Chpt 01 boundaries of a good price

Tim J. Smith
Pricing Strategy: Setting Price Levels,
Managing Price Discounts, &
Establishing Price Structures
PowerPoint by
Tim J. Smith, PhD
Managing Principal, Wiglaf Pricing
Adjunct Professor of Marketing & Economics, DePaul University
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 1
Boundaries of a Good Price
Using Exchange Value Models to
Understand Price Competition and
Define Your Value Add

Agenda
• Who is involved in pricing decisions?
• Why is pricing so important to the health of the firm?
• Can firms influence their pricing power?
• What is the nature of a good price?
• How relevant are marginal costs and consumer surplus
in setting a good price?
• How should the comparable alternatives on the market
influence the pricing of a product?
• How can exchange value models be used to set prices?
• Stretch Question: How are exchange value models
related to market segments?

Pricing Errors Are Costly
• Too high
– Lost profits from lack of volume
– The price is eventually dropped and the company must fight for market
interest and perception repositioning
– Potential allegations of price gouging and unfairness, leading to public
relations and regulatory ramifications
• Too low
– Forgone profit in an attempt to gain volume which may not come
– Incorrectly set expectations for the product category, making future price
increases being driven against a headwind of customer expectations
• Ultimately, lost profits, revenues, and a shrinking/irrelevant firm

Pricing Decisions are Stakeholder Decisions
• CFO
– Responsible for measuring and reporting performance
– Almost always involved in pricing decisions from a
quantitative analysis / forecasting perspective
– General bias towards higher contribution margins
• Sales & Marketing
– Responsible for promotion, product strategy, and
placement, along with pricing
– Almost always involved in pricing decisions from a
value positioning perspective
– General bias towards discounting and market share
• Research & Development
– Responsible for developing new products that
customers value
– Technical individuals often are challenged to
understand commercial aspects
• Production
– Responsible for quality, throughput, and capacity
utilization
– General bias towards volume to reduce overhead
allocation
• CEO
– Arbitrator between competing stakeholders
Executives
Customers
Shareholders
CEO

Value Exchange and Profit Capture
• Price is the value that the firm captures in a mutually beneficial exchange
with its customers
– Firm’s reason for existence is to produce value for customers, value which they
exchange for cash
– Customers purchase because they gain value from the product in excess of the
price they pay
• Profit
Profit = Quantity X (Price – Variable Costs) – Fixed Costs
p = Q (P – V) – F
Variable Costs (V)
Fixed Costs (F)
Volume or Quantity Sold (hence the Q)
Price (P)
Profit (p)

Marginal Improvement – Price Has Impact
• Consider a firm that improves one
of the levers in the profit equation
by 1%, holding all else constant
• Example:
– P = $5.00
– Q = 200,000
– V = $3.00
– F = $325,000
– Improve either P, Q, V, or F by 1%
– How does this affect profit?
• Initial Profitability
p = 200,000 ($5.00-$3.00) - $325,00
p = $75,000
• Fixed Cost Reduction
– New Fixed Cost = $321,750
– New Profit = $78,250
– Improvement of 4%
• Variable Cost Reduction
– New Variable Cost = $2.97
• Quantity Sold Increase
– New Quantity = 202,000
• Price Increase
– New Price = $5.05

Quantitative & Qualitative
• Quantitative Modeling and Price
Optimization
– Careful selection of model
– Careful treatment of data (cleansing)
– Careful market segmentation
• Qualitative Modeling
– Potential methods of influencing
willingness to pay
– Relationship to corporate strategy and
industry dynamics
– Customer acceptance to approach of price
discrimination
Finance
Marketing Sales
Economics
Price

Setting Prices with
Exchange Value Models

Boundaries of Price
• There is a range of “right prices”
– Range implies boundaries, upper and lower
• Extremes from standard economics:
– Marginal Cost is the Extreme Lower Boundary
– Consumer Utility is the Extreme Upper Boundary
• Example: Cypher Drug Eluting Stent by Cordis released 2003
– Drug Eluting Stent is a metal “spring” that fits within an artery. Once placed, it
expands the artery to ensure proper blood flow. Pharmaceuticals encoat the
stent to reduce acceptance failure.
– Upon release, the Drug Eluting Stent was considered a revolutionary
advancement in the treatment of coronary disease
• Evolutionary: Marginal improvement to the status quo
• Revolutionary: Breakthrough improvement to status quo, with potentially
dramatically different benefits gained.

Marginal Cost = Extreme Lower Bound
• Marginal costs are the sellers bottom line.
– Any price below marginal costs leave the seller worse off then they would be without the
transaction.
– Any price above it leaves the seller better off.
– Thus, marginal costs is the extreme lower boundary of the “right” price.
• Standard metal stents average unit costs are reported below $150.
• Drug encoated stents average unit costs are estimated at $325.
– Coating a stent with pharmaceuticals is not an expensive challenge adding only a few dollars per
stent, yet pharmaceutical companies routinely charge much more for the technology
– Average unit costs are not marginal costs, they are always higher, hence marginal costs are still below
this metric.
– Since marginal costs are the lower bound of the pricing challenge, using a higher number, the
average unit costs, adds extra caution in setting prices.
– This overly conservative approach is inappropriate for some pricing decisions.
• Should Cordis price the stent near variable costs plus a management acceptable margin of a
few percent?

Consumer Utility = Extreme Upper Bound
• Consumer utility are the buyers bottom line.
– The customer would be worse off if they paid more for a product than they gained
in utility
– Any price below consumer utility would be leave the customer better off than
going without
• What is the utility of a stent? What is the value of life?
– Life is exactly what is at stake with coronary heart disease: strain on the heart and
reduced life span, heart attacks and potential death.
– Some economists value a life under the assumption that it is equal to the future
earnings of the individual over their lifespan, discounted back to the present time.
– Yet economics doesn’t capture the value people will pay for one more day with
their spouse, seeing their children and grand children mature, and being able to
participate in life fully, attending weddings, baby showers, working and being
productive, taking vacations … etc.
– Some philosophers would claim that all life is equally valuable, and many would
claim its value is immeasurable.
– Accepting these limitations, lets make a very frugal and crude estimate that the
benefits delivered though using a stent is $500,000.
• Should Cordis price the drug eluting stent just below $500,000?

Marginal Costs and Consumer Utility
Extreme Boundaries
• From this example, we know only two
extreme boundaries,
– Bottom boundary of marginal cost
generously estimated $325
– Upper boundary of consumer utility
frugally estimated at $500,000
• Clearly, $325 and $500,000 is a wide
range, with the upper bound a factor of
1000 above the lower bound.
– $400
– $4,000
– $40,000
– $400,000
• Managers need a tighter bound than
this for decision making.
• Blunt force economics of producer cost
and consumer utility alone is
insufficient.
Consumer Utility
$500,000
Marginal
Costs
Price Floor
$325
Range of
Potential Prices
lies between the
Extreme
Boundaries

Competing Alternative and Differential Value
Narrow Boundaries
• Marketing Strategy
– Products are valued because they enable a customer to do
something, accomplish a goal, from that product.
– Utility is derived from Goal accomplishment
– Prior to the existence of the product, most consumers
found an alternative means of accomplishing the same
goal
• What are those alternatives?
• How much better can they achieve that goal, and perhaps others
simultaneously, from the product?
• Narrower band is defined by the competing
alternatives and differential value

Competing Alternatives / Substitutes
• Competing offers are often readably identifiable, and form a reference price.
– Reference Price = Price of nearest comparable offer
• Substitutes are sometimes more challenging to identify, but they always exists.
– Substitutes: any alternative means of achieving a similar set of benefits
• When possible, use more direct competitors to consider when modeling price decisions
• For Cordis
– Cordis produced a standard stent, priced roughly at $1050 per unit.
• Standard stent procedures resulted in restenosis (re-clogging of the artery) 25% of the time
• The Drug Eluting Stent by Cordis reduced restenosis to 5% in clinical trials
– Prior to stents, bypass surgery was common. Prior to bypass surgery, there were dietary changes, bed rest, and other
approaches and pharmaceuticals to manage the challenge. Substitutes always exist.
• The standard stent forms the most relevant competing alternative for the drug eluting stents
– The standard stent is clearly an inferior alternative, since it has a higher rate of restenosis, as such the drug eluting
stent could likely be priced higher, but how much higher?
– Inferior Alternative: competing alternative that produces similar benefits to the one with the pricing challenge, but
overall less consumer utility

Differential Value
• Differential value is the change in consumer utility that a product in comparison to its comparable
alternative
• Exchange value is the price of the competing alternative adjusted for the differential value
• The drug eluting stent clearly delivers more benefits than standard stents. Quantify it with a model.
• The stent is a component in a larger process.
• Implanting a stent is a roughly $12,000 operation, of which the standard stent is only a $1050
component.
– Operation cost = $10,950
– Standard Stent Cost = $1050
– Assume the procedure must be repeated 25% of the time due to restenosis
– Total Maximum Expected Cost
($12,000) + ($12,000) 25% + ($0) 75% = $15,000
Repeat the Procedure
$12,000, 25%
Don’t Repeat the Procedure
$0, 75%
Original Procedure
$12,000, 100%
Expectation Value = $15,000
$12,000(100%) + $12,000(25%) + $0(75%)

Differential Value
• The Drug Eluting Stent reduces restenosis to 5%
• Repeat the Model, but this time let the price of the stent be unknown and the
expectation cost be held constant to that of the nearest competing alternative
– Solve for the unknown, using algebra.
• Total Maximum Expected Cost
$15,000 = ($10,950 + X) + ($10,950 + X) 5% + ($0) 95%
• X = [$15,000 – ($10,950)1.05]/1.05
• X = $3,340
• Exchange Value of the new Drug Eluting Stent at $3,340
– This price leave the patient economically equally well off as with the lower price for the lower
quality competing alternative
– Ignores quality of life issues, the risk of a second failure, etc. It is a “conservative estimate”
Repeat the Procedure
$ 10,950 + X, 5%
Don’t Repeat the Procedure
$0, 95%
Original Procedure
$10,950 + X, 100%Expectation Value = $15,000

Exchange Value Model for
Drug Eluting Stent by Cordis
• Exchange value = Price of
Alternative + Differential Value
– $3,340 = $1,050 + DV
– Differential Value is a whopping
$2,290
• Consumer Surplus is the
difference between the price paid
and the total consumer utility
Consumer Surplus
$$$$$
Exchange
Value
$3,340
Reference
Value
$1050
Differential Value
$2,290
PriceofComparable
Alternative
Maximum
PotentialPrice
Consumer
Utility
$500,000
Marginal
Costs
Price Floor
$325

Modeling and Strategic Thinking Improves
Pricing
• Reduce extreme and to narrow boundaries to improve pricing
– $325 to $500,000, the Marginal Cost and Consumer Utility, or Extreme Boundaries
– $1050 to $3,340, the price of the nearest competing offer and the exchange value
– Strategic thinking reduced the range significantly, from a factor of 1000 to now near 3
• What price did Cordis release Cypher?
– $3195, largely from negotiations with insurance companies and governmental bodies
– $ 3195 is miniscule compared to the consumer utility
– $ 3195 is huge compared to the marginal cost
– $ 3195 is also high above the inferior competitor yet less than the exchange value
• Still, $3195 is much higher than what doctors are used to, at $1050 per stent? Would
consumers balk at this new price as unfair? No.
– In the first year of its release, the Cypher Drug Eluting Stent took 60% US market share, a dramatic
improvement from the 10% market share Cordis had.
– Financial success for Cordis, rewarding investors and employees collectively.
– Added benefits for consumers at a better price than the comparable alternative even after adjusting
for the differential value.

Exchange Value Model
Consumer Surplus
$$$$$
Exchange
Value
Reference
Value
Differential Value
PriceofComparable
Alternative
Maximum
PotentialPrice
Consumer
Utility
Marginal
Costs
Price Floor
Contribution
Margin
Price

Summary
• Model your value add with Exchange Value Models to determine the boundaries of a
reasonable price
– Consumer Utility
– Marginal Cost
– Price of Nearest Alternative
– Differential Value
– Exchange Value
• Use Exchange Value Models to Identify a rational range for your price
• Use Exchange Value Models to Communicate Pricing decisions with CFO / Sales Team
• Use Customer Utility Models to Communicate Value with Customers
• Accept that different customers have different perspectives on value. Use differences in
valuation to drive price segmentation

Chpt 01 boundaries of a good price

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