Kotler pom 13e_im_10

Part 3: Designing a Customer-Driven Strategy and Mix

Chapter 10
PRICING: UNDERSTANDING AND CAPTURING
CUSTOMER VALUE

CHAPTER OVERVIEW
Use Power Point Slide 10-1 Here

Firms successful at creating customer value with the other marketing mix activities must capture
this value in the prices they earn.
Despite its importance, many firms do not handle pricing well.
In this chapter, we begin with the question, What is a price? Next, we look at customer-value
perceptions, costs, and other factors that marketers must consider when setting prices.
Price can be defined as the sum of all the values that customers give up in order to gain the
benefits of having or using a product or service. Pricing decisions are subject to an incredibly
complex array of company, environmental, and competitive forces.
Finally, we examine pricing strategies for new-product pricing, product mix pricing, price
adjustments, and dealing with price changes.

CHAPTER OBJECTIVES
Use Power Point Slide 10-2 Here

1. Answer the question “What is price?” and
discuss the importance of pricing in today’s fast changing environment.
2. Discuss the importance of understanding
customer value perceptions when setting prices.
3. Discuss the importance of company and
product costs in setting prices.
4. Identify and define the other important
external and internal factors affecting a firm’s pricing decisions.

CHAPTER OUTLINE
P. 289 INTRODUCTION P. 289
Photo: Trader Joe’s
Trader Joe’s is not really a gourmet food store. Then again,
it’s not a discount food store either. It’s actually a bit of
both. One of America’s hottest retailers, Trader Joe’s has

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 48


put its own special twist on the food price-value equation –
call it “cheap gourmet.”

Trader Joe’s describes itself as an “island paradise” where
“value, adventure, and tasty treasures are discovered, every
day.” Customers don’t just shop at Trader Joe’s, they
experience it.

Shelves bristle with an eclectic assortment of gourmet-
quality grocery items. Trader’ Joe’s stocks only a limited
assortment of about 2,000 specialty products (compared
with 45,000 items found at a Safeway). However, the
assortment is uniquely Trader Joe’s.

A special store atmosphere, exclusive gourmet products,
helpful and attentive associates – this all sounds like a
recipe for high prices. Not so at Trader Joe’s.

How does Trade Joe’s keep it gourmet prices so low? It all
starts with lean operations and a near-fanatical focus on
saving money. Trader Joe’s also saves money by spending
almost nothing on advertising.

It’s all about value and price – what you get for what you
pay.

 Opening Vignette Questions
1. What do you believe to be the ‘secret’ to Trader
Joe’s success?
2. How does Trader Joe’s keep prices so low
(compared to Whole Foods, for example)?
3. Is Trader Joe’s a gourmet store?
 Assignments, Resources
Use Web Resources 1 and 2 here
P. 290
WHAT IS A PRICE? Chapter Objective 1
PPT 10-3
In the narrowest sense, price is the amount of money P. 290
charged for a product or service. Key Term: Price

More broadly, price is the sum of all the values that
customers give up in order to gain the benefits of having or
using a product or service. P. 290
Photo: Panera Bread
PPT 10-4 Price is the only element in the marketing mix that produces Company
revenue.

49 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 10: Pricing: Understanding and Capturing Customer Value

Price is one of the most flexible marketing mix elements.

P. 291 FACTORS TO CONSIDER WHEN SETTING PRICES Chapter Objective 2

Figure 10.1 summarizes the major considerations in setting
price.
P. 291
P. 291 Customer Perceptions of Value Figure 10.1:
Considerations in
PPT 10-5 In the end, the customer will decide whether a product’s Setting Price
price is right.
PPT 10-6 P. 291
Value-Based Pricing Key Term: Value-
Based Pricing
PPT 10-7 Value-based pricing uses buyers’ perceptions of value, not
the seller’s cost, as the key to pricing.

Price is considered along with the other marketing mix P. 292
variables before the marketing program is set. Photo: Bentley

Cost-based pricing is product driven. P. 292
PPT 10-8 Figure 10.2: Value-
“Good value” is not the same as “low price.” Based Pricing
Versus Cost-Based
Two types of value-based pricing are good-value pricing Pricing
PPT 10-9 and value-added pricing.

PPT 10-10 1. Good-Value Pricing. Good-value pricing is
offering just the right combination of quality and
good service at a fair price. P. 293
Key Terms: Good-
PPT 10-11 Everyday low pricing (EDLP). EDLP involves Value Pricing,
charging a constant, everyday low price with few or no Value-Added
temporary price discounts. Pricing

High-low pricing involves charging higher prices on
an everyday basis but running frequent promotions to lower
prices temporarily on selected items.

PPT 10-12 2. Value-Added Pricing. Value-added pricing is the P. 293
strategy of attaching value-added features and Photo: Value-Added
services to differentiate their offers and thus support Pricing
higher prices.




Use Real Marketing 10.1 here
Use Discussing the Concepts 1, 2 and 3 here
Use Applying the Concepts 1 here
Use Video Case here
Use Focus on Technology here
Use Additional Projects 1, 2, and 3 here
Use Individual Assignments 1 and 2 here
Use Small Group Assignment 1 here
Use Think-Pair-Share 1, 2, 3 here
Use Outside Example 1 here
Use Web Resources 3 and 4 here
 Troubleshooting Tip
1) Even if a few students have worked in a family
business, it is a very safe bet that none of them
have ever set prices on anything. Even if they are
a devotee of eBay and have been buying and
selling items for years, they still won’t have set
prices because of the auction environment of that
and other sites that have sprung up in the years
since the explosion of the World Wide Web. So,
although the “What Is a Price?” section is very
short, it is well worth spending some time
talking about the difference between fixed-price
policies and dynamic pricing. A discussion of
what it’s like to buy a meal at a restaurant, where
you cannot typically haggle on price, and buying
a car, where you are expected to haggle on price,
can drive home the difference between the two.
A discussion of what has happened with auctions
and exchanges online will also help.

2) Value-based pricing could engender a
considerable amount of conversation,
particularly if someone thinks it is unethical to
charge a price for something that yields the
company a very large margin. Why wouldn’t
you treat customers “right” by charging them
less? A discussion of the meaning of customer
focus and of benefits to the customer will help
the class to understand that if the customer
thinks he is getting value, he will happily pay the
price.

P. 295 Company and Product Costs Chapter Objective 3

PPT 10-13 Cost-based pricing involved setting prices based on the P. 295



costs for producing, distributing, and selling the product Key Terms: Cost-
PPT 10-14 plus a fair rate of return for its effort and risk. Based Pricing,
Fixed Costs
PPT 10-15 Types of Costs (Overhead)

PPT 10-16 Fixed costs (also known as overhead) are costs that do not
vary with production or sales level.
P. 296
PPT 10-17 Variable costs vary directly with the level of production. Key Terms:
They are called variable because their total varies with the Variable Costs,
number of units produced. Total Costs

PPT 10-18 Total costs are the sum of the fixed and variable costs for
any given level of production.

Costs at Different Levels of Production P. 296
Figure 10.3: Cost
To price wisely, management needs to know how its costs Per Unit at Different
PPT 10-19 vary with different levels of production. Levels of
Production Per
Figure 10.3A shows the typical short-run average cost curve Period
(SRAC).

Figure 10.3B shows the long-run average cost curve
(LRAC).

Average cost tends to fall with accumulated production P. 296
experience. This is shown in Figure 10.4 (P. 309). This drop Key Term:
PPT 10-20 in the average cost with accumulated production experience Experience Curve
is called the experience curve (or the learning curve). (Learning Curve)

A single-minded focus on reducing costs and exploiting the
experience curve will not always work. The aggressive
pricing might give the product a cheap image. The strategy P. 297
also assumes that competitors are weak and not willing to Figure 10.4: Cost
fight it out by meeting the company’s price cuts. Finally, Per Unit as a
while the company is building volume under one Function of
technology, a competitor may find a lower-cost technology Accumulated
that lets it start at prices lower than those of the market Production: The
leader, who still operates on the old experience curve. Experience Curve

Cost- Based Pricing P. 297
Key Term: Cost-
PPT 10-21 The simplest pricing method is cost-plus pricing—adding a Plus Pricing
standard markup to the cost of the product.



Does using standard markups to set prices make sense?
Generally, no.

Markup pricing remains popular for many reasons.

1. Sellers are more certain about costs than about
demand.
2. When all firms in the industry use this pricing
method, prices tend to be similar and price
competition is thus minimized.
3. Many people feel that cost-plus pricing is fairer to
both buyers and sellers. P. 298
Key Term: Break-
PPT 10-22 Break-Even Analysis and Target Profit Pricing Even Pricing
(Target Profit
Another cost-oriented pricing approach is break-even Pricing)
pricing, or a variation called target profit pricing. The
firm tries to determine the price at which it will break even
or make the target profit it is seeking.
P. 298
PPT 10-23 Target pricing uses the concept of a break-even chart that Figure 10.5: Break-
shows the total cost and total revenue expected at different Even Chart for
sales volume levels. Figure 10.5 shows a break-even chart. Determining Target
Price
PPT 10-24 The manufacturer should consider different prices and
estimate break-even volumes, probable demand, and profits P. 299
for each. This is done in Table 10.1. Table 10.1: Break-
Even Volume and
Profits at Different
Prices

Use Discussing the Concepts 4 here
Use Additional Projects 4 here
Use Think-Pair-Share 4 and 5 here
 Troubleshooting Tip
Students may need further explanation regarding
why cost-based pricing isn’t the right way to price
everything. It’s simple, it’s easy to apply a formula,
and there is no guesswork involved. You need to
drive home the point that it ignores the customer
completely—cost-based pricing is internally
focused, without a thought to the demand parameters
or competitors’ prices. You can talk about this from
the perspective of a high-cost manufacturer—how
much would they be able to sell if their product cost



50% more than the competition simply because the

company hadn’t figured out how to manufacture it
effectively?

P. 299 Other Internal and External Considerations Affecting Chapter Objective 4
Price Decisions
PPT 10-25
Overall Marketing Strategy, Objectives, and Mix

General pricing objectives might include survival, current
profit maximization, market share leadership, or customer
retention and relationship building.

Price is only one of the marketing mix tools that a company
uses to achieve its marketing objectives.

Price decisions must be coordinated with product design,
distribution, and promotion decisions to form a consistent
and effective integrated marketing program.

Companies often position their products on price and then
tailor other marketing mix decisions to the prices they want
to charge.

PPT 10-26 Target costing starts with an ideal selling price based on
customer-value considerations, and then targets costs that P. 300
will ensure that the price is met. Key Term: Target
Costing
Companies may deemphasize price and use other marketing
mix tools to create nonprice positions.
P. 300
PPT 10-27 Organizational Considerations Ad: Titus

In small companies, prices are often set by top management
rather than by the marketing or sales departments.

In large companies, pricing is typically handled by
divisional or product line managers.

In industrial markets, salespeople may be allowed to
negotiate with customers within certain price ranges.

In industries in which pricing is a key factor, companies
often have pricing departments to set the best prices or to



help others in setting them.

PPT 10-28 The Market and Demand

PPT 10-29 Pricing in Different Types of Markets.

Pure competition: The market consists of many buyers and
sellers trading in a uniform commodity. No single buyer or
seller has much effect on the going market price.

In a purely competitive market, marketing research, product
development, pricing, advertising, and sales promotion play
little or no role. Thus, sellers in these markets do not spend
much time on marketing strategy.

Monopolistic competition: The market consists of many
buyers and sellers who trade over a range of prices rather
than a single market price. A range of prices occurs because
sellers can differentiate their offers to buyers.
P. 302
Oligopolistic competition: The market consists of a few Ad: Kohler
sellers who are highly sensitive to each other’s pricing and
marketing strategies.

There are few sellers because it is difficult for new sellers to
enter the market.

Pure monopoly: The market consists of one seller. The
seller may be a government monopoly, a private regulated
monopoly, or a private nonregulated monopoly.

Use Real Marketing 10.2 here
Use Discussing the Concepts 5 and 6 here
Use Focus on Ethics here
Use Additional Projects 5 here
Use Outside Example 2 here
Use Web Resources 5 here

Analyzing the Price-Demand Relationship.
P. 303
PPT 10-30 The relationship between the price charged and the resulting Key term: Demand
demand level is shown in the demand curve (Figure 10.6). Curve

In the case of prestige goods, the demand curve sometimes
slopes upward. Consumers think that higher prices mean P. 303



more quality. Figure 10.6:
PPT 10-31 Demand Curve
In a monopoly, the demand curve shows the total market
demand resulting from different prices.

If the company faces competition, its demand at different
prices will depend on whether competitors’ prices stay
constant or change with the company’s own prices.

PPT 10-32 Price Elasticity of Demand.
P. 304
Price elasticity is how responsive demand will be to a Key Term: Price
change in price. Elasticity

If demand hardly changes with a small change in price, we P. 303
say demand is inelastic. Ad: Gibson Guitars

If demand changes greatly with a small change in price, we
say the demand is elastic.

PPT 10-33 Competitors’ Strategies and Prices
P. 305
In assessing competitors’ pricing strategies, the company Ad: Annie Bloom’s
should ask several questions. Books

1. How does the company’s market offering compare
with competitors’ offerings in terms of customer
value?
2. How strong are current competitors and what are
their current pricing strategies?
3. How does the competitive landscape influence
customer price sensitivity?

PPT 10-34 Other External Factors

Economic conditions can have a strong impact on the
firm’s pricing strategies.

The company must also consider what impact its prices will
have on other parties in its environment, such as resellers
and the government.

Social concerns may have to be taken into account.

Use Applying the Concepts 2 and 3 here



Use Marketing by the Numbers here
Use Company Case here
Use Small Group Assignment 2 here
Use Web Resources 6 here

END OF CHAPTER MATERIAL
Discussing the Concepts

1. What is price? List five other words that mean the same thing as price (for example, tuition).
(AACSB: Communication; Reflective Thinking)

Answer:

In the narrowest sense, price is the amount of money charged for a product or service. More
broadly, price is the sum of all the values that customers give up in order to gain the benefits
of having or using a product or service. Examples of other terms used for price are rent, fee,
rate, tax, toll, commission, and assessment.

2. Explain the differences between value-based pricing and cost-based pricing. (AACSB:
Communication)

Answer:

Cost-based pricing is product driven. The company designs what it considers to be a good
product, adds up the costs of making the product, and sets a price that covers costs plus a
target profit. Marketing must then convince buyers that the product’s value at that price
justifies its purchase. If the price turns out to be too high, the company must settle for lower
markups or lower sales, both resulting in disappointing profits.

Value-based pricing reverses this process. The company first assesses customer needs and
value perceptions. It then sets its target price based on customer perceptions of value. The
targeted value and price then drive decisions about what costs can be incurred and the
resulting product design. As a result, pricing begins with analyzing consumer needs and
value perceptions, and price is set to match consumers’ perceived value.

3. Name and describe the two types of value-based pricing methods. (AACSB:
Communication)

Answer:

There are two types of value-based pricing: good-value pricing and value-added pricing.
Good-value pricing strategies offer just the right combination of quality and good service at
a fair price. In many cases, this has involved introducing less-expensive versions of
established, brand name products. In other cases, good-value pricing has involved
redesigning existing brands to offer more quality for a given price or the same quality for



less. An important type of good-value pricing at the retail level is everyday low pricing
(EDLP). EDLP involves charging a constant, everyday low price with few or no temporary
price discounts. To increase their pricing power, many companies adopt value-added
pricing strategies. Rather than cutting prices to match competitors, they attach value-added
features and services to differentiate their offers and thus support higher prices.

4. Compare and contrast fixed and variable costs and give an example of each. (AACSB:
Communication)

Answer:

Fixed costs (also known as overhead) are costs that do not vary with production or sales
level. For example, a company must pay each moth’s bills for rent, heat, interest, and
executive salaries, whatever the company’s output. Variable costs vary directly with the
level of production. Each product manufacturer involves costs related to raw materials and
parts. These costs tend to be the same for each unit produced. They are called variable
because their total varies with the number of units produced.

5. Discuss other internal and external considerations besides cost and customer perceptions of
value that affect pricing decisions. (AACSB: Communication)

Answer:

Internal factors affecting pricing include the company’s overall marketing strategy, objectives,
and marketing mix, as well as other organizational considerations such as who within the
organization should set prices.

External factors include the nature of the market and demand, competitors’ strategies and
prices, and other environmental factors.

6. Name and describe the four types of markets recognized by economists and discuss the
pricing challenges posed by each. (AACSB: Communication)

Answer:

Economists recognize four types of markets, each presenting different pricing challenges:



• Pure competition: the market consists of many buyers and sellers trading in a
uniform commodity such as wheat, copper, or financial securities. No single
buyer or seller has much effect on the going market price. A seller cannot charge
more than the going price, because buyers can obtain as much as they need at
that price. Nor would sellers charge less than the market price, because they can
sell all they want at this price. Marketing activities play little or no role.
• Monopolistic competition: the market consists of many buyers and sellers who
trade over a range of prices rather than a single market price because sellers can
differentiate their offers to buyers. Buyers see differences in sellers’ products
and will pay different prices for them.
• Oligopolistic competition: the market consists of a few sellers who are highly
sensitive to each other’s pricing and marketing strategies. There are few sellers
because it is difficult for new sellers to enter the market. Each seller is alert to
competitors’ strategies and moves and responds to each others’ changes in price.
• Pure monopoly: the market consists of one seller, which may be a government
monopoly, a private regulated monopoly, or a private nonregulated monopoly.
Pricing is handled differently in each case. In a regulated monopoly, the
government permits the company to set rates that will yield a “fair return.”
Nonregulated monopolies are free to price at what the market will bear.
However, they do not always charge the full price for a number of reasons: a
desire not to attract competition, a desire to penetrate the market faster with a
low price, or a fear of government regulation.

Applying the Concepts

1. In a small group, discuss your perceptions of value and how much you are willing to pay for
the following products: automobiles, frozen dinners, jeans, and athletic shoes. Are there
differences among members of your group? Explain why those differences exist. Discuss
some examples of brands of these products that are positioned to deliver different value to
consumers. (AACSB: Communication; Reflective Thinking)

Answer:

Students’ responses will vary because perceptions of value vary among consumers. For
example, some consumers think of athletic shoes as shoes to wear when not wearing dress
shoes or sandals and will not pay more than $30 or $40 for a pair. Keds might be an example
of a brand delivering this level of value to consumers. However, some see the value in shoes
that are designed for specific sports and are willing to pay more than $100 for a pair. Nike,
New Balance, and Asics could be brands delivering this value to consumers. Others may see
the fashion value in some athletic shoes and are willing to pay higher prices. Puma and K-
Swiss are brands that might deliver this value to consumers.

2. Find estimates of price elasticity for a variety of consumer goods and services. Explain what
price elasticities of 0.5 and 2.4 mean (note: these are absolute values, as price elasticity is
usually negative). (AACSB: Communication; Reflective Thinking)



Answer:

Students’ responses will vary depending on the source used to collect this information. One
useful Web site listing price elasticities of several consumer goods and services is
http://www.mackinac.org/article.aspx?ID=1247. Some examples of inelastic demand include
salt (0.1), gasoline (0.2), coffee (0.25), and physician services (0.6). Examples of
approximately unitary elasticity include movies (0.90) and private education (1.1). Examples
of elastic demand include restaurant meals (2.3), foreign travel (4.0), and automobiles
(1.2-1.5).

A price elasticity of 0.5 represents inelastic demand, which means the percentage change in
quantity demanded is less than the percentage change in price. The less elastic the demand,
the more it pays for the seller to raise the price. A price elasticity of 2.5 is elastic, meaning
the percentage change in quantity demanded is greater than the percentage change in price.

3. What does the following positioning statement suggest about the firm’s marketing objectives,
marketing-mix strategy, and costs? “No one beats our prices. We crush the competition.”
(AACSB: Communication; Reflective Thinking)

Answer:

This firm has adopted a low-price leader position, and a logical marketing objective would be
to gain share and maintain market share leadership. It relies heavily on price and less so on
the three other elements of the marketing mix. It is probably the low cost provider and as a
result is able to sustain its “No one beats our prices” position.

Focus on Technology
It seems a day doesn’t go by without some talk about gas prices. Consumers are more keenly
aware of the price now that it costs $40 to $100 to fill up the tank. And many consumers are
using technology to help find the lowest prices in their area. The Internet is making it much
easier to get price comparisons from Web sites such as GasBuddy.com (www.gasbuddy.com)
and GasPriceWatch.com (www.gaspricewatch.com). These sites give price information on maps
for a consumer’s zip code area. Consumers can download programs, called widgets, which
continually update this information on users’ computers. If you’re not at your computer, you can
get this information on your cell phone from www.getmobio.com/learn/cheapgas/. Most of the
Web sites rely on volunteers to update prices.

1. Visit some of these Web sites and evaluate their usefulness to consumers. Recommend some
other applications that would enable consumers to find the best gas prices. (AACSB:
Communication; Use of IT; Reflective Thinking)

Answer:



Students’ perceptions of the usefulness of these Web sites will vary. For example, when
searching a particular zip code on GasPriceWatch.com, only four of the several gas stations
had price information, and it was more than 72 hours old. Trying to find more recent
information resulted in “???” for price results for all stations, indicating that no data that
recent were available. Using GasBuddy.com didn’t have all of the gas stations in an area and
the map gave irrelevant information. For example, clicking on “map” for one of the Shell
stations gave location information for any business with the name “Shell,” such as Shell
Chiropractic Clinic. All of these sites rely on volunteers to update prices. An example of
another application is for consumers to get this type of information on navigation systems in
their automobiles.

2. Why are consumers so concerned about the price of gas and why are they willing to search
out stations with lower prices? (AACSB: Communication; Reflective Thinking)

Answer:

Students’ answers’ will vary. However, this is a good product to use when discussing price
elasticity. Demand for gasoline is inelastic. Most consumers still need to go about their daily
lives regardless of the price of fuel, and there are few substitutes. In many localities, mass
transit alternatives are limited. Choices for alternative-fuel automobiles are nonexistent or
limited and switching costs are high. However, consumers are concerned about it and are
willing to seek out the lowest prices within their geographic areas because many view
gasoline as a commodity. Many consumers do not see value differences among the different
brands of gasoline, so switching behavior is common.

Focus on Ethics

You’ve heard of a monopoly, but have you ever heard of a monopsony? A monopsony involves
one powerful buyer and many sellers. The buyer is so powerful that it can drive prices down. An
example is Wal-Mart, the world’s largest retailer. Wal-Mart’s power allows it to get the lowest
possible prices from its suppliers. Similarly, wine-making giant E. & J. Gallo has so much power
buying grapes that growers have to concede to the wine maker’s demands for lower prices.

1. Is it fair that a buyer can exert so much power over a supplier? Are there any benefits to
consumers? (AACSB: Communication; Ethical Reasoning)

Answer:

Some students will argue that it is the free market working and is inherently fair. However,
whereas larger suppliers can meet the demands of the powerful buyer, smaller suppliers will
not be able to compete. This may not be in the best interests of consumers if it reduces
competition or if product quality suffers. However, the lower prices will be passed on to
consumers, so some will argue that it is good for consumers. For example, Wal-Mart
leverages its buying power to obtain lower prices, which it in turn passes on to consumers in
the form of lower prices.



2. Should the government step in and set minimum price levels? Discuss the consequences of
your answer. (AACSB: Communication; Reflective Thinking)

Answer:

Students’ responses will vary. Some students will argue that government intervention is
necessary to protect the small suppliers. With minimum price levels set by the government,
the smaller firms may be able to compete with the larger suppliers. However, consumers may
be hurt if suppliers must sell at a minimum price, resulting in higher prices for consumers.

Marketing by the Numbers

One external factor manufacturers must consider when setting prices is reseller margins.
Manufacturers do not have the final say concerning the price to consumers—retailers do. So,
manufacturers must start with their suggested retail prices and work back, subtracting out the
markups required by resellers that sell the product to consumers. Once that is considered,
manufacturers know at what price to sell their products to resellers, and they can determine what
volume they must sell to breakeven at that price and cost combination. To answer the following
questions, refer to Appendix 2, Marketing by the Numbers.

1. A consumer purchases a flat iron to straighten her hair for $150 from a salon at which she
gets her hair cut. If the salon’s markup is 40 percent and the wholesaler’s markup is 15
percent, both based on their selling prices, for what price does the manufacturer sell the
product to the wholesaler? (AACSB: Communication; Analytical Reasoning)

Answer:
price − cost
Markup percentage on price = ——————
price
so,
Cost at each level = price − (price × markup%)

The retailer’s cost = $150 − ($150 × 0.4) = $90, which is the price the wholesaler sells it to
the retailer.

The wholesaler’s cost = $90 − ($90 × 0.15) = $76.50, which is the price the manufacturer
sells the product to the wholesaler.

Another way to compute this is:

Retail price: $150.00
minus retail margin (40%): −$ 60.00
Retailer’s cost/wholesaler’s price: $ 90.00
minus wholesaler’s margin (15%): −$ 13.50
Wholesaler’s cost/manufacturer’s price $ 76.50



2. If the unit variable costs for each flat iron are $40 and the manufacturer has fixed costs
totaling $200,000, how many flat irons must this manufacturer sell to breakeven? How many
must it sell to realize a profit of $800,000? (AACSB: Communication; Analytical Reasoning)

Answer:
Fixed cost
Breakeven volume = ————————
Price – Variable Cost

So,

$200,000
Breakeven volume = ——————— = 5,479.45 or 5,480 flat irons
$76.50 – $40

If the manufacturer wants to realize a $200,000 profit, then this amount is added to the fixed
costs in the numerator:

$200,000 + $800,000
Breakeven volume = ———————— = 27,397.28 or 27,398 flat irons
$76.50 – $40

Company Case Notes

Southwest Airlines: Staying Ahead in the Pricing Game

Synopsis

This case provides an in-depth look at why Southwest Airlines was by all measures the most
successful airline in the U.S. Southwest had devised a business model based on low costs and
low prices. But that model also included very reliable and personable service. With such a
winning combination, its no wonder that Southwest consistently did what no other airline
company could: it turned a profit.

When something works, you stick with it. Southwest did just that, changing its strategy very
little. But all good things come to an end. As market conditions began to change, it became very
apparent that Southwest would not be able to maintain its advantage based on the same model it
had been employing. So in 2004, Gary Keller, the newly crowned CEO, made some very
significant changes to Southwest’s game plan.

This case outlines that nature of Southwest original business plan as well as the changes
implemented during and after 2004. In both cases, the focus is on how Southwest implemented
pricing policy. The contrast provides an excellent opportunity for students to consider whether or
not the changes are changes in the right direction.

Teaching Objectives

The teaching objectives for this case are to:



1. Allow students to understand how a firm’s marketing objectives and marketing mix
strategy affect its pricing decisions.
2. Help students understand the nature of costs in the airline industry and how the
relationship of fixed and variable costs affect marketing decisions.
3. Enable students to understand how the nature of a market and market demand affect
pricing decisions.
4. Let students examine the pricing approaches airlines have used.
5. Allow students to make pricing and other marketing recommendations for Southwest.

Discussion Questions

1. What has been Southwest's traditional pricing strategy? Why has this pricing strategy
been so successful throughout the airline’s first three decades?

Southwest has historically and relentlessly pursued a low-price strategy. Its goal was to
always be the cheapest carrier in any market where it flew. This would ultimately require
the competing carriers to drop their prices to match those of Southwest in order to be
competitive. This is something that has come to be known as the “Southwest Effect”.

The easy answer to why it worked is based on Southwest’s cost structure. The business
plan that Herb Kelleher developed seemed to fly in the face of every aspect of airline
convention. No meals, no assigned seats, no amenities, no retirement plan, one kind of
plane, and flying point-to-point instead of hub-and-spoke. But every one of these things
were cheaper for Southwest and gave it a cost advantage. Thus, when competition
attempted to match Southwest’s prices, they could not match Southwest’s profits.

Students should recognize that in order to deliver low prices, Southwest must keep the
cost of the other marketing mix variables low. Thus, it offers a no-frills, point-to-point,
air transportation service (product) at out-of-the-way airports (places) where costs are
low, with limited and low-cost promotion. Price is the only marketing mix variable that
produces revenue, so with low prices the company must keep the cost of the other
variables low. Southwest has done an excellent job of getting the marketing mix variables
to fit with each other.

But the rest of why this strategy worked for Southwest has to do with consumers and their
perceptions of value. This is addressed in the next question.

2. What values do airline customers—both business and leisure travelers—seek when they
buy air travel tickets? Has Southwest done a better job than competitors of meeting the
needs of these air travelers? In what ways?

Students should recognize that there is more than one kind of airline traveler and that
each values different things. Some examples include the following.

Leisure travelers



• Low prices
• Friendly service
• On-time performance
• Accurate baggage handling

Business travelers
• Flexible scheduling
• Reserved seating
• First class options
• Meals
• Entertainment (movies, music)
• Larger, roomier planes
• Frequent flyer points
• Frequent flyer clubs
• On-time performance
• Accurate baggage handling

The bottom line is, leisure travelers may have very well enjoyed the perks and amenities
offered by other airlines. But at what cost? The thing that they valued the most was
getting from point A to point B as cheaply and effectively as possible. They would gladly
trade a meal and a movie for a lower price. Southwest recognized this and focused on
serving this target segment.

As this question is discussed, it may be helpful to put weights next to the different benefits
for each target segment. The interesting thing to note is that there are definitely benefits
that the business traveler seeks (on-time performance, accurate baggage handling) that
Southwest delivers better than any of the competition.

3. What internal and external factors affect airline pricing decisions? What impact are these
factors now having on airline pricing and profitability?

These are key questions for the students to understand. It is helpful to ask students to
think about which costs are fixed and which are variable in the airline business. Students
should quickly see that all the salaries of the pilots, flight attendants, ground crews,
terminal personnel, reservations systems personnel, and corporate employees are all
fixed. The costs of the planes, the gates at the airports, terminal fees, etc., are also fixed.
The only variable costs are the transaction costs of issuing a ticket (very low with e-
tickets), the extra fuel the
plane uses because of the extra weight of the passenger and luggage, and any in-flight
food or beverages. The true variable cost of flying one additional passenger is very low.

So, students should see that air transportation is a very high fixed-cost business. In such
a business, volume is important. The unit price minus unit variable cost (unit
contribution) is high. An airline must have a high volume of passengers to cover the high
fixed costs. Operating below break-even volume results in an airline losing lots of money
quickly. Operating above break-even volume results in an airline making lots of money



quickly. This is why the airlines can have lots of sales promotions and discounts—they
had rather have a passenger in a seat making some unit contribution than have that seat
be empty and produce no unit contribution. In this type of business, a company varies its
pricing to produce the volume it needs. The text discusses dynamic pricing—charging
different prices depending on individual customers and situations. The airline industry is
an excellent example of this practice.

Students should also see from the information in the case that the older airlines, like US
Airways, have very different cost structures from the newer entrants. Not only do they
have pilots, flight attendants, and ground crews that may be unionized and have higher
salaries, wages, and benefits, but also they may have high-cost airplanes and
infrastructure. Note in the case that Southwest has an important advantage in that it has
no fixed-cost pension system. Rather, it has a profit-sharing system. This converts
pension cost from a fixed cost to a variable cost, significantly reducing its break-even
point.

Since the year 2000, various things have changed in the industry that have affected the
nature of costs. First, the costs associated with travel agencies are dropping as Internet
booking services have replaced that intermediary. While this is a factor that is improving
the cost structure for the legacy airlines, it is not helping Southwest at all given that they
have never worked through travel agents. Second, fuel prices have gone up considerably.
The nature of the fuel contracts that many airlines have, including Southwest, are
changing. In some cases they may be more favorable. In Southwest’s case, they are
becoming less favorable. Other things that are affecting Southwest’s structure is that it is
adding amenities that it previously did not offer (satellite radio) and it is starting to
provide service out of the big airports that charge higher fees.

4. What is Southwest’s current pricing strategy? Does his strategy differentiate Southwest
from its competitors? Is the strategy sustainable?

Students should identify the main points of Southwest’s pricing strategy that have
changed:

• Price increases. We are only given the information that prices went up six times
and 11.4 percent in 2006.
• New pricing category. The Business Select category commanded prices of $30-
$50 more than other fares.
• Overall structural change. From five categories or pricing to three. The
interesting thing here is that the previous system had five categories focused on
non-business travelers. The current structure has only one pricing category
focused on non-business travelers.

Perhaps more important than the pricing changes in this case are the required changes
to the other marketing mix variables.



• Targeting business travelers with preferential seating, bonus frequent-flier
credits, free cocktails, and updated boarding areas with amenities.
• Expanding its sales force and working directly with corporate travel managers.
• Joining the computer ticketing system of the travel industry.

On all these counts, the question of differentiation becomes harder to identify. Southwest
is now doing many things that its competition has always done. At the same time,
competitors like Jet Blue are beating Southwest at its own low-price game while at the
same time offering amenities. The elements that Southwest seems to be able to hold on to
in terms of differentiation are on-time performance and baggage handling.

Sustainability is a question where student opinions will differ. It is important to note that
previously, Southwest’s strategy was working because it was focused on serving one
target segment, and serving it well. But it got to the point where Southwest could no
longer rely on that. So, it had to branch out to business travelers. Meeting the needs of
both segments with one basic product is definitely going to be a challenge.

5. What marketing recommendations, including pricing recommendations, would you make
to Southwest as it moves into the next decade?

Student responses will certainly vary here. But question may provide the richest
opportunity for discussion on this case. Students may discuss how Southwest should
position itself versus the other low-fare airlines. Southwest has a history of being
entertaining. Its flight attendants often work to get the customers to laugh. At a time
when flying has become more of a hassle due to security regulations, Southwest might
want to emphasize that positioning. Helping its customer relax and have some fun in the
midst of what can be a mentally and physically tiring trip could add value to flying
Southwest.

One recommendation that students may make is that Southwest should use its
promotional tools not only to communicate about its low fares but also to educate
customers about what Southwest is and what it offers. Although many customers may
know of or have used Southwest at a neighboring airport, many potential leisure
customers will not have had that experience. Southwest wants to use these customers to
expand the market. These customers may not have thought about how inexpensive it
might be to fly on their next vacation or family visit. Southwest wants these people to
consider flying versus driving.

Southwest’s strategy is about more than just low price. It has established a brand that
promises a total experience that will be satisfying to its customers. It offers on-time
departures and arrivals, friendly service, error-free baggage handling, the availability of
low fares, an easy frequent-flyer program, and direct flights. Students can suggest any
number of promotion ideas to communicate Southwest’s brand promise to the leisure
traveler.



For the thrift-minded businessperson, students will suggest that price may be the most
important factor, but the total experience will be what keeps that customer coming back
to Southwest. It may be that some businesspeople do not think about flying Southwest. So,
promotions should communicate that Southwest also serves businesspeople interested in
saving money. Some students may suggest that Southwest should segment the business
market and target that small business owner or manager who may travel only a few times
per year. There may be locally-oriented business newspapers or magazines that
Southwest can use to communicate with these customers.

The case mentions that other low-fare airlines are beginning to offer some frills, such as
JetBlue making Direct TV available at every seat free of additional charges. This points
out the disadvantage of letting customers focus only on price. Meeting a competitor’s
price may be easy. However, the company has to differentiate itself. A customer who can
get a low fare and free TV may well take that offer. Southwest is going to have to deal
with the issue of what it is going to do as competitors, some of whom have even lower
cost structures, enter its markets with enhanced product offerings. Again, the key will be
to get its customers and potential customers to see the value of the entire Southwest
experience, not just the price.

Teaching Suggestions

Through the questions asked, there is plenty of opportunity for discussing various concepts from
this chapter, particularly those related to costs and how costs affect the other elements of the
marketing mix. One of the primary purposes of this case is to show how pricing strategy is
directly tied to consumers’ perception of value. Thus, it can be used to illustrate value-based
pricing. This case can also be used to illustrate price elasticity of demand and how this principle
has worked both in and against Southwest’s favor. Finally, this is a case that easily bridges the
two pricing chapters. Consider Southwest’s history, its original business model, and its current
business model. Use this material to illustrate the appropriate pricing strategies.

This case goes well with the chapters on managing customer relationships and company strategy
(Chapters 1 and 2).

ADDITIONAL PROJECTS, ASSIGNMENTS, AND EXAMPLES

Projects

1. Interview a local business about their pricing philosophy and/or strategy. Use their terms
and then apply what you have learned from them to assess their approach to those
described in the text. What are the similarities and differences? (Objective 2)
2. Use the local newspaper to compare grocery store ads for price specials. What can you
determine about the competitors’ pricing strategies? How many of the techniques from
the chapter do the organizations seem to be using? What strategy appears to be the most
successful? How did you make this judgment? (Objective 2)
3. How does Wal-Mart make use of Good-Value Pricing? (Objective 2)



4. Explain how companies such as Dell use Cost-Plus Pricing. What are the competitive
disadvantages of such pricing strategies? (Objective 3)
5. Take a drive around town and look at the pricing of gasoline at a variety of different
stations. Use Oligopolistic Competition to explain what you are seeing. (Objective 4)

Small Group Assignments

1. Form students into groups of three to five. Each group should read Real Marketing 10.1
(p. 294). Each group should then answer the following questions and share their answers
with the class. (Objective 20
a. Is Ryanair utilizing an effective pricing strategy?
b. How has Ryanair been able to maintain their current pricing strategy in the wake of
the turbulent air travel market?
c. What is Ryanair’s position in the mind of the customer?

2. Form students into groups of three to five. Each group should read the Real Marketing
10.2 (p. 301). Each group should then answer the following questions and share their
answers with the class. (Objective 4)
a. Is Ferrari utilizing an effective pricing strategy?
b. Besides price, what is it that makes Ferrari positioning unique?
c. What pricing strategy is Stella Artois utilizing? Are they effective?
d. What is it that makes Stella Artois’ premium pricing worth it to consumers?

Individual Assignments

1. Reread the opening section of this chapter on “What is a Price?” Imagine you are
considering purchasing a new suit for interviewing. You are considering comparison-
shopping for your new suit at Saks Fifth Avenue (high-end department store) and
Dillard’s (moderate department store). Discuss the overall differences in “Price” between
the two establishments. (Objective 1)

2. What is Everyday Low Pricing? Besides Wal-Mart, what companies do you believe have
been able to use this pricing strategy to great success? (Objective 2)

Think-Pair-Share

Consider the following questions, formulate an answer, pair with the student on your right, share
your thoughts with one another, and respond to questions from the instructor.

1. What is price? (Objective 1)
2. Discuss the role that customer value plays in the determination of price. (Objective 2)
3. Explain the difference between value-based, good-value, and value-adding pricing
strategies. (Objective 2)
4. What is target-profit pricing? (Objective 3)
5. Explain the demand curve. (Objective 3)



Outside Examples

1. Take a look at The Poisoned Pen (http://www.poisonedpen.com/). The Poisoned Pen is a
small independent bookstore located in Scottsdale, Arizona. Their motto is “It’s more
than a Bookstore, It’s an Experience.” Look around their website. Read the blog by
Barbara, the owner. See what authors are scheduled to appear and sign their books.
Check out their pricing. Experience them. Discuss The Poisoned Pen’s approach to
pricing. How are they able to remain competitive against booksellers such as Amazon or
Borders? (Objective 2)

Possible Solution.

After spending some time looking around the website of The Poisoned Pen, it becomes
evident that they are certainly not a discount pricing operation. In an industry where it has
become normal to find newly released hardback books at 25% to 50% off of the
manufacturer’s suggested price, The Poisoned Pen does not discount. But, for their
customers, this pricing strategy is a bargain. The Poisoned Pen uses a Value-Based
Pricing approach. The prices of their products are set not on what the product costs them,
but, rather, on the buyer’s perception of value. Their approach is definitely value-added.
They provide a high level of personalized service to their clients, keeping track of what
they have previously purchased and making suggestions on what else they may be
interested in. Your personal information is kept on file with them allowing a customer to
simply call them up and say, “Hi, this is Mike. Would you please send me the new
Cussler book?” Additionally, they specialize in signed first editions. This high level of
personalized service combined with author signed editions of books is what ensures they
are capable of proving high value to their customers. This is value-added pricing at its
best.

2. Your text talks about Bang & Olufsen, the high-end consumer electronics producer. You
can explore their company and products at http://www.bang-olufsen.com. Take some
time to learn about the types of products they offer and find something you would like to
own. Use their store locator and find the retailer closest to you. All of their retailers have
their own website. Visit one and price the components of interest to you. How can they
charge what they charge? (Objective 4)

Possible Solution.

Bang & Olufsen does not sell on price. As a matter of fact, it is rather difficult to find any
reference to prices on the websites. As the text points out, they have worked to create a
“nonprice” position for B&O products. They build products know for exceptional quality
and construction, products that are on the cutting edge, both from a performance and
aesthetic perspective. They do not compare their products to any other products, because
they believe they have no peer. Since Bang & Olufsen has chosen to compete on non-
price variables, decisions about quality, promotion, and distribution become most
important.



Web Resources

1. http://247.prenhall.com
This is the link to the Prentice Hall support link.

2. http://traderjoes.com/
Here is Trader Joe’s homepage. It will be useful to you as you read and think about the
opening segment of this chapter.

3. http://www.panerabread.com/
Take a look at Panera Bread Co. and examine their pricing strategies.

4. http://www.stagumbrellas.com/
This is the home page for Ebrahim Currim & Sons, the manufacturer of Stag umbrella.

5. http://www.ferrariworld.com/FWorld/fw/index.jsp
Explore Ferrari’s world here. You can learn about their history and cars.

6. http://www.annieblooms.com
This is a great site to learn about how a small independent bookseller can successfully
compete with the major chains.


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