Month: February 2009

The first step to marketing is determining how products and services create value for customers. Value can vary between customers.

Value
Value is the total savings, monetary gains, or satisfaction that a customer receives from using a product or service.

The difference between this value and what people actually pay is called “consumer surplus.”  People often won’t pay for the entire value of the product because they know that the price charged in the market is less.  The price charged in the market is called the economic value.

Reference Value is the price of the customer’s best alternative or substitute for a product or service.

Differentiation Value is the economic value placed on the difference between a product or service and its best substitute.  Remember that perceptions can be the cause of the differentiation value.  This often makes differentiation value hard to estimate since its difficult to measure the subjective value of unquantifiable benefits.

Total Economic Value is the reference value plus the differentiation value.

Economic Value Estimation ®

Economic Value Estimation ® (EVE) is the process of measuring Total Economic Value. Graphically, the process looks like this:

(This picture was taken from http://mgmtblog.com).

The EVE for a product is not always what the consumer perceives the value to be. Some reasons are:

• The consumer may not know about the differentiating features of the product and doesn’t want to spend the time to find out.
• The brand image may convince the consumer that some product is worth more than the EVE.
• The customer may not be too picky about getting the most for her money.

Therefore, EVE only provides a good estimation of the maximum amount that can be charged for a product, assuming that consumers recognize all of the value that the product provides. If a product is under priced compared to its EVE, a good solution is to maintain or slightly raise prices while engaging in an aggressive consumer education campaign.

EVE is not the same for each consumer. That’s why price segmentation is beneficial, if possible.

The relationship between prices and economic value delivered can differ depending on circumstances. For example, new products usually must be priced below economic value to encourage people to try them. The opposite may be true for existing products with existing customers since consumers may not be motivated to switch. Or, perhaps, consumers don’t even care too much about determining economic value. This attitude of indifference toward price leads to a price premium called a regulation premium.

Its important for a firm’s sales force to use EVE so that they and the are focused on value of each part of an offering rather than on “price.” When there is price resistance, EVE can be used to present the customer with a less expensive alternative with fewer features. EVE can also be used to price segment among groups of consumers who need different bundles of features.

There are no shortcuts for estimating EVE. The steps for estimating EVE are:

1. Study Customer Economics – Study customers’ objectives and their “next best competitive alternative.” The next best competitive alternative’s price is the reference price.
2. Quantify Value Drivers – Customer depth interviews are the best source of information. The most important piece of information to try to obtain is the value driver algorithms. What does the consumer’s economic model say about the kinds of things that drive value?Note that its critical to do a good approximation about what drives consumer value rather than trying to do a complex calculation yielding an exact, but meaningless, number.
3. Estimate Differentiation Value – Estimate the impact of the product on the marketplace by estimating the monetary value that consumers give to it above and beyond the value they give to the reference product. Remember that this can be positive or negative since a particular product is seldom better in all respects.Needless to say, the sum of all of the differentiation attributes must be positive in order for a product to sell at a higher price than a competing product. When trying to determine differentiation value, be sure to use equivalent units when asking the consumers to compare a product with a reference product. For example, two units of a firm’s product may replace three units of the reference product. It is important for consumers to be aware of this when their attitudes are surveyed.Use the estimate of differentiation value and the quality value drivers to build the economic value model.

A common problem in marketing communications is documenting the economic value. For example, an advertiser might look at the total circulation of a publication and purchase advertising based on cost per customer reached. In reality, she should be looking at the cost of reaching the kinds of customers that she really wants to reach, how long they spend reading the publication, etc. To convince the advertiser to purchase advertising space, the publication may have to learn a significant amount about the advertiser’s business so that the price differential between its prices and those of other magazines can be justified.

Commodity products are essentially identical products that are offered by more than one manufacturer. A good example is a cheap portable radio. There is no differentiation between products. Since there is perfect competition in commodity markets, prices will be set very close to the actual economic value of the product.

Consumer Value Modeling (CVM)

CVM relies on customers’ subjective judgments about price and attribute based performance. CVM assumes that consumers look for products that give them the most benefit for the money and time invested in using it. It rates various product strengths or weaknesses according to the weight that the consumer puts on them. Then, CVM tries to create an average linear relationship between price and perceived value for the attributes.

Consumer Value Modeling emerged from the TQM movement. Companies tried to use it to measure and deliver superior quality at a competitive price. The problem is that people may be willing to pay for a particular attribute of a product or may be willing to pay for combinations of attributes. Each consumer is different.

The biggest problem with CVM is that it underestimates the value of significantly different products for people who are willing to pay premiums for combinations of attributes. On the other hand, it also overestimates the value of products that are similar to each other.

All firms set prices for their products. Poor pricing is easy. But, pricing well is very difficult. Proper determination of product pricing requires knowledge, preparation, and insight. Good pricing separates top executives from the pack.

The four P’s of marketing are:

1. Product
2. Price
3. Placement
4. Promotion

Pricing is the most important. The reason is that the other 3 P’s all deal with creating value whereas pricing is method for capturing value. Bad pricing decisions decrease the effectiveness of product, placement, and promotion.

A firm’s environment costs of:

1. Costs
2. Demand
3. Competition
4. Antitrust/Legal

Slotting Allowance

Slotting Allowance is money that a firm gives to a retailer for the privilege of putting a product on the store shelf. The amount of money spent on slotting allowances alone is more than all of advertising and consumer promotion expenditures, such as coupons, combined.

Smart Cards

Many stores, especially grocery stores, use smart cards to track a customer’s purchasing behavior. A customer is encouraged to scan her cards each time she makes a purchase. The retailers collect purchasing data into a database with her name, all of the purchases she’s ever made, and what kinds of coupons she uses. This information can be used to determine price sensitivity and can be used to create targeted pricing schemes. In theory, the data can be used to charge different prices to different individuals for the same product. One supermarket chain in California is doing this. There is a kiosk in supermarket which displays customized special offers when the smart card is inserted. Another retailer has a terminal display on the shopping cart itself where a customer puts your card in the slot. The cart buzzes if it wants her attention. For example, it might tell her that she will get 25 cents off the cookies she just passed.

Profit Maximization – Raise Prices or Increase Market Share?

Consider the following situation:

A soap manufacturer has annual sales of 100000 units. The selling price is $1 per bar. It costs $30000 to set up a factory to make soap, and it costs $0.60 to make each bar.

$3000 are fixed costs and $0.60 are variable costs. Fixed costs do not change as more bars are made. But, variable costs increase each time the firm makes another bar of soap. The profit of the firm is:

 

Profit = (100000 bars)*($1 per bar) – $3000 – (100000 bars)*($0.60 per bar)

 

= $100000 – $30000 – $60000

= $10000

Would the firm be better off if sales were increased by 1% (1000 bars) or if, instead, the price were increased by 1% ($0.01)?

Profit for 1% Increase in Sales = (101000 bars)*($1 per bar) – $3000 – (101000 bars)*($0.60 per bar)

= $101000 – $30000 – $60600

= $10400

Profit for 1% Increase in Price = (100000 bars)*($1.01 per bar) – $3000 – (10000 bars)*($0.60 per bar)

= $101000 – $30000 – $60000

= $11000

This example can be extended to firms in general. A study by McKinsey and Company based on average economics showed that, on average, a 1% increase in a product’s price cases a 11.1% increase in profits. But, a 1% increase in sales, on average, only results in a 3.3% increase in the firm’s profit.

Some Easy, but Poor Ways to Set Price

Firms often use these easy techniques for setting price; but they result in foregone profits:

• Cost-Driven Pricing

• Customer-Driven Pricing

• Competition-Driven Pricing

Cost-Driven Pricing

Firms engaging in cost-driven pricing set prices based on their costs and profit objectives. Cost-Driven Pricing is sometimes called “Cost Plus Pricing.”

A firm typically puts a significant amount of money upfront into product design. Then, the engineering team turns the product design over to the manufacturing team which determines how to produce the product at a cost that will be at least marginally profitable. Next, the finance team is asked for determine, based on per unit cost and markup, what the product selling price should be. Finally, the marketing and sales group is tasked with sell the product at the cost that has been predetermined. Here is an Example of Cost-Driven pricing:

A firm has a product which has a marginal cost of $3 per unit. This marginal cost is constant regardless of the volume produced. The fixed costs for setting and remaining in production are $4.5M.

The per unit cost is $3 per unit plus ($4.5M / [Number of Units Produced]). Obviously, the per unit cost decreases as the number of units produced increases.

Many companies get around the lack of a static unit cost by artificially setting a desired production rate. So, let’s assume that this firm decides it wants to sell a million units. Then, the price per unit is:

Price Per Unit = $3 + ($4.5M/ 1M) = $7.50

The firm wants to make a profit of $1.50 per unit. So, it will try to sell the product for $9.

But… Will customers really pay $9 for the product? What are competitors charging? The sales number of one million units is totally made up!

What if the firm is only able to sell 750000 units at $9 each? It will only break even. That’s obviously not the desired outcome. Does the firm raise price? Lower the price? It would need to know what the demand curve for the product looks like in order to answer these questions. Otherwise, there’s no way of knowing what the effect of changing the price will be.

The problem is that Cost-Driven Pricing gives an apparent sense of objectivity to the price. The price is not objective.

A Cost-Driven Pricing scheme ignores customers. It fails to capture customers’ additional willingness to pay. The firm has no idea about what customers are willing to pay – if they’re willing to pay anything at all!

Another problem with Cost-Driven Pricing is that it ignores competitors. Competitors could be charging a lot less for similar items.

Cost-Driven Pricing usually results in charging one price to all customers. A one price fits all philosophy is often not a good practice because the firm cannot engage in price discrimination.

There are advantages to this pricing scheme. Its easy to understand and implement. If it works, the firm will have cover all of its variable costs and, in addition, the markup should cover some of the business’ general administrative costs. A decent return on investment will result.

These disadvantages of Cost-Driven Pricing outweigh the advantages.

Customer Driven Pricing

The problems with Cost Driven Pricing can be avoided by asking what price that customer is willing to pay. Then, the firm charges the maximum price that the customer is willing to pay.

There are problems with Customer Driven Pricing too. First, Customer Driven Pricing ignores the competition. And it ignores the costs of making the product.

Customer Driven Pricing is particularly poor for pricing a new product because customers don’t know how much they like it or how much value they place on it. Lastly, if customers know this is how a firm is setting prices, why would they tell the firm what they’re willing to pay? They have no incentive to tell the truth.

Competition Driven Pricing

Competition Driven Pricing focuses on what the competition is charging.

Problems with Competition Driven Pricing:

• Price wars can result.
• Competition Driven Pricing ignores costs. A competitor may have a whole different cost structure which allows them to make a profit at a much lower selling price.
• Ignores customer willingness to pay. The firm’s product may be better or worse than the competitors, making the customer willing to pay more or less for it.

Each of these strategies as positive points. But, none of them are optimal. Optimal pricing strategy takes in account costs, customers, competition, and the legal environment.