Session 10

1. Pricing
Innovation, Entrepreneurship & Design Toolbox
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2. • Businesses often price a product offering based on
 Cost plus pricing – determine a unit cost, then add a percentage mark-up
 Competitive pricing – trying to beat or undercut competitors’ value offering
• However, optimal price depends on product’s perceived value to the customer
• Price also affects perceived value
 Under-priced products may be perceived as low-value/quality and actually
attract fewer customers than a higher price would
• ‘Value pricing’ is usually more appropriate for new/innovative products
 though cost must be reviewed to check that your business will be financially
viable!
• Revenue models also affect perceived value and determine pricing
Entrepreneurial Pricing and Revenue
models
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3. • Examples:
• Sales
– List price
– Customer determined pricing:
• Auction (e.g. eBay)
• match customer-stated price for a type of product, to a specific product in that range (e.g. Priceline.com)
• Rental/leasing
• Franchising
• Licensing – IP or software product
– Offer use of (software) product plus technical support for periodic licensing fee (e.g. SAS)
– License the use of a patent to another producer
• Open source – dual licensing
– Offer (software) product free for personal use, build a community of users, then charge for any commercial
use
• Website content/advertising
– offer free content to attract users and sell space to advertisers (e.g. Google, newspaper sites)
• Subscription (e.g. magazines, premium/specialist online media - FT.com and WSJ online)
Which of these models can unlock the most value for your business and for your buyer? (What
is your customer’s likely preferred way of using/paying for your product? Can it be profitable for
you? – Use your Entrepreneurial Market Research)
Revenue models
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4. Cost-Plus Pricing -
Determine a unit cost, then add a percentage mark-up
• With Marginal (aka ‘variable’) costing
Price = (1 + m) (variable cost per unit)
• With Average costing
Price = (1 + m) (Average Cost per unit)
• m is the percentage markup over cost
(markup is different from margin!!)
• variable costs are costs tied to the number of product units produced (e.g.
materials, manufacturing, etc.)
•average costs include variable costs plus allocated fixed costs (overheads)
e.g. cost per unit = £100; with 80% markup, price = £180
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5. • Simplicity
- Easy to use, manage, and implement
• Easily justifiable
– Based on “hard” cost data, which managers usually feel they know well
• Sometimes required by the Government
(e.g., aerospace industry)
Arguments For Cost-Plus
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6. • Market and demand conditions never enter the model
 the product’s value as perceived by customers is not considered – you might
under- or over-price with respect to customer demand
• Unit or average cost varies with price
 Price affects demand and the volume sold
 Volume then changes the average cost of production
 Volume may also change variable costs (e.g. bulk orders of raw materials are
cheaper)
• Average costs are not relevant costs
 Only incremental and avoidable costs are relevant
 Pricing decisions should never be based on truly fixed costs, because these
are not influenced by price or volume
Arguments Against Cost-Plus
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7. Cost-plus uses
Because of its simplicity, Cost-plus is usually used in
corporate environments, where a lot of overhead
resources are already in place.
Start-ups have to minimise overheads and maximise
revenue, so Value Pricing is more appropriate.
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8. • Economic Value to the Customer (EVC)
 A good way to get started for new products and ventures
 Provides valuable input to the selling process for any product or service
• EVC can help to
 Identify segments
 Determine the feature improvements that bring the largest gain in EVC
• EVC analysis can help determine whether
 Product is overpriced
 Product is under-appreciated
Value Pricing
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9. Step 1: Identify the cost of the competitive product or best available substitute
process (i.e., the benchmark or reference value)
Step 2: Identify all factors that differentiate the new product from the reference
product or substitute process (+ or - , objective or subjective)
Step 3: Determine the economic value to the customer of the differentiating
factors
Step 4: Sum the reference value and the differentiation value to determine the
total economic value to the customer
Top –Down: Calculating Economic Value to
Customer
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10. Miracle Shield Auto Finish – Consumer EVC
Miracle Shield Auto Finish is a substitute for wax, but it protects and maintains the shine of
a car’s finish at least 20% longer than regular car wax. Regular car wax is sold in a
container that is enough for two applications, costs about £4.00 / container.
About half the cars have oxidized paint (no shine) at the time wax is to be applied,
requiring cleaning with an oxidation cleaner before one can apply regular wax. Oxidation
cleaner costs £2.50 per bottle (good for one application) and can be applied in about the
same time required to apply regular wax (about two hours).
The advantage of Miracle Shield is that it removes the oxidation and shines the car’s
surface in one step. Consequently, Miracle Shield can be applied directly to a car’s
surface that is already highly oxidized.
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11. Miracle Shield Auto Finish EVC
Segment 1
Oxidized Cars
Segment 2
Non-Oxidized
Cars
REFERENCE VALUE
(£4.00 or £2.00 per application) £2.00 £2.00
DIFFERENTIATION VALUE
Savings from not cleaning
Oxidation Cleaner £2.50 NA
Labor Savings of 2 hrs (£5.00 / hr) £10.00 NA
Improved performance
Savings in labor (20% of £10.00) £2.00 £2.00
Savings in wax (20% of £2.00) £0.40 £0.40
TOTAL ECONOMIC VALUE £16.90 £4.40
There are two segments relevant
for determining the EVC
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12. The approach does not provide a definite price but it bounds the pricing problem
• Customer value provides a ceiling
• Variable costs provide a floor
Usually price set < EVC for a new product
(a substantial “inducement” to try the product is usually required)
What degree of inducement is warranted?
• Assess value relative to competitive benchmarks
• Is there potential competitive entry or reaction?
• Will there be large cost experience effects?
• Assess price sensitivity qualitatively
EVC in Practice
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13. Setting Upper and Lower Bounds
Economic Value
Variable Costs
Reference
Product
Perceived
Value
Differentiating
Value
Price
Contribution
Margin
Possible
Intervention
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14. EVC in Practice (cont.)
Business
Markets
•Usually possible to determine EVC
objectively (product or services associated
with financial savings or increased revenues)
• For some products and services value is
not directly associated with clear benefits
(e.g., consulting, advertising, or auditing)
Consumer
Markets
• In most cases value is less tangible
• Difficult to determine EVC objectively
(unless there are clear cost savings for consumer)
• Rely on inferences from similar products
or choice-based research
(most cases use perceived value and WTP, not
actual value) Copied with permission from
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15. • Value to customer is generally based on
• Value of product
 (benefits of using the product – cost savings, higher sales, etc.)
• Value of supplier
 (timely fulfilment, technical support, extras)
• Cost of switching from currently used product
 (not just price of new product, but staff training, transition-related costs, etc.)
• Revenue model
 Customer may prefer a lease, license, or other model to an outright sale
 Your model might find a way to ‘share’ the financial benefit to the customer,
e.g.: you might offer a somewhat higher price than a competitor but include
added services which will lower customer’s other costs, and which are
cheaper for you to provide than for the customer to have in-house
Determining EVC in a B2B setting
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16. Goals:
• Find a target market price and make sure your costs leave an acceptable profit margin
• Estimate the price/volume relationship likely to yield most profit (see below)
• Look for a win-win situation: where buyers perceive higher value than competing products, and the entrepreneur
makes a higher profit thanks to the extra value delivered.
• Avoid leaving money on the table!
Setting an optimal price
Price/unit Units sold @ price Revenue Cost
(£50/unit)
Contribution
(towards fixed costs
and profit)
£100 5000 £500,000 £250,000 £250,000
£150 4000 £600,000 £200,000 £400,000
£200 2500 £500,000 £125,000 £375,000
Also make sure the contribution can cover your fixed costs (overheads) and
also leave a profit!
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17. During your Entrepreneurial Market Research (‘preferred witnesses’)
• Survey and estimate value of benefits your product will create for customer
• Find out about preferred business models (buy, rent, license, etc.)
• Include questions about price
During your later Market testing, e.g.
• Focus groups – for a hypothetical idea only
• In-Market sales testing – observe customers in a real purchasing situation
 Direct sales – telephone, trade fairs, special events, shops
 Web sales – if properly advertised (banner ads, sponsored listings) a web
site can create a high volume of sales traffic in a short time and provide a
fast, cheap market test for certain products
Bottom-up: Verifying Economic Value to
Customer
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18. • Avoid asking a customer to express a preference between several possible prices –
this is not reliable.
– Start with the higher price you are considering, and if they reject it work your way down.
• Set up a market test (direct or online) where you offer a set number of prices, but only
one price to each customer (e.g. three prices, three sets of customers, each 3rd
customer is offered price no. 3); compare buy/reject responses.
• If you are in a market where customers are likely to communicate and discover (to
their dismay) that they were offered different prices, you can
 Use different points of sale and/or product names to run several tests
 Offer a customisable product, where different combinations of optional
components lead to different prices, e.g.:
(product(s) + technical support + servicing) x the number of licence users.
Even if you change the component prices it is harder for customers with
different purchasing plans to compare.
Bottom-up: ways to survey potential
customers on price/volume
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19. • Lodish, L.M., Morgan, H.L. and Archambeau, S., 2007. Entrepreneurial Pricing.
Marketing That Works. New Jersey: Wharton School Publishing, Ch. 3.
References and further reading
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