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  1. 1. FRED (Fast Resources for Enterprise Development) MARKET DRIVEN PRICING STRATEGIES Document # 565 April 2002 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 profitability 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? 1
  2. 2. 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- 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 have used: 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. 2
  3. 3. 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 3
  4. 4. 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 response. 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 1.) 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 market survey. 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 levels. 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 4
  5. 5. 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. Table 1 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) Table 2 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 5
  6. 6. 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 the following: 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. 6
  7. 7. 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 profit. 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. or service. 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 7
  8. 8. 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- 8
  9. 9. 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 9
  10. 10. holographic video. 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. Conclusion 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 10
  11. 11. 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 pre-venture considerations. Acknowledgment: 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: 11