hour, the value of using Dyna-Test on this dimen-

sion is $38 ($24 × 16 × 0.1).

In sum, for pharmaceutical and commercial biotechnology ﬁ rms, the

estimated total economic value of Dyna-Test is calculated by adding together

the reference value of $30, plus the estimates of differentiated value associated

with each value driver, yielding a total estimated economic value of $2,528.

EXHIBIT 2-5

Monetary Value Estimation for Dyna-Test Industrial Buyers

Chapter 2 • Economic Value 39

In other words, purchasing the new Dyna-Test kit instead of the EnSyn kit

would produce $2,528 in cost reductions and new product proﬁ t gains for a

commercial researcher. Exhibit 2-5 illustrates the monetary value estimation

for that industrial buying segment.

Non-industrial markets such as academic institutions and government

laboratories estimate economic value in a similar fashion. Their reference

value is also the $30 price of the EnSyn test kit; however, the most price sensi-

tive among them simply have lab assistants—essentially free student labor—

who make DNA test products from scratch. Their differentiating value drivers

are similar to those of industrial customers, but modiﬁ ed to reﬂ ect the busi-

ness model in this market, which has a different research environment and

economic reward structure.

Value Driver 1—Yield Opportunity Costs: The yield opportunity cost

avoided by using Dyna-Test is $1,055, somewhat less than for commercial

researchers because of the lower economic rewards from breakthroughs in

primary research.

Value Drivers 2, 3, 4, and 5: The yield labor savings of $231, quality control

savings of $29, sample size opportunity cost avoided of $317, and sample size

labor savings are also less because of the reduced cost of labor within univer-

sity systems.

Thus, the estimated total economic value of Dyna-Test for academic

laboratories is calculated by adding the reference value of $30 plus the esti-

mates for each value driver, yielding a total monetary value estimate of

$1,685.

Exhibit 2-6 illustrates the relationships.

EXHIBIT 2-6

Monetary Value Estimation for Dyna-Test Academic and

Government Buyers

Chapter 2 • Economic Value40

Remember that the economic value derived from monetary value esti-

mation is not necessarily the perceived value that a buyer might actually place

on the product. A customer might not know about a reference product and

won’t be inﬂ uenced by its price. A buyer might be unsure of a product’s dif-

ferentiating attributes and may be unwilling to invest the time and expense

to learn about them. If the product’s price is small, the buyer may make an

impulse purchase without really thinking about its economic value. Similarly,

brand image and equally unquantiﬁ able factors can inﬂ uence price sensitivity,

reducing the impact of economic value on the purchase decision, as in the case

of Rolex watches. Ultimately, a product’s market value is determined not only

by the product’s economic value, but also by the accuracy with which buyers

perceive that value and by the importance they place on getting the most for

their money.

This limitation of monetary value estimation is both a weakness and

a strength. It is a weakness because economic value does not indicate the

appropriate price to charge. It only estimates the maximum price a segment

of buyers would pay if they fully recognized the product’s value to them

and were motivated to purchase. It is a strength, however, in that it indi-

cates whether a poorly selling product is overpriced relative to its true value

EXHIBIT 2-7

Monetary Value Proﬁ le for Dyna-Test

Chapter 2 • Economic Value 41

or is under-promoted and unappreciated by the market. The only solution

to the overpricing problem is to cut price. A better solution to the percep-

tion problem often is maintaining or even increasing price while aggres-

sively educating the market. That is what GenetiCorp did with Dyna-Test.

After previously cutting price to meet the demands of its apparently price-

sensitive buyers, GenetiCorp raised prices two- to ﬁ vefold, at the same time

launching an aggressive marketing campaign. While customer purchasing

agents expressed dismay, sales continued growing because even the new

prices represented but a small fraction of the value delivered. Proﬁ ts increased

signiﬁ cantly in the following year as purchasers learned about Dyna-Test’s

superior economic value to their institutions and accepted, sometimes grudg-

ingly, the need to pay for that value.

GenetiCorp’s experience also shows how value can vary among market

segments. To determine a pricing strategy and policy for a product, you must

determine the economic value delivered to all segments and the market size of

each. With that information, you can develop an economic value proﬁ le of the

entire market and determine which segments you can serve most proﬁ tably at

which prices. Exhibit 2-7 proﬁ les the economic value and market potential for

each Dyna-Tech market segment.

Monetary value estimation is an especially effective sales tool when buy-

ers facing extreme cost pressures are very price sensitive. For example, since

health-care reimbursement systems began giving hospitals and doctors ﬁ nan-

cial incentives to practice cost-effective medicine, pharmaceutical companies

have been forced to add cost and performance evidence to their traditional

claims about a drug’s clinical effectiveness.

Estimating Psychological Value

Psychological value drivers such as satisfaction and security, by virtue of their

subjective nature, do not lend themselves to estimation via qualitative research

techniques like in-depth interviewing. Instead, pricing researchers must rely

on a variety of quantitative techniques to estimate the worth of a product’s

differentiated features. The most widely used of these techniques is conjoint

analysis—a technique developed in the late 1970s and early 1980s that can

discern the hidden values that customers place on product features. The basic

approach is to decompose a product into groups of features and then provide

customers with a series of choices among various feature sets to understand

which they prefer. In recent years, marketing researchers have extended the

basic conjoint techniques so that virtually any type of consumer choice can be

tested including choices involving different brands, budget constraints, and

even purchasing environments.

Using conjoint analysis makes it possible to estimate the value of differ-

ent feature sets in driving willingness-to-pay and, ultimately, the purchase

decision. For example, a ﬂ at screen TV can be described in terms of attributes

such as size of screen, number of pixels, and brightness. In a conjoint study,

each of these attributes is divided into levels that can be tested. For instance,

screen size might be broken into 36 inches, 42 inches, and 52 inches, as a means

to estimate the relative value placed on greater screen size. Similarly, conjoint

is a common approach to estimating brand value because it enables brand to

be treated as any other attribute. Treating brand as another attribute in the

Chapter 2 • Economic Value42

choice decision allows us to understand how customers might value a 36-inch

Sony TV relative to a 42-inch Samsung model. Regardless of the attributes

tested, the value estimates derived from a conjoint study can then be used as

an input to a variety of pricing decisions.

Psychological Value Estimation: An Illustration

Sport Co. (a ﬁ ctitious company), a leading sporting goods manufacturer, has

developed a revolutionary golf club named the “Big Drive.” The new design

has led to signiﬁ cant increases in distance and accuracy for both beginning

and advanced players. The question facing the management team was how

to set prices given that there were many different types of golfers who would

be potential customers. Beginning players found the club appealing because

it was much more forgiving of poorly hit balls compared to traditional clubs.

However, the management team believed that beginners would be relatively

price sensitive and unwilling to pay a premium price for the technology.

More advanced players concerned about improving performance found

the added distance of the Big Drive very appealing, and qualitative research

indicated they would be willing to pay a substantial premium for the club.

Knowing that there were multiple segments with different value drivers and

willingness-to-pay created a quandary for Sport Co. management—how

should they set prices to maximize proﬁ ts?

The approach involved several steps. The ﬁ rst was to identify the differ-

ent segments that might be interested in the new club and proﬁ le them based

on actionable descriptors. This segmentation work uncovered four unique

segments, as follows:

• Innovators: Frequent golfers who are highly focused on performance.

They tend to have higher incomes and purchase clubs through their local

pro shop after extensive consultation with the club pro and friends.

• Value Seekers: Casual players who play ﬁ ve to ten times during the

season. They have moderate income and purchase from major sporting

goods retailers. Value seekers are thrifty, but they will pay a premium

for added performance.

• Lost Players: This is a large segment of occasional players who have

largely drifted away from the game. They do not purchase signiﬁ cant

amounts of golf equipment, but they can be drawn back to playing if a

new innovation creates enough buzz to capture their attention.

• Budget Shoppers: These players range widely in ability and frequency

of play, but they have budget constraints that limit the amount they can

spend on equipment. They typically buy new equipment through dis-

count stores and online outlets.

Having identiﬁ ed the key segments, the next step was to identify the attributes

of the club that each segment found appealing so that they could be tested in

the conjoint study. Of the extensive list of attributes that were tested, three

were noted most commonly by all segments: Distance, straightness, and con-

sistency. These attributes were then tested along with some other features of

the offering such as warranty in a conjoint survey of 670 golfers.

The results of the conjoint study provided the needed inputs to develop

a segmented pricing strategy. For example, the study provided actionable data

Chapter 2 • Economic Value 43

on consumer willingness-to-pay for various attributes such as a warranty, as

shown in Exhibit 2-8. The initial hypothesis was that a warranty was not a key

driver in the purchase decision; potential purchasers were more focused on the

performance attributes of the club. The data revealed that the initial hypoth-

esis was not correct, because consumers across all segments were willing to

pay a premium for a one-year warranty. Interestingly, extending the warranty

from one to two years did not lead to a similar increase in willingness-to-pay.

The results also provided key insights into the value derived by differ-

ent market segments that, in turn, informed the channel pricing strategy. The

data in Exhibit 2-9 shows the differences in willingness-to-pay between the

Innovator and Budget Shopper segments based on the conjoint results.

The proﬁ t-maximizing price for the innovators was $425, which would lead

to approximately 40,000 unit sales. As expected, the optimal price point for

EXHIBIT 2-8

Impact of Warranty Length on Willingness-to-Pay

Chapter 2 • Economic Value44

budget shoppers was considerably less at $275. This difference in the value

(and hence willingness-to-pay) created a dilemma for Sport Co.: If they set the

optimal price for the innovator segment, they would lose many of the budget

consumers, who represent nearly 30 percent of the market. This challenge of

setting prices when value differs widely across segments is a common one that

we will address in detail in Chapter 3. In this instance, the quantiﬁ ed value

estimates of the different segments combined with a detailed understanding

of segment buying patterns and value drivers enabled the team to make a solid

business case for a two-tier pricing strategy. With some minor modiﬁ cations

to the club design, aesthetics, and brand, Sport Co. was able to introduce a

lower-performance model aimed at budget shoppers and sold through dis-

count retailers. At the same time, they introduced the premium model aimed

at Innovators and Value Buyers to be sold at a higher price in pro shops and

high-end sporting goods outlets.

It was possible to generate reliable estimates of psychological value for

the “Big Drive” because the key beneﬁ ts of distance and accuracy are ones

with which golfers have prior experience. They know what it feels like to hit

the best ball off the tee in their foursome and can imagine what they might pay

for that feeling.

Where conjoint and other similar survey research techniques can fall

short is when the differentiating beneﬁ ts are innovative. The research subject

in that case must guess what the beneﬁ ts are and how valuable they might

be. Most people, even those deeply familiar with the technology, are not

good at inferring the beneﬁ ts of innovation. In 1977, the founder and CEO of

the world’s second-largest computer company at the time asserted publicly,

EXHIBIT 2-9

Difference in Willingness-to-Pay and Market Potential by Segment

Chapter 2 • Economic Value 45

“There is no reason anyone would ever want a computer in their home.”

But

Steve Jobs did imagine the beneﬁ ts and set prices for the Apple computer that

sparked the growth of the home computer industry.

As the GenetiCorp and Sport Co. examples illustrate, the approach and

data used to estimate monetary and psychological values differ substantially,

with each having some advantages over the other. While both approaches

yield quantiﬁ ed value estimates that are essential to effective pricing strategy,

the qualitative approach used for monetary value enables the price-setter to

make an explicit linkage between a product’s differentiated features, the bene-

ﬁ ts those features create for customers and the value associated with each ben-

eﬁ t. The importance of this feature–beneﬁ t–value linkage will become clear in

later chapters where we discuss bundling and value communication choices.

Quantitative approaches such as conjoint analysis are appealing because they

enable the pricing researcher to perform a wide variety of statistical analyses

that can be readily used to test different offering designs and competitive sce-

narios. In each case, however, they provide the pricing manager with a solid

fact base from which to make more proﬁ table pricing choices.

An additional note about building EVE

models: In some cases, the focal

product may have net negative differentiation versus the next-best competing

alternative. For example, consider the case of a manufacturer that is begin-

ning to supply a generic equivalent of a food sweetener that is just coming off

of patent protection. While the generic is equivalent on a molecular level, the

branded product still has some signiﬁ cant advantages. It is produced locally

which means that lead times are much faster and thus customers do not need

to maintain as much buffer stock; it has an established brand name that enables

customers to earn a small premium from consumers who recognize and value

the brand; and the branded product has a better consistency that allows it to

mix more easily in a production process. Relative to the branded incumbent,

the generic has no positive differentiating attributes, only negative differen-

tiators. The EVE

model works just the same as illustrated previously, except

in this case the model will indicate the minimum discount needed to entice a

buyer of the branded product to consider the generic alternative. The useful

thing about the model is that in many cases, sellers, in the hopes of quickly

overcoming a sales hurdle, will often discount their prices too much; the EVE

model provides useful guidance on how much of a discount is actually needed.

In addition, the EVE

model will often highlight deﬁ ciencies that are

sometimes better addressed using non-price means. In the example of the

generic supplier of a food sweetener mentioned above, long lead times due to

foreign production may be more efﬁ ciently countered by stockpiling product

in a local warehouse to enable response times that are equivalent to the domes-

tic incumbent supplier.

The High Cost of Shortcuts

When setting prices, there are no shortcuts for understanding the economic

value received by the customer. Many companies, nonetheless, shortchange

themselves by assuming that if their differentiated product is “x” percent more

effective than the competition, then the product will be worth only “x” percent

more in price. While that relationship makes sense superﬁ cially, closer exam-

ination reveals how wrong it is. If you had cancer and knew of a drug that was

50 percent more effective than the competition’s in curing your disease, would

Chapter 2 • Economic Value46

you refuse to pay more than a 50 percent higher price? Of course not. Sup-

pose you were planning to paint your house and discovered a paint sprayer

that lets you ﬁ nish the job in half the usual time—a doubling of your produc-

tivity. Would you pay no more than twice the price of a brush? Obviously

not, unless you’re some rare individual who can paint twice as fast with two

brushes simultaneously. Otherwise, the value to a busy person of the painting

time saved by the sprayer is much greater than the price of a second brush.

As these examples show, the value-based price premium one can charge

is often much greater than the percentage increase in an offering’s technical

efﬁ ciency. The total economic value of a differentiated product is proportional

to its technical efﬁ ciency only when a buyer can receive the beneﬁ ts associated

with a superior product simply by buying more of the reference product. In

our example, that would be the case only if using 50 percent more of the com-

petitive cancer drug or painting with two brushes at the same time would pro-

duce the same increase in efﬁ ciency as using the superior products. Because

of this misunderstanding, many companies committed to value-based pricing

have been misled into believing that they cannot price to capture their value if

their ratio of price-to-use value would exceed that of their competitors.

The Problem with Customer Value Modeling

At the center of marketers’ misconceptions about pricing and value is

the popular concept of customer value modeling (CVM), which emerged

from the total quality management movement when companies tried

to measure and deliver superior quality at a competitive price. Market-

ers and a variety of value consultants have applied CVM in many con-

texts, including early criteria for the Malcolm Baldrige National Quality

Award, largely because it is easy to implement. CVM relies on customers’

subjective judgments about price and product attribute performances. It

assumes that customers seek to purchase the products that give them the

greatest perceived beneﬁ t—which might be quantiﬁ ed in monetary terms,

but need not be—per unit price. Avoiding the translation of relative attri-

bute performance into hard-dollar estimates, CVM is analytically simpler

than economic value estimation, particularly for pricing consumer prod-

ucts with their heavily psychological values.

The fact is, however, that CVM underestimates the value of the more

differentiated products in a market and overestimates the value of the less

differentiated products. CVM methods deﬁ ne value differently than eco-

nomic value estimation. CVM rates each competitive supplier’s relative

strength on each product attribute, weighing each attribute by customer

estimates of importance, according to customer and prospect surveys.

Then CVM calculates the average relationship between perceived quality

and price, creating what is variously called a “fair-value line,” a “value

equivalence line,” “indifference line,” or other term for the presumed

linear relationship between price and perceived quality. A point on the

line putatively indicates a “fair” balance of price for quality. For a given

price, a product with less than fair perceived quality is disadvantaged and

stands to lose market share, say CVM theorists, while a product offering

more than fair quality will gain share. There are ﬂ aws in this thinking.

Chapter 2 • Economic Value 47

VALUE-BASED MARKET SEGMENTATION

Market segmentation is one of the most important tasks in marketing. Identi-

fying and describing market subgroups in a way that guides marketing and

sales decision-making makes the marketing and pricing process much more

efﬁ cient and effective. For example, customers who are relatively price insen-

sitive, costly to serve, and poorly served by competitors can be charged more

than customers who are price sensitive, less costly to serve, and are served

well by competitors. At many companies, however, segmentation strategy

focuses on customer attributes that are not useful for pricing decisions, creat-

ing customer groupings that do not adequately describe differences in pur-

chase motivations among customers and prospects, or classify them in a way

that is meaningful for making pricing decisions.

First, customers don’t pay for average differential beneﬁ t estimates; they

pay for the worth of the beneﬁ ts they receive. That is, they mentally con-

vert beneﬁ ts into monetary terms so that they can judge how much more

they should pay for the extra value received from a more expensive prod-

uct. If it’s worth more than the price premium charged, they buy it.

Second, CVM fails to distinguish between the value of common ben-

eﬁ ts that are priced as commodities and the value of the unique beneﬁ ts

associated with a differentiated offering. Total economic value—what

the customer really gets from the offering in monetary and psychological

terms—does not have a single linear relationship to price. One of the two

components of economic value, the reference value, usually is much less

than the use value of the beneﬁ ts delivered by the reference product. The

reference value is the price a customer pays for the next-best alternative

offering—like the price of the second paintbrush, the price of the EnSyn

DNA test kit, or the price of a soda at the refreshment stand. Beneﬁ ts

offered by more than one supplier become commodity beneﬁ ts; custom-

ers can get them from more than one source. Competition among suppli-

ers drives the price for those beneﬁ ts below their use value, making the

price-to-use value ratio of the reference product lower than one-to-one.

In contrast, differentiation value, the second component of total eco-

nomic value in the EVE

model, is the extra use value a product delivers

compared to the reference product. The differentiation value, expressed

in monetary terms, is equivalent to the price premium the differentiated

supplier could charge as a fair price. It’s fair because the customer gets just

what she’s paying for in additional value, no more and no less. The price

premium-to-differentiation value ratio is one-to-one. In other words, the

relationship between price and economic value is a function of two dif-

ferent price-to-quality ratios, not the single average ratio hypothesized in

a CVM model.

This difference is signiﬁ cant because the larger the proportion of

differentiation value in a product’s total economic value delivered, the

more the truly fair price to the customer—the economic value estimation

price—can exceed the CVM-hypothesized “fair-value line” price.

Pricing

your highly differentiated product at the supposed “fair-value line” level

will be hazardous to your bottom line!

Chapter 2 • Economic Value48

Consultants and market researchers who offer segmentation-modeling

methodologies abound. Often those plans are driven by statistical differences

in personal demographics or company ﬁ rmographics (customer size, stan-

dard industrial classiﬁ cation, and so forth). While the results seem clear and

sometimes coincidentally differentiate buying motivations, those segmenta-

tions seldom assist pricing decisions, especially for setting different prices

that maximize proﬁ t from different segments. More useful are value-based

segmentation models that facilitate pricing commensurate with actual value

perceived and delivered to customers. Only then can a marketer ensure that

each different customer subgroup is paying the most proﬁ table price that the

marketer can charge. Charging the entire market a single price risks under-

charging some segments, causing foregone proﬁ t to you, and overcharging

others, costing you additional foregone proﬁ t since those customers buy

from other suppliers.

Signiﬁ cant differences between value-based segmentation and other

methods are especially critical for pricing. First, most segmentation criteria

correlate poorly with different buyers’ motivations to pay higher or lower

prices. Both plumbers and personal-injury lawyers consider online advertis-

ing to be very important, for example. They advertise to attract customers who

have an immediate, unexpected, and high-value need. Google could charge

both groups the same advertising rates, but the lawyer can afford to pay more

than the plumber because of the greater value of each legal client. Simply rais-

ing ad prices across the board would eventually price plumbers out of the

market and into less expensive media leading to lower proﬁ ts. But Google

has developed an ingenious bidding mechanism that allows customers to

pay whatever price reﬂ ects the value to them. The trade-off, of course, is that

the lower you bid the less prominent your ad or webpage will be displayed.

By enabling the customer to make price and value trade-offs via the bidding

mechanism, Google has successfully aligned prices with value and improved

the proﬁ tability of their advertising business.

Second, even needs-based segmentations give priority only to those differ-

ences that are important to the customer. They miss the other half of the story,

those customer needs that have the greatest operational impact on the seller’s costs

to serve those needs. The seller’s costs and constraints are also important to pricing

decisions, as we will see below, because our goal is not just sales and market share,

but proﬁ tability. Finally, the customer in-depth interviews required for value-

based segmentations also uncover why customers ﬁ nd certain product beneﬁ ts

appealing—or would ﬁ nd them appealing were they sufﬁ ciently informed. Such

knowledge reveals opportunities to develop new products and services and can

reveal ﬂ awed strategies based on less comprehensive research.

That is a lesson International Harvester Company (IH), in a classic exam-

ple, learned the hard way. For years, IH classiﬁ ed farmers according to sur-

veys of farmer “beneﬁ t perceptions,” particularly IH’s equipment reliability

compared to that of arch rival John Deere. Farmers consistently rated Deere

equipment as more reliable, so IH invested heavily to ensure that an IH trac-

tor could not possibly break down more frequently than a Deere tractor. Still,

Deere kept leading the reliability rankings by a wide margin. IH marketers

understood the true situation only when they conducted in-depth interviews.

Asking farmers about repair problems revealed that what was important to

farmers was the downtime caused by breakdowns. IH customers viewed a

Chapter 2 • Economic Value 49

breakdown as a big deal to be avoided because of the days of lost productivity

waiting for repairs. Deere customers viewed Deere’s equivalent reliability as

much less of a problem because Deere’s extensive, service-oriented dealer net-

work stocked spare parts and offered loaner tractors, getting a farmer working

again in less than a day. IH’s beneﬁ t segmentation had missed the mark. A

value segmentation would have revealed that Deere served a different seg-

ment of farmers—those driven by the value of a total-service solution, which

perfectly ﬁ t Deere’s strengths.

To conduct a value-based segmentation, we recommend a six-step

process.

Step 1: Determine Basic Segmentation Criteria

The goal of any market segmentation is to divide a market into subgroups

whose members have common criteria that differentiate their buying behav-

iors. A simple example illustrates the concept. A business marketer of, say,

an industrial grinding machine could segment customers in terms of their

industries, their applications for which they use the marketer’s product, or the

total value they receive from the product. A segmentation done by industry

using industrial classiﬁ cation criteria would not indicate, however, whether

customers use the grinders in similar ways. A segmentation based on appli-

cation criteria would account for different ways of using the grinders, but

would not indicate if the grinder is more important to one segment’s business

model than to another’s. Only a segmentation based on the value delivered

by the grinder would reveal, for instance, that customers in one segment con-

sider grinder use a small part of assembly line costs, while in another seg-

ment the grinder delivers much more value by performing a ﬁ nishing step

that allows the grinder buyer to earn a price premium from its customers. In

our tractor marketing example, had IH chosen rapid service needs as its seg-

mentation criterion, it would have seen that it could not match Deere’s ﬁ eld

service capabilities. Had IH done its homework, it would have realized that

it needed to try and outweigh its service shortcomings with other offering

attributes—which would be tough with farmers for whom downtime is very

costly—or concentrate on other segments that put relatively more emphasis

on attributes where IH excels.

Choosing appropriate segmentation criteria starts with a descriptive pro-

ﬁ le of the total market to identify obvious segments and differences among

them. In consumer markets, basic demographics of age, gender, and income

provide obvious discriminators. Enterprise ﬁ rmographics such as revenue,

industry, and number of employees clearly separate ﬁ rms into nominally

homogenous groups. Inputs for this basic analysis can include existing seg-

mentation studies, industry databases, government statistics, and other sec-

ondary sources. Outputs include buying patterns, customer descriptions, a

preliminary set of current customer needs, and a provisional list of unmet cus-

tomer needs. You should be able to design ﬁ rst-pass segmentation maps based

on those outputs. Along the way, check if those preliminary maps look sensi-

ble to salespeople and sales managers. Though your eventual pricing strategy

will rely on value-based segmentation, communications and sales strategies

are likely to be heavily dependent on those obvious customer characteristics

on which media choices and sales territory assignments are based.

Chapter 2 • Economic Value50

Step 2: Identify Discriminating Value Drivers

Having preliminary segmentations in hand, you identify those value drivers—

the purchase motivators—that vary the most among segments but which

have more or less homogenous levels within segments. This allows you to

zero in on what’s most important to each customer segment. The GenetiCorp

example earlier in this chapter determined that segments classiﬁ ed by obvi-

ous ﬁ rmographics—commercial and non-industrial research institutions—

also differed on several cost-reduction and proﬁ t-enhancement value drivers.

Never assume for pricing purposes that preliminary segmentations based on

obvious criteria will coincidentally yield effective discrimination on value

criteria. Commercial and non-industrial medical laboratories probably have

similar needs, for instance, and derive similar value from an undifferentiated

product such as laboratory glassware.

In-depth interviews probing how and why buyers choose among com-

petitive suppliers provide the additional input required. Industry experts, dis-

tributors, and salespeople can provide supplemental information for double

checking the value perception patterns revealed by the interviews. The out-

puts of this step include a number of useful building blocks for value-based

market segmentation, including a list of value drivers ranked by their ability

to discriminate among customers (statistical cluster analysis of quantitative

data is a useful tool here), an explanation of why each driver adds value, and

whether customers in each segment recognize that value. The list should also

include the value the customer will receive if your product or service offering

satisﬁ es unmet needs.

Step 3: Determine Your Operational Constraints and Advantages

In this step, you examine where you have operational advantages. Which

value drivers can you deliver more efﬁ ciently and at lower cost than others?

Also, which drivers are constrained by your resources and operations? Expe-

rience, capital spending plans, personnel capabilities, and overall company

strategy are among the inputs to this step. Use the discipline of activity-based

costing (a fascinating diagnosis of your own business, but a topic beyond the

scope of this book) to build a customer behavior spectrum mapping your true

costs serving different customers. Will some require more on-site service than

others? Which have shorter decision-making cycles? Those factors contribute

to customer proﬁ tability, value delivery, and the price you can charge for bun-

dled and unbundled offering features. You should also examine competitive

strengths and weaknesses on key drivers as closely as you can.

With these data, you can cross-reference and compare lists of customer

needs served and unserved, the seller’s advantages and resource limitations,

and competitors’ abilities. Where do you have sustainable competitive advan-

tages, and where do rivals hold the upper hand? Which customers can you,

therefore, better serve than can competitors, and which are likely to be beyond

your reach, assuming that prospective customers are well informed?

Step 4: Create Primary and Secondary Segments

This step combines what you’ve learned so far about how customer values

differ and about your costs and constraints in serving different customers.

Chapter 2 • Economic Value 51

Unless you’re comfortable with multivariate statistical analyses accounting

for several value drivers simultaneously, you’ll ﬁ nd it most convenient to seg-

ment your marketplace in multiple stages, value driver by value driver. The

number of stages depends on the number of critical drivers that create sub-

stantial differences in value delivery among customer groups. In theory, your

primary segmentation is based on the most important criterion differentiating

your customers. Your secondary segmentation divides primary segments into

distinct subgroups according to your second most important criterion. Your

tertiary segmentation divides second segments based on the third most impor-

tant criterion, and so on.

In practice, however, the deeper your successive segmentations, the

more unmanageable the number of segments you identify. It doesn’t make

sense to split hairs by segmenting according to drivers with less than critical

discriminating power. Minor differences among such sub-segments will have

little impact on pricing policies.

Also, your primary segmentation should account for your company’s

capabilities and constraints as well as customer needs. A primary value seg-

mentation that recognizes such a “strategic overlap” discriminates on what is

likely to be the most important differentiator among customers: The needs that

have the most impact on the seller’s operational constraints and whether those

needs can be satisﬁ ed proﬁ tably, if at all. Your secondary segmentation, there-

fore, will use the value driver that varies the most among the sub-segments

within each primary segment.

The example in Exhibit 2-10 illustrates the process for an industry-leading

commercial printing company serving catalog marketers. Catalog companies

have a variety of printing needs. Some are primarily concerned with brand

image and ensuring that their direct marketing integrates well with their other

sales channels such as retail stores. Others have unique needs, such as the abil-

ity to tailor catalogs to particular segments of a market by varying the “signa-

tures” (groups of printed pages) bound into different parts of the print run. In

this industry, print timing appears to be the major value differentiator. Some

catalog companies insist on ﬁ rm printing dates demanded by their business

models, while others are more willing to let the printer determine when their

jobs run. The strategic overlap is the cost-to-serve implication that results from

the printer having only a ﬁ nite number of presses and so many hours in the

day, which limits the ability to commit to a ﬁ rm print time.

Exhibit 2-10 shows a primary segmentation based on the strategic over-

lap of customer scheduling needs and printer operational capabilities. Two

primary segments emerge: Buyers needing precise timing and those who are

willing to relinquish timing control for a break on price. Within the “customer-

controlled scheduling” primary segment, three secondary segments have dif-

ferent needs for special service, as follows:

• A “brand focus” segment requires custom services and tailored solutions.

• A “consistency segment” is more value-driven and concerned with their

own margins, insist on getting high quality print every time but expect

standard services such as prooﬁ ng, binding, and trimming.

• A “unique equipment” segment has special needs such as odd trim sizes,

small print orders, and customer-tailored binding, yet still wants control

of the print scheduling process.

Chapter 2 • Economic Value52

The printer originally treated customers who could be ﬂ exible in their sched-

uling like all other customers, assigning them ﬁ rm print dates even as they

demanded and negotiated lower prices. Value-based segmentation revealed

that these buyers would be willing to trade some ﬂ exibility in scheduling for

reduced prices. The printer could schedule their jobs for off-peak demand

periods when capacity otherwise would be idle. These secondary segments

differed by the services they would trade for a lower price:

• The “cost-conscious” segment responded to service options that enabled

them to deliver copy to meet consistently in a ﬁ xed time window for

printing.

• The “low-touch, low-price” segment accepted bare-bones service,

including a ﬂ exible print time and direct internet-to-press transactions,

in return for even lower prices.

EXHIBIT 2-10

Primary and Secondary Segmentation: Catalog Printing Industry

Chapter 2 • Economic Value 53

Step 5: Create Detailed Segment Descriptions

Value-based segmentation variables can look ﬁ ne to the price strategist, but

segments should be described in everyday business terms so that salespeople

and marketing communications planners know what kinds of customers each

segment represents. Exhibit 2-11 lists the needs and typical ﬁ rmographics of

the customer-controlled scheduling segment’s three sub-segments. It also lists

speciﬁ c catalog publishers within each segment.

Step 6: Develop Segment Metrics and Fences

This is the next logical step in pricing strategy and management, a step we

cover in greater detail in Chapter 4. Here, it’s important to recognize that seg-

mentation isn’t truly useful until you develop the metrics of value delivery to

market segments and devise fences that encourage customers to accept price

policies for their segments.

Metrics are the basis for tracking the value customers receive and how

they pay for it. For example, car rental companies once used a distance-based

value metric and charged customers for the mileage traveled in addition to the

time used. Over time, competition forced rental companies to drop mileage

charges. Time alone has become the market-recognized value metric. Sellers

deﬁ ne discounts such as weekly and monthly rental rates on time bundles.

Fences are those policies, rules, programs, and structures that custom-

ers must follow to qualify for price discounts or rewards. For example, mini-

mum volume requirements, time-based membership requirements, bundled

EXHIBIT 2-11

Characteristics of Three Printer Customer Segments

Chapter 2 • Economic Value54

purchase requirements, and so on keep prices paid and the value delivered to

customers in line. Some fences can also force customers to pay higher prices

regardless of the seller’s costs; the notorious Saturday night stay requirements

for reduced airline fares are a good example. Until competition forced airlines

to drop the requirement, Saturday night stays effectively separated business

travelers, who, presumably, could afford higher fares, from price-sensitive

pleasure travelers.

Choose metrics and fences that establish and enforce premium prices

for high-value segments, and allow feature repackaging and unbundling to

appeal to low-value and low-cost-to-serve segments. As we shall see later in

this book, the result is a menu of prices, products, services, and bundles that

reﬂ ect different value received for different prices paid.

Identifying value-based segments, the metrics of pricing offerings, and

the fences that maintain a price structure allows a marketer to expand its proﬁ t

margins by aligning its prices, service bundles, and capacity utilization with

the different value levels demanded by different customers. That’s a win–win

balance for sellers and buyers; everyone gets something. But, as we will see in

later chapters, just how much either side wins depends on how much of the

differential value created in a transaction each side captures. That’s when poli-

cies to facilitate value-based price negotiations become important.

Summary

The foundation of a proﬁ table pricing

strategy begins with a complete under-

standing of the economic value the prod-

uct delivers to buyers because, ultimately,

value is the primary determinant of a

buyer’s willingness-to-pay. This founda-

tional understanding of value contrib-

utes to a comprehensive pricing strategy

in a number of ways. First, it provides

insight into how willingness-to-pay dif-

fers across segments. As the commercial

printing company example illustrates,

a value-based segmentation can inform

not only pricing, but offering design as

well. Second, understanding value is the

only way to develop effective communi-

cations campaigns to increase customer’s

willingness-to-pay. Although a hot beach-

goer probably recognizes the value of a

cold drink delivered to her blanket, most

customers are not so well informed, and it

is the job of the seller to get the value mes-

sage across. Finally, value can and should

be one of the key inputs to the price-setting

decision because, as we demonstrated in

Chapter 1, building a pricing strategy on

other metrics such as market share or costs

leads to less proﬁ table results.

Notes

1. Ron Johnson was the Senior Vice

President of Retail Operations at

Apple Inc.

2 . Toyota fuel savings calculator.

Accessed at www.toyota.com/prius

prime/calculator.

3 . Peter H. Lewis, “For Finances Past

the Checkbook, a Small-Business

Helper,” New York Times , May 3, 1992.

Accessed at www.nytimes.com/

1992/05/03/business/the-execu

tive-computer-for-ﬁ nances-past-the-

checkbook-a-small-business-helper.

html.

4. See Thomas Nagle, “Money Back

Guarantees and Other Ways You

Chapter 2 • Economic Value 55

Never Thought to Sell Your Drug”,

PharmaExecutive , April 2008; and

Tracy Staton, “Novartis Deﬁ es Nay-

sayers with Newfangled Pay-For-

Performance Deals on Entresto,”

FiercePharma.com, February 10,

2016. Accessed at www.ﬁ ercepharma

.com/sales-and-marketing/novartis-

defies-naysayers-newfangled-pay-

for-performance-deals-on-entresto.

5. The quote is attributed to Ken Olson,

founder of Digital, who reportedly

made the statement at a 1977 World

Future Society gathering. We should

note that the quote is a little out of

context; in later interviews Olson

explains that he was referring to the

idea of the “connected home,” where

lighting, temperature regulation, and

tracking pantry inventories was

controlled by computers. Source:

www.snopes.com/quotes/kenol

sen.asp.

6. For additional related discussion of

this “proportional value-proportional

price” argument, see Gerald E. Smith

and Thomas T. Nagle, “Pricing the

Differential,” Marketing Management ,

May/June 2005; and Gerald E. Smith

and Thomas T. Nagle, “A Question

of Value,” Marketing Management ,

July/August 2005.

CHAPTER 3

Price and Value

Communication

Strategies to Inﬂ uence

Willingness-to-Pay

Nowadays people know the price of everything and the value of nothing.

Oscar Wilde

In Chapter 2, we argued that developing an effective pricing strategy requires

understanding the value of your offer in order to set proﬁ t-maximizing prices

across segments. Yet even the most carefully constructed value-based pricing

strategy will fail unless your offer’s value, and how it differs from a competi-

tor’s, is actually understood by potential customers. Although getting a good

value is often one of the most important purchase considerations, customers

who do not recognize your differential value are vulnerable to buying inferior

offerings at lower prices supported by loosely deﬁ ned performance claims.

The role of value and price communications, therefore, is to convey your value

proposition in a compelling manner to accomplish three goals: Enable cus-

tomers to fully understand the beneﬁ ts; improve their willingness-to-pay; and

increase the likelihood of purchase.

In our research, we have found that business managers rated “commu-

nicating value and price” as the most important capability necessary to enable

their pricing strategies.

Ironically, the same study found that the ability to

communicate value is also one of the weakest capabilities in most sales and

marketing organizations. In retrospect, these results are not surprising because

effective value and price communications require a deep understanding of

customer value (which many ﬁ rms lack) combined with a detailed under-

standing of how and why customers buy (another shortcoming) to formulate

messages that actually inﬂ uence purchase behaviors.

Both sellers and buyers have made value communication complicated.

Among sellers, value communication often gets substituted by “feature com-

munication,” whereby sellers point to extensive product speciﬁ cations in the

Chapter 3 • Price and Value Communication 57

hopes that the buyer is able to recognize where and how these features might

deliver some beneﬁ ts. Mobile phones are often advertised to have “64GB

memory” or “4G connectivity,” yet few sellers translate these features into

customer beneﬁ ts such the ability to store a speciﬁ c number of pictures or

relative improvements in reception quality. As a result, the seller forces the

customer to divine the potential beneﬁ ts that these features convey. Invariably

this leads to a loss in ﬁ delity especially among the less-experienced buyers and

those lacking the time to perform research.

Simultaneously, the buyer, especially in B2B settings, is not incentivized

to ﬁ gure out the relative value propositions. When confronted with a choice

between a cheap offer and a more expensive one with hard-to-understand

beneﬁ ts, the easiest path for a purchasing agent is to simply buy the lowest

priced offer. He can easily justify the decision based on the cost savings, sum-

marize his decision in a quick memo, and get home early for his son’s baseball

game. On the other hand, to buy the more expensive offer, the agent needs to

understand why his organization prefers it, document the economic beneﬁ ts

of using it, and write up a memo summarizing why the price premium is justi-

ﬁ ed. This effort takes time and may require the agent to stay late at the ofﬁ ce.

A major goal for value communication is to provide the agent with the infor-

mation needed to justify paying a higher price.

A third challenge in value communication is that marketers often assume

that market demand is ﬁ xed and that the market alone will determine the

price that a buyer is willing to pay. Yet this assumption is not true. Even in the

most commoditized of markets, there are ways to differentiate an offering and

reframe how buyers make price comparisons. Buying a set of new tires for the

family minivan is a task rarely greeted with any enthusiasm. When confronted

with an array of choices at the tire store and lacking any knowledge of the cate-

gory, many consumers will treat the products as a commodity and instinctively

select a lower-priced tire offered in the store. However, after the same consumer

notices a Michelin advertisement, with a plump baby sitting in the middle of

a tire with an admonition to “ Remember what is riding on your tires ,” automo-

tive tires suddenly get reframed as important safety devices, and the premium

charged for a Michelin tire is but a small payment for improved safety.

A fourth challenge is that in order to sell on value, you need to sell to the

person that recognizes the value. Especially in business-to-business environ-

ments, there are usually multiple stakeholders involved in a purchase deci-

sion, and each stakeholder values different aspects of the offer. When selling

ﬂ exible packaging materials to a CPG company, plant managers will value

the technical support, the brand manager will be interested in the graphics

capabilities that allow a product to stand out on a grocery store shelf, and the

procurement group wants to understand the costs savings over the incumbent

supplier. A seller needs to break down their value story into discrete messages

and deliver the most relevant story to each stakeholder in the buying process.

The purpose of this chapter is to explain how to develop compelling

messages that convey the value of key product characteristics of your offer-

ing to the right people. This chapter will explore how to leverage quantiﬁ able

beneﬁ ts deﬁ ned by the Economic Value Estimation (EVE

) model as well as

how to use principles of behavioral economics to create messages that resonate

more powerfully. We will also discuss how to adapt the message across differ-

ent types of products and different purchase occasions. And importantly, will

Chapter 3 • Price and Value Communication58

show how effective value communication can inﬂ uence willingness-to-pay,

shape market demand, and make it easier for the buyer to justify paying a

price premium for more value.

VALUE COMMUNICATION

Value communication can have a great effect on sales and price realization

when your product or service creates value that is not otherwise obvious to

potential buyers. The less experience a customer has in a market or the more

innovative a product’s beneﬁ ts, the more likely it is that the customer will not

recognize nor fully appreciate the value of a product or service. For example,

without an explicit message from the seller, a business buyer might not realize

that a nearby distribution center offering shorter delivery times could reduce

or eliminate the cost of carrying inventories or even recognize how quickly

inventoried items depreciate. Properly informed, the customer would see how

much money faster delivery saves, justifying a price premium.

In addition, a buyer’s perceptions of value are shaped by the way infor-

mation is conveyed. For example, by highlighting that the cost of a pharma-

ceutical drug is covered by insurance, the role of price becomes less relevant

and the buyer is able to focus on other aspects of the message such as the rela-

tive efﬁ cacy of the drug.

ADAPTING THE MESSAGE FOR PRODUCT CHARACTERISTICS

The ﬁ rst step in developing a value message is determining which customer

perceptions to inﬂ uence. We start with an understanding of the value drivers

that are deemed most important to a customer segment. The goal is to help the

customer recognize the linkages between a product’s most important differen-

tiated features and the salient value drivers. The two dimensions that frame

a communications strategy are: (i) The type of value delivered—economic or

psychological; and (ii) the degree of buyer involvement—do they actively seek

information to make detailed comparisons or do they make a decision based

on what is known in the moment? Exhibit 3-1 summaries these dimensions.

Understanding the type of value sought has a signiﬁ cant implication for the

communication strategy. Measurable monetary beneﬁ ts such as proﬁ t, cost

savings, or productivity motivate many purchases and translate directly into

quantiﬁ ed value differences among competing offers. But for other purchases,

especially consumer products, psychological beneﬁ ts such as comfort, appear-

ance, pleasure, status, health, or personal fulﬁ llment play a critical role in cus-

tomer choice. Although the value of both psychological and monetary value

drivers can be quantiﬁ ed, the way in which that data should be used in market

communications differs. For goods in which monetary value drivers are most

important to the customer, value quantiﬁ cation should be a central part of the

message because the data calls attention to any gaps between the customer’s

perceptions of value and the actual monetary value of the product. For psy-

chological beneﬁ ts the value messaging will focus on how a product will make

the customer feel, much like the tire example cited earlier.

It is important to note that virtually every purchase has an economic and

a psychological element to it—for example, the purchaser of an electric car

Chapter 3 • Price and Value Communication 59

may feel signiﬁ cant beneﬁ ts from the virtues of protecting the environment,

yet justifying the price premium will require communication of the potential

fuel and operating cost savings during ownership. Likewise, purchase of a

weight-loss program may be primarily driven by psychological factors such

as a desire to improve one’s physical appearance or to feel more physically ﬁ t.

However, there is also a potential economic factor in play. In this case, research

has shown that obesity can lead to earnings that are lower for both men and

women,

so attaining a healthy weight can have monetary beneﬁ ts as well.

Another example of combining ﬁ nancial and psychological value mes-

sages occurred when a medical device manufacturer had to justify a substan-

tial price premium for its drug-coated coronary stent used to keep clogged

arteries open. The company priced its stent at $3,500—twice the price of tradi-

tional uncoated stents and well in excess of the cost of the drug used to coat the

stent. Such aggressive pricing aroused critics in the medical professions and

in the media who accused the company of price gouging and challenged the

company to reconcile the value of the new product with its price. The manu-

facturer did so by explaining the economic beneﬁ ts to medical professionals.

Stent implantation surgery costs more than $30,000, including the cost of the

EXHIBIT 3-1

Purchase Involvement and Beneﬁ t Types for Products and Services

Chapter 3 • Price and Value Communication60

stent. But in 20 percent of cases, an uncoated stent reclogs in less than a year,

requiring a repeated procedure at another $30,000 cost. With its new drug-

eluting stent reducing the likelihood of reclogging, the surgery repeat rate fell

to around 5 percent. Thus, the objective differentiation value from the smaller

reclogging rate was $4,500: The 15 percent rejection rate difference multiplied

by the cost of a second surgical procedure. In addition, patients received sub-

stantial psychological value in avoiding the risk and discomfort of a repeat

procedure, a beneﬁ t the company emphasized to the public. The combination

of economic and psychological justiﬁ cation enabled the company to not only

win a larger reimbursement from payers when surgeons used its drug-eluting

stent but also to defuse the initial hostility and resistance to its price.

The degree of buyer involvement varies dramatically from one product cat-

egory to the next as well as across purchase occasions. The level of involve-

ment tends to increase when the purchase is more expensive. A $5 purchase

may not require much consideration, but spending an hour evaluating alter-

natives before spending $5,000 would seem merely prudent. And for larger

purchases, the level of due diligence can increase; a ﬂ eet buyer planning to

purchase 2,000 cars may even consider buying several models and testing

them for three months to fully understand the relative differences across each

model. Involvement also increases when the item purchased is being used

in a high visibility environment. For example, purchase of a six-pack of beer

might be quite routine when it is for personal consumption. However, when

a six-pack is purchased as a gift for the host of a garden party, the level of

thought and consideration rises. If the host happens to be your boss, you may

opt for a more expensive brand than your usual choice. If the recipient is a beer

connoisseur, you may choose an unusual microbrew. If the party has a salsa

theme, you may choose a brand brewed in Mexico.

Low-Involvement, Psychological Beneﬁ ts

Low-involvement goods whose beneﬁ ts are mostly psychological include

many consumer packaged goods, cosmetics, or apparel (although the authors

fully recognize the existence of some consumers who are very passionate

about these categories and treat them as high-involvement purchases). Many

of these products are sufﬁ ciently low in cost that consumers do not ﬁ nd it

worthwhile to conduct extensive research prior to making a purchase. Instead,

simply trialing multiple brands over time is the more efﬁ cient way to establish

a personal preference. For products of this nature, the role of value communi-

cations will focus on the psychological beneﬁ ts as well as creating offers that

make it easier to try out the product. Nike’s “Just Do It” campaign conveys

little about the economic value of its products, but reinforces the psychologi-

cal: Buying our products lets you be the athlete you want to be! The messaging

is further reinforced by the Nike stores that allow consumers to “get close” to

their favorite athletes through unique in-store experiences.

Low-Involvement, Economic Beneﬁ ts

Many low-involvement products can have beneﬁ ts that are predominantly

economic. For example GE’s energy efﬁ cient light bulbs are supported by the

“Energy Smart, Bright from the Start” campaign in which each package of GE

Chapter 3 • Price and Value Communication 61

compact ﬂ uorescent bulbs contains a claim about the cost savings a consumer

could achieve through reduced power consumption as well as improved

longevity—and commensurate reduction in replacement costs—associated

with the bulb (Exhibit 3-2).

High Involvement, Psychological Beneﬁ ts

An example of a product that falls in the upper-left quadrant of Exhibit 3-1

would be the purchase of the weight-loss program referenced earlier. Engag-

ing in such a program is usually the outcome of a careful personal decision

and requires the evaluation of many competing offers such as gym member-

ships, dietary supplements, pre-packaged meal programs or, in some cases,

even surgical interventions. The potential psychological beneﬁ ts are enormous

and for most consumers take precedence over the economic beneﬁ ts. The role

of celebrity endorsements such as Oprah Winfrey’s promotion of Weight

Watchers, customer testimonials such as actress Kirstie Alley for the Jenny

Craig weight-loss program, or trial membership at a gym may make it easier

to try the product.

High Involvement, Economic Beneﬁ ts

Finally, high involvement products that deliver primarily economic beneﬁ ts

include services such as management consulting and university educations, as

well as products such as airplane engines and surgical devices. A key decision

criterion in the purchase of each of these products is their relative economic

EXHIBIT 3-2

Economic Value Messages for Low-Involvement Goods

Chapter 3 • Price and Value Communication62

beneﬁ t in the form of labor efﬁ ciency, future earnings potential, fuel savings,

or treatment costs. At the same time, given the cost and magnitude of poten-

tial beneﬁ ts, purchase in any of these categories tends to be a high involve-

ment activity. The decision is carefully deliberated with consultation of many

involved in the purchase decision; data is collected on the relative performance

levels of each alternative; and an evaluation of beneﬁ ts relative to any cost dif-

ferentials is carefully studied.

An interesting observation is that as customers gain expertise, the level

of involvement can change, and so does the value messaging. A technophile

can read the feature speciﬁ cations for a laptop computer and quickly infer

how it will perform various tasks. A more typical buyer, however, would

have to do considerably more research and test various offerings to make the

same inferences. As a result, less sophisticated buyers often develop strate-

gies to lower search costs such as purchasing a known brand or relying on the

advice of an expert. The endorsement of an expert can be very powerful, even

in business markets. For example, Kaiser Permanente, a western U.S. health

maintenance organization, has a reputation for being a well-informed buyer

of cost-effective medical products. The company often tests drugs and devices

itself and will not buy a more expensive product without economic justiﬁ ca-

tion.

Consequently, when other hospitals and health maintenance organiza-

tions (HMOs) learn that Kaiser Permanente has adopted a more expensive

product or service, they may assume that its price premium is cost-justiﬁ ed.

STRATEGIES FOR CONVEYING VALUE

Most market research on willingness-to-pay relies heavily on the assump-

tion that purchase decisions are motivated by considerations of value

delivered—whether economic or psychological. What distinguishes useful

from misleading research is the extent to which the researcher accounts for

differences between the assumptions of this basic model and the way cus-

tomers in a particular market actually make decisions. Unfortunately, many

researchers design a study assuming full knowledge of the prices and features

of common substitutes without ﬁ rst determining how much consumers actu-

ally know about the substitutes when making a purchase. These studies may

show how well-informed consumers may choose, but are rarely reﬂ ective of

actual market conditions.

When the beneﬁ ts are mostly economic, value communication needs

to be a central part of the message in order to educate the customer on the

actual value delivered. One of the best ways to convey economic value is to

leverage the EVE

model that was described in Chapter 2. Exhibit 3-3 shows

an example of a value-based selling tool used by salespeople to develop a

customer-speciﬁ c estimate of the value from installing a piece of telecom

equipment that reduces the service outages and the corresponding number

of calls from affected customers to a service center. While this example is only

illustrative, notice that the data and assumptions, derived from the value esti-

mation model, are well documented and quite detailed. While inexperienced

salespeople sometimes fear that they will be challenged if they make value

claims, more experienced salespeople relish the opportunity to engage in

give-and-take conversations about precisely how much value their product

creates. Only in that context can a salesperson justify a price premium that

Chapter 3 • Price and Value Communication 63

might otherwise seem unacceptable to a business buyer who is not the actual

user of the product. A key beneﬁ t of the EVE

model is that it can be dis-

played on a salesperson’s laptop or tablet, as an interactive tool where key

customer parameters as well as the characteristics of competitive products can

be entered to illustrate the value proposition.

When the important value drivers for a purchase decision are psycho-

logical rather than monetary, it is best to avoid incorporating quantiﬁ ed

value estimates into market communications because value is subjective and

will vary from individual to individual. However, one should not conclude

that subjective values, such as those that a customer might reveal in a con-

joint research study, cannot be inﬂ uenced by communication. There are two

ways to do this. One is to focus the message on high-value beneﬁ ts that the

customer might not have been thinking about when considering the differ-

entiating features of the product. The second is to raise perceptions of the

product’s performance beneﬁ ts that cannot be easily judged prior to expe-

riencing them. Batteries all look and feel the same, even after one begins to

use them. Not until they are entirely consumed can one actually know the

life, and even then one would have no comparison unless two brands were

EXHIBIT 3-3

Spreadsheet Value Communication Tool

Chapter 3 • Price and Value Communication64

bought and used in identical devices. It is perhaps no surprise that a certain

leading battery maker has developed a battery powered toy rabbit into an

iconic marketing mascot as a way to explain the long life of its batteries. The

advertisements do not need to make any explicit mention of pricing or rela-

tive battery life; the ability of the toy to operate seemingly forever is enough

to convey the message.

Estimating economic value to the customer is fundamental to marketing

in general and to pricing in particular, but it is just one facet of the role of price

in customer decision-making. When dealing with knowledgeable and sophisti-

cated purchasers (such as specialized purchasing agents or a dedicated bargain

hunter), economic value analysis can describe and predict buyer behavior quite

adequately. However, most customers, even those in B2B environments, do

not make purchase decisions exactly as economic value analysis would indi-

cate. Although getting good value is usually a critical purchase consideration,

customers will not always choose the very best value. And in cases where eco-

nomic value is not apparent such as the purchase of a bottle of wine, buyers

will revert to heuristics and market signals when making purchase decisions.

The role of non-economic factors becomes more important when the

expenditure is small or when someone else is paying the bill, the effort of dili-

gently evaluating all the alternatives is not worth the effort. At other times,

being aware of alternatives or being unable to evaluate them before purchase

makes ﬁ nding the best deal too difﬁ cult or risky. Occasionally, the desire to

impress others leads buyers to choose high-priced offerings as is sometimes

the case with luxury automobiles. Considerations like these often mitigate the

importance of economic value relative to the importance of psychological fac-

tors such as prestige, convenience, safety, or fairness.

These considerations tend to ﬂ y in the face of traditional economics

which has always posited that economic actors (buyers and consumers) are

rational and fully informed about competing offers. The exploding ﬁ eld of

behavioral economics has shown that people rarely fulﬁ ll the criteria of being

well informed or rational. Instead, buyers often depart from economic ratio-

nality in systematic and predictable ways. In other words, buying decisions

and the corresponding evaluations of price points are replete with market and

business process inefﬁ ciencies. As noted behavioral economist Richard Thaler

describes it:

[Economically rational actors] are really smart. They know as much about

economics as the best economist. They make perfect forecasts, have no self-

control problems and are complete jerks. They’ll steal your money if they

can and get away with it . . . Most of the people that I meet don’t have any

of those qualities. They have trouble balancing their checkbook without a

spreadsheet. They eat too much and save too little. But nevertheless they’ll

leave a tip at a restaurant even if they don’t plan to go back.

Applied to the world of pricing, creating an effective strategy to convey the

psychological values of an offering requires consideration of several critical

effects inﬂ uencing buyer behavior that have been developed in the literature

on behavioral economics. Following is a summary of the most common effects

and their inﬂ uence on a buyer’s perception of value and their consequent sen-

sitivity to price.

Chapter 3 • Price and Value Communication 65

Competitive-Reference Effect

True value is what is perceived by consumers who are fully informed of alter-

natives, understand the beneﬁ ts of differentiation, and act in rational ways.

In the real world, however, such customers are few and far between. Either

they do not have enough time to make informed decisions, are ﬂ oundering in

data, or do not understand the consequences of poor choices. As a result, they

will resort to heuristics and other mental shortcuts to help guide the deci-

sion process. Restaurateurs in resort areas face less pressure to compete on

price, in spite of the higher concentration of restaurants in those areas because

their transient clientele is usually unaware of better alternatives. Instead they

focus on the “signals” that inﬂ uence how tourists choose—convenient loca-

tions, good signage, and close relationships with local concierges who can

steer customers to favored restaurants. Local residents view the restaurants

near resorts as “tourist traps,” precisely because they can charge higher prices

than restaurants less visible to tourists but patronized by a more informed

clientele.

One of the most common shortcuts is to ﬁ nd a competitive reference

product—often a highly visible and high-cost brand in the market—to assess

relative value. By managing a customer’s understanding of the relevant

competitive alternatives, a seller can signiﬁ cantly inﬂ uence the customer’s

willingness-to-pay. Woolite laundry detergent has successfully defended a

signiﬁ cant price premium compared to conventional detergents by reframing

their product as an alternative to dry cleaning. In other words, by shifting the

customer’s attention to the cost of a dry cleaner and reminding audiences that

Woolite is intended for the more delicate clothes in one’s wardrobe, the brand

is viewed as a bargain relative to a drycleaner instead of a premium against

conventional detergents.

Presented with an array of choices, and absent much knowledge of

the category, customers’ perception of value is inﬂ uenced by the range of

prices available to them at the time of purchase. Most will choose options

in the middle of the assortment. They engage in an internal debate on not

being too cheap, nor appearing too extravagant and as a result tend to make

an intermediate selection. For example, a business machine company with

three models in its line found the sales of the top-end model disappoint-

ing. The company believed that many customers would beneﬁ t from the

additional features of the high-end model, yet customers were buying the

mid-tier model. Management’s initial assumption was that the high-priced

model must be too expensive. After interviewing customers however, they

learned that most did not think that the product was overpriced. Rather,

they simply could not overcome the objections of the ﬁ nancial controllers

that the company did not need “the most expensive model.” The solu-

tion: The company introduced a fourth, even more expensive model to its

line. The new model sold poorly, but sales of the previously top-end model

increased dramatically.

We see similar strategies play out on restaurant wine lists. We often

amuse ourselves thinking about which customer might be the one ordering the

$3,700 bottle of 2010 Chateau Petrus on the menu. The reality is that this offer-

ing is rarely purchased. In fact, it is often not even in the wine cellar! Its inclu-

sion on the wine list serves merely as a decoy to signal to the diner considering

Chapter 3 • Price and Value Communication66

a $30 bottle that this establishment is really the kind of place where a $70 bottle

is more appropriate.

Switching-Cost Effect

Buyers are less sensitive to the price of a product as the added costs (both

monetary and non-monetary) of switching a supplier rises. The reason

for this effect is that many products require that the buyer make product-

speciﬁ c investments to use them. If those investments do not need to be

repeated when buying from the current supplier, but do when buying from

a new supplier, that difference is a switching cost that limits inter-brand

price sensitivity. For example, an airline may be reluctant to change suppli-

ers, from say, Boeing to Airbus planes, because of the added cost to retrain

their mechanics and to invest in a new stock of spare parts. Once an airline

begins buying from a supplier, it may take a very attractive offer from a

competitor to induce them to switch. Similarly, even personal relationships

can represent signiﬁ cant intangible investments that limit the attractiveness

of a competing offer. For example, busy executives must invest considerable

time in developing rapport with their accountants, lawyers, and childcare

providers. Once these personal “investments” are made, they are reluctant

to repeat them simply because another otherwise qualiﬁ ed supplier offers a

lower price.

This is the switching cost effect: The greater the product-speciﬁ c invest-

ment that a buyer must make to switch suppliers, the less price sensitive that

buyer is when choosing between alternatives. Since this effect is most often

attributed simply to inertia, it is easy to underestimate its predictability and

manageability.

In a recent project involving a food ingredient that was coming off pat-

ent, buyers at large CPG companies immediately demanded that prices come

down to match the price of the new generic supplier. On the surface, their

demands made a lot of sense – the generics were indeed identical, right down

to the molecular structure. However, a closer analysis revealed that there were

signiﬁ cant switching costs. Any new supplier would have to go through a

rigorous qualiﬁ cation process that typically took three to six months to com-

plete, involved factory audits, and pilot runs. Supply chain logistics would

need to be redesigned to reﬂ ect that the generics were produced abroad and

not locally. And because the generics had a long route to market, any cus-

tomer would have to establish a local warehouse with buffer inventory in case

there was a disruption to a shipping channel. When these signiﬁ cant switch-

ing costs were considered, the economic incentive to switch to a lower-cost

supplier evaporated and the incumbent was able to continue charging a price

premium.

Difﬁ cult-Comparison Effect

The concept of economic value assumes that customers can actually compare

what the alternative suppliers have to offer. In fact, it is often quite difﬁ cult

to determine the true attributes of a product or service prior to purchase. For

example, when a child suffers from a fever, a parent may be aware of the many

alternate ﬂ u remedies that are cheaper than their usual brand and claim equal

Chapter 3 • Price and Value Communication 67

efﬁ cacy. But if they are unsure that these brands are technically identical to the

one they usually buy, or if they doubt that the cheaper brand will be as effec-

tive, they will not consider them perfect substitutes. Consequently, they will

often continue to pay higher prices for the assurance that their regular brand

offers what the substitutes do not: The conﬁ dence accumulated from past expe-

rience that their brand can do what the others only promise to do.

Branded grocery products are often packaged in unusual shapes and

sizes making price comparisons with cheaper brands difﬁ cult. When, how-

ever, stores offer unit pricing (showing the price of all products by the ounce

or gallon), grocery shoppers can readily identify the cheaper brands. In one

study of unit pricing, the market shares of cheaper brands increased substan-

tially after stores ranked brands by unit price.

These examples illustrate the difﬁ cult-comparison effect: Buyers are less

sensitive to the price of a known or reputable supplier when they have difﬁ -

culty comparing alternatives. Rather than attempting to ﬁ nd the best value in

the market and risk a poor value in the process, many purchasers simply settle

for what they are conﬁ dent will be a satisfactory purchase. Their conﬁ dence

in a brand’s reputation may be based on either their own experience with

the brand or on the experience of other people whose judgement they trust.

Examples of suppliers whose proﬁ tability rests on the trust that consumers

associate with their names include McDonald’s, KitchenAid, and Marriott.

The trust for which buyers will pay price premiums is not that sellers of these

brands will necessarily provide the highest quality, but rather that they will

consistently provide the good value-for-money that buyers come to expect

from them.

The same principle applies to business markets. Industrial buyers are

commonly thought to seek many suppliers whom they play against one

another for lower prices. In fact, industrial buyers usually follow such a policy

only for those products whose quality and reliability they can easily evalu-

ate at the time of purchase. When products are difﬁ cult to evaluate and the

cost of failure is high, industrial purchasers are at least as brand loyal, and

as price insensitive, as are household buyers. In fact, for purchases that are

relatively risky and difﬁ cult to evaluate (such as new plant construction, con-

sulting services, or incorporating a new technology into an existing product

formulation), industrial buyers will often develop loyal relationships with a

list of approved suppliers with whom they have had a satisfactory experi-

ence.

They will not even consider purchasing from an unknown supplier,

even though that supplier claims to offer the same quality at a lower price.

The cost of switching a supplier—both real economic costs as well as personal

career risks—should be important factors for any seller of a product that is

suddenly facing a low-cost competitor.

End-Beneﬁ t Effect

A buyer’s price sensitivity is inﬂ uenced by the importance of the beneﬁ t that

they are trying to derive from their purchase. Many years ago IBM used the

slogan “No one ever got ﬁ red for buying Big Blue,” a message that was aimed,

not at the user of their business machines, but at the purchasing agent to

remind him that he faced a very personal risk if he procured a less well-known

brand that did not deliver the desired performance.

Chapter 3 • Price and Value Communication68

The importance of the end result is a critical driver of the end-beneﬁ t

effect. The greater the risk and the higher the cost of failure, the more salient

this effect becomes. Consider the Boeing 787 jetliner. One of the signiﬁ cant

innovations in its design is that it is constructed from a composite material

that is lighter and stronger than aluminum. One interesting aspect of work-

ing with composites is that mechanical fasteners such as rivets are no longer

used to join parts together. Instead, signiﬁ cant assemblies like the wings are

attached to the fuselage using glue.

And while the glue is very similar to the

adhesives you might ﬁ nd in a hardware store, given the high stakes of failure,

the glue purchased by Boeing is aircraft grade, which is subject to substantially

higher quality controls, additional certiﬁ cations, and costs signiﬁ cantly more.

Price-Quality Effect

Generally, price represents nothing more than the money a buyer must give to

the seller as part of the purchase agreement. For a few products, however, the

price means much more and the old adage, “ you get what you pay for ” has spe-

cial resonance. These products fall into three categories: Image products, exclu-

sive products, and products without any other cues to their relative quality. In

these cases, the price is more than just an attribute, it is also a signal of the value

that a buyer can expect to receive. In such cases, a customer’s willingness-to-

pay is inﬂ uenced by the price-quality effect , which states that buyers are posi-

tively inﬂ uenced by a higher price, because it may signal better quality.

A buyer might use price as a quality signal for a number of reasons.

Consider what motivates the purchase of an obvious image product such as

a Rolex watch. In terms of tangible value—the ability to keep accurate time—

a smartphone incorporates all sorts of new technologies that have increased

the accuracy of timekeeping since the invention of the chronometer by John

Harrison who created Sea Watch No. 1 (H-4) in 1759, the ﬁ rst device to track

time accurately enough for nautical navigation.

While the Rolex uses many of

the same design principles of Harrison’s invention (and loses or gains up to

2 seconds per day due to the limits of mechanical devices), the time on a smart-

phone is continually updated to an atomic clock via its cellphone tower net-

work. And a smartphone costs less than one-tenth of the price of a Rolex! But

buyers of a Rolex do not purchase the watch as a cost-effective timekeeper any

more than they buy a Porsche as cost-effective transportation. They buy these

items in part to communicate to others that they can afford them. They pay a

premium for the conﬁ dence that their Rolex’s uniquely expensive method of

production ensures its continued value as a status of wealth.

Consumers often value such symbols when the product reﬂ ects on them

personally. Consequently, brands that can offer the consumer prestige in addi-

tion to the direct beneﬁ ts of consumption that can, and must, command higher

prices than less prestigious products. In many luxury goods categories, a con-

sumer’s price sensitivity decreases to the degree to which they value the recog-

nition or ego gratiﬁ cation that the premium brand gives them.

One of the authors regularly marvels at the many advertisements for

prestige goods that are placed in the Sunday New York Times . Are these

advertisements intended to prompt the reader to purchase a luxury good

for a spouse? Perhaps. But another conjecture is that the ads are placed on

behalf of consumers who have already purchased the luxury good. That is,

Chapter 3 • Price and Value Communication 69

the purchase of an expensive prestige good enters the buyer into an implicit

agreement with the seller whereby the seller agrees to communicate to buy-

er’s friends and neighbors just how special (and expensive) their recent pur-

chase was.

A prestige image is only one reason that buyers might ﬁ nd a more expen-

sive purchase more satisfying. The exclusivity that discourages some people

from buying at a high price can, in addition to image, add objectively to the

value. Many professionals—doctors, dentists, attorneys, and hairdressers—

set high prices to limit their clientele enabling them to schedule clients far-

ther apart. This ensures that each one will be served without delay at the

appointed time, a valuable service for busy people. Some business travelers

choose to ﬂ y ﬁ rst class, not because of the leg room or the food, but because

the high price reduces the probability of sitting next to a noisy child or a

loquacious vacationer who might interfere with the work they must do on the

ﬂ ight.

Often, the perception of higher quality at higher prices reduces price

sensitivity even when consumers seek neither prestige nor exclusivity. This

occurs when potential buyers cannot ascertain the objective quality of a prod-

uct before purchase and lack other cues such as known brand names, coun-

try of origin, or a trusted endorsement to guide their decision. In these cases,

consumers will often rely on the relative prices of the offerings as a cue to a

product’s relative quality, apparently assuming that a higher price is probably

justiﬁ ed by a correspondingly higher value.

In an experiment performed at Cal Tech,

researchers found that increas-

ing the stated price of a wine resulted in higher taste test ratings by consum-

ers. When presented with wines that were priced at $5, $10, $35, $45, and

$90 per bottle, consumers consistently preferred the $90 wine to the $5 wine, and

preferred the $45 bottle to the $35 bottle. The catch, however, was that while

subjects were told that they would taste ﬁ ve different wines, they in fact only

tasted three. The $90 wine actually retailed at that price, but was represented

to subjects as both a $90 as well as a $10 bottle wine. When it cost $90, subjects

loved the wine; at $10 they did not like it as much. The additional fascinat-

ing ﬁ nding from this research was that all subjects were connected to an MRI

machine while they were doing the wine tasting, and the brain scans showed

that when sampling the expensive wine, the medial orbitofrontal cortex—the

part of the brain that registers pleasure—showed higher activity than when

subjects were tasting the lower-priced wines. Finally, in a follow-up experi-

ment where subjects tasted the wine samples without any price information,

the cheapest wine was most preferred.

Price can also inﬂ uence the actual effectiveness of a product. In an exper-

iment where students about to take an exam were offered an energy drink

that was sold either at regular price or at a discount, those who paid full price

performed better on the exam.

Even though everything else was identical—

product, packaging, and branding—simply selling the item at a discount led

to a poorer test performance relative to those who purchased their energy

drink at full price. It makes one wonder whether it is a good idea to label off-

brand drugs as generics and convince consumers that they will beneﬁ t from the

cost savings over the branded version. Perhaps it could be a better idea to label

generics as “ brand-equivalent, clinically-approved therapy ,” and charge con-

sumers a little more?

Chapter 3 • Price and Value Communication70

Expenditure Effect

The expenditure effect states that buyers are more price sensitive when the

expenditure is larger, either in dollar terms or as a percentage of available bud-

get. As the expenditure increases, the potential return to shopping around for

a better deal increases. On the other hand, small impulse purchases are sim-

ply not worth any effort to ensure that the price is a good deal. This partially

explains why large transactions such as buying a full case of soda is cheaper –

and even accompanied by additional promotions – while the purchase of a

single can of soda from the cooler in the checkout line is signiﬁ cantly more

expensive on a per-unit basis and rarely discounted.

The effect of the expenditure size on price sensitivity is confounded in

consumer markets by the effect of income. A family with ﬁ ve children may

spend substantially more on food than a smaller family, yet still be less price

sensitive if the cost of food accounts for a smaller portion of the large family’s

high income. This relationship between a buyer’s price sensitivity and the per-

centage of income devoted to the product results from the trade-offs buyers

must make between conserving their limited income and conserving the lim-

ited time they have to shop. Higher-income buyers can afford a wider variety

of goods but cannot always afford more time to shop for them. Consequently,

they cannot afford to shop as carefully as lower-income buyers and so they

accept higher prices as a substitute for time spent shopping.

The expenditure’s size relative to income is also a constraint on both a

business’s and a household’s primary demand for a product. A young man

may long for a sports car believing that a Porsche clearly has differentiating

attributes (such as handling and engine performance) that justify its premium

price relative to similar cars. However, at his low income he is not making

a purchase decision among sports cars. His budget is currently consumed

by more important expenditures such as food, rent, and education. Until his

income rises, or the price of sports cars drops, his preference within the cat-

egory is not relevant.

Successful marketers of premium products will reframe premium prices

in a different context to lower the buyer’s price sensitivity. Life insurance is

a product that is particularly useful for a young family that has signiﬁ cant

long-term ﬁ nancial obligations in raising children, yet is at a life stage where

their present budget can’t cover all of their future needs. By offering dif-

ferent coverage levels and by breaking down an annual cost into quarterly

payments—or even a daily cost “ only $0.37/day! ”—the purchase can be framed

in a manner that makes it seem much more affordable even to a cash-strapped

young family.

Shared-Cost Effect

Although the portion of the beneﬁ t accounted for by the product’s price is an

important determinant of price sensitivity, so is the portion of that price that

is actually paid by the buyer. People purchase many products that are actu-

ally paid for in whole or in part by someone else. Insurance covers a share of

the buyer’s cost of a doctor’s visit or prescription drug. Tax deductions are

designed to reduce the price sensitivity to engaging in beneﬁ cial behaviors

such as investing in an education, purchasing equipment for a business, or

Chapter 3 • Price and Value Communication 71

charitable giving. When travel is paid for by an employer, employees might

choose an airline with better amenities, not necessarily the lowest cost. When

a child chooses a college to attend, he or she may be more likely to select an

expensive private school if they have a scholarship or a wealthy relative will-

ing to cover the cost of tuition. In each case, the smaller the portion of the

purchase price buyers must pay themselves, the less price sensitive they are.

The effect of partial or complete reimbursement on price sensitivity is called

the shared-cost effect .

The shared-cost effect is a fundamental design principle built into the

federal tax code. By offering tax breaks and credits for taking out a mortgage,

having a child, or purchasing health care, the government is essentially willing

to share the cost of engaging in behaviors that are deemed beneﬁ cial to society.

It should also be noted that sharing the cost does not always lead to

greater demand. Consider how a spouse would react if, after celebrating a

special occasion at a nice restaurant, their partner paid for the dinner using a

discount coupon. Unless the spouse is an economist or an accountant, sharing

the cost of the meal with the restaurant would probably be viewed as rather

unromantic.

Transaction Value Effect

The value of a transaction—both economic and psychological—is also inﬂ u-

enced by the structure of the ﬁ nancial terms and structure of the deal. Sup-

pose you are about to purchase a car from a dealership where you know that

haggling over prices is the norm. As a smart consumer, you have looked up

the dealer’s wholesale costs to determine the “price ﬂ oor,” you’ve logged onto

TrueCar, an information website for car buyers, to review recent transaction

prices, and you have formulated in your mind what you think would be an

aggressive, low-priced offer to start the negotiations. Consider the scenario in

which, upon hearing your offer, the dealer tells you that your price is far too

low, counters with a higher price, and engages in several rounds of negotia-

tions before you mutually agree on a price that is between your opening offer

and the dealer’s initial price. In this instance, even though the ﬁ nal transaction

price is higher than your opening offer, you generally feel conﬁ dent that you

got a good deal because the negotiations were laborious and resulted in the

dealer moving down from his opening offer.

By contrast, consider the same scenario as described above, except in this

instance, upon hearing your opening offer, the dealer immediately accepts

your offer. In this instance, your reaction is more likely one of dread that your

offer was too high—after all, why else would the dealer have accepted the deal

so quickly? The transactional value in this second scenario is likely lower than

in the ﬁ rst. And yet from an economic perspective, you are better off in the

second scenario.

Transaction value suggests that buyers are motivated by more than just

the “acquisition utility” associated with obtaining and using a product. They

are also motivated by the “transaction utility” associated with the difference

between the price paid and what the buyer considers a reasonable or fair offer for

the product. Transaction utility is framed by the difference between the actual

price paid and the reference price, which is the amount that the buyer would

consider reasonable or fair. In the car-buying example above, the reference

Chapter 3 • Price and Value Communication72

price in both instances is a price higher than the buyer’s opening offer—the

underlying expectation for the buyer is that their opening offer would be

considered unreasonably low to the dealer and that the ultimate price will be

higher. Thus in the ﬁ rst instance, when the dealer counters with a higher price,

the reference is set at a relatively high number. Any discount from that initial

counter-offer is seen as a discount off of the reference and contributes to a posi-

tive transaction value. In the second scenario, however, the immediate accep-

tance of the initial offer implies that the dealer may have accepted an even

lower offer—and signals to the buyer that he is probably overpaying relative

to the implied reference price. The transactional value has now become nega-

tive, even though the transacted price is lower than in the ﬁ rst scenario.

Fairness Effect

The concept of a “fair price” has bedeviled marketers for centuries. In the Dark

Ages merchants faced a death penalty for exceeding public norms regarding

the “just price.” In the more recent communist period, those who “proﬁ teered”

by charging more than the ofﬁ cial prices—even though the state was unable

to meet demand—were regarded as criminals. Even in modern market econo-

mies, “price gougers” are criticized in the press, hassled by regulators, and

boycotted by the public. After Hurricane Sandy hit America’s East Coast, the

governor of New Jersey, a state particularly hard hit, issued a warning: “Dur-

ing emergencies, New Jersians should look out for each other, not seek to take

advantage of each other,” and reminded citizens that price gouging was ille-

gal and would warrant harsh penalties, even though economic theory would

suggest that prices should naturally rise during periods of supply shortages.

There is no precise deﬁ nition of what is considered fair. It is a

community-held norm that is not guided by factors such as proﬁ tability (oil

companies are routinely accused of unfair price gouging even though their

proﬁ ts are below the U.S. industry averages), absolute value (makers of medi-

cal devices and pharmaceuticals are often accused of unfair pricing even when

their products are demonstrably shown to save lives) or supply (national

sports leagues will sell tickets to championship games at face value, even if

there is clear excess demand).

And notions of fairness can change over time. A car dealer charging a

premium that is more than the price on the manufacturer’s window sticker

for a popular new model will quickly be accused of gouging, even if the

adjusted price is a market-clearing price. By contrast, in the airline and hospi-

tality industries where demand-based pricing has been practiced for several

decades, consumers have become used to the idea that prices are linked to

relative demand and no longer ﬂ inch when prices rise threefold or more for

popular travel dates.

Markets will routinely view the pass-through of input cost increases as

fair even if these cost increases pose an economic burden on the buyer. The

reason is that it is generally accepted that sellers are allowed to preserve their

proﬁ ts in the face of rising costs. It is also generally considered fair for a seller

to retain the beneﬁ ts of input cost changes—there is no societal norm (at least

in the United States) that would compel a seller to share his or her cost efﬁ cien-

cies with their customers.

However, a sense of unfairness enters the moment that a seller exerts any

market leverage to increase prices. It is one of the reasons why price increases

Chapter 3 • Price and Value Communication 73

by public utilities—which, by virtue of being sole suppliers, are always viewed

with great suspicion and subject to signiﬁ cant regulatory review to ensure that

the utility is not merely using its market power to compel customers to pay more.

The form of a price change can have signiﬁ cant impact on perceptions of

fairness. The elimination of a discount is viewed as a fair way to raise prices in

cases where demand has risen. However adding a surcharge above the regular

price is viewed negatively even if the net economic impact on the buyer is the

same. Passing through a price increase via a change in product size—such as

when the once-standard 64-ounce container of orange juice was reduced to

59 ounces—is generally seen as fair, perhaps because these forms of price

change are less noticeable.

Fairness is often framed by the “shadow of the future.” For one-time

transactions, consumers tend to be more willing to accept market rate pric-

ing. However when they anticipate future interactions with the seller, the

norms of fairness are applied more rigorously. Home Depot will not raise

prices of building supplies after a hurricane, while one-off entrepreneurs who

make bulk purchase in other markets and truck it in to the hurricane area

will charge what the market will bear. Both are acting in a proﬁ t-maximizing

manner, however Home Depot’s ability to realize short-term premiums is con-

strained by the long-term memory of the customer that Home Depot hopes to

continue serving long after the short-term jobbers have gone back home.

And

yet consumers are willing to do business with both sellers.

MULTIPLE PARTICIPANTS IN THE BUYING PROCESS

The buying process frequently involves more people than just the customer

since others participate by providing information, facilitating search, and

inﬂ uencing the purchase decision. Multiple participants are, in fact, the norm

for purchases of high involvement goods characterized by complex offerings

and, often, higher prices. Multiple participants are also common in most busi-

ness markets where purchasing is managed by professional procurement

managers using sophisticated information systems and aggressive negotia-

tion tactics. The addition of individuals to the buying process complicates the

EXHIBIT 3-4

Distribution of Value Across the Organization

Chapter 3 • Price and Value Communication74

job of value communications because it forces marketers to adapt and deliver

multiple messages at different points in the process.

To illustrate how value communications can be adapted for multiple indi-

viduals in the buying process, we turn to the example of a chemical company

attempting to sell the value of a new chemical additive for a steel mini-mill.

Suppose that the chemical provided an incremental $18 per ton in monetary

value for the steel producer. However, the $18 is an aggregate, company-level

estimate that is not equally relevant to the different stakeholders in the cus-

tomer organization (see Exhibit 3-4). For example, the marketing manager

may appreciate the total value estimate, but he is impacted directly only by the

fact that the chemical additive enables him to penetrate new market segments.

The melt shop foreman will value the reduced scrap rate, worth $2 per ton,

but he will be less pleased about the $5 per ton cost created by the additional

process steps needed to incorporate the additive into the steel slurry. In the

end, the ﬁ nish mill supervisor may be negatively disposed toward the product

because it lowers his organization’s ﬁ nancial performance, even though the

overall value is positive. Finally, the value impact for the procurement agent

is neutral because her functional area has no operational involvement with the

additive; she is only involved in negotiating the price.

The need to adapt marketing communications to the product and the

customer’s context makes creating effective value communications more chal-

lenging today than ever before. It is not sufﬁ cient to adapt the content of the

message to the customer’s learning needs at different stages of the buying

process. You must also ensure that it is delivered to the right person at the

right time in the buying process. Accomplishing this task requires meaning-

ful insight about what value is created, how that value is generated across the

organization, and when the participants in the buying process are ready to

receive the value messages. Our research shows that successful value com-

munications requires close coordination between marketing and sales—a trait

lacking in many of the organizations we surveyed. For those companies that

make the investment to strategically communicate value, the return, in the

form of more proﬁ table pricing, can be substantial.

Summary

Although price is often more important to

the seller than to the buyer, the buyer can

still reject any price offer that is more than

he or she is willing to pay. Firms that fail to

recognize this fact and base price on their

internal needs alone generally fail to attain

their full proﬁ t potential. An effective

price communications strategy requires

a nuanced assessment of the quantiﬁ able

beneﬁ ts that a customer can realize from

the transaction, as well as a careful under-

standing of the psychological factors that

might inﬂ uence a customer’s decision. For

most products, an economic value analysis

does not fully capture the role of price in

the individual decision-making. Most cus-

tomers do not approximate the image of

a fully informed “economic individual,”

who always seeks the best value in the

market regardless of the effort required.

Therefore a pricing professional’s analysis

must go beyond the economic value to an

understanding of how the buyer’s under-

standing of value—and their willingness-

to-pay—can be shaped and inﬂ uenced

through the effective leveraging of the

psychological aspects of pricing described

in this chapter.

Chapter 3 • Price and Value Communication 75

Notes

1. Oscar Wilde, The Picture of Dorian

Gray, 1890.

2. John Hogan, “Building a Leading

Pricing Capability: Where Does

Your Company Stack Up?” Deloitte,

2014. Accessed at www2.deloitte.

com/content/dam/Deloitte/us/

Documents/strategy/us-consult

ing-building-a-leading-pricing-

capability.pdf.

3. Charles L. Baum and William F.

Ford, “The Wage Effects of Obesity:

A Longitudinal Study,” Health Eco-

nomics , 13 (2004), pp. 885–899.

4 . Steve Banker, “Kaiser Perman-

ente and Their Journey to Trans-

form Their Supply Chain,” Forbes.

com, October 8, 2014. Accessed at

www.forbes.com/sites/steve

banker/2014/10/08/kaiser-perma

nente-and-their-journey-to-trans

form-their-supply-chain/#b1f3115

109e8. Also see Kaiser Permanente

Division of Research, accessed at

www.dor.kaiser.org/external/dor

external/about/index.aspx.

5 . “The Importance of Misbehav-

ing, A Conversation with Richard

Thaler,” Deloitte Review , 18 (2016),

pp. 56–69. Accessed at https://

dupress.deloitte.com/dup-us-en/

deloitte-review/issue-18/behav

ioral-economics-richard-thaler-

interview.html.

6 . J. Edward Russo, “The Value of

Unit Price Information,” Journal of

Marketing Research , 14 (May 1977),

pp. 193–201.

7. Charlie Brown, “Too Many Execu-

tives Are Missing the Most Impor-

tant Part of CRM,” Harvard Business

Review , August 24, 2016.

8 . “Boeing’s New 787 Dreamliner:

How It Works,” Popular Mechanics ,

August 3, 2006. Accessed at www.

popularmechanics.com/flight/

a809/boeing-787.

9 . Marine timekeeper H4, at Royal

Museums Greenwich, Greenwich,

London, UK, online image accessed

at http://collections.rmg.co.uk/

collections/objects/79142.html.

Also Dava Sobel, Longitude: The True

Story of a Lone Genius Who Solved

the Greatest Scientiﬁ c Problem of His

Time (New York: Walker Books,

2007).

10 . Hilke Plassman, John O’Doherty,

Baba Shiv, and Antonio Rangel,

“Marketing Actions Can Modu-

late Neural Representations of

Experienced Pleasantness,” Pro-

ceedings from the National Acad-

emy of Sciences of the United States

of America , 105(2) (January 2008),

pp. 1050–1054.

11. Baba Shiv, Ziv Carmon, and Dan

Ariely, “Placebo Effects of Market-

ing Actions: Consumers May Get

What They Pay For,” Journal of Mar-

keting Research , XLII (November

2005), pp. 383–393.

12. Andre Gabor and Clive Granger,

“Price as an Index of Quality—

Report on an Inquiry,” Economica ,

February 1966, pp. 43–70. Also R. E.

Alcaly, “Information and Food

Prices,” Bell Journal of Economics , 7

(Autumn 1976), pp. 658–671.

13. David Futrelle, “Post-Sandy Price

Gouging: Economically Sound,

Ethically Dubious,” Time , Novem-

ber 2, 2012. Accessed at http://

business.time.com/2012/11/02/

post-sandy-price-gouging-eco

nomically-sound-ethically-du

bious.

14 . Daniel Kahneman, Jack L. Knetsch,

and Richard H. Thaler, “Fairness

and the Assumptions of Economics,”

Journal of Business , 59(4), part 2 (1986).

15 . “The Importance of Misbehaving, A

Conversation with Richard Thaler,”

pp. 56–69.

CHAPTER 4

Price Structure

Tactics for Pricing Differently

Across Customer Segments

Discovering in every man that which distinguishes him from others is to know him.

Hermann Hesse

After developing products or services that create value and making customers

aware of it, a marketer must determine how most proﬁ tably to capture a share

of that value in both volume and margin. The challenge is that individual cus-

tomers will value the differentiating features of products and services very

differently due to differences in their abilities to pay, their subjective prefer-

ences, their end-use applications, and their prior experience with the product

category. Moreover, the timing of customers’ needs, the speed of their pay-

ments, and the level of service and support they require can drive signiﬁ cant

differences in the cost to serve them. When a company tries to serve all cus-

tomers with one price, or even with a standard markup over cost, it is invari-

ably forced to make large trade-offs between volume and margin, with gains

in volume requiring either lower prices or higher costs. Fortunately, a well-

designed price structure can substantially mitigate that trade-off.

Except for highly competitive commodities, charging the same price per

unit is rarely the best way to generate revenues. A far more proﬁ table strat-

egy requires creating a structure of prices that aligns with the differences in

economic value and cost to serve across customer segments. The goal is to

capture more revenue from sales where value or cost to serve is higher, while

accepting lower revenue to earn additional proﬁ ts from incremental volume

to customers for whom value is less or the cost to serve them is low.

To illustrate the huge beneﬁ ts of a well-deﬁ ned segmented price

structure, suppose that a supplier faced ﬁ ve different segments, all willing

to pay a different price to get the beneﬁ ts they sought from a product (see

Exhibit 4-1). Segment A with sales potential of 50,000 units is willing to pay

$20 for the ﬁ rm’s product. Segment B with sales potential of 150,000 units is

willing to pay $15, and so on. What price should the ﬁ rm set? The right answer

in principle is whatever price maximizes proﬁ t contribution. If you calculate

EXHIBIT 4-1

The Incremental Contribution from Segmented Price Structure

Chapter 4 • Price Structure78

the proﬁ t contribution at each of the ﬁ ve prices assuming a variable cost of

$5 per unit, the single price that produces the maximum contribution ($2,750)

is $10.

However, a single-price strategy clearly leaves excess money on the

table for buyers who are willing to pay more: Those willing to pay $20 and

$15. At the price of $10, those high-end buyers are enjoying a lot of what

economists call “consumer surplus.” The ﬁ rm would be better off if it could

capture some of this surplus by charging them higher prices. The second

problem is that the supplier leaves nearly half of the market unsatisﬁ ed, even

though it could serve those customers proﬁ tably at prices above the $5 per

unit variable cost.

For industries with high ﬁ xed costs, serving those additional customers

is often very proﬁ table and, when they constitute large amounts of volume,

can be essential for a company’s survival. Railroads could not maintain, let

alone expand, their costly infrastructures without a segmented price struc-

ture. Railroad tariffs are designed to reﬂ ect the differences in the value of the

goods hauled. Coal and unprocessed grains are carried at a much lower cost

per carload than are manufactured goods, resulting in a much lower contribu-

tion margin per carload. Still, the large volumes of coal and grain transported

enables that low-priced business to make a substantial contribution to a rail-

road’s high ﬁ xed-cost structure. If railroads were required to charge all ship-

pers the tariff for manufactured goods, they would likely lose shippers whose

commodities would no longer be competitive on a delivered-cost basis and

so would lose that proﬁ t contribution. On the other hand, if railroads had to

charge all shippers the tariff currently charged for a carload of unprocessed

grain, their systems would reach capacity before they generated enough con-

tribution to cover their ﬁ xed costs and become proﬁ table. Freight railroads

survive and prosper by leveraging their capacity to serve multiple market

segments at value-based prices for each segment.

Companies that have a large market share but refuse to serve the lower-

value segments of a market take a risk in doing so. In his book, The Innova-

tor’s Dilemma , Clayton Christensen cites numerous examples of companies

that failed to meet demand from a potentially large, but lower-value segment

in a market that they otherwise dominated. Invariably, someone eventually

addressed that need and used it as a base to partially support the ﬁ xed cost

investments necessary to compete for business in higher margin segments.

For example, Xerox owned the high end of the copier market. It lost that

dominant position only after companies that had entered at the bottom of the

market developed service networks of sufﬁ cient size to support sales of large,

higher-priced copiers, such as those bought by copy centers that required

quick service to minimize downtime.

How many segments with different price points should a supplier

serve? To return to our illustration, Exhibit 4-1 shows that if the ﬁ rm were

able to set two price points serving two general price segments—high-end

buyers willing to pay $15 or more, and mid-level buyers willing to pay $8 or

more—it could increase proﬁ t contribution by 40 percent. But if the supplier

could charge separate prices to each of the ﬁ ve market segments, it could

increase proﬁ t contribution by 80 percent relative to the single price strat-

egy! In principle, more segmentation is always better. In practice, the extent

of price segmentation is limited by the ability of the seller to manage the

Chapter 4 • Price Structure 79

complexity of managing across multiple segments and to enforce the segmen-

tation at an acceptable cost.

CHALLENGES THAT CAN UNDERMINE

SEGMENTED PRICING

Segmentation is much more challenging for pricing than for other aspects of

marketing because customers to whom you intend to charge a higher price have

a strong incentive to undermine it. They will not freely identify themselves as

members of a relatively price-insensitive segment simply to help the seller charge

them more, but will try to disguise themselves as customers who should qualify

for a lower price. Channel intermediaries too can undermine a segmented pric-

ing strategy by buying the product intended for delivery to customers entitled

to a lower price but then actually diverting it for resale to customers targeted

to receive a higher price. Commonly referred to as gray-market sales, they cre-

ate a huge challenge for companies serving international markets because dis-

tributors in countries where prices are lower cross ship products to ones where

prices are higher. A manufacturer then loses higher-priced sales in the high-

value country due to gray-market competition from its own products that have

been parallel imported from lower-priced countries. And, to add to the insult,

sales are lost even in the low-price country due to shortages that develop when

products are diverted away from the low-price market.

Gray-market diversions by channel intermediaries can undermine not

only different pricing by region but also by application. There are examples

where a speciﬁ c drug can have two different uses with correspondingly two

different levels of clinical value delivered. For example, a drug used to treat a

high-risk disease like cancer might also be useful for treating eye irritation. The

challenge for a pharmaceutical company is to develop a strategy that allows it

to charge differently depending on how the drug is being used. One common

tactic is to introduce two versions of the drug, each with a unique brand name

and dosing guidelines, even if the active ingredient is the same. The challenge,

of course, is that some enterprising physicians might purchase the cheaper

version of the drug, adjust the dosing to achieve the same result in the higher

clinical-value setting, and pocket the difference in cost of the drugs used in the

procedure.

In markets where sales are made directly, without a channel interme-

diary, it is easier to charge different prices to different customers. Recogniz-

ing the huge potential for proﬁ t improvement from aligning price with value,

many companies adopt ﬂ exible pricing policies, empowering sales reps and

sales management to discount prices for customers whom they perceive to

be more price sensitive, while charging higher prices when the customer is

unaware of better alternatives or perceives that what differentiates the offer

is worth a higher price.

Flexible pricing can work in markets where customers buy a complex

product or service very infrequently, such as when they are purchasing

funeral services for a recently departed relative or a business hires a law ﬁ rm

to defend it against a novel civil suit. Customers making infrequent purchases,

especially of products that are difﬁ cult to compare prior to purchase, are often

uninformed about the differences in price and features among competitors

and about the value that those differences might create for them. They must

Chapter 4 • Price Structure80

rely on the supplier for advice about what to buy, which leads them to reveal

information to the supplier that enables the supplier to judge their relative

price sensitivity with some accuracy.

Staying ﬂ exible in negotiating customer-speciﬁ c prices in this way can

improve both revenue and proﬁ tability when selling to uninformed buyers.

It has proven horribly counterproductive, however, for setting prices for cus-

tomers with whom a seller has, or hopes to establish, an ongoing commercial

relationship. The problem arises because buyers, especially those who are pro-

fessional purchasing agents, learn over time how to manipulate a seller’s ﬂ ex-

ible pricing policy and will do so aggressively to gain competitive advantage,

or to avoid being put at a disadvantage. Moreover, sales reps learn that it is

easier to make a case to their own management for why some customer needs

a bigger discount than it is to justify prices to buyers where access to decision-

makers is more limited and the real purchasing process less well understood.

Soon, a ﬁ rm’s negotiated prices become aligned with differences among buy-

ers’ ability to negotiate and manipulate the seller’s expectations rather than

with differences in value received and cost to serve. Flexible pricing in this

case undermines rather than reinforces proﬁ tability.

To prevent losing control of pricing to entrepreneurial channel inter-

mediaries or to customers who are the smart negotiators, a company must

understand how drivers of value and cost to serve differ across customers and

develop price structures that align price levels proactively to reﬂ ect those dif-

ferences. In the next chapter, we will describe how to deﬁ ne price policies

proactively for managing price exceptions without undermining the integrity

of a price structure. The balance of this chapter is devoted to explaining how

to create a segmented price structure that distinguishes between applications

or customer types that should be priced differently in order to optimize proﬁ t-

ability. There are three mechanisms that one can use, individually, but more

often in combination, to form a segmented price structure: Offer conﬁ gurations ,

price metrics , and price fences .

OFFER CONFIGURATIONS

When differences in the value of an offer across segments is caused by dif-

ferences in the features and services that customers need or value, a seller

can segment the market by conﬁ guring different offers consisting of different

bundles of features and services for different segments. Using offer conﬁ gura-

tions to implement segmented pricing requires minimal enforcement of price

differences because customers will self-select the offers that determine their

prices. An airline’s segmented price structure (see Exhibit 4-2) enables passen-

gers to choose freely whether they want to pay only the most discounted price,

want to pay a little more for the ability to check a bag or board early enough

to get overhead space, or need the ability to cancel or change ﬂ ights. The price

structure also includes separate à la carte charges for priority seats that are

closer to the front of the plane (enabling faster exit) and have more leg room.

Additional categories (Refundable and Business/First) afford travelers more

services such as ﬂ exibility and privileged bag delivery.

To create an effective bundled offer structure, one must ﬁ rst determine

which features and services the ﬁ rm should include in bundles, rather than

pricing each element à la carte and leaving customers to customize their own

Chapter 4 • Price Structure 81

offers. There are multiple arguments against pricing all individual features

and services separately. A single price for a bundle of features and services

reduces transactions costs for both customers and sellers. The costs to make

and deliver most products and services increase with the number of varia-

tions allowed, although technology is reducing the cost of mass customization.

Lastly, research shows convincingly that people are less sensitive to the cost

of value-added features and services when bundled as a single expenditure.

Still, something that is particularly high-cost or difﬁ cult to provide in greater

quantities (e.g., the best seat locations) should be charged separately from any

bundled price to ensure that customers who most value that feature can be

conﬁ dent that it will be available to them at some price while simultaneously

maximizing the seller’s income from that feature.

Optimizing the Structure of Offer Bundles

Creating bundles is simple when customers targeted for higher prices value

some feature, like the ability to make changes in an airline ticket, which other

customers do not. By including that feature only in the higher-priced bundle,

high-value customers (e.g., business travelers with schedules subject to change)

choose to pay the higher fare. Sometimes value-adds can be used, to attract the

lower-value customer. When they have capacity, airlines make seats available

to tour operators at prices lower than their lowest published fares with the pro-

viso that the airline seat is sold only as part of a bundle including other items

such as tickets to tourist attractions and nights in tourist hotels. That bundle

insures that those tickets will not end up being sold to non-tourists who other-

wise could have been sold a seat at a higher fare.

Cable TV operators create different bundles focused on families, sports

enthusiasts, and movie buffs that simply include types of programming that

they value most. The challenge occurs when different customers value the

same features and services enough to make sales to both proﬁ table, but they

value them differently. Segmenting by bundled offer conﬁ gurations can still

be more proﬁ table than pricing elements separately if different segments of cus-

tomers simply rank the importance of features differently that they would like to have

in a bundled offering . The following example illustrates this principle.

Sports channels create an ideal opportunity for bundling to maximize

proﬁ tability. Some sports enthusiasts highly value “ﬁ ght sports” like boxing

and mixed martial arts. They may also value access to “team sports” like base-

ball and soccer, but to a lesser extent than team sport enthusiasts do. Team

sport enthusiasts have exactly the opposite ranking. They will subscribe to

a channel or a sports package of channels primarily for the team sports, but

EXHIBIT 4-2

Segmented Price Structure in Airlines

Chapter 4 • Price Structure82

would also value the occasional “ﬁ ght sport”—but would not value a sub-

scription as much as “ﬁ ght sport” enthusiasts do. The challenge is to maximize

income from these two segments combined, since, with most costs ﬁ xed, there

is a large return from maximizing total revenue by getting them both to watch

both types of sporting events.

Now let’s make the pricing challenge a bit more complicated. Let’s say

that there are many more team-sport broadcasts than ﬁ ght-sport broadcasts,

so that it is possible to charge more to both segments for team-sport access.

Based upon past research and experimentation, assume that those pricing

cable TV options believe that the subscription prices in Exhibit 4-3 represent

roughly the acceptable prices that would optimize revenue from each segment

for access to each type of event. Now, how could a pricing manager maxi-

mize revenue? (To simplify the illustration, we assume that the payment to

the teams for broadcast rights is a percentage of revenue rather than a variable

cost per subscriber so that everyone is aligned with revenue maximization as

the goal.)

The maximum viable price per event would be $18/month for a ﬁ ght-sport

package and $33/month for a team-sport package. That strategy would, how-

ever, exclude a lot of potential viewers and their revenue. An alternative that

would not restrict the market would be to charge $6/month for a ﬁ ght sports

subscription and $25/month for a team sports subscription—for a total of $31/

month. That option would slightly increase total revenue and overall customer

satisfaction. But there is a still better strategy. Can you see it?

Instead of offering a price structure with a separate price for ﬁ ght sports

and team sports, observe what happens if the seller offers a combined all-

sports bundle? They could then charge $39/month and still get both seg-

ments of sports enthusiasts to subscribe earning $8/month more revenue per

subscriber than if they set prices for the individual elements low enough to

generate the same volume of subscriptions. So, should cable companies force

customers to buy such bundles. Some do, but the lack of choice annoys their

customers. A better option is to offer the all-sports bundle at $39/month and

the option to buy ﬁ ght sports for $18/month and team sports for $33/month.

Not only does that open the market for what may be some customers who only

value one or the other, but it establishes in the customer’s mind a reference

value for the package elements separately. Even if few people buy the separate

options, the company can advertise that buyers of the all-sport package can

get both streams of shows that would individually sell for $51/month for the

low discount price of only $39!

EXHIBIT 4-3

Revenue Optimizing Subscription Pricing by Segment

Chapter 4 • Price Structure 83

In practice, there are often more than two segments, segments of very

different sizes, and more than two types of products to bundle. Maximizing

proﬁ t contribution requires building a spreadsheet or employing a complex

optimization model to evaluate bundling alternatives.

The principle, how-

ever, is the same for bundling features in auto packages, items to include

in the four-course dinner special, items in a vacation package, or spots for

advertising at different times embedded in different shows on a television

network. The key is to bundle elements that are valued differently by differ-

ent segments, so long as the incremental revenue earned from inducing more

customers to buy an element of the bundle exceeds the incremental cost to

supply it. In principle, one could maximize revenue from three segments with

one bundle containing three different elements, each valued most highly by

one of the segments.

Designing Segment-Speciﬁ c Bundles

Bundling can also facilitate segmented pricing, thus increasing proﬁ tability,

when different customer segments have different price sensitivity for a core

product or service (for example, lodging at a popular vacation spot). When

it is possible to ﬁ nd features or services that one segment values highly and

another does not (for example, access to a pro-quality golf course or a kids’

club where children can be left safely and entertained), it is easy to design

segment-speciﬁ c pricing by bundling. The golfer evaluates the sum of the

room cost plus the golf cost in ﬁ guring the cost of the vacation. If the golfer

values lodging at this location by $100 per night more than the family, he will

pay up to $100 more per day for greens fees than he would at an equal quality

course in a less desirable location. (Assuming, of course, that no cheaper but

equal quality course is available near this location.) Since the family did not

come to play golf, they are unaffected by high greens fees.

As rewarding, but often overlooked, is the potential for bundling value-

added features and services to attract customer segments that require a lower

price to win their patronage. Although they pay a lower price, their purchase

volume may, nevertheless, be proﬁ table, especially during off-peak periods or

economic downturns when excess capacity would otherwise remain unused.

Simply cutting prices to win their business would, however, make it difﬁ -

cult to continue charging other customer segments a higher price and could

cheapen the image of the brand. Bundling a “free” or low-cost service or

feature speciﬁ cally preferred by this segment, however, can improve the value

proposition for that segment without having to cut the offer price explicitly.

For example, the resort hotel could charge a higher price for the room

but bundle the kids’ club free for one child with each paying adult, admit

children free at the breakfast buffet, or provide a shuttle and discount tickets

to nearby family-friendly entertainment. Since the golfers would ﬁ nd none of

this worthwhile, the attraction to the buyer and the added cost to the seller are

limited to the targeted segment. Similar bundles exist in business-to-business

markets. Companies that cannot discount prices to small businesses without

facing demands for lower prices from larger customers may offer their price-

sensitive small business customers low-cost ﬁ nancing, free software for better

inventory management, or anything else that they would value but that large

company customers would not want.

Chapter 4 • Price Structure84

There is an alternative to adding a feature that raises the value of the

discounted offer to only the low-price segment. That is to add a feature to the

lower cost offer that kills value for the higher-priced segment without affect-

ing the value to the discount segment. Dick Harmer, a former colleague of

ours, gave this practice the memorable name “selective ugliﬁ cation.” Chem-

ical companies often do not have separate lines for making “food grade”

and cheaper “industrial grade” chemicals. They simply add something to

the industrial grade that makes it no longer acceptable for food manufac-

turers and consumers. A Saturday night stay requirement for a discount

airline ticket is another example, since it has no effect on the pleasure trav-

eler who wants the trip to include the weekend anyway, but precludes most

business travelers.

Unbundling Strategically

While bundling can be a proﬁ t-enhancing strategy for segmentation, it often

has the opposite effect when variable cost services are bundled simply to

differentiate an offering. For example, a business-to-business equipment

company might try to convince customers to pay more for its machines by

bundling the promise of faster warranty repair service and free delivery

anywhere, and an airline might hope to charge more for its tickets because

they include free baggage handling and agent assistance with reservations.

Such price-offer structures often undermine rather than enhance proﬁ ts

and can be fatal to companies that cling to them in competitive markets for

two reasons.

The ﬁ rst problem is that the cost to provide bundled service can be

widely different across customers. Customers who have a high need for the

bundled services gravitate to the companies that offer them for free. As com-

panies gain share among these high cost-to-serve users, the average cost to

deliver the bundle increases. If they try to add the increasing average service

cost to the price, they begin losing sales to customers who are not high-service

users. If they avoid raising the price of the bundle to reﬂ ect the increasing cost

of the service, the increasing cost erodes their margins. The second problem

is that customers often fail to recognize the value of differentiating services

unless they have a price attached to them.

Even when included in a bundle,

the price assigned to the unbundled services draws attention to their value,

making the bundled price appear to be a better deal relative to the sum of the

component parts.

Unless the cost to deliver a service is trivial relative to the overall value

of the offer, bundling optional services for free will undermine proﬁ tability.

Unbundling them as many airlines have done for baggage handling or for

using an agent to make reservations, is in fact strategically essential when fac-

ing intense competition. This can be accomplished either by charging per-use

fees for the services and/or by including them only in higher-priced bundles

of services, as airlines commonly due if one pays for a full-fare airline ticket

rather than a discounted one. Companies can unbundle the price structure

without upsetting customers who have come to expect a costly service as part

of the package by including it in the price but offering rebates for forgoing its

use. For example, one company whose customers had become accustomed to

placing orders on short notice for free raised its prices but, at the same time,

Chapter 4 • Price Structure 85

offered a discount of more than the price increase for orders that could be

shipped with a delay of up to seven days. That enabled it to avoid disrupting

relationships with customers who valued its ability to receive delivery quickly

by more than the price premium, while enabling it to match competitive prices

when necessary with a slower, lower-cost service option.

PRICE METRICS

Not all differences in value across segments reﬂ ect differences in the features

or services desired. Value received is sometimes not even related to differ-

ences in the quantity of the product consumed necessitating a price structure

that involves earning revenues unrelated to the quantity of the product or

service provided. For example, in the ﬁ eld of health care, both government

and private payers are resisting paying for health care on a fee-for-service

basis since delivery of more days in the hospital or more tests is often indica-

tive of poor treatment choices, not better patient care. Both payers and health

care providers, like Kaiser Permanente

and Mayo Clinic,

that have a proven

ability to deliver care more cost-effectively than their peers, have beneﬁ ted

from adopting more value-based price metrics: Either a “capitation price” that

covers all services required by a patient during a year, or a price per illness or

procedure that covers all services required to treat a condition to a satisfactory

outcome. By adopting such metrics, health care providers that can provide

better care in less time or with less resources expended can avoid the difﬁ cult

problem of having to convince payers to pay more per service to reﬂ ect the

value of better treatment. It is much easier to make the case that they can get

patients “back on their feet” for no more than the cost per patient of less effec-

tive providers.

The example just described involved changing from a feature-based

to a beneﬁ t-based price metric. Price metrics are the units to which the price

is applied. They deﬁ ne the terms of exchange—what exactly the buyer will

receive per unit of price paid. There are often a range of possible options. For

example, a health club could charge per hour of use, per visit, per an annual

membership for unlimited access, or per some measure of beneﬁ t (inches lost

at the waist or gained at the chest). The club might also vary those prices by

time of day (low for a midday membership, higher for peak-time membership)

or by season of the year to reﬂ ect differences in the opportunity cost of capac-

ity. Finally, it might have a multi-part metric: An annual membership with an

additional hourly charge for use of the tennis courts. These reﬂ ect the common

categories of price metrics: Per unit, per use, per time spent consuming, per

person who consumes, per amount of beneﬁ t received.

The problem with most price metrics is that they are adopted by default

or tradition. For example, initially, software companies charged a price per copy

installed on one server machine. In most cases, that led to a poor alignment

with value. A few creative vendors recognized that when more users accessed

the software, the buyer was getting more value. Consequently, they changed

the price metric from a price “per server” to a price “per seat,” resulting in cus-

tomers paying more when they had more users accessing the software. When

this per-seat metric proved much more proﬁ table for the computer-aided

design and ﬁ nancial analysis companies that adopted it, other software com-

panies copied it. For many of their applications, however, the number of users

Chapter 4 • Price Structure86

still aligned poorly with value, leaving many customers underpriced while

pricing others out of the market. The most thoughtful among them created still

better price metrics. Leaders in manufacturing software replaced “price per

seat” with “price per production unit.” Storage management software suppli-

ers replaced “price per server” with a “price per gigabit of data moved.” Each

time a company discovers a better metric than its competitors, it gains margin

from existing customers, incremental revenue from customers formerly priced

out of its markets, or both.

Creating Good Price Metrics

There are ﬁ ve criteria for determining the most proﬁ table price metrics for an

offering (Exhibit 4-4). The ﬁ rst criterion for a good price metric is that it tracks

with differences in value across segments. While offer design facilitates pric-

ing differently based upon what people chose to buy, a price metric not based

upon units of purchase can facilitate different pricing for the same offer. For

example, it often makes more sense to price drug per day of therapy rather

than per milligram of the drug—as Eli Lilly did when it launched the anti-

depressant Prozac. Someone who requires only a 10-milligram dose gets no

less value than someone who requires a 30-milligram dose to control the dis-

ease. Consequently, the company charged the same amount per pill regard-

less of the quantity of active ingredient it contained. Second, a good metric

tracks with differences in cost to serve across customer segments. When

customers’ behavior inﬂ uences the incremental cost to serve them and those

costs are signiﬁ cant, a proﬁ t-maximizing price metric needs to reﬂ ect that as

EXHIBIT 4-4

Criteria for Evaluating Pricing Metrics

Chapter 4 • Price Structure 87

well. The cost to deliver a service is signiﬁ cant if it exceeds the cost of measur-

ing, monitoring, and charging for differences in its usage. Marketers are often

reluctant to charge for services, even when costs are signiﬁ cant, because they

fear that they will become uncompetitive relative to others who do not charge

for them. In fact, the opposite is the case.

Giving services for free attracts customers who are relatively higher

users of them. Customers who want to minimize their inventories will

gravitate to suppliers who offer free rush orders. Customers with a lot of

employee turnover resulting in poor equipment maintenance, will gravitate

to equipment suppliers who offer unlimited and quick on-site service. Cus-

tomers who require only minimal amounts of service will, in similar fashion,

gravitate to competitors offering little or no service but lower prices. As a

result, marketers often ﬁ nd that they have differentiated their companies

into lower proﬁ tability by improving their service offerings because they

lack an appropriate metric to capture the value and discourage excessive

use of services.

By adding charges for services, at least for those customers who are exces-

sively costly to serve, companies are able to keep their core product prices

competitive and avoid attracting a mix of customers who are costly to serve.

As their markets have become more competitive, software suppliers added

charges for formerly free online telephone support. Banks have added charges

for small account holders to use a teller, or to access a teller machine more than

some authorized amount. United Parcel Service has a $3.80 charge for delivery

to a residential address and a $13.40 charge for shipments with a missing UPS

account number or that require an address correction. These charges reﬂ ect

the added cost of service for such packages, and the tendency for customers

to cause those costs when they don’t have to pay for them. Suppliers with

separate service charges can price more competitively for the core business

(the software, the checking account, the package delivery) to win the custom-

ers who are lower cost to serve, while still attracting higher cost customers if

they are willing to pay for the higher service levels that they demand. In fact,

companies with unbundled service can offer better service because they have

a ﬁ nancial incentive to do so.

A third criterion for a good metric is that it is easy to implement without

any ambiguity about what charge the customer has incurred. Proﬁ t-sharing

or performance-based pricing are theoretically ideal ways to achieve the ﬁ rst

two criteria for a good metric—tracking with value and cost. But in practice,

these methods often end in rancorous debate about how proﬁ t or performance

should be measured. At minimum, it is important to have absolute clarity in

advance about what the metric is and who will measure it. That generally

means that the metric must be objectively measured or veriﬁ ed.

We once helped to create a value-based metric at a company whose lubri-

cant enabled manufacturers to cut through difﬁ cult materials more quickly

with less wear on their tools. The company’s product was an easy sell at

launch when potential customers were operating at maximum capacity. Cut-

ting materials faster increased capacity at this stage in the production process

enabling many customers to increase revenues without additional capital cost.

But when a recession hit, the value associated with increased capacity fell to

zero. The value created by the company’s product was reduced to the savings

in labor costs and machine wear.

Chapter 4 • Price Structure88

In theory, the price could be adjusted to reﬂ ect the customer’s capacity

utilization. However, whenever price depends upon the customer voluntarily

reporting information that will lead to a higher price, the potential for con-

ﬂ icts and misinformation is almost always too high. Fortunately we found a

published industrial sales index that seemed to track well with the customers’

capacity utilization. The company continued to charge a price per pound for

its product, but in return for lower pricing during the recession, the custom-

ers accepted automatic price adjustments monthly based upon changes in the

level of an industry sales index.

The fourth criterion for evaluating a price metric is how the metric makes

your pricing appear in comparison with competitors’ pricing and the impact

of that on the perceived attractiveness of your offer. A new, hosted voice-

recognition software that enabled a call center to process more callers without

as much need for human intervention promised to create huge differential

economic value for purchasers. Unfortunately, the traditional metric for pric-

ing and evaluating hosted call center software was a price per minute of use.

Since voice-recognition software processes callers faster, minutes using tradi-

tional call center software were not comparable to minutes using the voice-

recognition software. A value-based price using that per-minute metric would

need to be at least 72 percent higher than the price per minute for traditional

software—which was inviting resistance from potential purchasers.

To overcome that, the company adopted a new metric: “Cost per call

completed.” That metric naturally required conversion of the competitors’

cost-per-minute metric into a cost-per-call metric. While the new software was

still more expensive, its percent price premium was much smaller (5 percent)

when framed in terms of cost per call than in terms of a cost per minute (see

Exhibit 4-5). Moreover, the differentiation value of the avoided operator inter-

vention was much more dramatic when framed in terms of cost-per-call rather

than cost-per-minute basis. The total cost per call completed was 11 percent

less with the new software, despite being higher on a per-minute basis. While

the favorable economics of the new software was exactly the same using either

metric, the per-call basis of comparison made the sales effort a lot easier.

The ﬁ fth criterion for evaluating a price metric is how the metric aligns

with how buyers experience the value in use of the product or service. The

better the alignment—how a price metric ﬁ ts the timing and magnitude of

EXHIBIT 4-5

Hosted Call Center Software

Chapter 4 • Price Structure 89

the customers’ expenditure—the more attractive the offer. At a time when

Blockbuster video stores dominated the market for movie rentals and Netﬂ ix

was a struggling competitor, Netﬂ ix changed the metric in a way that made it

much more competitive. Before most people had the capability to stream ﬁ lms

online, movie renters liked the ability to get a movie on DVD immediately

from Blockbuster rather than having to wait to get it by mail from Netﬂ ix. But

movie renters disliked the Blockbuster price metric, a daily charge commonly

around $3.95, since the value was related to watching the movie once, not to

how many days the DVD disk sat around before it was returned. When Netﬂ ix

changed its metric to a monthly membership fee based on the number of ﬁ lms

out at a time ($8.99 per month for one DVD at a time, $13.99 per month for

two, and so forth), Netﬂ ix eliminated the inconvenience of having to acquire

the movie shortly before watching it and return it shortly thereafter, or to pay

what felt like a ﬁ ne for extra days unrelated to the value sought from the pur-

chase. Netﬂ ix’s new metric was more compelling than the video store metric

for a large share of the video rental market, while it also had the effect of dis-

counting to the heavy users who watch many ﬁ lms per month. Consequently,

Netﬂ ix’s market share and proﬁ tability boomed.

In some cases it is not possible to achieve all of these criteria with one

metric, but they can be achieved with a multi-part metric. Mobile telephone ser-

vice providers charge a ﬁ xed monthly fee, capturing the value of simply having

access to a phone when needed, plus charges for the amount of different services

consumed (calls, text messages, internet time). Amusement parks sometimes

have an entry fee plus a ticket charge for each ride. Banks may charge a monthly

fee for an account, plus additional charges for transactions. Each of these struc-

tures is designed to strike a balance between service cost recovery, winning cus-

tomers with pricing that is seen as aligned with value, and capturing more proﬁ t

from those customers who are getting more value without losing those who are

still proﬁ table despite the need for lower pricing to retain them.

It should also be noted that, depending on the context, the criteria out-

lined above may need to be modiﬁ ed or added to. For example, in highly regu-

lated markets such as utilities, health care, or insurance, any potential new

price metric also needs to pass muster with regulators and legal requirements.

In other markets, there may be well-established norms around fairness that

may limit the application of new metrics. For example, while it is seen as fair

for airlines and hotels to adjust prices relative to demand (with a tactic called

yield management), raising the price of a taxi ride when it is raining outside is

generally not viewed as fair, although several ride-sharing services at the time

of writing have successfully challenged that norm.

Performance-Based Metrics

An ideal price metric would tie what the customer pays for a product or

service directly to the economic value received and the incremental cost

to serve. In a few cases, called performance-based pricing, price structures can

actually work that way.

Attorneys often litigate civil cases for which they are

paid their out-of-pocket expenses plus a share of the award if they win, rather

than for hours worked. Internet ads are usually priced based on the num-

ber of click-throughs rather than the traditional metric for advertising: Cost

“per thousand” exposure. Systems that control the lights, heating, and cool-

ing within ofﬁ ce buildings are sometimes installed in return for contracts that

Chapter 4 • Price Structure90

share the energy cost savings, rather than charges for the equipment installed.

In each case, the price metric naturally charges customers differently for the

same product or service based on differences in the value they receive.

Most importantly, performance-based pricing has the effect of shifting

the performance risk from the buyer to the seller. General Electric (GE) used

bundling to reduce risk when it launched a new series of highly efﬁ cient air-

craft engines, its GE90 series. These engines promised greater fuel efﬁ ciency

and power that could make them much more proﬁ table to operate. The catch

was a high degree of uncertainty about the cost of maintenance. Some airlines

feared that these high-powered engines might need to be overhauled more

frequently, thus easily wiping out the ﬁ nancial beneﬁ ts from operating them.

This undermined GE’s ability to win buyers at the price premium that power

and fuel efﬁ ciency would otherwise justify.

Rather than accept a lower price to account for a buyer’s perceived risk,

GE responded by changing the price metric. Instead of selling or leasing an

engine alone, GE effectively rented aircraft engines for a fee per hour ﬂ own

that included all costs of scheduled and unscheduled maintenance. Without

the uncertainty of maintenance cost, GE90 engines quickly became popular,

despite a price premium.

In many cases, however, performance-based pricing is simply impracti-

cal. It requires too much information and too much trust that the buyer will

actually report the information accurately. It also leaves the buyer uncertain

regarding the cost of a purchase until after it is used. In practice, therefore,

marketers must design proﬁ t-driven price structures by ﬁ nding measures

that at least roughly predict the value a customer will receive and the costs to

serve, even if the resulting price metric does not allow for a perfect correlation

between price and value. Often the difference between a good and a great pric-

ing strategy lies in ﬁ nding, or creating, such measures.

Evolution of the Price Metric for Mobile Video Games

As video gaming grew from being the passion of hard-core fanatics with

dedicated equipment to a widely practiced pastime on practically any

device with an internet connection, the challenges for pricing multiplied.

How could a game developer optimize revenues from games with which

some hard-core users engaged intensely while millions of others simply

dabbled? And in a market with a huge and growing number of substi-

tutes, how could a developer induce lots of players to try a game without

giving away the value if it turned out to be highly engaging? Fortunately

for game developers and the gaming category, game marketers have been

particularly adept at adapting their price and revenue models to rapid

changes in their market.

For several decades, video games were largely published for three

mediums: Personal computers, TV-based gaming consoles, and portable

gaming consoles.

The established consumer price metric for the industry

was price per video game title, which resulted in the acquisition of a physi-

cal DVD or a cartridge containing the software. Customers were then free

to play the video game as much or as little as they wished. Most games

were designed to be played either in narrative form by a single individual

Chapter 4 • Price Structure 91

(as is the case with ﬁ rst-person shooter games) or in a multi-player format

with several players in the vicinity of the same game console (as is the case

in sports and combat titles).

Although the price-per-title metric served to recover development

costs, it was far from optimal. Yes, price per title was easy to measure

and consistent with how retailers liked to acquire products for resale, but

it didn’t really allow for differences in value across different segments

of players. It didn’t align with how a user might experience value when

playing the game, and it didn’t really track with cost to serve. It also did

not lend itself to discounting to induce product trial. Unfortunately,

given the developers’ loss of control once the game was sold to a retailer,

it was difﬁ cult to imagine how game publishers might overcome these

limitations—although retailers tried alternative pricing schemes such as

membership fees to borrow games and buy-back options to induce heavy

users to try new games.

The success of the Apple and Android smartphones beginning in

the mid-2000s created a relatively huge new market for games—there are

an estimated 2.9 billion smartphone users worldwide,

compared to an

estimated 529 million game consoles sold from 2008 to 2016

—and new

opportunities to engage more directly with game players on an ongoing

basis. In the United States, for example, close to 80 percent of consumers

with mobile phones were using smartphone models at the end of 2015.

Prior to smartphones, mobile devices lacked the high-performance com-

puting and graphics-processing capability required for really engaging

games. With a much larger potential market suddenly opening up, the

traditional price elasticities of video games changed. The relatively huge

installed base on this new platform created at least the possibility to sell

many more units and to earn much more revenue at a lower price per sale

than game publishers were earning selling games to people with dedi-

cated game consoles. Still, the volume gain would have to be huge. Con-

sider that while the average price of a game for the Nintendo 3DS console

was $40, a similar game title on the Apple Store

was priced at around $2.

The fundamental problem that the price metric didn’t track well with

how buyers experienced value remained. A game that people loved and

kept them engaged for a long time could earn no more revenue than one

that a gamer found interesting initially but tired of quickly. Fortunately,

two other evolutions in technology opened opportunities for improve-

ment. Access to cheap, high-speed internet ultimately became ubiquitous

in most developed markets, allowing for online multi-player gameplay

and the digital delivery of IP versus physical delivery through a retail

store.

Even more important, platforms developed to enable in-app pur-

chases that some creative game developers recognized could be used to

make revenues track more closely with a gamer’s engagement.

Publishers of popular, technically sophisticated, but previously

expensive game titles soon realized that it was possible to compete with

less sophisticated free titles by transforming the price structure of games

to a “freemium” model, in which it is free for the end-user to download a

game, and then pay for value delivered within the game. The next ques-

tions that each game developer needed to answer were: How do users

experience value? and, What are the primary drivers of the differences in

Chapter 4 • Price Structure92

Tie-Ins as Metrics

A very common challenge for a company that sells capital goods is that the

value of owning them can vary widely across segments based upon how

intensely they are used. For example, a company that makes a uniquely efﬁ -

cient canning machine might like to sell it both to salmon packers in Alaska,

who will use it intensely for only a couple months each year, as well as to fruit

value experienced? The answers would drive decisions, unique to each

game, about how best to design product options and price metrics that

would effectively drive revenues based upon value received.

The most sophisticated game publishers now either give away

access to the game or charge a very low price to download it. They earn

revenues reﬂ ecting the amount and intensity of players’ engagement with

the game as revealed by their purchases within three broad categories of

virtual products offered within a game:

1. Consumables help a player to continue playing a game or to ascend to

the next level in the game without the effort of earning it. They are

“consumable” because once they are used, they can’t be used again.

Virtual poker chips in the game Zynga Poker, a category-leading

title, is an example of a consumable available for purchase.

2. Durables are in-app purchases that help a player to succeed in the

game but do not get consumed. An improved billiard cue for use

in the 8 Ball Pool mobile game can be purchased to achieve greater

shooting and spin precision, nicely mimicking the real-world expe-

rience for a high-end billiard cue.

3. Personalization enables the user experience to be customized—as the

social media game Highrise, that lets users purchase clothes for their

game avatar that don’t directly impact gameplay but enable a more

customized user experience.

Rather than initiate a credit card transaction for each purchase, games

generally involve the purchase with real money of a digital currency used

for making smaller purchases quickly. Some mobile video game publish-

ers have taken game monetization and value capture a step further by

paying gamers in digital currency to view online ads. When they do so,

their ad network partners pay real money to the game publisher based

upon views.

By all accounts, this evolution of price metrics has been an extremely

successful strategy for mobile game publishers. According to Distimo, a

market research ﬁ rm, in-game purchase revenue accounted for 79 percent

of iOS mobile app revenue (and up to 94 percent in Asian markets) with

only 21 percent coming from the traditional model of paying for the title

upfront at the start of 2014.

More importantly, popular games that col-

lect revenue from in-game purchases rather than from upfront purchases

earn up to three times more revenue per game.

Prepared by Junaid Qureshi, who is both an accomplished gamer and consultant at Deloitte Consult-

ing LLP .

Chapter 4 • Price Structure 93

and vegetable packers in California, who will use it to can crops all year round.

One option would be to put a meter on the machine to record every time that

machine went through one cycle. That, in fact, is how Xerox priced its copiers

at launch, by leasing them at a price based upon machine usage and refusing

to sell them outright.

For the canning machine manufacturer, a usage-based lease was not

practical because it did not have service people at the client site on a regular

basis to monitor usage. Instead, a more practical metric was a tie-in sale that

contractually required purchasers of the canning machine to use it only with

cans sold by the seller at a premium price. Thus, the true cost of the machine

was not just its low explicit price but also the net present value of the price

premiums paid for the tied-in cans. Since buyers who used the machine more

intensely must buy more of the tied-in product to use it, they effectively paid

more for the asset.

Tie-in sales like those that tied purchase of cans contractually to purchase

of the machine were quite common until 1949, when the federal courts decided

that such contracts were not enforceable under U.S. antitrust law because of

their impact on the otherwise freely competitive market for the tied commod-

ity.

Although contractual tie-ins are no longer enforceable, companies still

frequently use technological design to tie a unique consumable to an asset—

often referred to as the proverbial razor-and-razor blades strategy. For exam-

ple, some manufacturers of document printers will often price the printer—the

asset—low to drive adoption of the product. The corresponding replacement

ink cartridges—the consumables—are often designed with proprietary tech-

nology to ﬁ t uniquely with the asset and carry high wholesale margins. The

key to the success of this business model is that the pricing allows the seller

to build a signiﬁ cant installed base of users, and earn signiﬁ cant proﬁ ts from

users who use—and beneﬁ t from—the printers the most.

In service-based companies, tie-in contracts are frequently used to

reduce the cost for new buyers to try their services. Wireless phone providers

offer a digital telephone for a nominal fee, and sometimes free, if the buyer

agrees to purchase a long-term service contract to use the company’s wireless

network for 12 or 24 months. Satellite entertainment companies offer house-

holds a satellite dish and receiver unit for a greatly reduced price when buyers

agree to subscribe to a higher-priced entertainment package of channels for a

minimum of 12 or 24 months. These packages can be particularly effective for

low-knowledge buyers who perceive signiﬁ cant risk in investing in a new and

little-known technology—and then developing them into loyal buyers who

become accustomed to the ﬁ rm’s technology and programming.

Value-Based Pricing Finances Hamlet’s Castle

The seeds of value-based pricing were planted centuries ago with the ﬁ rst

documented use of value-based pricing metrics to improve proﬁ tability.

The use occurred in the 15th century when Erik of Pomerania, King of

the United Kingdom of Scandinavia, summoned to Copenhagen a group

of merchants from the powerful German Hanseatic League, which at the

time dominated nearly all trade in northern Europe. He informed them

that henceforth, he intended to levy a new toll: Every ship wishing to sail

Chapter 4 • Price Structure94

past Elsinore, whether on its way out of or into the Baltic, would have to

dip its ﬂ ag, strike its topsails, and cast anchor so that the captain might go

ashore to pay the customs ofﬁ cer in the town a toll of “one English noble.”

Nobody challenged the right of the King of all Scandinavia to impose

a toll of this kind. After all, mere barons who owned castles on the banks

of the Rhine, the Danube, and other major European waterways had for

centuries forced all passing ships to pay a similar toll. However, its rela-

tive heaviness, combined with the obligation to cast anchor at Elsinore in

order to hand over the money, made it highly unpopular. Erik foresaw

that if he also established a proper town at Elsinore, sea captains, after

paying their toll and then waiting for a favorable wind, would welcome

an opportunity to replenish stocks of water, wine, meat, vegetables, and

whatever else they needed. In other words, even if they had to pay a toll,

calling in at Elsinore could have its attractions—all he had to do was pro-

vide them.

Elsinore’s fortunes changed in 1559 with the accession to the throne

of Frederik II, aged 25. He was young, ambitious, and entertained imperi-

alistic ideas about reconquering Sweden and restoring the Nordic Union.

Consequently, he declared war, and it dragged on for seven years. Like

all wars, it was a severe drain on Denmark’s ﬁ nances. By 1566, the situ-

ation was so serious that Frederik II and his councillors decided as a last

resort to enlist the help of a man with special talents named Peder Oxe.

Oxe was acknowledged to be a ﬁ nancial wizard, which was just what

Frederik needed.

Erik of Pomerania’s toll of one English noble per ship had long been

regarded by skippers and ship owners as grossly unfair. After all, ships

were of so many different sizes, carried so many different cargoes, and

according to nationality, had various interests and afﬁ liations. The sys-

tem had also been proving increasingly disadvantageous from the Danish

king’s point of view. The ﬁ rst four or ﬁ ve kings after Erik of Pomerania

had therefore continually tried to introduce amendments of one kind or

another, and these in turn made it necessary to introduce various special

concessions. Some nationalities were exempted completely and others

enjoyed preferential treatment in certain respects.

By this time, the basic toll had been raised from one to three nobles

per ship, but it was still far from being a satisfactory system. Peder Oxe

realized that the only answer lay in a radical reform of the whole basis

upon which the tolls were calculated. Henceforth, instead of a simple toll

per ship, payment must be made, he suggested, on the basis of the cargo

carried. To start with, two Rixdollars per last (a “last” being approxi-

mately two tons of cargo). Soon this was changed to an even subtler and

more ﬂ exible system: A percentage of the value of each last of cargo.

The King held the right of pre-emption, that is to say an option to

buy, if he so chose, all cargoes declared. This royal prerogative encour-

aged the captain of a ship to make a correct declaration. Naturally, if he

thought the King might be interested in buying his cargo, he was tempted

to put a high value on it. However, in doing so, he ran the risk that His

Majesty might be totally disinterested, in which case he would have to

Chapter 4 • Price Structure 95

PRICE FENCES

Sometimes value differs between customer segments even when all the fea-

tures and measurable beneﬁ ts are the same. Value can differ between customer

segments and uses simply because they involve different formulas for con-

verting features and beneﬁ ts into economic values. The difference may be tied

to differences in income, in alternatives available, or in psychological beneﬁ ts

that are difﬁ cult to measure objectively. Unless there is a good proxy metric

that just happens to correlate with the resulting differences in value, the seller

needs to ﬁ nd a price fence : A means to charge different customers different

price levels for the same products and services using the same metrics.

Price fences are ﬁ xed criteria that customers must meet to qualify for a

lower price. At theaters, museums, and similar venues, price fences are usu-

ally based on age (with discounts for children under 12 years of age and for

seniors) but are sometimes also based on educational status (full-time stu-

dents get discounts), or possession of a coupon from a local paper (beneﬁ ting

locals who know more alternatives). All three types of customers have the

same needs and cost to serve them, but perceive a different value from the

purchase. Price fences are the least complicated way to charge different prices

to reﬂ ect different levels of value. Unfortunately, while simple to adminis-

ter, the obvious price fences sometimes create resentment and are often too

easy for customers to get over whenever there is an economic incentive to

do so. Thus, ﬁ nding a fence that will work in your market usually requires

some creativity.

Buyer Identiﬁ cation Fences

Occasionally pricing goods and services at different levels across segments

is easy because customers have obvious characteristics that sellers can use to

identify them. Barbers charge different prices for short and long hair because

long hair takes more time to cut. But, during non-peak hours, barbers also cut

children’s hair at a substantial discount, despite the fact that children can be

more challenging and time-consuming. The rationale in this case is entirely

to drive business with a discount for a more price-sensitive segment. Many

pay a duty calculated on this high valuation. Conversely, if he played

safe and declared a low value in the hope of getting away with paying

a low duty, the King might decide to buy the whole consignment which

could leave the captain seriously out of pocket. Summoning Peder Oxe to

reorganize the levying of the Sound Dues proved to be a masterful stroke.

Within a few years, the King’s income from this source practically tripled.

At the age of 38, Frederik II married his 15-year-old cousin, Sophie of

Mecklenburg, and in 1574 embarked on what was to become the major

architectural project of his life, the building of a new castle at Elsinore.

Abridged from Hamlet’s Castle and Shakespeare’s Elsinore by David Hohnen (Copenhagen:

Christian Ejlers, 2000) .

Chapter 4 • Price Structure96

parents view home haircuts as acceptable alternatives to costly barber cuts

for their children, even though they would never bear the risk of letting their

spouses cut their own hair. For barbers, simple observation of the customer

segment, children, is the key to segmented pricing.

Issuers of credit cards resort to far more sophisticated, proprietary mod-

els to anticipate the price sensitivities and costs to serve for different types of

consumers. Some are more sensitive to the annual fee, some to the interest

rate, and others to the frequent ﬂ yer miles or other beneﬁ ts they can earn.

On the cost side, some consumers are more likely to default or to use their

card only infrequently, thus generating fewer fees from retailers for process-

ing charges. Finally, the companies can see from consumers’ credit reports

what competitive cards they hold and can estimate their annual fee and inter-

est rates, thus determining the reference value of the next best competitive

alternative (NBCA). Based upon these analyses, credit card companies very

ﬁ nely segment their potential customer base and send out different offers that

optimize the expected proﬁ tability of each segment. The metrics are the same,

but the levels vary depending on which metric the issuer can use most cost-

effectively to capture the most value. Rarely is identiﬁ cation of customers in

different segments straightforward. Yet, management can sometimes structure

price discounts that induce the most price-sensitive buyers to volunteer the

information necessary to identify them. Many service providers, from hotels

and rental car companies to theaters and restaurants, offer senior discounts

to those who will show an American Association of Retired Persons (AARP)

card, Medicare card, or some other ID that conﬁ rms their eligibility. College

students qualify for discounts on various types of entertainment because their

low incomes and alternative sources of campus entertainment make them, as

a group, price-sensitive shoppers. Seniors and students readily volunteer their

identiﬁ cation cards to prove that they are members of the price-sensitive seg-

ment. Members of the less price-sensitive segment identify themselves by not

producing such identiﬁ cation.

Even schools and colleges charge variable tuitions for the same educa-

tion based on their estimates of their students’ price sensitivities. Although the

ofﬁ cial school catalogs list just one tuition, it is not the one most students pay

at private colleges. Many receive substantial discounts disguised as “tuition

remission scholarships” obtained by revealing personal information on ﬁ nancial-

aid applications. By evaluating family income and assets, colleges can set

tuition for each student that makes attendance attractive while still maximiz-

ing the school’s income.

Deal proneness is another form of self-induced buyer identiﬁ cation—

especially through the use of coupons and sales promotions, a frequent tool

of consumer marketers. Coupons provided by the seller give deal-prone shop-

pers a way to identify themselves.

Supermarkets and drug stores put cou-

pons in advertising circulars because people who read those ads are part of

the segment that compares prices before deciding where to shop. Packaged-

goods and small appliance manufacturers print coupons and rebate instruc-

tions directly on the packages, expecting that only price-sensitive shoppers

will make the effort to clip them out and use them for future purchases.

Often a buyer’s relative price sensitivity does not depend on anything

immediately observable or on factors a customer freely reveals. It depends

instead on how well informed about alternatives a customer is and on the

Chapter 4 • Price Structure 97

personal values the customer places on the differentiating attributes of the

seller’s offer. In such cases, the classiﬁ cation of buyers by segment usually

requires an expert salesperson trained in soliciting and evaluating the infor-

mation necessary for segmented pricing.

Purchase Location Fences

When customers who perceive different values buy at different locations,

they can be segmented by purchase location. This is common practice for a

wide range of products. Dentists, opticians, and other professionals some-

times have multiple ofﬁ ces in different parts of a city, each with a different

price schedule reﬂ ecting differences in the target clients’ price sensitivity.

Many grocery chains classify their stores by intensity of competition and

apply lower markups in those localities where competition is most intense.

Colorado ski resorts use purchase location to segment sales of lift tickets.

Tickets purchased slope side are priced the highest and are bought by the

most afﬂ uent skiers who stay in the slope-side hotels and condos. Tickets

are cheaper (approximately 10 percent less) at hotels in the nearby town of

Dillon, where less afﬂ uent skiers stay in cheaper, off-slope accommodations.

In Denver, tickets can be bought at grocery stores and self-serve gas stations

for larger discounts (approximately 20 percent less). These discounts attract

locals, who know the market well and who are generally more price sensitive

because the ticket price represents a much higher share of the total cost for

them to ski.

A clever segmented pricing tactic common for pricing bulky industrial

products such as steel and coal is freight absorption . Freight absorption is the

agreement by the seller to bear part of the shipping costs of the product, the

amount of which depends upon the buyer’s location. The purpose is to seg-

ment buyers according to the attractiveness of their alternatives. A steel mill

in Pittsburgh, for example, might agree to charge buyers the cost of shipping

from either Pittsburgh or from Gary, Indiana, where its major competitor is

located. The seller in Pittsburgh receives only the price the buyer pays, less the

absorbed portion of any excess cost to ship from Pittsburgh. This enables the

Pittsburgh supplier to cut price to customers nearer the competitor without

having to cut price to customers for whom his Chicago competitors have no

location advantage. The Chicago competitor probably uses the same tactic to

become more competitive for buyers nearer Pittsburgh.

Trade barriers between countries once made segmentation by location

viable even for products that were inexpensive to ship. As trade barriers

have declined around the world, and especially within the European Union,

the tactic has become less effective. For example, automobiles used to be

sold throughout Europe at prices that varied widely across borders. Ger-

man luxury cars sold in Britain were at least 20 percent more expensive than

when sold just across the channel in Belgium. But after Britain joined the

EU, brokers in Britain began to survey the continent for cars, which peo-

ple could ﬂ y to pick up and drive home—or even have the broker bring it

back for them. To ﬁ ght back, some makers of German luxury brands, which

are cheaper in Germany than in some other countries where they carry a

more premium image, have used their warranties to enforce location fences.

A car bought in Germany and imported to Britain cannot get warranty service

Chapter 4 • Price Structure98

in the United Kingdom without paying an additional charge for warranty

transfer to a British dealership.

Time-of-Purchase Fences

When customers in different market segments purchase at different times,

one can segment them for pricing by time of purchase. Theaters segment their

markets by offering midday matinees at substantially reduced prices, attract-

ing price-sensitive viewers who are not employed during the day at times

when the theater has ample excess capacity. Less price-sensitive evening

patrons cannot so easily arrange dates or work schedules to take advantage

of the cheaper midday ticket prices. Restaurants usually charge more to their

evening patrons, even when their peak demand is at lunch, because demand

(in the United States, but not in Europe) is more price sensitive for the mid-

day meal. Why? There are more numerous inexpensive substitutes for lunches

than there are for dinners. A fast food meal or a brown bag, acceptable for

lunch, is often viewed as a poor substitute for a formal dinner as part of an

evening’s entertainment.

Priority pricing is one example of segmenting by time of purchase. Inno-

vative new retail products are offered at full price, or even at a premium.

Over time, as product appeal fades in comparison to still newer competitive

alternatives, buyers discount the product’s value until they are willing to

pay only a fraction of its original price for leftover models. This is common

in the retail fashion and automobile industries, where customers with high

incomes and low price sensitivity pay premium prices for the latest styles

and models. Over time, as inventories age and novelty declines, prices are

reduced in successive rounds of promotions to appeal to more price-sensitive

buyers who are willing to wait for the opportunity to buy high-quality, but

less trendy, inventory.

Priority pricing also applies in business-to-business purchases. A strat-

egy of Intel has long been to introduce a leading-edge semiconductor at a pre-

mium price that reﬂ ects the higher performance level, and then adjust prices

on its existing product lines to make them viable upgrades for less demanding

applications, as well as to reduce the inventory of the now older semiconduc-

tors. Leading-edge original equipment manufacturer (OEM) computer manu-

facturers that produce and sell the fastest and latest computers to innovative

professional buyers with low price sensitivity pay the price premium for the

latest chip technology. More price-sensitive buyers who do not require the

highest levels of performance are able to choose from a tiered selection of Intel

semiconductors that vary in price and performance levels.

Predictable, periodic sales offering the same merchandise at discounted

prices can also segment markets. This tactic is most successful in markets with

a combination of occasional buyers who are relatively unfamiliar with the

market, and with more regular buyers who know when the sales are and plan

their purchases accordingly. Furniture manufacturers employ this tactic with

sales every February and August, months when most people usually would

not think about buying furniture. However, people who regularly buy home

furnishings, and who are more price sensitive because of the reference-price

and total-expenditure effects, know to plan their purchases to coincide with

these sales.

Chapter 4 • Price Structure 99

Time is also a useful fence when demand varies signiﬁ cantly with the

time of purchase but the product or service is not storable. This problem plagues

airlines, hotels and restaurants, electric utilities, theaters, computer time-sharing

companies, beauty salons, toll roads, and parking garages. Unable to move

supplies of their products from one time to another, their only option is to

manage demand to match supply by charging high prices when supply would

otherwise exceed demand and lower prices when it is highly unlikely that the

seller will face demand that exceeds capacity.

Pricing for travel through the Eurotunnel between England and France is

an interesting application of segmented pricing for a product with ﬁ xed capac-

ity. The channel tunnel allows transport of an automobile and its occupants

between England and France for a ﬂ at price. Prices that allow travel at what-

ever time of day you choose are twice as high as during the off-peak evening

and night periods. This reﬂ ects the opportunity cost of limited capacity. More

interesting is the fact that rates increase with the time elapsed between the

outbound and the return trips. Roundtrip use of the tunnel for a two-day, one-

night visit from the United Kingdom to France costs from £53 per auto, while

roundtrip use for a three- to seven-day visit costs from £79 at the same times

of day. Clearly, this has nothing to do with cost or available capacity, so what

drives it? The answer is that the value of having your own car with you on the

trip versus having to rent one after traveling by plane or train increases with

the length of the stay.

Purchase Quantity Fences

When customers in different segments buy different quantities, one can some-

times segment them for pricing with quantity discounts. There are four types

of quantity discount tactics: Volume discounts, order discounts, step dis-

counts , and two-part prices . All are common when dealing with differences in

price sensitivity, costs, and competition.

Customers who buy in large volume

are usually more price sensitive. They have a larger ﬁ nancial incentive to learn

about all alternatives and to negotiate the best possible deal. Moreover, the

attractiveness of selling to them generally increases competition for their busi-

ness. Large buyers are often less costly to serve. Costs of selling and servic-

ing an account generally do not increase proportionately with the volume of

purchases. In such cases, volume discounting is a useful tactic for segmented

pricing.

Volume discounts are most common when selling products to business

customers. Steel manufacturers grant auto companies substantially lower

prices than they offer other industrial buyers. They do so because auto manu-

facturers use such large volumes they could easily operate their own mills or

send negotiators around the world to secure better prices. Volume discounts

are based on the customer’s total purchases over a month or year rather than

on the amount purchased at any one time. At some companies, the discount is

calculated on the volume of all purchases; at others, it is calculated by product

or product class. Many companies give discounts for multiple purchases of a

single model but, in addition, give discounts based on a buyer’s total expendi-

ture on all products from the company.

Although less common, some consumer products are volume dis-

counted as well. Larger packages of most food, health, and cleaning products

Chapter 4 • Price Structure100

usually cost less per ounce, and canned beverages cost less in 12-packs than

in six-packs. These differences reﬂ ect both cost economies for suppliers and

the greater price sensitivity for these products by large families. Warehouse

food stores, such as Costco, Sam’s Club, and BJ’s Wholesale Club often

require consumers to buy in large-quantity packages to qualify for dis-

counted prices.

Often sellers vary prices by the size of an order rather than by the size

of a customer’s total purchase volume. Order discounts are the most common

of all quantity discounts. Almost all ofﬁ ce supplies are sold with order dis-

counts. Copier paper, for example, can be purchased for about $20 per case of

ten reams, but purchased individually it costs several dollars per ream. The

logic for this is that many of the costs of processing an order are unrelated

to the size of it. Consequently, the per-unit cost of processing and shipping

declines with the quantity ordered. For this reason, sellers generally prefer

that buyers place large, infrequent orders, rather than small frequent ones. To

encourage them to do so, sellers give discounts based on the order quantity.

Order discounts may be offered in addition to volume discounts for total pur-

chases in a year, because volume discounts and order discounts serve sepa-

rate purposes. The volume discount is given to retain the business of large

customers. The order discount is given to encourage customers to place large

orders.

Step discounts differ from volume or order discounts in that they do not

apply to the total quantity purchased, but only to the purchase beyond a speci-

ﬁ ed amount. The rationale is to encourage individual buyers to purchase more

of a product without having to cut the price on smaller quantities for which

they would pay a higher price. Thus, in contrast to other segmentation tactics,

step discounting may segment not only different customers, but also different

purchases by the same customers. Such pricing is common for public utilities,

from which customers buy water and electricity for multiple uses and place a

different value on it for each use.

Consider, for example, the dilemma that local electric companies face

when pricing their product. Most people place a very high value on having

some electricity for general use, such as lighting and running appliances. The

substitutes (gaslights, oil lamps, and hand-cranked appliances) are not very

acceptable. For heating, however, most people use alternative fuels (gas, oil,

coal, and kerosene) because of their lower cost. Utilities would like to sell

more power for heating and could do so at a price above the cost of generating

it. They do not want to cut the price of electricity across the board, however,

since that would involve unnecessary discounts on power for higher-valued

uses. One solution to this dilemma is a step-price schedule. Assume that the

electric company could charge a typical consumer $0.06 per kilowatt-hour

(KWH) for general electricity usage but that it must cut its price to $0.04 per

KWH to make electricity competitive for heating. If the company charged the

lower price to encourage electricity usage for heating, it would forgo a third

of the revenue it could earn from supplying power for other uses. By replac-

ing a single price with a block-price schedule, $0.06 per KWH for the ﬁ rst

block of 100 KWH and $0.04 for usage thereafter, the company could encour-

age people to install electric heating without forgoing the higher income it

can earn on power for other purposes. To encourage people to use electricity

for still more uses, such as charging their car batteries during off-peak hours,

Chapter 4 • Price Structure 101

utilities often add another step discount for quantities in excess of those for

general use and heating. Exhibit 4-6 illustrates a step-price schedule for an

electric utility.

Two-part pricing is another way to structure volume discounts and is used

most commonly in situations where there is an incremental cost to take on a

new customer but a lower cost to sell an existing customer additional volume.

For example, a company that supplies fuel oil or LPG to homes and businesses

must send a truck to each customer location to top-off the tank on a regular

basis. Customers who require only a small amount at each visit would need

to be charged a high price per gallon or cubic foot simply to cover the delivery

cost, while those who require much larger quantities could be served proﬁ t-

ably at a lower price per unit and would therefore have a lot of competition

for their business. The typical solution is a two-part price, which in this case

would be a price to make the delivery plus a price for the amount of product

actually delivered.

Given the clear increase in proﬁ t from offering step discounts, effectively

moving along an individual customer’s demand curve, why do most compa-

nies still offer each individual customer volume at only one price? The answer

is that segmenting different purchases by each customer is possible only under

limited conditions. It is proﬁ table only when the volume demanded by indi-

vidual buyers is signiﬁ cantly price sensitive.

PEAK PRICING AND YIELD MANAGEMENT

In industries where the product or service is not storable, a seller’s current

capacity imposes a limit on the amount of demand that can be satisﬁ ed at

EXHIBIT 4-6

Step-Price Schedule for Electricity

Chapter 4 • Price Structure102

any point in time, while any capacity that is not sold when available is lost

forever. This is a common problem for airlines, hotels, taxi ﬂ eets, and amuse-

ment parks. It is also a common problem for services from government such

as the capacity of roads and central city streets that become congested and

impassable at peak times. The easiest solution to this problem involves simply

raising price reactively, or peak pricing , whenever supply is inadequate to meet

the quantity demanded. Uber, for example, adjusts its prices upward when

demand exceeds supply, ensuring that at some price it is almost always pos-

sible to get an Uber car while rewarding drivers for joining the pool of cars

when demand is greatest. Even some governments have come to recognize

how peak pricing can both improve the quality of life for its citizens while

earning revenues disproportionately from people who are willing to pay

a premium at peak times. Cities from London to Singapore have begun to

charge drivers a “congestion charge” for the right to drive on inner-city streets

when trafﬁ c would otherwise exceed capacity, while highways throughout the

U.S. have additional priority lanes where trafﬁ c is kept ﬂ owing by setting an

access charge high enough to keep the number of cars using the lanes within

the available capacity.

The most challenging pricing problems occur when a seller attempts

to manage both the peak demand problem and pricing across different seg-

ments simultaneously. In the distant past, most sellers would attempt to man-

age one and simply accept management of the other as a lost opportunity.

As the cost of computing power and data management declined over recent

decades, companies with the most to gain began developing a process called

Yield Management to optimally manage these two pricing problems simulta-

neously. A few ﬁ rms in the airline industry and petroleum reﬁ ning have led

the way in developing sophisticated yield management techniques. The abil-

ity to do so proved to be a huge competitive advantage substantially increas-

ing the return on capital invested relative to those ﬁ rms that simply adjust

price reactively.

There are three tasks required for effective yield management. The ﬁ rst

is to use one of the pricing tactics described above to enable segmented pric-

ing based upon value to the purchaser. Second, because one must generally

set the price level by segment before potential customers reveal their demand,

yield management requires a means to forecast changes in demand by seg-

ment over time. Initially, airlines used past variation over days of the week

and over weeks of the year to forecast demand by segment in the future. Over

time, the best yield management practitioners have added more variables to

their forecasting models to anticipate demand even more accurately. Third,

yield management involves estimating demand price elasticity by segment to

determine which prices should be adjusted to optimize the balance between

margin and capacity utilization.

With those three bits of information—a segmented price structure,

demand forecasts and elasticities by segment—yield managers can optimize

prices to maximize revenue and proﬁ t. The ultimate goal is to target price

changes to induce the more price-sensitive customers to adapt their purchase

behavior while maintaining pricing for the less price-sensitive segments,

where inducing changes in demand would be more costly to the seller and

painful for the buyer. To illustrate how they do this, consider the recent pric-

ing on the route from Boston to Chicago. The fully refundable, changeable

Chapter 4 • Price Structure 103

fare, purchased almost exclusively by relatively price-insensitive business

travelers, is $302 for all ﬂ ights during the work week. At that price, the air-

line makes a lot on each seat sold and so would like to ensure that seats are

always available at that price point on every ﬂ ight, even if purchased near the

ﬂ ight time. On the other hand, since the costs of a ﬂ ight are mostly indepen-

dent of the number of customers actually on the plane, the airline would also

like to ﬁ ll as many seats as possible, since an empty seat is a wasted revenue

opportunity.

To achieve these conﬂ icting goals in a way that maximizes the revenue,

or yield, on each ﬂ ight, the airline focuses its price management on the cus-

tomers who are most price sensitive. On Monday morning, usually a time of

peak demand, the price for a non-refundable, non-changeable ticket at the

most popular ﬂ ight times is $232. A price that high is sufﬁ cient to discourage

some discretionary travelers from traveling at that time, leaving seats avail-

able to sell more proﬁ tably and refundable tickets to business travelers. On

Wednesdays, however, demand from business travelers is much less than on

Mondays, so there are potentially many empty seats. The solution, however, is

not to discount the refundable fare, since few if any additional business travel-

ers would take a trip on Wednesday simply because fares were lower.

Instead, the airline holds the refundable fare at the same $302 level,

despite the lower demand for it, because that demand is not particularly price

sensitive. To ﬁ ll the additional seats that cannot be sold at full price, the yield

manager will lower the price for a non-refundable, non-changeable ticket on

Wednesday morning. But an airline cannot wait until it sees how many people

will buy a refundable ticket before deciding whether and how much to dis-

count non-refundable tickets, since the buyers of refundable tickets often wait

to book until close to the time of the ﬂ ight. Consequently, the airline must esti-

mate how many seats it can sell in advance at a discount without foreclosing

the ability to sell those seats at a higher price later. To do that, a yield manager

must ﬁ rst forecast how many higher-priced, refundable tickets the airline will

be able to sell closer to ﬂ ight time.

Apparently, the yield manager in this case expected demand for Wednes-

day morning ﬂ ights to fall substantially relative to Monday ﬂ ights, leaving a

lot of empty seats. Consequently, the airline reduced its lowest, non-refundable

fare for Wednesday morning to only $127. Since that is 37 percent below its

price for the same time on Mondays, the airline apparently estimated from

past experience that it could sell, and would have the capacity to serve, greater

than 37 percent more seats on Wednesday morning than it could have sold by

retaining the same price it offered on Monday.

Obviously, the better an airline’s ability to forecast demand, and the bet-

ter the ability to estimate the impact of price on seats demanded, the more

successful the yield management will be in loading capacity with the most

proﬁ table passengers available for each date and ﬂ ight time. The key to trans-

forming simple peak pricing into sophisticated yield management in any

industry is the forecasting of demand and adjustment of price based upon

how current sales are tracking against forecasted sales. While software to do

this was initially built in house, software companies have since developed

sophisticated software packages to make and display these estimates auto-

matically, drawing upon analysis of past demand patterns for similar days of

the week and times of the year. Those yield management packages are now

Chapter 4 • Price Structure104

widely used to set prices for hotel rooms, rental cars, and advertising space

as well as for airline seats. Less sophisticated versions are sometimes used to

price seats at concerts and other popular performance venues.

Summary

Designing an optimal price structure that

effectively segments your market and

maximizes your proﬁ table sales oppor-

tunities is clearly among the most difﬁ -

cult, but potentially rewarding, aspects of

pricing strategy. For companies that are

launching an offering with differentiated

beneﬁ ts or employing a business model

with a different cost structure, creating a

new price structure that aligns with those

differences is usually necessary to capture

the proﬁ t potential associated with them.

Even without such a change, a company

that can incrementally improve the price

structure can gain proﬁ table incremental

volume. The principles of price structure

discussed in this chapter, and the exam-

ples cited to illustrate them, can serve as

a guide to a better basis for collecting rev-

enues across segments. There is no simple

formula. Each case requires creativity to

ﬁ nd the best means to implement those

principles within your market. It is, how-

ever, one of the most important activities

that a marketer can do to improve prof-

itability, since the investment required is

small relative to other marketing invest-

ments, and the payoff is often very large.

Notes

1. Herman Hesse, Narcissus and Gold-

mund , trans. Ursule Molinaro (New

York: Picador, 1968), p. 41.

2 . Clayton M. Christensen, The Inno-

vator’s Dilemma (Cambridge, MA:

Harvard Business School Press,

1997), pp. 44–46.

3 . Daniel Kahneman, Jack L. Knetsch,

and Richard H. Thaler, “The

Endowment Effect, Loss Aversion,

and Status Quo Bias,” Journal of

Economic Perspectives , 5(1) (Winter

1991), pp. 193–206.

4 . Gary D. Eppen, Ward A. Hanson,

and R. Kipp Martin, “Bundling—

New Products, New Markets, Low

Risk,” Sloan Management Review ,

32(4) (Summer 1991), pp. 7–14,

describes a model for optimizing

very complex bundles.

5 . Marco Bertini and Luc Wathieu,

“How to Stop Customers from Fixat-

ing on Price,” Harvard Business Review

(May 2010). Accessed at https://hbr.

org/2010/05/how-to-stop-custom

ers-from-ﬁ xating-on-price.

6 . “Kaiser Permanente—California: A

Model for Integrated Care for the

Ill and Injured,” Brookings Institu-

tion, May 4, 2015. See also: Reed

Abelson, “The Face of Future

Health Care,” The New York Times ,

March 20, 2013. Accessed at www.

nytimes.com/2013/03/21/busi

ness/kaiser-permanente-is-seen-

as-face-of-future-health-care.html.

7 . Atul Gawande, “The Cost Conun-

drum: What a Texas Town Can

Teach Us About Health Care,”

The New Yorker , June 1, 2009.

Accessed at www.newyorker.com/

magazine/2009/06/01/the-cost-

conundrum.

8 . For a complete treatment of

performance-based pricing, see

Benson P. Shapiro, “Performance-

Based Pricing Is More Than Pric-

ing,” Harvard Business School

Note 9-999-007, February 25, 2002.

9 . “The Global Games Market Reaches

$99.6 Billion in 2016, Mobile Gener-

ating 37%,” Newzoo.com, April 21,

2016. Accessed at https://newzoo.

com/insights/articles/global-

games-market-reaches-99-6-bil

lion-2016-mobile-generating-37.

Chapter 4 • Price Structure 105

10 . Statista, “Number of Smartphone

Users Worldwide from 2014 to

2020.” Accessed at www.statista.

com/statistics/330695/num

ber-of-smartphone-users-world

wide.

11 . Statista, “Global Unit Sales of Cur-

rent Generation Video Game Con-

soles from 2008 to 2016.” Accessed

at www.statista.com/statistics/27

6768/global-unit-sales-of-video-

game-consoles.

12 . “Smartphone Penetration Nears

80% of the US Mobile Market,”

MarketingCharts.com, February 8,

2016, cites statistics from comScore.

Accessed at www.marketingcharts.

com/online/smartphone-pene

tration-nears-80-of-the-us-mobile-

market-65214/.

13 . Ali Shah, “Nintendo 3DS vs Smart-

phone Gaming: Which Wins?”

Gigaom, March 31, 2011. Accessed at

https://gigaom.com/2011/03/31/

nintendo-3ds-vs-smartphone-gam

ing-which-wins.

14 . Andrew Burger, “LRG: U.S. Broad-

band Penetration Rises to 79%

of Households, Smartphone Role

Increasing,” Telecompetitor.com,

October 24, 2014. Accessed at www.

telecompetitor.com/lrg-u-s-broad

band-penetration-rises-to-79-

of-households-smartphone-role-

increasing.

15 . Brian Rifkin, “How to Win With

In-Game Advertising,” Adweek ,

September 28, 2015. Accessed at

www.adweek.com/socialtimes/

how-to-win-with-in-game-adver

tising/627399.

16 . Shane Schick, “Distimo: In-app

Purchases Accounted for 79% of

iOS Revenue in January,” Fierce-

Wireless.com, March 24, 2014.

Accessed at www.ﬁ ercewireless.

com/developer/distimo-app-pur

chases-accounted-for-79-ios-reve

nue-january.

17 . Sourcebits, “Paid vs. Free Apps in

the App Store vs. Google Play,”

July 16, 2014. Accessed at http://

sourcebits.com/app-development-

design-blog/paid-vs-free-apps-

app-store-vs-google-play.

18 . United States v. American Can

Company (Northern District court

of California, 1949).

19 . See Narasimhan Chakravarthi,

“Coupons as Price Discrimination

Devices—A Theoretical Perspective

and Empirical Analysis,” Marketing

Science , 3 (Spring 1984), pp. 128–147;

Naufel J. Vilcassim and Dick R.

Wittink, “Supporting a Higher Shelf

Price Through Coupon Distribu-

tions,” Journal of Consumer Marketing ,

4(2) (Spring 1987), pp. 29–39.

20 . See the discussion in Chapter 5 of

the framing effect to understand

why rebates may inﬂ uence pur-

chases by customers who do not

ultimately redeem them.

21 . Source: Fare ﬁ nder function at

www.eurotunnel.com.

22 . For an in-depth discussion of the

motivations for quantity discount-

ing, see Robert J. Dolan, “Pricing

Structures with Quantity Discounts:

Managerial Issues and Research

Opportunities,” Harvard Business

School working paper, 1985.

CHAPTER 5

Pricing Policy

Inﬂ uencing Customer Expectations

and Purchase Behaviors

There can never—and I mean never —be a discount on a new car coming out of

the factory in pristine condition.

Elon Musk

As described in the previous chapter, Price Structure and Pricing Policy are

closely related, both having the objective to align differences in price paid

with differences in value received and cost to serve. Price structure involves

establishing that alignment across macro segments of customers and applica-

tions. Although a price structure can sometimes be quite complex, involving

multiple price points and even different price metrics associated with dif-

ferent applications, different levels of volume, and different customer loca-

tions, a particular customer would typically see only pricing associated with

that customer’s intended application, volume requirements, and location. In

contrast, price policy deﬁ nes the rules and conditions for price discounts or

surcharges that could be applied to a transaction within a segment. Pricing

policies involving things like an upcharge for rush orders or a discount for

must-take orders to which the customer commits far in advance of shipment,

can and usually should be transparent because their goal is to inﬂ uence cus-

tomer behavior.

In consumer markets, for example, a retailer will sometimes offer a

short-term price promotion (e.g., buy one, get one free) on a popular brand

to stimulate store trafﬁ c. The risk is that regular customers, who buy the

product weekly because they think it is a good value at the regular price, will

stock up during promotions, undermining both revenues and store visits in

the future. A policy limiting the quantity that a consumer may purchase at

the promotional price would help to prevent that costly change in customer

behavior. Amazon has a Subscribe-and-Save policy to apply an increasing dis-

count when customers order more unique items to be shipped together on a

regular basis. But this discount policy wisely does not apply to ordering more

units of the same item.

Chapter 5 • Pricing Policy 107

When purchasing large quantities for a business, savvy purchasing

agents often split their purchases among multiple suppliers based upon price,

giving say 60 percent to the one with the best price, 30 percent to the one with

the second best, and 10 percent to the one with the third best price. They then

regularly switch company rankings in order to induce sellers into bidding wars

that ratchet down their prices. Again, a policy choice can mitigate the incentive

for such behavior. One policy option is for the seller to require that the buyer

take any extra discount as a rebate to be paid at year end if the buyer’s total

volume of purchases exceeds a target percentage of the buyer’s annual volume.

That eliminates the incentive for the buyer to maintain an ongoing competition

among suppliers for the preferred position because, if the buyer awards its lead

supplier position for only a few months and then switches after receiving a

better offer from a competitor, the buyer will fall short of achieving the annual

volume necessary to qualify for the expected rebate. Moreover, once the buyer

is essentially locked in for a year in order to get the best price, there is a ﬁ nan-

cial incentive to give the lead supplier an even larger share of the volume.

PRICING POLICIES AND PRICE EXPECTATIONS

The examples above illustrate an important challenge to the principle of value-

based pricing: A customer’s willingness-to-pay an offered price is not deter-

mined solely by whether that price is fair or reasonable when compared to

economic value. If customers come to expect that some change in their pur-

chasing behavior will enable them to get the same product or service at an

even better price, then the regular price becomes no longer acceptable. Some-

times that change in behavior can be a good thing for the seller (for example,

when the customer agrees to commit to buy more or to accept a longer contract

term in return for a better price). More often, the change in behavior is an

unanticipated consequence of poor or non-existent policies that fail to account

for the impact of the seller’s behavior on the buyer’s future price exceptions.

Expectations drive buyer behavior and nowhere more so than when

responding to prices. For example, a retail consumer may believe that a new

fall fashion is well worth the price asked for it in September, but not buy it if

she expects that the store, following its past behavior, will have a 20-percent-

off sale within the next month. A policy of regular, predictable discounting has

trained many retail consumers to wait for the sale price. As a result, sales at

regular prices are less than they would otherwise be, increasing the amount of

inventory that ultimately will be sold at the lower sale price.

The same dynamic plays out—only more so—when businesses sell prod-

ucts and services to other business (hereafter referred to as B-to-B sales and

purchases). Professional buyers have learned to hold their purchases from

some suppliers until the last couple of weeks of each quarter when sales man-

agers are often willing to discount more deeply to achieve their quarterly sales

goals. Once customers recognize this pattern, they will delay purchases until

late in a quarter and buy forward to cover their expected needs in the fol-

lowing quarter. Sellers often misinterpret the declining sales at regular prices

and the increasing portion of their sales at discounted prices as a sign that

customers have become more price sensitive. In fact, they are only responding

to incentives for how to get a better deal on what they would otherwise have

been willing to buy at higher prices.

Chapter 5 • Pricing Policy108

Periodic, predictable discounting is just one of many ways that sellers

undermine their pricing power by making decisions for short-term sales gains

that adversely affect buyers’ expectations and future behavior. When sellers

adopt a policy of making price exceptions when necessary to meet the lower

price of a competitor, they create the expectation among buyers that creating a

competitive process for their business will be rewarded. Consequently, buyers

create purchasing policies that require multiple bids for each order or create a

reverse auction for awarding an annual contract.

A pricing policy is a rule or habit, consistently applied, that deﬁ nes the criteria

under which a company will change a price for an individual customer, for a limited

period of time or for particular transactions. To avoid creating customer expecta-

tions that a seller’s prices can be manipulated by adopting purchasing poli-

cies that disconnect price from value, sellers facing repeat customers need to

anticipate the expectations that their pricing policies create for customers. For-

tunately, a company can change its customers’ expectations by adopting pric-

ing policies designed to inﬂ uence those expectations positively. Some retailers

have changed the expectations that it is better to wait for a sale by offering

“30-day price protection,” enabling deal-sensitive shoppers to buy now and

receive a credit for the difference between the price paid and a sale price

offered within the next 30 days. Some B-to-B companies have wisely adopted a

policy that they will not participate in a buyers’ reverse auction when, as often

occurs, they would be allowed to see only competitive price offers but not

differences in the quality, capabilities, and services that lower-priced bidders

are willing and able to provide. In each of these cases, the goal of the pricing

policy is to stop rewarding customer behaviors that erode unnecessarily the

difference between the prices they pay and the value they receive.

THE EMERGENCE OF STRATEGIC SOURCING

Unfortunately, some companies evaluate their pricing decisions, particularly

when deciding whether to make a price exception, considering only the effect

of sales in the current quarter or on the likelihood of winning the next deal. As

a result, they inadvertently create expectations that change customer behavior

adversely. B-to-B companies caught in a cycle of increasing frequency of price

exceptions usually attempt to regain control by creating rules regarding who

in the organization has the authority to approve discounts of what magnitude.

For example, a B-to-B sales rep may be granted the discretion to discount a

sale only by up to 5 percent, but his regional manager can approve discounts

up to 15 percent, and the vice president of sales by up to 25 percent. Unfortu-

nately, as customers learn these rules from their own experience and that of

other customers with whom they talk, they learn not to accept any offer that

the sales rep can make, instead responding with demands, arguments, and

even misinformation designed to motivate the sales rep to make the case to his

management for a larger discount. Furthermore, many companies mistakenly

believe their discount approval process serves as a discount policy, when, in

fact, the approval process is a personnel policy that is ﬁ lling in for a missing

price-and-discount policy.

In business-to-business markets where large companies make high-

volume, repeat purchases, buyers have generally moved far ahead of most

Chapter 5 • Pricing Policy 109

sellers in adapting their behavior to achieve more favorable pricing. Under

the rubric of “strategic sourcing,” they have developed sophisticated pro-

cesses and policies to ensure they get the lowest prices possible while sellers,

in contrast, often understand little about how their behaviors inﬂ uence buy-

er’s expectations and reward more aggressive purchasing tactics. Exhibit 5-1

illustrates this contrast. Purchasing departments that practice strategic sourc-

ing have goals and a long-term strategy for driving down acquisition costs,

while their suppliers often lack comparable long-term strategies for raising or

at least preserving margins.

Buyers at large organizations are usually full-time professionals who

are separate from those who specify or use the product, while the seller’s

counterpart is a rep whose main job is customer service. The purchasing

professional is rewarded for cutting acquisition costs or establishing condi-

tions that increase future leverage, while the typical sales professional is

rewarded simply for making the next sale—and may be punished for losing

it. The purchasing professional typically has access to a database of infor-

mation about all the offers and counteroffers that the supplier has made to

his company in the past, and often about the pricing and terms that other

companies have received. Sales reps, in contrast, often have little knowl-

edge of account history except for volumes purchased and are usually less

well informed about the pricing of their competitors. Not surprisingly, sales

EXHIBIT 5-1

Typical Capabilities of Purchasing Versus Sales

Chapter 5 • Pricing Policy110

reps often feel like the biblical David confronting a more powerful and

better-armed Goliath.

POLICIES FOR PRICE NEGOTIATION

Becoming better prepared to meet the challenge of price negotiation with stra-

tegic purchasers is not a responsibility that sales reps, or even the sales orga-

nization, can meet on their own. It requires developing a long-term strategy

supported by pricing policies that are applied consistently. To develop good

policies for price negotiation, it is necessary to treat every proposal or request

for a price exception not as a one-off event but as an opportunity to create or

change a policy that would be applied to all similar situations in the future.

The more often a company ﬁ nds it necessary to make price exceptions, the

more likely that its policies are poorly deﬁ ned or in need of revision.

If a ﬁ rm has few clearly deﬁ ned or consistently followed policies, a lot

of potential deals will end up as requests for price exceptions. As new, well-

thought-out policies are put in place, customers and sales reps will learn that

ad hoc exceptions to policies will not be granted. The only requests for special

pricing that should be considered are those involving situations not already

covered by a policy. Putting a “no exceptions” stake in the ground is a key to

making pricing decisions that are proﬁ t-enhancing. Most discount proposals,

whether to reduce price to win business or to increase price to exploit tight

supply, have an immediate reward that is obvious but a corresponding cost

that is delayed, diffused over more accounts, and less transparent. In contrast,

pricing by policy forces companies to consider the impact on the entire mar-

ket when making a pricing decision and reﬂ ects the “shadow of the future,”

whereby today’s discounting decisions affect pricing power in future transac-

tions. It should involve asking whether it makes sense to establish a policy that

the proposed pricing option could be offered to all customers like this one and

still be proﬁ table.

Making the decision by policy forces decision-makers to think through

the broader and longer-term implications of the precedents they are setting.

Creating policies cannot be the responsibility of sales management alone, since

they do not have the perspective on the overall market or the authority to

make the trade-offs that may be required. Pricing policies need to cover more

than just discounting. They should include the company’s pattern for passing

along changes in raw materials costs (such as requiring that all long-term con-

tracts allow for adjustments versus adjusting only after a ﬁ xed-price contract

expires) and its pattern for inducing product trials.

Pricing policies should also deal with how a company will respond to

low-price offers made to its customers by a competitor. Any pattern creates

expectations for how the company will deal with such issues in the future, and

thus can change customers’ future buying behavior. Policies also inﬂ uence

how your sales reps sell and which ones succeed. Who is most rewarded at the

company, the sales rep who sells at high margins by understanding customers

well enough to communicate value, or the rep who drives big volume at a few

accounts by understanding his company’s management well enough to make

the case internally for price exceptions?

Ideally, policies are transparent, are consistent, and enable companies

to address pricing challenges proactively. If your policies are transparent,

Chapter 5 • Pricing Policy 111

customers need not engage in threats and misinformation to learn the trade-

offs you are willing to make. Airlines have transparent pricing rules that we

may not like (low prices only when purchased well in advance, charges for

making changes, no transfer of tickets to another passenger), but we accept

them because we know what they are. Consistency communicates that it is

impossible to “game the system” by contacting multiple points in the com-

pany to ﬁ nd the best deal while mitigating a buyer’s fear that a competitor

who negotiates harder may be getting a better deal. Communicating policies

proactively is much less contentious than telling a customer reactively that a

proposal of theirs has, after some delay for review, been rejected.

Despite all that we have written so far about creating a value-based price

structure and avoiding “price exceptions,” nearly all companies in B-to-B mar-

kets and some in B-to-C markets will need in some cases to negotiate prices

because the product application or the customer is genuinely unique. For some

products, such as a contractor building a unique building (e.g., a new research

center), a consulting ﬁ rm bidding to develop a plan to solve a unique customer

problem (e.g., how to develop the market for self-driving cars) or a manufac-

turer selling the same product to a unique and very demanding customer (e.g.,

drugs to national health authorities in countries with single-payer health care

systems, or lawn mowers and snow blowers to a category-leading retailer like

Walmart), price negotiation is unavoidable.

Once the door is opened for price negotiation, there are myriad oppor-

tunities for savvy customers to manipulate the process to their beneﬁ t—

potentially undermining pricing and proﬁ tability across the entire market.

Following is a list of four common tactics used by professional purchasers to

disconnect price from value, and effective pricing policies that ﬁ rms have suc-

cessfully adopted to defend against them:

1. Commoditizing the Offers : Particularly in B-to-B markets, custom-

ers often refuse to discuss what differentiates the offers of various competi-

tors. Instead, they distribute “specs,” short for speciﬁ cations, of exactly what

they require. They then solicit bids to meet or exceed that speciﬁ cation. In

some cases, the bids are “closed,” meaning that no one knows what anyone

else is bidding until they are opened. In the worst cases, competitors are

invited to submit their bids electronically. Over a few hours, the bids are

“open” for everyone to see what others have bid, but not who the other

bidders are. During that time, they can revise their bids based upon the

prices that others have offered. This is called a reverse auction. Suppliers

generally hate them, in part because they are unprepared to deal with them

proactively.

Policy Prescriptions : If the buyer is committed to buying from the lowest

bidder, this is not necessarily a bad situation. If you really want such business,

which you may if it involves signiﬁ cant volume and does not compete directly

with your main market, look at the specs carefully and think about how you

could reduce your costs by cutting quality and service levels to meet but not

exceed the specs. Does your manufacturing process yield a certain amount of

“rejects” that do not meet the standards for most customers but would for this

one? Do you have inventory that is about to expire yet still meets spec? Could

this customer’s service needs be met in a cheaper way? Calculate the lowest

price that would make this business worthwhile without all those costs, and

do not go below that price in your bidding.

Chapter 5 • Pricing Policy112

Be prepared, however, for the customer to object to your adherence to

their own specs after granting you the business, especially if you have previ-

ously been a supplier to the customer and have already established expecta-

tions about how you normally do business. At that point, it is essential that

you have a menu of very proﬁ tably priced product and service “upgrades”

that the customer can buy as needed. For example, the customer may not have

speciﬁ ed order lead times in the spec so you set minimum lead times for this

customer equal to those that would have been required by other bidders serv-

ing the customer from some distant, low-cost location. A customer who then

wants to take advantage of your ability to deliver orders with shorter lead

times must pay a “rush order” charge that reﬂ ects the value of your differenti-

ated ability to offer that service.

If the customer is not committing to buy from the lowest bidder when

running a bidding process, then specs that devalue differentiating quality and

service are simply a sham designed to bring low-cost bidders into the pro-

cess. Do not take the bait. Make a policy either to refuse to participate in sham

reverse auctions or to bid your list prices. Now the customer must choose

either to pay list prices or abandon the bid process and engage in a more hon-

est Give-Get negotiation.

Whether you win the business upfront but then make money by eliminat-

ing unnecessary costs or selling the upgrades, or you force the customer into

a negotiation that involves acknowledging the differences that are important

to them, you need to prepare in advance. You will need to create an unbun-

dled price structure (Chapter 4) that afﬁ xes a monetary cost to the levels of

quality and service that differentiate you.

2. Double discounting of price increases : Some companies’ pricing

strategies have suffered for years from the effects of poorly negotiated price

increases. The seller in these cases establishes an across-the-board price

increase—say 6 percent—that is presented to buyers. Buyers without power

are forced to take it or leave it. Larger buyers, however, often make the case

that since they deserve a volume discount, they should not have to bear the

full increase. If they typically enjoy a 25 percent discount off list prices, they

argue that they should get only a 4.5 percent price increase—25 percent off the

6 percent increase in list prices.

Only a little thoughtful analysis reveals that this is a bogus argument

leading to a costly mistake that compounds as years go by. The large buyer

who gets a 6 percent increase is already getting a discount on the increase rela-

tive to smaller buyers. For example, if the large buyer is currently paying $75

for what other buyers pay $100, a 6 percent increase for the large buyer is only

$4.50 versus $6 for everyone else. By demanding a discount on the increase, a

purchasing agent is demanding that the seller pay twice for the same volume.

When buyers use this tactic repeatedly and the seller falls for it, their dis-

counts quickly compound. One client saw its prices for volume buyers drop

to less than 50 percent of list price in only seven years. To compensate for this

loss, the company began asking for higher increases to create room for erosion

with large buyers. As a result, it lost progressively more of its medium and

small customers, making it ever more reliant on and vulnerable to intimida-

tion from its largest buyers.

Policy Prescription : When increasing prices, there must be no exceptions.

If more powerful buyers must have a concession, give it without undermining

Chapter 5 • Pricing Policy 113

the integrity of the price increase. For example, rather than discounting the

price increase by 25 percent, give the powerful buyer a three-month delay

before it will take effect. This is also a very useful tactic for buyers who have

been paying unjustiﬁ ably lower prices that must be corrected. Begin by telling

them what their new price needs to be to make them worth serving. You must

be prepared to justify that price as fair, given what others pay, and you cannot

back down without undermining the principle of pricing by policy. However,

if the buyer signs a new contract to buy for some period in the future, say one

year, you could agree to implement the increase in stages: 25 percent of the

increase immediately and 25 percent at the beginning of each of the next three

quarters. Ultimately, in the last quarter of the contract, the customer is pay-

ing the higher price aligned with what other customers pay, but the purchas-

ing department can show “savings” in the current contract relative to market

prices.

3. Discounting for volume . Sometimes buyers will offer a seller incre-

mental volume in return for a price concession. There is nothing in principle

wrong with accepting or, even better, proactively proposing such a deal. In

practice, however, sellers often get taken. Here’s how. A buyer who offers to

purchase 10 percent more volume in return for “only” a 2 percent price dis-

count is actually getting a 22 percent price cut on the incremental volume!

If the buyer is currently spending $10,000 per year and offers to purchase

10 percent more volume, he would be buying $1,000 of additional product

at the pre-discounted price. If the buyer receives a 2 percent discount on that

$11,000 worth of product, he pays $220 less, which is 22 percent off the $1,000

of what would otherwise be incremental revenue.

Is the incremental volume really proﬁ table at such a low price? If sellers

actually calculated that incremental discount, many would never be willing to

make such a large concession. Actually, the long-term cost of the concession is

even higher because the lower price concession becomes incorporated into the

starting point for all future negotiations.

Policy prescription : If you’re going to give a discount for volume, focus

the discount on the incremental volume and give it as a rebate. For example,

instead of offering a 2 percent discount on all of the volume, including what

you have already won, offer a 10 percent rebate on the year-to-year increase in

volume. This focuses the customer on the real value of the concession, it cre-

ates a much stronger incentive for the customer to reject a competitor’s offer

to try their product, and it costs less! Making the discount into an end-of-year

rebate instead of an upfront discount has the added advantage of protecting

you from duplicitous buyers who promise more business to get the discount,

but never order the promised incremental volume. With the discount focused

entirely on the increment, they don’t get the savings until they have bought

the required volume, and the lower price doesn’t get incorporated into the

buyers’ expected price level.

4. Discounting to compensate for past failure . There is no situation in

which sellers are more vulnerable than when their ﬁ rm has failed to meet its

commitments. Failure to deliver on time or to deliver the promised quality

clearly undermines the case that your ﬁ rm deserves either a higher price or

a higher share of a customer’s business. Sophisticated purchasers will exploit

that vulnerability by demanding an exceptional price concession to compen-

sate for your prior failure.

Chapter 5 • Pricing Policy114

There are two things that make this a powerful weapon for the pur-

chaser. First, the seller does owe the customer something for having failed to

meet its obligations. Second, by making that “something” a price concession,

the seller exploits a common psychological bias that makes forgoing revenue

less psychologically painful than making an equal-sized expenditure, even

though each would affect bottom-line proﬁ t equally. The problem with the

price concession is that it gets built into the price from which future negotia-

tions begin—making it potentially an indeﬁ nite purgatory.

Policy Prescription : Make it a policy to negotiate with the customer a fair

compensation for the cost of any legitimate failure, but pay that compensation

as a lump-sum payment, rather than letting it reduce your established price

point. If that is not ﬁ nancially possible, then make the compensation a “credit”

that the customer can take for a portion of each future invoice until the agreed-

to compensation is exhausted. This preserves the integrity of the price and

automatically terminates the “discount” after the agreed amount is reached.

For a customer who is upset about a past failure, you might even build a pen-

alty (e.g., a 5 percent invoice credit for every week of delay in delivery beyond

the promised date) into the contract. While these options may feel more pain-

ful than a simple price concession because they make the cost explicit, they

are actually less costly because they expire automatically and maintain the

principle that your price is justiﬁ ed by the quality or service that a customer

can usually expect you to deliver.

Analyzing pricing challenges and developing policies to deal with them

is an ongoing process, and one that is generally the responsibility of a pricing

staff overseen by a group of managers with collective responsibility to pre-

serve or improve proﬁ tability. Over time, a company’s policies can become

a source of competitive advantage—creating expectations that drive better

behavior on the part of customers, competitors, and sales reps and empower-

ing sales reps to offer creative solutions more quickly and with less wasted

effort selling their ideas internally. Still, building that set of policies takes time,

and policy-based pricing will lose organizational support if few of the initial

applications produce positive results. To avoid that problem, the remainder

of this chapter will identify the common challenges that call for policy-based

solutions and describe successful policies that we have seen for dealing with

each of them.

POLICIES FOR RESPONDING TO PRICE OBJECTIONS

The most common, and therefore, most important domain for policy devel-

opment falls into the arena of responding to price objections from custom-

ers with whom pricing involves a process of negotiation. The lack of policies

for dealing with price objections is not only a challenge for companies that

sell directly. Consumer goods manufacturers face just as much price pressure

from powerful retailers as they do from consumers who switch to alternatives

because of price.

The Problem with Reactive, Ad Hoc Price Negotiation

To illustrate the problem created in price negotiation by non-existent or poorly

enforced pricing policies, think about how the process commonly plays out

Chapter 5 • Pricing Policy 115

badly for the seller. Imagine that to cover the increased costs of raw materials,

your company announces a 5 percent price increase. When sales reps attempt

to get their next orders at those higher prices, purchasing agents confront

them with the assertion that the increase is unacceptable. How each sales rep

responds to that resistance is critical to the success of this and any future price

increases. Unfortunately, most companies lack consistent policies for how to

respond, so that the mistakes of even a few can leave the company worse off

than if it never even attempted the increase. The reason is that the response

will create an expectation among the company’s customers about how to get

a better price.

Let’s look ﬁ rst at what happens when a company has poorly deﬁ ned

or unenforced pricing policies for discounting, leaving sales reps with no

authority or guidance on how to react to a customer’s insistence on a lower

price. Imagine that when confronted by the purchasing agent, a sales rep

looks ﬂ ustered and says only that he cannot change any pricing without the

approval of his manager. This simple statement will make all future negotia-

tions much more difﬁ cult. The sales rep has communicated to the purchasing

agent that: (i) his company makes price concessions to some customers; (ii) to

get a concession requires resisting any offer until a sales manager is involved;

and (iii) that the customer is speaking to the wrong person. In short, by com-

municating that it makes exceptions, the company and the sales rep have lost

their price integrity: The belief that the initially quoted price is actually a fair

market price that other customers pay for the same thing. Exhibit 5-2 illus-

trates this downward cycle of reactive, ad hoc discounting.

Given that lack of integrity, the purchasing agent realizes that either she

must ﬁ gure out how to exploit it or she will be paying higher prices than com-

petitors pay. A purchasing agent’s worst nightmare is that someone discovers

that a competitor is buying the same product from the same supplier for less

than she was able to negotiate. On the other hand, ad hoc discounting creates

EXHIBIT 5-2

Cycle of Reactive Price Negotiation

Chapter 5 • Pricing Policy116

the possibility that adroit negotiation might enable the buyer to achieve an

even better price than competitors. The greater the perceived potential to win

a better discount, the greater the return to an investment in strategy of aggres-

sive price negotiation.

Buyers exploit a lack of price integrity by adopting negotiation tactics

that undermine value-based pricing. These usually involve purchasing poli-

cies that shift the negotiation from one where the seller manages the buyer’s

expectations to one where the buyer manages the seller’s expectations. The

expectation that the purchasing agent wants to create is that the buying com-

pany views the seller’s product or service as essentially a commodity for

which there are easy, cheaper substitutes. Creating this expectation involves

minimizing direct contact between sales reps and users who could acknowl-

edge the value of differences. It also involves creating at least the impression

of a highly competitive market for the customer’s business.

We have seen many cases where a seller lost market share at a large cus-

tomer because it became more ﬂ exible in negotiating price exceptions. Once

customers learn that their price is dependent upon creating substitutes, they

have a motivation to solicit bids from cheap competitors, even if they have no

intention of ever doing business with them. In other cases, they will “diver-

sify” their purchases among two or three qualiﬁ ed suppliers and then create an

ongoing competition among them by giving more share to whichever supplier

offers the lowest price. Of course, they give their preferred supplier a “last

look” chance to match lower bids to retain a larger share. But every time the

preferred supplier matches, it reinforces the idea that it is better to maintain

multiple competitive suppliers despite a preference for one, and undermines

the idea that whatever differentiation makes the preferred supplier preferred

has economic value.

Seeing this erosion of market share and customers’ willingness-to-pay for

differentiation causes sellers to believe that their products and services have

become more commoditized. Because they fear additional sales loss, they dis-

count more, often cutting expenditures for the differentiation that customers

appear not to appreciate. When a company with poor policies that have under-

mined its price integrity is the market leader, the damage is compounded.

Competitors never know the real price against which they are competing,

since there is no consistency. Their information about what the market leader

is offering on any particular deal comes from the purchasing agent who has

an incentive to underrepresent competitors’ prices and forgets to mention any

restrictive terms to qualify for them. As a result, competitors will on average

imagine that the leader is pricing lower than it is, and so they will price lower

than necessary to win sales.

The Beneﬁ ts of Proactive, Policy-Based Price Negotiation

Now consider the impact on expectations when aggressive negotiation is met

with strong pricing policies that maintain price integrity. Your company has

announced a 5 percent price increase to cover rising raw materials costs. When

confronted by the purchasing agent, the sales rep knows that his company will

back him in holding ﬁ rm on the increase, even at the cost of a sale. He conﬁ -

dently explains to the purchasing agent why all suppliers will face the same

cost increases and so cannot maintain their same quality and service levels

Chapter 5 • Pricing Policy 117

without passing it along. The goal is to make clear that the buyer will not be

put at a competitive disadvantage by accepting the increase.

Many purchasing agents will still refuse to accept the increase at that point

unless the ﬁ rm’s price integrity has already been proven in the past. Some may

only be blufﬁ ng or may be prudently planning to check what other suppliers

are doing before deciding to accept the increase. Others, however, may be oper-

ating under a mandate to keep total costs from increasing. Although your price

increase is creating a problem for these buyers, it is the seed of an opportunity

to change their behavior by changing their expectations. That begins a virtuous

cycle of Proactive, Policy-based Price Negotiation illustrated by Exhibit 5-3.

The sales rep who works for a company with pricing policies can be

armed with more than just the conﬁ dence that he can lose the sale. He can also

be empowered with pre-approved value trade-offs and discount policies that

in a policy-free company would require review by someone higher up. The

sales rep can build credibility with the customer by offering the customer win-

win, or at least win-not-lose, trade-offs. For example, if the purchasing depart-

ment could get the multiple users in the company to place one consolidated

order each month rather than many smaller orders, the sales rep explains, his

company can cut the buyer’s shipping costs. If the purchaser would buy a

wider variety of products from the seller under a multi-year contract, it would

be possible to reach the volume threshold for an end-of-year rebate. If the pur-

chaser would allow the seller’s technical people to talk with the users, they

might be able to suggest some process improvements to cut waste by more

than enough to offset the price increase.

To take advantage of these trade-offs, the purchasing agent would need

to change purchasing behavior to focus more on understanding what creates

value in his ﬁ rm and to optimize the trade-off between what the ﬁ rm buys and

EXHIBIT 5-3

Cycle of Proactive Policy-Based Price Negotiation

Chapter 5 • Pricing Policy118

the sellers cost to provide it. To make the trade-offs, the purchasing agent would

need to bring actual users into the decision process to evaluate them. If the poli-

cies are well designed, she will learn either that savings can come from work-

ing with this supplier rather than by threatening him, or that she already has a

deal that represents the best overall value for her company. Once she develops

the expectation that the best way to minimize cost is to work with her sales

rep and that there is no reward to be had from deceiving him, she will become

more open with information that enables the seller to identify other trade-offs

that could be mutually beneﬁ cial. As buyers come to trust the process, there is

no need for the seller to maintain multiple suppliers simply to gain leverage in

price negotiations. This does not mean that the process will be free of conﬂ ict,

anger, or occasional threats. But it will force the interactions to focus on value.

Regaining the ability to capture value when negotiating prices requires

more than training the sales force on “SPIN selling”

or any other sales program.

Value-based sales tactics need to be backed by a pricing process that is consis-

tent with those same principles. Unless a company is selling a unique product

to each customer, pricing should not be driven by a series of requests for one-

off price approvals from the sales force, since the sales force then becomes little

more than a conduit for strategies designed by the customers. Changes in price

should be driven by consistent policies designed to achieve the seller’s market-

level objectives. When the policies are aligned with those objectives and clearly

articulated for the sales force, the sales reps (as well as distributors and channel

partners) are empowered and motivated to sell on value rather than on price.

Policies for Different Buyer Types

Given the growing power of some buyers, and the increasing transparency of

pricing to all buyers, any proﬁ table and sustainable solution for dealing with

price objections must be codiﬁ ed in policies. But what policies? The answer to

this question depends upon the type or types of buyers from whom you are

encountering the objection. Exhibit 5-4 illustrates four general types of buy-

ers, who differ in the importance to them of differentiation among suppliers

within the product class (for example, how important is durability or immedi-

ate availability when buying ofﬁ ce furniture), and the cost of search among

suppliers relative to the potential savings. You need policies that enable your

company to respond appropriately to price objections driven by the different

motivations of these different types of buyers.

Value-driven buyers purchase a disproportionate share of sales volume

in most business-to-business markets. They have sophisticated purchasing

departments that consolidate and buy large volumes, and they can afford the

cost to search and evaluate many alternatives before making a purchase. They

are trying to manage both the beneﬁ ts in the purchase to get all the features

and services that are important to them, as well as to push down the price as

low as possible. The policies that the sales rep needs to deal with value buyers

are ones that empower him or her to make trade-offs, while at the same time

offering a defense against pressure on price alone.

The key to creating value-based policies is to understand every way in

which your product or service might add more value to the customer than

the product or service of a competitor, and every way that a change in a cus-

tomer’s behavior could add or reduce the value to you. Then create a set of

Chapter 5 • Pricing Policy 119

EXHIBIT 5-4

Buyer Types

pre-approved trade-offs. For example, if a source of your value is higher-

quality service that competitors do not offer, you need to ﬁ nd a way that the

service can be unbundled even if that is not the way you prefer to deliver your

product. It may not even save you any money to unbundle it. But it gives the

sales rep a low-cost alternative to walking away or simply giving in on the

price without any cost to the buyer for the concession. With that lower cost

option, the rep can call the bluff of purchasing agents at companies that do in

fact value your differentiation. If too many buyers are actually taking the low-

service, lower-price option, it is time for management to reconsider whether

the service differentiation is really worth what they think it is.

The other option is to think of things the customer can do for you that

would justify a discount. For example, could you create an end-of-year rebate

based upon the customer buying more broadly from your product line, increas-

ing volume by at least 20 percent (but reward for only the incremental volume,

as described earlier in this chapter!), establishing a regular steady order that

will not be changed less than seven days before the shipping date? Each of

these illustrates a principle that we call give-get negotiation. The policy for

dealing with value-driven buyers is that no price concession should ever be

made that does not involve getting something from the other side. The price

concession need not be fully covered by any cost savings to the seller, but it

should eliminate any differentiation that the buyer claims not to value. This

principle, which if the sales reps are empowered with pre-approved trade-offs

can be established at the moment when the purchaser raises the price objec-

tion, educates the buyer that there is always a cost to price concessions. That

cost puts a limit on the buyer’s willingness to pursue price concessions indeﬁ -

nitely. Once purchasers understand these new rules of the game, it also creates

an incentive for them to think of new trade-offs that they might propose (for

example, partnering on developing a new product) that would warrant con-

sideration by the seller’s management as a new policy.

Chapter 5 • Pricing Policy120

The fear that too many companies have is that if they adopt give-get tac-

tics rather than simply conceding to price objections with an ad hoc deal, they

will lose too many value-driven customers, or that customers will automati-

cally choose the cheapest, most basic offering. The problem with this thinking

is that if you never test it, you never know whether the objections are driven

by a lack of value or simply by the expectation that objections are rewarded

with price concessions. Moreover, because value buyers know their market,

they sometimes do not even give you the beneﬁ t of a price objection. You just

lose their business because your product or service levels are beyond what

they need.

By proposing trade-offs, you can learn what value buyers value. By lis-

tening to how they respond to proposed trade-offs, you can gauge whether

the problem is that you are offering too much or that you are uncompetitive

for the same things. If your proposed trade-offs are rejected and you lose busi-

ness, then your prices may not be competitive. In that case, it is better to lower

your price proactively by policy than to wait for each customer to object. Price

integrity is worth more in the long run than the extra revenue you can earn for

a while from the customers who are slowest to recognize that you no longer

offer a good value.

Brand-driven buyers are those for whom differentiation, particularly of the

type that is difﬁ cult to determine prior to purchase, is valuable but the cost

to evaluate all suppliers to determine the best possible deal is just too high.

Perhaps the buyer is new to the market and just lacks the experience to make a

good judgment. The buyer will buy a brand that is well known for delivering a

good product with good service without considering cheaper but riskier alter-

natives. Other times, the buyer may have had positive past experience with a

current supplier and the cost to evaluate another supplier versus any potential

savings is too high; consequently, the buyer becomes “loyal” to the seller.

A price objection from a brand-driven buyer, or a customer satisfaction

survey showing a decline in such buyers’ beliefs that the company offers fair

value for money versus competitors, is something to take very seriously. It

can signal one of two things: That the brand buyer has been disappointed by

the supplier relative to expectations; or that he has learned something about

market prices that leads him to expect that the price he is paying for security

is excessive. A price concession is never a good response in the ﬁ rst case and

may not be in the latter.

If the issue is disappointment, it is important to understand the nature

of it and make recompense, rather than giving a price concession going for-

ward; such a concession signals to this customer that it is reasonable to expect

such disappointment in the future, and the adjusted price reﬂ ects that less-

than-adequate result. A client of ours in the printing industry failed to print

and ship the client’s catalog when promised which, since the catalog was for

seasonal merchandise, represented a serious breach of trust. The customer

opened the catalog bid to other printers for the next year and the sales rep,

having been berated by the customer, felt certain that the only way to keep

the account was to slash the price. After understanding the high value that

this customer placed on the quality and technical relationship that they had

built up over many years with the printer’s technical personnel, we proposed

a different approach.

The president of the printer went to see his counterpart of this mid-

size catalog company to express personally that what happened reﬂ ected an

Chapter 5 • Pricing Policy 121

unacceptable misunderstanding of how important the promised mail date was

to their business. He explained how, because the client was not one of the larg-

est in the printing plant, their job had been given lower priority when prob-

lems arose. The president explained that they now realized what a poor policy

that was for sequencing jobs. The president indicated that if given another

chance, his company would put together a proposal by which the client could

purchase the right to be, during the weeks of time-sensitive print runs, the

top-priority job in the plant. The deal would involve a sizable ﬁ nancial guar-

antee from the printer that its job would ship exactly as promised. By way of

apology and to prove its commitment, the printer would give the client a large

credit that would offset all of the cost of this service in the ﬁ rst year of a new

three-year contract.

A few days later, the sales rep and the vice president of sales arrived

with the proposal, including the option to “own” their desired time on the

presses for what amounted to a 24 percent premium over the already high

rate this customer had been paying. The proposal also gave the customer the

promised credit to compensate for the prior year’s failure. After some further

negotiation that slightly increased the size of the credit, the customer accepted

the deal and expressed appreciation that the printer was ﬁ nally giving their

relationship the respect that they felt it deserved. Allowing this customer to

negotiate a larger credit was acceptable because it was based upon the value

lost by the past failure while still preserving the policy that the price the cus-

tomer would pay reﬂ ected the value going forward.

Of course, if this buyer’s objection were driven not by any disappoint-

ment in the service but by a belief that it was already being exploited on the

price, the solution would have needed to be very different. One way to avoid

that problem is to understand the value you are delivering and have a policy

to never let the price premium for the relationship buyer exceed that value.

As important is the need to ensure that the buyer recognizes the added value

that you are delivering. The key to doing that is to track all the value-added

services that the customer gets and associate a quantiﬁ able value to them. For

example, a company can itemize differentiating features and services with

prices for each on its invoice; it can also tabulate the number of no-charge cus-

tomer support calls ﬁ elded each month or any other services delivered. Then,

at the bottom, show a credit for the sum of those charges reﬂ ecting the fact that

they are covered in the all-inclusive price.

Price-driven buyers are the polar opposite of brand buyers. They genu-

inely are not looking for a feature or service that exceeds some level that they

specify in advance. The clearest symptom of a price buyer is the “sealed bid”

or “reverse auction” purchasing process. The buyer commits in writing to the

speciﬁ cation of an acceptable offer and is distinctly unwilling to invest time

in hearing about the value of an offer that exceeds those specs. He wants a

proposal that simply communicates your capability to achieve the specs and

your price. If managed appropriately, price buyers can be useful as a place to

unload excess inventory, to ﬁ ll excess capacity, or generate incremental proﬁ t-

ability, but only if the risks are recognized and managed.

The most effective policy for dealing with price buyers is the following:

Strip out every cost that is not required to meet the minimum speciﬁ cation;

design the low-cost offer in a way that makes it unattractive to your exist-

ing customer base; and be prepared with a credible justiﬁ cation when existing

customers inquire why someone else is receiving a lower price. Many branded

Chapter 5 • Pricing Policy122

pharmaceuticals companies have traditionally ignored developing markets

such as India and Southeast Asia because of low prices, but rapid growth in

those markets has caused big pharma to take a new look at how they could

generate incremental revenue from patented drugs.

They have done so by

licensing reputable local suppliers to make local versions, without the use of

the brand name or distinctive shape and often combined with local ingredi-

ents that have not received approval as part of the formula in higher-priced

Western countries. The companies earn incremental revenue from these price-

buyer markets with minimal investment while effectively fencing off their

more lucrative markets.

Sometimes value-driven buyers, and even brand-driven buyers, will mas-

querade as price-driven buyers in an attempt to extract reactive concessions from

their preferred supplier. They hold a reverse auction, for example, that is widely

open and they share the prices among the bidders with the sole goal being to get

lower pricing from their existing supplier. There are a number of tip-offs to look

for to determine whether this is a sham. One is that the buying company still

spends a lot of time evaluating the differences among suppliers before the bid.

Second is that its RFP is vague about the details of product and service speciﬁ ca-

tions. Third is a lack of commitment to buy from the lowest-price bidder who

meets the specs. If any of these happen, then there is reason to believe that the

buyer is not really ready to make the ﬁ nal decision solely on price.

There are two common policies that expose value and relationship buy-

ers disguised as price-driven buyers. One is to adopt and publicize a policy

never to respond with a bid unless minimum acceptable product and service

speciﬁ cations are fully deﬁ ned, enabling you to infer which lower-quality bid-

ders will be excluded and to understand exactly what the buyer is willing to

give up. The other approach, recommended only when the volume at stake

is very large, is to submit a bid that you can deliver proﬁ tably within the ill-

deﬁ ned spec but is explicit in stating the lower quality or service levels that

reﬂ ect the “gives” you expect from the buyer in return for a lower price. If the

customer wants what they have had from you in the past—such as the ability

to place rush orders, to order shipments that are less than one truckload, and

to demand longer payment terms—you will enforce ﬁ rm policies that will trig-

ger additional charges for those services. Either of these policies by a supplier

with an existing relationship will usually result in a return to more traditional

give-get negotiations.

A common error that we see in dealing with genuine price buyers is the

attempt to make them into value buyers by offering them a “promotional”

price. The argument is that by giving a proven price buyer more quality or

service than they have paid for, particularly when the users could really ben-

eﬁ t from it, these customers will see what they have been missing and be will-

ing to pay more in the future. In practice, exactly the opposite occurs. If price

buyers learn that they can get priority service or superior quality when they

really need it without paying for it, they have no incentive to ever change their

policy of price buying. A better strategy is to let the price buyer know that you

can deliver a much higher level of quality and service. When the price buyer

needs a rush order or technical support because the low-priced bidder shipped

defective product or failed to ship at all, a strategic pricer should have a policy

to ﬁ ll the order, but only at the highest list or spot price, perhaps including

charges for a rush order, services, or anything else out of the ordinary. When

Chapter 5 • Pricing Policy 123

the buyer has seen the cost of not dealing with a higher-quality supplier, the

seller may offer the customer a contract retroactively that would cover those

services going forward at prices equal to what other buyers pay. If the price

buyer declines the offer, at least you will have earned a good proﬁ t as an emer-

gency supplier.

Convenience-driven buyers don’t compare prices; they just buy from the

easiest source of supply. Convenience buyers are value, loyal, or price buyers

in categories where they spend more or buy more frequently, but will pay a

price that is much more than the economic value deﬁ ned in the market for

a relatively small or infrequent purchase. They expect to pay a premium for

convenience, so price objections from them are rare.

Policies for Dealing with Power Buyers

A subset of value buyers is what we call power buyers , who control so much

volume that they have the power to deliver or deny huge amounts of market

share. They expect to get better prices than any other buyer because of that

power. As one supplier reported being told by a purchasing agent at a large

retailer, “We expect your price to us to cover your costs. Earn your proﬁ ts from

somebody else.” The worst of these were the large auto ﬁ rms, which bank-

rupted many of their suppliers before bankrupting – or nearly bankrupting –

themselves. Other power buyers—such as Walmart or Home Depot—have

used their power to force suppliers to become more efﬁ cient and, in the pro-

cess, those power buyers have grown both by capturing more market share in

their original markets and expanding into new product lines. Power buyers

have also arisen in the market for hospital supplies as integrated hospital net-

works and as “buying groups” of independent hospitals. Buying groups are

not really buyers, but associations of buyers that increase their power to nego-

tiate deals collectively by refusing to buy from suppliers that have not signed a

contract with the group. Dealing with power buyers reactively is risky; a seller

is almost certain to suffer a decline in proﬁ tability as a result.

So how can a seller deal with power buyers proactively? First, stay real-

istic. The effect of power buyers is to reduce the value of brands. Many com-

panies that were seduced by the large volumes offered by power buyers have

consequently experienced signiﬁ cant margin declines. Their mistake was to

think of power buyer volume as purely incremental, leading them to cut ad

hoc deals without thinking about the effect on the overall market. If a brand

has enough value to consumers that they will go to a store that has it rather

than accept whatever is offered at a big-box store or from a buying group, then

the brand has value beyond the retailer’s margin on that product. The brand

can draw store trafﬁ c. Retailers competing with the big-box stores will pay

more than the power buyers precisely because the brand can draw a buyer to

them. For example, Benjamin Moore paints have high value to local hardware

stores and home centers, not just because they have high customer loyalty, but

also because they are not available at Home Depot or Lowe’s.

Still, in many markets, power buyers control so much volume that one

cannot grow without them. For brands without broad customer recognition

and preference, the broad distribution and access to volume that power buyers

offer may be the key to proﬁ table growth. Even companies such as Procter &

Gamble with strong brands have found dealing with power buyers proﬁ table,

Chapter 5 • Pricing Policy124

but not on their terms. Here is how others have made the choice to deal with

power buyers and still preserve their proﬁ tability.

Make power buyers compete . Many companies with strong brand pref-

erence miss a big opportunity by framing the strategic issue poorly. They ask

themselves whether they should continue with their traditional retail channel,

targeting customers who are less price sensitive, or sell to retail power buyers

at lower margins to win high volumes. But a third way to win the business

of a power buyer, without making a price concession, is to offer one of them

a way to drive store trafﬁ c. This generally involves giving the power buyer

something that they can sell exclusively. For example, the retailer Target has

been willing to do deals at the margins expected by famous designers of jew-

elry, women’s accessories, and home goods in return for exclusive designs that

attract customers who might not otherwise be willing to drive to a “big-box”

retailer.

Quantify the value to the power buyer . There are many ways that a

brand can bring differential value to a big-box retailer. Even if the retailer

already has someone as a customer, the brand can drive store visit frequency.

Disposable diapers are very valuable to Walmart because their bulk requires

frequent visits from a high-spending demographic group, new parents. Dia-

pers are placed strategically in the back of the store so that each visit takes the

new parents past other items that they might be tempted to buy. A large man-

ufacturer capable of serving all of a big-box retailer’s volume across multiple

locations also has the advantage of reducing the retailer’s vendor management

costs.

Eliminate unnecessary costs . The most difﬁ cult challenge to manage

is trying to serve both high-volume power buyers who are unwilling to pay

for your pull marketing efforts, and non-power buyers who value your brand

because you support its marketing. One option is to specialize in serving only

power buyers, enabling the company to eliminate costs of marketing and dis-

tribution. Shaw Industries, the largest carpet supplier in North America, has

a core competence in eliminating unnecessary costs from carpet manufacture.

To leverage its economies of scale, it sells massive volume though big-box

retailers and large retail carpet buying groups.

Segment the product offering . There is no need to offer exactly the same

product through a power buyer and through traditional channels where there

is a conﬂ ict. In the case of some packaged goods, only large sizes are available

through other big-box retailers. Toro, the maker of high-quality lawn mowers

traditionally sold through local lawn and garden centers declined for many

years to pursue the business of big-box stores. Ultimately, however, the com-

pany came up with a strategy that has worked to serve both types of retailers.

Toro sells a high quality, but entry-level, mower in high volumes to Home

Depot. For repairs and maintenance, buyers are referred to the traditional

lawn centers where the specialized retailer not only earns margins from after-

sale serving, but also has the opportunity to up-sell consumers to the more

expensive machines. Selling different packages and models through different

channels cannot entirely prevent cannibalization, but a thoughtful strategy

can often reduce it to acceptable levels.

Resist “divide and conquer” tactics . Power buyers get their power

from their ability to deny a brand or product line any volume through their

Chapter 5 • Pricing Policy 125

stores or buying group. The key to their success is to structure the discus-

sion as being about the pricing of each of the manufacturer’s products indi-

vidually. As a result, they maximize the competition for each product line

and minimize any negotiating beneﬁ t that the supplier gets from offering

a full line. Thus a large hospital buying group will tell a medical products

manufacturer with nine product lines that there will be nine separate buying

decisions, occurring at different times, for each product line. The implication

for the seller is that, in the absence of the best price for each, it could end up

with a few orphaned products that are excluded from the buying group’s

distribution channel.

If you have a product line with some strong brands, you do not need to

react passively to purchasing policies that undermine your advantages; proac-

tively set policies of your own. When a large medical products company was

confronted with these divide and conquer tactics, it simply returned multiple

bid forms for each product with different prices, adding a line to the top margin

of each specifying the conditions under which those prices would apply. The

lowest applied only if all the manufacturer’s products were approved by the

buying group, while the highest would apply if only a subset were approved.

The hospital buying group hated this tactic, but the seller maintained its pol-

icy, explaining how the value of the channel to it was vastly reduced without

complete acceptance of its product line. Recognizing the cost of losing all the

seller’s products, some of which had large market share among members, the

buying group approved all the products.

Perhaps the most important thing to remember in dealing with power

buyers is to be emotionally prepared for them to be bullies who have seen

intimidation tactics succeed. If you are conﬁ dent of the value you offer and

you are willing to unbundle differentiation that you know the customer

values, be prepared for the fact that someone high up in purchasing may

become furious. He may demand to speak to your CEO and threaten unspec-

iﬁ ed consequences of a damaged relationship with his company. If and when

that happens, remember that power buyers who do not need you rarely get

mad; they can easily get others to supply them. The power buyers who get

mad are those that need something from you as a supplier and are frustrated

that they are not going to get the lop-sided deal that they expected.

POLICIES FOR SUCCESSFULLY MANAGING

PRICE INCREASES

One of the most difﬁ cult discussions to have with a customer involves telling

them that you will increase their prices. One of our clients in the New York

metro area actually had a customer in the habit of throwing things—particularly

shoes—at sales reps who proposed pricing that he did not like. Other custom-

ers would quietly ignore the increase when placing an order but, when paying

bills, adjust them to reﬂ ect the old prices and return the invoice with a check

marked “paid in full.” As a result of being cowed by such antics, this company

typically realized on average less than half the amount of the increases, with

customers who already paid the lowest prices being the ones who avoided

paying more. There are two very different occasions that call for increases, and

well-designed policies can help to make all of them more successful.

Chapter 5 • Pricing Policy126

Policies for Leading an Industry-Wide Increase

The most important increase to achieve quickly is the one that results from a

large, sustained increase in variable cost of production or a shortage of indus-

try capacity. These should be the easiest price increases since all suppliers are

facing the same problem. There is no real alternative for the customers, regard-

less of how difﬁ cult the increase may prove for them. Problems arise, how-

ever, from poorly designed policies that fail to manage expectations. Good

policies can inﬂ uence expectations in ways that help such increases get a better

reception.

Even when customers realize that a price increase is ultimately inevi-

table, none wants to be the ﬁ rst to take it. They do not want to be the ﬁ rst to tell

their customers that their prices are increasing, or the ﬁ rst to tell their investors

that their margins have declined because of rising prices. That means that they

need to trust that their competitors are all taking the same hit. The only way to

get the ﬁ rst large customers to go along is to make them conﬁ dent that doing

so will not put them at a competitive disadvantage. Your policy must be that

you will not back off the increase for anyone without doing so for everyone

who is a customer in the same industry.

There are a few things you can do to create the expectation that taking

the increase will not put them at a competitive disadvantage. First, before you

announce the increase, let it be known publicly why the increase is necessary

for the industry as a whole based upon costs that the industry is incurring

or demands on capacity. Listen carefully for similar sentiments that all of

your major competitors recognize the same need before proceeding. Second,

announce the size and effective date of the increase, stating exactly which

product lines are increasing by how much. Explain the cause and effect rela-

tionship (for example, energy accounts directly or indirectly for X percent of

costs and that translates into Y percent price increases). The public announce-

ment reinforces that this is an across-the-board increase and insulates your

sales reps from any personal responsibility for it.

Third, if customers are fearful that their competitors will not have to take

the increase or will not take it as quickly, empower them to give your most

important customers a transition guarantee. If you are the supplier to their

competitors, you guarantee that if you agree to a lesser or delayed increase

with any of their major competitors for the same product and service, they will

get the same concession retroactively. If they are concerned that a competitor

who is served by one of your competitors will not get the increase, you might

agree that you will delay their increase until the effective date of a competi-

tor’s increase. All of these will help create the impression that the cost increase

problem is one that you are willing to solve together in a way that recognizes

their legitimate business needs as well as yours. Because it is easier for any

individual customer to accept the increase given these conditions, it is more

likely that all will ultimately accept it.

Under no circumstances should you back off on the full increase for

customers who are more resistant while leaving loyal customers to take it, a

common practice. Although such a policy can generate greater return in the

immediate quarter, it reinforces that resistance pays and outrages loyal cus-

tomers whenever they learn that they have been taken advantage of. On the

other hand, if a major competitor fails to initiate a comparable price increase,

a general rollback may be necessary. If so, contact your customers proactively

Chapter 5 • Pricing Policy 127

to let them know that you are protecting them by temporarily suspending the

increase out of concern for their competitiveness. The increase will automati-

cally be reinstated when it can be accomplished without putting them at any

disadvantage. This builds trust with your customers, keeps the price increase

agreement with them in play, while letting your competitor realize that there

is nothing to gain from delay.

Finally, there are situations where you can safely make concessions

for good customers, but only ones that involve the timing, not the fact, of an

inevitable increase. For example, you can build loyalty by being sympathetic

that they may have ﬁ xed price commitments with some of their customers.

For volumes necessary to fulﬁ ll those contracts, you can legitimately agree to

share the pain until those commitments have been fulﬁ lled. Thus, a customer

receives a concession for some volume in the near term by agreeing to the

increase going forward.

Policies for Transitioning from Flexible to

Policy-Based Pricing

In markets where volume comes mostly from repeat purchasers, it is difﬁ -

cult to transition from poor policies to good ones all at once. Customers have

already developed expectations that they can get rewards from certain behav-

iors. They will continue those behaviors for a while until their expectations

change. The change takes time within the seller’s own company, too; mar-

keting and sales management needs that time to develop good policies, and

the plans to carry them out. We have seen the move to policy-based pricing

fail when management implements a rigid ﬁ xed-price policy of no more dis-

counting before developing policy-based discount options and a plan for the

transition.

To minimize the risk of transition and create time to test new policies for

managing discounts consistently, one needs to begin with policies for manag-

ing the transition. Chapter 11, on price management, describes a technique

called price banding that enables managers to estimate how much of the price

variation is illegitimate, both on an aggregate and a per account basis. The ﬁ rst

policies should focus on managing the outliers: “Outlaws” who now enjoy

prices much lower than other customers for the same products, service levels,

and commitments, and the “at-risks” who are paying more than can be justi-

ﬁ ed relative to the average.

The ﬁ rst step is to identify the outlaws and how they got that way. The

reason to start here is because they are the least-proﬁ table accounts, so there

is less at risk if they take their business elsewhere. These outlaw accounts pull

down other customers over time—either as a result of information leaking into

the market about their pricing or because their competitive advantage in pur-

chasing enables them to take share from others who buy at a higher price. If an

outlaw is in a unique industry or different market from other customers and

the low price reﬂ ects low value and low cost to serve, then an amendment is

called for in your price structure that articulates objective criteria to qualify

for the price and deﬁ nes fences necessary to keep it from undermining your

general price level. When there is no logical rationale for the low prices these

accounts pay, an effective fence means to make an outlaw and others like him

legitimate. That requires ﬁ guring out how the outlaw got such pricing in the

Chapter 5 • Pricing Policy128

ﬁ rst place and creating a policy to correct that mistake. If the original reason

for such low pricing no longer exists (for example, a service mistake in the

past led management to allow a discount to compensate, or the price reﬂ ected

expectations of volume that never materialized), the customer needs to be

confronted with that reality. Most importantly, the customer needs to be con-

tacted by someone above the sales rep (the level dependent upon the size of

the customer) to communicate that, while the customer has had a much better

deal than others in the past, top management is unwilling to continue pricing

that is unfair to other customers and unhealthy for the supplier.

With the bad news delivered unequivocally by management, the sales

rep is now free to initiate a give-get negotiation in an attempt to save the

account. He can contact the customer to learn whether there might be some

trade-offs they would consider, to mitigate the size of the mandated increase.

Various concessions on the part of the customer consistent with those made

by other customers could reduce some costs. With the ability to use a second

or third source as a bargaining chip now unnecessary, the buyer might even

be willing to sign up for an exclusive supply contract to qualify for a discount

that would reduce the impending increase.

Finally, the ﬁ rm may create a policy authorizing a period of transition

to a legitimate pricing level in steps. An outlaw buyer who agreed to either

an exclusive contract or minimum “must take” volumes under a long-term

contract (say 18 months), would then be allowed to take the necessary price

increases in steps: One-third of the increase becoming effective immediately,

one-third in six months, and the last third in 12 months. What makes this

effective is that the purchasing agent will be able to argue that he precluded

an average increase over the contract that would have been twice as large as

originally proposed and pushed realization of most of it to the back end. What

is important to the seller is that by the end of the contract, the buyer will be

purchasing at a price comparable to what other customers pay.

Of course, some of these outlaws will be genuine price buyers who may

not accept any increase. Walking away from such customers, and publicly

acknowledging it as a good business decision, signals your resolve exter-

nally and internally. It will communicate a new-found commitment to doing

business only with good business partners, and put others who may be mas-

querading as price buyers on notice that there is a potential cost. Unless your

industry has excess capacity, it might also strain your competitor’s capacity

with low-margin business. If that makes it more difﬁ cult to serve some of their

higher-margin customers well, if only during a transition period, it gives you

the chance to win some more proﬁ table volume.

POLICIES FOR PRICING IN AN ECONOMIC DOWNTURN

Pricing policies are most likely to be abandoned when the market enters a reces-

sion and sales turn down. Revenue then seems much more important than pre-

serving proﬁ tability in the future. But unmanaged price-cutting in a recession not

only undermines price levels that you will want to sustain in the later recovery,

it can trigger a price war that makes all competitors worse off while still in the

downturn. Fortunately, if a company thoughtfully manages pricing by policy

though the downturn, it can minimize the damage in both the short and long run.

Chapter 5 • Pricing Policy 129

First, you must enforce a ﬁ rm policy not to use price to take market

share from close competitors during the downturn, since they can easily

respond with price cuts of their own. (But you can and should retaliate

selectively against price-based moves by close competitors, as explained in

Chapter 7 on managing price competition.) At one point during a recent

recession, a large supermarket chain initiated a price war that increased its

share of revenue but tanked its share of proﬁ ts. Smarter competitors, such

as Winn-Dixie, promoted their lower-priced brands to help thrifty shop-

pers cut costs, and weathered the recession with much less damage to their

proﬁ tability.

In business markets, the value that some products can justify is tied to

the health of their customer’s markets. For example, the value of a page of

advertising in a magazine or space at a trade show is related to the size of

the market for the product being advertised. In 2009, the return from adver-

tising real estate was not what it was in earlier years. In such markets, par-

ticularly when variable costs are low, sellers sometimes “index” their pricing

for customers willing to make long-term commitments, with the index tied

to conditions in their customer’s market. Such a policy supports customers

and maintains volume during difﬁ cult times, while establishing an automatic

mechanism for price increases when customers can better afford them. An

alternative is to unbundle elements of your product or service that the cus-

tomer can no longer afford (such as, new product development and technical

support), even though they value them. The point in all these cases is that

these price-discounting options can be designed to expire when they are no

longer needed and do not directly threaten competitors.

But what can a company do to gain volume during a downturn when

demand from its current customers is shrinking but taking share will only trig-

ger a price war that will shrink the market further? As discussed in Chapter 4

on price structure, there are various ways to attract a new, more price-sensitive

segment, without cutting price to most of your existing customers. Moreover,

when you have excess capacity, the cost to serve a new segment is minimal.

Although you want to maintain policies that protect margins in the market

where you are investing for long-term growth, you have nothing to lose from

price competition, even of the ad hoc variety, in markets from which you hope

to gain incremental business in only the short term. For those markets only,

a policy of one-off pricing to ﬁ ll excess capacity can be worth pursuing if the

business can be carefully fenced.

For example, one high-end chain of hotels in Europe, which would never

consider serving tour groups in good times, approached tour companies

catering to small groups of high-income travelers with some very good deals.

They brought in both incremental revenue and introduced their chain to a

market segment of people they would want to have as nightly guests, while

still enabling themselves to exit the tour segment in better times. Our commer-

cial printer client approached direct mail advertisers accustomed to accepting

poor quality from printers who use inferior presses. For mail circulars and

newspaper inserts only, they offered better quality that nearly matched what

advertisers were paying already. The low-end competitors could not match

the offer, and the company won some incremental contribution that kept its

press operators employed during some lean months.

Chapter 5 • Pricing Policy130

POLICIES FOR PROMOTIONAL PRICING

A discount to induce product trial is a legitimate means to gain sales, but if

poorly managed it can have the effect of depressing margins, as regular cus-

tomers learn how to qualify for them as well. For search goods, a promotional

discount is the incentive for the customer to investigate the supplier’s offer.

For experience goods, it is the incentive to take the risk of what could turn out

to be a disappointing purchase.

The size of the promotional discount necessary to induce trial can be

mitigated by policy. A liberal returns policy if the customer is unsatisﬁ ed

is one way to take away the risk of trying a product at full price. Bowﬂ ex

does not discount its unique, high-end exercise equipment. But it combines

direct-to-customer value communication with a money-back guarantee within

the ﬁ rst six weeks of delivery. When product performance can be measured

objectively, a performance-based rebate policy can accomplish the same thing.

Rebating is becoming a common means for pharmaceutical and medical device

companies to win acceptance of higher-priced products with as yet unproven

differentiating beneﬁ ts. When Velcade, a cancer treatment, was deemed not

cost-effective and rejected for payment by the British National Health Service

(NHS), the company did not reduce its price. Instead, it came back with a

new offer to guarantee effectiveness without lowering its premium price. The

company would refund the entire cost of the drug for any patient who did not

show adequate improvement after an initial period of treatment. The guaran-

tee won approval for payment within the NHS and created the potential for

the company to earn higher proﬁ ts if justiﬁ ed by superior performance.

putting money on the line, the seller raises expectations that the product prob-

ably will produce the superior treatment outcomes that the company claims,

increasing trial of the product even at a higher price.

For consumer products, promotional pricing is one of the most impor-

tant issues for which a company needs pricing policies and a process for

reviewing their effectiveness. Even companies that have established brands

with large market shares face the problem that a high percentage of buyers

will leave the market or, particularly in the case of food products, will become

“fatigued” and look for something different. Consequently, manufacturers

must constantly win new customers to maintain a ﬁ xed market share. Pro-

motional discounts are often a very cost-effective way to educate consumers,

particularly for frequently purchased consumer products, which are usually

experience goods.

The easiest way to induce trial with little additional cost of administra-

tion is simply to offer the product at a low price for a time, say one week each

quarter. For frequently purchased products sold through retailers, the sales

increases resulting from such “pulsed” promotions are usually huge—easily

justifying the deal if looked at in isolation. But there are various reasons why

a company might want to ban such promotions as a policy. First, there is some

evidence that when a product is bought at a promotional price, it depresses

willingness-to-pay for the product in the future. Second, both consumers and

retailers will stock up on the product when promoted, giving the appearance

of a big increase in volume that simply depresses sales in later periods. There

are categories, usually among food products, for which stocking up is a good

thing. The more inventory people have of sodas and snack foods, for example,

Chapter 5 • Pricing Policy 131

the more they consume. For most products, however, stocking up at promo-

tional prices simply reduces the average price that customers pay while edu-

cating them to wait for the discount.

Consequently, a policy of limiting the availability of promotional dis-

counts and targeting them to prospective buyers is often advisable. One way

to do this is with coupons. Coupons have the advantage of limiting the ability

of already loyal customers to stock up. With new scanner technology, retailers

offer manufacturers the ability to print coupons on cash register receipts for

customers who have bought competing products, or a combination of items

that indicate that they might be good prospects for something that the manu-

facturer wants them to try. Rebates can be offered on the item but be limited

to one per family.

Many service companies are in need of more disciplined policies for pric-

ing to induce trial. Cable TV companies offer large discounts to sign up new

subscribers for a year, as do newspapers and magazines, and mobile telephone

services. The problem in many of these cases is that, at the end of the discount

period, they have to go back to the customer and ask for a much higher price to

continue the service. A high percentage of those customers balk, knowing that

either they can win an incentive from another supplier to try that supplier’s

product for a while, or can wait a week or two and sign up for another incentive

from the same supplier who just tried to raise their price. None of this should

be surprising given what we have learned from the study of behavioral eco-

nomics.

Once someone spends six or 12 months enjoying a service at one price,

renewing it at a higher price is viewed as a “loss” to be resisted. No services

company should ever use a discount on the service price as its means to induce

trial. Instead, it should create an inducement that maintains the integrity of the

price and builds the habit of paying it. For example, a far better inducement to

purchase is a “free” gift for signing up—such as the choice from a list of new best

sellers for signing up for a magazine, or $100 in pay-per-view credits for signing

up for a year of cable TV. After the initial commitment, the incentive is gone but

the customer is paying the monthly cost that reﬂ ects the value. As a result, there

is no perception of “loss” that drives away subscribers at the back end.

Summary

Good policies cannot magically make pric-

ing of your product or service proﬁ table,

but poor ones can certainly undermine

your ability to capture prices justiﬁ ed by

the value of what you offer. Good poli-

cies lead customers to think about the

purchase of your product as a price–value

trade-off rather than as a game to win at

your expense. As such, they are an essen-

tial part of any pricing strategy designed

to capture value and maintain ongoing

customer relationships.

Notes

1. Reuters, “Tesla’s Elon Musk directs

staff to give no more discounts on

new cars,” September 30, 2016. Acc-

essed April 21, 2017 at http://tech.

economictimes.indiatimes.com/

news/technology/teslas-elon-musk-

directs-staff-to-give-no-more-dis

counts-on-new-cars/54596279

2 . Neil Rackman, SPIN Selling (McGraw-

Hill, 1988).

Chapter 5 • Pricing Policy132

3 . Laura Lorenzetti, “Why Drug Com-

panies Are Betting Big on ‘Phar-

merging’ Countries,” Fortune.com,

August 14, 2015. See also Laurence

Capron and Will Mitchell, “The

Company Outsmarting Big Pharma

in Africa,” Harvard Business Review

(August 2012).

4 . Dan Mitchell, “Manufacturers Try

to Thrive on the Walmart Work-

out”, New York Times , February 20,

2005.

5 . “Winn-Dixie CEO: Supermarket

Pricing Rational, No Price War,”

Dow Jones News Wire, May 12, 2009.

6 . “NICE Responds to Velcade NHS

Reimbursement Scheme,” PMLive.

com, June 7, 2007.

7 . Daniel Kahneman, Jack L. Knetsch

and Richard H. Thaler, “The

Endowment Effect, Loss Aversion,

and Status Quo Bias,” Journal of

Economic Perspectives 5(1) (Winter

1991), pp. 193–206.

CHAPTER 6

Price Level

Setting Prices that Capture a

Share of the Value Created

Pricing is the moment of truth—all of marketing comes to focus in the pricing

decision.

E. Raymond Corey, Harvard Business School

To this point, we have explained and illustrated how to create the conditions

necessary to sustain price points that reﬂ ect the value that one’s products and

services create for customers. Now we need a process to select value-based

prices at which the ﬁ rm can expect to sell its products and services most proﬁ t-

ably. Economic theory prescribes a process for setting an “optimal” price level

against a known demand curve assuming “all others things being equal.”

However, in reality, all other things can never be ignored.

Take the example of a pharmaceutical company that purchased an old

prescription drug and hiked the price many-fold. The price change may have

been considered economically rational—after all, the drug had few substitutes

and consequently demand was very inelastic. Yet what the company failed to

consider was the power of community-held norms of fairness in the decision

and the resulting backlash against it, and the entire pharmaceutical industry

in general, by an outraged public. The public pressure for legislators to do

something eventually led to a congressional hearing on price gouging that

may have occurred at the company.

When it comes to setting prices, the reality is that in most companies

the task is a complicated process in which conﬂ icting, function-speciﬁ c objec-

tives come into play. Financial managers may allocate costs to determine

how high prices need to be in order to repay past investments and achieve

margin objectives. Marketing and salespeople may analyze buyers and com-

petitive offerings to determine how low prices should be in order to achieve

their sales objectives. The pricing decisions that result are often politically

charged compromises, and not a thoughtful, market-relevant implementa-

tion of a commercial strategy. An effective pricing decision should involve

Chapter 6 • Price Level134

a blending of, not a compromise between, internal ﬁ nancial constraints and

external market conditions.

Unfortunately, few managers have any idea how to facilitate a price-

setting dialogue across the various functions. From traditional cost account-

ing, many learn to take sales goals as “given” before allocating costs, thus

precluding the ability to incorporate market forces into the pricing decisions.

From marketing they are told that effective pricing should be entirely “cus-

tomer driven,” ignoring costs except as a minimum constraint below which

the sale would become unproﬁ table. Perhaps along the way, these managers

study economics and learn that, in theory, optimal pricing is a blending of cost

and demand considerations. In practice, however, they ﬁ nd the economist’s

assumption of a known demand curve hopelessly unrealistic. Consequently,

price setting at most companies remains trapped between cost- and customer-

driven procedures that are inherently incompatible.

Another price-setting trap that companies fall into is to assume that if

their differentiation is “x” percent better than a competitor’s, then they can

price at no more than an “x” percent premium. Yet if you had cancer and knew

of a drug that was 50 percent more effective than the competition’s in curing

cancer, would you refuse to pay more than a 50 percent premium? Suppose

you are planning to paint your house and discover a tool that will enable you

to ﬁ nish the job in half the usual time—a 100 percent increase in technical efﬁ -

ciency. Unless you enjoy the drudgery of painting or place little value on your

time, you would no doubt happily pay more than twice the price of a brush to

buy this tool. Conversely, improving the accuracy of a common quartz wrist-

watch by 50 percent is unlikely to command a 50 percent premium—after all,

quartz wristwatches are already accurate to within less than one second per

day and the improved accuracy would be hardly noticeable to most people.

As these examples illustrate, the price premium associated with the economic

value of a product is often much greater (or much less) than the percentage

improvement in performance.

The purpose of this chapter is to suggest how managers can break tactical

pricing deadlocks and avoid the error of leaving money on the table by infus-

ing strategic balance into pricing decisions. We describe a simple, logically

intuitive procedure for setting prices that integrates the relevant customer,

competitor, and cost data in a way that enables marketers to set more proﬁ t-

able price levels. The process is designed to be efﬁ cient and adaptable to most

products, services, and market contexts. It integrates data on value estimation

and segmentation, drivers of price sensitivity, costs, strategic objectives, and

market response analysis in a way that can be supported by the organization

and understood by customers.

THE PRICE-SETTING PROCESS

Price setting is the ultimate intersection of value creation and value extraction,

where the seller seeks simultaneously to capture a fair share of the value cre-

ated, maximize long-term proﬁ tability, and enhance his or her market posi-

tion. Because different customers have different motivations for purchase,

there is rarely one “optimal” price that is right for every customer. One needs

to look no further than the passengers on an airplane who individually hold

tickets at many different prices for essentially the same basic service. However,

Chapter 6 • Price Level 135

every sold ticket shares two common characteristics: No one paid more than

the value of getting to their destination, and no one paid less than the marginal

cost incurred by the airline of transporting an incremental customer on the

ﬂ ight. The trick, of course, is to set the right prices in a consistent, repeatable

manner.

In most cases, the process of setting prices is iterative, starting with a

broad deﬁ nition of feasible price points and then applying a series of “ﬁ lters”

to narrow down to the most market-relevant feasible price point for each mar-

ket segment. Exhibit 6-1 illustrates the process that we typically use. It begins

by deﬁ ning a viable price range for each customer or application segment

established earlier when creating a price structure (as described in Chapter 4).

Step 1: Deﬁ ne the Viable Price Range

Deﬁ ning the viable price range starts with deﬁ ning the highest and lowest

price points that a business might sustainably charge for the product or ser-

vice. The feasible price ceiling is deﬁ ned by the product’s value proposition,

as summarized by the Economic Value Estimation (EVE

) model described in

Chapter 2. The total economic value represents the maximum theoretical price

that a fully informed customer in a particular market segment would ever be

willing to pay. When trying to win a new customer, it is the absolute upper

limit of price that could possibly be achieved. For an incumbent supplier, it

is the price that would have to be met to insure that an informed customer

would not see a competitor’s price as a better deal. For purposes of illustration,

we will describe the model from the perspective of a company trying to win

new customers.

The feasible price ﬂ oor for a product that is positively differentiated is

the price of the next-best competitive alternative. Theoretically, the price ﬂ oor

is the variable cost of the product—after all, any price above the variable cost

will allow the seller to earn a positive contribution margin on a sale. However,

if the price is set below the price of the next best competitive alternative, we

EXHIBIT 6-1

The Six-Step Process for Setting Prices

Chapter 6 • Price Level136

place the competitor in an untenable position in which its product creates a

negative economic beneﬁ t for its customers—a situation that they can only

address through a price drop. Therefore, to mitigate the risk of a price war, the

value-based price ﬂ oor, for practical purposes, is deﬁ ned as the price of the

next-best competing offer.

For a product that is negatively differentiated, the price ceiling will also

be deﬁ ned by the economic value, which in this case is below the price of the

next-best competing alternative. For negatively differentiated products, the

price ﬂ oor is deﬁ ned by the product’s variable cost. An example of a nega-

tively differentiated product would be a mobile phone carrier that only offers

local coverage and is not able to offer roaming services like the market leaders.

In this case, the local carrier will set their price below the market leaders that

reﬂ ects its lower value proposition, yet still high enough to cover its variable

costs. These offers may still represent a good value for a segment of customers

who rarely leaves the coverage area.

Taken together, the price ceiling and the price ﬂ oor represent the “rea-

sonable price range” in which a price can be set, as illustrated in Exhibit 6-2.

Ultimately, setting the price will deﬁ ne how any differentiating value gets

shared between the seller and the buyer. If buyers were able to keep all the

added value, paying no more than the competitive price for a superior product

or service, they could be easily won over—but probably not proﬁ tably. If sell-

ers were to set prices that fully reﬂ ect the value of their positive differentiation,

there would be no ﬁ nancial incentive for the customer to purchase that brand

over a more generic alternative. In reality, prices for new products are usually

EXHIBIT 6-2

Illustration of the Reasonable Price Range

Chapter 6 • Price Level 137

set below the level of value delivered. The difference between the actual price

and the maximum value can be viewed as “the incentive to purchase.” Done

correctly, a price premium over a competitor can often be framed as a “dis-

count relative to the value delivered,” a framing that can fundamentally shift

the dynamics of value communication and price negotiation. The challenge is

to ﬁ gure out what balance between creating a ﬁ nancial incentive and earning

a higher margin per sale is in the best interest of the seller.

The decision on how value should be shared between buyer and seller

is not driven by altruism but rather by judgment about what is most likely to

yield long-term, sustainable proﬁ ts. Leaving more of the economic value on

the table may, other things being equal, induce customers to migrate to a new

product or service more quickly. But “other things” are rarely equal. Although

a higher price is by itself a deterrent, a higher price per sale can simultaneously

justify greater expenditures to win the sale. Does the customer understand

the value of the differentiation offered? If not, educating the customer may

win more sales at a higher price than offering the product at a lower price to

someone ignorant of the true value. Or perhaps the customer understands the

value story but also sees risk that may turn out not to be true. In that case, a

money-back guarantee may be much more effective than a lower price. Price

is all too often used as an inducement to overcome resistance that can be dealt

with more cost-effectively, and therefore more proﬁ tably, in other ways.

If the product in question is already on the market and has an established

price, we suggest using the current price as the starting point for analysis so

long as it sits within the “reasonable price range.” For a new product, one

might do some formal or informal research with a few potential customers

about the product concept and its differentiating beneﬁ ts to determine what

they would expect to pay for such added beneﬁ ts. As a last resort, one can

choose a 50:50 sharing of the differentiating value as a starting point for the

analysis. In the following sections of this chapter, we will describe additional

considerations that will guide a further narrowing and reﬁ nement of the price

range.

Step 2: Make Strategic Choices

Step 1 deﬁ ned an externally “Reasonable Price Range” consistent with eco-

nomic value and the importance that customers place on it when making

purchase decisions. It did not indicate where in that range a company might

reasonably expect to operate most proﬁ tably. Should prices reﬂ ect the high

value to a relatively exclusive set of buyers, even at the expense of restricted

market share? Fazioli (pianos), Porsche (automobiles), and Festool (power

tools) have been very successful pursuing that strategy. But other companies

have been highly successful making lower prices a reason to buy from them.

Ryanair (air travel), Old Style (beer), Samsung (electronics), and the so-called

“dollar stores” (retailing) have all pursued that strategy successfully. Still oth-

ers seek to get the highest price they can justify but only to the point where

is does not exclude their product from consideration by most of the potential

market.

It is essential that price levels be set in a way that supports and advances

the broader marketing objectives of the ﬁ rm. When a leading software maker

dropped prices on its operating system by nearly 50 percent in 2009, the

Chapter 6 • Price Level138

move was consistent with the company’s long-held goal of maintaining and

growing market share. The critical question for the software company’s man-

agers was whether the price cuts would result in higher proﬁ ts over the long

term. It is easy to envision scenarios in which a competitor’s response limits

any volume gains from the price cuts, thereby reducing proﬁ tability. If the

software maker’s primary business objective was to increase current proﬁ t-

ability, it might have been better served by maintaining a premium pricing

strategy, even at the expense of some lost volume.

To be useful, pricing objectives must be set relative to some reference

point. Given the strategic importance of customer value to the overall pricing

strategy, we deﬁ ne pricing objectives in terms of the share of differentiating

value that the ﬁ rm attempts to capture in its price. This decision should be

driven by judgments about what will yield long-term, sustainable proﬁ tabil-

ity. As noted earlier, a low price will, other things being equal, induce custom-

ers to migrate to a new product or service more quickly. On the other hand, if

the product’s differentiation is likely to be sustained by patents or copyrights,

a low price established to drive sales means foregoing considerable margin

over the long run. Pricing low initially in the hope that one can raises prices

later is difﬁ cult given the effect of the initial prices on buyers’ future percep-

tions of price fairness.

There are three alternative strategic choices that one might adopt for a

pricing strategy: Skimming the market , penetrating the market , or neutral market

pricing .

But the choice is not arbitrary. Given a ﬁ rm’s relative capabilities and

market position, usually only one positioning will represent the most proﬁ t-

able option and often only one positioning will be sustainable.

Let us examine the conditions under which each strategic choice might

be most appropriate.

OPTION 1: SKIM THE MARKET Skim pricing (or skimming) is designed to cap-

ture superior margins, even at the expense of large sales volume. By deﬁ ni-

tion, skim prices are high in relation to what most buyers in a segment can be

convinced to pay. Consequently, this strategy optimizes immediate proﬁ tabil-

ity only when the proﬁ t from selling to relatively price-insensitive customers

exceeds that from selling to a larger market at a lower price. In some instances,

products might reap more proﬁ t in the long run by setting initial prices high

and reducing them over time—the “sequential skimming” strategy we discuss

below—even if those high initial prices reduce immediate proﬁ tability.

Buyers are often price insensitive because they belong to a market seg-

ment that places exceptionally high value on a product’s differentiating attri-

butes. For example, in many sports a segment of enthusiasts will often pay

astronomical prices for the bike, club, or racquet that they think will give them

an edge. You can buy a plain aluminum canoe paddle for $35. You can buy a

Bending Branches Double Bent paddle (wood laminate, 44 ounces) for $149.

Or you can buy the Werner Camano paddle (graphite, 26 ounces) for $249.

The Werner Camano not only makes canoeing long distances easier but also

signals that one belongs to a select group that has a very serious commitment

to the sport.

Of course, simply targeting a segment of customers who are relatively

price insensitive does not mean that they are fools who will buy at any price.

It means that they can and will pay a price that reﬂ ects a large portion of the

Chapter 6 • Price Level 139

exceptionally high value they place on the differentiating beneﬁ ts they expect

from the purchase. Thus skim pricing generally requires a substantial com-

mitment to communicate why the differentiating features of the product or

service can be expected to yield beneﬁ ts that justify a high price to at least

some customers. If effective value communications are neither practical nor

cost-effective, then the ﬁ rm must limit its pricing to reﬂ ect what it can commu-

nicate or to what potential customers are likely to believe simply from what

they can observe.

The competitive environment must also be right for skimming. A ﬁ rm

must have some source of competitive protection to preclude competitors

from providing lower-priced alternatives with comparable beneﬁ ts. Patents

or copyrights are one source of protection against competitive threats. Phar-

maceutical companies cite their huge expenditures on research to justify the

skim prices they command until a drug’s patent expires. Even then, they enjoy

some premium because of the name recognition. Other forms of protection

can include a brand’s reputation for quality and prestige, access to a scarce

resource, and preemption of the best distribution channels.

A skim price isn’t necessarily a poor strategy even when a ﬁ rm lacks the

ability to prevent competition in the future. If a company introduces a new

product at a high price relative to manufacturing cost, competitors may be

attracted by the high margin even if the product is priced low relative to its

economic value. Pricing low in the face of competition makes sense only when

it serves to deter competitors or to establish a competitive advantage. If a low

price cannot do either, the best rule for pricing is to charge the most that you

can while you are able. If and when competitors enter by duplicating the prod-

uct’s differentiating features and, thus, undermine its competitive advantage,

the ﬁ rm can then reevaluate its strategy.

Sequential skimming can be a more appropriate strategy for products and

services with low repurchase rates. The market for long-lived durable goods

that a customer purchases infrequently such as the latest smartphone model,

or products that most buyers would purchase only once, such as a ticket to

a stage play, can be skimmed for only a limited time at each price because

the buyers willing to pay the highest prices leave the market after making a

purchase. Skimming, in such cases, cannot be maintained indeﬁ nitely, but its

dynamic variant, sequential skimming, may remain proﬁ table for some time.

Sequential skimming, like the more sustainable variety of skimming,

begins with a price that attracts the least price-sensitive buyers ﬁ rst. After the

ﬁ rm has “skimmed the cream” of buyers, however, that market is gone. Con-

sequently, to maintain its sales, the ﬁ rm must reduce its price enough to sell

to the next-most-lucrative segment. The ﬁ rm continues this process until it

has exhausted all segments with proﬁ table volume potential. In theory, a ﬁ rm

could sequentially skim the market for a durable good or a one-time purchase

by lowering its price in hundreds of small steps, thus charging every segment

the maximum it would pay for the product. In practice, however, potential

buyers catch on rather quickly and begin delaying their purchases, anticipat-

ing further price reductions. To minimize this problem, the ﬁ rm can cut price

less frequently, thus forcing potential buyers to bear a signiﬁ cant cost of wait-

ing. It can also launch less attractive models as it cuts the price. Tesla seems to

be using this strategy as it builds the market for electric cars. The ﬁ rst Tesla,

the Roadster, was introduced in 2008 at a base price of $109,000 in the United

Chapter 6 • Price Level140

States. The second Tesla model, the Model S, was introduced in 2012 at a price

of $71,500, and was followed by the more recently announced Tesla Model 3

that was slated to start deliveries at the end of 2017 at a base price of $35,000.

This variant to sequential skimming has been described as “pushing down the

stack” and is used frequently in technology markets such as semiconductors

and cellular phones.

OPTION 2: PENETRATE THE MARKET Penetration pricing involves setting a price

low enough to attract and hold a large base of customers. Penetration prices

are not necessarily cheap, but they are low relative to perceived value in the

target segment. Hyundai, for example, used a sustained penetration pricing

strategy to enter the U.S. market in which the company offered high value

in the form of reliability, ten-year warranties, and well-appointed interiors at

prices far below those of Japanese makers of similar quality cars. Similarly, T.J.

Maxx and Marshalls stores have positioned themselves as offering products of

the same or better value as their competitors at lower prices.

Penetration pricing will work only if a large share of the market is willing

to change brands or suppliers in response to a lower price. A common miscon-

ception is that every market will respond to lower prices, which is one reason

why unsuccessful penetration pricing schemes are so common. In some cases,

penetration pricing can actually undermine a brand’s long-term appeal. When

Lacoste allowed its “alligator” shirts to be discounted by lower-priced mass

merchants, high-image retailers refused to carry the product any longer and

traditional Lacoste customers migrated to more exclusive brands. Lacoste has

since restored its prestige brand status by revamping its look, signing endorse-

ments with leading tennis stars, managing its pricing more tightly, and using

outlet stores for discounted products so that the brand image is not diluted in

its premium retailers.

Warehouse clubs such as Sam’s, Costco, and B.J.’s Wholesale Club have

designed retail formats that use penetration pricing to attract only buyers

willing to purchase in large quantities. Charter vacation operators sell heav-

ily discounted travel to people who do not mind inﬂ exible scheduling. T.J.

Maxx and Marshalls target those price-sensitive customers willing to shop

frequently through limited and rapidly changing stocks to ﬁ nd a bargain.

Xiameter, a division of Dow Corning, has been able to win a large share

of price-sensitive buyers with previously unachievable prices for silicones

by eliminating costly services and delivering only in the most cost-effective

shipping quantities.

To determine how much volume one must gain to justify penetration

pricing, a manager must also consider costs. Conditions are more favorable for

penetration pricing when incremental costs (variable and incremental ﬁ xed)

represent a small share of the price, so that each additional sale makes a large

contribution to proﬁ t. Because the contribution per sale is already high, a lower

price does not represent a large cut in the contribution from each sale. For

example, even if a company had to cut its prices 10 percent to attract a large

segment of buyers, penetration pricing could still be proﬁ table if the product

had a high contribution margin. In order for the strategy to be proﬁ table in a

case where the original contribution margin is 90 percent, the sales gain would

need only exceed 12.5 percent. The lower the contribution per sale, the larger

the volume gain required before a penetration price is proﬁ table.

Chapter 6 • Price Level 141

Penetration pricing can succeed even without a high contribution mar-

gin if the strategy itself creates sufﬁ cient variable cost economies to be self-

funding, enabling the seller to offer penetration prices without suffering lower

margins. The willingness of price-sensitive shoppers to change brands enables

the so-called “dollar stores” and similar discounters to vary the products and

brands they offer depending on who gives them the best deal, thus increasing

their leverage with suppliers. The penetration prices of Save-A-Lot grocers

(a division of Supervalu Inc.) enables them to maintain such high turnover,

high sales per square foot, and high sales per employee that they can offer rock-

bottom prices and still earn higher proﬁ ts than traditional grocers do.

To cite

a manufacturing example, as personal computer users became more knowl-

edgeable buyers willing to buy without ﬁ rst visually inspecting the product,

manufacturers such as Dell used penetration pricing to sell high-quality prod-

ucts to knowledgeable buyers online while still earning exceptional proﬁ ts per

sale from the savings associated with direct sales and distribution.

Of course, for penetration pricing to succeed, competitors must allow a

company to set a lower price that is attractive to a large segment of the market

without their matching it. Competitors always have the option of undercut-

ting a penetration strategy by cutting their own prices, preventing the penetra-

tion pricer from successfully offering a better value. Only when competitors

lack the ability or incentive to do so is penetration pricing a practical strategy

for gaining and holding market share. There are three common situations in

which this is likely to occur:

1. When the ﬁ rm has a signiﬁ cant cost advantage and/or a resource

advantage so that its competitors believe they would lose if they began

a price war.

2. When the ﬁ rm has a broader line of complementary products, enabling

it to use one as a penetration-priced “loss leader” in order to drive sales

of others.

3. When the ﬁ rm is currently so small that it can signiﬁ cantly increase

its sales, beyond the breakeven level illustrated by the constant proﬁ t

curve, without affecting the sales of its competitors enough to prompt a

response.

The telecommunications industry offers an illustrative example of successful

penetration pricing. As regulators opened telecom markets to competition in

most developed countries, new suppliers successfully used penetration pricing

to capture market share. The low variable costs of carrying a call or message

make such a strategy desirable. Regulatory constraints and the unwillingness

of large, established competitors to match the lower prices of new entrants on

their large installed base of customers enabled the strategy to succeed. Still,

many telecom managers would question whether a heavy reliance on penetra-

tion strategies is sustainable indeﬁ nitely because it conditions some portion of

the market simply to seek deals rather than good value.

OPTION 3: NEUTRAL PRICING Neutral pricing involves a strategic decision

not to use price to gain market share, while not allowing price alone to

restrict it. Neutral pricing minimizes the role of price as a marketing tool in

favor of other tactics that management believes are more powerful or cost-

effective for a product’s market. This does not mean that neutral pricing is

Chapter 6 • Price Level142

easier. On the contrary, it is less difﬁ cult to choose a price that is sufﬁ ciently

high to skim or sufﬁ ciently low to penetrate than to choose one that strikes a

near-perfect balance.

A ﬁ rm generally adopts a neutral pricing strategy by default because

market conditions are not sufﬁ cient to support either a skim or penetration

strategy. For example, a marketer may be unable to adopt skim pricing when

buyers consider the products in a particular market to be so substitutable that

no signiﬁ cant segment will pay a premium. That same ﬁ rm may be unable to

adopt a penetration pricing strategy because, particularly if it’s a newcomer

to the market, customers would be unable to judge its quality before purchase

and would infer low quality from low prices (the price–quality effect described

in Chapter 3) or because competitors would respond vigorously to any price

that undercuts the established price structure. Neutral pricing is especially

common in industries where customers are quite price sensitive, precluding

skimming, but competitors are quite protective of volume, precluding success-

ful penetration.

Although neutral pricing is less proactive than skimming or penetra-

tion pricing, its proper execution is no less important to proﬁ tability. Neutral

prices are not necessarily equal to those of competitors or near the middle of

the range. A neutral price can, in principle, be the highest or lowest price in the

market and still be neutral. For many years, Sony TVs were consistently priced

above competitors, yet they captured large market shares because of the high

perceived value associated with their clear screens and reliable performance.

Disney theme parks are premium amusement destinations, yet they still attract

a large number of visitors, many more than their competitors do. While Dis-

ney adroitly segments this market, offering some higher-priced options such

as priority admission, its regular prices represent good value for the money.

Step 3: Assess Breakeven Sales Changes

The next consideration when determining where to set price levels is the rela-

tionship between changes in price, volume and proﬁ tability. Economic theo-

rists propose pricing based upon estimating the “demand curve” for a product

and then “optimizing” the price level given the incremental cost of produc-

tion. In a relatively small number of markets, this advice is practical. When

a company lacks competition so that the demand curve for its brand is the

market demand, the effect of price on a ﬁ rm’s sales is more predictable than

when it must also account for the effect of price on customer choice between

competing brands. It is also possible in some highly competitive markets to

estimate demand because large quantities of data are accessible. Manufactur-

ers of leading brands of beer and soft drinks can measure quite accurately

the effect of price on sales of a brand, or even a package size, because they

can now acquire “big data” from retail stores that enable them to control for

changes in almost all of the other factors that can affect brand price elasticity

for their product: The type of retailer, the prices in nearby stores, the day of the

week, the time of day, and even the weather. This enables them to optimize

prices for the sale of small package sizes in convenience stores that occur at the

end of a workday, while optimizing differently for larger package sizes sold

on weekends in grocery stores. They can quickly re-optimize in response to

changes by competitors.

Chapter 6 • Price Level 143

Unfortunately, while price optimization against a known demand curve

is ideal in theory, it is in practice usually impractical. The reason lies in the

assumption that a “demand curve” is something stable, enabling one to mea-

sure price elasticity at a point in time and then use that estimate going forward

to predict the effect of price changes on sales. Unfortunately, the demand for

individual products or brands within markets is rarely stable or easily mea-

sured. The reason: Sensitivity to price depends as much on ever-changing

purchase contexts and perceptions as on underlying needs or preferences.

For example, contradicting the assumption of a demand curve, the amount

of a product that customers will buy at a price point is strongly affected by

the prices they paid recently. When gasoline prices are rising, the demand for

premium grades of gasoline will fall quickly by a much greater percentage

than demand for regular grades. But when prices decline back to where they

started, demand for premium grades will not recover quickly. That is, demand

when prices are going up is generally much more “price elastic” than when

prices are coming down.

Still, one cannot deny the fact that the proﬁ tability of a price increase will

depend upon whether the loss in sales is not too great, while the proﬁ tability

of a price decrease depends upon whether the gain in sales is great enough.

Economists refer to the actual percentage change in sales divided by the per-

centage change in price as the “price elasticity” of demand, as expressed in the

following equation:

E = (% ΔQ ) / (% ΔP)

Where E is price elasticity, Δ indicates “change in,” Q stands for sales quantity,

and P is price.

Price elasticity, E , is generally a negative number since positive price

changes (price increases) generally lead to sales declines while negative price

changes (price reductions) generally lead to sales increases. The greater the

absolute value of E , the more “elastic,” or responsive, demand is to price

changes.

Actual elasticity depends in part upon how effectively marketers man-

age customer perceptions and the purchase context, as described in Chapter 3.

Moreover, many factors that inﬂ uence price elasticity are not under the mar-

keter’s control, making precise estimates of actual price elasticity very difﬁ cult.

BREAKEVEN SALES CHANGE CALCULATION Because price elasticity is so dif-

ﬁ cult to measure precisely in most markets, we have found that instead of

asking “What is price elasticity for this product?” it is often more practical

and useful to ask “What is the minimum elasticity that would be necessary

to justify a particular price change?” that has been proposed to achieve some

business objective. To put the question in less technical jargon, we ask “What

percent change in sales would be necessary (which is the same as asking what

price elasticity would be necessary) for a proposed price change to maintain

the same total proﬁ t contribution after a price change?” We refer to the answer

as the breakeven sales change associated with a proposed price change.

If we create a graph of breakeven sales changes associated with different

potential price changes, we can create a breakeven sales curve that looks much

like a demand curve, as shown in Exhibit 6-3. In fact, it is a representation

of how much demand is needed to maintain current proﬁ tability as prices

Chapter 6 • Price Level144

change. If actual demand proves to be less elastic (steeper) than the constant

proﬁ t curve, then higher prices will be more proﬁ table. If the actual demand

proves to be less steep (more elastic) than the constant proﬁ t curve, then

lower prices will be more proﬁ table. Technical details about how to calcu-

late a correct breakeven sales change for any particular product and pricing

decision are described in Chapter 9.

The key to price optimization with limited information is to hypothesize

price alternatives (e.g., pricing near-competitive prices versus a 10 percent

price premium that reﬂ ects the value that most customers should enjoy from

the differentiating features of the product or service). Then, rather than ask-

ing “ How will sales volume change following this price change ?” which is devil-

ishly difﬁ cult to answer with conﬁ dence, we suggest that managers answer a

pair of questions with more readily achievable answers to guide their pricing

choice:

• How much sales volume can I afford to lose before a particular price

increase would become unproﬁ table?

• How much sales volume do I have to gain in order for a particular price

decrease to improve proﬁ tability?

These are actually much easier questions to answer. As illustrated in Exhibit 6-4,

the changes in sales necessary to make a change in price proﬁ table depends

essentially on the size of the incremental contribution margin associated with

those sales. When performing a breakeven analysis, additional complexi-

ties can be introduced, such as what happens if the variable costs change as

volume shifts; what if higher sales volumes lead to incremental ﬁ xed costs

EXHIBIT 6-3

Constant Proﬁ t Curve Associated with Different Price Changes

Chapter 6 • Price Level 145

(to expand production capacity, for example); or what if a competitor changes

its price? Another important consideration is the existence of substitutes and

complementary products within the ﬁ rm’s own product line. It is easier to

justify skim pricing when some customers who are deterred by the skim price

will substitute a lower-priced offer from the same supplier rather than defect

to a competitor. The suppliers of smartphones thus skim price their leading,

full-featured option without putting all of the potential margin of a sale at risk.

These scenarios can be evaluated through a similar analysis, and all calcula-

tions are described in detail in Chapter 9.

The major beneﬁ t of a breakeven analysis is its practicality. Very few

pricing decisions are made with the luxury of knowing in advance how cus-

tomers and competitors will react. Even the most rigorous research techniques

used to measure expected customer response to price change (described in

Chapter 8) rely either on making inferences from past data or rely on customer

responses to surveys, both of which are only imperfect predictors of the future.

Most managers must make decisions with less quantitative information, rely-

ing on subjective judgments and after-the-fact measurement of effects. Incre-

mental breakeven analysis is an approach that leverages knowable data such

as current costs and sales volumes to establish clear, indisputable bench-

marks that any price change has to meet in order to be proﬁ table. It is a very

effective initial step to grounding an internal debate on whether to raise or

lower prices.

Step 4: Gauge Price Elasticity

After establishing the breakeven sales change necessary for a potential price

change to be proﬁ table, it is necessary to make a judgment about whether

that sales change is likely to be achievable. Sometimes an estimate of past

price elasticity can be gleaned from historical transaction data, especially in

the case of high transaction volume goods such as groceries or gasoline or

common grades of steel. Sometimes examples of past “natural experiments”

can be found in such data where prices were changed and the market had

EXHIBIT 6-4

Breakeven Sales Changes Required Given Different Contribution

Margins

Chapter 6 • Price Level146

an opportunity to react. These price changes could take the form of changes

in list price, temporary price reductions, or competitive price moves that

changed the relative price position of competitive products. Even when

such natural experiments exist, management still needs to make a subjec-

tive judgment about the applicability of the price elasticity measured in

the past to estimate the likely effect of a price change now. Are market

conditions similar now to those in the past or have they changed? Gener-

ally, both consumers and businesses become more price sensitive during

poor economic conditions than during times when incomes and proﬁ ts are

rising. Has the competitive set changed? If competitors have now copied

some of what was your ﬁ rm’s differentiation, it is reasonable to assume

that customers will have become more price sensitive in their brand choice.

On the other hand, if competitors have recently had well-publicized quality

problems, then it is reasonable to assume that price elasticity might be less

than in the past.

One should not avoid incorporating qualitative judgments as well. For

example, it is reasonable to ask sales reps whether they would be willing to

accept an increase in their sales goals equal to the breakeven sales change in

return for granting the additional discounting authority for which they have

been asking. Although subjective and subject to bias, their response is still

valuable information that may be less precise, but more informed, than “hard”

quantitative estimates that were based upon surveys rather than upon actual

behavior. It is also reasonable to make some inference from public information

from the success or failure of price increases for other product lines similar to

your own and sold to the same customers.

In cases where historical transaction data is not available, where there

have been no prior price changes to study, or where market conditions are

signiﬁ cantly different from those during which past transaction data is avail-

able, it can be beneﬁ cial to perform research to estimate the potential impact

that a price change might have on future demand. Techniques for estimat-

ing price elasticity range from the most sophisticated and costly to the least

effective but easy to implement; broadly speaking they are: Controlled-price

experiments , purchase-intention surveys , structured inferences , and incremental

implementation .

A thoughtful choice from among these options involves trade-offs

between the cost to implement and the quality of data gained to aid in making

the pricing decision. Chapter 8 describes these methodologies in detail.

Finally, unless one has the beneﬁ t of “big data” to estimate price elastic-

ity with conﬁ dence, it is generally wise to implement price changes incremen-

tally. This approach often works well for products for which price changes

are not very costly to make or to reverse, such as frequently purchased prod-

ucts and B-to-B products, without long contracts. In this approach, managers

simply test customer response by making limited price changes in a series of

small steps. The goal is to gradually arrive at a proﬁ t-maximizing price point

by calculating breakeven sales changes and testing the market to see whether

sales changes are on the proﬁ table side of that breakeven point. For example,

a maker of distinctive pre-manufactured homes slowly repositioned its brand

from being a cheaper alternative to being a premium-priced product with dis-

tinctive value in design and reliability. During that period, it raised prices a

few percentage points more each year than the prices of similar traditional

Chapter 6 • Price Level 147

homes and tracked the effect on its sales relative to the industry. When the

changes no longer improved proﬁ ts, the manufacturer stopped making them.

Step 5: Account for Psychological Factors

Although by the time you set a price, you should already have segmented

your market to reﬂ ect the differences in value for different applications or

occasions, there will remain differences in the prices customers will pay even

within segments. The drivers of those differences were described in Chapter 3

and are summarized in the box below. They affect what we call “price sensitiv-

ity:” a term for the effort and attention that customers will devote to making

a purchase with the largest gap between the value they receive and price they

pay. For example, even within the same application segment, knowledgeable

and highly sophisticated purchasers (such as professional purchasing agents

and dedicated bargain hunters), will be much more likely to change their

behavior in response to a change in price than will less well-informed custom-

ers. The later will risk getting less for their money in return for making the

simple decision to buy the well-known brand or the next brand they encoun-

ter. Similarly, customers purchasing larger quantities who have a more urgent

need to achieve an objective, or who are making the purchase to achieve a

higher-valued end beneﬁ t, will pay more.

If a large share of a segment is made up of people who are driven to

high-price sensitivity by one or more of these factors, then pricing further

below value to win business, or lowering price closer to value to retain busi-

ness, will be important to motivate the desired customer purchase behaviors.

Factors That Inﬂ uence Price Sensitivity

Researchers have identiﬁ ed a list of factors that inﬂ uence a buyer’s price

sensitivity, including the following:

• Reference value : Value is always relative in the minds of customers.

By re-framing a customer to view a more expensive alternative as

the reference, buyer price sensitivity can be reduced.

• Switching costs : Buyers are less sensitive to the price of a product

the greater the added cost (both monetary and non-monetary) of

switching from their current supplier (if any).

• Difficult comparison : Buyers are less price sensitive when it is dif-

ﬁ cult to compare suppliers and the cost of not getting the expected

beneﬁ ts of a purchase are high.

• Importance of end-benefit : Buyers are less price sensitive when the

product is a small part of the cost of a beneﬁ t with high economic or

psychological importance.

• Price-quality perceptions : Buyers are less sensitive to a product’s

price to the extent that price is a proxy for the likely quality of the

purchase.

• Size of expenditure : Buyers are more (or less) price sensitive when

expenditures are relatively large (or small) as a portion of the overall

budget.

Chapter 6 • Price Level148

In considering these price sensitivity factors, marketers should seek to under-

stand which of them are relevant for their particular products, and for which

segment of customers, in order to inﬂ uence them favorably through price and

value communications. One of the major differences between tactical and stra-

tegic pricing is that tactical pricing assumes that price sensitivity is a constant

that cannot be inﬂ uenced. That assumption, which often is made implicitly,

simpliﬁ es price setting by reducing it to a measurement task. But experienced

marketers understand that this simpliﬁ cation comes at a cost, because thought-

ful price and value communications can often decrease price sensitivity and

support higher prices with less adverse volume impact than would otherwise

have been expected.

Consider the example of the Toro Company. The value obtained from

purchasing one of their snow blowers depends on the amount of snowfall

that a customer is likely to experience—a big uncertainty. In addition, several

of the sensitivity factors listed above tend to amplify a buyer’s reluctance to

make a purchase: The machines are very expensive, the cost is fully borne by

the homeowner, and perhaps most intriguingly, there is a risk perception held

by homeowners that the year they purchase a snow blower will be the year

that it does not snow! Unfortunately, it is not in Toro’s or retailers’ interest

to take on a huge inventory of snow blowers in anticipation of when a snow-

storm might arrive and customers come rushing in.

Traditionally, suppliers in markets such as these would simply offer an

“early-bird” discount to induce most buyers to purchase well before the snow

falls. Toro, however, took a more innovative approach and developed the “S’No

Risk Guarantee” whereby the company would rebate a portion of the pur-

chase price should the season’s snowfall come in below average.

With its new

rebate policy, Toro in essence aligned their price with the value delivered—

the less snow to remove, the lower the effective price of the machine. Toro also

gave consumers a reason to make their purchases without having to give an

“early bird” discount even in years when its snow blowers might end up cre-

ating high value that justiﬁ es much higher pricing. Additionally, by making

the offer conditional on the homeowner making a purchase prior to the start

of winter, they eliminated the chaotic impact of demand spikes that regularly

occur on the day of a major snowfall.

Based upon the estimate of economic value, the strategic choice, and the

evaluation of possible price elasticity relative to the breakeven, it is possible

to use judgment to deﬁ ne a relatively narrow “Viable Price Range”. Within

• Shared costs : Buyers are less price sensitive when some or all the

purchase price is paid by others.

• Transaction value: Buyers are motivated by more than just the

“acquisition utility” associated with obtaining and using a product.

They are also motivated by the “transaction utility” associated with

the difference between the price paid and what the buyer considers

a reasonable or fair offer for the product.

• Perceived fairness : Buyers are more sensitive to a product’s price

when it is outside the range that they perceive as “fair or reasonable.”

Chapter 6 • Price Level 149

that range, it is important to take account of the price sensitivity effects and

determine whether there is a cost-effective marketing campaign that could

mitigate or leverage one or more of them to inﬂ uence price sensitivity. Then,

ultimately, management must pick a price level within the viable range that,

in their subjective judgment, is most likely to win sales proﬁ tably.

COMMUNICATING NEW PRICES TO THE MARKET

The ﬁ nal task in setting a new price level is to communicate the rationale for

the change, especially when there is potentially an issue of “fairness.” Per-

ceived fairness is one of the most powerful factors driving price sensitivity.

Done correctly, communicating fairness can have dramatic effects. For exam-

ple, a well-known medical device manufacturer successfully implemented a

40 percent price increase for one of its key products by carefully communicat-

ing a rationale for the change. The company recognized that it had made a

tactical mistake by not raising prices annually along with industry practice, so

it notiﬁ ed customers three months in advance of the increase to allow them to

plan for the new prices. Not surprisingly, some customers “bought forward”

at the lower prices, loading up before the price increase. But, giving them that

option to mitigate the immediate effect of the change made the company’s

decision seem fair and reasonable, while also making it more difﬁ cult for the

ﬁ rm’s competitor to exploit the increase to gain share.

To further communicate fairness, the company’s letter to customers

explained that it had not taken an increase in eight years and noted that the

new price was still less than what it would have been had its past prices

increased in line with the medical device price index. Finally, the sales force

met with each major account to explain that, prior to the price increase, the

product was not generating sufﬁ cient returns to fund continued research and

development (R&D). This was important to hospitals and doctors who relied

on the company, a technology leader, to continually incorporate new technol-

ogy. To reinforce the inherent fairness of the price change, they committed to

invest much of the additional proﬁ t in R&D that would beneﬁ t customers in

the form of new products.

Just as there are different reasons for price changes, there are different

approaches to communicating fairness. In some instances, rising raw mate-

rial costs require a price increase. In such situations, customers are concerned

about whether the vendor is being opportunistic by raising prices more than is

justiﬁ ed and whether all customers, particularly competitors, are being treated

equally. To communicate fairness in these situations, ﬁ rst send a letter, email,

or press release to all customers simultaneously that explains why across-the-

board price increases are necessary. Tie the increase clearly to the cost increase

(for instance, “Energy prices have increased 24 percent; energy accounts for

10 percent of the price you pay, so prices must increase by 2.4 percent”) and be

prepared to provide documentary evidence. Where possible, consider index-

ing prices to an objective measure of raw material costs such as a published

commodity price index. Customers, and competitors, too, are more likely to

accept a price increase if they know that prices will come back down when

costs are lower. Indexed pricing is especially useful in times of signiﬁ cant price

spikes because indices can be adjusted monthly or weekly depending on the

frequency of raw material price changes.

Chapter 6 • Price Level150

Second, avoid being opportunistic by attempting to gain share by com-

promising on the increase. It can be tempting to waive a 5 percent increase for

customers willing to give you 20 percent more volume, particularly in indus-

tries with excess capacity. But such an action may well be short-sighted if your

competitors cannot afford to lose volume any more than you can. Although

being opportunistic may lead to a short-term volume increase, it will surely

invoke a competitive response and send a clear message to customers that the

rationale for the price increase was not legitimate. In addition, we would cau-

tion against waiving all or part of price increases for your largest customers.

Not only is the impact of the price increase diminished, but the diminished

impact compounds over the course of several increases.

Third, consider non-price mechanisms to “raise” prices and lessen the

customer impact. When faced with a sluggish economy or input cost increases,

sellers often turn to less visible mechanisms such as adding a new “fuel recov-

ery” charge to bills for services or reducing package sizes for consumer prod-

ucts. These changes are often barely perceptible to consumers and the familiar

price point that consumers are accustomed to remains intact. And in some

instances, these non-price adjustments can be remarkably effective. In an

attempt to absorb a cost increase, a yogurt maker recently decreased its pack-

age size and actually saw its sales soar. The reason? The manufacturer empha-

sized the now lower calorie count per single-serve package and diet-conscious

consumers viewed this as a beneﬁ t!

Another mechanism to mitigate the effect of price increases is to use

a lower-priced brand (in groceries it is often a “house brand”), to provide

a ready alternative for price-sensitive consumers who are at risk of either

switching suppliers or reducing the quantity purchased. Another tactic is

to incentivize buyers to adopt low-cost behaviors such as online purchasing

(common among airlines who waived reservation charges online while cut-

ting payments to travel agents) or encouraging a shift to “off peak” purchase

(common among health clubs and cruise lines) to improve capacity utilization.

Finally, in some cases, it is possible to switch product formulation: When cot-

ton prices rose, some clothing manufacturers adjusted the ﬁ ber content in their

garments by substituting cheaper synthetic materials as a way to manage the

cost increase.

Another situation that requires communicating fairness occurs when a

company increases prices after underpricing its products relative to the value

delivered. This occurs frequently when companies begin to assess the eco-

nomic value of their products for the ﬁ rst time and discover that they have jus-

tiﬁ cation to increase prices for some products if they communicate value more

effectively. The fairness issue stems from the fact that the company was not

charging for value in the ﬁ rst place, so why start charging for it now? This is

a legitimate question, the answer to which should be that over time, all prices

will be adjusted to align with value. In some cases, this will mean lower prices

and in others, higher prices.

To ensure that customers do not think that price increases are being forced

on them, offer them options on how they can adjust to the new prices. For

example, when large customers resist the price change, offer them the ability to

“earn” lower prices by, for example, signing longer-term supply agreements,

committing to full-truckload shipments, or other activities that can lower costs.

Just be careful in cases where there is industry over-capacity—competitors will

Chapter 6 • Price Level 151

likely retaliate to recapture any lost share. Alternatively, be prepared to

unbundle the core offering from services and other value-added features in

order to provide a lower-value option at the old price. Whichever approach

the company adopts, it is critical that customers pay for the value received. By

providing choices for how that happens, you increase the perception of fair-

ness and improve the odds that the price change will be successful.

Summary

Setting market-relevant prices requires a

combination of both art and science. In

spite of the many sophisticated tools and

analytics available to marketers, price set-

ting usually comes down to using informed

judgment to ﬁ nd a price that balances

costs, customer value, strategic goals, and

potential competitive responses. The pro-

cess we have described in this chapter is

designed to create a structured dialogue

that leads to informed conversations that

“take the emotion out” from a complex

and fraught price setting decision. When

followed by managers who are informed

about their markets and possess basic

pricing knowledge, this process will

help lead to sustainable and proﬁ table

prices.

Notes

1. Raymond E. Corey, Industrial Market-

ing: Cases and Concepts (Englewood

Cliffs, NJ: Prentice Hall, 1962).

2 . Michael Lombardi, “The Accuracy

and Stability of Quartz Watches,”

Horological Journal (February 2008),

pp. 57–59.

3 . For a more detailed discussion, see

Gerard Tellis, “Beyond the Many

Faces of Price: An Integration of

Pricing Strategies,” Journal of Market-

ing 50 (October 1986), pp. 146–160.

4 . Janet Adamy, “To Find Growth, No-

Frills Grocer Goes Where Other

Chains Won’t,” Wall Street Journal ,

August 30, 2005. Accessed February 7,

2017 at www.wsj.com/articles/SB1

12536840884226388.

5 . “Toro S’No Risk Guarantee Offers

Money Back,” Green Industry Pros,

August 1, 2013. Accessed February 7,

2017 at www.greenindustrypros.

com/news/11076597/toro-sno-

risk-guarantee-offers-money-back-

snowthrower.

6 . Adrianne Pasquarelli, “Design-

ers Cotton to Synthetic Materials,”

Crain’s New York Business, Febru-

ary 27, 2011. Accessed February 7,

2017 at www.crainsnewyork.com/

article/20110227/SUB/302279977/de

signers-cotton-to-synthetic-materials.

CHAPTER 7

Price Competition

Managing Conﬂ ict Thoughtfully

Victorious warriors win ﬁ rst and then go to war, while defeated warriors go to war

ﬁ rst and then seek to win.

Sun Tzu

The sixth, and ﬁ nal element, of the Value Cascade is Price Competition.

A gap occurs between actual and potential value realization when a ﬁ rm

makes pricing decisions that fail to anticipate the response of competitors to

those decisions.

Ironically, there is little issue here for ﬁ rms that operate in markets with

so many competitors, each with a small market share, that there is no poten-

tial to manage it. Those ﬁ rms need merely remain alert to changes in market

prices and adjust prices quickly, as described in Chapter 6, when the reference

value changes. Managing price competition becomes more challenging, and

an unnecessary gap in proﬁ tability becomes much more likely, when a ﬁ rm’s

market share is large enough that competitors react to its decisions.

The ramiﬁ cations of competitive reaction can be substantial. Recall the

description in Chapter 1 of how Alamo Rent A Car went quickly from being

the most proﬁ table rental car company to one suffering losses because it

failed to anticipate the reaction of competitors to what may, otherwise, have

been a ﬁ nancially sound growth strategy. In contrast, large airlines ﬂ ying to

multiple destinations made a wise decision when they introduced frequent

ﬂ yer programs in an attempt to blunt the effect of lower prices from small,

low-cost competitors. Of course, the small competitors could also offer fre-

quent ﬂ yer programs offering the same number of points per mile of travel,

but they could not offer the ability to accumulate points as rapidly nor could

they offer the same variety of destinations once an award level was attained.

Thus the relative inability of lower-cost competitors to react with an offer of

equal value enabled larger competitors to create a much-needed source of

competitive advantage.

Chapter 7 • Price Competition 153

UNDERSTANDING THE PRICING GAME

Price competition is a “game,” as deﬁ ned by game theorists, because the ulti-

mate outcome resulting from any move that you make depends upon how

your competitors react to it. Making the right choices in a game is very differ-

ent from making the right choices to solve a puzzle—such as how to make a

product more efﬁ ciently. Moreover, competitive pricing is a type of game that

requires skills foreign to many managers. What most of us know about com-

petition has been learned from sports, academics, and perhaps from partici-

pating in intracompany sales contests. The rules for success in these types of

competition are quite different from those for success in pricing. The reason, in

technical jargon, is that the former are all examples of “positive-sum” games,

whereas price competition is usually a “negative-sum” game.

Understand-

ing the difference between positive-sum and negative-sum games is crucial to

making sound pricing decisions that contribute to proﬁ tability and business

value.

Positive-sum games are those in which the very process of competition

creates beneﬁ ts. Consequently, the more prolonged and intense the game—in

sports, academics, or sales—the greater the rewards to the players. The win-

ner always ﬁ nds playing such games worthwhile and even the loser may gain

enough from the experience so as not to regret having played. In fact, peo-

ple and companies with a healthy attitude toward these activities often seek

opportunities to challenge themselves. A strong competitive spirit is a crite-

rion commonly used to identify job candidates with high potential for success

not only in sports, but also in scientiﬁ c research. It is also indicative of people

likely to be successful in sales if the ﬁ rm creates a competitive culture that

honors those who excel in meeting or exceeding sales goals.

Unfortunately, that same gung-ho attraction to competition can be quite

unhealthy when applied to negative-sum games: those in which the process

of competition imposes costs on players. Warfare, labor strikes and dueling

are negative-sum games because the loser never beneﬁ ts from participation

and even the winner may end the confrontation badly wounded. The longer

the conﬂ ict drags on, the greater the cost it imposes on the players. Price com-

petition is usually a negative-sum game, since the more intense price com-

petition is, the more it can undermine the value of the market over which

one is competing. That is likely to be the case where total market demand is

increased very little by lower prices and competitors have similar cost struc-

tures. Therefore, price competitors do well to forget what they learned about

competing from sports and other positive-sum games, and to try instead to

draw lessons from what are, hopefully, less familiar competitive games such

as warfare.

Students of actual warfare, who are cognizant of its costs do not make

the mistake of equating success with winning battles. Sir Basil Liddell Hart,

author of more than 30 books on military strategy, offers advice to political

and military leaders that marketers would do well to note:

Fighting power is but one of the instruments of grand strategy—which

should [also] take account of and apply . . . ﬁ nancial pressure, diplomatic

Chapter 7 • Price Competition154

pressure, commercial pressure, and . . . ethical pressure, to weaken the

opponent’s will. . . . It should not only combine the various instruments,

but also regulate their use as to avoid damage to the future state of peace.

In short, winning battles is not an end in itself, and warfare is certainly not the

only means to an end. In the same vein, winning sales is not an end in itself

and reducing prices is not the only, and is rarely the most cost-effective, means

for winning new customers.

For marketers, as for diplomats, warfare should be a last resort, and even

then the potential beneﬁ ts of using it must be weighed against the cost. For-

tunately, there are many positive-sum ways for marketers to compete. Cre-

ating new products, creating new ways to deliver service, communicating

more effectively with customers about beneﬁ ts, and increasing the efﬁ ciency

of operation are all positive-sum forms of competition. Precisely because they

create proﬁ ts rather than dissipate them, building capabilities for positive-

sum forms of competition is the basis of a sustainable competitive strategy.

Price competition may also be part of an overall proﬁ table growth strategy.

But competing on price alone can succeed at best only in the short term until

competitors ﬁ nd it threatening enough to react.

COMPETING TO GROW PROFITABLY

Unfortunately, many managers erroneously believe that the key to ﬁ nancial

success is ﬁ rst to win market share, after which proﬁ ts will follow (see box

“Market-Share Myth” below). When many competitors pursue this same

strategy, they engage in mindless negative-sum competition, which does little

more than destroy proﬁ tability for everyone. Fortunately, there are competitive

strategies that can increase, or at least maintain, the value of markets through

positive-sum competition. Rather than attracting customers by taking less in

margin, positive-sum strategies attract customers by offering them new sources

of value or by meeting their needs in new ways that create value more cost effec-

tively. Recall our discussion of Exhibit 1-3 in Chapter 1, where we contrasted

Product-led versus Customer-led offer development. Companies grow both

top-line revenue and bottom-line proﬁ t simultaneously when they can create

new sources of customer value without adding as much to cost, or when they

can reduce costs without equally reducing the value, enabling them to reduce

prices to win sales without reducing margins below those of competitors.

Market-Share Myth

A common myth among marketers is that growing market share is the

key to proﬁ tability. If that were true, the largest airlines in North America

would be the most proﬁ table while the small upstarts would be strug-

gling. In fact, for most of the last few decades, the opposite has been the

case.

The source of this myth is a demonstrable correlation between mar-

ket share and proﬁ tability.

But as any student of statistics should know,

correlation does not necessarily imply a causal relationship.

A far more plausible explanation for the correlation is that both prof-

itability and market share are caused by the same underlying source of

Chapter 7 • Price Competition 155

business success: a sustainable competitive advantage in meeting customer

needs more effectively or in doing so more efﬁ ciently.

iii

When a company

has a competitive advantage, it can earn higher margins due to either a price

premium or a lower cost of production. That advantage, if sustainable, also

discourages competitors from targeting the company’s customers or from

effectively resisting its attempts to expand. Consequently, although a less

fortunate company would face equally efﬁ cient competitors who could take

market shares with margin-destroying price competition, a company with

a competitive advantage can sustain higher market share even as it earns

higher proﬁ ts. Market share, rather than being the key to proﬁ tability, is, like

proﬁ tability, simply another outcome of a fundamentally well-run company.

Unfortunately, when management misperceives the symptom of

a poor strategy (insufﬁ cient or declining market share) as a cause and

seeks it by some inappropriate means, such as price cutting, the expected

increase in proﬁ tability doesn’t materialize. On the contrary, a grab for

market share unjustiﬁ ed by an underlying competitive advantage will

usually reduce the company’s own and its industry’s proﬁ tability. The

ultimate objective of any strategic plan should not be to achieve or even

sustain sales volume, but to build and sustain competitive advantage.

Proﬁ tability and, in many cases, market share growth, will follow. In fact,

contrary to the myth that a higher market share causes higher proﬁ tability,

changes in proﬁ tability usually precede changes in market share, not the

other way around. For example, Walmart’s competitive advantages made

it the most proﬁ table retailer in the United States long before it became

the largest, whereas several of its key competitors’ poor proﬁ tability pre-

ceded by many years their loss of dominant market share. This pattern of

changes in proﬁ tability leading, not following, changes in market share is

equally visible in the automobile, steel, and banking industries.

A strategic plan based on building volume, rather than on creating a

competitive advantage, is essentially a beggar-thy-neighbor strategy—a

negative-sum game that ultimately will only undermine industry proﬁ tabil-

ity. Every point of market share won by reducing margins (either by offering

a lower price or by incurring higher costs) invariably reduces the value of

the sales gained. Since competitors can effectively retaliate, they probably

will—and at least partially eliminate any gain in share while reducing the

value of a sale even further. The only sustainable way to increase relative

proﬁ tability is by achieving a competitive advantage that will enable you to

increase sales and margins. In short, the goal of a strategic plan should not

be to become bigger than the competition (although that may happen) but to

become better. Such positive-sum competition, rather than undermining the

proﬁ tability of an industry, constantly renews it.

(i) “Global Earnings Scoreboard: Most Recent 12 Months Reported,” Airline Weekly , Janu-

ary 9, 2017.

(ii) Robert D. Buzzell, Bradley T Gale, and Ralph Sultan, “Market Share—a Key to Proﬁ t-

ability”, Harvard Business Review (January 1975).

(iii) Robert Jacobson and David Aaker, “Is Market Share All That It’s Cracked Up to Be?”

Journal of Marketing 49 (Fall 1985), pp. 11–22; Richard Schmalensee, “Do Markets Dif-

fer Much?” The American Economic Review 75(3) (June 1985), pp. 341–351; William W.

Alberts, “The Experience Curve Doctrine Reconsidered,” Journal of Marketing 53 (July

Chapter 7 • Price Competition156

When competitors cannot immediately or cost-effectively duplicate new ways

of creating value, a company that creates those new ways achieves a “compet-

itive advantage.” Unfortunately, some managers completely misunderstand

the concept of competitive advantage and its importance for long-term prof-

itability. We hear them report that they have a “competitive advantage” in

having more stores than the competition, more knowledgeable salespeople,

or higher quality. None of these is a competitive advantage unless they also

enable the ﬁ rm to deliver value more cost-effectively than their competitors

can or convince their customers to pay a premium for the extra value deliv-

ered. Offering customers a more attractive offer by accepting a lower mar-

gin than the competition may be a sales advantage, but it is not a sustainable

competitive advantage, since competitors can easily match it and because it

reduces the return from investing in other, non-price means to win sales.

How can a ﬁ rm achieve competitive advantage? Sometimes it’s by luck.

Oil companies in the Middle East, for example, enjoy oil ﬁ elds from which

oil can be more cheaply extracted than from those in Manitoba, Norway, or

Kazakhstan.

Often, advantage comes from moving ﬁ rst on a new idea. By

winning a patent, by gaining economies of scale, or by preempting the best

locations, a ﬁ rm may achieve an advantage that would be more costly for a

later entrant to match. Uber has built a lead in car hire by investing heav-

ily in technology—both current technology and in what will be required in

the future for driverless cars—thereby increasing the potential value and cut-

ting the cost of car services. Once frequent users had downloaded its app, it

became much more costly for potential competitors to acquire customers or to

recruit drivers.

More often, competitive advantages are carved out of the efﬁ cient man-

agement of a ﬁ rm’s value chain. Michael Porter, the Harvard competition

guru, cites three ways that companies can proactively manage operations to

achieve competitive advantage:

• Needs-Based Positioning —based on serving the needs of only a particular

customer segment or niche, which enables the ﬁ rm to tailor its opera-

tions to meet the unique needs of that segment more cost-effectively.

• Access-Based Positioning —based on the company’s ability to gain access

to customers in unique ways. Access can be a function of geography or

customer scale. For example, serving a uniquely wide or narrow geo-

graphic market, based on the ﬁ rm’s cost structure, can create a unique

cost and service advantage.

1989), pp. 36–49; Cathy Anterasiun, John L. Graham, and R. Bruce Money, “Are U.S.

Managers Superstitious about Market Share?” Sloan Management Review (Summer 1996),

pp. 67–77; Linda L. Hellofs and Robert Jacobson, “Market Share and Customers’ Per-

ceptions of Quality: When Can Firms Grow Their Way to Higher Versus Lower Qual-

ity?” Journal of Marketing 63 (January 1999), pp. 16–25; J. Scott Armstrong and Kesten C.

Green, “Competitor-Oriented Objectives: The Myth of Market Share” International Jour-

nal of Business 12(1) (2017), pp. 115–134.

(iv) For evidence that there are proﬁ t leaders in the bottom and middle ranges of market

share almost as frequently as in the top range, see William L. Shanklin, “Market Share Is

Not Destiny,” Journal of Business & Industrial Marketing 4 (Winter–Spring 1989), pp. 5–16;

and “The ‘Myth of Market Share’: Can Focusing Too Much on the Competition Harm

Proﬁ tability?” at Knowledge@Wharton, January 24, 2007.

Chapter 7 • Price Competition 157

• Focus-Based Positioning —based on developing a unique capability to do

one or more narrowly focused activities that add value to value chains

across industries. Because the focused activity does not add value alone,

a focused supplier must closely monitor and coordinate its operations

with other suppliers that manage the value chain.

Whole Foods is an example of a company that has created competitive advan-

tage with “needs-based positioning.” The company deﬁ ned a higher standard

for acceptable ingredients in foods and acceptable practices in dealing with

food suppliers. The standard appeals to food buyers who are exceptionally

concerned about the source and quality of ingredients when purchasing foods

and personal care products. More importantly, those people are willing to pay

more for products that meet Whole Foods’ high standards. In North America,

the company has essentially replaced a cottage industry of small “health food”

stores carrying a limited selection of items with large stores carrying a “purer”

substitute for practically anything one could ﬁ nd in a regular grocery store.

As regular grocers have expanded the number of products they offer for this

segment, Whole Foods has been able to expand its offers as well to maintain a

large portion of each customer’s shopping basket. Although the company has

suffered during economic downturns when a smaller share of the market is

willing to pay the Whole Foods price premium, the company’s sales and prof-

its recover equally as strongly during business cycle recoveries. Consequently,

the advantage created by the company’s unique positioning has enabled it

to outperform the traditional grocery retail segment on both proﬁ t margins

(EBITDA/Revenue) and growth over the long term.

The U.S. beer industry offers a classic case of “access-based positioning,”

with ﬁ rms both widening and narrowing their geographic reach to achieve

competitive advantage. Companies with a national presence, such as Anheuser-

Busch InBev enjoys a huge competitive advantage in purchasing television

advertising space at low national rates. It leverages that advantage to over-

whelm smaller regional competitors with a volume of advertising that they can-

not afford to match. The growth of smaller regional competitors is limited by the

need to rely on local cachet and word-of-mouth promotion to operate proﬁ tably.

MathWorks is a prime example of a focus-based supplier. The

Massachusetts-based company has developed a capability to develop math-

ematical algorithms that enable other companies’ equipment or software to

operate more efﬁ ciently. In some cases, an end-user might buy an algorithm—

which can be delivered on a thumb drive—to enable their CAD (Computer

Aided Design) equipment to operate better or a manufacturer might license

an algorithm from MathWorks to include in the original design of its product.

By focusing its business purely on the solution of complex math problems,

MathWorks mathematicians gain experience and cross-industry insight that

similarly skilled employees of a less specialized company could not duplicate.

These examples illustrate that the key to achieving sustainable proﬁ tabil-

ity is to manage the business for competitive advantage. Unfortunately, many

companies in competitive markets still focus on revenue growth, which they

pursue by trying to be all things to all people, rather than focusing on creating

value more cost-effectively. Porter calls the failure to achieve either a value

or a cost advantage “getting stuck in the middle.” When such companies are

exposed to competitors, some of whom offer higher quality or service while

others offer lower prices, the ﬁ rm’s proﬁ tability gets squeezed, despite its size.

Chapter 7 • Price Competition158

In the absence of a relative cost advantage, it is ultimately suicidal to

drive growth with price. During the internet technology bubble of the late

1990s, hundreds of internet retailers and willing investors were hoping to

prove this statement wrong. They accepted lower, even negative, margins

simply to build share in the belief that ultimately the high value-add from

the online shopping experience would make them proﬁ table. They ignored

a simple economic principle: Competition drives out proﬁ tability except for

those with a source of advantage that prevents competitors from fully match-

ing their costs or their value proposition. As a result, most of the early online

visionaries went bankrupt, at huge cost to their investors despite the growth

of the internet as a platform for doing business.

There were a few exceptions, namely, those internet newcomers who

could create online advantages that later competitors could not duplicate.

eBay, for example, enjoys margins and proﬁ tability that exceed those of both

online and bricks-and-mortar competitors, not just because of the high value

of trading online but because of the greater difﬁ culty any lower-priced com-

petitor would face in trying to duplicate its online offerings. Once eBay gained

a large user-base advantage, it became nearly impossible for any competitor

to duplicate the value it offers traders. PayPal is a similar story. It attracted

customers quickly because it satisﬁ ed a strong unmet need for greater secu-

rity when making purchases from previously unknown online retailers with

no known address. But no consumer or retailer needs a second service like

that one, so its ﬁ rst-mover advantage was huge. A new competitor would

likely have to pay for incentives to induce people to sign and use it rather than

remain with PayPal, creating a large barrier to entry.

The measure of a ﬁ rm’s competitive advantage is its relative gross margin

per sale, not its market share. We focus on gross margin, not operating margin,

because gross margin is a measure of the value of an incremental sale. A large

ﬁ rm with relatively low gross margin can be expected to shrink, even when com-

peting with a much smaller ﬁ rm that is nonetheless more efﬁ cient in creating

value. The latter ﬁ rm’s greater margin per incremental sale can fund more mar-

keting activities that will ultimately undermine the market share of the larger

ﬁ rm. That is exactly what happened to the “big three” U.S. auto companies

when smaller Japanese and Korean rivals entered the North American market

with lower costs and higher gross margins per car. Despite starting with a much

higher market share, the big three could not afford to match what these new

entrants could proﬁ tably invest in marketing, dealer incentives, and customer

service to acquire more customers at the expense of the larger competitors.

The airline industry tells a similar story. The low-cost structure of some

discount airlines makes them advantaged competitors in many markets, even

when competing against larger airlines, because their low cost-per-seat-mile

generates higher gross margins even after accounting for its lower prices. Con-

sequently, this cost advantage allowed some of the so-called “low-cost carri-

ers” (LCCs) to grow at the expense of their larger competitors. In the long run,

however, a ﬁ rm’s ability to acquire market share is limited to those market

segments it can acquire and hold with a higher gross margin than competitors

can. As these LCCs expanded into serving major airports, with their high gate

costs and ground delays, the size of advantage diminished for many of these

airlines. In fact, as their cost advantages narrowed, many LCCs have instead

invested in new offers such as in-air Wi-Fi, premium boarding and seating,

and expansion of their networks to compete on value, not just price.

Chapter 7 • Price Competition 159

REACTING TO COMPETITION: THINK BEFORE YOU ACT

Many managers are so fully aware of the risks of price wars and the impor-

tance of competing from a position of strength that they think coolly and logi-

cally before initiating price competition. It is much harder for most of us to

think logically about whether or how to respond when we are already under

attack. Consequently, we will discuss in step-by-step detail how to analyze a

competitive situation and formulate responses in price-competitive markets

that are not of your making.

When is it ﬁ nancially more prudent to accommodate a competitive threat,

at least in the near term, until you can improve your capabilities, than to retali-

ate? Thinking through this question does much more than prepare you, intel-

lectually and psychologically, to make the best competitive response. It also

reveals weakness in your competitive position. If you do not like how often

you must accommodate a competitor because your company cannot ﬁ ght the

threat successfully, you will begin searching for a competitive strategy that

either increases your advantage or moves you further from harm’s way.

Exhibit 7-1 illustrates the complex ﬂ ow of thinking required to make

thoughtful decisions about reacting to price competition. The exhibit begins

with the assumption that one or more competitors have cut their prices or have

introduced new products that offer at least some of your customers more value

for their money. How should you respond? Marketing theorists usually argue

that one should never respond, since there are better, positive-sum ways to com-

pete on product or service attributes. While that is often true, the time to have

explored and implemented those ideas is usually long before a low-priced com-

petitor is a threat. By the time the threat is obvious, a ﬁ rm’s strategic capabilities

are ﬁ xed in the short run. The question at hand is whether to respond with price

when threatened with a loss of sales by a lower-priced competitor. To determine

whether a price response is better than no response, one must answer the fol-

lowing questions and explore the interrelationships illustrated in Exhibit 7-1.

1. Is there a response that would cost less than

the preventable sales loss?

Although the need to ask this question might seem obvious, many managers

simply stop thinking rationally when threatened. They match any price cut

without asking whether the cost is justiﬁ ed by the beneﬁ t, or whether the same

beneﬁ t could be achieved by structuring a more thoughtful response. In Chapter

9, we describe how to calculate the amount of sales that would need to be at risk

(the Reactive Breakeven Sales Change) before the act of matching a competitor’s

price reduction justiﬁ es the cost. If we conclude that reacting to a price change

is cheaper than losing the sales, then it may be a good business decision. On the

other hand, if a competitor threatens only a small portion of your sales, the sales

loss associated with ignoring the threat may be much less than the cost associ-

ated with retaliation. Since the threat is small, the cost of cutting the price on all

of your sales in order to prevent the loss of some sales to a competitor is likely to

be unwise. Within a market or market segment that can be targeted for pricing

by a competitor, the larger a ﬁ rm’s total market share the less proﬁ table it will be

to cut prices to win the business of more price-sensitive customers.

It is also important to be realistic about how much of the projected sales

loss is really preventable. When a new grocery chain opens with lower prices,

160

EXHIBIT 7-1

Thoughtfully Reacting to Price Competition

Chapter 7 • Price Competition 161

the established competitors can surely reduce the sales loss by matching its

prices. Still, even if they match, some people will shift to the new store simply

because it is newer or more convenient to where they live. They will not return

even if the competitor’s price advantage is eliminated.

By constraining an organization’s competitive reactions to only those

that are cost-effective, managers also force their organizations to think about

how to make their price reactions more cost-effective. Following are some

principles that can substantially reduce the cost of reacting to a price threat.

Focus your reactive price cut on only those customers likely to be attracted by the

competitor’s offer. This requires developing a “ﬂ anking” offer that is attractive

or available only to the more price-sensitive buyer. Often, such an offer can be

developed in a short period of time, since it involves merely eliminating some

element of the product or service not highly valued by the price-sensitive seg-

ments. During the recession in 2009, consumers began migrating to cheaper

house brand grocery and cleaning products while supermarkets began pro-

moting them more aggressively. This contributed to an 18 percent decline in

revenues for Procter & Gamble. In response, the company introduced ﬂ anking

brands, like Tide Basic detergent at prices 20 percent lower than the original

brands.

Many analysts have questioned the wisdom of this move, but there is

an obvious beneﬁ t: it prevents some of the defection to house brands and gives

P&G the ability to eliminate the ﬂ anking brands when consumers again feel

able to pay for its more value-added brands.

Focus your reactive price cut on only the incremental volume at risk. A cheaper

competitor will often be unable to entirely replace an incumbent’s business,

but will be able to gain a share of its competitor’s business. For example, if a

smaller independent television network, such as the CW Network in North

America, cuts its ad rates, advertisers are not going to abandon the large net-

works like NBC or Fox. They are, however, going to be more likely to divert

some dollars to CW from the big networks. A big network could neutralize

that threat by offering to discount its ad rates to the level of the independent

network’s rates just for the amount of advertising likely to be diverted. One

way this could be structured is as a discount for all purchases in excess of, say,

80 percent of the prior year’s purchases or expected purchases. These types of

contracts are common not just for advertising, but also for drugs and medi-

cal supplies sold to health maintenance organizations (HMOs). Retaliatory

discounts applicable only to the incremental volume at risk are also common

when pricing to retailers and distributors.

Focus your reactive price cut on a particular geographic area or product line where

the competitor has the most to lose, relative to you, from cutting the price. A domi-

nant cement manufacturer in an Asian country (disguised as “Country A”)

began a drive to grow its share in a neighboring country (“Country B”) by

building its own unloading facility there and acquiring new mixing capacity,

after which it undercut prices in the newly entered market. What the company

from Country A failed to think through was the fact that its high prices and

high share in its home market left it vulnerable to retaliation. The incumbent

leader in Country B reacted by ﬂ ooding its competitor’s home market, driving

cement prices down by 26 percent in just one year.

Raise the cost to the competitor of its discounting. If the competitor’s price move

is limited only to new customers and the competitor has a market of existing cus-

tomers, it may be possible to retaliate without cutting your own price at all. Con-

sider retaliating by educating the competitor’s existing customers that they are

Chapter 7 • Price Competition162

being treated unfairly. A client of ours did this simply by making sales calls to its

competitor’s most proﬁ table accounts. In the process of the call, the salesperson

casually suggested, “You are probably paying about $X for this product now.”

When the customer questioned this, the salesperson confessed that he really did

not know what they were paying but had surmised the ﬁ gure based on the prices

that his competitor offered recently to some other accounts, which he named. In

short order, the customer was on the phone with its incumbent supplier demand-

ing similar discounts, and the competitor quickly backtracked on its aggressive

offers. Even in consumer markets, it is sometimes possible to appeal to custom-

ers’ sense of fairness or civic pride to convince them to reject a discounter. Small,

local retailers have successfully done this to prevent big-box retailers from open-

ing stores in Vermont that would no doubt hurt the less efﬁ cient, but traditional,

local retailers.

Retailers frequently use a related tactic of widely promoting a policy that

promises to match the price of low-priced competitors. If a competitor adver-

tises a lower price, then the retailer offers to refund the difference to any of its

customers paying a higher price within a reasonable time period, say 30 days

following the sale. Only a few very price-sensitive buyers will take the time

to gather evidence of the lower advertised competitor prices, and then ensure

that the sales receipt for their purchased model matches precisely the com-

petitor’s advertised model—all for merely the value of the price differential,

often relatively small. However, the price-matching policy is not targeted at all

buyers, or even just price-sensitive buyers; instead, it is a signal to other retail

competitors of the futility of aggressive price-discounting strategies. After the

substantial reduction in margins they incur by heavy discounting, their com-

petitors simply neutralize the advantage by rebating to customers the differ-

ence. The result is that these deep-discount competitors are better off playing

by the rules of established non-price competition in the category. In North

Carolina, the Big Star and Winn-Dixie supermarket chains both announced

price-matching policies to “meet or beat” the prices of aggressive rival Food

Lion. Two years later, the number of products with essentially the same prices

across these three competitors increased signiﬁ cantly, and the prices for these

products increased as well.

Leverage any competitive advantages to increase the value of your offer as an

alternative to matching the price. The key to doing this without simply replac-

ing a price war with a quality or service war is to make offers that are less

costly for you to offer than for your competitor to match. If, for example, you

have much better quality, offer a better warranty. If you have more service

centers in more locations, offer faster service. Major airlines respond to price

competition from smaller upstarts by offering increased frequent ﬂ yer miles

on newly competitive routes. Because of their large route systems, frequent

ﬂ yers accumulate miles faster and enjoy more choices of destinations than

anything the small competitors could offer other than price. Moreover, the

more sophisticated yield management systems of the large airlines mini-

mized the cost of such programs more effectively than smaller carriers could.

If any of these options is less costly than simply allowing the competi-

tor to take some sales, it is worth continuing to pursue the idea of possibly

reacting, rather than ignoring, a lower-cost competitor. Otherwise, it is almost

always better to preserve margins at the expense of market share, spending

the added cash ﬂ ow from those margins on other ways to improve your cost-

effectiveness or your ability to add value that justiﬁ es a price premium.

Chapter 7 • Price Competition 163

2. If you respond, is your competitor willing

and able to cut price again to reestablish

the price difference?

Matching a price cut will do you no good if the competitor will simply reestab-

lish the advantage. Ask yourself why the competitor chose to compete on price

in the ﬁ rst place. If that competitor currently has little market share relative to

the share that could be gained with a price advantage, and has no other way to

attract customers, then it has little to lose from bringing price down as low as

necessary to gain sales. This is especially the case where large sunk costs create

substantial “exit barriers.”

At one point, a pharmaceuticals company ask us to recommend a pric-

ing strategy to defend against a new entrant. Management was initially sur-

prised when we told them that defending their sales with price was unwise.

Only after thinking about the problem from the competitor’s standpoint did

we fully understand the competitive dynamics they faced. Customers had no

reason to try the competitor’s new drug without a price advantage, since it

offered no clinical advantages. The new entrant had absolutely nothing to lose

by taking the price down, since it had no sales anyway. Given that the huge

investment to develop and test the drug was entirely sunk but that the manu-

facturing cost was small, winning sales even at a low price would be a gain.

The conclusion was obvious that the competitor would cut price as often as

necessary to establish a price advantage. If our client insisted upon preventing

the new competitor from gaining signiﬁ cant market share, they would have

risked destroying the value of the market.

3. Will the multiple responses required to match a

competitor cost less than the avoidable sales loss?

Think about the total cost of a price war, not just the cost of the ﬁ rst shot, before

concluding that the cost to defend the sales at risk is worth bearing. Unfortu-

nately, the pharmaceutical client described above did not take our advice,

instead resolving to do whatever was necessary to prevent the new entrant from

gaining a signiﬁ cant foothold in any major pharma market. By the end of the

competitor’s ﬁ rst two years in the market, it had largely succeeded in retaining

more than 80 percent market share. It did so at the cost, however, of an average

wholesale price decline of more than two-thirds. The devastating effect on proﬁ t

contribution led to a complete review of what had happened and recognition

that they could not afford to repeat such a mistake in the future.

Partisans of pricing for market share would no doubt disagree with our

reluctance to use price defensively, especially when one is already in a stron-

ger market position. Large market-share companies, they will argue, are some-

times better capitalized and, thus, better able to ﬁ nance a price war than are

smaller competitors. Although price cutting might be more costly for the large-

share ﬁ rm in the short run, it can sometimes bleed the competitor ﬁ nancially

until it is forced to withdraw. The reason defensive pricing failed in the case of

our pharma client was, they would argue, that the competitor had many other

proﬁ table drugs that could subsidize its losses on its new launch. If the com-

petitor had relied on that one drug’s proﬁ tability for survival, it would have

succumbed and been a lesson to others not to challenge our client’s market

leadership in the future.

Chapter 7 • Price Competition164

Although such a “predatory” response to competition sounds good in

theory, there are two reasons why it rarely works in practice. First, predatory

pricing is a violation of U.S. and European antitrust laws if the predatory price

is below the predator’s variable cost. Such a pricing tactic may in some cases be

a violation when the price is below the average of all costs.

Consequently, even

if a large competitor can afford to price low enough to bankrupt its smaller

competitors, it often cannot do so legally. But, even putting legal issues aside,

predation is cost-effective only if the predator gains some competitive advan-

tage as a result of winning the price war. This occurs in only two cases: when

eliminating a competitor destroys an important differentiating asset (for exam-

ple, its accumulated goodwill with customers); or when it enables the predator

to gain or maintain such a cost advantage (such as economies of scale) that it

can proﬁ tably keep its prices low enough to discourage new entrants.

Unless driving a low-cost competitor into bankruptcy somehow destroys

the assets of that competitor, a newly capitalized entrant can purchase the

assets of the bankrupt competitor, operate at a lower cost base, and initiate

price-based competition against the large ﬁ rm now itself ﬁ nancially weak-

ened by the cost of the ﬁ rst price war. Repeated price wars to defend market

share eventually weakens market leaders ﬁ nancially to the point where they

are vulnerable. For decades, the largest airlines in America fought price wars

with new entrants, most of which bought cheap, older planes and had much

lower labor costs, often from non-union labor. The market leaders still man-

aged to drive many of those new entrants from the market by operating at

a loss where they faced competition. Still, they all eventually succumbed to

bankruptcy. Eventually however, they learned from the lesson. Rather than

spending money on money-losing price wars, they reduced capacity in mar-

kets where competition made operations unproﬁ table, invested in more fuel

efﬁ cient planes than the old ones ﬂ own by many low-cost competitors, and

more creatively segmented their markets to reduce the cost to compete for

price-sensitive customers (by eliminating fees to agents and such amenities as

free bag check, food, and pillows).

The key to surviving a negative-sum pricing game is to avoid confronta-

tion unless you can structure it in a way that you can win, and calculate that

the likely beneﬁ t from winning exceeds the likely cost. It simply makes no

sense to match competitor’s price discounts unless one can do so at a cost that

is less than what one would lose from ceding some market share.

To recognize such situations, however, a manager must think rationally,

remember that this is a negative-sum game, and suppress the understandable

emotional reaction to never back down.

4. Is your position in other (geographic or product)

markets at risk if a competitor is successful in

gaining share?

Does the value of the markets at risk justify the cost of a response? Some sales

have a value that far exceeds the contribution directly associated with them.

Take this example from the competitive PC and peripherals market in 2004.

Following Dell Computer’s introduction of a new line of computer printers,

Hewlett-Packard (HP) immediately severed its relationship to supply HP

printers to Dell, signaling the strategic importance to HP of its printer busi-

ness. HP strengthened its response by cutting its PC prices to match Dell’s,

Chapter 7 • Price Competition 165

where Dell had much more to lose. Finally, HP realized that Dell’s printer

strategy had its own limitations. Dell sourced its printers and cartridges from

a third-party supplier, Lexmark, limiting Dell’s typical cost advantage. So

HP defended its lucrative printer business, not with price, but with aggres-

sive product innovations. It introduced new printer models, including digital

printing with greater savings for corporate customers that led to higher rev-

enues and overall printer market share gains.

Retaliatory price cuts are all too often justiﬁ ed by vague “strategic” rea-

sons unrelated to proﬁ tability. Before approving any retaliatory price cut for

strategic reasons, two things should be required. The ﬁ rst is a clear statement

of the long-term strategic beneﬁ t and risks. The beneﬁ t can be additional sales

in this market in the future. It can be additional immediate sales of comple-

mentary products, such as sales of software and peripherals if one wins the

sale of a computer. It can be a lower cost of future sales because of a com-

petitive cost advantage resulting from the added volume. The risks are that

a targeted price cut will spread to other customers and other markets, and

that competitors will react, again creating a downward price spiral that under-

mines proﬁ ts and any possibility of long-term gain.

5. Does the value of the markets at risk

justify the cost of response?

The second requirement to justify a strategic price cut is a quantitative esti-

mate of the value of the strategic beneﬁ t. This need to quantify often encoun-

ters resistance because managers feel that the task will delay response to an

imminent threat. Usually, however, rough estimates are all that is necessary

to achieve enough precision to make a decision. A company told us that they

always defended price in the institutional segment of their market because sales

in that segment drove retail sales. While the relationship was no doubt true, the

magnitude of the effect was important given that pricing to the institutional

segment had fallen to less than manufacturing cost. A simple survey of retail

customers about how they began using the product revealed that only about

16 percent of retail sales were driven by institutional sales. We then estimated

the cost of maintaining those sales by retaining all of the client’s current insti-

tutional sales and compared that with the cost of replacing those sales through

expenditures on alternative forms of promotion. That simple analysis drove a

complete change in the institutional pricing strategy. Moreover, as institutional

prices rose, “leakage” of cheap institutional product into the retail chain market

declined, producing an additional return that had not been anticipated.

MANAGING COMPETITIVE INFORMATION

All wars, whether shooting wars or price wars, occur because someone made a

terrible mistake. Since wars are negative-sum games, it is always the case that

the loser would have been better off not to capitulate, or at least to retreat to

ﬁ ght another day on better terms. This is the reason that the skills of a diplo-

mat are as important for managing negative-sum conﬂ ict as are the skills of a

general. This does not mean that one should be friendly with one’s competitors

or even fair. Diplomats are not always nice, but they manage information and

expectations to achieve their goals without unnecessary confrontation. If they

ﬁ nd it necessary to use force, they seek to limit its use to the amount necessary

Chapter 7 • Price Competition166

to make their point. In the diplomacy of price competition, the meaning that

competitors ascribe to a move is often far more important than the move itself.

The decision to cut price to gain a customer may have radically different

long-term effects, depending upon how the competitor interprets the move.

Without any other information, the competitor would probably interpret the

move as an opportunistic grab for market share and respond with defensive

cuts of its own. If, however, the discount is structured to mimic exactly an offer

that the same competitor made recently to one of your loyal customers, the

competitor may interpret the cut as reﬂ ecting your resolve to defend that seg-

ment of the market. As such, the cut may actually reduce future opportunism

and help stabilize industry prices.

Consider how the competitor might interpret one more alternative: your

price cut is totally unprovoked but is exceptionally large, more than you have

ever offered before and probably more than is necessary to take the business.

Moreover, it is preceded by an announcement that your company’s new, pat-

ented manufacturing process not only added to capacity but also substantially

reduced incremental manufacturing costs. In this case, an intelligent competi-

tor might well interpret the price cut as fair warning that resistance against

your grab for market share will be futile.

Managing information requires collecting and evaluating information

about the competition, as well as communicating information to the market that

may inﬂ uence competitors’ moves in ways desirable to your own objectives.

COLLECT AND EVALUATE COMPETITIVE INFORMATION

Many companies operate with little knowledge of their competitors’ prices

and pricing strategies. Consequently, they cannot respond quickly to changes.

In highly competitive markets, such ignorance creates conditions that invite

price warfare. Why would an opportunist ever cut price if it believed that

other companies were willing to retaliate? The answer is that the opportunist’s

management believes that, by quietly negotiating or concealing its price cuts,

it can gain sufﬁ cient sales volume to justify the move before the competitors

ﬁ nd out. This is especially likely in industries with high ﬁ xed costs (or high-

percentage contribution margins) and during peak seasons when dispropor-

tionate amounts of business are at stake.

To minimize such opportunistic behavior, competitors must identify and

react to it as quickly as possible.

If competitors can react in one week rather

than three, the opportunist’s potential beneﬁ t from price cutting is reduced

by two-thirds. At the extreme, if competitors could somehow react instantly,

nearly all beneﬁ t from being the ﬁ rst to cut price could be eliminated. In highly

competitive markets, managers “shop” the competitors’ stores and monitor

their advertising on a daily basis to adjust their pricing

and the large chains

maintain communication systems enabling them to make price changes

quickly in response to a competitive threat. As a consequence, by the time

most customers even learn what the competition is promoting in a given week,

the major competitors have already matched the price.

Knowledge of competitors’ prices also helps minimize a purchasing

agent’s ability to promulgate misinformation. Frequently in business-to-

business markets, price wars begin without the intention of any competitor

involved. They are caused by a purchasing agent’s manipulation of information.

Chapter 7 • Price Competition 167

A purchasing agent, frustrated by the inability to get a better price from a

favored supplier, may falsely claim that he or she has been offered a better

deal from a competitor. If the salesperson doesn’t respond, a smart purchasing

agent may give the threat more credibility by giving the next order to a com-

petitor even without a price concession. Now the ﬁ rst company believes that

its competitor is out “buying business” and will, perhaps, match the claimed

“lower price” on future orders to this customer, rewarding this customer’s

duplicitous behavior. If the ﬁ rst company is more skilled in price competi-

tion, it will not match the “lower price,” but rather will retaliate by offering

the same discount to other good customers of the competitor. The competitor

will now see this company as a threat and begin its own cuts to defend its

share. Without either competitor intending to undermine the industry price

level, each has unwittingly been led to do so. The only way to minimize such

manipulation is to monitor competitors’ prices closely enough so that you can

conﬁ dently predict when a customer is lying.

Even when purchasers do not lie openly, their selective communication

of information often leaves salespeople with a biased perspective. Most sales-

people think that their company’s prices are too high for market conditions.

Think about how a salesperson is informed about price. Whenever the sales-

person loses a piece of business, the purchaser informs the salesperson that

the price was “too high.” When he or she wins the business, however, the

purchaser never tells the salesperson that the price was unnecessarily low. The

purchaser says the job was won with “the right price.” Salespeople get little or

no information about how much margin they may have left on the table.

There are many potential sources of data about competitors’ prices, but

collecting those data and converting the data into useful information usually

requires a formalized process. Many companies require that the sales force

regularly include information on competitors’ pricing in their call reports.

Having such current information can substantially reduce the time necessary

to respond to opportunism since someone collecting information from mul-

tiple salespeople and regions can spot a trend much more quickly than can

an individual salesperson or sales manager. Favored customers can also be

a good source of information. Those that are loyal to the company, perhaps

because of its quality or good service, do not want their competitors to get

lower prices from another source. Consequently, they will warn the favored

supplier when other suppliers issue new price sheets or when they hear that a

competitive supplier is discounting to someone else. A partnership with such

a customer is very valuable and should be treated as such by the seller.

In highly competitive markets, the information collected should not be

limited to prices. Understanding plans and intentions is equally important.

We recently worked with a client frustrated by the low proﬁ tability in its ser-

vice industry, despite record revenue growth. In the process, we learned that

the industry had suffered from overcapacity but recently had experienced

multiple mergers. What was the purpose of those mergers? Was it to gain cost

efﬁ ciencies in manufacturing or sales that would enable the new company to

offer low prices more proﬁ tably? Or was it to eliminate some inefﬁ cient capac-

ity, enabling the merged company to consolidate its most proﬁ table customers

in fewer plants, eliminating the need to win incremental business? We found

answers to those questions in the competitor’s brieﬁ ngs to securities analysts,

causing our client to rethink its own strategy.

Chapter 7 • Price Competition168

Trade associations, independent industry monitoring organizations, secu-

rities analysts, distributors, and technical consultants that advise customers on

large purchases are all good sources of information about competitors’ current

pricing moves and future intentions. Sometimes trade associations will collect

information on prices charged in the prior week and disseminate it to members

who have submitted their own prices. Monitoring prices quoted at trade shows

can also be another early tip-off. In retail businesses, one can simply “shop” the

competitive retailers on a regular basis. In the hotel industry, nearby competi-

tors regularly check their competitors’ prices and room availability on particular

nights by calling to make an unguaranteed reservation or checking an online

hotel booking site. If price competition is important enough as a determinant of

proﬁ t in an industry, managers can easily justify the cost to monitor it.

Selectively Communicate Information

It is usually much easier for managers to see the value of collecting competi-

tive information than it is for them to see the value in knowingly revealing

similar information to the competition. After all, information is power. Why

should anyone want to reveal a competitive advantage? The answer: So that

you can avoid having to use your advantage in a negative-sum confrontation.

The value of sharing information was obvious, after the fact, to a com-

pany supplying the construction industry. Unlike most of its competitors as

well as most economists, the company accurately predicted a recession and

a construction slowdown looming on the horizon. To prepare, the company

wisely pared back its inventories and shelved expansion plans just as its com-

petitors were continuing to expand. The company’s only mistake was to keep

its insight a secret. Management correctly felt that by retrenching more quickly

than its competitors, it could weather the hard times more successfully, but

when competitors desperately cut prices to clear bloated inventories, the entire

industry suffered. Had the company publicly shared its insight, which would

have thus discouraged its competitors from overexpansion, its own ﬁ nancial

performance would have been more proﬁ table even though relatively less out-

standing. The lesson: It is often better to earn just an average return in a proﬁ t-

able industry than to earn an exceptional return in an unproﬁ table one.

Even company-speciﬁ c information—about intentions, capabilities, and

future plans—can be useful to reveal unless doing so would preclude achieving

a ﬁ rst-mover advantage into a new market. Such information, and the informa-

tion contained in competitors’ responses, enables a company to establish plans

“on paper” that are consistent with competitors’ intentions, rather than having

to reach consistency through the costly process of trial and error.

• Pre-announce price increases . One of the most important times to com-

municate intentions is when planning a price increase. Even when a price

increase is in the interest of all suppliers, an attempt to raise prices will

often fail. All may not immediately recognize that an increase is in their

interest, and some may hope to gain sales at the expense of the price lead-

ers by lagging in meeting the increase. Other times, an increase may not be

in the competitor’s interest (perhaps because its costs are lower), meaning

that any attempt to raise prices will ultimately fail. Consequently, before

initiating a price increase that it anticipates competitors will follow, a ﬁ rm’s

management should publicly explain the industry’s need for higher prices

Chapter 7 • Price Competition 169

and, if possible, announce its own increase well in advance of the effective

date. This “toe in the water” approach enables management to pull back

from the price increase if competitors do not join in. This approach can be

repeated multiple times until competitors understand that a price increase

won’t go through without them or the ﬁ rm learns that it lacks the competi-

tive strength necessary to lead such a change.

• Show willingness and ability to defend . Some pricing policies that

may seem to weaken a seller’s position with customers may actually

reduce competitive pressure by discouraging competitor’s low price

offers. For example, when a retailer offers to meet or beat any com-

petitor’s price on the same brand of product, the tactic reduces com-

petitors’ expectations that advertising low prices to take share will be a

successful strategy, thus reducing price competition. Similarly, a sup-

plier who negotiates a “right of ﬁ rst refusal” to match any competitive

price in order to remain a customer’s exclusive supplier may discour-

age competitors, if they know about this clause, from wasting time to

prepare competitive bids that will fail unless they are so low as to make

the business unproﬁ table.

• Back up opportunism with information . While an opportunistic price

cut to buy market share is usually short-sighted, it is sometimes an ele-

ment of a thoughtful strategy. This is most often the case when a com-

pany uses pricing to leverage or to enhance a durable cost advantage.

Even companies with competitive advantages, however, often win only

pyrrhic victories in battles for market share. Although they ultimately can

force competitors to cede market share by undercutting rivals on price,

the costs of battle frequently exceed the ultimate value of the reward.

This is especially true when the war reduces customer price expectations

and undermines loyal buyer–seller relationships.

The key to proﬁ tably using price as a weapon is to convince competitors to

capitulate. A Japanese company invited the two top operations managers of

its American competitor to the opening of its new plant. After attending the

opening ceremony, the company took all guests through the highly automated

facility. The American managers were surprised to see the process so highly

automated, all the way to ﬁ nal packing, since quality control usually required

human intervention at many points in the process. When asked about this, the

Japanese hosts informed the guests that this plant was the ﬁ rst to use a new, pro-

prietary process that essentially eliminated the major source of defects. They also

indicated that development of the process had taken them more than a decade.

On the way home, realizing now what could be done, the American

engineers were eagerly speculating about how this improvement might be

achieved and how much they should ask for in a budget to pursue research.

They also wondered why their Japanese counterparts would reveal the exis-

tence of such an important trade secret. Within a few months they got their

answer. The Japanese competitor announced a 20 percent price cut for exports

of this product to the American market. If you were the American competitor

with a large market share, how would knowledge of this trade secret change

your likely response? In this case, the American company wisely chose to

“adapt” rather than “defend.”

Although the information disclosures discussed here are the most com-

mon, they are hardly comprehensive. Almost every public decision a company

Chapter 7 • Price Competition170

makes will be gleaned for information by astute competitors.

Consequently,

companies in price-competitive industries should take steps to manage how

their moves are seen by competitors, just as they manage the perceptions of

stockholders and securities analysts. For example, will competitors in a highly

price-competitive industry interpret closure of a plant as a sign of ﬁ nancial

weakness or as a sign that the company is taking steps to end an industry-

wide overcapacity problem? How they interpret such a move will probably

affect how they react to it. It is in the company’s interest to supply information

that leads competitors to reach a more favorable interpretation. Think twice,

however, before disseminating misleading information that competitors will

ultimately discover is incorrect. You may gain in the short run, but you will

undermine your ability to inﬂ uence competitors’ decisions and, therefore, to

inﬂ uence price competition in the long run.

WHEN SHOULD YOU COMPETE ON PRICE?

We have been discussing the beneﬁ ts of avoiding negative-sum competitive

confrontation, but some companies have clearly built successful strategies

for proﬁ table growth based primarily on winning share by undercutting the

prices of their competitors. Did not Walmart become the largest, while still

very proﬁ table retailer, in America, and did not Ryanair become the largest

and most proﬁ table airline in Europe, primarily based upon the promise of

lower prices? Yes, and understanding the special circumstances that enabled

them to grow proﬁ tably despite offering lower prices is necessary for any-

one trying to replicate such success. Every company that succeeds in growing

proﬁ tably with a low-price strategy must ﬁ rst create a business model that

enables it to cut incremental costs below those of its competitors. Walmart

did so by creating an efﬁ cient distribution network and managing inventory

more efﬁ ciently than its competitors. Ryanair did so by, among other things,

building a non-union workforce and ﬂ ying planes to underutilized airports.

So long as each could attract customers with a price difference smaller than its

cost advantage, it could win customers without reducing industry proﬁ tabil-

ity. Or, to put it another way, when Walmart or Ryanair won a customer from

a competitor, it was not a negative-sum game. In fact, by serving customers

more cost-effectively, these companies actually earned proﬁ ts from each cus-

tomer above those earned by their higher-priced competition—making their

competitive efforts a positive-sum game.

However, a competitive cost advantage was not by itself enough to win

market share proﬁ tably. All of these companies must also orchestrate a cam-

paign of information to convince their competitors that their cost advantages

are decisive. Eventually, even companies that grow through price competition

usually recognize that unless they can continue to grow faster than competi-

tors, price cutting cannot be a proﬁ table growth strategy indeﬁ nitely. Conse-

quently, they ultimately shift their strategies toward adding more value in

ways that enable them to sustain their large market shares without having to

sustain such a large price advantage indeﬁ nitely.

Under what conditions are the rewards from aggressive pricing large

enough to justify a low price growth strategy? There are only four:

1. If a company enjoys a substantial incremental cost advantage or can

achieve one with a low-price strategy, its competitors may be unable to

Chapter 7 • Price Competition 171

match its price cuts. Walmart, Dell, and Ryanair created low-cost busi-

ness models that enabled them to grow proﬁ tably using price. In some

markets, there may be an “experience effect” that justiﬁ es aggressive

pricing based on the promise of lower costs. By pricing low and accu-

mulating volume faster than competitors, a ﬁ rm reduces its costs below

those of competitors, thus creating a competitive advantage through low

pricing. We, however, are skeptical that such effects exist in any but a

few high-technology markets.

2. If a company’s product offering is attractive to only a small share of the

market served by competitors, it may rightly assume that competitors will

be unwilling to respond to the threat. The key to such a strategy, however,

is to remain focused. Enterprise Rent-A-Car initially managed to grow

quite large before any major competitor responded to its growth because

Enterprise stuck to serving off-airport customers. By the time it challenged

the market leaders for the more lucrative on-airport business, it had already

achieved a scale of operations that enabled it to be cost-competitive.

3. If a company can effectively subsidize losses in one market because of

the proﬁ ts it can generate selling complementary products, it may be

able to establish a price differential that competitors will be unable to

close. For example, after its launch in 1995, Amazon’s rationale for its

low pricing on books was to build up a body of loyal customers to which

it could sell a broad range of other products—which now comprise a

much larger share of revenue than its sales of books. More recently,

Amazon has offered discounts on its Prime membership fee to build up

viewership for its new content offerings like “Grand Tour”—as well as

increase the installed base of consumers interested in purchasing from its

vast assortment of other products and content.

4. Sometimes price competition expands a market sufﬁ ciently that, despite

lower margins and competitors’ refusals to allow another company to

undercut them, industry proﬁ tability can still increase. Managers who

take this course are assuming that they have insight that their competi-

tors lack and are, in effect, leading the industry toward pricing that is, in

fact, in their best interest.

Before embarking on a price-based strategy, ask which of these four points

describes your rationale and recognize that a growth strategy can rarely be

built on price alone or sustained indeﬁ nitely.

Summary

No other weapon in a marketer’s arsenal

can boost sales more quickly or effec-

tively than price. Price discounting—

whether explicit or disguised with

rebates, coupons, or generous terms—is

usually a sure way to enhance immedi-

ate proﬁ tability. However, gaining sales

with price is consistent with long-term

proﬁ tability only when managed as part

of a marketing strategy for achieving,

exploiting, or sustaining a longer-term

competitive advantage. No price cut

should ever be initiated simply to make

the next sale or to meet some short-term

sales objective without being balanced

against the likely reactions of competi-

tors and customers. The key to proﬁ table

pricing is building and sustaining com-

petitive advantage. There are times when

price cutting is consistent with building

advantage, but it is never an appropriate

substitute for it.

Chapter 7 • Price Competition172

Notes

1. Sun Tzu, The Art of War, Chapter IV,

“Disposition of the Army,” 5th cen-

tury B.C.

2 . For more on the practical applica-

tions of game theory, see Adam

Brandenburger and Barry Nalebuff,

Competition (New York: Doubleday,

1996); Rita Koselka, “Evolutionary

Economics: Nice Guys Don’t Fin-

ish Last,” Fortune , October 11, 1993,

pp. 110–114; and Kenichi Ohmae,

“Getting Back to Strategy,” Har-

vard Business Review (November–

December 1988), pp. 149–156.

3 . B. H. Liddell Hart, Strategy (New

York: Meridian, 1967), p. 322.

4 . Gordon Kristopher, “Crude Oil’s

Total Cost of Production Impacts

Major Oil Producers,” Market Realist ,

January 13, 2016.

5 . Michael E. Porter, “What Is Strat-

egy?” Harvard Business Review

(November–December 1996), pp.

60–78. See also Michael E. Porter,

Competitive Strategy (New York: The

Free Press, 1980), p. 34.

6 . Porter, op. cit., pp. 41–43. A ﬁ rm

can become large without getting

“stuck in the middle” simply by

taking on multiple segments. The

segments must be managed, how-

ever, as a conglomerate of focused

businesses rather than as a one-

size-ﬁ ts-all marketing organization.

Procter & Gamble is an excellent

example of a large company that

nevertheless carefully targets each

product to meet the needs of a par-

ticular focused segment.

7 . Ellen Byron, “Tide Turns ‘Basic’ for

P&G in Slump,” Wall Street Journal ,

August 6, 2009.

8 . Akshay R. Rao, Mark E. Bergen,

and Scott Davis, “How to Fight a

Price War,” Harvard Business Review

(March–April 2000), pp. 107–116.

9 . See the discussion on predatory

pricing in Chapter 12.

10 . “As Alliances Fade, Computer Firms

Toss Out Playbook,” Wall Street

Journal , October 15, 2002, p. A1;

“Dude, You’re Getting a Printer;

Dell’s Printer Business Is Puny

Next to HP’s, But It’s Quickly

Gaining Ground,” Business Week

Online , April 19, 2004, p. 12.

11 . Note that this principle applies

in the other direction as well. If

competitors quickly follow price

increases, the cost of leading such

increases is vastly reduced. Con-

sequently, companies that wish to

encourage responsible leadership

by other ﬁ rms would do well to fol-

low their moves quickly, whether

up or down.

12 . See Francine Schwadel, “Ferocious

Competition Tests the Pricing Skills

of a Retail Manager,” Wall Street

Journal , December 11, 1989, p. 1.

13 . Another useful tactic that can con-

trol such duplicitous behavior in

U.S. markets is to require the cus-

tomer, in order to get the lower

price, to initial a clause on the order

form that states the customer under-

stands this is “a discriminatorily

low price offered solely to meet the

price offered by a competitor.” Since

falsely soliciting a discriminatorily

low price is a Robinson–Patman

Act violation, the purchasing agent

is discouraged from using leverage

unless he or she actually has it.

14 . For more guidance on collecting

competitive information, see “These

Guys Aren’t Spooks, They’re Com-

petitive Analysts,” Business Week ,

October 14, 1991, p. 97; and Leon-

ard M. Fuld, Competitor Intelligence:

How to Get It—How to Use It (New

York: Wiley & Sons, 1985).

15 . For a comprehensive and insightful

survey of the research on commu-

nicating competitive information,

see Oliver P. Heil and Arlen W.

Langvardt, “The Interface Between

Competitive Market Signaling and

Antitrust Law,” Journal of Marketing

58(3) (July 1994), pp. 81–96.

CHAPTER 8

Measurement of

Price Sensitivity

Research Techniques to

Supplement Judgment

Look into nature, and then you will understand it better.

Albert Einstein

Quantitative estimates of customer price sensitivity and willingness-to-pay

can substantially improve both price setting and price segmentation. Indeed,

some estimate of price sensitivity, whether it be quantitative or qualitative,

is required for the price-setting process described in Chapter 6. Sometimes

research can provide very speciﬁ c estimates of the impact of prices on sales

volume. Other times estimates provide only a rough indication of a customer’s

willingness-to-pay given a set of circumstances. At their worst, estimates of

price sensitivity fail to reﬂ ect the real nature of the buying decision, mislead-

ing management to make ineffective pricing decisions. This is often the case

when a research design causes respondents to pay much more attention to

price than real customers would.

In almost all cases, it is possible to develop an estimate of price sensi-

tivity. The key to using the estimate effectively is to recognize that even a

precise estimate is not necessarily accurate or unbiased. It is only an approxi-

mation of the actual value of a customer’s price sensitivity. We always need

to consider how differences between a real purchase situation in the future

and an experiment in the present or past can change the impact of price

on a customer’s choice. There are numerous procedures for measuring and

estimating price sensitivity. Each procedure offers particular advantages

in terms of accuracy, cost, and applicability, so the choice is not arbitrary.

One must think carefully about the appropriate procedure for any particular

product before beginning research. In no case should a manager use a tech-

nique just because it is cheap, convenient, or fast. Instead, managers need to

carefully assess their needs and adopt techniques that are most appropriate

Chapter 8 • Measurement of Price Sensitivity 174

for their situation. Even if the cost for those techniques is high, the beneﬁ t is

often sufﬁ ciently large to justify the expense.

TYPES OF MEASUREMENT PROCEDURES

Procedures for estimating price sensitivity differ on two major dimensions:

The conditions of measurement and the variable being measured. Exhibit 8-1

classiﬁ es the various procedures according to these two dimensions. The con-

ditions of measurement range from a completely uncontrolled to a highly

controlled research environment. When making uncontrolled measurements,

researchers are only observers. They measure what people actually do, or say

they would do, in a situation not of the researcher’s making. For example,

marketing researchers might collect data on consumer purchases of laundry

detergent in a grocery store, but the prices and other variables that inﬂ uence

those purchases are beyond their control. This is often the case when analyz-

ing historical sales data.

In contrast, when making controlled measurements, researchers manip-

ulate the important variables that inﬂ uence consumer behavior to more pre-

cisely observe their effect. Researchers conducting a controlled study of price

sensitivity for a laundry detergent could select the prices as well as the adver-

tising and shelf placement of various brands in order to make the data more

useful. They might attempt to gain even more control by conducting a labora-

tory experiment in a simulated store, carefully selecting the individuals whose

purchases would be recorded. Participants for the experiment could be cho-

sen to represent various demographic variables (such as geographic location,

gender, income, and family size) in proportions equal to those of the prod-

uct’s actual market or to represent a particular group (such as mothers with

children) to whom the product was intended to appeal. Generally, controlled

research produces more accurate estimates of the effects of the controlled vari-

ables on price sensitivity, but depending on the level of realism, it is often

costly to implement in a real-world setting. A laboratory setting is often used

to better control other factors that may affect price sensitivity as well as to

reduce costs, but these improvements come at the expense of realism.

EXHIBIT 8-1

Techniques for Measuring Price Sensitivity

Chapter 8 • Measurement of Price Sensitivity 175

The dependent variable for estimating price sensitivity is either actual

purchases or purchase preferences and intentions. Actual-purchase studies

measure behavior, whereas preference-intention studies measure the intended

choices that people claim they would make in a hypothetical purchase situa-

tion. Since the ultimate goal of the research is to estimate how people respond

to price changes in actual purchase situations, research that measures actual

behavior is generally more desirable, but it is also more costly, time-consuming,

and sometimes impractical, given the need to move products to market

quickly. The following discussion summarizes these research techniques and

some of the trade-offs of choosing one method over another.

Uncontrolled Studies of Actual Purchases

One way to estimate price sensitivity is to analyze past sales data. Naturally,

one would expect this to work well in assessing the price sensitivity of cus-

tomers for existing products in which consumers have prior-use experience.

Given the increased use of scanners in supermarkets and mass merchan-

disers, databases maintained by hotels and airlines on their most frequent

customers, and user proﬁ les by online sellers, analysis of historical pricing

and sales data has become an important source of information to evaluate

customer response to pricing, promotions and other marketing activities.

Still, changes in (i) the number of brands on the market, (ii) how recently

competitors offered price promotions, (iii) the amount and effectiveness of

advertising by each brand, (iv) increased price sensitivity of more-educated

consumers, and (v) general economic conditions can undermine the ability of

historical data analysis to diagnose the true effects of a price change.

There are three types of past sales data from which a marketing researcher

might attempt to estimate price sensitivity: (i) Historical sales data—sales

reports from a company’s own records or from a sales-monitoring service;

(ii) panel data—individual purchase reports from members of a consumer

panel; and (iii) store scanner data—sales data for an individual retail outlet.

Historical Sales Data

Sales data collected as part of a company’s regular operation are cheap and

available for all products that have prior sales histories. Given the ability to

actually track data on a daily or even real-time basis, marketers are able to

analyze trends and project future movement of product sales. One needs to be

careful in recognizing that sales data only allow for the estimation of price

elasticity of the next level in the channel. For example, in a retail environ-

ment, unless a manufacturer sells directly to the end-user, its sales data reﬂ ect

shipments to retailers, not actual retail sales during the period. Retailers may

stockpile products purchased at promotional prices with no intention of pass-

ing the savings on to the consumer, or in anticipation of increases in demand

on the part of consumers in a later period. Understanding this, some marketers

at manufacturers have direct links with the inventory movement of their retail

outlets, combined with up-to-date retail price data. While this is generally part

of a manufacturer’s inventory-management system to facilitate timely replace-

ment of stock, it also provides the marketer with instant data that can be ana-

lyzed for important trends in demand.

Chapter 8 • Measurement of Price Sensitivity 176

In the past, using historical data for any product not sold directly to the

end consumer was problematic. Sales data was usually available only at an

aggregated level for a long period of time—say, a week. In any given week,

some stores will charge higher prices than others. Over time, the same store

will put the product on sale for a week and then return its price to the reg-

ular level. These price variations inﬂ uenced sales, but were masked by the

aggregation.

Unfortunately, data that aggregate sales for all stores over a number of

weeks conceal these individual price differences. Given the aggregation in the

data, the researcher is forced to explain sales variations by looking at only

the average retail price across stores and throughout the time period. Since

average prices have less variation and fewer observations than actual prices at

individual stores in particular weeks, the data have less statistical power than

data on individual purchase prices. In addition, some stores serve segments

that are substantially more price responsive than others; for example, a drug

store located in a posh downtown area is often frequented by consumers who

are less price sensitive than those who might shop at a suburban location of

the same retailer. As a result, aggregated sales data can mask these differences

and will lead to price elasticity estimates that may, on average, be correct, but

do not really apply to any single store setting.

Now, however, nearly all retailers track their sales and most sell their

data to manufacturers (often via third party data aggregators). Since sales can

be observed within short time-frames, and loyalty cards can enable tracking

changes in an individual shopper’s behavior over time, researchers today have

more tools, and more data than ever before to readily track the impact of regu-

lar and promotional price differences.

Panel Data

A number of marketing research companies collect individual purchase data

from panels of a few thousand households. Each household keeps a daily

record of all brands purchased and prices paid, or uses a special credit card

that tracks purchases. Since products are purchased daily, the data for each

household must be aggregated to produce a series on weekly or bi-weekly

purchases. Such data have a number of advantages:

1. One can accumulate observations more quickly with weekly panel data

than with bimonthly or quarterly sales data, reducing the problem that

other factors may change and reduce the comparability of the data.

2. One can observe the actual price paid, rather than an average of the retail

prices that different stores charge, and one can identify sales that were

made with coupons or promotions that alter the price actually paid.

This captures more price variation in the data, making the effects of price

changes easier to detect.

3. One can get data on the sales and prices of competing products (pro-

vided someone in the panel bought them), as well as on the sales of one’s

own product.

4. One can correlate price sensitivity with various demographic clas-

siﬁ cations of consumers and possibly identify opportunities for

segmentation.

Chapter 8 • Measurement of Price Sensitivity 177

One potential drawback is that panel data may not be adequately represen-

tative of the market as a whole. Of all households invited to join a panel,

fewer than 5 percent accept the offer and accurately record their purchases.

There is reason to suspect, therefore, that panel members are a biased sample

of the population. Moreover, the fact that panel members must record their

purchases tends to make them more price aware, and thus more price sensi-

tive. This problem increases the longer a household participates in a panel.

Fortunately, technological advances have enabled research companies to

develop panels that do not require consumers to record most of their pur-

chases.

Instead, in-store scanners record purchases automatically whenever

panel members identify themselves in the store’s checkout line. This vastly

simpliﬁ es panel membership, increasing the panel participation rate to more

than 70 percent and attenuating the problem of heightened price awareness.

Further, the data tend to be more representative of real purchasing behavior

of consumers without the bias that has been problematic in the past.

A second potential drawback to panel data is that typically only one

member of the household agrees to participate in the panel, yet in most house-

holds multiple people perform shopping duties. As a result, it is easy to miss

purchase data from the non-participating member(s) of the household, who

often have very different criteria for making purchase decisions. For example,

if the non-participating family member joins a discount warehouse club and

purchases cereal by the bushel, the family is essentially out of the cereal mar-

ket for a while, no matter how substantial a discount is offered to the partici-

pating panel member.

Even with these caveats, panel data remains valuable. Given the ever-

widening use of scanners and the ability to link scanner data with panel data,

increasing numbers of consumer products can be analyzed using this type of

analysis. The superiority of panel data estimates over those from aggregate

sales data is due to the availability of more observations from a shorter and

more comparable time period. With the availability of advertising and other

promotional data, researchers are able to estimate price sensitivities for differ-

ent customer groups with a reasonable degree of reliability (see “Using Panel

Data to Measure the Impact of Promotion on Choice” below). Since multiple

companies share the cost of the same ongoing research, estimates based on

panel data are also less expensive than estimates based on an equal number of

observations from proprietary research.

Using Panel Data to Measure the Impact of Promotion on Choice

As an example of how panel data can be used, consider a study where the

authors asked two important questions: Whether consumers are getting

more price sensitive and whether the group of price-sensitive consumers

is growing. To evaluate these and other questions, the authors examined

more than eight years of usage data from a panel of consumers and were

able to compare those data with quarterly advertising data from manufac-

turers of non-food household products. They were able to evaluate three

different types of price promotions: Temporary price reduction, price fea-

ture of the product, and the offering of a coupon. A multinomial logit

Chapter 8 • Measurement of Price Sensitivity 178

Store-Level Transaction Data

An alternate source of actual sales comes from auditing price transactions and

sales at individual retail stores. Modern point-of-sale technologies have made

accurate daily sales and price data available at reasonable cost. Retailers, both

online and bricks-and-mortar, generate such data as part of their normal oper-

ations. The high frequency of transaction-level data makes it vastly superior to

aggregate sales data, providing marketers with almost immediate information

on the movement of their product. Although transaction data alone lacks the

balanced and complete demographics of consumer panel data, mechanisms

such as loyalty cards and online proﬁ les allow many transactions to be con-

nected to speciﬁ c consumers to study differences across consumer segments

and to track changes in purchase behavior over time.

Transaction data generally also costs less than panel data. When store

scanner data can be combined with panel data that track the demographic

and broader behavioral characteristics of consumers, researchers often get

model was used to evaluate the impact of the promotional (price and non-

price) activities on the consumer’s choice of a product. Further, they were

able to segment users into loyal and non-loyal segments and compare the

price sensitivities of the two groups. The summarized results are shown

in Exhibit 8-2.

Price sensitivities shown are averaged across all of the periods ana-

lyzed. Based on the elasticities, the loyal segment showed little price sensi-

tivity, but it did increase over time. The non-loyal, price-oriented segment

showed higher price sensitivities that increased over time as well. The

study authors did note that the size of the non-loyal segment increased

over time, indicating that “an increasing proportion of consumers have

become more price and promotion sensitive over time.”

Source: Carl F. Mela, Sunil Gupta, and Donald R. Lehmann, “The Long-Term Impact of

Promotion and Advertising on Consumer Brand Choice,” Journal of Marketing Research 34

(May 1997), pp. 248–261.

EXHIBIT 8-2

Regression Analysis Results

Chapter 8 • Measurement of Price Sensitivity 179

huge insights into shoppers’ price sensitivity and purchasing behaviors.

Transaction data are a major source of information on the price sensitivity of

consumer-packaged goods.

While transactional sales data—in the form of panels, purchase histories,

and scanner data—are quite prevalent in the consumer-packaged goods indus-

try, in many business-to-business markets there are simply too few transactions

and insufﬁ cient market oversight to develop similar data sets. However, not

all is lost. We recently spoke with a company that created a competitive sales

database. This company, a tractor manufacturer, created an internal database

in which its sales force would register any competitive bid information. Over

time the company built a database of competitive price information which,

combined with the record of its own bid outcome history, allows the ﬁ rm to

estimate the price sensitivity of customers, by segment if necessary, as well as

to estimate the incremental value its tractors offered over the competition. The

total investment for creating this competitive intelligence capability was on

the order of $50,000—a small sum for this multi-billion dollar company.

In this case, there is some level of bias in the data that one needs to be

aware of—the competitive quotes are being obtained from customers who

have an incentive to provide lower-than-actual prices. One thus needs to

adjust the distribution to reﬂ ect the bias; if one can conﬁ rm actual quotes for

a sample of transactions, then it is possible to estimate the actual level of bias.

One also needs to be careful to normalize competitive quotes so that equiva-

lent comparisons are being made. Are after-sales services, special ﬁ nancing

terms, or training included, for example? Companies such as Gigwalk have

cultivated a cloud-based workforce that can rapidly execute a range of tasks

such as gathering in-store prices across the country, sourcing competitive price

information, completing short surveys, and gathering other market insights.

Further, when the quote history is overlaid with actual sales success

data, it is possible to estimate the likelihood of achieving a sale at any given

price level. It also is possible to estimate the decline in the probability of a sale

as price increases—a form of estimating price sensitivity as well as a way to

estimate the amount of money left on the table in successful bids.

Finally, as ﬁ rms update their pricing capabilities, many are discover-

ing new opportunities to study responses to pricing actions. For example,

as companies invest in technologies that allow for rapid and frequent price

changes, they can look to yield management techniques that allow for the

study of demand changes in response to pricing actions. Motel 6 for example,

has the ability to post prices electronically on its billboards and can change

these prices—at nearly no cost—by the hour. In only a short span of time, this

company can study the price responsiveness of its customers by location, by

day of week, and even by time of day. As companies add to their ability to set

and manage prices, new opportunities will become available to create “natural

experiments” to allow for the study of price reactions at relatively low cost.

Analyzing Historical Data

Analysis of historical sales data often involves application of multivariate

regression analysis. This statistical technique attempts to show how much of

the historical variation in a product’s sales can be explained by each of the

explanatory variables, including price, that the researcher includes in the

Chapter 8 • Measurement of Price Sensitivity 180

analysis. One should not expect, however, that the researcher will necessarily

succeed in identifying the effect of price with such an analysis. For example,

if there has been little historical variation in a product’s price, then no statistical

technique applied to its sales data can reveal the effect of price changes. Another

common challenge in pricing analytics is the effect of multi-collinearity:

If another variable—such as advertising—is always changed along with price,

perhaps to advertise a price discount, it is very difﬁ cult to disentangle the

impact of the price discount from the promotion. Fortunately, there are many

sophisticated multivariate techniques available to help with such situations;

a detailed discussion is beyond the scope of this book. We recommend the

reader interested in advanced modeling techniques to consult a good econo-

metrics textbook.

In any case, one must be careful to recognize the limits of a success-

ful analysis of historical data. To estimate any equation, the researcher must

develop a mathematical form for the relationship between price and sales,

taking into account other inputs that may affect the buying decision such as

competitive prices, consumer conﬁ dence, weather patterns, among other fac-

tors. To the extent that the assumed form incorrectly speciﬁ es the relationship,

estimates of price sensitivity may be misleading. Moreover, the researcher’s

estimate of price sensitivity is valid only over the range of price and other

input levels used to estimate the relationship. There is no reason to believe

that the same relationship would necessarily apply to price changes outside

that range. One also needs to be careful to look at the size of the corresponding

error terms in the model to understand its quality and accuracy.

Finally, regardless of how well an estimated equation ﬁ ts past data, its

value in predicting the effect of future price changes rests on the assumption

that the future is like the past. The more other factors change, the less the past

can predict the future. Despite these limitations, if a researcher has a lot of

historical data with enough price variation in it, useful estimates of price sen-

sitivity are possible.

For multiproduct companies, an understanding of price

responsiveness can be used to help optimize demand ﬂ ow across a product

line. Speciﬁ cally, prices can be adjusted to direct demand to speciﬁ c products

to better manage inventories, obtain better leverage with suppliers, and yet

at the same time allow a wide product selection for customers who require

speciﬁ c items.

Exhibit 8-3 shows the results of research that utilized regression analysis to

evaluate the relative importance of interest rates (a form of credit-card pricing)

relative to other product attributes among two groups of credit-card holders:

Those who are loyal (more than one year of ownership) and those who are

new (less than one year). The categorization of customers as new or loyal was

based on input from the managers of the credit-card company, who found that

people who used their card for at least one year tended to stay users for an

extended period of time. Of interest is the marginal increase in price sensitiv-

ity as measured by sensitivity to interest rates, for non-loyal customers (attri-

bute importance of 0.16 compared to 0.14 for loyal customers) and the very

large difference in need for service. As is the case in many product categories,

the relative importance of price—and other elements of the offer—can vary

signiﬁ cantly over time and across customer segments. Understanding where

these differences reside usually leads to more precise targeting of offers and

key messages in order to drive sales more cost-effectively.

Chapter 8 • Measurement of Price Sensitivity 181

EXPERIMENTALLY CONTROLLED STUDIES OF

ACTUAL PURCHASES

A researcher might attempt to estimate price sensitivity by generating experi-

mental purchase data. Such data may come from pricing experiments con-

ducted in a store without the buyers’ knowledge or from pricing experiments

conducted in a laboratory. Since the researcher controls the experiment, price

variations can be created as desired to generate results while holding constant

other marketing variables, such as advertising levels, in-store displays, or

competitive prices which often change with price variations in uncontrolled

sales data.

With this method, the researcher can examine the effect of a number of

different prices quickly and either (i) exclude many unwanted external effects

in the laboratory experiment or (ii) establish a control for the in-store experi-

ment that will take account of them. Moreover, all this can be done while still

providing buyers with purchase decisions that are comparable to those they

make under normal conditions. As a result, to the degree that the experimental

setting reﬂ ects the actual purchase environment, experimental research pro-

vides fairly reliable estimates of price sensitivity.

In-Store Purchase Experiments

An in-store purchase experiment relies on actual purchase data collected when

buyers are unaware that they are participating in an experiment. Although

the term “in-store” reﬂ ects the fact that most such experiments are conducted

in stores, the principles of in-store experimentation are equally applicable to

EXHIBIT 8-3

Use of Regression Analysis

Chapter 8 • Measurement of Price Sensitivity 182

any natural purchase environment. Such experiments are often easier to con-

duct for products sold through more controlled direct-retail methods, such as

online sites, where a user’s web browser cookie history can be used to deter-

mine the offer to deliver and to track response. For example, the researcher can

select a subset of registered users to receive offers with experimental prices

that differ from those in the regular website. Even in direct sales to business,

one can sometimes select a representative sample of customers. When, for

example, Quaker Oats conducted an in-store experiment that focused on the

effect of price alone, the study required 120 stores and ran for three months to

provide enough data to create accurate market insights. Such studies can eas-

ily cost several million dollars.

In addition to the ﬁ nancial and time cost of in-store experiments, there

are other drawbacks. There is the potential loss of consumer goodwill when

some buyers are charged higher prices than others. On the other hand, charg-

ing prices below normal can become too costly when the product is a large-

expenditure durable such as a car or a piece of industrial equipment. An

in-store test also involves the very real risk of being discovered by a competi-

tor. If the product is new, a company may not wish to give its competitors an

advance look. Moreover, when competitors ﬁ nd out about a test market, they

may take steps, such as special promotions or advertising in selected areas, to

contaminate the results.

Thus, although in-store experiments have the poten-

tial for yielding very high-quality estimates, market researchers are more often

forced to use alternatives. The closest of those alternatives is a laboratory pur-

chase experiment.

Laboratory Purchase Experiments

Laboratory purchase experiments attempt to duplicate the realism of in-store

experimentation without the high cost or the possible exposure to competitors.

A typical laboratory experiment takes place in a research facility at a shop-

ping mall. Interviewers intercept potential participants who are walking by

and screen them to select only those who are users of the product category

being researched. Based on information from a short pre-test questionnaire,

the researchers can control the proportion of participants in each demographic

classiﬁ cation (for example, gender, age, race, income, or family size) to ensure

that the experimental population is representative of the actual population of

buyers, a technique known as proportionate sampling. If members of some

demographic categories cannot be found in adequate numbers in the mall,

telephone interviews may be used to contact such people and offer them an

incentive to come and participate in the experiment.

The laboratory researcher can control who participates and can quickly

manipulate prices and other elements in the purchase environment (such as

shelf location and point-of-purchase displays), all at a single location. More-

over, the researcher can almost entirely eliminate external factors, such as

changes in competitors’ prices, stock-outs of competing products, or differ-

ences among stores that may contaminate the results of an in-store test. Par-

ticipants exposed to different prices see exactly the same display at the same

location in the laboratory experiment. Even effects associated with the time of

day can be controlled by constantly changing prices for each new participant

in the experiment. Thus, if testing three different price levels, approximately

Chapter 8 • Measurement of Price Sensitivity 183

one-third of the consumers who take the test at any hour can be exposed to

each price level. This ability to control the experiment so closely enables the

researcher to draw inferences from far fewer purchases in much less time than

would be possible with an in-store experiment.

Laboratory research facilities vary greatly depending on the sophis-

tication of the research organization and the budget of the client company.

The simplest facilities may consist of an interviewing room with a display of

products from a single product category. The price for each brand is clearly

marked, and the participant is invited to make a purchase. In theory, since

the consumer is actually making a purchase, or can choose not to buy at

all, the purchase decision in a simple laboratory experiment is the same one

that the consumer would make shopping in an actual retail store. In practice,

however, that conclusion may not be true. The problem lies in the artiﬁ cial-

ity of a simple laboratory environment. First, a single display in a laboratory

encourages the consumer to give the purchase decision much more attention

than would be typical in an actual shopping situation. Research indicates that

most consumers are not entirely aware of price levels in a store, nor are they

acutely aware of the magnitude of price changes.

In a laboratory, however,

consumers do not want to appear careless. They are, therefore, much more

likely to note and respond to price differences. Second, when consumers know

they are being watched from behind two-way mirrors, they may act “as they

think they should” rather than as they would in real life. Thus some consumers

may buy the low-priced brand just to appear to be smart shoppers, or the high-

priced brand so as not to appear stingy. They may also buy something from

the category out of a feeling of obligation to the researcher who gave them the

money, even though they would not buy from that category in a store.

To overcome these limitations, a few research companies offer highly

sophisticated laboratory research facilities. The most elaborate facilities

attempt to duplicate as closely as possible the actual conditions under which

consumers buy the product. These facilities contain complete simulated stores

the size of small convenience stores. Before entering the simulated store, con-

sumers may view reruns of television programs that have embedded televi-

sion commercials for the research product, or they may read magazines that

contain print advertisements for the product. When consumers ﬁ nally enter

the store, they are invited to do all their shopping, purchasing whatever they

want, just as they would on a regular shopping trip.

The cost of even the most sophisticated laboratory experiment is only a

small fraction of the cost of in-store testing. As a result, the leading marketers

of consumer packaged goods and small appliances rely extensively on this

research technique when making pricing decisions.

In the past decade, the

number and frequency of laboratory purchase experiments for products sold

online has boomed. The cost to design a realistic purchase environment, to

control the promotional message, and to recruit respondents online is so low

that it is possible to test more frequently, to get answers faster, and to employ

much larger samples than marketers would usually have considered. Compa-

nies that design this type of research can solicit participants via pop-up ads on

targeted websites. To reach buyers in very “thin” markets, such as purchasers

of industrial equipment or adventure vacations, marketers can buy special-

ized panel data from research vendors to solicit participants. Consequently,

a realistic internet purchase experiment can take as little as a week and cost

Chapter 8 • Measurement of Price Sensitivity 184

one-tenth what similar research would cost in another purchase environment.

The story below, “Measuring Price Sensitivity for e-Books,” describes a lab-

oratory experiment for a company considering entry into an existing online

marketplace.

Measuring Price Sensitivity for e-Books

An online retailer wanted to test its ability to price some popular elec-

tronic book titles above the established level of $9.99 or less per down-

load. If proven successful, the retailer felt that publishers would become

less resistant to publishing their latest and best titles digitally. The retailer

hoped to understand whether its customers would accept a segmented

pricing model with higher prices for new, bestseller titles—particularly

since bookstores generally price hard copies of newly released titles as

loss leaders to draw store trafﬁ c. Such a model might use a lower e-book

price for older titles that had migrated to paperback while continuing to

price e-book titles that are still in hardback at higher prices.

The company engaged a research ﬁ rm to design an online laboratory

experiment, recruit 2,000 respondents, and analyze the results. To protect

its reputation, the online laboratory store was given a ﬁ ctitious name.

The goal of the experiment was to understand the extent to which higher

prices would affect consumers’ e-book purchase behavior. The market

research company spent one-and-a-half weeks designing the experiment

and recruiting respondents from email lists of electronic book purchasers.

Respondents participating in the experiment were ﬁ rst asked their genre

preferences, following which they were presented with several e-book

options in each of their preferred genres. The e-books varied in price and

time since publication. Some e-books were given prices above the stan-

dard $9.99 and some were priced at or below $9.99. The experiment was

designed to replicate, as closely as possible, the experience a consumer

would have purchasing a book online. Respondents were asked to add

e-books to their shopping basket as if they were actually shopping on a

website and they could monitor how much they had in their shopping

cart. At the end of the experiment, respondents were presented with their

total order and cost and given the opportunity to remove items from their

shopping basket before conﬁ rming their order.

Only one-and-a-half weeks after the launch online, more than

2,000 respondents had completed the experiment through conﬁ rming a

purchase. After another week, the research company had completed its

analysis of price sensitivity by demographic, type of book, and various

other segmentations.

Exhibit 8-4 shows the answer to the retailer’s main research question.

The online experiment demonstrated that e-book demand is relatively price

inelastic for prices below $9.99 but very elastic for prices above $9.99 for titles

generally available anywhere. However, respondents did show a willing-

ness to purchase new titles, not generally available in paperback or in e-book

format, at prices above $9.99. The experiment proved very insightful for the

online book retailer. They learned that there was some upward ﬂ exibility

Chapter 8 • Measurement of Price Sensitivity 185

UNCONTROLLED STUDIES OF PREFERENCES

AND INTENTIONS

The most common research technique for directly estimating price sensitivity

is the survey of brand preferences or purchase intentions. Companies prefer to

measure preferences or intentions, rather than actual purchases, for a number

of reasons:

1. Survey data costs much less to collect than purchase data.

2. Survey data can be measured for large, infrequently purchased, durable

goods, such as automobiles or smartphones, for which in-store or labora-

tory experiments at various prices are impractical.

3. Survey data can be collected even before a product is designed, when the

information is most valuable in directing product development.

4. The results can be collected quickly.

Unfortunately, the problem with survey research is that many consumers do

not provide answers that are a reliable guide to their actual purchase behavior.

in their prices for newer books, but a downward adjustment for older

books would not generate sufﬁ cient additional purchases to justify the drop

in price. As a result of the experiment, the retailer decided to launch a seg-

mented pricing model, offering publishers the chance to earn higher proﬁ ts

on e-book sales if they authorized them along with the hardback edition.

Source: Deloitte research. Although this description is based on an actual study, some details have

been changed to maintain client conﬁ dentiality.

EXHIBIT 8-4

e-Books: Purchase Rate by Price

Chapter 8 • Measurement of Price Sensitivity 186

The reasons are varied, but one of the main issues is that surveys require a level

of abstraction that the respondent may or may not be able to perform. This is

especially true of new products that are wholly unfamiliar or whose applica-

tion is not readily apparent. As a result, determination of value delivered, or

willingness-to-pay, is difﬁ cult to arrive at even for a committed respondent. In

order to solve this problem, some research companies cross-validate the results

of one survey with the results of another, often using slightly different methods

of data collection and questioning. For example, a ﬁ rm might collect data using

personal interviews and validate the results by telephoning a different group of

respondents and asking the same set of questions. The closer the results are from

the two samples and methods, the more valid and accurate the ﬁ nal results.

Direct Questioning

Very early in the development of survey techniques for marketing, research-

ers learned that it was futile to ask consumers outright, “What is the most you

would be willing to pay for this product?” Direct questioning sometimes elic-

its bargaining behavior, with consumers stating a lower price than they would

actually pay. Other times, it elicits a desire to please the researcher, prompting

consumers to state a higher price than they would actually pay. Frequently,

it simply elicits a cursory answer that consumers would change were they

to give the question the same thought as an actual purchase decision. Conse-

quently, uncontrolled direct questioning as a research technique to estimate

price sensitivity should never be accepted as a valid methodology. The results

of such studies are at best useless and are potentially highly misleading.

Buy-Response Surveys

A slight variant of the direct-question survey involves showing consumers a

product at a preselected price and asking if they would purchase at that price.

Surprisingly, although directly asking consumers what they would pay usually

yields meaningless answers, asking them if they would buy at a preselected

price yields answers that are at least plausible. When the answers given by dif-

ferent consumers for different price levels are aggregated, they produce what

looks like a demand curve for market share, sometimes called a purchase prob-

ability curve. (For more on purchase probability curves, see “Purchase Probabil-

ity Curves: A Simple Buy-Response Study,” below). Presumably, questioning

willingness-to-buy generates better responses simply because it is structured

more like an actual purchase decision than as an open-ended question about

what the consumer would pay. Also, the consumer has no opportunity to bar-

gain with the researcher.

Interestingly, there are a number of studies that have

documented cultural differences that lead to large amounts of substantial and

systematic variation in the accuracy of buy-response surveys across countries

such as the United States, Germany, and Japan, among others.

Attribute Rating

Another method for evaluating price sensitivity is to include price as one of

the attributes describing a product or a purchase situation. Consumers rate the

importance of each attribute using a variety of scaling techniques. Those scales

Chapter 8 • Measurement of Price Sensitivity 187

can be a 1–5 or a 1–10 importance rating, or simply an evaluation of the percent

of respondents mentioning the attribute as being important.

This approach

is problematic because responses tend to be offhand and overly positive, due

to halo effects, where respondents tend to not carefully discriminate among

listed attributes and give similar ratings or responses to many attributes, espe-

cially those adjacent to each other.

Purchase Probability Curves: A Simple Buy-Response

Study—Opportunity for a Higher Price

A maker of software had developed an innovative ﬁ nancial management

program that allowed consumers to both manage their ﬁ nances as well as

prepare their tax returns. To understand the impact of price on demand,

the software company conducted a national study to assess how consum-

ers would value the new technology and whether they would be willing

to pay a premium. The research started with conducting in-home inter-

views of consumers (a research methodology known as ethnographic

research) to understand how they thought about personal ﬁ nances and

how they managed them. An initial ﬁ nding from the interviews was that

consumers typically did not enjoy managing their ﬁ nances for a host of

reasons, including inevitable spousal tensions that arose when assessing

household spending patterns. However, there was a general interest in

tools that could make it easier to manage personal ﬁ nances.

With a basic understanding of the key attributes that consumers

evaluate—such as an intuitive user interface, ability to automatically

download bank statements, and automated updating of new tax codes—

an online survey of 1,800 consumers was conducted. Each respondent

was allowed to evaluate a sample copy of the software and was then

EXHIBIT 8-5

Purchase Probability Curve for Financial Software

Chapter 8 • Measurement of Price Sensitivity 188

asked the likelihood of purchase at prices that ranged from $100 to $500.

The ﬁ ndings on purchase probability as a function of price are summa-

rized in Exhibit 8-5. At $100, 58 percent of the consumers indicated that

they would purchase the product. As price rose to $200, not surprisingly,

fewer respondents were willing to buy. However for successive increases

in price, the percent of respondents willing to buy did not change very

much. While increasing the price from $300 to $500 made little differ-

ence in the proportion of consumers willing to buy the product, the study

revealed a signiﬁ cant revenue opportunity by setting prices relatively

high, as shown in Exhibit 8-6.

One cannot, however, treat buy-response data as directly compa-

rable to or directly predictive of the sales that would actually occur at

the corresponding prices in a store. Most problematic is the fact that

consumers’ answers depend on their recollection of the actual prices of

competing products. To the extent that they overestimate or underes-

timate competing prices, they will misjudge their willingness-to-buy.

Even with this form of the question, some consumers will still want to

please the researcher, or will fear appearing stingy, and so will falsely

claim a willingness-to-buy the brand over competing brands regardless

of the price.

Nevertheless, such research is useful (i) as a preliminary study to

identify a range of acceptable prices for a new product, and (ii) to identify

changes in price sensitivity at different points in time or place, assuming

that the biases that affect these studies remain the same and so do not

affect the observed change. For example, buy-response surveys for low-

involvement consumer packaged goods often reveal little difference in

EXHIBIT 8-6

Total Revenue Estimate for Financial Software

Source: Deloitte study. The product category and price levels have been changed to protect client

conﬁ dentiality.

Chapter 8 • Measurement of Price Sensitivity 189

In-Depth Interviews

An in-depth interview is a “semi-structured” method that is used to elicit

responses from customers on how they use products and services, from which

the research infers value rather than asking about value directly. The inter-

view is often conducted one-on-one with a respondent and lasts for one to

two hours. In a consumer environment, it is used to understand how indi-

viduals and families use products and how they might value different fea-

tures or positioning approaches. In a business-to-business environment, the

interviewers attempt to understand how businesses gain revenues or reduce

costs by using a speciﬁ c product or service. To do this successfully, one needs

to have a deep understanding of the respondent’s business. In-depth inter-

views in pricing research are useful in (i) understanding which product or

service features and beneﬁ ts are important to a customer, (ii) assessing the

monetary or psychological value of these features and beneﬁ ts that a customer

receives as a result of using the product or service, and (iii) assessing roughly

what a customer might be willing to pay to obtain these features and beneﬁ ts.

In-depth interviews are also used to develop economic-value models of how

much a customer could gain in monetary terms from purchase of the product.

The model then becomes part of a promotional campaign to increase custom-

ers’ willingness-to-pay. Such models work well for business customers where

most beneﬁ ts can be translated into additional revenues or costs saved. It also

works well in consumer markets where the beneﬁ t is a cost saving (for exam-

ple, the value of buying a more efﬁ cient refrigerator), or where new usage

opportunities may be uncovered.

consumers’ willingness-to-buy at different prices before they try a new

product, but a signiﬁ cant difference at different price points after they

have tried it. In interpreting the study, one would not want to take the

absolute percentage of consumers who claimed they would buy as an

accurate prediction of the percentage of consumers who would actually

buy at different prices. However, differences in the stated probability of

purchase before and after trial may reliably predict the change in price

sensitivity caused by the product trial.

Intention measurement is also sometimes used successfully to pre-

dict actual purchases when researchers have past experience that allows

them to adjust for the bias in subjects’ stated intentions. Typically, pur-

chase intentions are measured by asking people to indicate which of the

following best describes their likelihood of purchase:

• Deﬁ nitely would buy

• Probably would buy

• Might/might not buy

• Probably would not buy

• Deﬁ nitely would not buy

The leading survey research ﬁ rms have asked such questions of mil-

lions of buyers for thousands of products. Consequently, they are able

to develop adjustments that reﬂ ect the average bias in these answers for

various product classes.

Chapter 8 • Measurement of Price Sensitivity 190

Like a focus group, an in-depth interview is relatively unstructured and

is usually conducted by an experienced interviewer who has a speciﬁ c inter-

view guide and objective, such as to quantify the value of differentiating fea-

tures. In-depth interviews are used less frequently in market research due to

the need for highly specialized interviewers, the relatively high expense per

interview, and the small sample size.

This is especially true for consumer

pricing research for mass-market products and services. However, for more

complex business-to-business pricing research, the interviews—in terms

of the quality of information obtained with regard to customer value and

willingness-to-pay—often yield fruitful insights and analysis. For example, in

business markets, in-depth interviews enable the interviewer to probe cus-

tomer needs, customer experiences, how they attempt to deal with problems,

how the supplier’s products or services could solve these problems, and the

value to the customer of the consequent savings or gains they would realize

from using the ﬁ rm’s products or services.

In-depth interviews do not ask customers directly how much they would

be willing to pay. Instead, the interview focuses on the ﬁ nancial beneﬁ ts to the

customer that a product or service could inﬂ uence. It is also possible to get a

sense of perceived value by identifying other items that the customer buys

to achieve the same beneﬁ t. One method used successfully in business-to-

business markets, called “evocative anchoring,” asks respondents to identify

items in their budget that they might consider a trade-off in order to obtain the

value and beneﬁ ts promised by a supplier’s proposed product or service

solution. For example, when helping a software client to price relationship-

management software, one identiﬁ ed beneﬁ t was reduction in customer

turnover. By asking potential buyers to identify the costs of acquiring new

customers, it became possible to estimate the value of customer retention.

In-depth interviews enable marketers to understand not only what

someone might perceive their product or service to be worth, but also why it

is worth that much. The in-depth interview attempts to understand the needs

that the product addresses and how the product or service addresses them.

The process often uncovers ways that suppliers can enhance their current

product or service offerings and, in doing so, provide the basis for creating

more differentiated products that can be sold at higher prices. It also exposes

who in the buying organization has goals that are likely to beneﬁ t from pur-

chase of the product.

The interview must be conducted outside the context of a selling oppor-

tunity or a negotiation, since customers are unlikely to reveal value at such

times. However, the data garnered often form the basis of a value-based sell-

ing approach in which salespeople, armed with an understanding of how

their products differ from those of competitors and how those differences

create value for customers, can justify their pricing to the customer and to

themselves. Companies often can use the information gained from in-depth

interviews to develop “value case histories.” These case histories describe the

experience of a particular customer in using a ﬁ rm’s products and the speciﬁ c

value that the customer received. These case histories eventually become a

sales support tool.

The in-depth interview is an excellent method for developing a better

understanding of how different product and service features create value for

customers, especially customers in a business-to-business environment. It

Chapter 8 • Measurement of Price Sensitivity 191

is especially useful in moving beyond the core product and understanding

how different service and support elements can create incremental value for a

user and provide insights into how a product might be priced to capture that

value. It often identiﬁ es similar service and support characteristics that can

successfully differentiate what are often thought of as commodity products.

A common concern is that customers won’t provide the data. However, our

experience is that most customers are quite willing to share insights and data

if it will help suppliers to serve them better.

Finally, a note on sample size: In-depth interviews do not require large

numbers of respondents in order to elicit the key needs of the market. Multiple

studies have shown that approximately 90 percent of key customer needs are

uncovered with 10–12 interviews per major market segment.

For most prod-

uct categories, this translates into 40–60 interviews across the typical four to

six segments that constitute a seller’s market. However, identifying key needs

is not the same as estimating the prevalence of those needs. Qualitative inter-

views are often followed up with quantitative surveys that aim to estimate

the portion of customers who identify with the key needs uncovered by the

qualitative interviews.

EXPERIMENTALLY CONTROLLED STUDIES OF

PREFERENCES AND INTENTIONS

To solve some of the problems of bias and extraneous factors when measuring

preferences and intentions, researchers try to exercise some control over the

purchase situation presented to respondents.

The questions must be designed to make the survey respondents con-

sider the questions in the same way they would consider an actual purchase

decision. The extent to which that can ever be fully accomplished is still an

open question, but marketing researchers, recognizing the potential value of

accurate survey information, are certainly trying.

Simulated Purchase Experiments

Many researchers believe that the best way to get consumers to think about

a survey question and to respond as they would in a purchase situation is to

simulate the purchase environment as closely as possible when asking the sur-

vey questions. With this type of research, the researcher asks the consumers to

imagine that they are on a shopping trip and desire to make a purchase from

a particular product class. Or, in more sophisticated setting, respondents may

be sent to a simulated store which can be either a physical or virtual location,

to conduct the shopping exercise. In this setting, the researcher shows con-

sumers pictorial representations, descriptions, or sometimes actual samples of

brands, and asks the consumers to choose among them, given various prices.

Since actual products need not be used, this technique enables one to test pric-

ing for new product concepts, as part of a general concept test, before the con-

cepts are actually developed into products.

The primary difference between such a simulated purchase experiment

and a laboratory purchase experiment is that participants only simulate the

choice decision to purchase a product and so do not get to keep their choices.

The simulated purchase experiment is a widely used tool in pricing research

Chapter 8 • Measurement of Price Sensitivity 192

that overcomes two important drawbacks of other types of surveys. If it is

structured as a choice task among alternative brands, a consumer’s thought

process should more closely approximate the process actually used when mak-

ing a purchase. Also, since consumers have no way of knowing which brand is

the one of interest to the researcher, they cannot easily think of the choice as a

bargaining position or as a way to please the researcher. Thus, simulated pur-

chase experiments can sometimes predict price sensitivity reasonably well.

While any type of research is prone to bias, the simulated purchase

experiments can often be an acceptable method for gaining quick and low-cost

information on the buying behavior of consumers. If, for example, a company

wants to estimate the price sensitivity of a product sold nationally, the cost of

hundreds of in-store experiments throughout the country would be prohibi-

tive. If the company conducted both an in-store experiment and a simulated

purchase experiment in a few locations and found them reasonably consistent,

it could conﬁ dently use the latter to cover the remaining locations and to con-

duct future research on that product class. Even if the experiment showed a

consistent tendency to be biased, simulated purchase experiments could still

be used successfully after the results had been adjusted by the amount of that

previously identiﬁ ed bias.

Trade-Off (Conjoint) Analysis

An experimental technique, called trade-off (or conjoint) analysis, has become

popular for measuring price sensitivity as well as sensitivity to other prod-

uct attributes.

The particular strength of trade-off analysis is its ability to

disaggregate a product’s price into the values consumers attach to each attri-

bute. Consequently, trade-off analysis can help a company identify the dif-

ferentiation value of unique product attributes and, more important, design

new products that include only those attributes that consumers are willing to

pay for as well as how much they are likely to pay for the entire product and

service package. Currently, trade-off analysis aids in the design of a range of

products, from apparel and ofﬁ ce equipment to household cleaners and vaca-

tion packages.

The basic data for trade-off analysis are consumers’ answers to questions

that reveal not their directly stated purchase intentions, but rather the prefer-

ences that underlie those intentions. The researcher collects such data by ask-

ing respondents to make choices between pairs of fully described products or

between different levels of product attributes. The product descriptions are

designed to vary systematically in the levels of certain attributes that deﬁ ne

the product as well as the price. When multiple priced levels are included in

the study design, it is possible to assess not only the value assigned to certain

product attributes but also to arrive at an estimate of price elasticity. The data

are typically collected via an online survey, but can also be gathered via in-

person interviews.

After obtaining a consumer’s preferences for a number of product or

attribute pairs, the researcher then manipulates the data to impute the value

(called utility) that each consumer attaches to each product attribute and the

relative importance that each attribute plays in the consumer’s purchase deci-

sion.

With these data, the researcher can predict at what prices the consumer

would purchase products containing various combinations of attributes,

Chapter 8 • Measurement of Price Sensitivity 193

including combinations that do not currently exist in the marketplace. The

researcher can also estimate how much of one attribute the consumer is will-

ing to trade off in order to obtain more of another attribute—for example, how

much more a consumer is willing to pay in order to obtain better fuel efﬁ ciency

in a new automobile.

With similar data from a number of consumers who are representative of

a market, the researcher can develop a model to predict the share of a market

segment that would prefer any particular brand to others at any particular

price. Since the researcher has collected data that reveal underlying prefer-

ences, consumers’ preferences can be predicted, or interpolated, even for

levels of price and other attributes not speciﬁ cally asked about in the question-

naire, provided the attributes are continuously measurable and bounded by

the levels that were asked about in the survey. When the researcher knows

independently the size of the market and the identity of market segments, it

is possible to create a simulation model for testing different price-offer com-

binations. “A Conjoint Study: Blue Sky Ski Company” (below) provides an

example of such a process. Readers should note how the basic features were

varied along with price in order to develop a relationship between features

and value, here termed “feature utility.”

It is useful to contrast trade-off analysis with direct questioning methods.

By having respondents evaluate a product in its entirety rather than in the

more abstract form of individual attributes, responses from a conjoint study

are more likely to mimic actual choices. For example, in a recent study of MBA

graduates, when asked about individual job attributes, the most important

was not ﬁ nancial reward. Instead, MBA job seekers ranked intellectual chal-

lenge of the work and job location as more important than ﬁ nancial rewards.

Of all the methods used to estimate price sensitivity from preferences or

intentions, trade-off analysis promises the most useful information for strat-

egy formulation. Researchers can do more than simply identify the price sen-

sitivity of the market as a whole; they can identify customer segments with

different price sensitivities and, to the extent that those differences result from

differences in the economic value of product attributes, can also identify the

speciﬁ c product attributes that evoke the differences. Consequently, research-

ers can describe the combination of attributes that can most proﬁ tably skim

or penetrate a market. The economic value of a product can also be identiﬁ ed,

even when the product is not yet developed, by presenting consumers with

different experimental product combinations in the form of pictorial and

descriptive product concepts, or new product prototypes.

As a result of these promised advantages, the use of trade-off analysis

by both market research ﬁ rms and internal research departments has grown

rapidly, but the performance of trade-off analysis is only as good as its abil-

ity to predict actual purchase behavior. There are a number of reasons why a

prudent manager might suspect the reliability of this technique for some mar-

kets. Trade-off analysis is an experimental procedure that can introduce bias

to the extent that it does not simulate the actual purchase environment. For

items that are commonly purchased online, such as music, apparel, or insur-

ance, online conjoint surveys can realistically mimic an actual purchase envi-

ronment. For other types of purchases such as homes, restaurant meals, or

many B2B transactions that are usually negotiated in person, an online con-

joint survey provides more directional guidance that should be augmented

Chapter 8 • Measurement of Price Sensitivity 194

with managerial judgment, experience from analogous products, or in-depth

customer interviews to better understand the purchase decision process.

Another potential source of bias is that the respondent of a conjoint test

sometimes focuses more attention on price and price differences than may

occur in a natural purchase environment, simply because side-by-side price

comparisons are provided in the choice task. In situations where purchasers

have difﬁ culty obtaining and comparing price and product attributes in a real

purchase situation, the conjoint study may overestimate the role of price. For

example, research companies have compared the predicted effects of price on

physicians’ prescribing decisions with data on the actual price of the pharma-

ceuticals they prescribed. Studies invariably predict much higher price sen-

sitivity among physicians than, in fact, is revealed by prescribing behavior.

Also, if respondents have little experience with the product category, as is usu-

ally the case with innovative product categories, the technique poorly predicts

the trade-offs that customers will make because of their inability to map differ-

ences in features into likely beneﬁ ts.

A Conjoint Study: Blue Sky Ski Company

A small sporting goods manufacturer designed a downhill ski that incor-

porated a unique vibration control technology, promising downhill skiers

easier turning, reduced “chatter” on rough surfaces, and a general reduc-

tion in the physical effort of skiing. To commercialize the most ﬁ nancially

lucrative offer, the company commissioned a market research study to

address several questions that would inform the marketing strategy.

Three of the research questions involved pricing:

1. What is the demand for the product, including the price–volume

trade-off?

2. For what segment(s) of skiers could the offer be targeted most

proﬁ tably?

3. Given the innovative technology, would it be ﬁ nancially worthwhile

to offer a longer warranty than the standard 90 days?

To address these questions, a market survey was developed that collected

information on skier demographics, ability levels, and willingness-to-pay

for different types of beneﬁ ts. The survey was administered to 1,200 skiers

across North America. The survey revealed four major segments:

• Budget shoppers are generally beginner and intermediate skiers

who are ﬁ rst-time purchasers or make purchases only when old

equipment is worn out or outgrown.

• Value seekers , who range in ability from intermediate to expert,

consider new purchases frequently, but they make careful price–

value trade-offs before actually spending any money.

• Innovators are intermediate to expert skiers who readily buy new

technology.

• Elite skiers , who actively participate in ski clubs and race competi-

tively, demo new equipment to ﬁ nd out what works best for them

before purchasing it.

Chapter 8 • Measurement of Price Sensitivity 195

In addition to questions about personal demographics and past pur-

chases, the survey included a conjoint-based simulated purchase exercise

that asked respondents to evaluate several scenarios for their next poten-

tial ski purchase and indicate their most likely choice. Respondents were

informed about the beneﬁ ts of the new technology and then presented

with several buying scenarios that included buying new skis with the

electronic damping technology, buying well-known conventional skis, or

keeping the skis they have and making no new purchase.

The early analysis of the survey generated disappointing ﬁ ndings:

Overall the market was quite sensitive to price. Revenues were maximized

at a price of $450, but the product captured a disappointingly small share

with a rapid drop-off at still higher prices. Complicating matters, the com-

pany would incur a high variable cost due to the relatively high cost of

manufacturing and the royalty arrangement with the patent holder. Even

at a proﬁ t-maximizing price for the overall market, the initial conclusion

was that the potential return was not worth the risk.

Fortunately, one of the beneﬁ ts of conjoint data is the ability to slice

samples in different ways. Analysis of only the “innovators” revealed that

they did indeed have a higher “take rate” for the product and, impor-

tantly, their take rate fell off much less rapidly at higher prices. Although

only a small subset of the market, innovators could proﬁ tably support a

price of $800 (see Exhibit 8-7: Youth-Seeking “Innovators” Segment). Fur-

thermore, it turns out that it is much cheaper to sell to innovators because

they actively seek out new products and tend to only shop at a handful

of high-end specialty shops, not the national sporting goods stores. As

a result, advertising costs are signiﬁ cantly lower, and the manufacturer

would not require an extensive distribution network. Apparently the

EXHIBIT 8-7

Analysis of Youth-Seeking “Innovators” Segment

Chapter 8 • Measurement of Price Sensitivity 196

higher take rate among the innovators reﬂ ected a demographic subset:

35- to 50-year-old men who had, in their youth, been very good skiers

but were now feeling the effects of age in their knees. The promise of

lower effort, reduced chatter, and easier turning were beneﬁ ts for which

this group was willing and able to pay a signiﬁ cant premium. This ﬁ nd-

ing opened the possibility that there was an opportunity to sequentially

“skim” the market with a high initial price at launch.

Finally, conjoint analysis enabled the company to isolate and measure

the impact of individual features on willingness-to-pay and overall pur-

chase rates. The research revealed that moving from a 90-day to a one-year

warranty more than doubled the take rate of the product by respondents in

the target segment (see Exhibit 8-8: Effect of Warranty on Take Rate).

Because trade-off analysis measures underlying preferences, researchers

have the ability to check if an individual consumer’s responses are at least

consistent. Consumers who are not taking the survey seriously, or who

are basically irrational in their choice processes, are then easily identiﬁ ed

and excluded from the sample. Even more comforting are three separate

studies that show a high degree of consistency, or reliability, when subjects

are asked to repeat a trade-off questionnaire a few days after having taken

it initially.

Since the subjects are unlikely to remember exactly how they

answered the questions in the earlier session, the consistency of the answers

over time strongly suggests that they do accurately reﬂ ect true underly-

ing preferences. More comforting still is the result of a study showing that

EXHIBIT 8-8

Effect of Warranty on Take Rate

Source: Deloitte study. The product category and price levels have been changed to protect client

conﬁ dentiality.

Chapter 8 • Measurement of Price Sensitivity 197

USING MEASUREMENT TECHNIQUES APPROPRIATELY

Numerical estimates of price sensitivity can either beneﬁ t or harm the effec-

tiveness of a pricing strategy, depending on how management uses them. This

is especially true when respondents have considerable experience with the use

and purchase of a product. If managers better understand their buyers and use

that knowledge to formulate judgments about buyers’ price sensitivity, as dis-

cussed in Chapter 6, an attempt to measure price sensitivity can be very use-

ful. It can give managers new, objective information that can either increase

their conﬁ dence in their prior judgments or indicate that perhaps they need

to study their buyers further. An understanding of price sensitivity also pro-

vides a reference by which to judge proposed price changes—how will sales

respond as we increase or decrease prices? Combined with variable cost data,

it is possible to judge whether proposed changes in price will have a positive

effect on proﬁ ts.

Integrating soft managerial judgments about buyers and purchase behav-

ior with numerical estimates based on hard data is fundamental to successful

pricing. Managerial judgments of price sensitivity are necessarily imprecise

while empirical estimates are precise numbers that management can use for

proﬁ t projections and planning. However, precision doesn’t necessarily mean

accuracy. Numerical estimates of price sensitivity may be far off the mark of

true price sensitivity. Accuracy is a virtue in formulating pricing strategy; pre-

cision is only a convenience.

No estimation technique can capture the full richness of the factors that

enter a purchase decision. In fact, measurements of price sensitivity are pre-

cise speciﬁ cally because they exclude all the factors that are not conveniently

measurable. Some estimation techniques enable the researcher to calculate a

conﬁ dence interval around a precise estimate, indicating a range within which

we may have some degree of statistical certainty that the true estimate of price

sensitivity lies. In other cases a conﬁ dence interval can be estimated by con-

sidering how demand might change under different scenarios. Fortunately, a

manager does not have to make the choice between judgment and empirical

estimation. Used effectively, they are complementary, with the information

from each improving the information that the other provides.

In any case, one needs to remember that estimating price sensitivity is

both “Art” and “Science,” and both analytical rigor and managerial judgment

need to be exercised. As described in earlier chapters, a consumer’s perception

of price and value, and hence demand curve, can be inﬂ uenced based on how

the offer is structured, communicated, and based on which price metric is used.

the exclusion from the questionnaire of some product attributes a subject

might consider important does not bias the subject’s responses concerning

the trade-offs among the attributes that are included.

Although trade-off

analysis is more costly than a simple survey, it also provides much more

information. Given its relatively modest cost and the fact that it has met

tests of reliability, trade-off analytics certainly warrants consideration, par-

ticularly to understand the value of features by segment when designing

new products and offers.

Chapter 8 • Measurement of Price Sensitivity 198

Using Judgment for Better Measurement

Any study of price sensitivity should begin with the collection of information

about buyers—who they are, why they buy, and how they make their purchase

decisions—since those are the essential inputs in the formulation of judgment.

At the outset, this information should come from open-ended, qualitative, or

exploratory research that enables managers to discover facts and formulate

impressions other than those for which they may have been speciﬁ cally look-

ing.

In industrial markets, such research may consist of accompanying sales-

people to observe the purchase process. After a sale, managers might follow up

to ask how and why the purchase decision was made. One can also look at past

bid histories to see the correlation between various price levels and the likeli-

hood of winning the bid. In many cases, managers can interview important

customers and intermediaries by telephone to gain their impressions about a

variety of price and marketing issues.

In consumer markets, such research

may consist of observing consumers discussing their purchase decisions in

focus groups or in-depth interviews as previously discussed. Insights gener-

ated from such informal observation could then be conﬁ rmed with more for-

mal research in the form of a survey administered to a larger number of buyers.

Having formed judgments about buyers based on qualitative impres-

sions developed from observing them, a manager will often ﬁ nd it practical

and cost-effective to expand this understanding through original primary

research that attempts to measure certain aspects of buyer behavior, such as

price sensitivity. That attempt is far more likely to produce useful results, to

the extent that management already understands the way buyers make their

purchase decisions and uses that information to help structure the attempt

at measurement. There are a number of ways that managerial judgment can,

and should, guide the measurement effort:

1. For experimentally controlled data estimation, managerial judgment

should determine the focus of the research on certain target demographic

groups and provide guidance for generalizing from those groups to the

population as a whole.

• Management may know that 80 percent of its product’s buyers are

women who are employed full-time. That information is important if

the researcher plans to measure price sensitivity with an in-home sur-

vey or an experiment in a shopping center. On a typical day between

9:00 a.m. and 5:00 p.m., few of the experimental subjects at home or

in the shopping center would be representative of that product’s buy-

ers. To get a representative sample, the researcher might need to con-

duct the in-home survey in the evenings or the experiment only during

the lunch hour at locations near where many women work. He or she

might also ask a prescreening question (Are you employed full-time?).

• If management also knows that different demographic groups buy the

product in different quantities, that information can be used to scale

the survey results differently for different subjects in the sample to

reﬂ ect their relative impact on the product’s actual sales.

2. For historical data estimations, the intervention of informed managerial

judgment into the analysis is even more essential, since the lack of any

experimental control invariably results in data that are full of potential

Chapter 8 • Measurement of Price Sensitivity 199

statistical problems. Managerial judgment should be used to reduce ran-

dom error and solve statistical problems.

• The effect of price changes tends to get overwhelmed in historical pur-

chase data by the amount of sales variation caused by other factors,

which may not be obvious to the researcher but may be to managers

who know their markets. For example, a researcher analyzing many

years’ worth of data on the sales of a frozen seafood product could

substantially improve the estimation of price sensitivity if manage-

ment pointed out that many buyers purchase the product as part of

their religious observance of Lent, a Christian holiday that shows up

at a different time every year. That one bit of information about why

consumers buy would enable the researcher to eliminate a substantial

amount of random variation in the data that would otherwise yield a

biased estimate of price sensitivity if it were not included.

• The researcher using historical data is also often confounded by the

problem called collinearity, where different explanatory variables

change together. Perhaps, at the same time that a ﬁ rm offers a promo-

tional price deal, it always offers retailers a trade deal in return for a

special product display. Without additional input from management,

the researcher cannot sort out the effect of the price deal from that of

the display. If, however, management knows that buyers of the prod-

uct are like those of another product that is sometimes sold on spe-

cial displays without a price deal, the researcher could use sales data

from that other product to solve the collinearity problem with this one.

Alternatively, if managers are conﬁ dent in making a judgment about

the effectiveness of special displays (for example, that they account for

between one-third and one-half of the total sales change), that informa-

tion can likewise help the researcher to narrow an estimate of the effect

of price on sales.

3. Managerial judgment should also be used to select the appropriate struc-

ture for an experiment or survey, and the appropriate speciﬁ cation of a

statistical equation for analysis of historical data.

• A manager who has studied buyers should know the length of the pur-

chase cycle (time between purchases) and the extent of inventory hold-

ing, both of which will govern the necessary length of an experiment

or the number of lagged variables to include when analyzing historical

data. Failure to appropriately specify the purchase cycle could cause

a researcher to grossly miscalculate price sensitivity by ignoring the

longer-term effects of a price change.

• Management may have much experience indicating that an adver-

tisement affects buyers differently when the advertisement focuses

on price rather than on other product attributes. If so, the researcher

should separate those types of advertising in an experiment or in his-

torical data analysis. The researcher might also treat price advertising

as having an effect that interacts with the level of price, and non-price

advertising as having an independent effect.

4. For survey research, managerial judgment should guide the preparation

of product descriptions, to ensure that they include the variables relevant

to buyers and that they describe them with the appropriate connotations.

Chapter 8 • Measurement of Price Sensitivity 200

• For an automobile survey, management can point out that 0–60 mph

acceleration time is an important attribute to include when describing

a sports car, but less so when describing a family car.

• For a survey on workwear, managers can point out that “abrasion resis-

tance” in a description will carry a connotation much different from the

word “tough,” which may inﬂ uence buyers’ perceptions about other

attributes such as long-term durability or warmth of the garment.

The common failure to use this type of managerial input (or the failure of man-

agement to know buyers well enough to provide it) is no doubt one reason

why research to measure price sensitivity is sometimes disappointing.

When measurement embodies managerial judgment, it is much more

likely to provide useful information, but even then the results should never

be taken uncritically. The ﬁ rst question to ask after any marketing research

is, “Why do the results look the way they do?” The measurement of price

sensitivity is not an end result but a catalyst to learn more about one’s buy-

ers. If the results are inconsistent with prior expectations, one should consider

how prior judgment might have been wrong. What factors may have been

overlooked, or have been given too little weight, leading to the formulation of

incorrect expectations about price sensitivity? One should also consider how

bias might have been introduced into the measurement process. Perhaps the

measurement technique heightened buyers’ attention to price or the sample

subjects were unrepresentative of the product’s actual buyers. Regardless of

the outcome of such an evaluation, one can learn more about the product’s

buyers and the factors that determine their price sensitivity. Even when one

concludes that the measurement technique biased the results, the bias reveals

information (for example, that the low level of price sensitivity that manage-

ment expected is substantially due to buyers’ low attention to price in the nat-

ural purchase environment, or that a segment of people who do not regularly

buy the ﬁ rm’s product has a different sensitivity to price).

Using Online and Mobile Techniques

Since the advent of the internet, market researchers and their clients are increas-

ingly using online surveys for gathering customer and market data. Over

50 percent of surveys today

are opened on mobile devices and online survey

research is driving growth in the market research industry.

Response rates

are generally high because online surveys are minimally intrusive and simply

require a response to an email. However, online research may be subject to

some sampling bias—online respondents are not necessarily representative of

the broader target population. Lower-income households, rural residents, and

older people, for example, are less likely to be represented among online sam-

ples.

Nonetheless, online research can be particularly effective for identifying

very speciﬁ c or specialized subgroups to target for research.

Outside Sources of Data

In addition to performing experiments and evaluating available sales data,

one should be aware of the many external sources of data that are available to

shed light on price sensitivity. Public records such as those found at govern-

ment institutions or industry trade groups contain vast sources of data and

Chapter 8 • Measurement of Price Sensitivity 201

information on historical sales trends, industry actions, as well as a record of

other factors that may affect the market of interest. Market research ﬁ rms spe-

cialize in performing the types of experiments and analyses described in this

chapter. The journals published by various academic and industry institutions

offer lessons from the past that may apply to new products. The Society of

Competitive Intelligence Professionals (SCIP) is an industry trade group that

is devoted to the quest of ﬁ nding competitive intelligence.

Other secondary sources of data for industrial markets, including the

Census of Manufacturers, the Survey of Industrial Buying Power, and numer-

ous other governmental and private sources,

can tell sellers the types of busi-

nesses their buyers engage in and the share of the total market each accounts

for, the average size of their purchases in major product classes, and their

growth rates. In consumer markets, consumer panel surveys are widely avail-

able to tell managers the demographics of their buyers (income, family size,

education, use of coupons), as well as those of their closest competitors. Other

companies develop complete psychographic proﬁ les of buyers that go beyond

just demographics to delve into the innermost psychological motivations for

purchase. These are relatively inexpensive sources of data from which man-

agement can form judgments about price sensitivity.

Regardless of the method of intelligence gathering, recognize that the

key aim of the marketer is to listen to the voice of the customer, understand

how product attributes get translated into beneﬁ ts, and how beneﬁ ts are con-

verted into a willingness to pay money to obtain a good.

Selecting the Appropriate Measurement Technique

The choice among measurement techniques is not arbitrary. Each is more

appropriate than another under certain circumstances. Information about

trade-offs between price and attributes is most valuable when a company is

developing new products or improving old ones. Since one cannot use histori-

cal data or a purchase experiment to test undeveloped products, one must turn

to research on preferences and intentions that require only product descrip-

tions or experimental prototypes. Trade-off (conjoint) analysis is a great choice

at this point. But surveys of preferences, like conjoint analysis, sometimes

yield poor predictions of actual price sensitivity in real-world purchase situ-

ations because they create an artiﬁ cial purchase environment in which price

awareness and knowledge of substitutes is made easy. At the time of product

development, however, those are not factors about which management need

be concerned. Product development focuses on efforts to enhance the attrac-

tiveness of the product when customers are aware of differences. Even when

survey research accurately measures only the effect of product attributes on

price sensitivity, it is a useful tool for product development, although it may

be inadequate for actually setting prices later on.

Once a product is developed, management would like to have measure-

ments that capture as many of the different determinants of price sensitiv-

ity as possible. In-store or sophisticated laboratory purchase experiments are

deﬁ nitely the ﬁ rst choice for frequently purchased, low-cost products. With

few exceptions, such products are bought by consumers who have low price

awareness and give the purchase decision little attention. Consequently, sur-

veys to estimate price sensitivity for such products focus much more attention

Chapter 8 • Measurement of Price Sensitivity 202

on price in the purchase decision than would occur naturally, thus distort-

ing the estimates. The cost of in-store experiments, however, may make them

impractical for testing on a large scale. In that case, management might best

do a few in-store experiments with matched simulated purchase surveys. If

the amount of bias in the latter is stable, the survey could be used for further

research and adjusted by the amount of the bias between the survey and the

in-store experiments.

When the fully developed product is a high-cost durable such as a tele-

vision or a new car model, an in-store experiment is impractical. A labora-

tory purchase experiment may be practical since experimental control permits

inferences from fewer purchases but will be too costly for many products.

Fortunately, high-value products are also products for which consumers nat-

urally pay great attention to price. In fact, they may give all aspects of the pur-

chase careful thought because it involves a large expenditure. Consequently, a

simple laboratory experiment or a simulated purchase survey may be reason-

ably accurate in predicting price sensitivity for these types of products. Even a

buy-response survey may be useful to identify the range of prices that poten-

tial customers might ﬁ nd acceptable for such products, although the exact esti-

mates of sales at various prices should not be treated with much conﬁ dence.

Once a product has been on the market for a while, historical data become

available. Such data are most useful when managers are willing to implement

marketing decisions in ways that can increase the research value of the data.

For example, sales data become more useful if price changes are sometimes

accompanied by a change in advertising and other times not, enabling market-

ing researchers to isolate their separate effects. A log of unusual events that

cause distortions in the actual sales data (for instance, a strike by a competitor’s

truckers may be causing stock-outs of the competitor’s product and increased

sales of yours) is also extremely useful when the time comes to adjust the his-

torical data. Moreover, as managers talk with and observe buyers, they should

keep questions in mind that would aid the researcher using historical data.

What is the length of the purchase cycle? To what extent do buyers purchase

extra for inventories when price is expected to rise in the future? Even if his-

torical data are so ﬁ lled with random variations that no conclusions can be

drawn from them with conﬁ dence, they may still point toward possible rela-

tionships between price and sales or other marketing variables that would be

worth examining with another research technique.

Summary

Numerical estimation of price sensitiv-

ity is no shortcut to knowing a prod-

uct’s buyers—who they are, how they

buy, and why they make their purchase

decisions. Numerical estimates are an

important source of objective information

that can supplement the more subjective

observations that usually dominate man-

agerial judgments about price sensitivity.

As a supplement, they can substantially

improve the accuracy of such judgments

and the effectiveness of a ﬁ rm’s pricing.

Measurement techniques differ in

the variables they measure and in the

Chapter 8 • Measurement of Price Sensitivity 203

conditions of measurement. The variable

measured may be either actual purchases

or preferences and intentions. Since the

ultimate goal of research is to predict

customers’ actual purchases, research

based on actual purchase data is gener-

ally more reliable than research based

on preferences and intentions. Unfortu-

nately, collecting and analyzing actual

purchase data costs more, requires much

more time, and is entirely impossible for

products that are not yet fully developed

and ready for sale. Consequently, most

research on price sensitivity infers pur-

chase behavior from questions potential

customers answer about their preferences

and intentions.

Pricing research studies range from

those that are completely uncontrolled to

those in which the experimenter controls

almost completely the alternative prod-

ucts, their prices, and the information that

customers receive. Although research

techniques that permit a high degree of

experimental control are more costly than

uncontrolled research, the added cost is

usually worth it. Uncontrolled data on

actual purchases are plagued by too little

variation in prices and too many vari-

ables changing at once. Uncontrolled data

on preferences and intentions are biased

by people’s untruthful responses and by

their inability to recall competitive prices.

In contrast, controlled in-store experi-

ments and sophisticated laboratory pur-

chase experiments often predict actual

price sensitivity well. Even experiments

using preferences and intentions seem to

warrant conﬁ dence when they are highly

controlled. In particular, trade-off analy-

sis is proving highly useful in predicting

at least that portion of price sensitivity

determined by the unique-value effect.

The appropriate technique for

numerically estimating price sensitivity

depends on the product’s stage of devel-

opment. When a product is still in the

concept or prototype stage, research mea-

suring preferences or intentions is the only

option. Trade-off analysis is especially

useful at this stage because it can identify

the value of individual product attributes,

thus helping to decide which combination

of attributes will enable the ﬁ rm to price

the product most proﬁ tably. When a

product is ready for the market, in-store

or laboratory purchase experiments are

more appropriate because they more real-

istically simulate the actual purchase envi-

ronment. After a product has been on the

market for a while, actual purchase data

can be an inexpensive source of estimates,

provided that management monitors sales

frequently and makes some price changes

independently of changes in other mar-

keting variables. Even when actual pur-

chase data cannot provide conclusive

answers, they can suggest relationships

that can then be measured more reliably

with other techniques.

Regardless of the technique used

to measure price sensitivity, it is impor-

tant that managers not allow the estimate

to become a substitute for managerial

judgment. The low accuracy of many

numerical estimates makes blind reli-

ance on them very risky. One always

needs to be aware of the range of values

an elasticity estimate can take, the factors

that can inﬂ uence price sensitivity, and

one must generally get an understand-

ing of the range of values one can expect.

They always should be compared with

a manager’s own expectations, based on

his or her more general knowledge of

buyers and their purchase motivations.

When inconsistencies occur, the manager

should reexamine both the measurement

technique and the adequacy of his or her

understanding of buyers. The quality

of numerical estimates depends in large

part on the quality of managerial judg-

ment that guides the estimation process.

Managers who know their buyers can

get substantially better estimates of price

sensitivity when they use that knowledge

(i) to select a sample of consumers that

accurately represents the product’s mar-

ket, (ii) to identify and explain extraneous

changes in sales that might camouﬂ age an

effect, (iii) to provide information to sort

out the effects of price from other variables

that tend to change with it, (iv) to identify

an appropriate equation or experimental

structure, and (v) to properly describe the

product for survey research.

Chapter 8 • Measurement of Price Sensitivity 204

Notes

1 . Albert Einstein, quoted by Margo

Einstein in a letter to Carl Seelig,

May 8, 1955.

2 . Actually, the researcher observes

only the price that the consumer

reports having paid. There is some

risk of erroneous reporting, which

weakens the data but does not

bias it. Fortunately, this problem is

being solved by technologies that

enable consumers to avoid the task

of reporting.

3 . See Ronald E. Frank and William

Massy, “Market Segmentation and

the Effectiveness of a Brand’s Deal-

ing Policies,” Journal of Business 38

(April 1965), pp. 186–200; Terry

Elrod and Russell S. Winer, “An

Empirical Evaluation of Aggrega-

tion Approaches for Developing

Market Segments,” Journal of Mar-

keting 46 (Fall 1982), pp. 65–74.

4 . The companies are Information

Resources Inc. (headquarters in

Chicago) and Burke Marketing

Research (headquarters in Cincin-

nati, Ohio).

5 . See, for example, David R. Bell, Joen-

gwen Chiang, and V. Padmanabhan,

“The Decomposition of Promotional

Response: An Empirical General-

ization,” Marketing Science 18(4)

(1999), pp. 504–526; Shuba Sriniva-

san, Peter T. L. Popkowski Leszczyc,

and Frank M. Bass, “Market Share

Response and Competitive Inter-

action: The Impact of Temporary,

Evolving, and Structural Changes

in Prices,” International Journal of

Research in Marketing 17 (2000), pp.

281–305; and Koen Pauwels, Shuba

Srinivasan, and Philip Hans Franses,

“When Do Price Thresholds Matter

in Retail Categories?” Marketing Sci-

ence 26(1) (January–February 2007),

pp. 83–100.

6 . Gigwalk website: www.gigwalk.com.

7 . For example, Econometric Analysis,

7th edn., by William H. Greene

(Boston, MA: Pearson, 2012) is

an excellent resource, as is Econo-

metric Analysis of Cross Section and

Panel Data , 2nd edn., by Jeffrey

Wooldridge (Cambridge, MA: MIT

Press, 2010).

8 . For a brief introduction to regres-

sion analysis, see Thomas C.

Kinnear and James R. Taylor, Mar-

keting Research: An Applied Approach ,

4th edn. (New York: McGraw-Hill,

1991), pp. 626–628; or Mark L.

Berenson and David M. Levine,

Basic Business Statistics: Concepts and

Application (Upper Saddle River,

NJ: Prentice Hall, 1992), Chapter 16.

9 . William D. Barclay, “Factorial

Design in a Pricing Experiment,”

Journal of Marketing Research 6(4)

(November 1969), p. 428.

10 . Paul Solman and Thomas Fried-

man, Life and Death on the Corporate

Battleﬁ eld (New York: Simon and

Schuster, 1982), Chapter 24.

11 . James Allen, “You Cut Your Prices.

So Why Didn’t Consumers Notice?”

Wall Street Journal , February 20,

2017. Accessed at https://blogs.

wsj.com/experts/2017/02/20/

you-cut-your-prices-so-why-didnt-

consumers-notice.

12 . Several good discussions of the

increased use and application of

laboratory test markets (called

Simulated Test Marketing by the

authors) can be found in Kevin J.

Clancy and Robert S. Shulman,

“Simulated Test Marketing: A

New Technology for Solving an

Old Problem,” in The Advertiser , by

Association of National Advertis-

ers (Fall 1995), pp. 28–33; and also

in Kevin J. Clancy and Robert S.

Shulman, “Test for Success: How

Simulated Test Marketing Can Dra-

matically Improve the Forecasting

of a New Product’s Sales,” Sales

and Marketing Management (October

1995), pp. 111–114.

13 . One might well argue that buy-

response surveys should be

included with the experimen-

tally controlled studies since the

researcher does exercise control

over the price asked. That obser-

vation is correct. The reason that

buy-response questioning is better

Chapter 8 • Measurement of Price Sensitivity 205

than direct questioning is precisely

because the researcher introduces

a bit of control. Still, the amount

of control that the researcher can

exercise in these studies is slight.

No attempt is made to control the

respondents’ perception of compet-

itive prices, exposure to promotion,

or demographics.

14 . Gerard Tellis and Deepa Chan-

drasekaran, “Extent and Impact of

Response Biases in Cross-National

Survey Research,” International

Journal of Research in Marketing 27(4)

(December 2010), pp. 329–341.

15 . Henry Assael, Consumer Behavior and

Marketing Action , 4th edn. (Boston,

MA: PWS Publishing Co., 1992).

16 . For a good discussion on the appli-

cation of and difference between

focus group and depth interviews

as unstructured/uncontrolled data-

collection techniques, see Thomas

C. Kinnear and James R. Taylor,

Marketing Research: An Applied

Approach , 4th edn. (New York:

McGraw-Hill, 1991).

17 . Abbie Grifﬁ n and John R. Hauser,

“The Voice of the Customer,” Mar-

keting Science 12(1) (Winter 1993),

pp. 1–27.

18 . James C. Anderson and James A.

Narus, “Business Marketing: Under-

stand What Customers Value,”

Harvard Business Review (November–

December 1998), pp. 53–65.

19 . For an excellent discussion on

the types of value drivers and how

to uncover those value drivers

in both consumer and business-

to-business research, see Ian C.

MacMillan and Rita Gunther

McGrath, “Discovering New Points

of Differentiation,” Harvard Busi-

ness Review (July–August 1997),

pp. 133–145.

20 . Tellis and Chandrasekaran, “Extent

and Impact of Response Biases in

Cross-National Survey Research,”

pp. 329–341.

21 . D. Frank Jones, “A Survey Tech-

nique to Measure Demand under

Various Pricing Strategies,” Jour-

nal of Marketing 39 (July 1975),

pp. 75–77.

22 . John R. Nevin, “Laboratory

Experiments for Estimating Con-

sumer Demand,” Journal of Mar-

keting Research 11 (August 1974),

pp. 261–268.

23 . The ﬁ rst article on trade-off

analysis to appear in the market-

ing literature was Paul E. Green

and Vithala R. Rao, “Conjoint

Measurement for Quantifying

Judgmental Data,” Journal of Mar-

keting Research 8 (August 1971),

pp. 355–363. For a non-technical

discussion of applications speciﬁ -

cally to pricing, see Patrick J. Rob-

inson, “Applications of Conjoint

Analysis to Pricing Problems,” in

Market Measurement and Analysis ,

ed. David B. Montgomery and

Dick R. Wittink (Cambridge, MA:

Marketing Science Institute, 1980),

pp. 183–205.

24 . For a more detailed perspective on

how to design a conjoint study, see

Vithala Rao, Applied Conjoint Analy-

sis (Berlin Heidelberg: Springer-

Verlag, 2014).

25 . The following articles describe

data manipulation procedures for

conjoint analysis: J. B. Kruskal,

“Analysis of Factorial Experiments

by Estimating Monotone Trans-

formations of the Data,” Journal of

the Royal Statistical Society , Series B

(1965), pp. 251–263; Dove Peckel-

man and Subrata Sen, “Regression

Versus Interpolation in Additive

Conjoint Measurement,” Associa-

tion for Consumer Research Proceed-

ings (1976), pp. 29–34; Philip Cattin

and Dick Wittink, “Further Beyond

Conjoint Measurement: Toward

Comparison of Methods,” Associa-

tion for Consumer Research Proceed-

ings (1976), pp. 41–45.

26 . David B. Montgomery and Cath-

erine A. Ramus, “Calibrating

MBA Job Preferences for the 21st

Century,” Academy of Management

Learning & Education 10(1) (March

1, 2011), pp. 9–26.

27 . Mariana Carrera, Dana Goldman,

Geoffrey Joyce, and Neeraj Sood,

“Do Physicians Respond to the

Costs and Cost-Sensitivity of Their

Chapter 8 • Measurement of Price Sensitivity 206

Patients?” American Economic Journal

(2017, forthcoming).

28 . Franklin Acito, “An Investigation

of Some Data Collection Issues in

Conjoint Measurement,” in Pro-

ceedings of the American Marketing

Association , ed. B. A. Greenberg and

D. N. Bellenger (Chicago: Ameri-

can Marketing Association, 1977),

pp. 82–85); James McCullough

and Roger Best, “Conjoint Mea-

surement: Temporal Stability

and Structural Reality,” Journal of

Marketing Research 16 (February

1979), pp. 26–31; Madhav N. Segal,

“Reliability of Conjoint Analysis:

Contrasting Data Collection Proce-

dures,” Journal of Marketing Research

19 (February 1982), pp. 139–143.

29 . McCullough and Best, “Conjoint

Measurement: Temporal Stability

and Structural Reliability,” Journal

of Marketing Research 16(1) (Febru-

ary 1979), pp. 26–31.

30 . Bryan K. Orme, Getting Started with

Conjoint Analysis (Madison, WI:

Research Publishers LLC, 2005).

31 . Bobby J. Calder, “Focus Groups

and the Nature of Qualitative Mar-

keting Research,” Journal of Mar-

keting Research 14 (August 1977),

pp. 353–364.

32 . Johny K. Johansson and Ikujiro

Nonaka, “Marketing Research the

Japanese Way,” Harvard Business

Review (May–June 1987), pp. 4–7.

33 . For the reader trained in classi-

cal statistics, these suggestions for

adjusting the data with manage-

rial judgment may seem unscien-

tiﬁ c. But it is important to keep in

mind that the purpose of numerical

measurement of price sensitivity is

to derive useful estimates, not to

objectively test a theory. If manag-

ers have strongly held beliefs, in

light of which the historical record

of sales could yield much better

estimates, it is simply wasteful to

ignore those beliefs simply because

they may not be objective. See

Edward E. Leamer, “Let’s Take the

Con Out of Econometrics,” American

Economic Review 73 (March 1983),

pp. 31–43.

34 . “With mobile surveys, market

research gets a makeover,” For-

tune.com, March 25, 2014. Accessed

April 14, 2017 at http://fortune.

com/2014/03/25/with-mobile-

surveys-market-research-gets-a-

makeover.

35 . Edward Rivera, “Market Research

in the US—Industry Market

Research Report”, ibisworld, report

ID 199100 (October 2016).

36 . “Internet Surveys,” online article

at Pew Research Center. Accessed

April 14, 2017 at www.people-

press.org/methodology/collect

ing-survey-data/internet-surveys.

See also “Who Has Home Broad-

band?” Internet/Broadband Fact

Sheet, Pew Research Center, Janu-

ary 12, 2017.

37 . See, for example, www.scip. org.

38 . The Census of Manufacturers is a

publication of the U.S. Department

of Commerce. For other federal

sources, see the Commerce Depart-

ment publication titled A Guide to

Federal Data Sources on Manufactur-

ing . The “Survey of Industrial Buy-

ing Power” is published annually

as an issue of Sales and Marketing

Management magazine. Other use-

ful sources of information about the

demographics and motivations of

buying ﬁ rms can be obtained from

the buying ﬁ rms’ trade associations

(such as the Rubber Manufactur-

ers Association and the National

Machine Tool Builders Associa-

tion) and from privately operated

industrial directory and research

companies (for example, Predicasts,

Inc., Dun & Bradstreet, Standard &

Poor’s).

CHAPTER 9

Financial Analysis

Analyzing Costs and

Proﬁ ts for Pricing

It was only a sunny smile and little it cost in the giving but like morning light it

scattered the night and made the day worth living.

F. Scott Fitzgerald

Internal ﬁ nancial considerations and external market considerations are, at

many companies, antagonistic forces in pricing decisions. Financial managers

allocate costs to determine how high prices must be to achieve proﬁ t objec-

tives. Marketing and sales staff analyze buyers to determine how low prices

must be to achieve sales objectives. Neither approach will lead to optimiz-

ing the ﬁ rm’s proﬁ tability and growth. An effective pricing strategy requires

taking account of, and making trade-offs between, both internal ﬁ nancial and

external market constraints.

This chapter describes how managers can make that integration. It

describes a simple, logically intuitive procedure for quantitatively evaluat-

ing the potential impact of a price level change on proﬁ tability, even if their

knowledge of price elasticity is imprecise and qualitative. Although the accu-

racy of the resulting decision will be only as good as the accuracy of the infor-

mation used to reach it, the process we propose helps ensure that a decision

about what price level to set for any targeted segment is the best possible given

the available information and previously chosen price metric.

EVALUATING THE FINANCIAL IMPLICATIONS

OF PRICE ALTERNATIVES

A company’s margin goals, return on capital goals, and operating proﬁ t goals

are, or at least should be, entirely irrelevant to pricing decisions. They are quite

relevant for determining whether a company should invest to enter a mar-

ket or to offer a line of products or services. Thus, a company should antici-

pate the prices it expects will be possible before making such investments,

and reject those investments where it seems that viable price scenarios will be

Chapter 9 • Financial Analysis208

inadequate to generate an adequate return on investment. Having made

that investment, however, the best choice between two or more alternative

price points is determined entirely by which one will generate the most proﬁ t

contribution—revenue minus incremental, avoidable costs.

This makes evaluating price levels much easier than most people imag-

ine as they go through various means to allocate costs under different sce-

narios. There are only two things that need to be considered when comparing

alternative price level proposals: What is the difference in revenue expected

and what is the difference in costs that will be incurred to generate that rev-

enue. In most cases, the difference in costs is the easier of the two to estimate,

but even there it is possible to make mistakes that can lead to poor decisions.

Consequently, we will begin with guidance on how to select the appropriate

costs for price analysis.

Not all costs are relevant for every pricing decision. A ﬁ rst step in pric-

ing is to identify the relevant costs: Those that actually determine the proﬁ t

impact of the pricing decision. In principle, identifying the relevant costs for

pricing decisions is actually fairly straightforward. They are the costs that are

incremental (not average) and avoidable (not sunk). In practice, identifying

costs that meet these criteria can be difﬁ cult unless a company has a good

managerial accounting system in place. If one must rely on ﬁ nancial accounts,

which describe past averages and include costs that are no longer avoidable,

a pricing manager will need to create a “roughly right” approximation of the

incremental, avoidable costs in order to create a pricing capability. We will

now explain each of these distinctions in detail and illustrate it in the context

of a practical pricing problem.

WHY INCREMENTAL COSTS?

Pricing decisions affect whether a company will sell less of the product at a

higher price or more of the product at a lower price. In either scenario, some

costs remain the same (in total). Consequently, those costs do not affect the

relative proﬁ tability of one price versus another. Only costs that rise or fall

(in total) when prices change affect the relative proﬁ tability of different pricing

strategies. We call the costs that change with the change in a pricing decision

“incremental” to that decision.

Incremental costs are the costs associated with changes in pricing and

sales. The distinction between incremental and non-incremental costs paral-

lels closely, but not exactly, the more familiar distinction between variable and

ﬁ xed costs. Variable costs, such as the costs of raw materials in a manufactur-

ing process, are costs of doing business. Because pricing decisions affect the

amount of business that a company does, variable costs are always incremen-

tal for pricing. In contrast, ﬁ xed costs, such as those for product design, adver-

tising, and overheads, are costs of being in business.

They may be incremental

when deciding whether to be in the business of selling a particular type of

product or, in some cases, to serve a particular segment of customers. But ﬁ xed

costs that are not affected by how much a company actually sells (such as R&D

and corporate overhead) are not incremental and therefore not relevant when

management must decide what price level to set to maximize proﬁ t.

Some ﬁ xed costs, however, are incremental for pricing decisions, and

they must be appropriately identiﬁ ed. Incremental ﬁ xed costs are those that

Chapter 9 • Financial Analysis 209

directly result from implementing a price change or from offering a version of

the product at a different price level. For example, the ﬁ xed cost for a restau-

rant to print menus with new prices or for a public utility to gain regulatory

approval for a rate increase would be incremental when deciding whether to

make those changes. The ﬁ xed cost for an airline to advertise a new discount

service or to upgrade its planes’ interiors to offer a premium-priced service

would be incremental when deciding whether to offer products at those price

levels.

To further complicate matters, many costs are neither purely ﬁ xed nor

purely variable. They are ﬁ xed over a range of sales but vary when sales go

outside that range. The determination of whether such semiﬁ xed costs are

incremental for a particular pricing decision is necessary to make that deci-

sion correctly. Consider, for example, the role of capital equipment costs

when deciding whether to expand output. A manufacturer may be able to

ﬁ ll orders for up to 100 additional units each month without purchasing any

new equipment, simply by using the available equipment more extensively.

Consequently, equipment costs are non-incremental when ﬁ guring the cost

of producing up to 100 additional units. If the quantity of additional orders

increased by 150 units each month, though, the factory would have to pur-

chase additional equipment. The added cost of new equipment would then

become incremental and relevant in deciding whether the company can proﬁ t-

ably price its units low enough to attract that additional business.

To illustrate the importance of properly identifying incremental costs

when making pricing decisions, consider the problem faced by the business

manager of an annual one-day music festival produced by a small town near

a major metro area. The summertime festival is a source of pride for the town

but the event must turn a proﬁ t, ideally one sufﬁ cient to subsidize other cul-

tural events throughout the year. The festival incurs the following costs.

Planning and management overhead $15,000

Performer compensation $40,000

Venue (rentals and security) $20,000 per day

Variable costs (e.g., programs, ticketing) $10 per patron

When the town’s new business manager came on board a few years ago, she

began to increase prices with the festival continuing to sell out capacity at

1,000 tickets. Last year, however, ticket sales fell to only 914 after she increased

prices once again, from $90 to $100 per ticket. That price covered all the costs

and the town eked out a small proﬁ t of $7,260. But the failure of the festival to

sell out hurt civic pride, as well as local merchants who rely on the festival for

a boost in summer sales.

The town manager is reluctant to roll back prices, believing that the fes-

tival should make more of a ﬁ nancial contribution to the town. However, she

is under pressure to revive festival attendance. Two proposals were put for-

ward, although both involved selling seats at lower prices.

PROPOSAL A: ADDITIONAL PERFORMANCE Offer the same program of per-

formers on Friday as well as Saturday. The manager expects that making Fri-

day tickets available for $85 would deﬁ nitely revive interest from patrons who

were deterred by the $100 price. Based upon the demand turned away in prior

Chapter 9 • Financial Analysis210

years, she estimates that a Friday program could sell 700 tickets, but as many

as 200 of those could be sold to people who would otherwise have attended

the higher-priced Saturday performance. The net increase in ticket sales, after

accounting for the cannibalization of Saturday sales, would still be 500 tickets,

generating a 50% increase in total festival attendance and incremental revenue

of $39,500. Performers indicated that they would give a second performance

of the same program at half the one-day fee. The cost to set up staging and

seating for the venue ($8,000) would not need to be borne again to offer the

program two days in a row, reducing the venue cost to $12,000 for the added

performance.

PROPOSAL B: STUDENT RUSH DISCOUNT A less ambitious, but not neces-

sarily exclusive, proposal would involve offering half-price tickets to bona

ﬁ de full-time students for any seat still unsold 24 hours before the festival

performance. The manager estimates she could easily sell 100 such tickets,

but as many as 20 might be to students who otherwise would have bought

a full price ticket rather than waiting for the chance to get one at half price.

The net increase in ticket sales from this option, after accounting for canni-

balization of full price tickets, is 80 tickets generating incremental revenue

of $3,000.

Which, if either, of these proposals should the town manager adopt if

the goal is to maximize net income to the town? An analysis of the alterna-

tives is shown in Exhibit 9-1 and there are a few points that are noteworthy.

First, the ticket prices proposed for either proposal do not cover the fully allo-

cated average cost per ticket, a little over $85. At companies that still use the

antiquated and ﬂ awed practice of “absorption cost” accounting for manage-

rial decisions, both options would be rejected outright as unproﬁ table unless

ticket prices covered that cost. But the advantage of both proposals is that

much of the cost of the festival, although necessary for those options, is not

incremental to making the additional sales that they would generate. At the

proposed ticket prices, the incremental revenue expected to be generated by

either proposal more than covers the incremental cost. Also noteworthy is that

the Student Rush proposal is expected to be almost as proﬁ t-enhancing as the

additional Friday performance, even though it generates less than one-tenth

of the revenue.

Second, an important cost that is often overlooked in such an analysis is

the “opportunity cost” of revenues forgone from other sales: In this case, the

forgone sales of some $100 tickets when cheaper tickets are offered under the

new proposals. Although the “student rush” option involves selling tickets

at the lowest price, that price is easily “fenced” to minimize cannibalization

of higher-priced ticket sales by limiting it to bona ﬁ de students. Offering dis-

counted student rush tickets enables the potential to sell out the full venue

while maintaining the $100 price that most patrons ﬁ nd acceptable, adding

over $2,000 to the town’s expected $7,260 income from offering the festival at

$100 per ticket to everyone else. The Friday option, however, relies on custom-

ers self-segmenting. Considering the greater uncertainty involved in offering

the extra Friday performance, with a greater potential for loss if the expected

incremental sales are not achieved or if more patrons shift from the Saturday

to the cheaper Friday performance, the student rush might well be a better

choice.

Chapter 9 • Financial Analysis 211

Although the music festival example is hypothetical, the analytical chal-

lenges it illustrates are not. Scores of companies add to proﬁ t from sales that

are priced below average cost, which they can do when that average includes

costs that are not incremental to the additional sales:

• Packaged goods manufacturers often supply generic versions of their

branded products at prices below average cost. They can do so proﬁ t-

ably because they can produce them with little or no incremental costs of

capital, shipping, and selling beyond those already incurred to produce

their branded versions.

• A leading manufacturer of industrial cranes also does milling work for

other companies whenever the ﬁ rm’s vertical turret lathes would not

otherwise be used. The price for such work does not cover a proportion-

ate share of the equipment cost. It is, however, proﬁ table work since the

equipment must be available to produce the ﬁ rm’s primary product. The

equipment cost is, therefore, not incremental to the additional milling

work.

• Airlines ﬂ y weekend ﬂ ights that do not cover a proportionate share of

capital costs for the plane and ground facilities. Those costs must be

incurred to provide weekday service and so are irrelevant when judging

whether weekend fares are adequate to justify this service. In fact, week-

end fares often add incrementally more to proﬁ ts than higher weekday

fares precisely because they require no additional capital.

In each of these cases, the key to getting the business is having a low price.

Yet one should never be deceived into thinking that low-price sales are nec-

essarily low-proﬁ t sales. In some cases, they make a disproportionately

large contribution to proﬁ t because they make a small incremental addition

EXHIBIT 9-1

Analysis of Music Festival Revenue Options

Chapter 9 • Financial Analysis212

to costs. The goal of pricing is not to make higher priced sales; it is to make

higher proﬁ t sales.

WHY FOCUS ON AVOIDABLE COSTS?

The hardest principle for many business decision-makers to accept is that

the costs which are relevant for pricing are the ones that are still avoidable,

not the historical ones already incurred. Avoidable costs are those that either

have not yet been incurred or can be reversed. The costs of selling a product,

delivering it to the customer, and replacing the sold item in inventory are

avoidable, as is the rental cost of buildings and equipment that are not cov-

ered by a long-term lease. The opposite of avoidable costs are sunk costs—

those costs that a company is irreversibly committed to bear. For example,

a company’s past expenditures on research and development are sunk costs

since they cannot be changed regardless of any decisions made in the pres-

ent. The rent on buildings and equipment within the term of a current lease

is sunk, except to the extent that the ﬁ rm can avoid the expense by subletting

the property.

The cost of assets that a ﬁ rm owns may or may not be sunk. If an asset

can be sold for an amount equal to its purchase price times the percentage

of its remaining useful life, then none of its cost is sunk, since the cost of the

unused life can be entirely recovered through resale. Popular models of air-

planes often retain their value in this way, making avoidable the entire cost

of their depreciation from continued use. If an asset has no resale value, then

its cost is entirely sunk even though it may have much useful life remaining.

A neon sign depicting a company’s corporate logo may still function for a long

time, but its cost is entirely sunk since no other company would care to buy

it. Frequently, the cost of assets is partially avoidable and partially sunk. For

example, a new truck could be resold for a substantial portion of its purchase

price but would lose some market value immediately after purchase. The por-

tion of the new price that could not be recaptured is sunk and should not be

considered in pricing decisions. Only the decline in the resale value of the

truck is an avoidable cost of using it.

From a practical standpoint, the easiest way to identify the avoidable

cost is to recognize that the cost of making a sale is always the current cost

resulting from the sale, not costs that occurred in the past. What, for example,

is the cost for an oil company to sell a gallon of gasoline at one of its company-

owned stations? One might be inclined to say that it is the cost of the oil used

to make the gasoline plus the cost of reﬁ ning and distribution. Unfortunately,

that view could lead reﬁ ners to make some costly pricing mistakes. Most oil

company managers realize that the relevant cost for pricing gasoline is not the

historical cost of buying oil and producing a gallon of gasoline, but rather the

future cost of replacing the inventory when sales are made. Even LIFO (last-in,

ﬁ rst-out) accounting can be misleading for companies that are drawing down

large inventories. To account accurately for the effect of a sale on proﬁ tability,

managers should adopt NIFO (next-in, ﬁ rst-out) accounting for managerial

decision-making.

The distinction between the historical cost of acquisition and the future

cost of replacement is merely academic when supply costs are stable. It

becomes very practical when costs rise or fall.

When the price of crude oil

Chapter 9 • Financial Analysis 213

rises, companies quickly raise prices, long before any gasoline made from the

more expensive crude reaches the pump. Politicians and consumer advocates

label this practice “price gouging,” since companies with large inventories of

gasoline increase their reported proﬁ ts by selling their gasoline at much higher

prices than they paid to produce it. So what is the real incremental cost to the

company of selling a gallon of gasoline?

Each gallon of gasoline sold requires the purchase of crude oil at the

new, higher price for the company to maintain its gasoline inventory. If that

price is not covered by revenue from sales of gasoline, the company suffers

reduced cash ﬂ ow from every sale. Even though the sales appear proﬁ table

from a historical cost standpoint, the company must add to its working capital

(by borrowing money or by retaining a larger portion of earnings) to pay the

new, higher cost of crude oil. Consequently the real “cash” cost of making a

sale rises immediately by an amount equal to the increase in the replacement

cost of crude oil.

What happens when crude oil prices decline? If a company with large

inventories held its prices high until all inventories were sold, it would be

undercut by any company with smaller inventories that could proﬁ tably take

advantage of the lower cost of crude oil to gain market share. The company

would see its sales, proﬁ ts, and cash ﬂ ow decline. Again, the intelligent com-

pany bases its prices on the replacement cost, not the historical cost, of its

inventory. In historical terms, it reports a loss. However, that loss corresponds

to an equal reduction in the cost of replacing its inventories with cheaper crude

oil. Since the company simply reduces its operating capital by the amount of

the reported loss, its cash ﬂ ow remains unaffected by that “loss.”

The impact of sales on cash is usually a much better gauge of the incre-

mental, avoidable proﬁ tability of a sale than the cost of any historical decisions

enabling those sales.

UNDERSTANDING THE FINANCIAL IMPLICATIONS

OF ALTERNATIVE PRICE LEVELS

Far too often, price changes get made with little or no analysis of their likely

ﬁ nancial impact on proﬁ tability. Instead, decisions are made to lower prices

to protect sales or meet sales goals, and decisions are made to raise prices

to recover costs. As a result, price reductions occur without consideration of

whether the sales goal is appropriate. And opportunities to raise prices are

missed because decision-makers are never confronted with the potential prof-

its that could have been earned if they had acted.

The primary excuse for the failure to estimate and manage pricing for

proﬁ tability is that it requires estimates of relevant internal costs and of the

effect of price on external demand. We have described earlier in this chapter

how it is possible to make roughly accurate estimates of relevant costs. We

are also sympathetic to the challenge of estimating “demand price elasticities”

precisely and cost-effectively, although the cost of doing so for frequently pur-

chased consumer goods has declined immensely due to declines in the cost of

technology and the willingness of retailers to sell detailed sales data by brand

and package size.

For infrequently purchased products, for products new to the market,

and for products where prices are negotiated with large buyers, information

Chapter 9 • Financial Analysis214

about demand price elasticity is rarely precise enough to “optimize” the price.

But however difﬁ cult it is to know price elasticity with any certainty, it will

determine the difference in proﬁ tability that could be generated at different

price levels. Even if one cannot possibly estimate demand elasticity with a

high level of accuracy, it may still be possible to estimate the likelihood that it

will be at least whatever it needs to be to prevent a price change from damag-

ing proﬁ tability.

With an estimate of the minimum change in sales necessary to make a

price change proﬁ tably—what we call the breakeven sales change—it is pos-

sible to bring qualitative judgment to bear by, for example, asking a sales or

product manager whether she would prefer to retain the current sales goal

and target price level, a lower price level with a higher sales goal, or a higher

price level with a lower sales goal. It is also possible to track the effect of a

price change on sales levels to determine quickly whether the change is meet-

ing the minimum effects necessary for it to be proﬁ table. While the resulting

level of uncertainty may be uncomfortable, it is preferable to making decisions

blindly or failing to make them out of fear. Over time, as managers learn to

think in terms of managing pricing to achieve proﬁ t goals, rather than sales or

cost-recovery goals, they either become increasingly comfortable incorporat-

ing qualitative judgments or they invest to gain more quantitative insight.

Evaluating the Potential Proﬁ tability of a Price Change

The remainder of this chapter describes a simple, logically intuitive procedure

to quantitatively evaluate the potential proﬁ tability of a price change. First,

marketing or pricing managers must deﬁ ne a baseline against which any pric-

ing alternative is to be compared. For example, they might compare the effects

of a pending price change with the product’s current level of proﬁ tability, or

perhaps with a hypothetical scenario that management is particularly inter-

ested in exploring. Second, they need to calculate an incremental “breakeven”

point for the price change to determine the minimum, or “breakeven” sales

response necessary to achieve at least as much proﬁ tability at the new price

as at the baseline price. Finally, the managers must then decide whether they

believe that the sales response will reach at least that breakeven level—a deter-

mination that can incorporate both quantitative and qualitative information.

The key to integrating costs and quantitatively assessing the conse-

quences of a price change is the incremental breakeven formula. Although

similar in form to the common breakeven points that managers use to evaluate

investments, an incremental breakeven for pricing is quite different in prac-

tice. Rather than evaluating the sales required for a product to achieve over-

all proﬁ tability, which depends on many factors other than price, incremental

breakeven analysis focuses on the incremental effect on proﬁ tability of a price

change. Consequently, managers start from a baseline then ask whether a

change in price could improve the situation. More precisely, they ask:

• How much would sales volume have to increase to make a price reduc-

tion profitable?

Managers advocating for a lower price can then be asked for evidence

and commitment that the higher volume can be achieved and for a cred-

ible plan to achieve it.

Chapter 9 • Financial Analysis 215

• How much would sales volume have to decline to make a price

increase unprofitable?

Managers advocating for a higher price can then be asked for evidence

and commitment that sufﬁ cient volume can be retained at higher prices

and for a credible plan to justify those prices to customers.

The sample problems in this chapter introduce four alternative formulas which,

under different circumstances, would be used to answer these questions. To

introduce and illustrate the application of these formulas, we will describe the

experience of Westside Manufacturing, a company that makes high-quality

pillows for sale through specialty bedding and dry-cleaning stores. Although

the examples are, for simplicity, based on a hypothetical small manufacturing

business, the equations are equally applicable for analyzing any size or type of

business that does not negotiate a unique price for each customer.

If custom-

ers are effectively segmented for pricing, the formulas apply to price levels

within a segment.

Following are Westside Manufacturing’s income and costs for a typical

month:

Sales 4,000 units

Wholesale price $10.00 per unit

Revenue $40,000

Variable costs $5.50 per unit

Fixed costs $15,000

Westside is considering a 5 percent price cut, which it believes would make

it more competitive with alternative suppliers, enabling it to further increase

its sales. Management believes that the company would need to incur no

additional ﬁ xed costs as a result of this pricing decision. How much would

sales have to increase for this company to proﬁ t from a 5 percent cut?

To answer Westside’s question, we calculate the breakeven sales change.

This, for a price cut, is the minimum increase in sales volume necessary for

the price cut to produce an increase in contribution relative to the baseline.

Fortunately, making this calculation is simple, as will be shown shortly.

First, however, it may be more intuitive to illustrate the analysis graphically

(see Exhibit 9-2). In this exhibit, it is easy to visualize the ﬁ nancial trade-

offs involved in the proposed price change. Before the price change, Westside

receives a price of $10 per unit and sells 4,000 units, resulting in total revenues

of $40,000 (the total area of boxes (a) and (b)). From this Westside pays vari-

able costs of $5.50 per unit, for a total of $22,000 (box b). Therefore, before the

price change, total contribution is $40,000 minus $22,000, or $18,000 (box a). In

order for the proposed price cut to be proﬁ table, contribution after the price

cut must exceed $18,000.

After the 5 percent price reduction, Westside receives a price of only

$9.50 per unit, or $0.50 less contribution per unit. Since it normally sells 4,000

units, Westside would expect to lose $2,000 in total contribution (box c) on

sales that it could have made at a higher price. This is called the price effect.

Fortunately, the price cut can be expected to increase sales volume.

The contribution earned from that increased volume, the volume effect

(box e), is unknown. The price reduction will be proﬁ table, however, when

the volume effect (the area of box e) exceeds the price effect (the area of box c).

Chapter 9 • Financial Analysis216

That is, in order for the price change to be proﬁ table, the gain in contribution

resulting from the change in sales volume must be greater than the loss in con-

tribution resulting from the change in price. The purpose of breakeven analy-

sis is to calculate the minimum sales volume necessary for the volume effect

(box e) to balance the price effect (box c). When sales exceed that amount, the

price cut is proﬁ table.

So, how do we determine the breakeven sales change? We know that the

lost contribution due to the price effect (box c) is $2,000, which means that the

gain in contribution due to the volume effect (box e) must be at least $2,000

for the price cut to be proﬁ table. Since each new unit sold following the price

cut results in $4 in contribution ($9.50 – $5.50 = $4), Westside must sell at least

an additional 500 units ($2,000 divided by $4 per unit) to make the price cut

proﬁ table.

The minimum percent change in sales volume necessary to maintain at

least the same contribution following a price change can be directly calculated

by using the following simple formula (see Appendix 9B for derivation):

−

In this equation, the price change and contribution margin may be stated in

dollars, percentages, or decimals (as long as their use is consistent within

the same formula). The result of this formula is a decimal ratio that, when

multiplied by 100, is the percent change in unit sales necessary to maintain

the same level of contribution after the price change. The minus sign in the

numerator indicates a trade-off between price and volume: Price cuts increase

the volume and price increases reduce the volume necessary to achieve any

particular level of proﬁ tability. The larger the price change—or the smaller the

EXHIBIT 9-2

Finding the Breakeven Sales Change

Chapter 9 • Financial Analysis 217

contribution margin—the greater the volume change necessary to generate at

least as much contribution as before.

Assume for the moment that there are no incremental ﬁ xed costs in

implementing Westside’s proposed 5 percent price cut. For convenience, we

make our calculations in dollars (rather than in percentages or decimals). The

contribution margin is:

$CM = $10.00 – $5.50 = $4.50

Given this, we can easily calculate the breakeven sales change as follows:

Breakeven sales chan

−

()

−

()

(

−

125

Thus, the price cut is proﬁ table only if sales volume increases by more than

12.5 percent. Relative to its current level of sales volume, Westside would have

to sell at least 500 additional units to maintain the same level of proﬁ tability it

had prior to the price cut, as shown below:

Unit breakeven sales change = 0.125 x 4,000 = 500 units

If the actual increase in sales volume exceeds the breakeven sales change, the

price cut will be proﬁ table. If the actual increase in sales volume falls short

of the breakeven sales change, the price change will be unproﬁ table. If West-

side’s sales increase as a result of the price change by more than the break-

even amount—say, by an additional 550 units—Westside will realize a gain in

proﬁ t contribution. If, however, Westside sells only an additional 450 units as

a result of the price cut, it will suffer a loss in contribution.

Once we have the breakeven sales change and the proﬁ t contribution,

calculating the precise change in contribution associated with any change in

volume is straightforward: It is simply the difference between the actual sales

volume and the breakeven sales volume, times the new contribution margin

(calculated after the price change). For Westside’s 550-unit and 450-unit vol-

ume changes, the change in contribution equals the following:

(550 – 500) × $4 = $200

(450 – 500) × $4 = –$200

The $4 in these formulas is the new contribution margin ($9.50 – $5.50). You

might have noticed that the denominator of the percent breakeven formula is

also the new contribution margin.

We have illustrated breakeven analysis using Westside’s proposed

5 percent price cut. The logic is exactly the same for a price increase. Since

a price increase results in a gain in unit contribution, Westside can tolerate

some reduction in sales volume and still increase its proﬁ tability. How much

of a reduction in sales volume can Westside tolerate before the price increase

becomes unproﬁ table? The answer is this: Until the loss in contribution due to

reduced sales volume is exactly offset by the gain in contribution due to the

price increase. As an exercise, calculate how much sales Westside could afford

to lose before a 5 percent price increase becomes unproﬁ table.

It is important to note that the calculation resulting from the break-

even sales change formula is expressed as the percent change in unit volume

required to break even, not the percent change in monetary sales (for example,

Chapter 9 • Financial Analysis218

the percent change in dollar sales) required to break even. In the case of a price

cut, the percent breakeven sales change in units necessary to justify the price

cut is larger than the percent breakeven sales change in sales dollars because

the price is now lower.

To convert from the percent breakeven sales change in units to the per-

cent breakeven sales change in dollars, you can apply the following simple

conversion formula:

% BE($) = % BE(units) + % Price change [1 + % BE(units)]

For example, for Westside’s proposed 5 percent price cut above, the percent

breakeven sales change in unit volume terms was 12.5 percent. What is the cor-

responding percent breakeven sales change in dollar sales terms? The answer

is calculated as follows:

% BE($) = 0.125 + (–0.05)(1 + 0.125)

= 6.88%

Thus, to break even on the proposed 5 percent price cut, Westside would have

to increase its total dollar sales by 6.88 percent, which is exactly equivalent to

a 12.5 percent increase in unit volume.

BREAKEVEN SALES INCORPORATING

A CHANGE IN VARIABLE COSTS

Thus far, we have dealt only with price changes that involve no changes in

unit variable costs or in ﬁ xed costs. Often, however, price changes are made

as part of a marketing plan involving cost changes as well. A price increase

may be made along with product improvements that increase variable costs,

or a price cut might be made to push the product with lower variable selling

costs. Expenditures that represent ﬁ xed costs might also change along with a

price change. We need to consider these two types of incremental costs when

calculating the price–volume trade-off necessary for making pricing decisions

proﬁ table. We begin this section by integrating changes in variable cost into

the ﬁ nancial analysis. In the next section, we do the same with changes in

ﬁ xed costs.

Fortunately, dealing with a change in variable cost involves only a sim-

ple generalization of the breakeven sales change formula already introduced.

To illustrate, we return to Westside Manufacturing’s proposed 5 percent price

cut. Suppose that Westside’s price cut is accompanied by a reduction in vari-

able cost of $0.22 per pillow, resulting from Westside’s decision to use a new

synthetic ﬁ ller to replace the goose feathers it currently uses. Variable costs are

$5.50 before the price change and $5.28 after the price change. By how much

would sales volume have to increase to ensure that the proposed price cut is

proﬁ table?

When variable costs change along with the price change, managers

simply need to subtract the cost change from the price change before doing

the breakeven sales change calculation. Unlike the case of a simple price

change, managers must state the terms on the right-hand side of the equation

in currency units (dollars, euros, yen, and so forth) rather than in percentage

changes:

Chapter 9 • Financial Analysis 219

Breakeven sales chan

−

()

−

()

In this equation Δ indicates “change in,” P = price, and C = cost. Note that

when the change in variable cost ($ΔC) is zero, this equation is identi-

cal to the breakeven formula previously presented. Note also that the term

($ΔP – $ΔC) is the change in the contribution margin and that the denomina-

tor (the original contribution margin plus the change) is the new contribution

margin. Thus, the general form of the breakeven pricing equation is simply

written as follows:

Brea

even sa

es c

−Δ

For Westside, the next step in using this equation to evaluate the proposed

price change is to calculate the change in contribution margin. Recall that the

change in price is $9.50 – $10 (or –$0.50). The change in variable costs is –$0.22.

Thus, the change in contribution can be calculated as follows:

$ΔCM = ($ΔP – $ΔC) = –$0.50 – (–$0.22) = –$0.28

Previous calculations illustrated that the contribution margin before the price

change is $4.50. We can, therefore, calculate the breakeven sales change as

follows:

Brea

even sa

es c

−

()

−

()

(

−

066

In units, the breakeven sales change is 0.066 × 4,000 units, or 265 units. Given

management’s projection of a $0.22 reduction in variable costs, the price cut

can be proﬁ table only if management believes that sales volume will increase

by more than 6.6 percent, or 265 units. Note that this increase is substantially

less than the required sales increase (12.5 percent) calculated before assuming

a reduction in variable cost. Why does a variable cost reduction lower the nec-

essary breakeven sales change? Because it increases the contribution margin

earned on each sale, making it possible to recover the contribution lost due

to the price effect with less additional volume. This relationship is illustrated

graphically for Westside Manufacturing in Exhibit 9-2. Westside can realize a

gain in contribution due to the change in variable costs (box f), in addition to a

gain in contribution due to any increase in sales volume.

BREAKEVEN SALES ANALYSIS FOR REACTIVE PRICING

So far we have restricted our discussion to proactive price changes, where

the ﬁ rm contemplates initiating a price change ahead of its competitors. The

goal of such a change is to enhance proﬁ tability. Often, however, a company

initiates reactive price changes when it is confronted with a competitor’s price

change that will impact the former’s sales unless it responds. The key uncer-

tainty involved in analyzing a reactive price change is the sales loss the com-

pany will suffer if it fails to meet a competitor’s price cut, or the sales gain the

company will achieve if it fails to follow a competitor’s price increase. Is the

Chapter 9 • Financial Analysis220

potential sales loss sufﬁ cient to justify cutting price to protect sales volume?

Or is the potential sales gain enough to justify forgoing the opportunity for

a cooperative price increase? A slightly different form of the breakeven sales

formula is used to analyze such situations.

To calculate the breakeven sales changes for a reactive price change, we

need to address the following key questions: (i) What is the minimum poten-

tial sales loss that justiﬁ es meeting a lower competitive price? (ii) What is the

minimum potential sales gain that justiﬁ es not following a competitive price

increase? The basic formula for these calculations is this:

Reac

eake

sales

cha

Chan

ntri

ion margin

To illustrate, suppose that Westside’s principal competitor, Eastside, has just

reduced its prices by 15 percent. If Westside’s customers are highly loyal, it

probably would not pay for Westside to match this cut. If, on the other hand,

customers are quite price sensitive, Westside may have to match this price cut

to minimize the damage. What is the minimum potential loss in sales volume

that justiﬁ es meeting Eastside’s price cut? The answer (calculated in percent-

age terms) is as follows:

Reac

tiv

eake

sales

cha

−

=−

−

Thus, if Westside expects sales volume to fall by more than 33 percent as a

result of Eastside’s new price, it would be less damaging to Westside’s proﬁ t-

ability to match the price cut than to lose sales. On the other hand, if Westside

expects that sales volume will fall by less than 33 percent, it would be less

damaging to Westside’s proﬁ tability to let Eastside take the sales than it would

be to cut price to meet this challenge.

This analysis has focused on minimizing losses in the face of a competi-

tor’s proactive price reduction. However, the procedure for analysis is the

same when a competitor suddenly raises its prices. Suppose, for example, that

Eastside raises its price by 15 percent. Westside might be tempted to match

Eastside’s price increase. If, however, Westside does not respond to Eastside’s

new price, Westside will likely gain additional sales volume as Eastside’s cus-

tomers switch to Westside. How much of a gain in sales volume must be real-

ized in order for no price reaction to be more proﬁ table than a reactive price

increase? The answer is similarly found using the breakeven sales change for-

mula with a reactive price change. If Westside is conﬁ dent that sales volume

will increase by more than 33.3 percent if it does not react, a non-reactive price

policy would be more proﬁ table. If Westside’s management does not expect

sales volume to increase by 33.3 percent, a reactive price increase would be

more proﬁ table.

Of course, the competitive analysis we have done is, by itself, overly

simplistic. Eastside might be tempted to attack Westside’s other markets

if Westside does not respond to Eastside’s price cut. And Westside’s not

matching Eastside’s price increase might force Eastside to roll back its

prices. These long-run strategic concerns might outweigh the short-term

proﬁ t implications of a decision to react. In order to make such a judg-

ment, however, the company must ﬁ rst determine the short-term proﬁ t

Chapter 9 • Financial Analysis 221

implications. Sometimes long-term competitive strategies are not worth the

short-term cost.

MAPPING A RANGE OF POTENTIAL FINANCIAL OUTCOMES

To grasp fully the potential impact of a price change, especially when the deci-

sion involves incremental changes in ﬁ xed costs, it is useful to calculate the

proﬁ t impact for a range of potential sales changes and to summarize them

with a breakeven table and chart. Doing so is relatively simple after having

calculated the basic breakeven sales change. Using this calculation, one can

then simulate “what if” scenarios that include different levels of actual sales

volume following the price change.

The top half of Exhibit 9-3 is a summary of the basic breakeven sales

change analysis for Westside’s 5 percent price cut, with one column summa-

rizing the level of contribution before the price change (the column labeled

EXHIBIT 9-3

Breakeven Sales Analysis and Simulated Scenarios: Westside

Manufacturing’s Proposed 5 Percent Price Reduction

Chapter 9 • Financial Analysis222

“Baseline”) and one column summarizing the contribution after the price

change (the column labeled “Proposed Price Change”). The bottom half of

Exhibit 9-3 summarizes nine “what if” scenarios, showing the proﬁ tability

associated with changes in sales volume ranging from 0 to 40 percent given

incremental semiﬁ xed costs of $800 per 1,000 units. Columns 1 and 2 show the

actual change in volume for each scenario. Columns 3 through 5 calculate the

change in proﬁ t that results from each change in sales.

To illustrate how these breakeven sales-change scenarios are calculated,

let us focus for a moment on scenario 6, where actual sales volume is projected

to increase 20 percent. A 20 percent change in actual sales volume is equivalent

to an 800-unit change in actual sales volume, since 800 units is 20 percent of the

baseline sales volume of 4,000 units. How does this increase in sales translate

into changes in proﬁ tability? Column 3 shows that a 20 percent (or an 800-

unit) increase in sales volume results in a change in contribution after the price

change of $1,200. This is calculated by taking the difference between the actual

unit sales change (800 units) and the breakeven sales change shown in the top

half of Exhibit 9-3 (500 units) and multiplying by the new contribution margin

after the price change ($4). However, the calculations made in column 3 do not

take into account the incremental ﬁ xed costs required to implement the price

change (shown in column 4). Column 5 shows the change in proﬁ t after sub-

tracting the change in ﬁ xed costs from the incremental contribution generated.

EXHIBIT 9-4

Breakeven Analysis of a Price Change

Chapter 9 • Financial Analysis 223

Where there is inadequate incremental contribution to cover the incremental

ﬁ xed costs, as in scenarios 1 through 4, the change in proﬁ t is negative. Sce-

nario 5 illustrates the breakeven sales change. Scenarios 6 through 9 are all

proﬁ table scenarios, since they result in greater proﬁ t after the price change

than before.

The interrelationships among contribution, incremental ﬁ xed costs, and

the sales change that results from a price change are often easier to compre-

hend with a graph. Exhibit 9-4 illustrates the relationships among the data in

Exhibit 9-3.

BREAKEVEN SALES CURVES

So far we have discussed breakeven sales analysis in terms of a single change

in price and its resultant breakeven sales change. In the example above, West-

side Manufacturing considered a 5 percent price reduction, which we calcu-

lated would require a 17.5 percent increase in sales volume to achieve enough

incremental contribution to cover the incremental ﬁ xed cost. (As shown in

Exhibit 9-3, scenario 5.) However, what if the company wants to consider a

range of potential price changes? How can we use breakeven sales analysis to

consider alternative price changes simultaneously? The answer is by charting

a breakeven sales curve, which summarizes the results of a series of breakeven

sales analyses for different price changes.

Constructing breakeven sales curves requires doing a series of “what

if” analyses, similar to the simulated scenarios discussed in the last sec-

tion. Exhibits 9-5 and 9-6 show numerically and graphically a breakeven

sales curve for Westside Manufacturing, with simulated scenarios of price

changes ranging from +25 percent to –20 percent. Note in Exhibit 9-6 that the

vertical axis shows different price levels for the product, and the horizontal

axis shows a volume level associated with each price level. Each point on

the curve represents the sales volume necessary to achieve as much proﬁ t

after the price change as would be earned at the baseline price. For example,

Westside’s baseline price is $10 per unit, and baseline sales volume is 4,000

units. If, however, Westside cuts the price by 15 percent to $8.50, its sales

volume would have to increase 70 percent to 6,800 units to achieve the same

proﬁ tability, to cover both the decrease in contribution as well as the incre-

mental ﬁ xed costs. Conversely, if Westside increases its price by 15 percent

to $11.50, its sales volume could decrease 25 percent to 3,000 units and still

allow equal proﬁ tability.

The breakeven sales curve is a simple, yet powerful tool for synthesiz-

ing and evaluating the dynamics behind the proﬁ tability of potential price

changes. It presents succinctly and visually the dividing line that separates

proﬁ table price decisions from unproﬁ table ones. Proﬁ table price decisions are

those that result in sales volumes in the area to the right of the curve. Unprof-

itable price decisions are those that result in sales volumes in the area to the

left of the curve. What is the logic behind this? Recall the previous discussion

of what happens before and after a price change. The breakeven sales curve

represents those sales volume levels associated with their respective levels

of price, where the company will make just as much net contribution after

the price change as it made before the price change. If the company’s sales

EXHIBIT 9-5

Breakeven Sales Curve Calculations (with Incremental Fixed Costs)

224

Chapter 9 • Financial Analysis 225

volume after the price change is greater than the breakeven sales volume (that

is, actual sales volume is to the right of the curve), the price change will add to

proﬁ tability. If the company’s sales volume after the price change is less than

the breakeven sales volume (that is, the area to the left of the curve), the price

change will be unproﬁ table. For example, for Westside a price of $8.50 requires

a sales volume of at least 6,800 units to achieve a net gain in proﬁ tability. If,

after reducing its price to $8.50, management believes it will sell more than

6,800 units (a point to the right of the curve), then a decision to implement a

price of $8.50 per unit would be proﬁ table.

The breakeven sales curve also clearly illustrates the relationship

between the breakeven approach to pricing and the economic concept of

price elasticity. Note that the breakeven sales curve looks suspiciously like

the traditional downward-sloping demand curve in economic theory, in

which different levels of price (on the vertical axis) are associated with dif-

ferent levels of quantity demanded (on the horizontal axis). On a traditional

demand curve, the slope between any two points on the curve determines

the elasticity of demand, a measure of price sensitivity expressed as the per-

cent change in quantity demanded for a given percent change in price. An

economist who knew the shape of such a curve could calculate the proﬁ t-

maximizing price.

Unfortunately, few ﬁ rms use economic theory to set price because of the

unrealistic expectation that they ﬁ rst have to know their demand curve, or at

least the demand elasticity around the current price level. To overcome this

shortcoming, we have addressed the problem in reverse order. Rather than

EXHIBIT 9-6

Breakeven Sales Curve: Trade-Off Between Price and Sales Volume

Required for Constant Proﬁ tability

Chapter 9 • Financial Analysis226

asking, “What is the ﬁ rm’s demand elasticity?” we ask, instead, “What is the

minimum demand elasticity required?” to justify a particular pricing decision.

Breakeven sales analysis calculates the minimum or maximum demand elas-

ticity required to proﬁ t from a particular pricing decision. The breakeven sales

curve illustrates a set of minimum elasticities necessary to make a price cut

proﬁ table, or the maximum elasticity tolerable to make a price increase proﬁ t-

able. One is then led to ask whether the level of price sensitivity in the market

is greater or less than the level of price sensitivity required by the ﬁ rm’s cost

and margin structure.

This relationship between the breakeven sales curve and the demand

curve is illustrated in Exhibits 9-7 and 9-8, where hypothetical demand curves

are shown with Westside’s breakeven sales curve. If demand is more elastic,

as in Exhibit 9-7, price reductions relative to the baseline price result in gains

in proﬁ tability, and price increases result in losses in proﬁ tability. If demand is

less elastic, as in Exhibit 9-8, price increases relative to the baseline price result

in gains in proﬁ tability, and price reductions result in losses in proﬁ tability.

Although few, if any, managers actually know the demand curve for their

product, we have encountered many who can comfortably make judgments

about whether it is more or less elastic than is required by the breakeven sales

curve. Moreover, although we have not found any market research technique

that can estimate a demand curve with great precision, we have seen many

(described in Chapter 8 on measuring price sensitivity) that could enable man-

agement to conﬁ dently accept or reject a particular breakeven sales level as

achievable.

EXHIBIT 9-7

Breakeven Sales Curve: Relationship Between Price Elasticity of

Demand and Proﬁ tability

Chapter 9 • Financial Analysis 227

WATCHING YOUR BASELINE

In the preceding examples, the level of baseline sales from which we calcu-

lated breakeven sales changes was assumed to be the current level. For sim-

plicity, we assumed a static market. In many cases, however, sales grow or

decline even if price remains constant. As a result, the baseline for calculating

breakeven sales changes is not necessarily the current level of sales. Rather,

it is the level that would be expected to occur if no price change were made.

Consider, for example, a company in a high-growth industry with cur-

rent sales of 2,000 units on which it earns a contribution margin of 55 percent.

If the company does not change its price, management expects that sales will

increase by 20 percent (the projected growth of total industry sales) to 2,400

units. However, management is considering a 5 percent price cut in an attempt

to increase the company’s market share. The price cut would be accompanied

by an advertising campaign intended to heighten consumer awareness of the

change. The campaign would take time to design, delaying implementation of

the price change until next year. The initial sales level for the constant contribu-

tion analysis, therefore, would be the projected sales in the future, or 2,400 units.

Consequently, the breakeven sales change would be calculated as follows:

Breakeven sales chan

−

()

−

()

Or:

0.10 × 2,400 = 240 units

EXHIBIT 9-8

Breakeven Sales Curve: Relationship Between Price Elasticity of

Demand and Proﬁ tability: Changes in Proﬁ t with More Inelastic

Demand

Chapter 9 • Financial Analysis228

If the current sales level is used in the calculation, the unit breakeven sales

change is calculated as 200 units, understating the change required by 40 units.

COVERING NON-INCREMENTAL FIXED AND SUNK COSTS

By this point, one might be wondering about the non-incremental ﬁ xed

and sunk costs that have been ignored when analyzing pricing decisions.

A company’s goal must surely be to cover all of its costs, including all ﬁ xed

and sunk costs, or it will soon go bankrupt. This concern is justiﬁ ed and

is central to pricing for proﬁ t, but it is misguided when applied to justify

higher prices.

Note that the goal in price setting is to determine the price level that

maximizes a product’s proﬁ t contribution. Proﬁ t contribution, you will recall,

is the income remaining after all incremental, avoidable costs have been cov-

ered. It is money available to cover non-incremental ﬁ xed and sunk costs with,

ideally, a lot left over for proﬁ t. When managers consider only the incremen-

tal, avoidable costs in making pricing decisions, they are not saying that other

costs are unimportant. They simply realize that the level of those costs is irrel-

evant to decisions about which price will generate the most money to cover

them. Since non-incremental ﬁ xed and sunk costs do not change with a pric-

ing decision, they do not affect the relative proﬁ tability of one price versus an

alternative. Consequently, consideration of them simply clouds the issue of

which price level will generate the most proﬁ t.

All costs are important to proﬁ tability since they all, regardless of how

they are classiﬁ ed, have to be covered before proﬁ ts are earned. At some point,

all costs must be considered. What distinguishes value-based pricing from cost-

driven pricing is when they are considered. A major reason that this approach

to pricing is more proﬁ table than cost-driven pricing is that it encourages man-

agers to think about costs when they can still do something about them. Every

cost is incremental and avoidable at some time. For example, even the cost of

product development and design, although it is ﬁ xed and sunk by the time the

ﬁ rst unit is sold, is incremental and avoidable before the design process begins.

The same is true for other costs. The key to proﬁ table pricing is to recognize

that customers in the marketplace, not costs, determine what a product can sell

for. Consequently, before incurring any costs, managers need to estimate how

much customers can be convinced to pay for an intended product, given their

alternatives. Management must then decide, while all costs are still avoidable,

what costs they can proﬁ tably incur given the expected revenue.

Of course, no one has perfect foresight. Managers must make decisions

to incur costs without knowing for certain how the market will respond and

what alternatives competitors will offer. When their expectations are accurate,

the market rewards them with sales at the prices they expected, enabling them

to cover all costs and to earn a proﬁ t. When they overestimate a product’s

value, proﬁ t contribution may prove inadequate to cover all the costs incurred.

In that case, a good manager seeks to minimize the loss. This can be done

only by maximizing proﬁ t contribution (revenue minus incremental, avoid-

able costs). Short-sighted efforts to build non-incremental ﬁ xed and sunk costs

into a price to justify regretted investments made in the past will only reduce

volume further, making the losses worse.

Chapter 9 • Financial Analysis 229

Summary

The proﬁ tability of pricing decisions

depends largely on the product’s incre-

mental cost structure and the market’s

response to the change in price. We dis-

cuss the importance of identifying the

costs that are most relevant to the prof-

itability of a pricing decision, namely,

incremental and avoidable costs. Having

identiﬁ ed the right costs, one must also

understand how to use them. The most

important reason to identify costs cor-

rectly is to be able to calculate an accurate

contribution margin. An accurate contri-

bution margin enables management to

determine the amount by which sales

must increase following a price cut, or

by how little they may decline follow-

ing a price increase for any price change

to at least maintain the proﬁ t level that

would have been achieved without the

change. Understanding how changes in

sales will affect a product’s proﬁ tability

is the ﬁ rst step in pricing the product

effectively.

Notes

1. Elizabeth Drake, “F. Scott Fitzger-

ald: 10 Quotes on His Birthday,” The

Christian Science Monitor, September

23, 2012. Accessed April 21, 2017 at

www.csmonitor.com/Books/2012/

0923/F.-Scott-Fitzgerald-10-quotes-

on-his-birthday/A-smile.

2. Beware of costs classiﬁ ed as “over-

head.” Often costs end up in that

classiﬁ cation, even though they are

clearly variable, simply because

“overhead” is a convenient dump-

ing ground for costs that one has

not associated with the products

that caused them to be incurred. A

clue to the existence of such a mis-

classiﬁ cation is the incongruous

term “variable overhead.”

3. Most economics and accounting

texts equate avoidable costs with

variable costs, and sunk costs with

ﬁ xed costs, for theoretical conve-

nience. Unfortunately, those texts

usually fail to explain adequately

that this is an assumption rather

than a necessarily true statement.

Consequently, many students come

away from related courses with

the idea that a ﬁ rm should always

continue producing if price at least

covers variable costs. That rule is

correct only when the variable costs

are entirely sunk. In many indus-

tries (for example, airlines) the ﬁ xed

costs are often avoidable, since the

assets can be readily sold. When-

ever the ﬁ xed costs are avoidable if

a decision is not made to produce a

product, or to produce it in as large

a quantity, they should be consid-

ered when deciding whether a price

is adequate to serve a market.

4. LIFO and NIFO costs are the same

in any accounting period when

a ﬁ rm makes a net addition to its

inventory. In periods during which

a ﬁ rm draws down its inventory,

LIFO will understate costs after

the ﬁ rm uses up the portion of its

inventory values at current prices

and begins “dipping into old lay-

ers” of inventory valued at unreal-

istic past prices.

5. Sam Peltzman, “Prices Rise Faster

Than They Fall,” Journal of Politi-

cal Economy 108(3) (June 2000),

pp. 466–502.

6. The rule for analyzing the proﬁ t-

ability of independently negotiated

prices is simple: A price is proﬁ t-

able as long as it covers incremental

costs. Unfortunately, many manag-

ers make the mistake of applying

that rule when prices are not inde-

pendent across customers. They

assume, mistakenly, that because

they negotiate prices individually,

they are negotiating them indepen-

dently. In fact, because customers

talk to one another and learn the

Chapter 9 • Financial Analysis230

prices that others pay, prices are

rarely independent. The low price

you charge to one customer will

eventually depress the prices that

you can charge to others.

7. This equation can also accommo-

date a change in variable cost by

simply replacing the “change in

price” with the “change in price

minus the change in variable cost.”

One can also add to it the breakeven

necessary to cover a change in ﬁ xed

costs.

Chapter 9 • Financial Analysis 231

Appendix 9A

CASE STUDY: RITTER & SONS

CONSIDERATION OF PRICE

CHANGES FOR PROFIT

IMPROVEMENT

Ritter & Sons, an illustrative company, is

a wholesale producer of potted plants and

cut ﬂ owers. Ritter’s most popular prod-

uct is potted chrysanthemums (mums),

which are particularly in demand around

certain holidays, especially Mother’s

Day, Easter, and Memorial Day, but they

maintain a high level of sales through-

out the year. Exhibit 9A-1 shows Ritter’s

revenues, costs, and sales from mums

for a recent ﬁ scal year. After attending a

seminar on pricing, the company’s chief

ﬁ nancial ofﬁ cer, Don Ritter, wondered

whether this product might somehow be

priced more proﬁ tably. He then began a

serious examination of the effect of rais-

ing and lowering the wholesale price

of mums from the current price of $3.85

per unit.

Ritter’s ﬁ rst step was to identify the

relevant cost and contribution margin for

mums. Looking only at the data in Exhibit

9A-1, Don was somewhat uncertain how

to proceed. He reasoned that the costs of

the cuttings, shipping, packaging, and

pottery were clearly incremental and

avoidable and that the cost of administra-

tive overhead was ﬁ xed. He was far less

certain about labor and the capital cost of

the greenhouses. Some of Ritter’s work

EXHIBIT 9A-1

Cost Projection for Proposed Crop of Mums

Chapter 9 • Financial Analysis232

force consisted of long-time employees,

whose knowledge of planting techniques

was highly valuable. It would not be

practical to lay them off, even if they were

not needed during certain seasons. Most

production employees, however, were

seasonal laborers who were hired during

peak seasons and who found work else-

where in the off-season.

After consulting with the produc-

tion manager for potted plants, Don

concluded that about $7,000 of the labor

cost of mums was ﬁ xed. The remaining

$44,850 (or $0.52 per unit) was variable

and thus relevant to the pricing decision.

Don also wondered how he should

treat the capital cost of the greenhouses.

He was sure that the company policy of

allocating capital cost (interest and depre-

ciation) equally to every plant sold was

not correct. However, when Don sug-

gested to his brother Paul, the company’s

president, that since these costs were

sunk, they should be entirely ignored in

pricing, Paul found the suggestion unset-

tling. He pointed out that Ritter used all

of its greenhouse capacity in the peak sea-

son, that it had expanded its capacity in

recent years, and that it planned further

expansions in the coming year. Unless the

price of mums reﬂ ected the capital cost

of building additional greenhouses, how

could Ritter justify such investments?

That argument made sense to Don.

Surely the cost of greenhouses is incre-

mental when they are all in use, since

additional capacity would have to be

built if Ritter were to sell more mums.

But the greenhouses are used to the

45,000-unit capacity in only one of the

three growing seasons. In the other two

seasons combined, Ritter grew and sold

only 41,250 units. During those non-peak

seasons, Ritter could grow many more

mums. Ritter’s policy of making all mums

grown in a year bear a $0.77 capital cost

was simply misleading, since additional

mums could be grown without bearing

any additional capital cost during sea-

sons with excess capacity. Mums grown

in peak seasons, however, actually cost

much more than Ritter had been assum-

ing, since those mums require capital

additions. Thus, if the annual cost of an

additional greenhouse (depreciation,

interest, maintenance, heating) is $9,000,

and if the greenhouse will hold 5,000

mums for three crops each year, the capi-

tal cost per mum would be $0.60 ($9,000/

(3 x 5,000)) only if all greenhouses are

fully utilized throughout the year. Since

the greenhouses are ﬁ lled to capacity for

only one crop per year, the relevant capi-

tal cost for pricing that crop is $1.80 per

mum ($9,000/5,000), while it is zero for

pricing crops at other times.

As a result of his discussions, Don

calculated two costs for mums: One to

apply when there is excess capacity in

the greenhouses and one to apply when

greenhouse capacity is fully utilized. His

calculations are shown in Exhibit 9A-2.

These two alternatives do not exhaust

the possibilities. For any product, differ-

ent combinations of costs can be ﬁ xed

or incremental in different situations.

For example, if Ritter found itself with

excess mums after they were grown, pot-

ted, and ready to sell, the only incremen-

tal cost would be the cost of shipping. If

EXHIBIT 9A-2

Relevant Cost of Mums

Chapter 9 • Financial Analysis 233

Ritter found itself with too little capac-

ity and too little time to make additions

before the next peak season, the only way

to grow more mums would be to grow

fewer types of other ﬂ owers. In that case,

the cost of greenhouse space for mums

would be the opportunity cost (mea-

sured by the lost contribution) from not

growing and selling those other ﬂ owers.

The relevant cost for a pricing decision

depends on the circumstances. Therefore,

one must begin each pricing problem by

ﬁ rst determining the relevant cost for that

particular decision.

For Ritter, the decision at hand

involved planning production quanti-

ties and prices for the forthcoming year.

There would be three crops of mums

during the year, two during seasons

when Ritter would have excess growing

capacity and one during the peak season,

when capacity would be a constraint. The

relevant gross margin would be $2.25, or

58.5 percent ($2.25/3.85), for all plants. In

the peak season, however, the net proﬁ t

contribution would be considerably less

because of the incremental capital cost of

the greenhouses.

Don recognized immediately that

there was a problem with Ritter’s pricing

of mums. Since the company had tradi-

tionally used cost-plus pricing based on

fully allocated average cost, ﬁ xed costs

were allocated equally to all plants. Con-

sequently, Ritter charged the same price

($3.85) for mums throughout the year.

Although mums grown in the off-peak

season used the same amount of green-

house space as those grown during the

peak season, the relevant incremental

cost of that space was not always the

same. Consequently, the proﬁ t contribu-

tion for mums sold in an off-peak season

was much greater than for those sold in

the peak season. This difference was not

reﬂ ected in Ritter’s pricing. Don sus-

pected that Ritter should be charging

lower prices during seasons when the

contribution margin was large and higher

prices when it was small. Using his new

understanding of the relevant cost, Don

calculated the breakeven sales quantities

for a 5 percent price cut during the off-

peak season, when excess capacity makes

capital costs irrelevant, and for a 10 per-

cent increase during the peak season,

when capital costs are incremental to the

pricing decision. These calculations are

shown in Exhibit 9A-3.

Don ﬁ rst calculated the percent

breakeven quantity for the off-peak sea-

son, indicating that Ritter would need at

least a 9.3 percent sales increase to justify

a 5 percent price cut in the off-peak sea-

son. Then he calculated the basic break-

even percentage for a 10 percent price

increase during the peak season. If sales

declined by less than 14.6 percent as a

result of the price increase (equal to 6,570

units, given Ritter’s expected peak season

EXHIBIT 9A-3

Breakeven Sales Changes for Proposed Price Changes

Chapter 9 • Financial Analysis234

sales of 45,000 mums), the price increase

would be proﬁ table. Don also recog-

nized, however, that if sales declined

that much, Ritter could avoid construct-

ing at least one new greenhouse. That

capital cost saving could make the price

increase proﬁ table even if sales declined

by more than the basic breakeven quan-

tity. Assuming that one greenhouse

involving a cost of $9,000 per year could

be avoided, the breakeven decline rises

to 22.2 percent (equal to 9,990 units). If

a 10 percent price increase caused Ritter

to lose less than 22.2 percent of its pro-

jected sales for the next peak season, the

increase would be proﬁ table.

Judging whether actual sales

changes were likely to be greater or

smaller than those quantities was beyond

Don’s expertise. He calculated a series

of “what if” scenarios, called breakeven

sales change simulated scenarios, and

then presented his ﬁ ndings to Sue James,

Ritter’s sales manager (see Exhibit 9A-4).

EXHIBIT 9A-4

Breakeven Sales Change Simulated Scenarios (Vertical

Orientation)

Chapter 9 • Financial Analysis 235

Sue felt certain that sales dur-

ing the peak season would not decline

by 22.2 percent following a 10 percent

price increase. She pointed out that the

ultimate purchasers in the peak season

usually bought mums as gifts. Conse-

quently, they were much more sensi-

tive to quality than to price. Fortunately,

most of Ritter’s major competitors could

not match Ritter’s quality since they had

to ship their plants from more distant

greenhouses. Ritter’s local competition,

like Ritter, would not have the capac-

ity to serve more customers during the

peak season. The high-quality ﬂ orists

who comprised most of Ritter’s custom-

ers were, therefore, unlikely to switch

suppliers in response to a 10 percent

peak-period price increase. If peak sea-

son sales remained steady, proﬁ t con-

tribution would increase signiﬁ cantly,

by about $50,000. If peak season sales

declined modestly, the change in proﬁ t

contribution would still be positive.

Sue also felt that retailers who cur-

rently bought mums from Ritter in the

off-peak season could probably not sell

in excess of 9.3 percent more, even if they

cut their retail prices by the same 5 per-

cent that Ritter contemplated cutting the

wholesale price. Thus, the price cut would

be proﬁ table only if some retailers who

normally bought mums from competitors

were to switch and buy from Ritter. This

possibility would depend on whether

competitors chose to defend their mar-

ket shares by matching Ritter’s price cut.

If they did, Ritter would probably gain

no more retail accounts. If they did not,

Ritter might capture sales to one or more

grocery chains whose price-sensitive cus-

tomers and whose large expenditures on

ﬂ owers make them diligent in their search

for the best price.

Don and Sue needed to identify

their competitors and ask, “How does

their pricing inﬂ uence our sales, and

how are they likely to respond to any

price changes we initiate?” They spent

the next two weeks talking with custom-

ers and with Ritter employees who had

worked for competitors, trying to for-

mulate answers. They learned that they

faced two essentially different types of

competition. First, they competed with

one other large local grower, Mathews

Nursery, whose costs are similar to Rit-

ter’s. Because Mathews’s sales area gener-

ally overlapped Ritter’s, Mathews would

probably be forced to meet any Ritter price

cuts. Most of the competition for the larg-

est accounts, however, came from high-

volume suppliers that shipped plants

into Ritter’s sales area as well as into

other areas. It would be difﬁ cult for them

to cut their prices only where they com-

peted with Ritter. Moreover, they already

operated on smaller margins because

of their higher shipping costs. Conse-

quently, they probably would not match a

5 percent price cut.

Still, Sue thought that even the

business of one or two large buyers

might not be enough to increase Ritter’s

total sales in the off-peak season by more

than the breakeven quantity. Don recog-

nized that the greater price sensitivity of

large buyers might represent an opportu-

nity for segmented pricing. If Ritter could

cut prices to the large buyers only, the

price cut would be proﬁ table if the per-

centage increase in sales to that market

segment alone exceeded the breakeven

increase. Perhaps Ritter could offer a

5 percent quantity discount, for which

only the large, price-sensitive buyers

could qualify.

Alternatively, Ritter might

sort its mums into “ﬂ orist quality” and

“standard quality,” if it could assume that

its ﬂ orists would generally be willing to

pay a 5 percent premium to offer the best

product to their clientele.

Don decided to make a presenta-

tion to the other members of Ritter’s

management committee, setting out the

case for reducing price to large buyers

by 5 percent for the two off-peak sea-

sons and for increasing price by 10 per-

cent for the peak season as illustrated in

Exhibit 9A-5. After Don’s presentation,

Sue James explained why she believed

that sales would decline by less than the

breakeven quantity if price were raised

in the peak season. She also felt sales

might increase more than the breakeven

percent if price were lowered in the off-

peak seasons, especially if the cut could

be limited to large buyers.

Chapter 9 • Financial Analysis236

Since Ritter has traditionally set

prices based on a full allocation of costs,

some managers were initially skeptical of

this new approach. They asked probing

questions, which Don and Sue’s analysis

of the market enabled them to answer.

The management committee recognized

that the decision was not clear-cut. It

would ultimately rest on uncertain judg-

ments about sales changes that the pro-

posed price changes would precipitate.

If Ritter’s regular customers proved to be

more price sensitive than Don and Sue

now believed, the proposed 10 percent

price increase for the peak season could

cause sales to decline by more than the

breakeven quantity. If competitors all

matched Ritter’s 5 percent price cut for

large buyers in the off-peak season, sales

might not increase by as much as the

breakeven quantity.

The committee accepted the pro-

posed price changes. In related decisions,

they postponed construction of one new

greenhouse and established a two-tier

approach to pricing mums based on

selecting the best for “ﬂ orist quality” and

selling the lower-priced “standard qual-

ity” mums only in lots of 1,000.

Finally, they agreed that Don should

give a speech at an industry trade show on

how this pricing approach could improve

capital utilization and efﬁ ciency. In the

speech, he would reveal Ritter’s decision to

raise its price in the peak season. (Perhaps

Mathews’s management might decide

to take such information into account in

independently formulating its own pric-

ing decisions.) He would also let it be

known that if Ritter were unable to sell

more mums to large local buyers in the off-

peak season, it would consider offering the

mums at discount prices to ﬂ orists outside

of its local market. This plan, it was hoped,

would discourage non-local competitors

from ﬁ ghting for local market share, lest

the price-cutting spread to markets they

found more lucrative.

At this point, there was no way to

know whether these decisions would

prove proﬁ table. Management could

have requested more formal research

EXHIBIT 9A-5

Proﬁ t Impact of a 10 Percent Increase

Chapter 9 • Financial Analysis 237

into customer motivations or a more

detailed analysis of non-local competi-

tors’ past responses to price-cutting. Since

past behavior is never a perfect guide to

the future, the decision would still have

required weighing the risks involved

with the beneﬁ ts promised. Still, Don’s

analysis ensured that management identi-

ﬁ ed the relevant information for this deci-

sion and weighed it appropriately.

Notes

1. We are assuming that a greenhouse

depreciates no more rapidly when

in use than when idle. If it did depre-

ciate faster when used, the extra

depreciation would be an incremen-

tal cost even for crops grown during

seasons with excess capacity.

2. This option could expose Ritter to

the risk of a legal challenge if Rit-

ter’s large buyers compete directly

with its small buyers in the retail-

ing of mums. Ritter could rebut

the challenge if it could justify the

5 percent discount as a cost saving

in preparing and shipping larger

orders. If not, then Ritter may want

to try more complicated methods to

segment the market, such as offer-

ing somewhat different products to

the two segments.

Chapter 9 • Financial Analysis238

Appendix 9B

DERIVATION OF THE

BREAKEVEN FORMULA

A price change can either increase or

reduce a company’s proﬁ ts, depending

on how it affects sales. The breakeven for-

mula is a simple way to discover at what

point the change in sales becomes large

enough to make a price reduction proﬁ t-

able, or a price increase unproﬁ table.

Exhibit 9B-1 illustrates the break-

even problem. At the initial price P, a

company can sell the quantity Q. Its total

revenue is P times Q, which graphically

is the area of the rectangle bordered by

the lines 0P and 0Q. If C is the product’s

variable cost, then the total proﬁ t contri-

bution earned at price P is (P – C)Q. Total

proﬁ t contribution is shown graphically

as the rectangle left after subtracting the

variable cost rectangle (0C, 0Q) from the

revenue rectangle (0P, 0Q).

If this company reduces its price

from P to P’, its proﬁ ts will change. First,

it will lose an amount equal to the change

in price, ΔP, times the amount that it could

sell without the price change, Q. Graphi-

cally, that loss is the rectangle labeled A.

Somewhat offsetting that loss, however,

the company will enjoy a gain from the

additional sales it can make because of

the lower price. The amount of the gain

is the proﬁ t that the company will earn

EXHIBIT 9B-1

Breakeven Sales Change Relationships

Chapter 9 • Financial Analysis 239

from each additional sale, P’ – C, times the

change in sales, ΔQ. Graphically, that gain

is the rectangle labeled B. Whether or not

the price reduction is proﬁ table depends

on whether or not rectangle B is greater

than rectangle A, and that depends on the

size of ΔQ.

The logic of a price increase is simi-

lar. If P’ were the initial price and Q’ the

initial quantity, then the proﬁ tability of a

price increase to P would again depend

on the size of ΔQ. If ΔQ were small, rect-

angle A, the gain on sales made at the

higher price, would exceed rectangle B,

the loss on sales that would not be made

because of the higher price. However, ΔQ

might be large enough to make B larger

than A, in which case the price increase

would be unproﬁ table.

To calculate the formula for the

breakeven ΔQ (at which the gain from a

price reduction just outweighs the loss

or the loss from a price increase just out-

weighs the gain), we need to state the

problem algebraically. Before the price

change, the proﬁ t earned was (P – C)Q.

After the change, the proﬁ t was (P’ – C)

Q’. Noting, however, that P’ P + ΔP (we

write, “+ΔP” since ΔP is a negative num-

ber) and that Q’ Q + ΔQ, we can write the

proﬁ t after the price change as (P + ΔP – C)

(Q + ΔQ). Since our goal is to ﬁ nd the

ΔQ at which proﬁ ts would be just equal

before and after the price change, we

can begin by setting those proﬁ ts equal

algebraically:

(P – C)Q = (P +ΔP – C)(Q +ΔQ)

Multiplying this equation through yields:

PQ – CQ = PQ +ΔPQ – CQ + PΔQ +

ΔPΔQ – CΔQ

We can simplify this equation by sub-

tracting PQ and adding CQ to both sides

to obtain:

0 = ΔPQ + PΔQ + ΔPΔQ – CΔQ

Note that all the remaining terms in the

equation contain the “change sign” Δ.

This is because only the changes are rel-

evant for evaluating a price change. If we

solve this equation for ΔQ, we obtain the

new equation:

−

which, in words, is:

Brea

even sa

es c

Chan

ntr

tion

−

Pric

Chan

CHAPTER 10

Specialized Strategies

Adapting Pricing to Accommodate

Common Challenges

If you always do what you’ve always done, you will only get what you’ve always got.

Anonymous

There are infrequent, yet common, strategic pricing challenges that can dam-

age proﬁ tability unless recognized and managed appropriately. Appropriate

management generally requires changing goals and patterns of organizational

behavior to reﬂ ect a change in circumstances. Someone with cross-functional

authority—perhaps someone in top management, perhaps an empowered

manager of strategic pricing—must recognize the challenge and create an

organizational or a cross-functional process to address it. The purpose of this

chapter is to identify some of those challenges, enabling you to anticipate and

thus to manage them proactively. They are as follows:

• Adapting pricing strategy over the product category life cycle

• Managing export prices in foreign currencies

• Managing pricing when markets slump

• Establishing transfer prices to maximize proﬁ tability across proﬁ t

centers.

While the discussions that follow describe practices for dealing with each of

these challenges, they also illustrate how understanding pricing issues that

we have dealt with individually—customer value, competition, costing, and

internal organization—can reveal still more opportunities for proﬁ t improve-

ment when considered collectively.

ADAPTING PRICING STRATEGY OVER

CATEGORY LIFE CYCLE

The market for a product category passes through predictable phases, each

with its own challenges for pricing (see Exhibit 10-1). Innovations, which

offer customers new beneﬁ ts that they could not achieve previously, require

Chapter 10 • Specialized Strategies 241

EXHIBIT 10-1

Sales and Proﬁ ts Over the Product’s Life, from Inception to Demise

convincing customers that they should include the new category in the set of

things they purchase. Growth in a product category requires aligning value

with price across emerging market segments. Maturity requires making

choices designed to maintain margins in the face of increasing competition

and customers with enough accumulated experience to conﬁ dently evaluate

the features and beneﬁ ts of competing brands. Recognizing the need to adjust

proactively to a changing market is key to sustaining relatively high margins

and proﬁ ts over the entire life cycle of a product category.

Pricing an Innovation

The number one pricing challenge when launching an innovation is to estab-

lish a price level that reﬂ ects and communicates the unique value created by

the new “technology.”

Not all new products are innovations from a cus-

tomer perspective, since most new products simply offer more of the same

beneﬁ ts as their earlier substitutes or offer the same beneﬁ ts at a lower cost.

When a new technology enables customers to achieve entirely new beneﬁ ts, it

creates a new category of purchases. Since the category is new, most potential

customers lack direct experience from which to infer value. A small subset of

potential customers is likely to be induced to try an innovation because they

can afford the risk and may know more about the science or technology of the

category. Everyone else is unlikely to buy it, regardless of the price, because

they have no experience enabling them to infer the heretofore unexperienced

beneﬁ ts and because they have no anchor by which to determine whether the

price is “expensive” or “cheap” relative to value received.

The ﬁ rst automobiles, vacuum cleaners, electric stoves, automatic teller

machines, and desktop computers, as well as the ﬁ rst offers of acupuncture

sessions to treat illness, initially had to overcome considerable buyer apa-

thy despite what ultimately proved to be substantial beneﬁ ts. Why? Because

Chapter 10 • Specialized Strategies242

an innovation requires buyers to change patterns they have learned from

experience for how best to satisfy their needs. By deﬁ nition, most customers

know little about an innovative product or service and how it might address

unmet needs in new ways that produce new beneﬁ ts, let alone what the value

of those beneﬁ ts might be. Hence, successful launches of innovations hinge

upon a company’s ability not only to create good value, but to develop cus-

tomers who understand at least the potential of the product to create value

for them.

An important aspect of that process is called information “diffusion.”

Most of what individuals learn about innovative products comes from seeing

and hearing about the experiences of others.

The diffusion of that information

from person to person has proven especially inﬂ uential for large-expenditure

items, such as consumer durables, where buyers take a signiﬁ cant risk the ﬁ rst

time they buy an innovative product. For example, an early study on the dif-

fusion of innovations found that the most important factor inﬂ uencing a fam-

ily’s ﬁ rst purchase of a window air conditioner was neither an economic factor

such as income nor a need factor such as exposure of bedrooms to the sun. The

most important factor was social interaction with another family that already

had a window air conditioner.

This ﬁ nding has been replicated with dozens

of innovations ranging from consumer electronics to business computers.

This diffusion process is extremely important in formulating pricing

strategy for two reasons: First, empirical studies indicate that demand does

not begin to accelerate until the ﬁ rst two to ﬁ ve percent of potential buyers

adopt the product.

The attainment of those initial sales is the hardest part of

marketing an innovation. Obviously, the sooner the seller can close those ﬁ rst

sales, the sooner she will generate positive cash ﬂ ow and grow the market

to its long-run level of demand. Second, “early adopters” are not generally a

random sample of buyers. They are people particularly suited to evaluate the

product before purchase. In most cases, they are also people to whom the later

adopters, or “imitators,” look for guidance and advice.

Even early adopters, who may understand the technology and the poten-

tial beneﬁ ts of an innovation, usually know little about how to value them in

monetary terms. Value communications and effective promotional programs

can readily inﬂ uence which attributes drive those initial purchase decisions

and how those attributes are valued. Identifying the early adopters and mak-

ing every effort to ensure that their experience is positive is an essential part of

marketing an innovation.

The implication is that, in contrast to the launch of new products into

mature markets, innovative products that create new markets are unlikely to

win much additional volume by setting prices low, since neither “imitators”

nor “early adopters” are price sensitive when making their ﬁ rst purchase. The

“imitators” are not going to become early adopters simply because of a low

price, since they lack a reference for determining what would constitute a fair

or bargain price. “Early adopters,” on the other hand, are likely to place the

highest value among all segments on the product’s potential beneﬁ ts; that is

what motivates them to try new, unproven products and services. The goal

of pricing an innovation is to establish a reference price, via sales to early

adopters, that communicates their belief that the innovative product or ser-

vice offers differentiating beneﬁ ts that are worth a premium price. That price,

however, must not exceed a level that would cause early adopters to conclude

Chapter 10 • Specialized Strategies 243

after purchase that the product’s price was not justiﬁ ed by value received.

Their endorsement and, if the product is a consumable, their repeat purchase,

is what ultimately will drive growth as imitators, seeing the behavior and sat-

isfaction of the early adopters, gain conﬁ dence that a purchase in the category

is worth the risk.

So how can one drive initial adoption of an innovation if low pricing is

unlikely to be very effective? Instead of setting prices low, one is far better off

setting prices initially as if the only market for the product were those custom-

ers in the “early adopter” segment. The high margin from making a successful

sale gives the ﬁ rm a high incentive to mitigate hurdles than might otherwise

prevent purchase. For example, one of those hurdles is often that channel inter-

mediaries do not want to carry, let alone promote, a product that does not

already have a market. In such situations, a large, even if temporary, wholesale

price discount combined with resale price maintenance (see Chapter 12, pages

299–312) creates a high margin to motivate channel intermediaries. For con-

sumer packaged goods, the discount may be offered in return for displaying

the innovative product on an aisle “end cap” or other highly visible location.

Sellers of innovative B2B technology products offer discounts for a limited

time to inﬂ uential channel partners who in return offer a high level of technical

support that minimizes the risk of product adoption.

To motivate the early-adopter end customers, the goal is to overcome all

the non-price hurdles to purchase. To mitigate fear that an innovative product

or service might not actually generate the promised beneﬁ ts, the seller might

offer a high level of new purchase support, as Apple does with its Apple

Stores

staffed by “geniuses” who enable potential buyers to recognize and

personally experience the beneﬁ ts of its product innovations both before and

after purchase. For consumables, such as software products or memberships

to a newly opened gym, the seller can offer limited free trials. For example,

Tableau’s innovative data visualization software gives potential buyers

30 days of free use before requiring a payment to purchase continued access.

It is important to note that in these cases, while the word “free” is used to moti-

vate trial, the product is not in fact being discounted for a sustained period. In

fact, the customer is being framed on the price that reﬂ ects value, and expects

to pay that price once product performance is demonstrated and the beneﬁ ts

are experienced, or at least anticipated.

For innovative products that are infrequently purchased or experiential

products, companies sometimes offer money-back guarantees that the product

will be accepted for return for a refund if the customer is not fully satisﬁ ed.

In the most extreme cases, companies selling high-margin innovations will even

guarantee beneﬁ ts whenever they are easily and objectively measurable. Phar-

maceutical companies launching innovative drugs with relative high prices,

such as chemotherapies, will sometimes offer the payer a complete refund for

any patient who fails to respond to treatment.

Another example comes from

BulbHead, a seller of innovative lighting solutions. One of their top-selling

items is a “Star Shower Motion” that consists of a laser light that is planted in

front of a house and projects a decorative kaleidoscope of light onto it. One

challenge facing potential buyers is that the product has been so popular that

it has led to the less scrupulous holiday revelers stealing these lights from

people’s lawns. To mitigate this potential barrier to purchase, BulbHead offers

to send a replacement to any purchaser who has lost a Star Shower to theft.

Chapter 10 • Specialized Strategies244

Of course, these types of offers can be expensive ways to make initial sales,

but not nearly as expensive in the long run as offering a low price that is only

minimally effective in driving sales but very effective in anchoring future price

expectations at a needlessly low price point.

Price Reductions in Growth

The end-customer retail price for the growth stage is normally less than the

price set during the market development stage. In most cases, new com-

petition in the growth stage gives buyers more alternatives from which to

choose, while their growing familiarity with the product enables them to

better evaluate those alternatives. Both factors will increase price sensitivity

over what it was in the development stage. Moreover, even if a ﬁ rm enjoys a

patented monopoly, reducing price after the innovation stage can speed the

product adoption process and enable the ﬁ rm to proﬁ t from faster market

growth.

Such price reductions are usually possible without sacriﬁ cing proﬁ ts

because of cost economies from an increasing scale of output and accumu-

lated experience.

Price competition in the growth stage is not generally cut-throat. The

growth stage is characterized by a rapidly expanding sales base. New ﬁ rms

can generally enter existing markets and can expand without forcing com-

petitors’ sales to contract. For example, sales of Apple’s iPhone

continued

to grow, despite continual loss of some market share to new entrants during

growth of the smartphone category. Because new entrants can grow without

forcing established ﬁ rms to contract, the growth stage usually will not pre-

cipitate aggressive price competition. Watch out, however, for the following

situations that can presage unanticipated price competition:

1. Production economies resulting from manufacturing greater volumes

are large and the market is price sensitive. Consequently, each ﬁ rm sees

the battle for volume as a battle for long-run survival (as often occurs in

the electronics industry).

2. Sales volume determines which of two or more competing technologies

becomes the industry standard (as occurred in the market for digital

music players).

3. Growth in production capacity jumps ahead of the growth in sales (as

occurred in the market for solar panels), creating excess capacity.

In the cases above, price competition can become bitter as ﬁ rms sacriﬁ ce

short-term proﬁ t to sustain market share that they hope will become proﬁ table

as market size continues to increase.

Whether or not price competition becomes intense, the most proﬁ table

and generally viable pricing strategies in growth involve segmentation. In the

introduction phase, all customers are new to the market but over time custom-

ers naturally segment themselves between those who are making their ﬁ rst

purchase and those who are knowledgeable and experienced users of the new

technology. Experienced buyers know enough to compare products based on

online descriptions. Consequently, they can get better pricing than less expe-

rienced buyers, who may require the help of a retailer to select and conﬁ gure

the product.

Chapter 10 • Specialized Strategies 245

In addition, different segments of the market emerge during the growth

stage that will get different amounts of value from a product and/or will

require different levels of costs to serve them. Innovative pharmaceuticals

are a case in point. In most cases, end consumers pay only a ﬁ xed amount

for a drug regardless of the cost to the healthcare system—which in some

countries is a governmental department and in others is an insurer. The dif-

ferent types of payers range from those that exercise little control over what

doctors prescribe, to those that create ﬁ nancial incentives for doctors and

patients to select one drug in preference to another, to those that will pay for

only a limited subset of drugs listed on an “approved formulary” list, leav-

ing patients to pay the full cost of using a drug not on that list. The challenge

when a market is highly segmented is to design a structure of discount crite-

ria for contracting with these different types of payers that maximizes total

proﬁ t contribution as described in Chapter 4.

Pricing the Established Product in Maturity

Many products fail to make the transition to market maturity because they

failed to achieve strong competitive positions with differentiated products

or a cost advantage earlier in the growth stage.

In the growth stage, the

source of proﬁ t is sales to an expanding market. In maturity, that proﬁ t

source becomes nearly depleted. A strategy in a mature market that is predi-

cated on continued expansion of one’s customer base will likely be dashed

by competitors’ determination to defend their market shares. Having made

capacity investments to produce a certain level of output, competitors

will usually defend their market shares to avoid being overwhelmed by

sunk costs.

Pricing latitude is further reduced by the three additional factors that

increase price competition as the market moves from growth to maturity:

1. The accumulated purchase experience of repeat buyers improves their

ability to evaluate and compare competing products, reducing brand

loyalty and the value of a brand’s reputation.

2. The imitation of the most successful product designs, technologies, and

marketing strategies reduces product differentiation, making the various

brands of different ﬁ rms more directly competitive with one another.

This homogenizing process is sometimes sped up when product stan-

dards are set by government agencies or by respected independent test-

ing agencies such as Underwriter Laboratories.

3. Buyers’ increased price sensitivity and the lower risk that accompanies

production of a proven standardized product attract new competitors

whose distinctive competence is copying and more efﬁ ciently producing

products for which there is already a strong category demand.

All three of these factors have worked to reduce the prices of cellular phone

services and of laptop computers by well more than half in competitive devel-

oped markets.

As discussed in Chapter 7 on Price Competition, effective pricing of com-

moditized products in maturity usually focuses not on valiant efforts to buy

market share but on making the most of whatever competitive advantages

the ﬁ rm has to sustain margins. Even before industry growth is exhausted

Chapter 10 • Specialized Strategies246

and maturity sets in, a ﬁ rm does well to seek out opportunities to main-

tain its margins in maturity, despite increased competition among ﬁ rms and

increased sophistication among buyers. The ﬁ ve situations described below

are good places to look for margin enhancement opportunities in mature mar-

kets despite the competitive pressures:

1. UNBUNDLING RELATED PRODUCTS AND SERVICES In the growth stage it

is important to make it easy for potential buyers to try the product and to

ensure that customers encounter no problems in experiencing the beneﬁ ts.

Consequently, it makes sense to sell everything needed to achieve the beneﬁ t

as a bundled package. During decades of rapid growth in the customer base

for video games, Nintendo launched uniquely popular video games—like

“Super Mario”—that could only be played on its own video consoles. But as

smartphones became more powerful, the growth in gaming shifted from dedi-

cated players to mobile devices. To sustain its growth, Nintendo began in 2016

to unbundle its popular software IP from its video player—creating “Super

Mario Run” for the iPhone.

Although the price to download Super Mario to a

mobile device is relatively low, the cost of sales and delivery is also low while

the market is huge. Nintendo also for the ﬁ rst time licenses its creative IP for

a theme park ride. Nintendo illustrates how, at the same time a market suffers

from saturation, the existing base of loyal customers usually creates opportu-

nities to grow by unbundling and leveraging the assets to grow in tangential

markets.

As a market moves toward maturity, bundling normally becomes less

a competitive defense and more a competitive invitation. As their numbers

increase, competitors more closely imitate the differentiating aspects of prod-

ucts in the leading company’s bundle. This makes it easier for someone to

develop just one superior part, allowing buyers to purchase other parts from

the leading company’s other competitors. If buyers are forced to purchase

from the leading company only as a bundle, the more knowledgeable ones

will often abandon it altogether to purchase individual pieces from innovative

competitors. Unless the leading company can maintain overall superiority in

all products, unlikely in the maturity stage, it is generally better to focus on the

products and services for which one can deliver a better value proﬁ tably, and

let knowledgeable customers buy other parts from competitors. In the per-

sonal computer industry, the most successful companies built their products

to accommodate whatever brand of printer or other peripheral products the

customer might prefer.

2. IMPROVED ESTIMATION OF PRICE SENSITIVITY Given the instability of the

growth stage of the life cycle, when new buyers and sellers are constantly enter-

ing the market, formal estimation of buyers’ price sensitivity is often a futile

exercise. Estimates of price–volume trade-offs during growth frequently rely

on qualitative judgments and experience from trial-and-error experimenta-

tion. In maturity, when the source of demand is repeat buyers and when com-

petition becomes more stable, a ﬁ rm can better gauge the incremental revenue

from a price change and discover that a little ﬁ ne-tuning of price can signiﬁ -

cantly improve proﬁ ts. Most large consumer packaged goods companies have

gained a competitive advantage relative to smaller competitors by investing in

the capability to track and maintain actual sales data of their products at the

Chapter 10 • Specialized Strategies 247

retail level. This has enabled them to more ﬁ nely optimize their competitive

pricing strategies by package size, geography, and channel.

3. IMPROVED CONTROL AND UTILIZATION OF COSTS As the number of cus-

tomers and product variations increases during the growth stage, a ﬁ rm may

justiﬁ ably allocate costs among them arbitrarily. New customers and new

products initially require technical, sales, and managerial support that is rea-

sonably allocated to overhead during growth, since it is as much a cost of

future sales as of the initial ones. In the transition to maturity, a more accurate

allocation of incremental costs to sales may reveal opportunities to signiﬁ -

cantly increase proﬁ t. For example, one may ﬁ nd that sales at certain times of

the year, the week, or even the day require capacity that is underutilized dur-

ing other times. Sales at these times should be priced higher to reﬂ ect the cost

of capacity, creating an incentive for customers who can shift their demand

to periods when capacity is underutilized. Examples of this tactic include dis-

counted gym memberships that restrict access to off-peak hours, lower ship-

ping costs if the recipient can accept delivery at off-peak hours, or “early bird

discounts” at restaurants for diners willing to eat before the evening rush.

More important, a careful cost analysis will identify those products and

customers that are simply not carrying their weight. If some products in the

line require a disproportionate sales effort, that should be reﬂ ected in the incre-

mental cost of their sales and in their prices. If demand cannot support higher

prices for them, they are prime candidates for pruning from the line.

The same

holds true for customers. If some require technical support disproportionate

to their contribution, one might well implement a pricing policy of charging

separately for such services. While the growth stage provides fertile ground in

which to make long-term investments in product variations and in developing

new customer accounts, maturity is the time to cut one’s losses on those that

have not begun to pay dividends and that cannot be expected to do so.

4. EXPANSION OF THE PRODUCT LINE Although increased competition and

buyer sophistication in the maturity phase erode one’s pricing latitude for the

primary product, the ﬁ rm may be able to leverage its position as a differenti-

ated or as a low-cost producer to sell peripheral goods or services that it can

price more proﬁ tably or by establishing charges for “discretionary” services.

Although car rental margins are slim because they are easy to compare, the

rental companies earn highly proﬁ table margins from sales of the related add-

ons: insurance, GPS systems, child safety car seats, and fuel purchase options.

Credit card companies make money on the over-limit and late payment

charges, the foreign currency fees, and the fees charged to retailers, even when

they barely break even on the annual fee and the interest charges that drive a

consumer’s choice of a card.

5. REEVALUATION OF DISTRIBUTION CHANNELS Finally, in the transition to

maturity, most companies begin to reevaluate their wholesale prices with an

eye to reducing dealer margins. There is no need in maturity to pay dealers

to promote the product to new buyers. Repeat purchasers know what they

want and are more likely to consider cost rather than the advice and promo-

tion of the distributor or retailer as a guide to purchase. There is also no longer

any need to restrict the kind of retailers with whom one deals. The exclusive

Chapter 10 • Specialized Strategies248

distribution networks for Apple, HP, and even IBM have given way to low-

service, low-margin distributors such as discount computer chains, off-price

ofﬁ ce supply houses, warehouse clubs, and direct sales websites. The dis-

counters who earlier could destroy one’s market development effort can in

maturity ensure one’s competitiveness among price-sensitive buyers. Airlines

discovered, to their ﬁ nancial beneﬁ t, that the same principle applies to ser-

vices. Once airlines realized that nearly all seats were ﬁ lled by people who

had experience traveling and so knew where they wanted to go, and probably

even the names of airlines who would take them there, they could stop paying

travel agents to book tickets. The few passengers who need help, say to book a

vacation in an exotic location, still pay for the service. All others book directly

with the airlines, online or by phone, saving the airlines millions in fees and

even generating booking fees on their own.

MANAGING EXPORT PRICES IN FOREIGN CURRENCIES

Although there is no difference in principle between managing prices in a for-

eign or domestic currency, it is much more challenging in practice, when man-

aging revenues in a foreign currency while incurring costs in a home currency.

The reason is that ﬂ oating currency exchange rates cause unplanned changes in

prices and in costs relative to competitors. Even between economies very closely

integrated, such as the United States and Canada, exchange rates can change by

much more in a year than would be typical for changes in domestic prices. On

July 1, 2014, $100 of Canadian dollar sales could be exchanged into $92.87 of

U.S. dollar revenue for a U.S.-based ﬁ rm. One year later, the same $100 of Cana-

dian sales could be exchanged for only US$79.62 of revenue, a 14 percent reduc-

tion in U.S. dollar terms without any change in Canadian dollar prices.

That

difference was larger than the entire gross margin of many exports. Such cur-

rency ﬂ uctuations can easily drain the proﬁ tability of an entire market, or mas-

sively improve it, in a short period of time.

There are two considerations that a ﬁ rm needs to take into account when

deciding how to respond to a change in exchange rates: one speciﬁ c to the

ﬁ rm’s strategy for export to a foreign market, the other speciﬁ c to how a shift

in an exchange rate impacts the relative competitive position of ﬁ rms in that

speciﬁ c market. Since companies can have different strategies for sales in

different markets, and can face different sets of competitors, there is no one

simple formula for adjusting prices for changes in exchange rates. There is,

however, a right approach given the circumstances the company faces for each

exchange rate change in each market.

Foreign Market Sales Strategy

Exhibit 10-2 summarizes two alternative strategies for foreign market sales,

which we have labeled “Opportunistic” and “Committed.” The ﬁ rm’s choice

of a foreign sales strategy should in part determine its approach to pricing for

foreign sales. Is the ﬁ rm’s objective simply to win proﬁ table incremental sales

in a foreign market, or to build a valuable brand franchise in that market?

While these two objectives may be compatible in the same market for a short

time, they will almost never be compatible at all times. In the former case, the

ﬁ rm may largely abandon a market when the depressed value of its currency

Chapter 10 • Specialized Strategies 249

EXHIBIT 10-2

Alternative Strategic Choices for Foreign Market Sales

makes sales less proﬁ table than elsewhere, while in the latter case, the ﬁ rm

will attempt to maintain its competitive position in a market even at times

when optimizing price for that market alone produces little or no immediate

contribution to the ﬁ rm’s overall proﬁ t. Companies selling commodities such

as industrial chemicals and paper will usually adopt an opportunistic strategy,

relying on local partners to actually sell their products, and set prices relative

to their home currency price or to a price that they set in their home currency

for exports. Companies with highly differentiated brands, such as luxury auto

and industrial equipment suppliers, will usually follow a “committed” strat-

egy, make investments in a market commensurate with that commitment, and

set prices relative to the prices of competing products within that market.

For an opportunistic market, currency hedging may play a limited role

if there is a signiﬁ cant gap between when sales are made and products are

delivered. A company that sells elevators worldwide, often with contracts in

the buyer’s currency and often for delivery a year in the future when a new

building is near completion, hedges all contracted revenue by buying “puts”

sufﬁ cient to cover all foreign currency sales for which it has made a price com-

mitment. While that is adequate for implementing an Opportunistic strategy,

it leaves a company with a Committed strategy still vulnerable since the latter

is making an implicit commitment to keep prices competitive, even for cus-

tomers to whom it has not yet made a sale.

A Committed company will need to hedge even more revenues. It may

opt to hedge a large portion of its entire expected revenues in currency markets

for a couple years forward, a costly but prudent strategy. Eventually, how-

ever, commitment will include making manufacturing investments in foreign

markets to balance changes in the value of revenues with changes in the value

of costs. The ﬁ ve largest auto manufacturers in the U.S. all have production

capacity, and thus incur costs, in Canada as well. This creates a natural hedge

for at least a large portion of their Canadian revenues since, if the Canadian

dollar declines, more cheaply produced Canadian cars and car parts can be

Chapter 10 • Specialized Strategies250

imported to the U.S. earning higher margins just as margins decline from sales

that generate Canadian dollar revenues. It is important to note that a Com-

mitted seller will have to manage grey markets—or redistribution of its

products—to ensure that buyers do not take advantage of arbitrage opportu-

nities which can undermine investments that a seller has made in local pro-

duction, retail presence, and aftermarket support.

Competitive Impact of Exchange Rate Shifts

Unfortunately, commitment is not the only consideration for determining the

right way to manage pricing in response to changes in exchange rates. One

must also consider how any particular movement in an exchange rate affects

your ﬁ rm’s costs relative to your competitors in that market. Is the change in

the exchange rate caused by a change in economic conditions affecting your

ﬁ rm’s home market currency or by conditions affecting the currency of the

market where you will generate revenues? Why should it matter? Because

something that affects the value of the foreign currency will affect it relative to

all major currencies. All major competitors incurring manufacturing costs in a

currency other than the currency of that particular foreign market will be simi-

larly affected. For example, when the value of the Brazilian real declined by

more than 20 percent in 2015 compared to the U.S. dollar, exporters of prod-

ucts to Brazil experienced a drastic decline in the revenue and proﬁ tability of

their Brazilian sales measured in terms of their home currencies, whether those

home currencies were euros, British pounds, Japanese yen, South Korean won,

or American dollars.

When every competitor is facing a loss because of a

weakening of the buyers’ currency, they all have the same incentive to recover

their losses by letting their foreign currency prices rise, and they can do so

without fear of becoming less competitive.

The same magnitude of a shift in exchange rates has a very different

strategic implication if caused by a strengthening of an exporter’s home cur-

rency. If the U.S. dollar appreciates due to a tightening of monetary policy

relative to that in other major currencies, only exporters incurring costs in the

U.S. dollar will experience a decline in dollar revenue and proﬁ ts earned from

sales in the foreign market. Since the proﬁ tability of exports costed in euros or

yen will remain unchanged by the dollar’s appreciation, U.S. exporters can-

not expect competitors from other countries to raise their prices to match the

increases American ﬁ rms would need to maintain their U.S. dollar margins.

In the reverse situation, when a company’s home currency depreciates, it will

gain a cost advantage in serving foreign markets relative to competitors incur-

ring costs in other currencies. Thus, the company’s leaders might well expect

that they could gain share from cutting foreign currency prices to reﬂ ect the

decline in its relative cost, since foreign competitors will not have the same

newly acquired cost advantage.

Four Generic Strategies for Managing Exchange

Rate Price Adjustments

These two factors—the strategic goal of the exporter in a particular foreign

market and the impact of the currency change on competition—create a two-

by-two of market conditions implying four different responses for adapting to

changes in currency exchange rates. Exhibit 10-3 illustrates these four options.

Chapter 10 • Specialized Strategies 251

EXHIBIT 10-3

Stratagies for Managing Foreign Exchange Rate Adjustments

STRATEGY: OPPORTUNISTIC; COMPETITIVE IMPACT: SIMILAR The easiest way to

pursue this strategy is to quote prices in terms of the home country currency, or

in terms of another major currency in which the ﬁ rm incurs its cost, letting the

cost in the buyer’s local currency adjust automatically. This often means that a

local distribution intermediary buys in the currency of the exporter and then

quotes prices in local currency. In either case, prices in the local currency adjust

quickly to changes in the exchange rate. If there is a delay between when sales

are made and product is to be delivered, either the exporter or the distributor

(usually the former) hedges the revenues associated with the sales commitment.

With competitors adjusting their local currency prices to reﬂ ect an exchange

rate change, the ﬁ rm making a full local price adjustment to an exchange rate

change can expect to maintain a similar market share proﬁ tably. If a commit-

ted competitor is willing to maintain local prices, that competitor will suffer in

terms of cash ﬂ ow to invest in the market. A ﬁ rm without commitment is better

off maintaining only whatever level of sales it can continue to make as proﬁ t-

ably as it could in any other market. This is a strategy pursued by many non-

branded oil reﬁ ners making gasoline and heating oil. They ship their product

into whatever wholesale market offers the best price at time of shipment.

STRATEGY: COMMITTED; COMPETITIVE IMPACT: SIMILAR Geographic mar-

kets sufﬁ ciently attractive for one company to adopt a committed strategy are

also ones where at least some of a ﬁ rm’s competitors are likely to have done

likewise. With everyone once again having similar incentives, one might eas-

ily assume that the impact of changes in a foreign currency’s strength would

be the same in committed markets as in ones where a ﬁ rm has adopted an

Chapter 10 • Specialized Strategies252

opportunistic strategy. But that assumption would generally be wrong. When

companies make a ﬁ nancial investment to develop and distribute a brand in

a market, they will not quickly abandon the market when those customers’

currencies are weak or seek to exploit them when those currencies are strong.

Their goal is to build brand awareness and reputation for the long term.

Recall from Chapter 7 the different ways that price competition impacts

a large-share ﬁ rm differently than a small-share competitor. If a local currency

weakens, making the local market shrink and sales in that currency less prof-

itable, smaller competitors are more likely to ﬁ nd that their proﬁ t contribu-

tion no longer covers the ongoing ﬁ xed costs of their commitment—local sales

ofﬁ ces, promotional expenditures, and service. Thus small-share ﬁ rms may be

tempted to hold prices hoping to win enough additional revenue to survive.

The challenge for the large ﬁ rm is to adopt competitive strategies that makes

it difﬁ cult for its smaller competitors to avoid either raising their prices or

withdrawing. The adjustment to higher pricing may be delayed but eventually

such strategies should enable local market prices to adjust to the strength of

the currency in the same way that they would in a market where all competi-

tors operate opportunistically.

STRATEGY: OPPORTUNISTIC; COMPETITIVE IMPACT: UNIQUE Being uniquely

impacted by an exchange rate shift in a market where you have an opportunis-

tic strategy involves primarily accepting that either sales or proﬁ t must change

radically: the faster the better for the ﬁ rm’s proﬁ tability. A strengthening of a

ﬁ rm’s home currency will make it less competitive in foreign markets; a weak-

ening will make it more competitive. If major competitors are not facing the

same exchange rate issue, they will be unlikely to make adjustments that are

in parallel with your ﬁ rm’s new costs, margins, and corresponding objectives.

Consequently, the impact of changes in local currency prices is likely to be much

larger, since it will likely involve losses or gains in market share. That may not

be a problem if the ﬁ rm’s home market or other foreign sales markets are large

enough relative to the ﬁ rm’s foreign sales to adjust to a change in available

supply. The strengthening of a ﬁ rm’s home currency may reﬂ ect strong growth

that could absorb sales lost in foreign markets due to reduced competitiveness.

Unfortunately, a ﬁ rm uniquely impacted by a strengthening home cur-

rency will face the problem of becoming less competitive in all of its foreign

currency markets simultaneously. If foreign sales consume a substantial por-

tion of the ﬁ rm’s output, it logically may make sense to salvage as much export

sales as possible to optimize any remaining contribution from those opportu-

nistic markets. In that case, the ﬁ rm should lower its export price to partially

offset some of the impact of home currency appreciation. Determining how

much it should discount its export price would require calculating breakeven

sales changes associated with such a discount and determining whether the

volumes that could be retained are sufﬁ cient to justify the discount.

STRATEGY: COMMITTED; COMPETITIVE IMPACT: UNIQUE The default assump-

tion in “committed” markets is that the ﬁ rm will set prices in local currency

and not adjust them automatically to changes in exchange rates, adjusting only

if competitors are adjusting their prices. But, in contrast to the case where the

market currency has weakened, an appreciation in a ﬁ rm’s home market cur-

rency is unlikely to trigger price increases by competitors who incur costs in

Chapter 10 • Specialized Strategies 253

other currencies that have not appreciated. A company can, for the next year

or so, buy a Put option or sell the expected foreign revenue forward to avoid

the risk of such an adverse movement in exchange rates. But such a temporary

solution works only for a temporary problem. There is no simple solution to

incurring costs in a currency that has strengthened relative to all others when

one has investments in export markets that would be lost if the ﬁ rm were to

withdraw its brand, even temporarily.

When change in the value of a home currency uniquely affects your ﬁ rm

in a foreign market, adapting requires a change in strategy, not just in price.

Fortunately, when general appreciation in a ﬁ rm’s home currency makes

foreign revenues worth less, it also makes foreign investments cost less. By

investing in production capacity where the currency is weaker, a ﬁ rm can

rebuild its margins and partially insulate future proﬁ tability from swings in

the relative value of currencies. Ideally, the ﬁ rm should look for such oppor-

tunities in countries whose currencies tend to weaken when its own home

country currency strengthens.

In the process of developing local production capacity, the ﬁ rm might

also develop versions of its products better adapted to the needs and ability to

pay in more price-sensitive markets.

MANAGING PRICING WHEN MARKETS SLUMP

Managing pricing when market demand slumps is an essential skill for a

pricing strategist in some industries. The economics for many products and

services are largely determined by the ability to manage ﬁ xed costs, often by

ensuring full plant utilization. For example, in capital-intensive industries

such as beer brewing, higher education, or airlines, the means of production—

whether a manufacturing plant, tenured professors, or an airplane—represent

signiﬁ cant ﬁ xed costs. Consequently, declines in revenue often precipitate a

much larger decline in proﬁ tability because these ﬁ xed costs, by deﬁ nition,

remain the same. The key to managing downturns successfully is to think

clearly about how the downturn is affecting value, not just volume, for differ-

ent customer segments and to use that knowledge to adjust pricing to drive

revenue-generating changes in the mix of your customer base.

Sometimes markets slump for reasons that are not temporary. For

example, new technologies make old ones obsolete. When there is a decline

in demand for an entire category of products or services, such as when digi-

tal technology replaced photographic ﬁ lm and when air travel replaced long-

distance trains, the shrinking of the market is permanent. The goal for the

company with the strongest advantages in cost or product differentiation is to

restructure the business quickly to serve a smaller market, focusing on a more

targeted segment of customers who remain loyal to the old technology. For

competitors without advantages in the declining market, the goal should to

refocus assets elsewhere as quickly as possible, making pricing decisions in the

declining market purely to generate short-term cash ﬂ ow.

More interesting, and more common, are the cases where a market slump

is cyclical and likely to be temporary. There are many industries that are highly

cyclical, with demand that swings by much larger percentages than changes

in growth of the economy as a whole. When an economic recession replaces

2 percent economic growth with a 2 percent decline, the demand for automobiles

Chapter 10 • Specialized Strategies254

and airline seats declines by multiple times as much. Learning to manage pric-

ing to minimize losses during downturns and to quickly recover proﬁ tability

during upturns is key to a ﬁ rm’s long-term survival in such industries.

The basic mistake by marketers who are ignorant about pricing is to cut

prices across the board when demand falls. Price differences do affect inter-

brand choice, especially during recessions when both business and consumer

buyers become more price sensitive, a price cut may quickly gain some market

share. But if, as can usually be expected, competitors match any cut to protect

their market share, any sales gain is likely to be short-lived but industry rev-

enues and proﬁ t contribution will remain depressed by even more than the

initial decline in unit volume. The goal of any pricing actions should be the

opposite: to sustain as much revenue and contribution as possible—both dur-

ing the recession and the recovery. But how?

Answering that question requires understanding how the general eco-

nomic decline affects the value perceived by your customers, and how that

impact differs by customer segment. There are two reasons why demand

may decline during economic recessions: because the number of customers is

reduced or because the value of your differentiation is lower. One or both can

reduce sales. Most revenue earned by major airlines comes from business trav-

elers. During a recession, many of those business travelers have fewer oppor-

tunities to sell their products and so need to make fewer business trips—but

the value of the trips they do make, including the differential value of ﬂ ying

on a carrier with direct and frequent ﬂ ights, is not reduced. If perceived value

is the same despite the reduced number of sales opportunities, it makes no

sense to reduce prices for the changeable, ﬂ exible airline tickets that business

travelers commonly demand. It may, however, make sense to reduce prices for

ticket types used for discretionary travel, the demand for which is more sensi-

tive to price than business travel. When businesses are planning internal meet-

ings, they will compare the cost to holding the meeting in different locations.

An airline (or a hotel) wishing to drive more discretionary business travel to a

location where it has much capacity may offer a larger group travel discounts

for tickets (or rooms) when sales are forecast to be far from capacity. To drive

discretionary leisure travel, the airline might offer more of its capacity through

tour operators who are required to offer the highly discounted ﬂ ights only as

part of leisure travel packages, thus precluding their use by business travelers.

To reiterate, determining when and how much to discount during an eco-

nomic downturn should not depend on how much demand has fallen. What

is important is how perceived value is affected and whether a lower price can

truly reinvigorate demand. When value is reduced because of a slump in eco-

nomic conditions, reducing price to reﬂ ect that change in value can stimulate

category demand, but it is important to do so in a way that does not undermine

the ability to charge a value-based price when demand and value recover.

A client of ours had a chemical additive that increased the production capac-

ity of a manufacturing plant, including both equipment and labor, by nearly

15 percent. Without their additive, the plant simply had to operate at a slower

pace. The company easily launched the product with very proﬁ table margins

during a period of strong economic growth, when customers were operating

their plants at capacity. When a recession occurred, however, demand for its

product collapsed, despite the fact that its customers had maintained about

75 percent of their previous production.

Chapter 10 • Specialized Strategies 255

An economic value estimation showed that the value of the additive was

maximized when plants were operating near full capacity. But when manu-

facturing capacity was underutilized, the saving associated with our client’s

innovative product was only the labor associated with being able to complete

work in a shorter period of time. In that case, there was no incremental, avoid-

able cost of physical capital saved by increasing the efﬁ ciency of plant opera-

tions. Consequently, to maintain use of the product during the recession, the

company would do well to reduce its price. The problem, of course, was how

to ensure that the lower price did not become the price that buyers would con-

tinue to expect when demand made the product much more valuable.

The solution to this problem, as is often the case, was to create a value-

based pricing metric. Instead of cutting the list price, the company offered

to “share the pain” of the downturn. For customers agreeing to exclusive

two-year contracts that rolled over each month unless canceled, the company

agreed to give rebates retroactively for purchases in any month when indus-

try data showed capacity utilization below 90 percent. Since the rebates were

equal to nearly half of the selling price and since industry capacity utilization

was nearer to 70 percent, the rebate structure made continued use of the prod-

uct cost-effective. But the 24 month contract meant that when the recession

ended and full production resumed, the price of the additive could reset to the

original, higher price.

Another alternative to addressing declining demand in a downturn is to

raise the value of the offer rather than cutting the price. Hyundai did this dur-

ing 2009 when U.S. auto sales had fallen by 21.2 percent. Hyundai’s research

revealed that the reason many consumers were holding off buying a car was

not that their incomes had fallen—consumers were still mostly employed (the

unemployment rate went from 5 percent in December 2007 to a peak of 10 per-

cent in October 2009

)—rather, it was a fear of becoming unemployed and the

perceived risk of committing to a long-term car payment. To overcome that

fear, Hyundai introduced the “Hyundai Assurance” program whereby a car

ﬁ nanced or leased from Hyundai could be returned without any further obli-

gation in the event that the purchaser became unemployed. The program was

very effective and did not require additional discounting; Hyundai achieved

a 14 percent year-to-year sales increase while the rest of the industry experi-

enced a 30 percent decline.

CREATING ECONOMICALLY EFFICIENT TRANSFER PRICES

A frequently overlooked opportunity to use costs as a source of advantage

occurs when the company can manage the prices of its upstream suppliers.

These upstream suppliers might be independent companies or independent

divisions of the same company that set the prices of products that pass between

them. This situation, known as transfer pricing, represents one of the most

common reasons why independent companies and divisions are sometimes

less price competitive and proﬁ table than their vertically integrated competi-

tors. Most discussions regarding transfer pricing involve setting internal trans-

fer prices between proﬁ t centers to minimize taxes across multiple tax regimes.

The goal in that case is to ﬁ nd justiﬁ cations (e.g., countries or states) for allocat-

ing costs to proﬁ t centers where taxes are relatively high, thus minimizing the

tax obligation there, so that the ﬁ rm can realize proﬁ ts in a tax regime where

Chapter 10 • Specialized Strategies256

tax rates are relatively low.

That is not the purpose of our discussion here nor

is it at cross-purposes. As described in Chapter 9 on Financial Analysis, there

is no reason why one’s system for allocating costs for pricing need be the same

as the system for allocating costs for ﬁ nancial reporting, since they have differ-

ent purposes. The goal in allocating costs and revenues for pricing is to create

incentives to maximize the collective proﬁ tability of the entire chain of proﬁ t

centers that creates a product or service.

Exhibit 10-4 illustrates this often-overlooked opportunity. Independent

Manufacturing Inc. sells its product for $2 per unit in a highly competitive

market. To manufacture the product, it buys different parts from two suppli-

ers, Alpha and Beta, at a total cost per unit of $1.20. The parts purchased from

Alpha cost $0.30 and those from Beta cost $0.90. Independent Manufacturing

conducts a pricing analysis to determine whether any changes in its pricing

might be justiﬁ ed. It determines that its contribution margin (price minus vari-

able cost) is $0.60, or 30 percent of its price.

EXHIBIT 10-4

Inefﬁ ciencies in Transfer Pricing

Chapter 10 • Specialized Strategies 257

It then calculates the effect of a 10 percent price change in either direc-

tion. For a 10 percent price cut to be proﬁ table, Independent must gain at least

50 percent more sales (Chapter 9 presents the formulas for performing these

calculations). For a 10 percent price increase to be proﬁ table, Independent can

afford to forgo no more than 25 percent of its sales.

Independent’s managers conclude that there is no way that they can pos-

sibly gain from a price cut, since their sales will surely not increase by more

than 50 percent. On the other hand, they are intrigued by the possibility of a

price increase. They feel sure that the inevitable decline would be far less than

25 percent if their major competitors followed the increase.

As Independent’s management considers how to communicate to the

industry the desirability of a general price increase, one of its major competi-

tors, Integrated Manufacturing Inc. announces its own 10 percent price cut.

Independent’s management is stunned. How could Integrated possibly jus-

tify such an “irrational” move? Integrated’s product is technically identical

to Independent’s, involving all the same parts and production processes, and

Integrated is a company with a market share equal to Independent’s. The only

difference between the two companies is that Integrated recently began manu-

facturing its own parts.

That difference, however, is crucial to this story (see Exhibit 10-5).

Assume that Integrated currently has all the same costs of producing parts as

Independent’s suppliers, Alpha and Beta, and expects to earn a proﬁ t from

those operations. It also has the same costs of assembling those parts ($0.20

incremental labor plus $0.40 ﬁ xed per unit). Moreover, Integrated enjoys

no additional economies of logistical integration. Despite these similarities,

the two companies have radically different cost structures, which respond

quite differently to changes in volume and which cause the two companies

to experience price changes differently. Integrated has no variable materials

EXHIBIT 10-5

Efﬁ ciency from Cost Integration

Chapter 10 • Specialized Strategies258

cost corresponding to Independent’s variable materials cost of $1.20 per unit.

Instead, it incurs additional ﬁ xed costs of $0.60 per unit ($0.20 plus $0.40) and

incremental variable costs of only $0.40 per unit ($0.05 plus $0.35). This differ-

ence in cost structure between Integrated (high ﬁ xed and low variable) and

Independent (low ﬁ xed and high variable) gives Integrated a much higher

contribution margin per unit than Independent’s margin. For Integrated, $1.40,

or 70 percent of each additional sale, contributes to bottom-line proﬁ ts. For

Independent, only $0.60, or 30 percent of each additional sale, falls to the bot-

tom line. Integrated’s breakeven calculations for a 10 percent price change are,

therefore, quite different. For a 10 percent price cut to be proﬁ table, Integrated

has to gain only 16.7 percent more sales. But for a 10 percent price increase to

pay off, Integrated could afford to forgo no more than 12.5 percent of its sales.

It is easy to see why Integrated is more attracted to price cuts and more

averse to price increases than is Independent. For Integrated, sales must grow

by only 16.7 percent to make a price cut proﬁ table, compared with 50 per-

cent for Independent. Similarly, Integrated could afford to lose no more than

12.5 percent of sales (compared with as much as 25 percent for Independent)

and still proﬁ t from a price increase. How can it be that two identical sets of

costs result in such extremely different calculations? The answer is that Inde-

pendent, like most manufacturers, pays its suppliers on a price-per-unit basis.

That price must include enough revenue to cover the suppliers’ ﬁ xed costs and

a reasonable proﬁ t if Independent expects those suppliers to remain viable

in the long run. Consequently, ﬁ xed costs and proﬁ t of both Alpha and Beta

become variable costs of sales for Independent. Such incrementalizing of non-

incremental costs makes Independent much less cost competitive than Inte-

grated, which earns more than twice as much additional proﬁ t on each unit

it sells.

Independent’s cost disadvantage is a disadvantage to its suppliers as

well. Independent calculates that it requires a 50 percent sales increase to make

a 10 percent price cut proﬁ table. Independent, therefore, correctly rejects a

10 percent price cut that would increase sales by 30 percent. With current

sales of 1 million units, such a price cut would cause Independent’s proﬁ t to

decline by $80,000. Note, however, that the additional sales volume would

add $240,000 ($75,000 plus $165,000) to the proﬁ ts of Independent’s suppliers,

provided that they produce the increased output with no more ﬁ xed costs.

They would earn much more than Independent would lose by cutting price.

It is clear why Integrated sees a 10 percent price cut as proﬁ table when Inde-

pendent does not. As its own supplier, Integrated captures the additional

proﬁ ts that accrue within the entire value chain (Alpha, $75,000; Beta, $165,000)

as a result of increases in volume.

Once Independent recognizes the problem, what alternatives does it

have, short of taking the radical step of merging with its suppliers? One alter-

native is for Independent to pay its suppliers’ ﬁ xed costs in a lump-sum pay-

ment, perhaps even retaining ownership of the assets while negotiating low

supply prices that cover only incremental costs and a reasonable return. The

lump-sum payment is then a ﬁ xed cost for Independent, and its contribution

margin on added sales rises by the reduction in its incremental supply cost.

Boeing and Airbus sometimes do this with parts suppliers, agreeing to bear the

ﬁ xed cost of a part’s design and paying the supplier for the ﬁ xed costs of tool-

ing and setup. They then expect a price per unit that covers only the supplier’s

Chapter 10 • Specialized Strategies 259

variable costs and a small proﬁ t. As a result, the airplane manufacturers bear

the risk and retain the rewards from variations in volume, giving them a larger

incremental margin on each additional sale and so a greater incentive to make

marketing decisions, including pricing decisions, which build volume.

An alternative approach is to negotiate a high price for initial purchases

that cover the ﬁ xed costs, with a lower price for all additional quantities that

cover only incremental costs and proﬁ t. Auto companies use this system;

allowing a supplier to be a sole source with high margins up to a certain vol-

ume, presumably enough to recover design and development costs. Beyond

that volume, they make the design public and usually expect all suppliers to

match the lowest price on offer. In Independent Manufacturing’s case, it might

negotiate an agreement with Alpha and Beta that guarantees enough pur-

chases at $0.30 and $0.90, respectively, to cover their ﬁ xed costs, after which

the price would fall to $0.10 and $0.50, respectively.

Both of these systems for paying suppliers avoid incrementalizing ﬁ xed

costs, but they do not avoid the problem of incrementalizing the suppliers’

proﬁ ts. They work well only when the suppliers’ proﬁ ts account for a small

portion of the total price suppliers receive. Lump-sum payments could be paid

to suppliers to cover negotiated proﬁ t as well as ﬁ xed costs. This is risky, how-

ever, since proﬁ t per unit remains the suppliers’ incentive to maintain on-time

delivery of acceptable quality merchandise. Consequently, when a supplier

has low ﬁ xed costs but can still demand a high proﬁ t because of little competi-

tion, a third alternative is often used. The purchaser may agree to pay the sup-

plier a small fee to cover incremental expenses and an additional negotiated

percentage of whatever proﬁ t contribution is earned from ﬁ nal sales.

It is noteworthy that most companies do not use these methods to com-

pensate suppliers or to establish prices for sales between independent divi-

sions. Instead, they negotiate arm’s-length contracts at ﬁ xed prices or let

prevailing market prices determine transfer prices.

One reason is that it is

unusual to ﬁ nd a signiﬁ cant portion of costs that remain truly ﬁ xed for large

changes in sales. In most cases, the bulk of costs that accountants label ﬁ xed are

actually semiﬁ xed; additional costs would have to be incurred for suppliers to

substantially increase their sales, making those costs incremental. One notable

case where costs are substantially ﬁ xed is in the semiconductor industry. The

overwhelming cost of semiconductors is the ﬁ xed cost of product develop-

ment, not the variable or semiﬁ xed costs of production. Consequently, inte-

grated manufacturers of products using semiconductors, such as Samsung,

have often had a signiﬁ cant cost advantage. Similarly, Tesla has recognized

that if the cost of batteries remains such a large part of the cost of electric cars,

a ﬁ rm that can internalize the ﬁ xed costs to make its own batteries will have a

large advantage over one that buys batteries at a variable cost.

Summary

Most decisions that people, including

managers, make are made from habit.

When the decision turns out to be the

right one in most cases, it gets applied

without thinking. When changes occur or

when a new market involves forces that

do not ﬁ t the pattern of one’s experience,

it is important to recognize that traditional

strategies need to be rethought. Pricing

an innovation is different from pricing an

Chapter 10 • Specialized Strategies260

established product, and pricing in matu-

rity is different from pricing in a growing

market. Setting prices in foreign curren-

cies when costs are incurred in domestic

currencies requires consideration of issues

that are not usually part of the pricing

decision process. Pricing when a market

faces a substantial, but temporary, down-

turn in demand requires a quick response

both to project margins from the current,

albeit shrunken market, while driving

incremental revenues from new sources.

Establishing transfer prices, for sales or

purchases, can substantially affect a ﬁ rm’s

competitive viability in those situations

where the suppliers’ prices cover largely

ﬁ xed costs. While these are challenges that

many companies encounter over years

in business, there are no doubt other less

common ones that a thoughtful pricer

should look out for. There are no tried and

true rules for pricing that apply to all situ-

ations, even in the same industry. When-

ever facing a situation that feels different,

it is wise to reevaluate how the forces that

drive your usual success in pricing are dif-

ferent and what changes may be necessary

in your strategy to accommodate them.

Notes

1 . We use the term “technology” in

the general sense of a concept by

which beneﬁ ts are created. Most

innovations are, in fact, enabled by

“technology” in the more narrow

sense of the word. But occasion-

ally an innovative “technology”

is something intangible, like an

innovative business model that

no one thought of previously. For

example, in the middle of the last

century, now famous companies

like McDonald’s and Holiday Inn

were innovators in developing and

applying the innovative technology

of “franchising.” The technology of

franchising enabled investors with

little or no prior knowledge of the

industry to enter and enjoy instant

success by leveraging a very stan-

dardized model—something that

was not achievable previously.

2 . See Everett M. Rogers and F. Floyd

Shoemaker, Communication of Inno-

vations , 2nd edn. (New York: The

Free Press, 1971); Frank M. Bass,

“A New Product Growth Model

for Consumer Durables,” Man-

agement Science 15 (January 1969),

pp. 215–227.

3 . William H. Whyte, “The Web

of Word of Mouth,” Fortune 50

(November 1954), pp. 140–143,

204–212.

4 . Rogers and Shoemaker, op. cit. ,

pp. 180–182.

5 . See Everett M. Rogers, Diffusion of

Innovations (New York: The Free

Press, 1962), Chapters 7 and 8; Rog-

ers and Shoemaker, op. cit ., Chapter

6; Gregory S. Carpenter and Kent

Nakamoto, “Consumer Preference

Formation and Pioneering Advan-

tage,” Journal of Marketing Research

26 (August 1989), pp. 285–298.

6 . Thomas Nagle, “Money-Back Guar-

antees and Other Ways You Never

Thought to Sell Your Drugs,” Phar-

maExecutive (April 2008).

7 . “Maker of Blockbuster Star Shower

Holiday Lights Will Help Theft

Victims by Replacing Lost Items

Free,” PRNewswire, November 21,

2016. Accessed at www.prnews

wire.com/news-releases/maker-

of-blockbuster-star-shower-holiday-

lights-will-help-theft-victims-by-re

placing-lost-items-free-300366889.

html.

8 . See Abel P. Jeuland, “Parsimonious

Models of Diffusion of Innovation,

Part B: Incorporating the Variable

of Price,” University of Chicago

working paper (July 1981).

9 . Nagle, op. cit.

10 . William K. Hall, “Survival Strategies

in a Hostile Environment,” Harvard

Business Review (September 1980).

Chapter 10 • Specialized Strategies 261

11 . This problem can even result in a

period of intensely competitive,

unproﬁ tably low pricing in the

maturity phase, if, as sometimes

happens, the industry fails to antici-

pate the leveling off of sales growth

and thus enters maturity having

built excess capacity.

12 . “It’s a-Me! How Super Mario

Became a Global Cultural Icon,” The

Economist , December 24, 2016.

13 . See Philip Kotler, “Phasing Out

Weak Products,” Harvard Business Review

43 (March–April 1965), pp. 107–118.

14 . Theodore Levitt, “Marketing When

Things Change,” Harvard Business

Review 55 (November–December

1977), pp. 107–113; Michael Porter,

Competitive Strategy: Techniques for

Analyzing Industries and Competitors ,

(Free Press, 1998), pp. 159, 241–249.

15 . OANDA currency converter web-

site. Accessed at www.oanda.com/

currency/converter.

16 . For a more detailed discussion of

grey markets and how to manage

them, please refer to the discussion

in Chapter 4 on Price Structure.

17 . Vinod Sreeharsha, “Sharp Drop in

Currency Adds to Growing List

of Woes in Brazil,” The New York

Times , September 24, 2015. Also see:

Joe Leahy, “Exports from China to

Brazil Collapse as Recession Deep-

ens,” Financial Times , February

26, 2016; and Raquel Landim and

Eduardo Cucolo, “Drop in Imports

Helps to Increase Brazil’s Trade

Surplus, the Largest since 2011,”

Folha de S. Paulo , January 5, 2016.

18 . U.S. Bureau of Labor Statistics,

“The Recession of 2007–2009,” BLS

Spotlight on Statistics , February 2012.

Accessed January 6, 2017 at www.

bls.gov/spotlight/2012/recession/

pdf/recession_bls_spotlight.pdf.

19 . Randall Beard, “Learning from

the Hidden Success Factors of the

Hyundai Assurance Program,”

Marketing with Impact blog , Octo-

ber 9, 2009. Accessed January 6,

2017 at https://randallbeard.

wordpress.com/2009/10/19/

hidden-success-hyundai-assurance.

20 . For additional discussion of the

goals of, and legal constraints on,

transfer pricing in ﬁ nancial report-

ing, see John McKinley, “Transfer

Pricing and Its Effect on Financial

Reporting: Multinational Companies

Face High-Risk Tax Accounting,”

Journal of Accountancy , October 1,

2013. Accessed January 6, 2017 at

www.journalofaccountancy.com/

issues/2013/oct/20137721.html.

21 . $CM − $2.00 − $0.20 − $0.60 %CM =

$0.60/$2.00 × 100 = 30%

22 . An integrated company does not

automatically gain this advantage.

If separate divisions of a company

operate as independent proﬁ t cen-

ters setting transfer prices equal

to market prices, they will also

price too high to maximize their

joint proﬁ ts. To overcome the prob-

lem while remaining independent,

they need to adopt one of the solu-

tions suggested for independent

companies.

23 . For a related perspective, see

Thomas W. Malone, “Bringing

the Market Inside,” Harvard Busi-

ness Review 82(4) (April 2004),

pp. 106–115.

CHAPTER 11

Creating Strategic

Pricing Capability

Assembling Talent, Processes, and Data

to Build Competitive Advantage

The facts which kept me longest scientiﬁ cally orthodox are those of adaptation.

Charles Darwin

Even after creating a pricing strategy that addresses all of the elements con-

tained in the value cascade, pricing leaders often ﬁ nd that much of their orga-

nization remains remarkably resistant to changing behaviors. As one senior

executive we know remarked: “ Given the attention we pour into pricing our prod-

ucts, why do the outcomes still seem like a random walk ?”

This executive is not alone. In a benchmarking study

of more than 200

companies, Deloitte assessed the impact of pricing strategy and execution on

proﬁ tability and revenue growth. Our research shows that more than 60 per-

cent of sales and marketing managers were frustrated by their organization’s

ability to improve pricing performance over time. And more than 75 percent

were unsure what they should be doing to drive more effective execution of

the organization’s pricing strategy.

In that study, each ﬁ rm’s pricing strategy was assessed based on key

inputs for making a pricing decision such as customer value, costs, competi-

tive conditions or market share goals. Executional capabilities were assessed

based on the quality of a ﬁ rm’s data and tools, the skill level of decision-

makers, and the clarity of the ﬁ rm’s processes. Firm performance was mea-

sured on operating proﬁ ts relative to peer ﬁ rms within their sector in an effort

to eliminate the impact of sector differences. A broad spectrum of ﬁ rms drawn

from a range of sectors including manufacturing, consumer products, health

care, ﬁ nancial services, high tech, retailing and services were included in the

analysis.

Chapter 11 • Creating Strategic Pricing Capability 263

EXHIBIT 11-1

Archetypal Pricing Organizations

To facilitate this analysis, ﬁ rms were classiﬁ ed based on the quality of

their pricing strategy (value-based or not) and the ability of a ﬁ rm to exe-

cute a pricing strategy (strong or weak). Each ﬁ rm was assigned to one of

four archetypes, as shown in the two-by-two matrix in Exhibit 11-1. There

were the “Value Masters” who employed value-based pricing and excelled

at execution; “Well Intentioned” ﬁ rms that were value-based but poor execu-

tors, “Directionally Challenged” ﬁ rms that did not have a value-based pric-

ing strategy and lagged in their executional capabilities; and the “Runaway

Trains” that were excellent at execution but did not employ a value-based

pricing strategy.

When operating proﬁ tability was compared among these four arche-

types, the results were clear: Firms that employ a value-based pricing strategy

paired with strong execution capabilities, outperform their peers by a signiﬁ -

cant margin. As shown in Exhibit 11-2, ﬁ rms that excel on both dimensions

were, on average, 24 percent more proﬁ table than their industry average. The

worst performers were those that did not link their pricing strategy to value

yet executed effectively, hence the moniker “Runaway Trains.”

One common trait among each of the “Value Masters” is that they

excelled in setting strategic goals and objectives across all elements of the

value cascade: They understood how to create value for customers, how to

Chapter 11 • Creating Strategic Pricing Capability 264

convey the value proposition, build offers for each segment served, design

policies that encourage proﬁ table transactions, and had the ability to monitor

transaction performance. But good strategy alone is not enough. The highest

performing ﬁ rms in our study also invested heavily in building an organiza-

tional structure to support execution of a value-based strategy. These ﬁ rms

exhibited an internal alignment around value: R&D efforts focused on inno-

vations that created value, not just new features; marketing communications

messages translated product features and services into beneﬁ ts to which cus-

tomers could assign value; and clear policies linked discounts to trade-offs

of value and price. Overall, these organizations exhibited a singular focus on

their customers and framed decisions based on how they would inﬂ uence cus-

tomers’ perceptions of value.

So why do most organizations still struggle to implement a strategic,

value-based approach to pricing that has proven to be more proﬁ table? While

there are many answers to this question, several organizational shortfalls

account for the majority of the challenge.

The ﬁ rst organizational challenge involves pricing skills and capabilities.

According to one study, only 9 percent of business schools offer a stand-alone

course on the topic of pricing,

explaining in part why only 6 percent of the

Fortune 500 have a dedicated pricing function.

In addition, many industries

went through a long period of stable, or in some cases decreasing, input costs

that lasted for much of the 1990s and early 2000s. The apparel industry, for

example, experienced declines in labor and cotton costs, two of its major input

EXHIBIT 11-2

Operating Proﬁ t Relative to Industry Peers

Chapter 11 • Creating Strategic Pricing Capability 265

costs, over a 15-year period dating back to 1995. Consequently, pricing was a

less pressing issue and many turned their attention to improving other sources

of proﬁ table growth. However, as cost shocks simultaneously hit cotton and

labor from 2008 to 2012, many apparel companies found that they did not have

the know-how to raise prices in an effort to preserve their margins.

A second challenge is the need to coordinate pricing decisions across

functional areas, requiring the input and support of many decision-makers.

Even when a company has a pricing function formally tasked with managing

pricing, compensation plans that reward sales revenue alone make it difﬁ -

cult for even well-intentioned sales representatives to ﬁ ght for an additional

percentage point of price when that might increase the probability of losing

a deal and the associated compensation. Along the same lines, marketers

are often incentivized to maintain or grow market share, which can often

be accomplished most quickly through price promotions that may erode

brand equity and long-term margins. Finance executives are often evalu-

ated on achieving a target margin percentage which leads them to argue

against low-margin/high-volume opportunities that could increase return

on investment even at the expense of return on sales. Operations executives

often focus on maintaining capacity utilization even when that drives down

market prices and reduces proﬁ ts for all. Our research shows, however, that

the Value Masters tended to have incentive structures that rewarded proﬁ t-

able pricing decisions.

A third challenge is access to the necessary information and tools to make

proﬁ table pricing decisions. The Value Masters in our survey generally had

some form of commercial-grade pricing software that expedited the task of

analyzing transactional data. Most had alerts that were triggered if discounts

exceeded a threshold. Many had historical price-trend data to determine mar-

ket prices. These systems allowed companies to assess proﬁ tability at the cus-

tomer and product level, identify costly customer behaviors that were worth

discouraging, and quickly detect and intervene with customers who were

receiving “exceptional” pricing.

Taken together, there are three underlying investments needed to build

a strategic pricing capability. As noted by Dutta et al .,

these investments can

be classiﬁ ed as: (i) The human talent needed to develop a value-based pricing

strategy; (ii) an organizational structure with well-identiﬁ ed roles and respon-

sibilities for managing and executing the pricing strategy; and (iii) the data

and analytical tools needed to supply the organization with relevant, timely

information (Exhibit 11-3).

To succeed, companies need to balance investment in all three elements;

investing too much in one at the expense of the others can lead to catastrophe.

The airline industry, for example, invested heavily in yield management tools

in the 1980s and used this new capability to engage in an extensive price war

that in 1991 managed to wipe out the cumulative proﬁ ts earned by airlines

up to that point in their history.

It can be argued that many airlines over-

invested in data and analytics (which enabled the price wars), and under-

invested in the other two components of a pricing capability: The ability to

innovate proﬁ table new sources of value and establishing an organizational

understanding that targeting market share alone is a recipe for disaster.

Chapter 11 • Creating Strategic Pricing Capability 266

Assessing the Maturity of the Pricing Organization

So how can you determine the relative capability of your pricing organi-

zation? A quick test would be to ask your top ﬁ ve executives to articulate

your ﬁ rm’s pricing strategy. If you get ﬁ ve different answers, you likely

have a problem! And while we raise this point a little tongue in cheek, the

responses can demonstrate a lack of maturity in a ﬁ rm’s pricing capabil-

ity. What to evaluate:

• Number of deviations from agreed-upon price schedules

• Clarity about lines of authority for pricing decisions

• Ability to implement upcharges for non-standard customer requests

• Number of uncollected charges and an increased number of write-offs

• Existence of unearned discounts

• Number of pricing errors

• Frequency of order processing and fulﬁ llment errors.

To help inventory a ﬁ rm’s capabilities more precisely, we use the frame-

work provided by the Value Cascade and assess each element on three

dimensions: (i) How well articulated is the strategy that supports each

element of the cascade; (ii) what is the degree of organizational alignment

behind each and is there someone responsible for managing that element

of the cascade; and (iii) are there systems and tools in place to help inform

and guide each element of the cascade?

Exhibit 11-4 provides a summary of the capabilities needed to sup-

port each element of the value cascade as well as organizational character-

istics at each level of maturity. In general, as companies become better at

quantifying their value and delivering that value consistently, their ﬁ nan-

cial performance tends to improve.

EXHIBIT 11-3

The Foundation for a Strategic Pricing Capability

267

EXHIBIT 11-4

Assessing Each Element of the Value Cascade

Chapter 11 • Creating Strategic Pricing Capability 268

ESSENTIAL ELEMENTS OF THE PRICING ORGANIZATION

The best strategy in the world is only as good as an organization’s ability to

make it come to life. A frequent barrier to implementing improved pricing

strategies—whether it is a new way of conﬁ guring the offer design or simply

applying more discipline to discounting—is that the change does not align

with “the way we do things around here.” Or worse, the idea of creating a

pricing function is seen as a threat to the political power of a member of the

management team who currently has the ability to adjust prices or approve

deals to achieve some short-term, functional objective.

Consider the example of an IT distributor that had long prided itself on

developing an array of high-quality services that included best-in-class cus-

tomer support that includes on-demand technical consulting delivered by in-

house engineers and next-day delivery logistics. These services were included

with the purchase of any product and available to any customer. However, a

closer look at the customer base revealed that not everyone needed this high

level of support—and in fact many price-sensitive customers were defect-

ing to competitors selling a cheaper offering bereft of many expensive ser-

vices. After careful consideration, this distributor received a recommendation

to create a tiered services model whereby customers could either get lower

product prices in exchange for lower service levels, or they could retain access

to high service levels by paying a small premium on their purchases. The

immediate response among senior executives was that “everyone needs the

high level of service, it’s just that some customers don’t know it yet.” Only

after losing 20 percent of their revenue base to low-cost competitors was this

company willing to test a low-cost offering. Once they did, the results were

staggering—the low-cost offer enabled the distributor to regain their price-

sensitive customers and to do so proﬁ tably by offering them a standardized

way to buy.

Ultimately, the characteristic that most distinguishes high-performing

organizations is the ability to continually reﬁ ne and re-imagine the process for

how value is exchanged between seller and buyer. High-performing compa-

nies exhibit the following characteristics:

• An ability to challenge industry norms governing how products and ser-

vices are sold to customers

• The capacity to experiment with new pricing models and a willingness

to accept the inherent risk of trying something new.

The ability to challenge norms of how value is exchanged has never been more

important. As disruptive forces such as autonomous driving, urbanization,

or a low-growth economic environment exert themselves on established busi-

nesses, we are seeing massive changes in how value is created, delivered, per-

ceived and captured. In the past ten years, entire industries have had their

pricing models upended, in some cases multiple times. Music labels used

to control the revenue model by selling albums in physical formats such as

records, CDs, and cassettes. In 2001, Apple undid this revenue model when it

launched iTunes

to allow for the sale of single songs and by 2011, revenues

from digital outpaced physical content sales. In 2016 the dominant revenue

Chapter 11 • Creating Strategic Pricing Capability 269

model switched yet again to streaming, led by the likes of Spotify, Apple itself

and others. There are many other industries, including hospitality, transporta-

tion, telecommunications, legal services and software that have seen similar

upheaval in their revenue models.

One remarkable characteristic of this disruption is that revenue mod-

els have typically been reinvented by industry newcomers who often har-

ness disruptive technologies and are themselves unencumbered by industry

norms or by the risk of failure. Kodak endured a legendary decline brought

on by digital technology, but its demise was not inevitable. In fact, Kodak

invented the original digital camera back in 1975. Management’s reaction

at the time when Kodak’s revenue was driven by the high-margin sales of

paper and chemicals, was “that’s cute but don’t tell anyone.”

Kodak viewed

themselves as being in the paper and chemicals business and had no idea how

to monetize the bits and bytes that underpin a digital photo. Yet consumers

who valued a cost-effective and convenient way to create a visual record of

their life adventures eagerly adopted new offerings from a host of companies

that offered digital cameras, storage devices, and ﬁ le-sharing services that

reshaped our relationship with photography. Along similar lines, companies

like Uber and Airbnb, unencumbered by decades of industry norms such as

selling high volumes of cars to ﬁ ll plant capacity or putting “butts in beds” to

utilize large real-estate investments, have re-imagined how consumer trans-

portation or hospitality needs could be addressed. Of course, newcomers are

able to take on more risk; after all, what is the worst that can happen to a

start-up company?

That said, successful incumbent companies will continually take

calculated risks to reinvent their business and stay ahead of the upstarts.

Any incumbent should ask whether their organizational culture is holding

back innovative ideas. If an organization is to survive, and even thrive, it is

critical that managers continue to challenge themselves on how their own

industry may become disrupted by upstarts with new ways of creating and

capturing value. Still, some companies are better than others at challenging

the status quo.

Amazon is a company that has throughout its history continuously tried

new ways of doing things. From a seemingly simple beginning of creating an

online bookstore, to replacing books with electronic readers, to creating the

world’s largest online department store, to delivering food from local restau-

rants, the company has shown a willingness to try new things and accept the

risk of failure. In 2016, its approach extended to launching a small chain of

physical bookstores in recognition of a consumer desire to browse and dis-

cover new content.

Amazon has continually explored new ways to reinvent

its own business model.

By contrast, other retailers may be more reticent to try entirely new busi-

ness models and instead focus on optimizing the deployment of existing assets

such as store locations, assortment designs, or ﬂ oor layouts. There is noth-

ing wrong with this type of learning and experimentation—indeed, there are

great gains to be had from optimization efforts in most businesses.

However

managers should be aware that optimization is inherently centered on current

business norms and runs the risk of missing opportunities to disrupt the exist-

ing business model or the risk of being disrupted.

Chapter 11 • Creating Strategic Pricing Capability 270

Creating Alignment on Pricing Objectives

One of the most common reasons why good pricing strategies fail when imple-

mented is that processes and incentives within the organization are inconsis-

tent with the strategy’s objectives. An executive at a global commercial bank

recently described the challenge:

At a global level, our leadership team is tasked with managing the proﬁ t-

ability of the entire business. We’ve made signiﬁ cant investments in cus-

tomer service and other value-added capabilities to better serve customers

and ensure that our products are at the forefront of the industry. Our

stated goals at the corporate level include an ambitious gross margin tar-

get that reﬂ ects the superior quality of our services.

Exploring New Ways to Manage a Price Increase: Lessons from Netﬂ ix

Done poorly, a pricing move can have disastrous consequences. The

example of Netﬂ ix, the innovative movie rental company, demonstrates

that there are effective and less effective ways to raise prices. In July

2011, when Netﬂ ix raised prices of its services by up to 60 percent and

split its DVD and streaming businesses into two entities, the consumer

outrage was immediate. Facing signiﬁ cantly higher prices and the need

to use two channels for accessing content, movie watchers everywhere

blogged, tweeted, emailed, unfriended, and even wrote old fashioned

letters to any organization that would listen.

The displeasure reached

a crescendo when Netﬂ ix’s CEO issued a public apology for the price

increase. However, the damage was done. More than 10,000 customers

posted their displeasure on the company’s blog; 1 million subscribers

had cancelled their service; and the company lost more than half of its

market value within two months.

By contrast, a more recent price increase by Netﬂ ix has been well-

received. On May 12, 2014, Netﬂ ix implemented a 12.5 percent price

increase, gained 1.7 million new subscribers during the quarter in which

the increase took effect, and the impact is estimated to total $500 million

in incremental revenue by 2017.

What was different this time around? Netﬂ ix segmented their cus-

tomer base between existing and new subscribers and only applied the

increase to new customers. Since existing customers were not subject to the

higher price, and new subscribers were opting in, consumers generally did

not perceive a “loss” typically associated with a traditional price change. In

addition, Netﬂ ix had announced its intent to raise prices, and offered guid-

ance that the increase would “be in the $1 to $2 range.” When the increase

came in at the bottom of the range, affected consumers were likely relieved

that it was not more. Given the range of potential market reactions, it’s no

wonder managers often approach price increases with trepidation.

The ability to challenge existing business norms and try new things

has enabled Netﬂ ix not only to manage the transition from a DVD-by-

mail business to a streaming model. It has also enabled Netﬂ ix to share in

the new value streams created for its customers.

Chapter 11 • Creating Strategic Pricing Capability 271

At the same time, this executive explained that sales were managed at the

country level and each country manager was responsible for setting prices

to reﬂ ect local-market and competitive conditions. Country managers, how-

ever, were primarily assessed on achieving volume and share targets. Conse-

quently, country managers viewed pricing as a lever for achieving sales goals,

with proﬁ ts as a secondary consideration. Not surprisingly, prices negotiated

by country managers were often below the expectations of global leadership.

To make matters even more challenging, country managers often customized

discount programs, often in ways that were not supported by the bank’s bill-

ing systems. As one might imagine, the end result was complete chaos with

hundreds of discounts that could not be tracked by the bank’s operations

team, millions of dollars in services that were not invoiced, and an inability to

perform even basic proﬁ tability analysis of customer accounts.

To break this cycle, the company created a weekly meeting to review all

new contracts to ensure some degree of consistency and internal alignment.

To further mitigate the price erosion, all parties agreed to adhere to criteria

that customers had to meet to qualify for price discounts. While a seemingly

simple mechanism, bringing key decision-makers into a conversation led to a

common understanding of global objectives yet still allowed the ultimate price

to reﬂ ect local market conditions.

Matching the Extent of Pricing Centralization

with Organizational Needs

The above example highlights a critical choice facing organizations in design-

ing a pricing function: The degree of centralization. Generally speaking, a more

centralized pricing function is effective when a company operates within a

single market or has business units operating in similar market contexts. Cen-

tralized pricing in these contexts enables the company to invest in developing

a core of expertise that can be leveraged across markets. However, the beneﬁ ts

of a centralized pricing function diminish when business units are operating

in markets that have signiﬁ cant variations in terms of competitive pressures,

product speciﬁ cations, or customer buying patterns. In those instances, it is

often more productive to push decision-making out to the business units while

maintaining coordination and support mechanisms more centrally.

These two dimensions of a pricing function, the role played and the

degree of centralization, provide the underpinnings for three archetypal orga-

nizational structures for the pricing function (Exhibit 11-5). The actual choice

of an organizational design may involve some combination of these arche-

types because each potential choice involves trade-offs that can enhance or

detract from the ability to execute the pricing strategy. Nevertheless, we have

found these archetypal structures prevalent across markets.

The ﬁ rst archetype is “Centralized Pricing,” in which pricing decisions

are made and managed at the corporate level. This archetype is commonly

used in industries such as energy or airlines where the product is highly com-

moditized and ﬁ nancial success is driven by achieving an advantage in the

cost of operation and capacity (yield) management. It is important to note that

even in centralized pricing organizations, actual price levels may vary in (con-

trolled) ways across markets; the key is that the pattern of variation is closely

managed.

Chapter 11 • Creating Strategic Pricing Capability 272

Where pricing is centralized, the role of the business unit is to collect

data and enforce process compliance in support of the pricing decisions made

at the corporate ofﬁ ce. Large airlines are examples of companies that typically

have a highly centralized pricing function. For example, as of this writing, one

of the major airlines offered 18 different prices for ﬂ ights from New York to

Miami.

Multiply this complexity by the more than 325 routes that this airline

serves and it is easy to see the complexity of responding to competitive price

moves. Adding to the challenge, any change in the price of one route imme-

diately creates shifts in demand that have a cascading effect on other routes

and markets served. In addition, given the hyper-competitive nature of the

airline industry where competing airlines will quickly respond to price moves,

a single pricing mistake has the potential to ignite a price war. Consequently,

for an organization like a major airline, it is imperative to manage pricing in

a centralized setting to ensure that any price change is considered in a global

context.

The second functional archetype is the “Center of Expertise,” which is

characterized by the business units maintaining control of the pricing deci-

sions and pricing processes. In this structure, the pricing function provides a

vehicle for sharing best practices and supports the development of more effec-

tive pricing strategies. The central group will often have specialized skills such

as the ability to perform advanced analytics or to build systems capabilities

that would not be cost effective to develop for each business unit individually.

Often the group assumes the role of functional coordinator. As noted previ-

ously, this team will often serve as an internal consulting function focused

speciﬁ cally on pricing that improves pricing outcomes through knowledge

transfer. Markets with unique local conditions, such as retail or telecommuni-

cations, will often have functional coordinators that assist local area managers

in decision-making.

The ﬁ nal functional archetype is the “Dedicated Support Unit” in which

each business unit has a dedicated pricing group that is only loosely aligned

with corporate pricing (if that function even exists). The role is typically

either a functional coordinator or commercial partner. This type of structure

EXHIBIT 11-5

Pricing Structure Archetypes

Chapter 11 • Creating Strategic Pricing Capability 273

is appropriate for diversiﬁ ed businesses with little overlap in market type or

customer base.

Decision Rights Specify Pricing Roles and Responsibilities

Formal structure alone is not the only consideration when organizing for pric-

ing; it is also necessary to specify decision rights of managers both within and

outside of the pricing function. Allocating decision rights ensures that each

participant understands their role and the constraints on what they can and

cannot do with respect to pricing. Failure to formally allocate pricing deci-

sion rights leads to more inconsistent pricing and greater conﬂ ict as managers

attempt to inﬂ uence pricing decisions.

A business services company unwittingly ran into this problem when it

created a key account team to augment their traditional sales force to better

serve its largest accounts. Unfortunately, there was no coordination between

the key account team and the traditional sales force in managing price quoting

activity. As a result, large accounts started to receive competing and inconsis-

tent price quotes, which only led these large customers to actively solicit addi-

tional quotes in hopes of getting a better deal. Although large accounts grew

considerably under the key account program, average selling prices declined

rapidly, along with proﬁ tability.

Decision rights, as the name implies, deﬁ ne the scope and role of each

person’s participation in the decision-making process as illustrated in Exhibit

11-6. There are four types of decision rights: Input, make, ratify and notify.

Input . Given the large amount of data required to make pricing decisions,

many managers are given “input” rights to pricing decisions. As the name

implies, input rights enable an individual to be an accepted source of some

speciﬁ ed information necessary for the decision. Typically, input rights are

granted to individuals from ﬁ nance, forecasting, and research to provide criti-

cal data, such as the additional cost imposed by rush orders, but they are not

responsible for commercial outcomes.

Make . In contrast to “input” rights, which can be allocated to many individ-

uals, the “make” decision rights should belong to only one person or committee.

This ensures clear accountability for pricing decisions and creates an incentive

to follow up on pricing choices to ensure that they are implemented correctly.

Ratify . Ratiﬁ cation rights provide a mechanism for senior managers to

overturn pricing decisions when they conﬂ ict with broader organizational

priorities. It is essential to separate “make” and “ratify” rights to ensure that

senior managers can regulate the decision-making process without the burden

of monitoring and analysis that leads to a recommendation. Granting ratiﬁ ca-

tion rights to a senior manager balances the need to incorporate her strategic

EXHIBIT 11-6

Types of Decision Rights

Chapter 11 • Creating Strategic Pricing Capability 274

perspective into the decision-making process against protecting her time and

ensuring that she does not get bogged down in day-to-day pricing operations.

Notify. Finally, “notiﬁ cation” rights should be allocated to individuals

that will use or be affected by the pricing decisions in other decision-making

processes. For example, it is quite common to grant notiﬁ cation rights for pric-

ing decisions to members of the product development team so that they can

build more robust business cases for new products and services.

Pricing Processes to Ensure Successful Strategy Implementation

Once the organizational structure has been established and decision rights

have been deﬁ ned, the ﬁ nal step for organizing the pricing function involves

the creation of clearly deﬁ ned pricing processes. In many organizations, pric-

ing processes are deﬁ ned quite narrowly, including only price-setting and dis-

count approval activities. But strategic pricing spans all of the activities that

contribute to more proﬁ table commercial outcomes. For example, the negotia-

tion process might not be considered part of the pricing function, but it is one

of the most critical determinants of transaction proﬁ tability. So too, are deci-

sions about whether and what to charge for services such as rush orders, spe-

cial packaging and extended terms. Moreover, a process to deﬁ ne and change

discount policies proactively is necessary to avoid creating by default a reac-

tive process for approval of ad hoc discounts. It is essential to think broadly

when deﬁ ning pricing processes.

Ensuring that all elements of pricing strategy get regular proactive

review makes the investment in formally deﬁ ning pricing processes a good

one. Thankfully, the steps to creating good processes are fairly straightforward

and facilitating the creation of them is an important role of the pricing function.

Step 1: Define major pricing activities . This step involves deﬁ ning the

major process activities such as opportunity assessment, price set-

ting, negotiation, and contracting. The objective is to put boundaries

around the commercial system so that all relevant activities affecting

proﬁ tability are included.

Step 2: Map current processes . This step creates a visual depiction of the

processes by which pricing decisions are currently made, as illus-

trated in Exhibit 11-7. Even if there are no formally deﬁ ned processes

currently in place, this is a critical step for ﬁ nding the source of unde-

sirable pricing outcomes.

Step 3: Identify profit leaks . This step uses a variety of pricing analyt-

ics (discussed in the next section of this chapter) to identify where

proﬁ t leaks—which we deﬁ ne as losses in proﬁ tability caused by, for

example, unwarranted or unmanaged discounts, incurrence of unnec-

essary costs, or unmet terms and conditions—are occurring in the cur-

rent pricing process.

Step 4: Redesign process . This ﬁ nal step creates a series of redesigned

pricing processes for each of the major pricing activities identiﬁ ed in

Step 1. In order to implement the new processes, it is frequently neces-

sary to revise decision rights to account for new individuals included

in the revised process and to account for current decision-makers

from whom decision rights have been taken away.

275

EXHIBIT 11-7

Map of Decision-Making Process for a Manufacturing Company

Chapter 11 • Creating Strategic Pricing Capability 276

Performance Measures and Incentives: Aligning

Sales Incentives with Strategy

Measuring performance motivates desirable behaviors, especially when

the measures lead to public rewards or ﬁ nancial recognition. Yet, many

companies struggle to obtain the desired results from their compensation

programs as evidenced by the more than 58 percent of managers in our

research who indicated that their incentive plans likely encourage choices

that reduce company proﬁ ts.

So why is it so difﬁ cult to design effective

incentive programs? The ﬁ rst and often most challenging barrier involves

ensuring that performance measures motivate the right behaviors. Employ-

ees engage in complex activities every day, and companies often get caught

in the trap of trying to design metrics and incentives to guide all of them.

But the inclusion of too many metrics can become confusing and lead to a

loss of focus as well-intentioned employees struggle to ﬁ gure out what to

prioritize.

Instead of trying to create an overly complicated set of performance met-

rics, successful companies often settle on a limited set of metrics that are tied

closely to proﬁ tability and then hold people accountable for their performance

against those measures. Consider the dilemma facing sales representatives,

independent dealers, and manufacturers’ representatives who are compen-

sated based on a percentage of sales. Say that a company’s margin is 10 percent

on high-volume deals. A sales rep who invests twice as much time with the

account, selling value and/or getting the customer to reduce costly behaviors

like asking for rush orders or production break-ins, might at best be able to

increase the proﬁ t earned on the deal by an additional 10 percent of sales—

doubling the proﬁ tability. Even if all that increase is in price however, the

sales rep’s revenue-based commission increases by only 10 percent because

the commission is based on a percentage of sales.

In contrast, consider the tactics of a colleague who spends the same

amount of time selling two deals of the same size. However, in order to close

two deals instead of just one, she economizes her time by not selling on value

and as a result only achieves a 10 percent margin. In this case, both sales reps

increase the company’s proﬁ t contribution by the same amount, but the one

who prioritizes volume over proﬁ tability earns twice as much commission for

doing so. Even worse, if the volume-focused colleague were to offer a 5 per-

cent price cut to close her deals (and thus cutting the proﬁ t contribution in

half), she would still earn a commission substantially higher, while the sales

rep who spent time selling value rather than volume hears about his failure to

meet sales goals.

Until you ﬁ x these perverse incentives associated with revenue-based

measurement and compensation—driving revenue at the expense of proﬁ t—it

will be difﬁ cult to get sales reps to do the right thing. The key to aligning sales

incentives with those of the company is to link compensation with proﬁ tabil-

ity. A common objection to doing so is that companies do not want to reveal

their costs and because they may have reason in some cases to drive volume

even when the immediate payback from sales of that product would be greater

from higher margins. For example, selling one product or service cheaply may

give the company an advantage in selling other, more proﬁ table products

Chapter 11 • Creating Strategic Pricing Capability 277

to the same customer. Fortunately, there is a way to incorporate proﬁ t contri-

bution into a sales compensation plan to whatever degree is desired without

actually publishing costs data.

The text box “Creating a Sales Incentive to Drive Proﬁ t” explains how to

implement a compensation system that incorporates margins, and other vari-

ables, when determining the credit that a sales rep earns for making a sale.

More than just theory, tying compensation to proﬁ tability in this way aligns

the interests of the sales rep with the ﬁ nancial interests of the company. And it

encourages salespeople to pay more attention to value drivers linked to inno-

vative product features, quality improvements, and delivery speed. Once the

company aligns sales incentives, salespeople ask for “price exceptions” much

less frequently, but they begin clamoring for the other things they need in

order to succeed at selling value. At one company, for example, sales reps

traded in their company sedans for vehicles in which they could transport

product to customers who had an urgent need. Why? Because customers with

an urgent need and little time to solicit deals from multiple suppliers could be

convinced to buy without demanding greater discounts.

Another challenge to the design of an effective incentive plan is the lack

of alignment among performance measures across functions. Salespeople

paid for generating proﬁ tability will be stymied if undercut in their efforts

to raise price by others who are measured on achieving market share or

volume. For example, a high-tech manufacturer we worked with had given

the ﬁ nance group ratiﬁ cation rights for price-setting to ensure that prices

were set with sufﬁ cient ﬁ nancial prudence. One ﬁ nancial policy that was

strictly enforced was that all products must maintain a minimum 64 per-

cent gross margin or be eliminated from the product portfolio. The ﬁ nancial

staff, which was evaluated on the ability to maintain gross margins, rou-

tinely vetoed requests for any prices that fell below the 64 percent thresh-

old regardless of the market conditions or the volume. Not surprisingly, the

sales organization, whose commission was based on sales volume, had a

very low regard for the business acumen of the ﬁ nancial staff. Moreover, the

salespeople would spend hours each week devising creative ways to work

around the ﬁ nancial staff to get approval for high-volume but lower-margin

deals.

The ﬁ rst step to align metrics and incentives across the organization is to

document current incentives for all of those that have been granted decision

rights in the pricing process. That documentation enables you to highlight

potential conﬂ icts that can detract from effective decision-making. Ideally, the

next step will be to change the incentive plan so that decision-makers will

share common objectives as they make pricing choices. But changing incen-

tives can be time-consuming and involve considerable upheaval in the orga-

nization and thus may not always be a desirable option. In these instances,

it is necessary to create policies that constrain how pricing decisions will be

made and ensure that the policy compliance is tracked with various price-

management analytics. For example, it may be too difﬁ cult to tie sales incen-

tives to all costs that could affect the proﬁ tability of a customer. Generally,

sales incentives reﬂ ect only variable product costs. In that case, it may be nec-

essary simply to have a policy that limits what is acceptable. For example,

Chapter 11 • Creating Strategic Pricing Capability 278

rather than including cost-of-capital-to-ﬁ nance receivables in product mar-

gins, it may be more practical to have a policy that limits the ability to offer

extended payment terms.

Creating a Sales Incentive to Drive Proﬁ t

The key to inducing the sales force to sell value is to measure their perfor-

mance and compensate them not just for sales volume, but also for proﬁ t

contribution. Although some companies have achieved this by adding

Rube Goldberg-like complexity to their compensation scheme, there is a

fairly simple, intuitive way to accomplish the same objective. Give sales-

people sales goals as before, but tell them that the sales goals are set at

“target” prices. If they sell at prices below or above the “target,” the sales

credit they earn will be adjusted by the proﬁ tability of the sale.

The key to determining the sales credit that someone would earn

for making a sale is calculating the proﬁ tability factor for each class of

product. To induce salespeople to maximize their contribution to the ﬁ rm,

actual sales revenue should be adjusted by that proﬁ tability factor (called

the sales “kicker”) to determine the sales credit. Here is the formula:

Sales Credit = [Target Price – k (Target Price – Actual Price)] × Units Sold

In the above equation, k is the proﬁ tability factor (or “kicker”).

In order to calculate sales credits varying proportionally to the

product’s proﬁ tability, the proﬁ tability factor should equal 1 divided

by the product’s percentage contribution margin at the target price. For

example, when the contribution margin is 20 percent, the proﬁ tability

factor equals 5 × (1.0/0.20). When a salesperson grants a 15 percent price

discount, the discount is multiplied by the proﬁ tability factor of 5, reduc-

ing the sales credit by 75 percent rather than by 15 percent had there

been no proﬁ tability adjustment. Consequently, when $1,000 worth of

product is sold for $850, it produces only $250 of sales credit. But when

$500 worth of product is sold for $550 (a 10 percent price premium), the

salesperson earns $750 of sales credit ($500 + 5 × $50).

Because salespeople are more likely to take a short-term view of prof-

itability and can always move to another company, the most motivating

proﬁ tability factor for the ﬁ rm is usually higher than the minimum kicker

value based solely on the contribution margin. Obviously, the importance

of this adjustment is directly related to the variable contribution margin.

The larger the margin and, presumably, the greater the product’s impor-

tance to the ﬁ rm, the greater the proﬁ tability factor’s ability to align what

is good for the salesperson with what is also good for the company.

This is not merely theory. Among companies that have moved

toward more negotiated pricing, many have adopted this scheme in mar-

kets as diverse as ofﬁ ce equipment, market research services, and door-to-

door sales. Although a small percentage of salespeople cannot make the

transition to value selling and proﬁ t-based compensation, most embrace

it with enthusiasm. Managers should be prepared for the consequences,

however, because salespeople’s complaints about the company’s competi-

tiveness do not subside. Instead, salespeople who previously fretted about

Chapter 11 • Creating Strategic Pricing Capability 279

SYSTEMS TO SUPPORT THE PRICING FUNCTION

If you cannot measure it, you cannot improve it.

Lord Kelvin

Establishing clearly deﬁ ned processes and decision rights helps ensure that

pricing strategy choices will be made in a consistent and repeatable manner.

But to ensure that those decisions will also maximize proﬁ ts, they must be

based on accurate, useful information. All too often, crucial pricing choices are

based on anecdotal data that may provide a limited, but unconﬁ rmed, under-

standing of market conditions.

Systems capability for a pricing function requires three key components:

(i) Objective data that provides insight into the available pricing opportunity;

(ii) a set of protocols for performing analytics that provide relevant, actionable

insights; and (iii) tools to perform the calculations and present results in prag-

matic ways that generate unambiguous management choices. We discuss each

of these components in more detail below.

Data Needed to Inform the Pricing Function

Some of the data required to inform pricing decisions is quite easy to ﬁ nd.

Most organizations, for example, have records of historical sales that contain

transacted prices, surcharges for additional services such as shipping, dis-

counts applied, and other descriptors of the transaction. Thinking back to the

value cascade, historical transaction data are particularly relevant for evaluat-

ing market responses to price changes, identifying sources of “revenue leak-

age,” such as when discounts are being given to customers who do not qualify

for them, or evaluating which customers are most proﬁ table.

Other data sources will be more difﬁ cult to obtain. Competitive pricing

moves, for example, may be difﬁ cult to detect quickly because a competitor

may not announce a price cut when they are attempting to gain market share.

In this instance, information regarding a competitive price change will typi-

cally ﬁ lter in from customers or ﬁ eld sales representatives. Many retailers have

instituted “price match guarantees” in an effort to not only remain price com-

petitive, but also to institute a mechanism to “crowd source” competitive price

information in real time.

Common Protocols for Creating Relevant Insights

The array of analytics that can inform pricing decisions is practically endless,

covering data about product costs, cost to serve, purchase trends, customer

value, transaction prices, and more. It is beyond the scope of this text to detail

all of these analytics and demonstrate how they can best be used to improve

strategy choices. Therefore, we focus on two categories that have historically

the company’s high prices begin complaining about slow deliveries, quality

defects, lack of innovative product features, the need for better sales sup-

port to demonstrate value, and so on. In short, sales force attention moves

from reﬂ exive gripes about price to legitimate concerns about value drivers

the company does or does not provide to customers. This is a good thing.

Chapter 11 • Creating Strategic Pricing Capability 280

proven most useful to pricing strategists: Customer analytics and process ana-

lytics. In addition, we will review analytics that gauge the efﬁ cacy of the pric-

ing decision processes we described in the discussion of the pricing function

earlier in this chapter.

Customer Analytics to Guide Management Choices

Customer analytics focus on understanding customer motivations and behav-

iors that are relevant to pricing choices. We have already examined one of

these analyses with the discussion of value assessment in Chapter 2. In the

following discussion, we will focus on the analytics of win–loss data and

customer proﬁ tability, both key inputs for measuring the success of pricing

strategies.

Analysis of Win–Loss Data

Tracking the frequency with which a company’s offers win or lose to the com-

petition is probably the most valuable piece of information that a company

can collect. Amazingly, many do not do so. Instead, they measure perfor-

mance relative to plan, which is usually based upon extrapolation from past

experience when conditions may have been quite different. If overall market

demand begins to increase more rapidly than expected, a company can meet

its plan but still be losing share to competitors. Failing to recognize quickly

that a competitor has improved its product or service, reducing the differen-

tiation value of your offer, will reduce the time available to prevent further

loss through either investment in new sources of differentiation or thoughtful,

selective price adjustments. On the other hand, a company may fail to achieve

expected sales because of an overall decline in market demand even while

maintaining its market share. Reacting in that situation with an ill-advised

price cut could lead an industry into a price war that compounds the adverse

impact of the economic downturn on proﬁ tability.

EXHIBIT 11-8

Illustrative Data Sources for Pricing Analytics

Chapter 11 • Creating Strategic Pricing Capability 281

For companies that sell direct, how frequently do customers that request

a proposal or that check pricing on a website actually make a subsequent pur-

chase? Comparing current period win–loss ratios with previous periods may

require comparing orders from the same geographical area or for purchases

with similar end-use application. Signiﬁ cant losses may indicate a need for

a price reduction; signiﬁ cant gains may indicate the need for a price increase

unless you believe that competitors cannot or will not cut their prices to defend

their traditional market shares.

For companies that sell through channels of distribution, market share

data is the best indicator of changes in win–loss ratios. However, published

market shares usually reﬂ ect performance in the all too distant past. To get

data that is current enough to act upon, a company can often purchase very

current data from samples of stores or from distributors.

Of course, the ultimate goal is not to maximize the share of “wins,” but to

maximize proﬁ t contribution earned. Looking at win–loss data alone tells some-

thing about performance only if prices are unchanged. If the win rate is up but

prices have declined, was the gain in volume sufﬁ cient to compensate for the

decline in margins? If the win rate is down following a price increase, was the

contribution lost from the additional lost bids less than what was gained from

the higher prices? Similar analyses can be conducted across regions or customer

segments to evaluate differences in price sensitivity that can inform future pric-

ing decisions. A similar analysis of changes in the win–loss ratio can be used to

evaluate the effectiveness of advertising or a value-communication campaign.

Customer Proﬁ tability and Cost to Serve

Historically, marketers have long tracked product proﬁ tability as a key met-

ric for managing the product portfolio and allocating marketing resources.

In recent years, however, customer proﬁ tability has emerged as another metric

that can be instrumental to marketers seeking to improve proﬁ tability. Cus-

tomer proﬁ tability measures are created by assessing prices paid by speciﬁ c

customers and combining them with cost-to-serve measures that allocate costs

to customers based upon customer demands and requirements that actually

drive them. Creating customer proﬁ tability measures often requires some

effort because most accounting systems either do not allocate costs at the

customer level or do so arbitrarily. But the beneﬁ ts are generally worth the

effort because customer proﬁ tability analysis provides actionable guidance to

improve the proﬁ tability of a customer portfolio.

The data drawn from a ﬁ nancial services ﬁ rm (shown in Exhibit 11-9)

shows shows one approach for analyzing customer proﬁ tability that charts each

customer based on average selling price and cost to serve. There are opportu-

nities for proﬁ t improvement in each quadrant, and the fact that customers are

charted individually allows for highly targeted actions. The “Platinum” cus-

tomers located in the upper-left quadrant need to be protected. They are some-

times taken for granted because they pay high prices and do not incur a lot of

costs. However, it is essential to understand why these customers are paying

a premium and to ensure they are getting good value for that price. Other-

wise, they may be lost when competitors discover them and offer a better deal.

In contrast, the “Lead” customers in the lower-right quadrant merit a differ-

ent course of action. The most egregious of these “outlaws” in the lower-right

Chapter 11 • Creating Strategic Pricing Capability 282

EXHIBIT 11-9

Customer Proﬁ tability Map

EXHIBIT 11-10

Customer Proﬁ tability by Peer Group

quadrant must be made proﬁ table by either reducing cost-to-serve or raising

prices. Raising prices on the unproﬁ table customers in this quadrant can result

in two outcomes; the customer pays the higher price because of the value

delivered, or they defect and move to a competitor. This is a low-risk move

for the company because it will increase average proﬁ tability, and, often, total

proﬁ tability, regardless of the outcome.

Assessing customer proﬁ tability provides high-level guidance for pric-

ing or cost-reduction moves that can improve company proﬁ ts. Additional

proﬁ t improvement opportunities can be uncovered by a more detailed indi-

vidual customer proﬁ tability assessment, as illustrated in Exhibit 11-10. This

analysis, which details the speciﬁ c sources of revenue and cost, allows for the

comparison of individual customers to segment averages to identify outliers

that are consuming too many resources or not generating sufﬁ cient revenues.

This individual customer proﬁ tability analysis, from the same ﬁ nancial ser-

vices ﬁ rm, was instrumental in helping management take corrective actions

such as increased use of automation and the bulking of claims that helped

reduce direct labor costs and processing costs and drove a 37 percent improve-

ment in proﬁ tability.

Chapter 11 • Creating Strategic Pricing Capability 283

Process Management Analytics

The intent behind process management analytics is to measure unsatisfactory

pricing outcomes (such as proﬁ t leaks) and trace them back to the pricing pro-

cess where they can be “sealed.” Whereas customer analytics focus on strategy

development period. Analytics reviewing process efﬁ cacy can identify proﬁ t

leaks in the pricing process such as those caused by unwarranted or unmanaged

discounts. Process analytics are generally performed on transaction data con-

taining individual records of each transaction’s products, volume, prices, and

discounts. The goal is to identify types of customers or transactions that are get-

ting excessive discounts and then to trace the source of those discounts back to

the pricing process in order to seal the proﬁ t leak by changing decision rights,

developing new policies, or simply ensuring that mangers have the right data

to make effective decisions. The source of the problem may range from a sales-

person granting unwarranted discounts to a pricing policy that is not aligned

with market conditions. The process compliance analytics we discuss below,

price bands and price waterfalls, will not necessarily reveal what the corrective

action for a bad outcome should be. The analytics will, however, help to pin-

point where the problem occurs, which is a useful ﬁ rst step toward correcting it.

Price Bands

Price banding is a statistical technique for identifying which customers are pay-

ing signiﬁ cantly more or signiﬁ cantly less than the band of “peer” prices for a

given type of transaction. This analysis identiﬁ es customers whose aggressive

tactics enable them to earn unmerited discounts and customers who are paying

more than average because they have not pushed hard enough for appropriate

discounts. Exhibit 11-11 graphs the inconsistent, apparently random pattern of

pricing that we often encounter at companies with ﬂ awed policies. However,

the sales force or sales management team responsible might argue that there

is a hidden logic to it—a method to the madness. To the extent that they are

right, and sometimes they are, the pricing manager’s job is to make that logic

transparent to herself and the pricing steering committee. To the extent that the

EXHIBIT 11-11

Price Band Analysis

Chapter 11 • Creating Strategic Pricing Capability 284

variation is truly random, and therefore, damaging the ﬁ rm’s proﬁ t and price

integrity, the pricing committee’s job is to create policies to eliminate it.

There are ﬁ ve steps to a price band analysis:

1. Identify the legitimate factors (service levels, size of orders, geographic

region, customer’s business type, and so forth) that justify price varia-

tions across accounts based on value.

2. Perform a regression of price levels or discount percentages against mea-

sures of those legitimate variations:

Percent discount = f (volume, services, region, etc.) + Ɛ

3. For each observation (an actual customer account or order), use the

regression equation to estimate the price or discount that this customer

would have gotten if given the average discount offered by all sales reps

for each of the legitimate discount factors relevant to that customer.

This is the “ﬁ tted value” of the regression. Label these the “peer prices,”

which are deﬁ ned as the average price for transactions or customers with

the same characteristics.

4. Plot the actual prices customers pay and compare them to the peer prices

along the regression line, and examine the positive and negative differ-

ences, as illustrated in Exhibit 11-11. Plot a line one standard deviation

above and one standard deviation below the “peer price” line to reveal

the outliers. To the extent that price variation is caused by legitimate

factors, the variables in the regression will “explain” the actual price dis-

tribution well. In other words, the R

(called the coefﬁ cient of determina-

tion) will be high (between 0.8 and 1.0) and the band will be narrow. To

the extent that discounting is random, or occurs for reasons that no one

is willing to propose as legitimate, the R

will be low (below 0.4) and the

band around the fair price line will be wide.

Once the analysis is completed, the next step is to brainstorm possible causes

of the random variation and identify correlations to test those hypotheses. For

example, do a minority of sales reps account for most of the negative varia-

tion while a different group accounts for the positive? Is the negative-variation

minority composed of the newest reps while the group accounting for the pos-

itive differences is more experienced? If so, the solution may be to document

what the savvy reps know about selling value and sharing that information

with the low-performing group. Other explanations for the random variation

could relate to the customer’s buying process (is it centralized?), indicating a

need for different policies. In one case, price-band analysis revealed a pattern

that was ultimately traced to one sales rep in a particularly corrupt market

who was taking bribes for price concessions.

Price Waterfalls

In some companies, the possible sources of lost revenue and proﬁ t are many

and poorly tracked. In a classic and oft-quoted article, two McKinsey con-

sultants used waterfall analysis to show how simply managing the plethora

of discounts can improve company proﬁ tability.

Exhibit 11-12 illustrates

this price waterfall analysis. Although the company might estimate account

proﬁ tability by the invoice price, there are often many other sources of proﬁ t

285

EXHIBIT 11-12

Price Waterfall Analysis

Chapter 11 • Creating Strategic Pricing Capability 286

leakage along the way. The “pocket price,” revenue that is actually earned

after all the discounts are netted out, is often much less. More important, the

amount of leakage could range from very small to absurdly high. In one case,

a company that analyzed its pocket prices discovered that sales to some of

its customers resulted in more leakages than the gross margin at list price!

In addition to the salesperson’s commission, there was a volume incentive for

the retailer, a commission for the buying group to which the retailer belonged,

a co-op advertising incentive, an incentive discount for the distributor to hold

inventories, an early payment discount for the distributor, a coupon for the

end customer, and various fees for processing the coupons.

Agreements to let the customer pay later, to let the customer place smaller

orders, to give the customer an extra service at no cost and so on, all add up.

The result can become a much wider variance in pocket prices than in invoice

prices. Because companies often monitor such concessions less closely than

explicit price discounts, these giveaways tend to grow. This does not mean

that such discounts should be stopped; they often provide valuable incentives

and can be effective in hiding discounts while still maintaining the important

appearance of price integrity. The danger is simply in letting them go unman-

aged, without applying rigid policies on their use. For example, after discover-

ing that sales reps waived shipping charges for customers much more often

than necessary, a large distributor imposed policies to require more documen-

tation before such orders were processed. That simple policy change resulted

in tens of millions more dollars to the bottom line.

Pricing Systems

Pricing systems generally need to perform two functions: (i) Support the data

analytics described above; and (ii) enable the systematic execution of a chosen

strategy.

There are several common software tools such as Excel and Tableau that

allow most organizations to analyze their transaction data and assess their

pricing performance. These tools can be used to generate the price waterfalls

and price bands that were described in the prior section and offer a great start-

ing point for assessing a ﬁ rm’s pricing outcomes. As a ﬁ rm scales its pricing

practices and starts to standardize its analytics, there may be a desire to invest

in specialized commercial pricing software products that are able to ingest

real-time transaction data, systematically share outputs across the organiza-

tion, and create automated alerts and interventions.

In addition, a pricing system should also enable an organization to execute

its chosen pricing strategy in an efﬁ cient and repeatable manner. As an example

of how pricing systems can present limitations, one of the authors recalls chap-

eroning his son’s class outing many years ago that included a stop at a McDon-

ald’s for lunch. Wanting to impress two dozen third-graders with his pricing

expertise, he asked the restaurant manager whether he could receive a 10 per-

cent quantity discount for the class. The manager replied that he would gladly

do so, but explained that his cash registers did not allow him to apply a percent-

age discount—each button on the register corresponded to a speciﬁ c menu item

with a pre-programmed price. So the question was rephrased: Would he be will-

ing to provide 24 Happy Meals for the price of 22 Happy Meals? Reframed as

Chapter 11 • Creating Strategic Pricing Capability 287

a question of quantity and not percentages, the manager happily obliged because

his pricing system allowed him to accommodate such a request. It should of

course be noted that some systems limitations are very purposeful—it is not

clear that the owner of the franchise would want cashiers to invent new pricing

strategies. However, it is useful to consider how choices in systems design can

enhance or hinder a company’s ability to execute a given pricing strategy.

Conversely, many of the world’s airlines have invested signiﬁ cantly in

systems capabilities that allow them to implement an array of new pricing

strategies to capture the value of transporting checked bags, offering window

seats, providing in-ﬂ ight meals or Wi-Fi access, among other services, allow-

ing them to capture over $38 billion in non-ticket revenues in 2014.

The trick to investing in pricing systems is to ensure that pricing strategy

dictates the systems requirements, and not the other way around. For com-

panies that have not yet invested in a clearly articulated pricing strategy, it

is likely a mistake to invest in an industrial-grade pricing software system;

these systems will offer conﬁ guration choices that a less-than-mature pricing

organization will be unable to decide on. The reality is that too many compa-

nies adopt pricing technology that is seldom used or eventually abandoned.

Preparing for change is not about writing a user manual and telling the orga-

nization to “go do.” Rather, any systems investment needs to be supported by

an organizational culture change that is all about doing things in a new way.

To assess a company’s readiness for a new pricing system, it is worth asking

a few questions:

• What would the organization like to achieve with the new pricing

solution?

• What are the key beneﬁ ts that the solution will enable? Are these beneﬁ ts

aligned with the broader corporate strategy?

• Has senior leadership fully bought in?

• Who will be affected within the organization and is there a plan to posi-

tion each stakeholder for success?

• What is the appetite both within and outside of the company to absorb

the change?

The answers to these questions will help align the organization against the

right type of pricing solution; the less developed the answer to these ques-

tions, the more likely a simpler solution is appropriate.

In terms of functionality, there are four distinct elements that are

addressed by commercially available systems. The functionality that is com-

mon across all providers is the ability to perform pricing analytics . Key ana-

lytics include the ability to create price waterfalls and price bands that provide

an overview of price and margin performance. Another common analytic is

segmentation analytics, which can zero in on speciﬁ c customer types, geogra-

phies, product categories and other attributes. Most pricing analytics systems

include the ability to build dashboards and alerts to monitor pricing trends

and activities.

The second functionality is price optimization , which is the execution

of statistical models to calculate the price points that optimize against a given

objective such as proﬁ t, unit volume or market share. Price optimization is

valuable in cases where transaction volumes are large and data about all prices

Chapter 11 • Creating Strategic Pricing Capability 288

(yours and competitors’) is available. Retail grocery products, airlines seats,

and hotel rooms are examples where it is easy to buy data for all retail prices

available in the market as well as information about the context (e.g., how

the product was displayed in the retail store, whether the travel was booked

through an online site, a travel agent, or directly). Price optimization algorithms

typically ingest large amounts of historical transaction data that includes price

as well as promotions and any other marketing activities to estimate the impact

of price on sales, or to estimate the impact of context and marketing efforts on

the demand price elasticity.

A third functionality offered by many vendors is price management ,

which allows the user to set the rules and conditions that can automatically

change prices in dynamic fashion. These tools allow the user to manage price

lists by market, customer, and product category. Given the rules-based algo-

rithms that adjust prices, this functionality allows ﬁ rms to automate mass price

updates that reﬂ ect real-time changes in market conditions. These systems are

typically deeply integrated with a ﬁ rm’s ERP system.

The forth functionality is called deal management , which pulls together

the data needed to enable a sales person to negotiate more proﬁ table quotes

and contracts, while ensuring that the deal remains within the bounds deﬁ ned

by a ﬁ rms pricing and discount policies. This functionality allows a sales per-

son to perform scenario modeling for quotes and contracts when negotiating

with a customer and can highlight how a customer might qualify for better

pricing—by, for example, consolidating orders to minimize shipping costs, or

making a slightly larger quantity to qualify for the next volume discount tier.

Deal management is also used to capture any pricing approvals and to load

the resulting customer-speciﬁ c prices and terms into the order entry or ERP

system.

For a more detailed discussion of pricing technology, we refer the reader

to Pricing and Proﬁ tability Management by Julie Meehan et al .

MANAGING THE ORGANIZATIONAL CHANGE PROCESS

Organizational structure, decision rights, processes, and incentives are impor-

tant levers that provide managers with the opportunity to make pricing

choices in different and more proﬁ table ways. Transforming an organization

into one that commits to and executes on the principles of strategic pricing

requires that managers act in ways that may run counter to their past experi-

ence and training. Some individuals may be resistant to change because they

legitimately believe that the new approach is less effective, while others may

be resistant because their compensation would be adversely affected under

the new approach. Regardless of the reason, individuals must be motivated to

go through a potentially uncomfortable transition process before accepting a

new pricing strategy.

There are a number of levers that can be used to facilitate adoption of the

new approach including clear leadership from senior management and dem-

onstrating successes through trial projects. Successful change efforts require

an integrated and consistent use of these change levers to overcome organiza-

tional inertia and effect change.

Chapter 11 • Creating Strategic Pricing Capability 289

Senior Management Leadership

One of the most important actions that leaders can take to encourage adoption

of strategic pricing is to truly “talk the talk and walk the walk.” All too often,

senior managers indicate strong support for a new pricing strategy and then

revert to ad hoc discounts the ﬁ rst time a customer asks for a lower price. Not

only must senior leaders avoid falling back on old pricing practices, they must

actively seek high-proﬁ le opportunities to demonstrate support for the new

strategy. A telecommunications company we worked with had invested heav-

ily to develop a more strategic approach to pricing in its consumer markets.

The implementation plan included extensive training for the sales team and

conducting a couple of high-proﬁ le negotiations with the new approach to

demonstrate its effectiveness. The company seemed to be on its way to making

a successful transition when the COO, who had been a tireless advocate for the

strategy, began to respond to pressure from the board to meet sales targets by

offering “one-time” discounts to win business. As soon as the regional sales

managers learned about these discounts, they demanded the right to negotiate

similar discounts. It was not long before these pricing “exceptions” became the

norm across the organization and the pricing strategy was abandoned. In this

example, the COO missed a critical opportunity to send a clear message about

the organization’s commitment to the new strategy and, instead, began the

process that left the organization stuck in its old pricing habits.

Senior managers have many opportunities to signal their support of

a new pricing strategy. Speciﬁ c actions they should consider include the

following:

1. Mandate a comprehensive training program to (i) introduce the strategic

pricing concepts and (ii) demonstrate what “good looks like” based on

company speciﬁ c examples of recent wins with the new approach.

2. Build in regular progress review sessions with business leaders to dis-

cuss challenges and to hold individuals accountable for progress.

3. Seize opportunities to communicate support for the new approach such

as internal blogs, newsletters, and speeches.

4. Ensure that other senior leaders are actively involved in the decision-

making process so that they can understand the challenges and model

desirable behaviors.

Demonstration Projects

Perhaps the most important method for helping managers understand and

adopt strategic pricing is the use of demonstration projects that test the new

approach and provide an example of “what good looks like.” Successful dem-

onstration projects can be pivotal in building momentum for the new approach

and should be given as much exposure as possible. They should be designed

to demonstrate the strategy and provide feedback and real outcomes from the

commercial teams. They should be focused and of limited duration, or they

risk losing the attention of the organization and undermining interest in the

new strategy. A good example is when an entertainment company tested a

new pricing strategy and price points by selecting a very speciﬁ c post-holiday

Chapter 11 • Creating Strategic Pricing Capability 290

period and one focused metric to track growth in total gross proﬁ t. By focus-

ing on a discrete period and clearly deﬁ ning success, the organization built not

only interest in the new strategy, but also credibility when it quickly declared

the strategy a success and began a full rollout.

A challenge that must be overcome when designing a demonstration

project is how to deﬁ ne a baseline for measurement. Skeptical managers

across the organization will ask, “How do I know if it was the pricing strategy

that drove the outcomes when there are so many moving parts in the mar-

ket and with our own commercial activities?” The best and quickest way to

address this concern is to treat the demonstration project as a price experiment

in which two similar groups of customers are selected. One group receives

the new strategy and new prices while the other maintains current prices and

policies. This provides an objective measure of the effect of the new strategy

and builds credibility within the organization. The consumer entertainment

company did a thoughtful job of deﬁ ning a control sample of similar products

that were used to establish a baseline against which the new strategy could be

tested. The positive results of the test were then distributed to everyone in the

sales organization through webcasts and sales meetings. The test contributed

signiﬁ cantly to the organization’s acceptance of the new prices.

One of the major beneﬁ ts of demonstration projects is that the leaders of

the project often become internal champions for the change effort. There is no

better spokesperson for strategic pricing than someone who has experienced the

outcomes ﬁ rst-hand. This is especially true for pricing, where even small barri-

ers are seen as reason for abandoning an effort and sticking with the tried and

true. Having more managers express conﬁ dence in the new pricing approach

legitimizes the effort and provides conﬁ dence that it can lead to success. While

having the most senior leader supporting an effort can be extremely important

to success, there is also great value in having junior managers’ support as they

face challenges similar to their peers, giving them strong credibility.

Summary

Progressive companies have been doing

more than just worrying about pricing—

they are actively making pricing a core

part of their strategic capabilities. To

drive proﬁ ts in a low-growth economy,

many are graduating from attempts

to improve tactical price reactions to

developing the capability to drive ongo-

ing price improvement proactively. More

than ever before, successful companies

are building their businesses—including

core products, ancillary services, and the

business model itself—to support a pric-

ing strategy rather than the other way

around. Traditional industry leaders such

as General Electric

and Procter & Gam-

ble

have made explicit corporate deci-

sions to change their focus from top-line

growth to driving proﬁ tability growth. As

they do so, they are changing not only the

prices they charge, they are fundamen-

tally altering the way they go to market,

all with the aim of increasing the proﬁ t-

ability of a sale.

Building pricing into a source of

competitive advantage is one of the most

challenging activities facing commercial

leaders today. Success requires a com-

bination of structural changes, such as

building organizational alignment on the

role of pricing, it requires investment in

tools and data to inform decisions and

monitor their implementation, and it

requires building the knowledge base of

the organization to understand the objec-

tives of value-based pricing. The degree

Chapter 11 • Creating Strategic Pricing Capability 291

of change is substantial! We would be

remiss if we did not acknowledge that

the change process can often take years

to complete. However, the data

clearly

show that the ﬁ nancial results justify the

effort—ﬁ rms that successfully complete

the transformation to value-based pricing

and build the supporting capabilities are

signiﬁ cantly more proﬁ table than their

industry peers.

Notes

1. Charles Darwin, letter to Asa Grey,

September 5, 1857. Accessed April

24, 2017 at www.darwinproject.

ac.uk/commentary/evolution#

quote4.

2 . John Hogan, “Building a Leading

Pricing Capability: Where Does

Your Company Stack Up?” Deloitte,

2014. Accessed at www2.deloitte.

com/content/dam/Deloitte/us/

Documents/strategy/us-consulting-

building-a-leading-pricing-capabil

ity.pdf.

3. P. H. McCaskey and D. L. Brady,

“The Current Status of Course

Offerings in Pricing in the Busi-

ness Curriculum,” Journal of Product

and Brand Management 16(5) (2007),

pp. 358–361.

4 . Kevin Mitchell, “The Current State

of Pricing Practice at U.S. Firms,”

opening speech, Professional Pric-

ing Society Annual Spring Confer-

ence, May 30, 2011.

5 . Georg Müller, Tom Nagle, and Lisa

Thompson, “Everything Manufac-

turers Want to Know About Rais-

ing Prices but Are Afraid to Ask,”

Deloitte DBrief presentation, May 28,

2015.

6 . Shantanu Dutta, Mark Bergen, Dan-

iel Levy, Mark Ritson, and Mark

Zbaracki, “Pricing as a Strategic

Capability,” MIT Sloan Management

Review (Spring 2002), pp. 61–66.

7. Dirk Beveridge, “After Record

Losses, Airline Industry Sees Bleak

1992,” Associated Press, January

6, 1992, via Post Bulletin, Roch-

ester, MN. Accessed at www.

postbulletin.com/after-record-

losses-airline-industry-sees-bleak/

article_7a0f913d-69c7-5a9d-ad29-

99fd04a42472.html?mode=jqm.

8. Andreas Hinterhuber, “Value

Quantiﬁ cation Capabilities in

Industrial Markets,” Journal of

Business Research 76 (July 2017),

pp. 163–178. DOI: 10.1016/j.jbusres.

2016.11.019.

9. Peter Kafka, “Apple and Spotify

Are Generating $7 Billion a Year

in Streaming Music Revenue,”

Recode, December 7, 2016.

Accessed at www.recode.net/

2016/12/7/13864776/apple-spo

tify-60-million-subscribers-7-bil

lion-revenue.

10. Vincent Barabba, The Decision Loom:

A Design or Interactive Thinking in

Organizations (Devon: Triarchy

Press, 2011).

11. Leena Rao, “Amazon’s Third

Bookstore Will Be in Portland,”

Fortune , June 15, 2016. Accessed at

http://fortune.com/2016/06/15/

amazon-store-portland.

12 . James G. March, “Exploration and

Exploitation in Organizational

Learning,” Organization Science

2(1), Special Issue: Organizational

Learnings: Papers in Honor of (and by)

James G. March (1991), pp. 71–87.

13. Jason O. Gilbert, “Netﬂ ix Price

Increase Causes Bigger Subscriber

Loss Than Expected,” Hufﬁ ngton

Post, September 15, 2011. Accessed

at www.hufﬁ ngtonpost.com/2011/

09/15/netflix-price-increase-

subscriber-loss_n_964026.html.

14 . “The Impact of Netﬂ ix’s Price

Rise,” by contributors from Treﬁ s,

Forbes.com, May 15, 2014. Acc-

essed at www.forbes.com/sites/

greatspeculations/2014/05/15/

the-impact-of-netﬂ ixs-price-rise.

15. “Airline Fluctuations: Can a Flight

Price Really Change 135 Times?”

Chapter 11 • Creating Strategic Pricing Capability 292

blog at Cheapair.com, January 21,

2014. Accessed at www.cheapair.

com/blog/travel-tips/airfare-fluc

tuations-can-a-flight-price-really-

change-135-times.

16. Hogan, op. cit .

17. Lecture on “Electrical Units of

Measurement” (3 May 1883), pub-

lished in Popular Lectures Vol. I,

p. 73 .

18. Michael Marn and Robert Rosiello,

“Managing Price, Gaining Proﬁ t,”

Harvard Business Review (Septem-

ber–October 1992).

19. Martha C. White, “More Fees Pro-

pel Airlines’ Proﬁ ts, and Embitter

Travelers,” New York Times , July 27,

2015. Accessed at www.nytimes.

com/2015/07/28/business/more-

fees-propel-airlines-profits-and-

embitter-travelers.html.

20. Questions adapted from “Your

Pricing Technology Journey,”

Monitor Deloitte white paper,

2016. Accessed at www2.deloitte.

com/us/en/pages/operations/

articles/pricing-technology-jour

ney.html.

21. Julie M. Meehan, Michael G. Sim-

onetto, Larry Montan Jr., and

Christopher A. Goodin, Pricing and

Proﬁ tability Management (Singapore:

John Wiley & Sons Inc., 2011).

22 . “GE to Create Simpler, More Valu-

able Industrial Company by Selling

Most GE Capital Assets; Potential

to Return More than $90 Billion to

Investors Through 2018 in Divi-

dends, Buyback and Synchrony

Exchange,” General Electric press

release, April 10, 2015.

23 . Procter & Gamble 2016 annual

report. See also Rachel Abrams,

“P&G Sells 43 Beauty Brands to

Coty,” New York Times , July 9,

2015.

24 . Hogan, op. cit . Also see: Stefan

Michel, “Capture More Value,”

Harvard Business Review (October

2014).

CHAPTER 12

Ethics and the Law

Understanding the

Constraints on Pricing

Illegal price ﬁ xing is an “actual or potential threat to the central nervous system

of the economy.”

Justice William O. Douglas

When making pricing decisions, the successful strategist must consider not

only what is proﬁ table, but also what will be perceived as ethical and legal.

Unfortunately, good advice on both of these issues is all too often unavail-

able or misleading. Attorneys who do not specialize in antitrust law tend to

be overly conservative—advising against activities that are only sometimes

illegal or that could trigger an investigation. In fact, benign changes in ques-

tionable pricing policies are often all that is necessary to make them both prof-

itable and defensible. On the other hand, product and sales managers eager to

achieve quarterly objectives will sometimes fail to consider these constraints

at all, resulting in costly condemnations of their companies in courts of law or

public opinion. This chapter is intended to raise awareness of the issues and

educate managers sufﬁ ciently enough to question the advice received.

ETHICAL CONSTRAINTS ON PRICING

“Perhaps no other area of managerial activity is more difﬁ cult to depict accu-

rately, assess fairly and prescribe realistically in terms of morality than the

domain of price.”

This oft-quoted assessment reﬂ ects the exceptional diver-

gence of ethical opinions with respect to pricing. Even among writers sym-

pathetic to the need for proﬁ t, some consider it unethical to charge different

prices unless they reﬂ ect differences in costs, while others consider pricing

unethical unless prices are set “equal or proportional to the beneﬁ t received.”

Consequently, there is less written on ethics in pricing than on other market-

ing issues, and what is written tends to focus on the easy issues, like deception

and price-ﬁ xing.

The tougher issues involve strategies and tactics for gaining

proﬁ t.

This book is intended to help managers capture more of the value created

by the products and services they sell. In many cultures, and among many who

Chapter 12 • Ethics and the Law294

promulgate ethical principles, such a goal is morally reprehensible. Although

this opinion was once held by the majority, its popularity has generally

declined over the past three centuries due to the success of capitalism and the

failure of collectivism to deliver an improvement in material well-being. Still,

many people, including many in business practice and education, believe that

there are legitimate ethical constraints on maximizing proﬁ t through pricing.

It is important to clarify your own and your customers’ understanding

of those standards before ambiguous situations arise. The topology of ethical

constraints in pricing illustrated in Exhibit 12-1 is a good place to start. Read-

ers should determine where to draw the line concerning ethical constraints—

for themselves and their industry—and determine as well how other people

(family, neighbors, social groups) might view such decisions.

Most people would reject the idea of zero ethical constraints, in which

the seller can dictate the price and terms and force them on an unwilling

buyer. Sale of “protection” by organized crime is universally condemned. The

practice of forcing employees in a one-company town to buy from the “com-

pany store” is subject to only marginally less condemnation. Even when the

government itself is the seller that is forcing people to purchase goods and

services at a price (tax rate) it sets, people generally condemn the transaction

unless they feel empowered to inﬂ uence the terms. This level of ethical con-

straint was also used to condemn the “trusts” that, before the antitrust laws,

sometimes used reprehensible tactics to drive lower-priced competitors out of

business. By denying customers alternative products, trusts arguably forced

them to buy theirs.

Ethical level one, embodied in all well-functioning, competitive market

economies, requires that all transactions be at least voluntary. Historically,

Exhibit 12-1

When Is Price Ethical? Ethical Constraints

Chapter 12 • Ethics and the Law 295

some of the fastest-growing economies that produced the greatest opportu-

nity to escape poverty condoned any and all voluntary transactions. The legal

principle of caveat emptor , “Let the buyer beware,” characterized nearly all

economic transactions in the United States prior to the 20th century. In such

a market, people often make regrettable purchases (for example, expensive

brand-name watches that turn out to be cheap substitutes, or stocks in over-

valued companies). On the other hand, without the high legal costs associ-

ated meeting licensing, branding, and disclosure requirements, new business

opportunities abound even for the poor—making unemployment negligible.

Ethical level two imposes a more restrictive standard, condemning even

voluntary transactions by those who would proﬁ t from unequal information

about the exchange. Selling a used car without disclosing a known defect,

concealing a known risk of using a product, or misrepresenting the beneﬁ ts

achievable from a product are prime examples of transactions that would be

condemned by this ethical criterion. Thus, many would condemn selling land

in Florida at inﬂ ated prices to unware out-of-state buyers, or selling lottery

tickets to people unlikely to recognize their poor return. Since sellers naturally

know more about the features and beneﬁ ts of products than most consumers

do, they may have an ethical duty to disclose what they know completely and

accurately.

Ethical level three imposes a still more stringent criterion: that sellers

earn no more than a “fair” proﬁ t from sales of “necessities” for which buyers

have only limited alternatives. This principle is often stated as follows: “No

one should proﬁ t from other people’s adversity.” Thus, even nominally capi-

talist societies sometimes impose rent controls on housing and price controls

on pharmaceutical costs and physicians’ fees. Even when this level of ethical

constraint is not codiﬁ ed into law, people who espouse it condemn those who

raise the price of ice during a power failure or the price of lumber following a

hurricane, when the demand for these products soars.

Ethical level four extends the criteria of ethical level three to all prod-

ucts, even those with many substitutes and not usually thought of as necessi-

ties. Proﬁ t is morally justiﬁ able only when it is the new minimum necessary

to induce companies and individuals to make decisions for the good of less-

advantaged members of society.

Proﬁ t is ethically justiﬁ able only as the price

society must pay to induce suppliers of capital and skills to improve the well-

being of those less fortunate. Proﬁ ts from exploiting unique skills, great ideas,

or exceptional efﬁ ciency (called “economic rents”) are morally suspect in this

scenario unless it can be shown that everyone, or at least the most needy, ben-

eﬁ ts from allowing such proﬁ ts to be earned, such as when a high-proﬁ t com-

pany nevertheless offers lower prices and better working conditions than its

competitors. Proﬁ ts from speculation (buying low and selling high) are clearly

condemned, as is segmented pricing (charging customers different prices to

capture different levels of value), unless those prices actually reﬂ ect differ-

ences in cost.

Ethical level ﬁ ve, the most extreme constraint, is inconsistent with mar-

kets. In some “primitive” societies, everyone is obliged to share good fortune

with those in the tribe who are less fortunate. “From each according to his

ability, to each according to his need” is the espoused ethical premise of Marx-

ist societies and even some respected moral philosophers. Those that have

actually tried to put it into practice, however, have eventually recoiled at the

Chapter 12 • Ethics and the Law296

brutality necessary to force essentially self-interested humans to “give accord-

ing to their abilities” without reward. Within families and small, self-selected

societies, however, this ethical principle can thrive. Within social and religious

organizations, members often work together for their common good and share

the results. Even within businesses, partnerships are established to share,

within deﬁ ned bounds, each other’s good and bad fortune.

For each level of ethical constraint on economic exchange, one must

determine the losses and gains, for both individuals and societies, that will

result from the restriction. What effect does each level have on the material

and social well-being of those who hold it as a standard? Should the same

standards be applied in different contexts? For example, is your standard

different for business markets than it is for consumer markets? Would your

ethical standards change when selling in a foreign country where local com-

petitors generally hold a higher or lower ethical standard than yours? In

assessing the standards that friends, business associates, and political repre-

sentatives apply, managers must ask themselves if their personal standards

are the same for their business as well as for their personal conduct. For exam-

ple, would they condemn an oil company for earning excess proﬁ ts as a result

of higher crude prices, yet themselves take excess proﬁ ts on a house that had

appreciated substantially in a hot real-estate market? If so, are they hypocrites

or is there some justiﬁ cation for holding individuals and ﬁ rms to different

standards?

Although we certainly have our own beliefs about which of these ethical

levels is practical and desirable in dealing with others and would apply differ-

ent standards in different contexts, we feel that neither we nor the people who

claim to be experts on business ethics are qualiﬁ ed to make these decisions for

someone else. Each individual must make his or her own decisions and live

with the personal and social consequences.

Regardless of one’s personal ethical beliefs about pricing, it would be

foolish to ignore the legal constraints on pricing. Antitrust law in the United

States has developed over the years to reﬂ ect both citizens’ moral evaluations

of companies’ actions and companies’ attempts to get laws passed that protect

them from more efﬁ cient or aggressive competitors. As the summary below

illustrates, the meaning of these laws changes over time as courts respond to

changing social attitudes and the placement of judges with differing political

views.

THE LEGAL FRAMEWORK FOR PRICING

When making pricing decisions, the strategist must consider not only what

is proﬁ table, but also what is lawful. Since the late 19th century, the United

States has been committed to maintaining price competition through estab-

lishing and enforcing antitrust policy. Statutes, regulations, and guidelines, as

well as countless judicial decisions, have deﬁ ned what constitutes anticompet-

itive pricing behavior and the rules under which the government and private

parties may pursue those who engage in it.

For more than 125 years, U.S. antitrust law has responded to a complex

and dynamic marketplace by being both of these things, resulting in policies

that are always being scrutinized and questioned and sometimes stretched

and revised. The overall trend in the United States for the last several decades

Chapter 12 • Ethics and the Law 297

has been to move away from judging behavior based on economic assump-

tions toward focusing on demonstrable economic effect, something that has

fostered a great deal of contemporary pricing freedom. Of course, a necessary

companion to evolving policies, as well as the lag time sometimes necessary

for the law to catch up with the marketplace, is ambiguity. In return for some

uncertainty, there is more latitude for businesses to cope creatively with both

new and old challenges.

This section discusses key aspects of the law regarding pricing, focusing

primarily on that of general applicability in the United States at the federal

level.

Due to its long history, U.S. law in the pricing area has served as a

model for other parts of the world, including the European Union (E.U.) and

Japan. For example, E.U. antitrust law historically prohibited such things as

territorial restrictions on intermediaries that interfered with cross-border trade,

but a “safe harbor” became effective in 2000.

That, much like the change in

the U.S. view that occurred more than 20 years earlier, recognizes a supplier’s

legitimate interest in controlling how its products are resold under certain

circumstances.

In the United States, the antitrust laws are enforced by both government

and private parties. The Department of Justice is empowered to bring crimi-

nal and civil actions, although the former are reserved primarily for price

ﬁ xing and hardcore cartel activity.

At the same time, the Federal Trade Com-

mission (FTC) may bring civil actions,

as can private parties. Often, civil plain-

tiffs pursue injunctions to stop certain conduct and, in the case of private parties,

they may also or alternatively seek three times their actual economic damages

(something known as “treble damages”), as well as their legal fees and court

costs.

While the volume of private antitrust litigation dwarfs that brought by

the government, private suits often follow signiﬁ cant government cases.

The Effect of Sarbanes–Oxley on Pricing Practices

In direct response to highly visible corporate ﬁ nance scandals involving such

companies as Enron and WorldCom, the Sarbanes–Oxley Act—a signiﬁ cant

and sweeping piece of securities reform legislation—became law in 2002.

Because one of the main purposes of the act is to facilitate more accurate pub-

lic disclosure of ﬁ nancial information and provide accountability measures

in reporting and monitoring of corporate conduct, its impact on pricing prac-

tices has been in general to make antitrust compliance more rigorous than had

been present in many companies before the law was passed. While most of

the requirements of Sarbanes–Oxley apply only to an “issuer,” or a publicly

traded or listed company,

some commentators have recommended that even

private companies should strive to comply with the full demands of this law.

Among other things, Sarbanes–Oxley speciﬁ cally provides for stricter

ﬁ nancial and auditing procedures and reporting. For example, the act

requires that an issuer’s chief ﬁ nancial ofﬁ cer (CFO) and chief executive

ofﬁ cer (CEO) certify ﬁ nancial reporting documents (such as the company’s

quarterly and annual reports) and make the knowing certiﬁ cation of non-

compliant ﬁ nancials a criminal offense.

The statute also outlines disclosure

procedures and internal accounting control mechanisms, as well as whistle-

blowing provisions, including language that makes retaliation against truth-

ful informants subject to criminal penalties of a ﬁ ne or up to ten years’

imprisonment, or both.

Chapter 12 • Ethics and the Law298

While Sarbanes–Oxley was not created with the express intent of polic-

ing antitrust compliance in pricing matters, the broad scope of the act clearly

affects this area. Some of the most obvious examples in the context of pricing

policies and related issues include tighter controls on the accounting and dis-

closure procedures relating to the treatment and use of discounts, allowances

and promotional funds, regardless of whether a company is giving or getting

them. As a result, companies are well advised, among other things, to address

in their internal control policies requirements and guidelines for pricing and

pricing actions, process documentation for such actions and a procedure for

investigating and responding to employee reports of internal violations.

PRICE FIXING OR PRICE ENCOURAGEMENT

In an effort to reduce or avoid market risks, businesspeople have long been

interested in setting prices with their competitors or dictating or inﬂ uencing

the prices charged by their downstream intermediaries, such as distributors,

dealers, and retailers. Over the years, U.S. law has taken a rather dim view of

this behavior. At the same time, it is now clear that there is some ﬂ exibility in

what companies that collectively affect market prices can do, but the biggest

changes are in the area of distribution channels, where price setting is lawful

if done properly.

There are two types of price ﬁ xing: horizontal and vertical which the law

treats differently. In horizontal price ﬁ xing, competitors agree on the prices

they will charge or key terms of sale affecting price. In vertical price ﬁ xing,

a supplier and a reseller agree on the prices the reseller will charge or the

price-related terms of resale for the supplier’s products. However, where an

intermediary, such as an independent sales representative, does not take own-

ership of the supplier’s products and acts only as the supplier’s agent, there

cannot be any vertical price ﬁ xing because the law views the sale as taking

place directly between the supplier and the end-user, with the intermediary

serving merely as a conduit. Consequently, the supplier is only setting its own

prices and terms of sale.

The primary law affecting price ﬁ xing is Section 1 of the Sherman Act,

an 1890 statute that prohibits “[e]very contract, combination . . . or conspiracy

in restraint of trade.”

The contract, combination, or conspiracy requirement

necessarily means that there must be an agreement between two or more

individuals or entities. As a result, the law does not affect unilateral behav-

ior.

Moreover, in the horizontal context, the Sherman Act does not ban

merely imitating a competitor’s pricing behavior (something called “conscious

parallelism”).

In rare cases, there are written contracts or other direct evidence of price-

ﬁ xing conspiracies. Far more often, evidence of agreement must be inferred

from the actions of the parties involved. Although conscious parallelism by

itself is not enough to establish an agreement, when uniform or similar behav-

ior is coupled with one or more “plus factors,” courts have found illegal con-

certed activity. Perhaps the most powerful of these factors is if the conduct in

question would be against the self-interest of each party if it acted alone, but

consistent with their self-interest if they all behaved the same way, such as the

uniform imposition of unpopular restrictions or price increases in the face of

surplus.

Another factor is the opportunity to collude (often shown by com-

munications between or among the parties), followed by identical or similar

Chapter 12 • Ethics and the Law 299

actions, although the probative effect of such opportunity or communications

can be undercut by legitimate business explanations.

Once concerted action has been found, the next step is to evaluate it. Case

law has further reﬁ ned Section 1 of the Sherman Act to require two levels of

proof, depending on the nature of the alleged offense. Some offenses are con-

sidered to be “per se” illegal, while others are analyzed under the “rule of rea-

son.” Per se offenses require that the presence of the objectionable practice be

proven and that there be antitrust injury and damages, while offenses subject

to the rule of reason add a third element—that the practice at issue be unrea-

sonably anticompetitive. In general, it is easier to prove a violation under the

per se test and more difﬁ cult to do so under the rule of reason, because the lat-

ter starts with a presumption of legality and requires detailed economic analy-

sis and a balancing of pro-competitive and anticompetitive effects. Of course,

the rule of reason also provides defendants with the opportunity to justify

their behavior, something denied under the per se rule.

Historically, all concerted activities affecting price were presumed to be

unreasonably anticompetitive on their face and, therefore, per se illegal. How-

ever, during the last 40 years or so, the U.S. Supreme Court has placed more

emphasis on showing demonstrable economic effect rather than relying on

assumptions, so there has been an erosion of per se application to both hori-

zontal and vertical pricing issues.

Horizontal Price Fixing

In the horizontal arena, direct price ﬁ xing—competitors in the stereotypical

smoke-ﬁ lled room agreeing to set prices or rig bids—remains per se illegal.

The same treatment is accorded to indirect price ﬁ xing, where there is an

ambiguous arrangement between competitors that a court has determined

constitutes illegal price ﬁ xing after conducting a detailed factual review or

market analysis.

However, when a restriction on price is merely the incidental effect of

a desirable pro-competitive activity (sometimes referred to as “incidental

price ﬁ xing”), it is now clear that the more forgiving rule of reason applies.

This point is illustrated by National Collegiate Athletic Association v. Board of

Regents , where the U.S. Supreme Court applied the rule of reason and noted

that association rules covering athletic equipment standards and schedules

were appropriate, but those that limited the television exposure of member

football teams were an unreasonable restriction on output that unlawfully

increased prices.

RESALE PRICE FIXING OR ENCOURAGEMENT

Vertical Price Fixing

Vertical price ﬁ xing by agreement was considered per se illegal in the U.S. until

a pair of modern-day Supreme Court cases spaced ten years apart established

the current rule that all forms of resale price setting—maximum, minimum or

exact—are judged under federal law by the rule of reason. The 1997 decision

in Khan overturned a 29-year-old case to declare that the rule of reason applies

to maximum price agreements, while the far more controversial Leegin deci-

sion in 2007 jettisoned a 96-year-old precedent by extending Khan to minimum

Chapter 12 • Ethics and the Law300

prices (and the analytically equivalent exact prices).

Likely because maxi-

mum price setting has the effect of holding down prices, while minimum or

exact prices prop them up, bills have been introduced both in Congress and

at the state level to legislatively overturn Leegin by restoring the per se rule to

minimum resale price agreements, but, so far, only Maryland’s efforts have

been enacted into law.

While application of the rule of reason in this context

is too new to assess its effect and the empirical evidence supporting the con-

sumer welfare arguments in favor of going back to the per se rule is lacking,

the emotion seems to have diminished, but has not disappeared.

However, regardless whether Leegin survives, none of the legislative

efforts aimed at minimum resale price agreements affect the Supreme Court’s

1919 ruling in Colgate that setting maximum, minimum or exact resale prices

without an agreement (that is, unilaterally) is not illegal price ﬁ xing prohib-

ited under the Sherman Act.

As a result, a supplier may announce a price

at which its product must be resold (that is, establish a ceiling, ﬂ oor, or exact

price policy) and refuse to sell to any reseller that does not comply, as long

as there is no agreement between the supplier and its reseller on what resale

price levels to set. Even when resellers follow the supplier’s resale price policy,

there is no unlawful agreement. With this latitude, many manufacturers of

desirable branded products have successfully discouraged discounting (often

in response to corrosive price competition over the internet) in such diverse

industries as consumer electronics, furniture, appliances, apparel, footwear,

sporting goods, tires, luggage, handbags, agricultural supplies, electronic test

equipment, and automotive aftermarket products.

A frequent justiﬁ cation given for minimum or exact resale price policies

is to permit resellers sufﬁ cient margin to provide a selling environment that

is consistent with the supplier’s objectives for its products, including brand

image. For example, the supplier may want knowledgeable salespeople, show-

rooms, substantial inventory, and superior service. Of course, such policies

also may help support higher supplier margins. Sometimes, the imposition of

such policies is sought by resellers to insulate them from price competition. As

long as there is no agreement on price levels, such requests, even if acted upon

by the supplier, are not unlawful.

Pricing policies may be used broadly or selectively to cover everything

from a single product to all of those in a supplier’s line. Similarly, they can be

used in certain geographic areas and with speciﬁ c channels of distribution in

which price erosion is a problem, or they can be used throughout the country.

In any event, a policy violation typically requires that the supplier stop selling

the offending reseller the products involved, although it also is permissible to

pull a product line or all of the supplier’s business.

When and if the supplier

wishes to resume selling is the supplier’s unilateral decision, although some

cases suggest that warnings, threats, and probation short of termination sup-

port the inference that some form of agreement has been reached.

To make such a policy stick, the supplier must generally have brand or

market power. Otherwise, resellers simply won’t bother to follow the policy,

as there are plenty of substitutes available. Ironically, it is those highly desir-

able products that are most susceptible to discounting anyway, so the requisite

power is typically present. In addition, it is important to note that resale price

policies have a vertical reach that is limited to one level down the distribu-

tion channel. If all resellers buy directly from the manufacturer, this restriction

Chapter 12 • Ethics and the Law 301

poses no problem, but if a signiﬁ cant amount of sales are made through mul-

tiple levels of distribution, a policy will be too porous to be effective. In other

words, a manufacturer can control a direct-buying retailer’s sell price by pol-

icy, but it can’t reach that of a retailer that buys from a wholesaler. To address

this problem, the manufacturer may “jump over” the wholesaler by making a

sale directly to the retailer, or it may convert the wholesaler into an agent for

the purpose of such a sale. Alternatively, the policy may be circulated to both

direct- and indirect-buying resellers, while wholesalers are permitted to sell

to “approved” resellers only. One way to remain on the approved list is to

comply with the policy.

Resale price policies are potent, but the rules for managing them within

the law are necessarily stringent. Careful implementation keeps otherwise

lawful programs from going astray. This means that any form of agreement

regarding resale prices must be avoided. There must be no resale pricing

contracts, no assurances of compliance, and no probation. Because this area

can be a legal mineﬁ eld, it’s crucial to understand it. At the same time, many

companies have adopted such programs with low risk and considerable

success.

Direct Dealing Programs

Another way to control the prices charged to end-users is for the supplier to

sell them directly or, constructively, by the use of agents. When the supplier

agrees with the end-user on price, but the latter cannot handle delivery of large

quantities or maintain sufﬁ cient inventory to justify direct shipments from the

supplier, some suppliers look to a reseller to ﬁ ll the order out of the reseller’s

warehouse. This can be done by consignment or by the supplier buying back

inventory from the reseller immediately prior to its transfer to the end-user,

so, in either event, the sale runs directly from the supplier to the end-user. The

reseller becomes the supplier’s warehousing and delivery agent and is com-

pensated by the supplier for performing only these functions.

When the supplier has negotiated the price to the end-user, but the

reseller has or retains the title, the supplier has another alternative. Under the

“reseller’s choice” approach, the reseller may either choose to sell the product

to the end-user at the price set by the supplier or refuse to do so. Even if the

reseller agrees to sell at the contracted price, there is no per se illegal price ﬁ x-

ing, as this practice is subject to the rule of reason.

Resale Price Encouragement

Instead of dictating a resale price by agreement, policy, or direct sale, some

suppliers encourage desirable resale pricing behavior by providing ﬁ nancial

or other incentives, such as advertising allowances to promote certain prices.

Although these practices are judged under the rule of reason, the provision of

incentives is subject to the prohibitions in the Robinson–Patman Act against

price and promotional discrimination.

In the area of price advertising, a common practice is to use a Minimum

Advertised Price (MAP) program, although the underlying concept could

also be used for maximum or exact prices. Under this approach, the reseller

receives an advertising allowance (often in the form of co-op advertising funds)

Chapter 12 • Ethics and the Law302

in return for adhering to the appropriate price in advertising, in a catalog,

or over the internet.

Some companies pay an explicit allowance (such as a

percentage rebate on purchases), while others employ an implicit allowance

stating that failure to follow program requirements results in the loss of the

allowance and an increase in price. The latter is found in consumer electronics.

Alternatively, a supplier sets the advertised price (but not the selling price)

and cuts off all resellers that don’t allow it.

A variant on MAP programs is group or shared-price advertising,

through which a supplier sponsors an ad, but resellers can be listed in it only

if they agree to sell at the promoted price during the period indicated. Again,

resellers that wish pricing freedom may decline to be in the ad, and, because of

the voluntary nature of this approach, there is no per se illegality.

Another option is target-price rebates. Here, the supplier rewards the

reseller with ﬁ nancial incentives that vary depending upon how close the

retailer’s resale prices are to the target set by the supplier. This practice

requires point-of-sale (POS) reporting, typically easier to get in the consumer

area due to the widespread use of scanners, but becoming more common in

the industrial marketplace.

PRICE AND PROMOTIONAL DISCRIMINATION

Although economists maintain that the ability to charge different prices to dif-

ferent customers promotes efﬁ ciency by clearing the market, U.S. law on that

issue has focused on maintaining the viability of numerous sellers as a means to

preserve competition. Consequently, while lawful price discrimination has been

limited since 1914, the Robinson–Patman Act amended existing legislation in

1936, so this entire area is commonly referred to by the name of the amendment.

This complex, Depression-era legislation was enacted to protect small

businesses by outlawing discriminatory price and promotional allowances

obtained by large businesses, while exempting sales to government or “chari-

table” organizations for their own use.

At the same time, the emergence of

contemporary power buyers through internal growth or consolidation (large,

big-box retailers and hospital buying groups), as well as supplier efforts to

make discounts and allowances provided to customers more efﬁ cient, have

forced or encouraged sellers to provide lawful account-speciﬁ c pricing and

promotions by creatively ﬁ nding ways through the Robinson–Patman maze.

This trend is likely to continue, as further consolidation and evolving distribu-

tion channels (brought on by e-commerce, among other things) will demand

and reward more sophisticated differentiation in pricing.

As is the case with the other antitrust laws, the Department of Justice, the

FTC, and private parties may each bring Robinson–Patman cases, although

the enforcement agencies have not focused on this area for some time. Indeed,

the Justice Department has criminal powers in this area that have gone unused

for many years, while the FTC today brings few signiﬁ cant cases in this area

after being particularly active through the 1970s. Private suits on behalf of

businesses (consumers have no standing to sue under the statute) account for

most of the enforcement activity.

Successful plaintiffs are entitled to the same

remedies as those available under the antitrust laws discussed previously

(injunctions, treble damages, attorneys’ fees and costs).

Chapter 12 • Ethics and the Law 303

Price Discrimination

Keep in mind that discrimination in price is not always unlawful. In order

to prove illegal price discrimination under the Robinson–Patman Act and

assuming that the supplier sells in interstate commerce, each of ﬁ ve elements

must be present:

1. Discrimination . This standard is met simply by charging different prices

to different customers. However, if the reason for the difference is due to a dis-

count or allowance made available to all or almost all customers (like a prompt

payment discount), but some customers choose not to take advantage of it, the

element of discrimination drops out, ending the inquiry. This is known as the

“availability defense.”

2. Sales to Two or More Purchasers. The different prices must be charged

on reasonably contemporaneous sales to two or more purchasers—a rule that

permits price ﬂ uctuations. In other words, it is inappropriate under the stat-

ute to compare two widely separated sales in a highly volatile market. Yet, if

prices typically change annually or semiannually, a sale made in January may

be compared with one made in March.

In addition, offering different prices is not enough. Actual sales or agree-

ments to sell at different prices must exist. For example, if two electrical supply

distributors seek special pricing from the manufacturer to bid on a construc-

tion job or an integrated supply contract that only one will get, the manufac-

turer may, if it is careful, give one a better price than the other, because in

doing so, it is providing two offers, but making only one sale.

3. Goods . Robinson–Patman applies to the sale of goods only (“commodi-

ties” in the statute), so services—such as telecommunications, banking, and

transportation—are not covered.

When a supplier sells a bundled offering,

such as repair services that include parts or computer hardware that includes

maintenance services, Robinson–Patman is relevant only if the value of the

goods in the bundle predominates. Also, it is possible to turn goods into ser-

vices if the manufacturer procures raw materials and produces and stores the

products on behalf of the customer, with the customer owning the inventory

every step of the way and bearing the risk of loss.

4. Like Grade and Quality. The goods involved must be physically or

essentially the same. Brand preferences are irrelevant, but functional varia-

tions can differentiate products. In a key case, the Supreme Court stated that

a branded product and its physically and chemically identical private-label

version must be priced the same by the manufacturer.

While the distinctions

drawn in the case law sometimes appear arbitrary, meaningful functional or

physical variations can result in different products that legitimize different

prices. For example, two air conditioners that have meaningful differences in

cooling capacity are distinct products, even if they otherwise are or appear

physically identical.

5. Reasonable Probability of Competitive Injury. The law generally focuses

on injury at one of two levels. The ﬁ rst, called “primary line,” permits a sup-

plier to sue a competitor for the latter’s discriminatory pricing. But here the

law also requires that the supplier’s discriminatory pricing be below its cost,

something designed to drive its rival out of business or otherwise injure com-

petition in the market as a whole (called “predatory intent”), rather than to

merely take some incremental market share. Moreover, the structure of the

Chapter 12 • Ethics and the Law304

market must be such that the discriminating supplier can raise prices after it

disposes of the targeted competitor or that market injury otherwise is threat-

ened through reduced output.

Not surprisingly, there are few contemporary

primary-line cases due to this tough standard.

Far more common is “secondary-line” injury, where a supplier’s disfa-

vored reseller or end-user customer may sue the supplier for price discrimina-

tion. However, the law is clear that only competing customers must be treated

alike. To the extent that customers do not compete due to their locations or

the markets they serve, different prices are appropriate under the Robinson–

Patman Act. If these customer distinctions do not occur naturally, they may be

introduced or formalized by contract or policy through the use of vertical non-

price restrictions. (For more on this point, see the later section in this chapter

on “Vertical Non-Price Restrictions.”)

Defenses to Price Discrimination

Even if all ﬁ ve price-discrimination elements are present, there are three

defenses that may be used to help avoid what otherwise is unlawful

discrimination.

1. Cost Justiﬁ cation. This defense permits a price disparity if it is based on

legitimate cost differences. For example, freight is usually less on a per case

basis for a truckload shipment. However, while there is no requirement to

pass on any savings, if the supplier does so, the law states that some or all of

the actual savings may be passed on to the customer, but not a penny more.

One common problem area is volume discounts, particularly those that

are stair-stepped with large differences in amount between levels or those

that go back to the ﬁ rst dollar. Perhaps this structure reﬂ ected real cost dif-

ferences many years ago when it was adopted by the supplier, but unless

the underlying cost analysis is regularly updated, the discounts probably

do not track today’s costs. Indeed, the dynamic nature of business and the

precision required to support this defense make it difﬁ cult to apply success-

fully, although the sophistication of activity-based costing holds a great deal

of potential. Indeed, some manufacturers keep proﬁ t-and-loss statements on

their customers and adjust their pricing accordingly.

2. Meeting Competition . Under this defense, discrimination is permissible

if it is based on a good-faith belief that a discriminatory price is necessary to

meet the price of a competitive supplier to the favored customer or to maintain

a traditional price disparity.

Many managers are familiar with the applica-

tion of this defense on the micro level, that is, when a buyer tells the seller that

the seller’s competitor offered a lower price. However, meeting competition

may also be used on the macro level to justify things like volume discounts

that are so institutionalized in the industry that adjusting them to reﬂ ect true

cost savings would result in the loss of business.

Of course, it is at the micro level where this defense is most often used.

Unfortunately, this means relying on the purchaser for competitive pricing

information when the buyer has every incentive to lie.

Some companies pro-

vide their salespeople with detailed meeting competition forms that require

competitive invoices and other documentary evidence. While this sort of evi-

dence is helpful, it is not essential if the seller has a reasonable basis at the time

of the decision to believe that the competitive price described by the buyer is

Chapter 12 • Ethics and the Law 305

legitimate, even if it turns out to be wrong later. Nevertheless, a written or

electronic record of why the otherwise discriminatory price was provided is

useful.

Because meeting competition is a defense, there is no obligation to pro-

vide the special price to anyone other than the customer that asked for it. Of

course, smart buyers will attempt to secure “most-favored-nations” clauses in

their contracts or purchase orders to automatically get the beneﬁ t of a lower

price elsewhere, regardless of whether they would otherwise be entitled to

it. Such clauses may cause tension between a supplier’s Robinson–Patman

responsibilities and those under the law of contract.

3. Changing Conditions . Special prices may be provided to sell perishable,

seasonal, obsolete, or distressed merchandise, even though the full price had

been charged up to the point of offering the special prices.

Promotional Discrimination

The Robinson–Patman Act also bans promotional discrimination in an effort

to deny an alternative means of achieving discriminatory pricing. The dis-

tinction between price and promotional discrimination is an important one,

because different legal standards apply and, while the requirements in certain

respects are tougher for promotional discrimination, there is ultimately more

ﬂ exibility.

Price discrimination covers the sale from the supplier to the reseller or to

the direct buying end-user, while promotional discrimination usually relates

only to the reseller’s sale of the supplier’s products.

Historically, promo-

tional discrimination was largely the purview of consumer goods marketers,

as industrial goods sellers concentrated on such things as volume discounts

subject to price discrimination standards. However, the need for creative

account-speciﬁ c marketing and the desire to make supplier incentives work

harder have caused many industrial sellers to face the same issues. Both con-

sumer and industrial suppliers are now focusing on how their resellers sell

their products (promotional discrimination), rather than only on how they buy

them (price discrimination).

As was the case with price discrimination, each of several elements must

be present to violate the law:

1. The Provision of Allowances, Services, or Facilities . Here, the supplier

grants to the reseller advertising or promotional allowances (like $5 off per

case to promote a product) or provides services or facilities (such as demon-

strators or free display racks), usually in return for some form of promotional

performance.

2. In Connection with the Resale of the Supplier’s Goods. As is the case with

price discrimination, the law regarding promotional discrimination does not

apply to service providers. In addition, promotional discrimination generally

applies only to resellers. Typically, this does not cover purchasers that use or

consume the supplier’s product in making their own. Also, it usually does not

cover the incorporation of a product, such as sugar used in baked goods or

sound systems installed at the automotive factory. However, these purchasers

are resellers for promotional discrimination purposes if they receive allow-

ances or other beneﬁ ts from the supplier for promoting the fact that the ﬁ n-

ished goods were made using the supplier’s product or contain it, such as an

Chapter 12 • Ethics and the Law306

ice cream producer that advertises the use of a particular brand of chocolate

chips or a manufacturer that promotes the use of an axle brand in its heavy-

duty trucks.

3. Not Available to All Competing Customers on Proportionally Equal Terms .

Once again, not all of the supplier’s customers need to be treated alike, only

those that compete. In addition, the services or facilities offered or the perfor-

mance required to earn the allowances must be “functionally available,” that

is, usable or attainable in a practical sense by all competing resellers, some-

thing that may require alternatives. In other words, if a reseller could take

advantage of a promotional program, but chooses not to do so, the supplier

is off the legal hook.

For example, if a warehouse club chain could advertise

in newspapers, but it decides not to do so, the supplier is under no legal obli-

gation to offer an alternative to a newspaper advertising allowance. On the

other hand, if the supplier pays for advertising on grocery carts, but some of

its retail customers can’t have them due to the size of their stores, the supplier

must make available an alternative means of performance, such as a poster or

window sign in lieu of cart advertising.

The ﬂ exibility available under promotional discrimination standards is

based on the fact that competing customers do not have to receive the same

level of beneﬁ ts, something contrary to the implicit mandate to do so under

price discrimination rules. Instead, the promotional discrimination require-

ment is one of “proportional equality,” and there are three ways to propor-

tionalize what is provided: (i) on unit or dollar purchases (buy a case, get a

dollar—something that lawfully favors larger resellers that buy more); (ii) on

the cost to the reseller of the promotional activity (a full-page ad in a national

trade magazine costs more than that in a regional newsletter); or (iii) on the

value of the promotional activity to the supplier (salespeople dedicated exclu-

sively to the supplier’s brand have more value than those who are not).

Competitive Injury, Defenses, and Indirect Purchasers

There also are other, somewhat less attractive differences between price and

promotional discrimination. First, no competitive injury is necessary for ille-

gal promotional discrimination, making it more like a per se rule.

Second,

meeting competition is the only defense, as cost justiﬁ cation and chang-

ing conditions are irrelevant. Third, if the supplier provides promotional

allowances to direct-buying resellers, it must also furnish them to competi-

tive resellers that buy the promoted product through intermediaries, some-

thing that may be accomplished with ultimate reseller rebates or mandatory

pass-throughs.

USING NON-PRICE VARIABLES TO

SUPPORT PRICING GOALS

Vertical Non-Price Restrictions

Under the standards for price and promotional discrimination, the Robinson–

Patman Act requires that only competing reseller and direct-buying end-user

customers be treated similarly. For this reason, or to be consistent with other

price-related or marketing objectives, the supplier may wish to control the

Chapter 12 • Ethics and the Law 307

degree to which its resellers compete with each other, something known as

“intrabrand competition.” In 1977, the Supreme Court’s Sylvania decision pro-

vided suppliers with considerable ﬂ exibility in this regard, by holding that

vertical non-price restrictions are subject to the rule of reason and that intra-

brand competition could be reduced to promote “interbrand competition,” or

the rivalry between competing brands.

As a result, suppliers may impose vertical restraints on resellers to help

manage distribution channels and to provide considerable leeway in pricing

design using the carrot approach (ﬁ nancial incentives), the stick approach

(contractual requirements), or some combination of the two. Certain restric-

tions may also be useful in dealing with sales agents, the provision of services,

and direct-buying end-users, as illustrated in the discussion about “Product

Restrictions” later in this chapter. Historically, industrial sellers have favored

the use of vertical restrictions and the more selective distribution that goes

with them, while many consumer goods suppliers (except those which sell

durables) have been more interested in widespread distribution without the

same sort of restrictions. However, the challenges of internet sales and other

factors have focused more attention on limiting how products may be resold.

Broadly speaking, there are three types of vertical non-price restraints,

each subject to the rule of reason:

1. Customer Restrictions . Rather than selling to any customer, the reseller

is restricted only to particular customers or is prohibited from selling to certain

customers. For example, in the industrial area, the reseller could be required

to sell only to plumbing contractors or to stay away from accounts that are

reserved to the supplier or another reseller. On the consumer side, the reseller

could be limited to customers who order over the internet or prohibited from

selling to such customers at all.

2. Territorial Restrictions. Although generally designed to prevent or dis-

courage selling outside of a geographic area, these can also be thought of as

market restrictions. An “exclusive distributorship” is actually a restraint on

the supplier, as it agrees that a particular reseller will be the exclusive outlet

in the latter’s territory or market (however deﬁ ned) for some or all of the sup-

plier’s products. When the reseller is required to sell inside only a particular

territory or market, it is subject to “absolute conﬁ nement.” By combining an

exclusive distributorship with absolute conﬁ nement, the result is known as an

“airtight territory.” In other words, if a supplier promises a dealer that the lat-

ter will be the only outlet in Oregon for a particular product, it has granted an

exclusive distributorship. If the dealer is limited to selling in that state, there is

absolute conﬁ nement and, when it is combined with an exclusive distributor-

ship, the reseller has an airtight territory.

Due to some ﬂ ip-ﬂ opping on the part of the Supreme Court, vertical non-

price restrictions were per se illegal from 1968 until the Sylvania decision in

1977. In response, a number of so-called “lesser restraints” were established

that may not be as helpful in pricing as other restrictions, but still can be use-

ful. The ﬁ rst of these is an “area of primary responsibility” that permits sales

outside a reseller’s territory, but expects the reseller to focus its efforts on its

designated geographic area.

The second is a “proﬁ t passover” that allows the

reseller to sell anywhere, but, to neutralize the “free-rider effect,” the reseller

must split revenue or proﬁ t for sales outside its territory with the reseller in

the area encroached upon. The third is a “location clause” that restricts the

Chapter 12 • Ethics and the Law308

reseller to approved sites only. While this last approach is ineffective if sales

are made over the internet or by phone, it can be useful where a physical pres-

ence in the territory is necessary, especially in an environment where resellers

are consolidating.

3. Product Restrictions. Suppliers have no legal obligation to sell their

reseller or end-user customers any of their products, except in two instances—

when the supplier has a contract to do so or in the relatively rare situation

when the supplier is a monopolist with excess capacity.

In other words, the

supplier may generally determine what products, if any, it sells to its reseller

or direct-buying end-user customers, something that can be referred to as des-

ignated products. In this way, it may limit intrabrand competition or other

conﬂ icts by restricting what can be purchased by whom.

In addition, if the reseller or the end-user is not permitted to purchase

particular products or services or types of products or services from another

supplier, this practice is known as exclusive dealing . Alternatively, it may be

discouraged from doing so through ﬁ nancial or other incentives, often called

“loyalty programs.” Judged under the rule of reason, the test is whether com-

peting suppliers are unreasonably foreclosed from the market. As long as such

suppliers have reasonable access to the market through other resellers or other

means, exclusive dealing is permissible.

In some respects, tying is the other side of the coin from exclusive dealing,

with the same effect.

In its most extreme form, tying requires that in order to

purchase a desirable product or service, the customer must also buy another

product or service that is less desirable. Although tying is often described

as per se illegal, the analysis necessary to prove a violation is more like that

required by the rule of reason.

Bundling is not illegal tying, as long as the

products or services are available separately, even at a somewhat higher, but

reasonable, cost.

Full-line forcing, judged under the rule of reason, is a variation on tying

that requires a reseller to carry the supplier’s entire line or a speciﬁ ed assort-

ment to avoid the customer’s cherry-picking of the more desirable products.

Note that tying and full-line forcing can effectively crowd competitive prod-

ucts off the shelf.

Non-Price Incentives

To motivate desired behavior, a supplier may provide a favored reseller or

end-user with certain non-price beneﬁ ts, such as ﬁ rst access to new products

or enhanced technical support. Due to their non-price nature, this type of dis-

criminatory reward is not covered by the Robinson–Patman Act, although the

other laws still may apply.

At the same time, anything that the supplier does

to assume or subsidize an expense that normally would be incurred by the

customer triggers application of the Robinson–Patman Act.

OTHER PRICING ISSUES

Predatory Pricing

The practice of setting a price so low that a seller harms its own proﬁ tability

in an attempt to do greater harm to a competitor is predatory pricing. The

Chapter 12 • Ethics and the Law 309

purpose of such behavior is either to discipline a competitor for competing

too intensely or to drive it from the market and thus reduce or eliminate its

competition.

Long-term aggressive pricing that is below marginal cost (or its mea-

surable surrogate, average variable cost) can be attacked as monopolization

or attempted monopolization under Section 2 of the Sherman Act and by the

FTC under Section 5 of the FTC Act.

However, in 1993, the Supreme Court

ruled that a successful prosecution requires proof that the price-cutting seller

could likely recoup its losses with higher prices later on.

This heavy burden

of proof severely limits claims of predation and favors the presumption that

price-cutting is procompetitive.

Price Signaling

The practice of a supplier communicating its future pricing intentions to its

competitors is known as price signaling . It is usually done to facilitate price

parallelism through such means as supplying advance notice of price changes

to customers or the media. In DuPont , the court of appeals overturned an FTC

decision that such behavior violates the antitrust laws, ruling that consciously

parallel pricing is not unlawful unless it is collusive, predatory, coercive, or

exclusionary.

While signaling raises questions about the possibility of collu-

sion, it can have legitimate business purposes as well. According to the court

of appeals, signaling serves the lawful purpose of aiding buyers in their ﬁ nan-

cial and purchasing planning.

Summary

The development and implementation of

pricing strategies and tactics that do not vio-

late the law is an important aspect of pric-

ing. In addition to the risk of legal actions

initiated by the government, a company

can be sued by private parties, usually its

competitors or its customers. If the Justice

Department can prove that the company’s

pricing violated the criminal provisions of

the antitrust laws, the company is subject to

ﬁ nes and its managers may face both ﬁ nes

and imprisonment. In successful civil cases

brought by the Justice Department or the

FTC, the company may be enjoined from

certain conduct and subject to civil penal-

ties, while in civil actions ﬁ led by private

parties, defendants that lose may also be

enjoined and have to pay treble damages

and the attorneys’ fees and court costs of

the plaintiff. Even if antitrust claims are

successfully defended, their defense is usu-

ally disruptive to the business and expen-

sive in terms of monetary and management

costs, as well as the effects on reputation.

At the same time, it is obvious that

the law is rarely black-and-white, particu-

larly in the area of pricing. Over the last

several decades, U.S. courts have placed

more emphasis on showing demonstrable

economic effect, rather than relying on

assumptions to ﬁ nd antitrust violations.

Indeed, once the business objectives are

clear, contemporary antitrust law pro-

vides considerable ﬂ exibility to develop

alternative strategies and tactics, which

are usually compatible with the degree of

legal and trade relations risk a business

wishes to assume. While there often are

no easy answers, in most cases the ends

are achievable with some modiﬁ cation of

the means.

Eugene F. Zelek, Jr. wrote The Legal

Framework for Pricing section of this chap-

ter. He is a partner and co-chairs the Antitrust

and Trade Regulation Group at the law ﬁ rm of

Freeborn & Peters LLP. The author wishes to

thank his colleague, Lauren Berheide, for her

assistance.

Chapter 12 • Ethics and the Law310

Notes

1 . U.S. v. Socony-Vacuum Oil Co. , 310

U.S. 150, 224 n.59 (1940).

2 . Clarence C. Walton, Ethos and the

Executive (Upper Saddle River, NJ:

Prentice Hall, 1969), p. 209.

3 . William J. Kehoe, “Ethics, Price

Fixing and the Management of

Price Strategy,” in Marketing Ethics:

Guidelines for Managers , ed. Gene R.

Laczniak and Patrick E. Murphy

(Lexington, MA: D.C. Heath, 1985),

p. 72.

4 . Kehoe, “Ethics, Price Fixing and

the Management of Price Strategy,”

p. 71.

5 . Manuel G. Velasquez, Business Ethics ,

3rd edn. (Upper Saddle River, NJ:

Prentice Hall, 1992), pp. 282–283.

6 . Tom L. Beauchamp and Norman E.

Bowie, Ethical Theory and Business ,

4th edn. (Upper Saddle River, NJ:

Prentice Hall, 1993), pp. 697–698.

7 . Specialized or industry-speciﬁ c stat-

utes are outside the scope of this dis-

cussion. However, federal and state

laws of general applicability tend

to be consistent. For antitrust issues

(particularly in pricing), it is wise to

have the assistance of knowledge-

able legal counsel. This section is not

a substitute for such help.

8 . See 1999 O.J. (L 336) 21; 1999 O.J.

(C 291) ¶ 119 (the safe harbor is avail-

able to the supplier if its market

share is 30 percent or less, and there

is some additional ﬂ exibility when

new products are involved). The

U.S. approach does not establish

a numerical market-share thresh-

old, but instead looks at economic

effects as a whole under the “rule of

reason” discussed in the next sec-

tion. For an even more signiﬁ cant

difference between U.S. and E.U.

antitrust law, see text accompany-

ing notes 21–26 infra .

9 . Criminal violation of the Sherman

Act, the country’s principal anti-

trust statute, is a felony punishable

by a $100 million ﬁ ne if the per-

petrator is a corporation or other

entity and a $1 million ﬁ ne or ten

years in prison or both if the viola-

tor is an individual. 15 U.S.C. § 1

(the penalties were substantially

raised in 2004). Application of the

Comprehensive Crime Control Act

and the Criminal Fine Improve-

ments Acts, 18 U.S.C. §§ 3571–3572,

permits an even greater ﬁ nancial

penalty by allowing the ﬁ ne to be

increased to twice the gain from the

illegal conduct or twice the loss to

the victims, while the Federal Sen-

tencing Guidelines can also impact

the penalties imposed. See United

States Sentencing Commission,

2016 Sentencing Guidelines, Part

R, § 2R1.1. Accessed at www.ussc.

gov/guidelines/2016-guidelines-

manual.

10 . The FTC has no authority under the

Sherman Act and relies on other

antitrust statutes, including Section

5 of the Federal Trade Commission

Act, 15 U.S.C. § 45.

11 . Since the 1980s, state attorneys gen-

eral also have been active in civil

antitrust enforcement at the federal

level, suing on behalf of the citi-

zens of their states and often coor-

dinating their efforts through the

National Association of Attorneys

General (NAAG).

12 . On July 30, 2002, the Sarbanes–

Oxley Act of 2002, Pub.L. 107–204,

116 Stat. 745, enacted 15 U.S.C.

§ 7201, et. seq., 15 U.S.C. §§ 78d-3,

78o-6, and 78kk, and 18 U.S.C.

§§ 1348 to 1350, 1514A, 1519, and

1520, amended 11 U.S.C. § 523, 15

U.S.C. §§ 77h-1, 77s, 77t, 78c, 78j-1,

78l, 78m, 78o, 78o-4, 78o-5, 78p,

78q, 78q-1, 78u, 78u-1, 78u-2, 78u-3,

78ff, 80a-41, 80b-3, and 80b-9, 18

U.S.C. §§ 1341, 1343, 1512, and

1513, 28 U.S.C. § 1658, and 29 U.S.C.

§§ 1021, 1131, and 1132, enacted

provisions set out as notes under 15

U.S.C. §§ 78a, 78o-6, 78p and 7201,

18 U.S.C. §§ 1341 and 1501, and 28

U.S.C. § 1658, and amended pro-

visions set out as notes under 28

U.S.C. § 994.

Chapter 12 • Ethics and the Law 311

13 . An “issuer” is deﬁ ned by the statute:

“The term ‘issuer’ means an issuer

(as deﬁ ned in Section 3 of the Secu-

rities Exchange Act of 1934 (15

U.S.C. § 78c)), the securities of which

are registered under Section 12 of

that Act (15 U.S.C. § 78l), or that is

required to ﬁ le reports under Sec-

tion 15(d) (15 U.S.C. § 780(d)), or

that ﬁ les or has ﬁ led a registration

statement that has not yet be-come

effective under the Securities Act of

1933 (15 U.S.C.§ 77a et. seq.), and

that it has not withdrawn.” 15 U.S.C.

§ 7201(7).

14 . See, e.g., ABA Antitrust Section,

Antitrust Compliance: Perspectives

and Resources for Corporate Coun-

selors, 37–38 (2005).

15 . 15 U.S.C. § 7241; 18 U.S.C. § 1350.

16 . 18 U.S.C. §§ 1513–14.

17 . Similarly, vertical price ﬁ xing does

not apply to the sale of services

through intermediaries when the

services are performed by the sup-

plier for the end-user (such as cellular

telephone services), because owner-

ship of the services never passes to

the intermediaries. Indeed, the role

of the intermediaries is that of selling

agent on behalf of the supplier.

18 . 15 U.S.C. § 1.

19 . This also is why sales of goods

through agents are not subject to the

price-ﬁ xing prohibitions of Sec-

tion 1 of the Sherman Act nor are

consignment sales where the sup-

plier retains title to the goods in the

reseller’s possession until they are

sold to the end-user. These are uni-

lateral activities on the part of the

supplier, because ownership ﬂ ows

directly to the end-user from the

supplier.

20 . For a discussion of “price signaling,”

a practice that facilitates conscious

parallelism, see “Other Pricing

Issues,” below.

21 . See Interstate Circuit, Inc. v. United

States , 306 U.S. 208, 222 (1939)

(restrictions); American Tobacco Co. v.

United States , 328 U.S. 781, 805

(1946) (price increases). Of course, if

the challenged conduct is consistent

with rational individual behavior or

there is little reason for the defen-

dants to engage in a conspiracy, it

is more difﬁ cult to ﬁ nd one. See In

re Text Messaging Antitrust Litig. ,

630 F.3d 622, 627–29 (7th Cir. 2010)

(addressing so-called “tacit collu-

sion,” which is an outcome of an

oligopolistic market structure and

is lawful) .

22 . See, e.g., In re Baby Food Antitrust

Litig ., 166 F.3d 112 (3d Cir. 1999).

Moreover, the validity of the pur-

ported reasons for engaging in the

conduct under examination is a

consideration, but even a pretext

for doing so does not alone estab-

lish a conspiracy.

23 . For a case illustrating direct price

ﬁ xing, see United States v. Andreas ,

216 F.3d 645 (7th Cir. 2000) (Archer

Daniels Midland executives). For a

situation involving indirect price

ﬁ xing, see United States v. Container

Corp. , 393 U.S. 333 (1969).

24 . 468 U.S. 85 (1984). This case vali-

dated the court’s decision in Chicago

Board of Trade v. United States , 246

U.S. 231 (1918), which upheld an

exchange rule that after-hours trad-

ing had to be at prices at which the

market most recently closed. Such a

rule was supportive of the free-for-

all competition that occurred dur-

ing the trading day and, therefore,

was reasonable even though it set

prices among members.

25 . State Oil Co. v. Khan , 522 U.S. 3

(1997); Leegin Creative Leather Prods.,

Inc. v. PSKS , 551 U.S. 877 (2007).

26 . S.148, 111th Con. (2009); H.R. 3190,

111th Con. (2009); Md. Commercial

Law Code Ann. § 11-204(b) (2009).

Although Maryland is the only state

that has addressed Leegin head-on,

many states, like New York and

California, generally construe their

antitrust laws consistently with

those at the federal level, but will

diverge when state policy requires.

See, e.g., Darush MD APC v. Revi-

sion LP, No. 12-cv-10296, 2013 WL

1749539 (C.D. Cal. Apr. 10, 2013). In

what could have been an important

Chapter 12 • Ethics and the Law312

showdown under Leegin , the Attor-

neys General of New York, Michi-

gan and Illinois ﬁ led suit against

Herman Miller in 2008 under fed-

eral and state law, claiming that the

company had entered into illegal

minimum price-ﬁ xing agreements.

However, only four days after ﬁ l-

ing, the case was settled by consent

decree, so there was no opportunity

for the court to consider a Leegin

defense. New York v. Herman Miller,

Inc ., No. 08 Civ. 2977 (S.D.N.Y.

March 25, 2008) (Stipulated Final

Judgment and Consent Decree).

Like all other consent decrees and

consent orders, this decree also has

no precedential value.

27 . Ironically, amid the considerable

handwringing in the U.S. over

Leegin , Canada, which by statute

banned all forms of resale price

setting and treated violations as

criminal, amended its laws in 2009

to drop this approach in favor of

something more akin to the rule

of reason. Competition Act, R.S.C.,

ch. C 34 (1985), § 76.

28 . See United States v. Colgate & Co .,

250 U.S. 300 (1919 ); Leegin Creative

Leather Prods., Inc. v. PSKS , 551 U.S.

at 880. Colgate is the ﬁ rst Supreme

Court decision that permitted this

conduct, and unilateral vertical

price ﬁ xing is said to apply the “ Col-

gate doctrine.” Strictly speaking, the

supplier is not “setting” prices. It is

only “suggesting” or “recommend-

ing” them, but the result is the same

if the supplier’s unilateral price

policy is effective. For a detailed

discussion of the application of the

Colgate doctrine, see Brian R. Henry

and Eugene F. Zelek, Jr., Establish-

ing and Maintaining an Effective Min-

imum Resale Price Policy: A Colgate

How-To , Antitrust 8 (Summer 2003)

(written pre- Leegin , but still use-

ful). Note that vertical price ﬁ xing

of any sort (maximum, minimum,

or exact) by agreement is illegal in

the E.U., and there is also nothing

analogous to the Colgate doctrine.

However, in 2010, the E.U. seemed

to soften its stance a bit with respect

to new products, but this approach

is seldom, if ever used. See 2010 O.J.

(C 130) ¶ 225.

29 . See Business Electronics Corp. v.

Sharp Electronics Corp ., 485 U.S. 717,

726–27 (1988).

30 . The ﬂ exibility under antitrust law

notwithstanding, pulling all of the

supplier’s business may trigger

reseller protective statutes at the

federal or state level that are usually

industry-speciﬁ c (covering auto-

mobile dealers or beer wholesalers,

for example), although some states

have more general protections.

(See, e.g., Wisconsin Fair Dealer-

ship Law, Wisc. Stat. § 135.) Also,

unless the deletion of one or more

products is allowed by the appli-

cable agreement, doing so under an

otherwise lawful price policy could

still constitute breach of contract.

31 . Although litigation in this area is

rare, an example of what not to do

is to negotiate a unilateral policy so

that it becomes an agreement, some-

thing alleged in In re: Disposable

Contact Lens Antitrust Litig. , 109 F.

Supp. 3d 1369 (U.S. Jud. Pan. Mult.

Lit. 2015). Worse, that litigation led

to Utah banning any form of resale

price policy or agreement for con-

tact lenses, Utah Code § 58-16a-901,

et seq ., something then attacked on

constitutional grounds by contact

lens manufacturers, so far unsuc-

cessfully. Johnson & Johnson Vision

Care, Inc. v. Reyes , No. 15-4071, 2016

WL 7336568, at *1 (10th Cir. Dec. 19,

2016).

32 . This approach is common in the

area of consumable medical prod-

ucts. Interestingly, the supplier-

negotiated sell price to a large

hospital chain or buying group may

be below the reseller’s buy price

from the supplier. However, after

proof of such a sale is provided to

the supplier, it rebates the differ-

ence, along with additional funds

to provide the reseller with a mar-

gin. Such conduct was subject to

the rule of reason pre- Leegin when

Chapter 12 • Ethics and the Law 313

minimum price agreements were

per se illegal, so it is likely that such

status will be retained.

33 . 15 U.S.C. § 13. This statute is dis-

cussed in the next section. For

example, until 1987, the FTC viewed

advertised price restrictions in pro-

motional agreements as per se ille-

gal, but then changed its mind. See

6 Trade Reg. Rep. (CCH) ¶ 39,057

at 41,728 (FTC May 21, 1987). The

same treatment is relevant under

the Sherman Act. See, e.g., Lake Hill

Motors, Inc. v. Jim Bennett Yacht Sales,

Inc., 246 F.3d 752, 757 (5th Cir. 2001).

Of course, where there is no agree-

ment, the Colgate doctrine applies.

34 . Of course, practices that go too far

are still subject to attack, as was

the case of ﬁ ve major suppliers of

consumer audio recordings that

are faced with an FTC enforcement

proceeding alleging the effective

elimination of price competition,

agreed to drop their MAP pro-

grams by consent order. Because

such proceedings were settled in

this fashion, there was no real fac-

tual determination and they are not

binding as legal precedent. At the

same time, they provide some guid-

ance, especially in the rather rare

situation where virtually identical

MAP programs are widely used in

an industry, they suppress almost

all forms of price communication,

they have a demonstrated adverse

effect on industry pricing, and they

lack any procompetitive justiﬁ ca-

tion. See In re Sony Music Entertain.

Inc., No. 971-0070, 2000 WL 689147

(FTC May 10, 2000); In re Univer-

sal Music & Video Dist. Corp ., No.

971-0070, 2000 WL 689345 (FTC

May 10, 2000); In re BMG Music ,

No. 971-0070, 2000 WL 689347 (FTC

May 10, 2000); In re Time Warner

Inc ., No. 971-0070, 2000 WL 689349

(FTC May 10, 2000 ); In re Capitol

Records, Inc ., No. 971-0070, 2000 WL

689350 (FTC May 10, 2000).

35 . 15 U.S.C. § 13. Price discrimination

is covered by Section 2(a) of the act,

while promotional discrimination

is addressed under Sections 2(d)

and 2(e). Id . §§ 13(a), (d)-(e). States

tend to have laws that are compa-

rable to that at the federal level.

Canada also has a statutory pro-

hibition on economic discrimina-

tion, which was decriminalized in

2009 and is now analyzed under a

standard similar to the rule of rea-

son. Competition Act, R.S.C., ch. C

34 (1985). §§ 76, 77, 79. In 2007, the

Antitrust Modernization Commis-

sion chartered by Congress called

for repeal of the Robinson–Patman

Act, but no action has been taken.

See Antitrust Modernization Com-

mission, Report and Recommenda-

tions, iii (April 2007).

36 . To be clear, direct sales by a sup-

plier to the government or a

charitable organization (like a not-

for-proﬁ t school) for its own use are

outside the Robinson–Patman Act.

However, if the supplier sells to an

intermediary that resells to such

an entity, the intermediary’s sale is

exempt, but that of the supplier to

the intermediary is not.

37 . For example, certain pharmaceuti-

cal companies paid more than $700

million to settle a consolidated law-

suit brought by thousands of drug

resellers who alleged that health

maintenance and managed care

organizations received preferential

pricing in violation of the Robinson–

Patman Act and as part of a price-

ﬁ xing conspiracy. In re Brand Name

Prescription Drugs Litig ., No. 94 C

897, 1999 WL 639173, at *2 (N.D. Ill.

Aug. 17, 1999). Other companies

fought the suit and succeeded in get-

ting essential portions of it thrown

out. In re Brand Name Prescription

Drugs Litig ., 1999-1 Trade Cas. (CCH)

¶ 72,446 (N.D. Ill), aff’d in part , 186

F.3d 781 (7th Cir. 1999).

38 . For structuring purposes, there is

no violation if one or more of the

elements are missing. Often over-

looked is that resellers selling to

other businesses in interstate com-

merce are required to follow the

Robinson-Patman Act with respect

Chapter 12 • Ethics and the Law314

to their selling activities. In addi-

tion, buying activities by resellers

or end-users are covered by Section

2(f) of the Act, 15 U.S.C. § 13(f). See

note 47 infra .

39 . See Volvo Trucks North America,

Inc. v. Reeder-Simco GMC, Inc ., 546

U.S. 164 (2006). In this situation,

many companies insist on treating

both resellers the same, a some-

what more conservative approach

that avoids the trade relations risk

of the disfavored reseller ﬁ nding

out what occurred, as well as the

legal risk that a sale will be made

at the special price for the project

and another of the identical goods

and quantity at a higher price

will be made to a second com-

petitive reseller at about the same

time. Alternatively, if the supplier

wishes to provide favorable bid

pricing on a selective basis, it could

implement a clearly articulated

policy that each piece of bid busi-

ness is discrete from every other

and from everyday sales for inven-

tory. In addition, a tiered-price

program that is available to com-

peting resellers may be a useful

vehicle to permit discrimination in

bid pricing by favoring those that

chose to meet certain criteria in the

program over those that do not.

40 . This distinction between a good

and a service is not always obvious.

For example, printing, advertis-

ing, and real estate are all services,

even though something tangible

is involved. In addition, off-the-

shelf software is a good (much

like a book or a music CD), while

customized software is most likely

a service. The courts have split as

to whether electricity is a good or

a service, a particularly important

distinction in the era of deregula-

tion. While service sellers are free

from the Robinson–Patman Act,

economic discrimination on their

part may give rise to other antitrust

claims or violate industry-speciﬁ c

statutes. Moreover, state law can

cover discrimination in service

pricing, such as that in California.

See Cal. Bus. & Prof. Code § 17045.

41 . FTC v. Borden Co ., 383 U.S. 637

(1966) (evaporated milk). Although

this result is counterintuitive, if

brand preferences translate into dif-

ferent costs to produce or sell, these

costs may be taken into account

in pricing the otherwise identical

products by relying on the defense

known as “cost justiﬁ cation,” which

is discussed in the section titled

“Defenses to Price Discrimination.”

42 . Consistent with its modern focus on

actual economic effect, the Supreme

Court substantially raised the bar in

this area by adopting this standard

in Brooke Group v. Brown & William-

son Corp ., 509 U.S. 209 (1993). See

the discussion of “Predatory Pric-

ing” below.

43 . Note that a defense shifts the bur-

den of proof from the plaintiff to

the defendant, so record-keeping

on the part of the defendant takes

on added importance.

44 . Sometimes a supplier provides a

trade discount to a purchaser that

is based on the latter’s role in the

supplier’s distribution system and

that reﬂ ects in a generalized way

the services performed by the pur-

chaser for the supplier. For example,

a wholesaler may receive a lower

price than a direct-buying retailer

for such functions as warehousing

and taking credit risk. There is no

requirement or blanket Robinson–

Patman exemption to differentiate

between distribution levels (except

to the extent that wholesalers and

direct-buying retailers likely don’t

compete), so if it is done, the differ-

ences may be cost-justiﬁ ed or legit-

imized as meeting competition. If

either of these defenses is not avail-

able, a functional discount may still

be lawful if it reﬂ ects reasonable

compensation for the services pro-

vided. See Texaco Inc. v. Hasbrouck ,

496 U.S. 543 (1990). Danger areas

include (i) the use of intermediar-

ies controlled by the ultimate cus-

tomer to disguise discounts and

Chapter 12 • Ethics and the Law 315

(ii) situations in which the inter-

mediary makes some sales as a

wholesaler and others as a retailer,

but the supplier provides it with

the wholesaler discount on all

purchases.

45 . Section 2(f) of the Robinson–

Patman Act, 15 U.S.C. § 13(f), prohib-

its buyers from knowingly inducing

discriminatory prices, but this provi-

sion is largely toothless, as the FTC

is not as zealous in its enforcement

as it once was and suppliers almost

never sue their customers.

46 . While it is possible that an indus-

trial manufacturer that consumes

the supplier’s products could be

covered under the promotional

discrimination provisions of the

Robinson–Patman Act in certain sit-

uations (see the discussion below),

it is far more common for these

provisions to apply only to resell-

ers. For consistency in this section,

the party that purchases from a

supplier will be referred to as the

“reseller,” unless otherwise noted.

47 . Things like package sizes are not

included in the broad deﬁ nition of

services and facilities. Woodman’s

Food Mkt., Inc. v. Clorox Co., 833 F.3d

743, 750 (7th Cir. 2016), cert. denied

sub nom. Woodman’s Food Mkt., Inc. v.

The Clorox Co. (U.S. Feb. 27, 2017)

(denial of “club packs” to retailer).

48 . Of course, the supplier may still

face trade relations issues.

49 . In its Guides for Advertising Allow-

ances and Other Merchandising Pay-

ments and Services , 16 C.F.R. § 240,

the FTC endorses the ﬁ rst two

approaches and ignores the third,

although there is case support for it.

Fortunately, the guides do not carry

the force of law.

50 . As is the case with price discrimi-

nation, it is illegal for buyers to

knowingly induce discriminatory

promotional allowances, but, due

to a drafting quirk, only the FTC

can chase lying buyers here. See 15

U.S.C. § 13(f).

51 . Continental T.V., Inc. v. GTE Sylvania

Inc ., 433 U.S. 36, 51–52 (1977).

52 . The best area-of-primary-

responsibility contract or policy

language requires that a quantita-

tive goal be attained before out-

side sales are permitted. The worst

provision uses a meaningless “best

efforts” clause that requires the

reseller to use its best efforts to

sell the supplier’s products in the

reseller’s area. Note that if the sup-

plier does not have written con-

tracts with its resellers, it may use

written policies to impose vertical

restrictions.

53 . The same rule applies to non-

customers who want to become cus-

tomers and request certain products.

54 . When a monopolist uses a loyalty

program to entrench or extend its

monopoly, it can run afoul of the

prohibitions on monopolization

and attempted monopolization

under Section 2 of the Sherman

Act. 15 U.S.C. § 2. See ZF Meritor,

LLC v. Eaton Corp. , 696 F.3d 254,

282–83 (3d Cir. 2012), cert. denied,

133 S. Ct. 2025 (2013); LePage’s Inc. v.

3M (Minnesota Mining and Mfg. Co .),

324 F.3d 141 (3d Cir. 2003), cert.

denied, 124 S. Ct. 2932 (2004); and

note 55 infra .

55 . Both exclusive dealing and tying

may be challenged under Section

1 of the Sherman Act, 15 U.S.C. § 1

(goods or services); Section 3 of the

Clayton Act, id. § 14 (goods only);

and Section 5 of the Federal Trade

Commission Act, id. § 45 (goods or

services).

56 . The elements of unlawful tying

are (i) two separate products or

services; (ii) the sale of one (the

“tying product”) is conditioned on

the purchase of the other (the “tied

product”); (iii) there is sufﬁ cient

economic power in the market for

the tying product to restrain trade

in the market for the tied product;

(iv) a not insubstantial amount of

commerce in the market for the tied

product is affected; and (v) there is

no defense or justiﬁ cation available,

such as proper functioning or trade

secrets. See, e.g., E & L Consulting,

Chapter 12 • Ethics and the Law316

Ltd. v. Doman Indus. Ltd. , 472 F.3d

23, 31–32 (2d Cir. 2006) (also identi-

fying “anticompetitive effects in the

tied market” as an element, as some

courts require).

57 . Under certain distributor, dealer,

or franchisee protective laws at

the state level, suppliers may be

required to treat all intermediaries

more or less the same in all business

dealings, or, as in Wisconsin, not

change their “competitive circum-

stances” without cause. See Wis-

consin Fair Dealership Law, Wisc.

Stat. § 135.

58 . 15 U.S.C. §§ 2, 45. Monopolization

requires (i) monopoly power in the

relevant market and (ii) the willful

acquisition or maintenance of that

power, while attempted monopo-

lization consists of (i) predatory or

exclusionary conduct, (ii) speciﬁ c or

predatory intent to achieve monop-

oly power in the relevant market,

and (iii) a dangerous probability

that the defendant will be success-

ful. See, e.g., Verizon Commc’ns Inc. v.

Law Ofﬁ ces of Curtis V. Trinko, LLP ,

540 U.S. 398, 407 (2004), citing United

States v. Grinnell Corp. , 384 U.S. 563,

570–571 (1966) (monopolization);

Spectrum Sports, Inc. v. McQuillan ,

506 U.S. 447, 456 (1993) (attempted

monopolization). The presence of

a conspiracy to engage in preda-

tory pricing can violate Sections 1

and 2 of the Sherman Act. 15 U.S.C.

§§ 1, 2.

59 . Brooke Group v. Brown & William-

son Corp ., 509 U.S. 209 (1993). The

Supreme Court later extended this

approach to predatory buying, i.e.,

overpaying for inputs to drive out

competitors. Weyerhaeuser Co. v.

Ross-Simmons Hardwood Lumber Co .,

549 U.S. 312 (2007). A variation is

the “price squeeze,” where an inte-

grated manufacturer with a large

market share in a key input sells it

at a higher price to manufacturers

of competing ﬁ nished goods than

the input manufacturer sells its own

ﬁ nished products. However, the

Supreme Court has held that there is

no antitrust issue as long as the input

manufacturer is under no obliga-

tion to sell to others and its ﬁ nished

goods are not priced below cost. Pac.

Bell Tel. Co. v. linkLine Communica-

tions, Inc. , 129 S.Ct. 1109 (2009).

60 . E. I. Du Pont de Nemours & Co. v.

FTC , 729 F.2d 128, 139–40 (2d Cir.

1984).

61 . Id . at 134. Of course, not all types of

price signaling fare as well. Eight

airlines and their jointly owned

data collection and dissemination

company settled a price-ﬁ xing case

brought by the Justice Department

over a computerized system that

was used to communicate fare

changes and promotions in advance

to the participants and permitted

later modiﬁ cation or withdrawal of

such announcements. United States v.

Airline Tariff Publishing Co ., 1994-2

Trade Cas. (CCH) ¶ 70,686 (D.D.C.

1994) (all defendants, except United

Air Lines, Inc. and USAir, Inc.); 836 F.

Supp. 12 (D.C.C. 1993) (United and

USAir). In the government’s view,

the non-public nature of this data

exchange and its method of opera-

tion were tantamount to the airlines

having direct discussions in the

same room.

INDEX

Aaker, David 155–6n3

ABB Group 28

Abelson, Reed 104n6

access-based positioning 156, 157

Acito, Franklin 206n28

actual purchases: experimentally controlled

studies of 181–5; uncontrolled studies

of 175

Adamy, Janet 151n4

additional performance, ﬁ nancial analysis and

209–10

Airbnb 269

Airline Weekly 155n1

airlines: price structures of 17–18; segmented

pricing of 81, 102–4

Alamo Rent-A-Car 21, 152

Alberts, William W. 155–6n3

Allen, James 204n11

Alley, Kirstie 61

alternative price levels, ﬁ nancial implications

of 213–18

Amazon 171, 269; Subscribe and Save

policy 106

American Association of Retired Persons

(AARP) 96

American Tobacco Co. v. United States (1946)

311n21

Anderson, James C. 205n18

Android smartphone 91

Anheuser-Busch InBev 157

Anterasiun, C., Graham, J.L. and Money, B.R.

155–6n3

antitrust law 294, 296, 297, 298, 299, 302,

309, 312n30; Antitrust Modernization

Commission Report (2007) 313n35

Apple 91, 248

Apple iPhone

6, 10–11, 30, 244, 246

Apple iTunes

268–9

Apple Mac

Apple Music

1–2

Apple Stores

91, 243; proﬁ tability and

growth of 27

Ariely, Daniel 24n10

Armstrong, J. Scott 155–6n3

Assael, Henry 205n15

assets, cost of 212

attribute rating, price sensitivity and 186–7

Avis 21

avoidable costs 212–13

Banker, Steve 75n4

Barabba, Vincent 291n10

Barclay, William D. 204n9

baseline sales 227–8

Bass, Frank M. 260n2

Baum, C.L. and Ford, W.F. 75n3

Beard, Randall 261n19

Beauchamp, Tom L. 310n6

behavioral economics: price and value

communication 64; research in 7–8

Bell, D.R., Chiang, J. and Padmanabhan, V.

204n5

Bellenger, D.N. 206n28

Bending Branches Double Bent paddle 138

Berenson, Mark L. 204n8

Berheide, Lauren 309

Bertini, Marco 24n9, 104n5

Best, Roger 206n28–9

Beveridge, Dirk 291n7

“big data”: beneﬁ t of 146; from retail stores

142; statistical models 9

Big Star 162

BJ’s Wholesale Club 100, 140

Blockbuster Video 89

Blue Sky Ski Company 194–7

Boeing Corporation 15, 66, 68

Bowﬂ ex 130

Bowie, Norman E. 310n6

“box-pusher” business model 34

Brady, D.L. 291n3

brand-driven buyers, dealing with 120–21

Brand Name Prescription Drugs Litigation (1999)

313n37

Brandenburger, Adam 172n2

breakeven sales analysis: contribution,

incremental ﬁ xed costs and,

interrelationships between 222–3; price

reduction situation 221–2; for reactive

pricing 219–21

breakeven sales curve: price level setting

143–4; strategic pricing 8–9

breakeven sales changes 214–15; assessment

of 142–5; break-even formula, derivation

of 238–9; break-even sales curves 223–7;

calculation of 143–5, 216–17; conversion

between unit and cash values 217–18;

strategic pricing and 8; variable costs

change and 218–19

Brooke Group v. Brown & Williamson Corp.

(1993) 314n42, 316n59

Brown, Charlie 75n7

Buffett, Warren 1, 23n1

BulbHead 243

bundled offers 81–3

Burger, Andrew 105n14

Business Electronics Corp. v. Sharp Electronics

Corp. (1988) 312n29

business markets, comparison effects in 67

business-to-business (B2B) 57, 64; pricing

policy 107, 108–9, 111

Index318

buy-response surveys 186, 187–9

buyer types, dealing with differences in

118–23

buying groups, pricing policy and 123, 124,

125

buying process: buyer involvement in 60;

participants in 73–4; transaction value and 72

Buzzell, R.D., Gale, B.T. and Sultan, R.G.M.

24n6 , 155n2

Byron, Ellen 172n7

cable TV, bundled offers from 81–2

Cal Tech 69

Calder, Bobby J. 206n31

Carpenter, Gregory S. 260n5

Carrera, M., Goldman, D., Joyce, G. and

Sood, N. 205–6n27

Cattin, Philip 205n25

Chakravarthi, Narasimhan 105n19

Chandrasekaran, Deepa 205n14, 205n20

Chicago Board of Trade v. United States (1918)

311n24

choice, panel data of impact of promotion on

177–8

Christensen, Clayton M. 78, 104n2

Clancy, Kevin J. 204n12

Comcast 31

commoditization of offers 111–12

communication of value see price and value

communication

comparison effects: difﬁ culty with 147; price

and value communication 66–7

competition: proﬁ table growth and 154–8;

reacting to 159–65; see also price competition

competitive advantage 156–8; leveraging of

162

competitive analysis, variability in nature of

220–21

competitive dynamics 162, 163

competitive edges for power buyers, provision

of 124

competitive impact of exchange rate shifts 250

competitive information: aims of uses of

169–70; evaluation of 166–70; management

of 165–6; opportunism and 169; selective

communication of 168–70

competitive injury 303–4, 306; reasonable

probability of 303–4

competitive reference effect 65 –6

competitive reference prices 30, 31–2, 33;

estimation of 31–3

competitive threat, accommodation to 159

Comprehensive Crime Control Act (1984)

310n9

congestion charges 102

conjoint (trade-off) analysis: economic value

and 33–4, 41–3, 44–5; example of 194–7;

price sensitivity and 192–7; reliability of

196–7

consumer packaged goods (CPG) companies

9, 31, 57, 60, 66, 179, 183, 188–9, 243, 246

consumer surplus 78

Continental T.V., Inc. v. GTE Sylvania Inc. (1977)

315n51

contribution margin 216–17, 219, 222, 227, 228,

229, 231, 233

convenience-driven buyers, dealing with 123

Corey, E. Raymond 133, 151n1

cost control: pricing in maturity and 245–8;

utilization and, improvement in 247

cost integration, efﬁ ciencies from 257

cost justiﬁ cation, ethics and 304

cost-plus pricing 4–5

cost to serve, customer proﬁ tability and 281–2

Costco 100, 140

Criminal Fine Improvements Act (1987) 310n9

Cucolo, Eduardo 261n17

currency exchange rates 250–53

customer analytics, management choices and

280

customer-driven pricing 5–6

customer proﬁ tability: cost to serve and 281–2;

customer proﬁ tability map 282

customer-speciﬁ c pricing 83–4

customer value modeling (CVM) 46–7;

difference from EVE model 47

CW Network 161

Darush MD APC v. Revision LP (2013)

311–12n26

Darwin, Charles 262, 291n1

defensive pricing 163; demonstration of

potential for 169

Dell Computer 164–5, 171

Della Bitta, A.J. and Monroe, K.B. 24n12

Deloitte Consulting LLP. 90–2, 262; time-series

dataset of 394 companies (1970–2013) 3

demand, price elasticity of 8–9, 213–14

demand curve: assumption of stability of 143;

‘shifts’ in 8

depth interviews, see in-depth interviews

differentiated product offerings 28; valuation

of 76

differentiation value: drivers of 37–9;

economic value and 30; strategic pricing

and 20

difﬁ cult comparison effect 66–7

direct dealing programs 301; resellers choice

approach 301

discounting: ‘early bird’ discounts 148; as

compensation for failure to perform 113–14;

order discounts 100; pricing power and 108;

raising costs to competitors of 161–2; step

discounts 100–101; student rush discount

210–11; volume, discounting for 99–100,

113

discrimination, ethics and 303

Disney 142; Theme Parks 21

Index 319

Disposable Contact Lens Antitrust Litigation

(2015) 312n31

Distimo 92

distribution channel reevaluation 247–8

DNA analysis 36, 37–9

Dolan, Robert J. 105n22

Douglas, Justice William O. 293

Dow Corning 140

Drake, Elizabeth 229n1

Drucker, Peter F. 24n15

Dun & Bradstreet 206n38

DuPont 309

Dutta, S., Bergen, M., Levy, D., Ritson, M. and

Zbaracki, M. 265, 291n6

E. I. Du Pont de Nemours & Co. v. FTC (1984)

309, 316n60

E & L Consulting, Ltd. v. Doman Indus. Ltd.

(2006) 315–16n55–6

eBay 158

e-books, price sensitivity of 184–5

economic downturn, policies for pricing in

128–9

economic value 26–55; Apple Stores

®,

proﬁ tability and growth of 27; “box-

pusher” business model 34; competitive

reference prices 30, 31–2, 33; competitive

reference prices, estimation of 31–3; conjoint

(tradeoff) analysis 33–4, 41–3, 44–5; cost

drivers 35; customer apathy 31; customer

value modeling (CVM) 46–7; customer

value modeling (CVM), difference from

EVE model 47; customers as information

resource 32, 35; data availability, difﬁ culties

of 31; detailed segment descriptions,

creation of 53; differential value algorithms

34–6; differentiated product offerings 28;

differentiation value 30; differentiation value

drivers 37–9; discriminating value drivers,

identiﬁ cation of 50; economic value 28;

Economic Value Estimation (EVE

) Model

29, 45, 47; estimation of 30–47; estimation of,

price communication and 64; estimation of

monetary value illustration 36–41; estimation

of psychological value illustration 42–5;

exchange value 28; in-depth customer

interviews 35; labor savings 37, 38–9;

market segmentation, value-based 47–54;

messages about (low-involvement goods)

61; monetary value 28–9, 33–6; monetary

value, estimation of 33–6; monetary value,

estimation of, illustration of 36–41; monetary

value, quantitative research techniques 33–4;

NBCA (Next Best Competitive Alternative)

30, 36; non-normalized reference price data

32; normalized reference data 33; operational

constraints and advantages, determination

of 50; opportunity costs 37, 38, 39; price

structure and 76; pricing, role of value in

27–30; primary and secondary segments,

creation of 50–52; psychological value 28–9,

33–4; psychological value, estimation of 41–2;

psychological value, estimation of, illustration

of 42–5; psychological value, quantitative

research techniques 41; quality control labor

savings 38–9; quantitative data, cluster

analysis of 50; reference price data 31–3;

reference product 30, 40, 46, 47; reference

value (and price) 29–30, 31–2; revenue

drivers 35; secondary price data 31; segment

metrics and fences, development of 53–4;

segmentation criteria, determination of 49;

segmentation-modeling methodologies 48–9;

shortcuts, high cost of 45–6; strategic overlap

in value-based market segmentation 51;

summary 54; “systems integrator” business

model 34; utility, value and 27; value,

role in pricing 27–30; value-based market

segmentation 47–54; Value Cascade 27; value

driver algorithms 34–6; value drivers 37–9;

value estimation 26, 30, 32–3, 36–42, 42–5,

46–7; willingness-to-pay 41–2, 43–4

Economic Value Estimation (EVE

) Model

see EVE

Einstein, Albert 26, 54n1, 173, 204n1

Eli Lilly 86

Elrod, Terry 204n3

end-beneﬁ t effect 67–8

end-beneﬁ t importance 147

Enron 297

Enterprise Holdings 21

Enterprise Rent-A-Car 171

Eppen, G.D., Hanson, W.A. and Martin, R.K.

104n4

ethics, law and 293–316; absolute conﬁ nement

307; allowances, provision of 305; American

Tobacco Co. v. United States (1946) 311n21;

antitrust law 294, 296, 297, 298, 299, 302,

309, 312n30; Antitrust Modernization

Commission Report (2007) 313n35; area-

of-primary responsibility 315n52; Baby

Food Antitrust Litigation (1999) 311n22;

Brand Name Prescription Drugs Litigation

(1999) 313n37; Brooke Group v. Brown &

Williamson Corp. (1993) 314n42, 316n59;

Business Electronics Corp. v. Sharp Electronics

Corp. (1988) 312n29; changing conditions

305; Chicago Board of Trade v. United States

(1918) 311n24; competitive injury 303–4, 306;

Comprehensive Crime Control Act (1984)

310n9; Continental T.V., Inc. v. GTE Sylvania

Inc. (1977) 315n51; cost justiﬁ cation 304;

Criminal Fine Improvements Act (1987)

310n9; customer restrictions 307; Darush

MD APC v. Revision LP (2013) 311–12n26;

direct dealing programs 301; direct dealing

programs, resellers choice approach 301;

discrimination 303; Disposable Contact

Lens Antitrust Litigation (2015) 312n31;

Index320

E. I. Du Pont de Nemours & Co. v. FTC (1984)

309, 316n60; E & L Consulting, Ltd. v.

Doman Indus. Ltd. (2006) 315–16n55–6;

ethical constraints on pricing 293–6; ethical

opinions on pricing, divergence in 293;

ethics in pricing, lack of information on 293;

exclusive dealing 308, 315n55; exclusive

distributorship 307; facilities, provision of

305; FTC v. Borden Co (1966) 314n41; full-line

forcing 308; goods 303; goods, services and,

distinction between 314n40; horizontal

price ﬁ xing 299; indirect purchasers 306;

Interstate Circuit, Inc. v. United States (1939)

311n21; Johnson & Johnson Vision Care, Inc. v.

Reyes (2016) 312n31; Justice Department

(US), enforcement powers of 297, 302,

309, 316n61; Lake Hill Motors, Inc. v. Jim

Bennett Yacht Sales, Inc. (2001) 312n33;

Leegin Creative Leather Prods., Inc. v. PSKS

(2007) 299–300, 311–12n25–8, 312–13n32;

legal framework for pricing 296–8; like

grade and quality 303; meeting competition

304–5; Minimum Advertised Price (MAP)

programs 301–2, 313n34; monopolization

316n58; National Association of Attorneys

General (NAAG) 310n11; National Collegiate

Athletic Association v. Board of Regents (US

Supreme Court) 299; New York v. Herman

Miller, Inc. (2008) 311–12n26; non-price

incentives 308; non-price variables, use

in support of pricing goals 306–8; Paciﬁ c

Bell Tel. Co. v. linkLine Communications, Inc.

(2009) 316n59; point-of-sale (POS) reporting

302; predatory pricing 308–9; predatory

pricing, burden of proof on 309; price and

promotional discrimination 302–6; price

competition 313n34; price discrimination

303–4, 313n35; price discrimination,

defenses against 304–5; price discrimination,

elements of unlawful practice 303–4; price

discrimination, Robinson-Patman Act

(1936) and 302, 303, 304, 305, 313–14n35–8;

price ﬁ xing, horizontal 299; price ﬁ xing,

or encouragement in 298–9; price ﬁ xing,

vertical 299–301, 311n17; price signaling 309,

311n20, 316n61; pricing, ethical constraints

on 293–6; pricing, legal framework for

296–8; pricing practices, effect of Sarbanes-

Oxley on 297–8; product restrictions

308; promotional discrimination 305–6;

promotional discrimination, defenses

against 306; promotional discrimination

standards, ﬂ exibility available under 306;

reasonable probability of competitive

injury 303–4; resale of supplier’s goods,

promotional discrimination in 305–6;

resale price ﬁ xing or encouragement

299–302; resale price maintenance (and

encouragement) 301–2; Robinson-Patman

Act (1936) 302, 303, 304, 305, 306, 308,

313–14n35–8, 314–15n44–6, 314n40; safe

harbors 297, 310n8; sales to two or more

purchasers 303; Sarbanes-Oxley Act (2002)

310n12; Sarbanes-Oxley Act (2002), effect on

pricing practices 297–8; Securities Exchange

Act (1934) 311n13; services, provision of

305; Sherman Act (1890) 298, 299, 300,

309, 310n9–10, 311n19, 313n33, 315n54–5,

316n58; Spectrum Sports, Inc. v. McQuillan

(1993) 316n58; State Oil Co. v. Khan (1997)

299–300, 311n25; States v. Grinnell Corp.

(1966) 316n58; summary 309; Sylvania

decision (US Supreme Court, 1977) 307;

territorial restrictions 307–8; Texaco Inc. v.

Hasbrouck (1990) 314–15n44; Text Messaging

Antitrust Litigation (2010) 311n21; tying 308,

315–16n55–6; United States v. Airline Tariff

Publishing Co. (1994) 316n61; United States v.

Andreas (2000) 311n23; United States v.

Colgate & Co. (1919) 300, 312n28, 313n33;

US Federal Trade Commission (FTC) 297,

302, 309, 310n10, 313n33–4; US Sentencing

Commission Guidelines (2016) 310n9;

Verizon Commc’ns Inc. v. Law Ofﬁ ces of

Curtis V. Trinko, LLP. (2004) 316n58; vertical

non-price restrictions 306–8; vertical

price ﬁ xing 299–301, 311n17; Volvo Trucks

North America, Inc. v. Reeder-Simco GMC,

Inc. (2006) 314n39; Weyerhaeuser Co. v.

Ross-Simmons Hardwood Lumber Co. (2007)

316n59; Woodman’s Food Mkt., Inc. v. Clorox

Co. (2016) 315n47

European Union (EU) 97, 297

Eurotunnel 99

EVE

(Economic Value Estimation) 4, 29,

45, 47, 57, 62–3, 135; price and value

communication 57, 62–3; price level setting

135; strategic pricing 4

Excel 284

exchange rate price adjustments 250–53

exit barriers, sunk costs and 163

expectations, buyer behavior and 107

expenditure effect 70

expenditure size 147

experimental purchase data studies 181–5

expertise, centers of 271, 272, 286

export prices in foreign currencies 248–53

facilities, provision of 305

failure, discounting in compensation for 113–14

fairness: communication of 149; fairness effect,

value communication and 72–3; norms of,

consideration of 133, 148

Fazioli 137

Festool 137

ﬁ nancial analysis 207–39; additional

performance 209–10; alternative price

levels, ﬁ nancial implications of 213–18;

assets, cost of 212; avoidable costs 212–13;

Index 321

baseline sales 227–8; breakeven formula,

derivation of 238–9; breakeven sales

analysis, contribution, incremental ﬁ xed

costs and, interrelationships between 222–3;

breakeven sales analysis, price reduction

situation 221–2; breakeven sales analysis

for reactive pricing 219–21; breakeven

sales change 214–15; breakeven sales

change, calculation of 216–17; breakeven

sales change, conversion between unit

and cash values 217–18; breakeven sales

change, variable costs change and 218–19;

breakeven sales curves 223–7; case study,

price changes for proﬁ t improvement

231–7; competitive analysis, variability

in nature of 220–21; contribution margin

216–17, 219, 222, 227, 228, 229, 231, 233;

demand price elasticity 213–14; ﬁ nance and

marketing, relationship between 4; ﬁ nancial

outcomes, mapping potential of 221–3; ﬁ xed

costs, incremental costs and 208–9, 222–3;

historical and replacement costs, distinction

between 212–13; incremental costs 208–12;

incremental costs, example of identiﬁ cation

of 209–11; incremental costs, importance of

identiﬁ cation of 209–12; incremental costs,

non-incremental costs and, distinction

between 208; incremental ﬁ xed costs 208–9,

222–3; last-in, ﬁ rst out (LIFO) accounting

212, 229n4; low-price sales, proﬁ tability

and 211–12; next-in, ﬁ rst out (NIFO)

accounting 212, 229n4; non-incremental

ﬁ xed and sunk costs 228; opportunity

cost, incremental costs and 210; price

alternatives, evaluation of ﬁ nancial

implications of 207–8; price changes

for proﬁ t improvement, case study

231–7; price level evaluation 208; pricing

decisions, ﬁ nancial considerations and 207;

proﬁ tability of price changes, evaluation

of potential for 214–18; reactive pricing,

breakeven sales analysis for 219–21; relevant

costs, identiﬁ cation of 208; revenue options,

analysis of 211; sales volume, proﬁ tability

and 214–15; semiﬁ xed incremental costs 209;

student rush discount 210–11; summary

229; sunk costs, non-incremental ﬁ xed and

228; value-based pricing, cost-driven pricing

and 228; variable costs, breakeven sales

incorporating change in 218–19

Fitzgerald, F. Scott 207

ﬂ anking offers, development of 161

ﬂ exible pricing: price structure 79–80; pricing

policy 127–8

focus-based positioning 157

Food Lion 162

Ford Mustang story 13–15

foreign currencies, management of export

prices in 248–53

foreign market sales strategy 248–50

Fortune 500 264

Fox TV 161

Frank, Ronald E. 204n3

Frederik II of Denmark 94–5

Freeborn & Peters LLP. 309

Friedman, Thomas 204n10

FTC v. Borden Co (1966) 314n41

Fuld, Leonard M. 172n14

full-line forcing 308

function-speciﬁ c objectives in price setting

133–4

Futrelle, D. 75n13

Gabor, A. and Granger, C. 75n12

game theory 153, 172n2

Gartner Inc. 24n14

Gawande, Atul 104n7

General Electric (GE) 60–61, 90, 290, 292n22

Gilbert, Jason O. 291n13

globalization of markets 2

Godiva chocolates 6

goods 303; services and, distinction between

314n40

Google 48; Google Shopping 31

Gourville, J.T. 24n18

Green, Kesten C. 155–6n3

Green, Paul E. 205n23

Greenberg, B.A. 206n28

Greene, William H. 204n7

grey market diversions, segmented pricing

and 79

Grifﬁ n, Abbie 205n17

growth, price reductions and 244–5

Hafner, K. and Stone, B. 24n13

Hall, William K. 260n10

Hanseatic League 93–4

Harmer, Dick 84

Harrison, John 68

Harvard Business Review 2–3

Harvard Business School 2, 104n8, 105n22, 133

Hauser, John R. 205n17

health maintenance organizations (HMOs)

62, 161

Heil, Oliver P. 172n15

Hellofs Linda L. 155–6n3

Henry, Brian R. 312n28

Hertz 21

Hesse, Herman 76, 104n1

Hewlett-Packard (HP) 164–5, 248

Hinterhuber, Andreas 291n8

historical and replacement costs, distinction

between 212–13

historical data, analysis of 179–81

historical sales data, price sensitivity and 175–6

Hodgman, John 16

Hogal, Paul 75n2

Hogan, John 25n23, 75n2, 291n2, 292n16, 292n24

Index322

Hohnen, David 93–5

Holiday Inns 260n1

Home Depot 73, 123, 124

horizontal price ﬁ xing 299

Hurricane Sandy 72

Hyundai 255, 261n19

Iacocca, Lee 15

IBM 67, 248

in-depth interviews: customer interviews 35;

price sensitivity, measurement of 189–91

in-store purchase experiments 181–2

incremental costs 208–12; example of

identiﬁ cation of 209–11; importance of

identiﬁ cation of 209–12; incremental ﬁ xed

costs 208–9, 222–3; non-incremental costs

and, distinction between 208

indirect purchasers, law and 306

Industrial Buying Power, Survey of 201

innovation: innovative pricing strategies 2;

innovative products, underpricing of 6;

pricing for 241–4; strategic pricing and

1–2

The Innovator’s Dilemma (Christensen, C.) 78

input decision rights 273

International Harvester Company (IH) 48–9

Interstate Circuit, Inc. v. United States (1939)

311n21

Intuit QuickBooks 30

Jacobsen, Robert 155–6n3

Jenny Craig weight-loss program 61

Jeuland, Abel P. 260n8

Jobs, Steve 45

Johansson, Johny K. 206n32

John Deere 48–9

Johnson & Johnson Vision Care, Inc. v. Reyes

(2016) 312n31

Jones, D. Frank 205n21

Justice Department (US), enforcement powers

of 297, 302, 309, 316n61

Kafka, Peter 291n9

Kahneman, D., Knetsch, J.L. and Thaler, R.H.

75n14

Kahneman, Daniel 104n3, 132n7

Kaiser Permanente 62, 85, 104n6

Kehoe, William J. 310n3–4

Kelvin, William Thomson, Lord 279, 292n17

Kinnear, Thomas C. 204n8, 205n16

KitchenAid 67

Knetsch, Jack L. 104n3, 132n7

Kodak 269

Koselka, Rita 172n2

Kotler, Philip 261n13

Kristopher, Gordon 172n4

Kruskal, J. B. 205n25

labor savings 37, 38–9

Labor Statistics, US Bureau of 261n18

laboratory purchase experiments 182–5

Lacoste 140

Lake Hill Motors, Inc. v. Jim Bennett Yacht Sales,

Inc. (2001) 312n33

Landim, Raquel 261n17

Langvardt, Arlen W. 172n15

last-in, ﬁ rst out (LIFO) accounting 212, 229n4

law see ethics, law and

Leahy, Joe 261n17

Leamer, Edward E. 206n33

Leegin Creative Leather Prods., Inc. v. PSKS

(2007) 299–300, 311–12n25–8, 312–13n32

legal framework for pricing 296–8

Levine, David M. 204n8

Levitt, Theodore 261n14

Lewis, Peter H. 54n3

Lexmark 165

Liddell Hart, Sir Basil 153–4, 172n3

life cycle, adaptation of pricing strategy over

240–48

Lombardi, Michael 151n2

Long, Justin 16

Lorenzetti, Laura 132n3

low-cost carriers (LCCs) 158

low-price competition, responses to 110

low-price sales, proﬁ tability and 211–12

luxury goods, prestige and 68–9

McCaskey, P. H. 291n3

McCullough, James 206n28–9

McDonald’s 19, 67, 260n1, 284–5

McGrath, Rita Gunther 205n19

McKinley, John 261n20

McKinsey & Company 284

Mackrill, Cali 24n17

MacMillan, Ian C. 205n19

Malcolm Baldrige National Quality Award 46–7

Malone, Thomas W. 261n23

Manufacturers, Census of 201, 206n38

March, James G. 291n12

market segmentation, value-based 47–54

market-share myth 154–5

market slumps, management of pricing in

253–5

marketing, elements of 1

markets at risk, price responses and value of

164–5

Marn, Michael 292n18

Marriott Hotels 15, 67

Marshalls 140

Massy, William 204n3

MathWorks 157

Mayo Clinic 85

Medicare 96

Meehan, J.M., Simonetto, M.G., Montan Jr, L.

and Goodin, C.A. 288, 292n21

Index 323

Mela, C.F., Gupta, S. and Lehmann, D.R. 177–8

Michel, Stefan 292n24

Michelin 57

Minimum Advertised Price (MAP) programs

301–2, 313n34

Mitchell, Dan 132n4

Mitchell, David 16

Mitchell, Kevin 291n4

monetary value 28–9, 33–6; estimation of

33–6; estimation of, illustration of 36–41;

quantitative research techniques 33–4

monopolization 316n58

Montgomery, David B. 205n23, 205n26

Moore, Benjamin 123

Motel 6 179

Muller, G., Nagle, T. and Thompson, L. 291n5

Musk, Elon 106, 131n1

Nagle, Thomas 54–5n4, 260n6, 260n9

Nakamoto, Kent 260n5

Nalebuff, Barry 172n2

Narus, James A. 205n18

National Association of Attorneys General

(NAAG) 310n11

National Broadcasting Company (NBC) 161

National Collegiate Athletic Association v. Board

of Regents (US Supreme Court) 299

National Health Service (NHS, UK) 130, 132n6

NBCA (next-best competitive alternative) 30,

36, 96

needs-based positioning 156, 157

negative-sum games 153–4, 164, 165, 170

negative-sum pricing 164

Netﬂ ix 89, 291n14; price increase management

270

neutral pricing 141–2

Nevin, John R. 205n22

New York Times 68

New York v. Herman Miller, Inc. (2008)

311–12n26

next-in, ﬁ rst out (NIFO) accounting 212, 229n4

Nextag 31

Nielsen 31

Nike 60

Nintendo 246; 3DS console 91

non-price incentives 308

non-price variables 306–8

Nonaka, Ikujiro 206n32

Noosa International 16

normalized reference data 33

notiﬁ cation decision rights 274

offer conﬁ gurations 80–85; offer bundles,

optimizing structure of 81–3; segment-

speciﬁ c bundles, design of 83–4; selective

ugliﬁ cation 84; strategic unbundling 84–5;

value-added features, bundling of 83

offer development 154

Ohmae, Kenichi 172n2

Old Style 137

Olson, Ken 55n5

online media 1–2

online techniques, use of in pricing research

200

opportunism: price competition and 166, 167,

169; strategy of in foreign markets, similar

competitive impact 251; strategy of in foreign

markets, unique competitive impact 252

opportunity costs: economic value and 37, 38,

39; incremental costs and 210

optimization, role in strategic pricing 7–9

organizational change, management of

process 288–90

organizational needs, matching pricing

centralization with 271–3

Orme, Bryan K. 206n30

Osborne, Alistair 24–5n20

outside sources of data 200–201

Paciﬁ c Bell Tel. Co. v. linkLine Communications,

Inc. (2009) 316n59

panel data 176–8

Pasquarelli, Adrianne 151n6

Pauwels, K., Srinivasan, S. and Franses, P.H.

204n5

PayPal 158

peak pricing, yield management and 101–4

Peckelman, Dove 205n25

peer group, customer proﬁ tability by 282

Peltzman, Sam 229n5

penetration pricing 140–41

performance measures and incentives 276–8

personal relationships, value communication

and 66

Peterbilt trucks 6

Pew Research Center 206n36

PIMS (Proﬁ t Impact of Market Strategy) 2–3

Plassman, H., O’Doherty, J., Shiv, B. and

Rangel, A. 75n10

point-of-sale (POS) reporting 302

policy-based pricing, transitioning to 127–8

Porsche 68, 70, 137

Porter, Michael E. 261n14; on price

competition 156, 157, 172n5–6

positive-sum games 153–4, 155

power buyers: competitive edges for,

provision of 124; dealing with 123–5; ‘divide

and conquer’ tactics with, avoidance of

124–5; elimination of unnecessary costs

for 124; quantiﬁ cation of value for 124;

segmentation of product offering for 124

predatory pricing 308–9; burden of proof on

309; costs and beneﬁ ts of 163–4

Predicasts, Inc. 206n38

preferences: experimental studies of intentions

and 191–7; uncontrolled studies of

intentions and 185–91

Index324

prestige, symbols of 68

price alternatives, ﬁ nancial implications of

207–8

price and promotional discrimination 302–6

price and value communication 56–75;

behavioral economics 64; business markets,

comparison effects in 67; buying process,

buyer involvement, degree of 60; buying

process, participants in 73–4; buying process,

transaction value 72; communication of

new prices to markets 149–51; comparison

effects 66–7; competitive reference effect

65–6; context, marketing communications

and 74; customer involvement, expertise

gain and 62; difﬁ cult comparison effect 66–7;

economic value estimation 64; economic

value messages (low-involvement goods)

61; end-beneﬁ t effect 67–8; EVE

(Economic

Value Estimation) 57, 62–3; expenditure

effect 70; fairness effect 72–3; feature

communication, value communication

and 56–7; luxury goods, prestige and 68–9;

non-economic factors, role of 64; personal

relationships 66; prestige, symbols of 68;

price-quality effect 68–9; price sensitivity,

perceptions of unfairness and 72–3; price

sensitivity, prestige goods and 69; product

characteristics, adaptation of message

for 58–62; product characteristics, buyer

involvement, degree of 60; product

characteristics, high-involvement products

with economic beneﬁ ts 61–2; product

characteristics, high-involvement products

with psychological beneﬁ ts 61; product

characteristics, low-involvement products

with economic beneﬁ ts 60–61; product

characteristics, low-involvement products

with psychological beneﬁ ts 60; product

characteristics, type of value sought,

importance of understanding 58; product

effectiveness, price and 69; psychological

value drivers, dealing with 63–4; purchase

involvement, beneﬁ t types and 59; reference

price, transaction utility and 72; shared cost

effect 70–71; strategic pricing, importance

for 56; subjective values 63–4; summary 74;

supply chain logistics 66; switching cost

effect 66; value communication 58; value

communication, adaptation of message in

58–62; value communication, centrality of

62; value communication, challenges for

57–8; value communication, competitive

reference effect 65; value communication,

complications of 56–7; value communication,

difﬁ cult comparison effect 66–7; value

communication, end-beneﬁ t effect 67–8; value

communication, expenditure effect 70;

value communication, fairness effect 72–3;

value communication, price-quality effect

68–9; value communication, purchases,

economic and psychological values in 58–9;

value communication, shared cost effect

70–71; value communication, spreadsheet

tool 63; value communication, strategies for

62–72; value communication, switching cost

effect 66

price banding 127; price bands, price band

analysis and 283–4

price ceiling 135–6

price changes: criteria for 108; for proﬁ t

improvement, case study 231–7

price competition 152–72; access-based

positioning 156, 157; competing on price as

sensible option 156–8; competition, proﬁ table

growth and 154–8; competition, reacting

to 159–65; competitive advantage 156–8;

competitive advantage, leveraging of 162;

competitive dynamics 162, 163; competitive

information, aims of uses of 169–70;

competitive information, evaluation of

166–70; competitive information,

management of 165–6; competitive

information, opportunism and 169;

competitive information, selective

communication of 168–70; competitive

reaction 152; competitive threat,

accommodation to 159; defensive pricing

163; defensiveness, demonstration of

potential for 169; discounting, raising costs to

competitors of 161–2; ethics, law and 313n34;

exit barriers, sunk costs and 163; ﬂ anking

offers, development of 161; focus-based

positioning 157; game theory 153, 172n2;

low-cost carriers (LCCs) 158; management

of 20–21; market-share myth 154–5; markets

at risk, price responses and value of 164–5;

needs-based positioning 156, 157; negative-

sum games 153–4, 164, 165, 170; negative-

sum pricing 164; offer development 154;

opportunism 166, 167, 169; Porter, Michael E.

156, 157, 172n5–6; positive-sum games 153–4,

155; pre-announcement of price increases

168–9; predatory pricing, costs and beneﬁ ts

of 163–4; price cutting, justiﬁ cation of 159;

price difference, potential for competitive

reestablishment of 163; price matching 162;

price wars, recognition of totality of costs

of 163; pricing game 153–4; reactive price

cutting, focus of 161; reference value 152;

retaliatory price cutting 165; risk in price

cutting, focus on incremental volume of 161;

sales loss, preventability of 159–61; strategic

beneﬁ t, value of 165; strategic pricing 20–21;

summary 171; timing of 170–71

price-cutting 6; justiﬁ cation of 159

price discrimination 303–4, 313n35; defenses

against 304–5; elements of unlawful practice

303–4; Robinson-Patman Act (1936) and 302,

303, 304, 305, 313–14n35–8

price-driven buyers, dealing with 121–3

Index 325

price elasticity: of demand, strategic pricing

and 8–9; guaging of 145–7

price exceptions 108

price expectations, pricing policies and 107–8

price fences 95–101; buyer identiﬁ cation fences

95–7; deal proneness 96; freight absorption

97; order discounts 100; predictability

98; priority pricing 98; purchase location

fences 97–8; purchase quantity fences

99–101; reference value, determination

of 96; relative price sensitivity 96–7; step

discounts 100–101; time of purchase fences

98–9; trade barriers between countries 97–8;

two-part pricing 101; variable demand and

99; volume discounts 99–100

price ﬁ xing: horizontal ﬁ xing 299; or

encouragement, ethics and 298–9; vertical

ﬁ xing 299–301, 311n17

price ﬂ oor 135–6

Price Grabber 31

price increases: communication to markets

149–51; double discounting of 112–13;

exploration on new ways to manage 270;

industry-wide increases, leading in 126–7;

policies for management of 125–8;

pre-announcement of 168–9

price latitude, reductive factors 245

price level setting 133–51; break-even sales

changes, assessment of 142–5; break-

even sales changes, calculation of 143–5;

communication of new prices to markets

149–51; comparison effect, difﬁ culty

in 147; constant proﬁ t curve 143–4;

demand curve, assumption of stability

of 143; dialogue on, facilitation of 134;

‘early bird’ discounts 148; end-beneﬁ t

importance 147; EVE

(Economic Value

Estimation) 135; expenditure size 147;

fairness, communication of 149; fairness,

consideration of norms of 133, 148; function-

speciﬁ c objectives in 133–4; goals for

price setting 146–7, 149; market-revelance

133–4; neutral pricing 141–2; penetration

pricing 140–41; price ceiling 135–6; price

elasticity, guaging of 145–7; price ﬂ oor

135–6; price increases, communication to

markets 149–51; price level evaluation 208;

price optimization 143, 144–5; price-quality

perceptions 147; price range, deﬁ nition

of viability for 135–7; price sensitivity,

factors inﬂ uencing 147–9; price-setting

process 134–49; price-setting traps 134;

psychological factors, accounting for 147–9;

reference effect 147; sequential skimming

139–40; shared costs 148; skim pricing

138–40; strategic choices 137–42; summary

151; switching costs 147; viable price range,

deﬁ nition of 135–7

price management, centralization of 271–2

price matching 162

price metrics 85–95; adoption of 85–6; buyer

experience, price alignment with 89;

competitive pricing and 88; cost additions

87; evaluation criteria for 86; fairness and

89; good price metrics, creation of 86–9;

hosted call center software 88; mobile

video games, evolution of metric for 90–92;

multi-part metrics 89; performance-based

metrics 89–90; performance-based pricing

87; tie-ins as metrics 92–3; value-based

metrics 87–8

price negotiation: policies for 110–14;

proactive, policy-based negotiation, beneﬁ ts

of 116–18; reactive, ad hoc negotiation,

problem with 114–16

price objections, policies for responding to

114–25

price optimization 143, 144–5

price-quality effect 68–9

price-quality perceptions 147

price range, deﬁ nition of viability for 135–7

price sensitivity 244, 245; factors inﬂ uencing

147–9; improving estimation of 246–7; key

to use of estimates of 173–4; perceptions of

unfairness and 72–3; prestige goods and 69

price sensitivity, measurement of 173–206;

actual purchases, experimentally controlled

studies of 181–5; actual purchases,

uncontrolled studies of 175; attribute rating

186–7; buy-response surveys 186, 187–9;

choice, panel data of impact of promotion

on 177–8; conjoint study, example of

194–7; conjoint (trade-off) analysis 192–7;

controlled measurements 174; demographic

variables 174; direct questioning 186; for

e-books 184–5; experimental purchase data

studies 181–5; historical data, analysis of

179–81; historical sales data 175–6; in-depth

interviews 189–91; in-store purchase

experiments 181–2; intention measurement

189; judgement, use for better measurement of

198–200; laboratory purchase experiments

182–5; measurement procedures, types

of 174–81; measurement techniques,

appropriate use of 197–202; mobile

techniques, use of 200; online techniques,

use of 200; outside sources of data 200–201;

panel data 176–8; preferences, experimental

studies of intentions and 191–7; preferences,

uncontrolled studies of intentions and

185–91; price sensitivity, key to use of

estimates of 173–4; purchase probability

curves 187–9; quantitative estimates of

173–4; reliability of trade-off analysis 196–7;

scanner data 175, 177, 178–9; selection of

appropriate measurement technique

201–2; simulated purchase experiments

191–2; store-level transaction data 178–9;

summary 202–3; trade-off (conjoint) analysis

192–7; transaction data, store-level 178–9;

Index326

willingness-to-pay, estimates of 173, 186,

189, 190, 194, 196

price signaling 309, 311n20, 316n61

price structure 76–105; airlines, segmented

pricing of 81, 102–4; bundled offers

81–3; cable TV, bundled offers from

81–2; congestion charges 102; consumer

surplus 78; customer-speciﬁ c pricing 83–4;

differentiating product features, valuation

of 76; economic value and 76; ﬂ exible

pricing 79–80; grey market diversions

and segmented pricing 79; The Innovator’s

Dilemma (Christensen, C.) 78; offer

conﬁ gurations 80–85; offer conﬁ gurations,

offer bundles, optimizing structure of

81–3; offer conﬁ gurations, segment-

speciﬁ c bundles, design of 83–4; offer

conﬁ gurations, selective ugliﬁ cation and 84;

offer conﬁ gurations, strategic unbundling

84–5; offer conﬁ gurations, value-added

features, bundling of 83; order discounts

100; peak pricing, yield management and

101–4; price fences 95–101; price fences,

buyer identiﬁ cation fences 95–7; price

fences, deal proneness 96; price fences,

freight absorption 97; price fences, order

discounts 100; price fences, predictability

98; price fences, priority pricing 98; price

fences, purchase location fences 97–8; price

fences, purchase quantity fences 99–101;

price fences, reference value, determination

of 96; price fences, relative price sensitivity

96–7; price fences, step discounts 100–101;

price fences, time of purchase fences

98–9; price fences, trade barriers between

countries 97–8; price fences, two-part

pricing 101; price fences, variable demand

and 99; price fences, volume discounts

99–100; price metrics 85–95; price metrics,

adoption of 85–6; price metrics, buyer

experience, price alignment with 89; price

metrics, competitive pricing and 88; price

metrics, cost additions 87; price metrics,

evaluation criteria for 86; price metrics,

fairness and 89; price metrics, good price

metrics, creation of 86–9; price metrics,

hosted call center software 88; price metrics,

mobile video games, evolution of price

metric for 90–92; price metrics, multi-part

metrics 89; price metrics, performance-

based metrics 89–90; price metrics,

performance-based pricing 87; price metrics,

tie-ins as metrics 92–3; price metrics, value-

based metrics 87–8; railroad tariffs 78;

segmented pricing, channel intermediaries

and 79–80; segmented pricing, control of

pricing and 80; segmented pricing, ﬂ exible

pricing and 79–80; segmented pricing,

grey market diversions and 79; segmented

pricing, incremental contribution from

76–8; segmented pricing, proﬁ t contribution

maximization 83; segmented pricing,

revenue optimizing subscription pricing

82; segmented pricing, single price policy

and 78; segmented pricing, undermining

challenges 79–80; single price structure

78; step discounts 100–101; step pricing

100–101; strategic pricing 17–18; summary

104; value-based pricing for Hamlet’s Castle

93–5; virtual products 92; volume discounts

99–100; yield management, effectiveness

tasks 102–4

price-volume trade-offs 19–20

price wars, recognition of totality of costs of

163

price waterfalls and waterfall analysis 284–6

pricing: activities within, deﬁ nition of 274;

benchmarking study on strategy 262–6;

ethical constraints on 293–6; function of,

data needed to inform 279; function of,

data solutions providers 279, 280; function

of, systems for support of 279–88; function

of, win-loss data, analysis of 280–81; legal

framework for 296–8; performance in 262,

286; process of 3–4; role of value in 27–30;

roles and responsibilities, decision rights

and 273–4; Sarbanes-Oxley Act, effect on

297–8; systems 286–8; technology 287, 288

pricing capability: change management

and 288–90; cross-functional nature of

265–6; demonstration projects 289–90;

informational shortfalls and 265;

investments needed for 265; organizational

shortfalls 264–6; senior management

leadership 289; skills and 264–5

pricing centralization, matching with

organizational needs 271–3

pricing decisions: ﬁ nancial considerations and

207; implications of 110

pricing game 153–4

pricing goal 6

pricing objectives, creating alignment on 270–71

pricing organizations: archetypal structures

263, 272–3; assessment of maturity of 266–7;

centralization of 271, 272; essential elements

of 268–78; less-than-mature organizations

287; roles and responsibilities within 273–4

pricing policy 106–32; brand-driven

buyers, dealing with 120–21; business-

to-business (B2B) sales and purchases

107, 108–9, 111; buyer types, dealing with

differences in 118–23; buying groups

123, 124, 125; commoditization of offers

111–12; competitive edges for power

buyers, provision of 124; consistency

110–11; consumer market stimulation 106;

convenience-driven buyers, dealing with

123; discounts, pricing power and 108;

‘divide and conquer’ tactics with power

buyers, avoidance of 124–5; economic

Index 327

downturn, policies for pricing in 128–9;

elimination of unnecessary costs for

power buyers 124; expectations, buyer

behavior and 107; failure, discounting in

compensation for 113–14; ﬂ exible pricing

127–8; low-price competition, responses to

110; policy-based pricing, transitioning to

127–8; power buyers, dealing with 123–5;

price banding 127; price changes, criteria

for 108; price-driven buyers, dealing

with 121–3; price exceptions 108; price

expectations, pricing policies and 107–8;

price increases, double discounting of 112–13;

price increases, industry-wide increases,

leading in 126–7; price increases, policies

for management of 125–8; price negotiation,

policies for 110–14; price objections, policies

for responding to 114–25; pricing decisions,

implications of 110; proactive, policy-

bases price negotiation, beneﬁ ts of 116–18;

promotional pricing, policies for 130–31;

quantiﬁ cation of value for power buyers

124; reactive, ad hoc price negotiation,

problem with 114–16; reverse auctions 108;

segmentation of product offering for power

buyers 124; short-term price promotions

106; special pricing, requests for 110;

splitting purchases, multiple suppliers

and 107; strategic pricing 18–19; strategic

sourcing 109; strategic sourcing, emergence

of 108–10; summary 131; transitioning from

‘ﬂ exible’ to ‘policy-based’ pricing 127–8;

transparency 110–11; value-based price

structures 111; value-driven buyers, dealing

with 118–20; volume, discounting for 113

Procter & Gamble 123–4, 161, 172n6, 290, 292n23

product characteristics: adaptation of message

for 58–62; buyer involvement, degree

of 60; high-involvement products with

economic beneﬁ ts 61–2; high-involvement

products with psychological beneﬁ ts 61;

low-involvement products with economic

beneﬁ ts 60–61; low-involvement products

with psychological beneﬁ ts 60; type of value

sought, importance of understanding 58

product effectiveness, price and 69

product line expansion 247

product restrictions 308

productive behaviors, development of 22–3

Proﬁ t Impact of Market Share (PIMS) database

2–3

proﬁ tability: leveraging proﬁ t into sustainable

growth 2–4; market share and, balance

between 7; of price changes, evaluation

of potential for 214–18; proﬁ t-driven

strategies 10–11; proﬁ t driving, creation

of sales invectives for 278–9; proﬁ t leaks,

identiﬁ cation of 274; sales proﬁ tability,

priority of 3; sales volume, proﬁ tability and

214–15

promotional discrimination 305–6; defenses

against 306; standards of, ﬂ exibility

available under 306

promotional pricing, policies for 130–31

psychological value: accounting for 147–9;

drivers of, dealing with 63–4; economic

value and 28–9, 33–4; estimation of

41–2; estimation of, illustration of 42–5;

quantitative research techniques 41

purchase intention measurement 189

purchase involvement, beneﬁ t types and 59

purchase probability curves 187–9

Quaker Oats 182

quality control labor savings 38–9

quantitative data, cluster analysis of 50

quantitative estimates of price sensitivity,

measurement of 173–4

Qureshi, Junaid 90–2

Rackman, Neil 131n2

railroad tariffs 78

Ramus, Catherine A. 205n26

Rao, A.R., Bergen, M.E. and Davis, S. 172n8

Rao, Leena 291n11

Rao, Vithala 205n23–4

ratiﬁ cation decision rights 273–4

Raynor, M.E. and Ahmed, M. 24n8

Raynor, M.E., Pankratz, D. and Kandasamy, S.

24n7

reactive ﬂ exibility, problem of 5–6, 18

reactive price cutting 161

reactive pricing, breakeven sales analysis for

219–21

recessions, management of prices in 254

reference effect 147

reference price, transaction utility and 72

reference price data 31–3

reference product 30, 40, 46, 47

reference value: economic value and 29–30,

31–2; price competition and 152; strategic

pricing and 20

relative value, evaluation of 15

relevant costs, identiﬁ cation of 208

resale of supplier’s goods 305–6

resale price ﬁ xing 299–302

resale price maintenance 301–2

retaliatory price cutting 165

revenue drivers 35

revenue options, analysis of 211

reverse auctions 108

Rifkin, Brian 105n15

Rivera, Edward 206n35

Robinson, Patrick J. 205n23

Robinson-Patman Act (1936) 172n13, 302,

303, 304, 305, 306, 308, 313–14n35–8,

314–15n44–6, 314n40

Rogers, Everett M. 260n2, 260n4–5

Index328

Rolex 28–9, 40, 68

Rosiello, Robert 292n18

Russo, J. Edward 75n6

Ryanair 18, 137, 170, 171

safe harbors 297, 310n8

Sales and Marketing Management 206n38

sales credit, calculation of team incentives 278

sales incentives: alignment with strategy

276–8; to drive proﬁ t, creation of 278–9

sales loss, preventability of 159–61

sales volume, proﬁ tability and 214–15

Sam’s Club 100, 140

Samsung 42, 137; Galaxy S phones 16–17

Sarbanes-Oxley Act (2002) 310n12; effect on

pricing practices 297–8

Save-A-Lot 141

scanner data 175, 177, 178–9

Schick, Shane 105n16

Schwadel, Francine 172n12

secondary price data 31

Securities Exchange Act (1934) 311n13

Segal, Madhav N. 206n28

segmented pricing: channel intermediaries

and 79–80; control of pricing and 80; ﬂ exible

pricing and 79–80; grey market diversions

and 79; incremental contribution from

76–8; proﬁ t contribution maximization

83; revenue optimizing subscription

pricing 82; segment metrics and fences,

development of 53–4; segmentation criteria,

determination of 49; segmentation-modeling

methodologies 48–9; segmentation of

product offering for power buyers 124;

single price policy and 78; strategic overlap

in value-based market segmentation 51;

undermining challenges 79–80

semiﬁ xed incremental costs 209

Sen, Subrata 205n25

senior management leadership 289

sequential skimming 139–40

services, provision of 305

Shah, Ali 105n13

Shanklin, William L. 156n3

Shapiro, Benson P. 104n8

share-driven pricing 6–7

shared costs: price level setting and 148;

shared cost effect 70–71

Shaw, Lucas 23n2

Shaw Industries 124

Sherman Act (1890) 298, 299, 300, 309,

310n9–10, 311n19, 313n33, 315n54–5, 316n58

Shiv, B., Carmon, Z. and Ariely, D. 75n11

Shoemaker, F. Floyd 260n2, 260n4

short-term price promotions 106

shortcuts, high cost of 45–6

Shulman, Robert S. 204n12

Simonson, I. and Tversky, A. 24n11

simulated purchase experiments 191–2

skim pricing 138–40

Slonim, R. and Garbarino, E. 24n12

Smith, G.E. and Nagle, T.T. 55n6

Snapon tools 6

Sobel, Dava 75n9

Society of Competitive Intelligence

Professionals (SCIP) 201

Solman, Paul 204n10

Sony 42, 142

specialized strategies 240–61; adaptation

of pricing strategy over category life cycle

240–48; category life cycle, adaptation of

pricing strategy over 240–48; committed

strategy, similar competitive impact 251–2;

committed strategy, unique competitive

impact 252–3; competitive impact of

exchange rate shifts 250; cost control,

pricing in maturity and 245–8; cost control

and utilization, improvement in 247; cost

integration, efﬁ ciencies from 257; currency

exchange rates, impact on management of

export pricing 250–53; declining markets,

pricing products in 253–5; distribution

channel reevaluation 247–8; economically

efﬁ cient transfer prices, creation of

255–9; exchange rate price adjustments,

management strategies for 250–53; export

prices in foreign currencies, management of

248–53; foreign currencies, management of

export prices in 248–53; foreign market sales

strategy 248–50; growth, price reductions

in 244–5; innovation, pricing for 241–4;

market slumps, management of pricing in

253–5; maturity, pricing established products

in 245–8; opportunistic strategy, similar

competitive impact 251; opportunistic

strategy, unique competitive impact 252;

price latitude, reductive factors 245; price

sensitivity 244, 245; price sensitivity,

improving estimation of 246–7; pricing

strategy, adaptation over category life

cycle 240–48; product category life cycle,

adaptation of pricing strategy over 240–48;

product line expansion 247; recessions,

management of prices in 254; related

products and services, unbundling of 246;

summary 259–60; transfer prices, creation of

economic efﬁ ciency in 255–9; transfer prices,

inefﬁ ciencies in 256

Spectrum Sports, Inc. v. McQuillan (1993)

316n58

splitting purchases, multiple suppliers and 107

Spotify 1–2

Sreeharsha, Vinod 261n17

Srinivasan, S., Popkowki Leszczyc, P.T.L. and

Bass, F.M. 204n5

Standard & Poor’s 206n38

State Oil Co. v. Khan (1997) 299–300, 311n25

States v. Grinnell Corp. (1966) 316n58

Staton, Tracy 54–5n4

Index 329

step discounts 100–101

step pricing 100–101

store-level transaction data 178–9

strategic pricing 1–25; airline price structures

17–18; behavioral economics research 7–8;

“big data” statistical models 9; breakeven

sales changes 8; capability for strategic

pricing, creation of 21–3; change, perpetual

nature of 1; congestion in cities 2; constant

proﬁ t curve 8–9; cost-plus pricing 4–5;

customer-driven pricing 5–6; data for 2–3,

9, 22; deﬁ nition of 9–12; Deloitte time-series

dataset of 394 companies (1970–2013) 3;

demand, price elasticity of 8–9; demand

curve ‘shifts’ 8; differentiating value 20;

EVE

(Economic Value Estimation) 4;

ﬁ nance and marketing, relationship between

4; Ford Mustang story. value-based pricing

13–15; globalization of markets 2; “Good

Value” offerings and value-based pricing 13,

15; Harvard Business School 2; importance

for value communication 56; information

quality, need for 22; information revolution

2; informed trade-offs, need for 7;

innovation 1–2; innovative pricing strategies

2; innovative products, underpricing of 6;

marketing, elements of 1; motivation for

implementation 22–3; online media 1–2;

optimization, role in 7–9; predictability 21;

price competition 20–21; price competition,

management of 20–21; price competition,

value of strategic beneﬁ t and 165; price-

cutting 6; price elasticity of demand 8–9;

price level setting, strategic choices for

137–42; price setting 19–20; price structure

17–18; price-volume trade-offs 19–20;

pricing goal 6; pricing policy 18–19; pricing

process 3–4; principles for 10–11; proactive

strategies 10; productive behaviors,

development of 22–3; proﬁ t, leveraging

into sustainable growth 2–4; proﬁ t-driven

strategies 10–11; Proﬁ t Impact of Market

Share (PIMS) database 2–3; proﬁ tability

and market share, balance between 7;

purpose of 5; reactive ﬂ exibility, problem of

5–6, 18; reference value 20; relative value,

evaluation of 15; requirements for 4; sales

proﬁ tability, priority of 3; share-driven

pricing 6–7; strategic, context of use of term

9–10; strategic pricing capability, creation

of 21–3; success in, requirements for 22;

summary 23; sustainable growth, leveraging

proﬁ t into 2–4; technological developments

1–2; unit cost determination 5; value-

based pricing 5; value-based pricing, Ford

Mustang story 13–15; value-based pricing,

“Good Value” offerings and 13, 15; value-

based pricing, strategies for 10; Value

Cascade 11; value communication 15–17;

value creation 12–15; value differentials,

advertising and 16; value messages, content

of 16–17; willingness-to-pay 5–6

strategic pricing capability 262–92; common

protocols for creation of relevant insights

279–80; cost to serve and customer

proﬁ tability 281–2; creation of 262; current

processes, mapping of 274; customer

analytics, management choices and 280;

customer proﬁ tability, cost to serve and

281–2; customer proﬁ tability map 282; deal

management 288; decision rights specify

pricing roles and responsibilities 273–4;

demonstration projects 289–90; expertise,

centers of 271, 272, 286; input decision

rights 273; make decision rights, clarity

of accountability and 273; Netﬂ ix, price

increase management and 270; notiﬁ cation

decision rights 274; organizational

change process, management of 288–90;

organizational needs, matching pricing

centralization with 271–3; peer group,

customer proﬁ tability by 282; performance

measures and incentives 276–8; price

bands, price band analysis and 283–4;

price centralization, matching with needs

271–2; price increases, exploration on new

ways to manage 270; price waterfalls and

waterfall analysis 284–6; pricing activities,

deﬁ nition of 274; pricing capability,

change management and 288–90; pricing

capability, cross-functional nature of 265–6;

pricing capability, demonstration projects

289–90; pricing capability, informational

shortfalls and 265; pricing capability,

investments needed for 265; pricing

capability, organizational shortfalls 264–6;

pricing capability, senior management

leadership 289; pricing capability, skills

and 264–5; pricing centralization, matching

with organizational needs 271–3; pricing

function, data needed to inform 279; pricing

function, data solutions providers 279,

280; pricing function, systems for support

of 279–88; pricing function, win-loss data,

analysis of 280–81; pricing objectives,

creating alignment on 270–71; pricing

organizations, archetypal structures 263,

272–3; pricing organizations, assessment of

maturity of 266–7; pricing organizations,

centralization of 271, 272; pricing

organizations, essential elements of 268–78;

pricing organizations, less-than-mature

organizations 287; pricing organizations,

roles and responsibilities within 273–4;

pricing performance 262, 286; pricing roles

and responsibilities, decision rights and

273–4; pricing strategy, benchmarking

study on 262–6; pricing systems 286–8;

pricing technology 287, 288; process

management analytics 283; proﬁ t driving,

Index330

creation of sales incentives for 278–9; proﬁ t

leaks, identiﬁ cation of 274; ratiﬁ cation

decision rights 273–4; redesign of pricing

process 274; relevant insights, common

protocols for creation of 279–80; sales credit,

calculation of team incentives 278; sales

incentives, alignment with strategy 276–8;

sales incentives to drive proﬁ t, creation

of 278–9; scaling of pricing practices 286;

senior management leadership 289; strategy

implementation, pricing processes to

ensure 274–5; summary 290–91; win-loss

data, analysis of 280–81; see also specialized

strategies

strategic sourcing 109; emergence of 108–10

student rush discount 210–11

subjective values 63–4

summaries: economic value 54; ethics, law

and 309; ﬁ nancial analysis 229; price and

value communication 72; price competition

171; price level setting 151; price sensitivity,

measurement of 202–3; price structure 104;

pricing policy 131; specialized strategies

259–60; strategic pricing 23; strategic pricing

capability 290–91

Sun Tzu 152, 172n1

sunk costs, non-incremental ﬁ xed and 228

Supervalu Inc. 141

supply chain logistics 66

sustainable growth, leveraging proﬁ t into 2–4

switching costs 147; switching cost effect 66

Sylvania decision (US Supreme Court, 1977)

307

“systems integrator” business model 34

Tableau 243, 284

Taylor, James R. 204n8, 205n16

technological developments 1–2

Tellis, Gerard 151n3, 205n14, 205n20

territorial restrictions 307–8

Tesla 139–40, 259

Texaco Inc. v. Hasbrouck (1990) 314–15n44

Text Messaging Antitrust Litigation (2010)

311n21

Thaler, Richard H. 24n10, 64, 75n5, 104n3,

132n7

T.J. Maxx 140

Toro Company 124, 148, 151n5

Toyota 34, 54n2; Prius 29

trade-off (conjoint) analysis: economic value

and 33–4, 41–3, 44–5; example of 194–7;

price sensitivity, measurement of 192–7;

reliability of 196–7

transaction data, store-level 178–9

transfer prices: economically efﬁ cient prices,

creation of 255–9; inefﬁ ciencies in 256

transparency in pricing policy 110–11

tying 308, 315–16n55–6

Uber 156, 269

Underwriter Laboratories 245

unit cost determination 5

United Parcel Service (UPS) 87

United States v. Airline Tariff Publishing Co.

(1994) 316n61

United States v. Andreas (2000) 311n23

United States v. Colgate & Co. (1919) 300,

312n28, 313n33

Urban Science 31

US Federal Trade Commission (FTC) 297, 302,

309, 310n10, 313n33–4

US Sentencing Commission Guidelines (2016)

310n9

utility, value and 27

value algorithms 34–6

value-based pricing 5; cost-driven pricing and

228; economic value, role in pricing 27–30;

Ford Mustang story 13–15; “Good Value”

offerings and 13, 15; for Hamlet’s Castle

93–5; strategies for 10; structures of 111

Value Cascade 152, 266–7; economic value 27;

strategic pricing 11

value communication 15–17; adaptation

of message in 58–62; centrality of 62;

challenges for 57–8; competitive reference

effect 65–6; complications of 56–7; difﬁ cult

comparison effect 66–7; end-beneﬁ t effect

67–8; expenditure effect 70; fairness effect

72–3; price and value communication

58; price-quality effect 68–9; purchases,

economic and psychological values in 58–9;

shared cost effect 70–71; spreadsheet tool 63;

strategies for 62–72; switching cost effect 66;