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MARKET DRIVEN PRICING STRATEGIES Document # 565
Description: A controversial review of pricing
A Controversial Approach
The owner of an exclusive women's clothing boutique was experiencing a
financial crisis. Even though her sales were brisk, and all of the prominent
women in the community frequented her shop, the business was not profitable.
When the owner asked her local banker for advice, he told her to lower her
prices to stimulate sales, and he lent her more money. After two more loans
and two more price reductions, her business defaulted. At the time that she
closed her business, she was charging prices that earned her minimum wage
to create exclusive creations, one of which was worn to President Bush's
inauguration. Price: the key to
Another retailer was puzzled by the fact that his interim reports always showed
a profit, while his annual tax return showed huge losses. Initially, this business
owner thought that his C.P.A.'s were helping him by saving money on taxes.
What was really happening, however, was that his C.P.A. used an estimate of
50 percent for cost of goods sold (or a 100 percent mark up). In reality, the
retailer was only marking up 33 percent, so cost of goods were actually 75
percent of sales. Naturally, the annual audit for tax purposes reflected reality.
The retailer (who had opened a second location) thought that he had been
borrowing money to expand his business, but in reality, the increased loans
were used to cover operating losses.
How should small business owners determine the prices of their
goods and services? Many people simply do not know, which may
explain why pricing problems are so prevalent. The two business
owners described above and many others have experienced great fi-
nancial losses that were directly related to their pricing strategies.
In this article, two traditional pricing methods that do not work well
for small businesses will be discussed. Next, two market-driven
strategies that do seem to make sense for small businesses will be
presented. The first is fairly well-known and has a solid reputation. The second
is a new idea that is being presented for the first time in this article.
Why "Selling it Cheaper" Doesn't Work
The first of two ineffective strategies is the "I can do it cheaper" strategy. Why
do so many small business owners confuse low pricing with proper pricing?
Maybe the answer is because it appears as though the easiest way to attract
customers is by offering low prices. Perhaps another part of the answer has
to do with the fact that low prices often work well for big businesses, and a
distinction is not made between big and small businesses.
We have all seen small retailers go out of business after trying to compete
with Wal-Mart or K-Mart on price. Harvard's Professor Michael Porter,
author of Competitive Strategy, tells us that "The presence of economies of
scale always leads to a cost advantage for the large-scale firm...over small-
scale firms ... (page 15)."
So why do so many small businesses charge low prices anyway? Porter
Use the Internet to compare says that small business owners "may be satisfied with a subnormal rate
competitor’s pricing. For of return on their invested capital to maintain the independence of
general information on self-ownership, whereas such returns are unacceptable and may appear
pricing strategies, try the irrational to a large publicly held competitor (page 19)."
following Web sites:
Let’s approach the critical question of "Why can't a small-business com-
http://www.toolkit.cch.com/ pete on the basis of price?" from another angle. This angle looks at it from
the broader perspective of strategies for managing a successful business.
pubs.html Porter identified three different strategies that successful businesses
1. Offer the lowest price: Be the premier high volume, low-cost
producer and under-price everyone else.
2. Offer differentiation: Be a high-volume producer, but differentiate
your product by quality, design, or brand, and charge a higher price.
3. Offer a sharper focus: Be a specialist who focuses on one segment of
the market and caters exclusively to it.
These are three examples of what Porter called "generic business strate-
gies" and are market driven pricing strategies. In other words, in each of
these cases, the pricing strategy has to fit the market. Before you can deter-
mine your price, you have to decide whether you want customers to select
your product because you have the cheapest prices, or because you have
the best quality, or because you have the best selection.
As a small business owner, which of these three strategies should you
select? According to Porter, the first two strategies work only for high-
volume businesses. Those who wish to build large volume by predatory
pricing must have a bankroll which equals big business. Since it is almost
a contradiction for a small business (other than a franchise) to be a
high-volume producer who dominates a market, you are left with the third
alternative. Your goal, then, should be to focus on a specific market
segment and price accordingly.
To conclude this section: Low prices work for only those who have high
sales volumes. The rest of us have to rely on other pricing strategies.
Why 33 to 44 Percent Mark-ups Do Not Work
One of the worst collections of advice on pricing is found in some
federal government information packages where retail examples use
mark ups of 33 to 44 percent. It is true that many of the largest American
retailers average a 37 percent mark up on cost. However, half of American
retail establishments in 1987 were trying to survive on gross receipts of less
than $150,000. (Statistics of Income, IRS).
If a retailer with sales of $100,000 followed this advice, he or she would
have only $25,000 to $30,000 to cover rent, taxes, utilities, phone,
fax, computers, employee wages, owner's salary, employee overhead,
advertising and profit (assuming there are no stock losses, pilferage, mark
downs or discounts).
Any pricing strategy
Does that mean that we should respond by saying, "Obviously, this retailer
that ignores market forces
should increase sales"? No. We can't deny the fact that $100,000 in gross
sales is fairly realistic for many shops, when you examine the size of the is incomplete. In other
facility, the location, the product line and the clientele. Rather, the problem words, we need to ask:
is caused by the one-size-fits-all pricing formula, not by the sales revenues. What will the market bear?
Big business pricing strategies are not suited for small businesses.
Why and When You Should "Ride the Price-Volume Curve"
This pricing strategy works especially well for the small businesses that
produce unique durable goods. (Durable goods are products that you don't
consume often, as opposed to non-durable goods, such as milk, shoes and
paper. "Unique" goods are products that may be protected by a patent or a
copyright, such as computer software, compact discs, art work, and "how
to" video tapes. Often, academics use the term "monopolistic" instead of
"unique," which means that the product is so unique that it has a monopoly
on a certain quality or feature.)
Often, unique durable goods have a relatively short marketing life. Either
the information is timely and/or the objects may be perishable or subject to
fads. Basically, the idea is this: Start with a high price, and gradually
decrease the price by calculated increments. Here's an example which will
illustrate exactly how to do it.
Harry Hypothetical of Hypothetical, Inc. has developed a new product,
called Dubegude. The Dubegude has a variable cost of $30 and Harry is in
the process of trying to price the product.
First, let's come to an agreement on our definitions of "fixed" and "variable"
costs because they are an important part of this formula. Fixed costs are
constant regardless of the volume sold. Rent is a good example of a fixed
cost. To a certain extent, product liability insurance depends on sales
volume so it is not constant at all sales levels. Variable costs increase in
proportion to the number of units sold. Raw materials and direct labor are
obvious examples. If a business must borrow money to build inventory to
increase sales, interest could be a variable cost.
Let's say that Harry Hypothetical hired a marketing firm that takes into
consideration market forces. First, the marketing firm developed a best
guess at the price-volume relationship, which is shown in Figure 1. Price
volume relationships can be developed by surveying the prices of potential
competitors and estimating their volume or, in the case of a new product,
test marketing in various locations at various prices and noting customer
As expected, the highest volume is at the lowest price and the lowest
volume is at the highest price. Based on fixed costs of $250,000 and
variable costs of $30, the marketing firm calculates the profit at various
prices and the corresponding sales volume. The maximum profit is
$130,000 at a price of $125 and a sales volume of 4,000 units. (See Table
This method yields higher profits than those derived from mark up
calculations, but it does not yield the maximum profits—yet—because
you haven't taken full advantage of the price volume curve developed in the
What if we sold 2,000 units at $150, and then lowered the price to $125?
We would expect to sell 2,000 additional units. (It would be 2,000 units
instead of the 4,000 listed on Table 1 because we can assume that 2,000
units had already been sold.) As we continue to lower the price to sell more
units, we can accumulate profit from higher priced sales.
Table 2 shows the cumulative sales volume as we lower the price and the
calculated profits. This is called "Riding the Price-Volume Curve." The
profits are 154 percent higher from this method. If we had simply charged
$125, and never altered the price, profits would be $130,000. But, by
starting with $150, and lowering the price by increments to $60, our total
profits would be $330,000.
In addition to higher profits, "Riding the Price-Volume Curve" has several
other advantages. Because sales volume will be lower at the start of the
campaign, time and personnel are available to insure high product quality
and to resolve all customer complaints. For a new product introduction, this
method of pricing also allows accelerated recovery of research costs before
competitors enter the market and prices are driven to unreasonably low
Also, keep in mind that consumers are much more amenable to a price
reduction than to a price increase. If they are already attracted to the product
because of product features or promotional activity, a price decrease might
stimulate a purchase decision. A price increase, on the other hand, in the
absence of excessive inflation will usually force consumers to re-evaluate
their purchase intention.
For consumer durable goods where the price volume relationship is well-
defined, market-driven pricing can be an exact science that maximizes
profits for the business. Does this strategy work for consumable goods (in
other words, products that you need to purchase often)? The answer is no.
Volume developed with
Pricing consumable goods is not as simple. The objective is to develop a
a low introductory price
loyal customer who will purchase the product on a frequent basis. A high
can also be misleading.
price may give people negative feelings about a new product, particularly if
Consumers may purchase
the price is only slightly high. Consumers will rarely admit that they hate a
the product when the price
price which is only slightly high. They focus discontent on other product
is low and switch brands
features, such as color, style, flavor, etc.
when the price is increased.
In high-level decisions of
consumer durable goods,
Price Demand Revenue Fixed Variable Profit price is only one of
Costs Costs many product attributes
$60 7,000 $420,000 $250,000 $210,000 ($40,000) considered. In low-level
decisions, such as milk,
$80 6,000 $480,000 $250,000 $180,000 $50,000 butter, beef or eggs,
price may be the only
$100 5,000 $500,000 $250,000 $150,000 $100,000 consideration.
$125 4,000 $500,000 $250,000 $120,000 $130,000
$150 2,000 $500,000 $250,000 $ 60,000 ($10,000)
Unit Price Potential Already New $ Sales
Sales Sold Sales
(1) (2) (3) (4) (1 X 4)
$150 2,000 0 2,000 $300,000
$125 4,000 2,000 2,000 $250,000
$100 5,000 4,000 1,000 $100,000
$80 6,000 5,000 1,000 $80,000
$60 7,000 6,000 1,000 $60,000
Total Sales $790,000
Fixed Costs $250,000
Variable Costs (7000 x $30) $210,000
Total Profit from Sale of 7000 Units $330,000
A New Approach to Pricing: Boyd's Rule
How should you price consumable goods? Let's use as an example, a small
winery. Let’s look at what was done, and what should have been done.
The winery opened in 1972 at the start of a boom in small boutique
Boyd’s Rule—a new wineries. It was located in New Jersey, 50 miles west of New York City
approach to pricing and 50 miles north of Philadelphia. The timing and location could not have
and named after the been better, and publicity for the winery generated over 100,000 visitors a
author of this article, year.
John A. Boyd.
To determine the price, an investigation of the other state wineries found
A. Two wineries sold wine at $1.00 to $1.50 per bottle.
B. Two wineries sold wine at $1.75 to $2.00 per bottle.
C. One winery sold wine at $2.50 per bottle.
D. One winery sold wine at a broad range of prices: $2.00 to $5.00 per
bottle. They sold very little wine at the five-dollar price.
The next step in the pricing decision was to bring in an outside accountant
to review our costs and recommend a price. The accountant reviewed our
projected variable costs and found that each bottle cost about 35 cents to
produce. He recommended a predatory pricing policy in order to gain a
good share of the regional market. So, assuming that mark-ups were a rea-
sonable 200 to 300 percent, the winery opened with prices of $1.00 to
$1.50 per bottle.
At the end of the first year of sales, the winery lost money. The account-
ant's solution was simple: borrow more money, expand operations and sell
greater volume. At the end of the second year, the winery had expanded
sales and had lost even more money. When the accountant offered the
same advice again, he was fired.
By the third year, the winery was in serious trouble. The gas crisis
curtailed tourists, who were the lifeblood of the winery. Interest rates
doubled, inflation resulted in escalating costs and the winery had built its
reputation on the basis of a good low-cost wine. Losses in the first two
years weakened the winery to the point that it could not survive the catas-
trophic third year.
The biggest part of the problem is that traditional accounting did not reveal
the true costs. For this winery, many so-called fixed expenses were truly
variable costs. Other expenditures, which we carried as capital investment,
were – upon closer inspection – really variable costs. In this case, insurance
was listed as a fixed cost. However, in order to expand, it was necessary to
purchase more equipment and raise inventory levels. Since insurance is
proportionate to both assets and sales volumes, the insurance costs rose with
the number of units sold.
In addition, the expansion was financed with borrowed funds, so interest
expenses also rose with our increased volume. Finally, the wine was stored
in wooden barrels which had a usable life that was approximately the same
as the inventory age of the wine that was stored in them. So, to sell more
wine, more barrels were purchased. When carefully tallied, the variable
costs were close to $1.00 or $1.50, while the accountant had calculated
them to be $0.35. Because of poor pricing, the winery could never make a
You have to know what your true variable costs are. The best advice in
finding your true variable costs is this: Look at each expense carefully and
ask yourself: If sales increase, would you spend more money in the area?
Obviously, raw materials and direct labor are variable costs but look at
other areas closely. Do you have to use the phone or your vehicle more to
increase sales? Will your utility bills increase with sales? Will you have to
spend more in advertising? Will product liability increase as you sell more
product? Anytime you answer yes, the item is a variable cost. As previously
mentioned, if you borrow money to expand, then interest is a variable cost.
If the owner expects to increase his salary as sales increase, it should be
considered a variable cost.
At this time, the author would like to present his pricing formula:
Boyd's Rule: For a small business, the price that maximizes profits is the
average of the company's variable cost and the ceiling price of the object or The ceiling price of an
service. Decreases in price (in the interest of expanding sales volume) object or service
will not contribute to increased profitability, unless the original price was is the highest price
incorrect. that is currently being
paid for an equivalent
This rule is built upon the assumption that small businesses cannot get rich product by an equivalent
by simply selling at the lowest price. Rather, the two most important fac- consumer with
tors are: the company's variable cost and the ceiling price of the object equivalent needs.
Let's return now to the case of the ill-fated winery. The ceiling price for a
regional winery in New Jersey in 1972 was established by a survey to be
about five dollars. It's very important, when determining the ceiling price of
your product or service, to record the going rates of products or services
that are truly equivalent. The ill-fated wine was clearly not in the same price
class as the wine that was being sold for $50 or $150 per bottle in the
"Wines of the World" store just a few miles away. (If you define your prod-
uct or service too broadly, you may make a mistake when determining the
ceiling price. Ask yourself, "Is this equivalent product or service meeting
equivalent needs of an equivalent consumer?"
As was discussed earlier,
the variable costs of the Now, to put Boyd's Rule into motion: $1.00 (variable cost) + $5.00 (ceiling
wine were originally Price) / 2 = $3.00 (Price which maximizes profit). Even if we use the
estimated to be $0.35 erroneous variable cost of $0.35, the calculated price to maximize profit
and later re-calculated would have been $2.68.
to be $1.00.
At the same time that the winery was getting into trouble, three other
wineries opened in the area, and priced their wine at $2.50 to $3.50. All
three survived and eventually prospered.
Reliable Auto Repairs—Case Study 1
Let's turn to a situation where an extensive capital investment is required for
the delivery of a service. Jim Smith is considering purchasing Reliable Auto
Repairs, which would require a large investment in a garage and tools. He
would like to earn a living and get a reasonable return on his investment.
What would his variable costs be based on? Once again, it would be the
replacement costs on his labor because once Jim spends the money, it
becomes a "sunk cost" which he cannot expect to recover by altering prices.
The public does not care if Jim spent $5,000 or $5 million on his garage;
they are buying a service and expect a certain amount of quality and
technical competence. They also have an expected price for the service. If
Jim's price is high because he is trying to recover a big investment, people
will not use his service. Also, once the investment is made, debt service or
expected return on investment is fixed and will not vary if Jim works one
hour or two thousand hours per year. Thus the initial investment is not a
variable cost and has no impact on the price which maximizes profit. This
concept is consistent with results obtained by marginal analysis.
The ceiling price would be determined by the results of a survey of similar
auto repair shops in the region. Assuming that at least one shop in the area
charges a high price and is under utilized, the survey should indicate what
the highest going rates would be.
Jim Smith would then add his variable costs to the ceiling price and divide
by two to see what his maximum prices would be. If the rates allow a
decent living and a good return on his investment, then purchasing the
business may be a good idea.
We should note that the optimum price just calculated does not guarantee
that Jim Smith will work 2,000 hours per year at that price. It does, how-
ever, mean that any attempt to lower the price to increase volume will result
in a lower contribution to overhead and an effort to increase the rate will
result in fewer hours worked.
Video Store—Case Study 2
Let's take a look at another example. An owner of a video store asked for an
examination of his pricing strategy. The major studios are publicly stating
that home viewers will pay more than current prices for the big hits and
therefore they are charging shop owners more for the big movies.
In the store owner’s local market, there are nine stores serving 18,000
households and all but one charge $3.00 for a first run video and $2.00 for
older titles. The one other store charges $1.50 for all movies.
What would the ceiling price be? You may be tempted to think that the
price would be $3.00, which is the highest going rate. And, it's true that
most stores do charge $3.00 while the title is on the Billboard Top 40
Rental List – even if the tape is 60 or 90 days old.
However, real movie buffs would pay more than $3.00 – if the tape could
be reserved for them and if the tape really was brand new. It is conceivable
that the movie buffs would pay $4.00. However, it is improbable that very
many would pay more than $5.00. In this case, the ceiling price is $5.00
even though no one is currently charging it.
The wholesale price of a major hit is about $70 and at the end of a month it
can be sold for $20. Thus, the cost is around $50 for the first month, which
is $1.67 per day. The average of the cost ($1.67) and the ceiling price
($5.00) is $3.33. In this case, there is not a sufficient difference to alter the
price from the prevailing custom.
However, you might point out that a new smash hit video is a lot like the
unique durable goods that we discussed earlier. You're right. If you use the
strategy of "riding the price-volume curve," it may be possible to charge
$4.00 for the first two weeks that a tape is in the store if you cater to those
who would pay more for new tapes (and especially if you added the service
of reserving the tapes.)
The only time the combination of riding the price-volume curve and Boyd's
Rule will work is when you are dealing with a unique durable good like a
video. The objective from riding the curve is to maximize cash flow for the
product as quickly as possible, and the final price selected by Boyd's Rule
yields the maximum long-term profit. It should be obvious from the
previous examples that Boyd's Rule can be used to price durable goods,
non-durable goods and services.
Perhaps another example of a mixed pricing strategy is in order. Let us
consider an obvious innovation of the next generation, three-dimensional
Homeowners have a track record of what they are willing to pay for
home-entertainment centers. When VCRs were introduced to the public,
homeowners willingly paid over $1,500 in current dollars. Also, they paid
as much as $5,000 for a big screen TV, but sales were not significant until
the price dropped below $3,000. Hence, it would appear that the ceiling
price for a home-entertainment center is around $5,000 and if we assume a
variable cost around $1,000, Boyd's Rule price for maximum profit is
around $3,000. What then should be the introductory price?
Consider all of the possibilities for such an item. Bars, meeting and seminar
centers and businesses paid much higher prices for big screen TVs. Perhaps
the market would support an initial price of $20,000 to $50,000. However,
at least one market could absorb a price above $1 million. That is for major
medical centers and research institutions.
Most people would agree that doctors observe and be refreshed on rare or
unusual procedures, particularly before they operate on us. A library of
three-dimensional procedures would allow the doctor to view the procedure
from any angle. Major medical centers are already paying million dollar
prices for critical equipment, so the price is not out of line. Sales to this
industry would be slow and allow further development of the technology
before it hits the mass market. Meanwhile, the cash flow would allow rapid
recovery of the development costs. Also, limited sales allow time for
dedicated customer service to debug the system.
As sales to major medical centers dry up, the price could be reduced to
stimulate other hospitals or industries to purchase the equipment. So long as
patent protection keeps a monopoly, the price reduction phase could take 17
years. This business would be among the most economically strong
companies in the nation. In this example, it does not matter that the variable
costs are $1,000 or the ceiling price for consumers is $5,000. The product
has so much potential with business customers, that the ceiling price should
be tested at almost every level.
To see real life parallels of this example, explore the origins of Microsoft,
Lotus and WordPerfect who sold programs for several hundreds of dollars
despite the fact that the variable cost to reproduce (pirate) a copy was less
than a dollar. This is approximately the same ratio of selling price to cost
used in the example just covered.
Two specific market-driven pricing strategies were discussed in this paper.
Both of them can be used to develop the actual price for an item even in the
absence of market information on the price-volume relationship. In the case
of a monopolistic durable good, it is possible to maximize profits by
starting high and then reducing the price even in the absence of cost
reductions and competition.
Boyd's Rule is applicable in pricing non-durable goods and services. One
very important feature is that the optimum price only depends on variable
costs and the ceiling price for an object. Destructive competition may
reduce the ceiling price, and variable costs may change, but the optimum is
not changed by fixed costs or any other factors. Decreases in price will
never contribute to increased profitability from expanding volume unless
the original price was incorrect. Once the optimum price has been selected,
the only way to increase profitability is to concentrate on marketing and
promotion and maximize sales at that price. If a company is truly successful
in their marketing, it is theoretically possible that the ceiling price will rise
and therefore, price increases will lead to increased profitability.
Many small-business owners operate under the delusion that they can be
successful by selling their product at a lower price than anyone else. The
analysis by Porter suggests that this will only work for large companies who
dominate a market. In this analysis, some advantages of market-driven pric-
ing strategies which focus on maximum profits have been demonstrated.
The intent was to demonstrate that there is high profit potential for small
businesses who differentiate their products and then price accordingly.
Once the significance of market driven pricing strategy is more widely
understood, pricing strategy will become one of the most important
The author would like to thank his marketing students at the University of
the Virgin Islands who consistently ask a very basic question, "How do you
choose the best price?" The thoughts contained in this article are from the
author’s lecture notes which attempt to answer that question.
Author: John A. Boyd, Virgin Islands SBDC
Source: Small Business Forum
This information is provided by:
Wyoming Small Business Development Center
P.O. Box 3922
Laramie, WY 82071
Phone Toll-Free: 800-348-5194
FRED toll-free number 1-877-700-2220
SBDC website: www.uwyo.edu/sbdc