01 Week 2 Slides

Price Discrimination
Intro to Price Discrimination
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Price Discrimination
• Cost-plus pricing
• Price discrimination based on
cost variation
• Price and margin waterfall
• Other incentives that lower
costs
• Three principles of product line
pricing
• Case application: Heinz
Ketchup
By the end of this module

you’ll be able to…
• Utilize cost-plus pricing to
determine prices
• Recognize the opportunity
for price discrimination and
use it to optimize prices
• Create price and waterfall
margin charts to analyze
your business
By the end of this module
you’ll be able to…
• Decide how to price a product
line based on volume
incentives
• Prevent margin leakage and
improve price realization along
the margin waterfall
• Apply knowledge of price
discrimination and pricing
through a distribution channel
to analyze a real-world case
Cost-Plus Pricing
#6
Economics – Cost-plus pricing

(Thomas)
How does a business decide what

to charge for its products?
Three main approaches to
setting prices
Price setting approaches
Cost- Value- Market-

plus based based
pricing pricing pricing
Marginal-cost
pricing
Cost-plus pricing
$ %
Full cost Markup Selling
per unit price
Seller is Buyer is
Price setter Price taker
Example calculation
$100 20% $120

Full cost Selling
Markup
per unit price
(
Total Total (
variable fixed
cost cost
Quantity
When is cost-plus pricing useful?
Situations Transactions
where sellers with very
have sufficient custom
pricing power specifications
and outcomes
Industries with Starting point

regulated prices to set the price
for a new
product
Advantages vs. disadvantages
of cost-plus pricing
Advantages
• Simple to execute
• Guarantees targeted margin
• Intuitively understandable
• Easy to defend
Advantages vs. disadvantages

of cost-plus pricing
Disadvantages
• Usually leads to sub-optimal pricing
• Promotes cost inefficiency
• Ignores opportunity cost
• Uses historical cost rather than

current or future replacement value
Target-cost pricing
$ $
Target cost Market price Target
per unit per unit margin
$90 $110 $20
Cost-plus vs. target-cost pricing
Cost-plus
pricing $ %
Full cost Markup Selling
"How much per unit price
to charge?"
$100 $20 $120
Target cost
"How much can
$ $
it cost?" Market Target Target cost
price margin per unit
per unit
$110 $20 $90
With target-cost pricing, buyers
set a product's price
Target-cost pricing
$ $
Market Target
Target
price cost
margin
per unit per unit
Buyer is Seller is
Price setter Price taker
Wrap-up
How would you go about setting the

price for the product in this box?
#7
Economics – Price
discrimination based on cost
variations
(Thomas)
Why does the price vary for the

exact same product by 3× ?
Airport
$3.99
Grocery store
$1.20
Price discrimination
Price discrimination describes the

practice of selling an identical
product to different buyers at
different sales prices
Synonyms
• Price differentiation
• Differential pricing
Price discrimination vs.

product differentiation
Branded spring water
• National brand
• Spring water $1.20
• Priced higher
Different products
Private label purified water Different prices

• No brand
• Purified water (not spring) $0.65
• Priced lower
Why do sellers discriminate
when setting prices?
because
• Improve margins
they can
• Incentivize buyers
to buy differently because
or more
they have
• Sell to new to
customer segments
Why do buyers accept

price discrimination?
Higher prices
Price can be less important than
other factors, e.g. convenience
Lower prices
Buyers can't afford to pay more and
enjoy a 'good deal'
What is cost-based price discrimination?
Cost of doing business often varies widely between

different customers and transactions
Higher cost:
Airport
• Rent
$3.99 • Labor
• Logistics
... But also:
Grocery store • Higher willingness to pay
$1.20 • Higher cost of next best
alternative
Let's be honest...
Cost of doing business at an airport

is certainly higher, but so much to
justify a price of 3× more?
... probably not
So what else is going on?
Cost-based price discrimination
helps sellers to optimize margins
Higher cost
Seller passes cost plus additional
markup through to buyer
Lower cost
Seller passes only part of cost
savings through to buyer
Wrap up
What you learned

• Price discrimination and how it is
motivated by differences in cost
• Product vs. price differentiation
• How price discrimination is used to
optimize margins
How could you discriminate prices in

your business to improve margins?
#8
Economics – Price and margin

waterfall
(Thomas)
Pricing practitioners have to

worry about two core issues
Setting prices
Managing
margin leakage
What's happening when products
make hardly any money ...
... despite a high starting price?

$/
unit 100
Starting Operating
Price Margin
Price and Margin waterfall is a great tool to

discuss margin leakage
Price waterfall Margin waterfall

$/
unit 100
75
Starting Price Net Cost Operating Margin

Price adjustments price
Price waterfall and its components
! NOTE: List price is before VAT
$/
+5 105 -22
unit 100
83 -8
75
Global FX rate Local On-invoice Invoice price Off-invoice Net

list & country list price deductions (gross) deductions price
price adjustments
• Exchange rate adjustments • Discounts (volume, payment, etc.) • Cash discounts

• Country specific adjustments, • Promotions • Coop advertising
e.g. for GDP/capita • Rebates • Buyback guarantee
Margin waterfall and its components

$/
unit
75 -52
-7
16 -7
-4 5
Net Cost of Cost to Contri- Direct Indirect SG&A Operating

price goods serve bution SG&A + other cost Margin
sold Margin
• Cost of materials and components • Freight, Warehousing • Direct sales expense • General management
• Factory conversion cost • Warranty (salary, travel) • Branding
• ... • Goodwill... • Other selling costs • Other overhead
Margin waterfall and full cost (per unit)
$/ Full cost
unit $ per unit
75 -52
-7
16 -7
-4
5

sold Margin
Margin waterfall and fixed and variable cost

$/
unit Fixed and variable
75 -52
cost in each category
-7
16 -7
-4 5

sold Margin
Variable cost Fixed cost
Closing thoughts
Price and margin waterfall

• ... illustrates relationship between price
and margin
• ... great tool to discuss your business with
stakeholders
Cost and margin buckets can be easily

benchmarked to identify root causes of
leakage
Closing thoughts
Often difficult to get the data. Do your best;
its important to determine profitability
Select most useful dimensions when

constructing waterfall charts
• Unit of analysis: a SKU, product category,
or business segment
• Dimension of Y-axis: $ per unit, absolute $
or % of Net Sales
Product Line Pricing Principles
Product Line Pricing

• Very few companies sell only one
product
• The products can have demand
interrelationships
• These products may (or may not) be
part of a product line.
• Product lines are generally
constructed to try to achieve some
level of price discrimination.
Types of Product Lines
• Quality differentiated
K2 Skis
Types of Product Lines
• Quality differentiated
• Quantity differentiated
Heinz Ketchup
Quantity Differentiated
Product Lines: 3 Principles
• Larger-size products should have a lower
price on a per-unit basis than smaller-size
products.
• The size of the per-unit price discount
should be greater if people consume
more of the item when they have a larger
quantity on hand.
should be lower if the economic or
psychological costs of an out-of-stock
situation are high.
Product Lines: Principle 1
• Larger-size products should
have a lower price on a
per-unit basis than
smaller-size products.
 Intuitive
 Retailers will generally enforce
this provision.
Pricing: Principle 2
• Larger-size products should
have a lower price on a per-
unit basis than smaller-size
products.
• The size of the per-unit price
discount should be greater if
people consume more of the
item when they have a larger
quantity on hand.
Product Line Pricing: Principle
3
• Larger-size products should have a lower
price on a per-unit basis than smaller-size
products.
should be greater if people consume
more of the item when they have a larger
quantity on hand.
should be lower if the economic or
psychological costs of stock-outs are
high.
Psychological Costs
• Cereal, yogurt
• Pharmaceuticals, toilet
paper
#9
Economics – Other incentives

to lower costs
(Thomas)
How do lower costs benefit
both buyers and sellers?
Seller wants
to sell more Buyer wants to
and at pay less
better margins
How do lower costs benefit

both buyers and sellers?
Win-win for buyer and seller!
Buyers need incentives to help

sellers achieve lower costs
Margin waterfall to illustrate sales incentives
$/
unit
75 -52
-7
16 -7
-4 5

sold Margin
Example for sales incentives (I)

$/
Reliable, predictable volume lowers
unit
production costs
75 -52 Customers who place orders in a very linear way,
i.e. a constant volume on a regular schedule,
creates predictability for the supply chain
-7
16 -7
-4 5

sold Margin
• Slight product variations

• Discounts for linear orders
Example for sales incentive (II)
$/
Shipping full containers lowers
unit
freight costs
75 -52 Shipping full truckloads (FTL) have a lower
per unit cost than smaller order sizes
-7
16 -7
-4 5

sold Margin
• Freight
• Different warranty and
goodwill terms
Example for sales incentives (III)

$/
Online purchases cost suppliers less
unit
than purchases made in-store
75 -52 Online sales or phone sales cost less than
direct face-to-face selling which involves
a salesperson's time
-7
16 -7
-4 5

sold Margin
• Variation in Sales expenses for

different customer segments
How can you use these categories
to create sales incentives?
• How could you prevent
margin leakage and
improve price realization
along the margin waterfall?
• What incentives to reduce

cost might you design to
create a win-win?
Module Takeaways
Price Discrimination Key
Points
• Cost-plus pricing
• Price discrimination based on
cost variation
• Price and margin waterfall
• Other incentives that lower
costs
• Three principles of product line
pricing
• Case application: Heinz
Ketchup

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Price Discrimination

Intro to Price Discrimination

By the end of this module

Economics – Cost-plus pricing

How does a business decide what

Price setting approaches

Cost- Value- Market-

$100 20% $120

When is cost-plus pricing useful?

Industries with Starting point

• Guarantees targeted margin

Advantages vs. disadvantages

• Promotes cost inefficiency

• Ignores opportunity cost

• Uses historical cost rather than

Cost-plus vs. target-cost pricing

How would you go about setting the

Why does the price vary for the

Price discrimination describes the

Price discrimination vs.

Private label purified water Different prices

Why do buyers accept

Cost of doing business often varies widely between

Cost of doing business at an airport

... probably not

So what else is going on?

What you learned

How could you discriminate prices in

Economics – Price and margin

Pricing practitioners have to

... despite a high starting price?

Price and Margin waterfall is a great tool to

Price waterfall Margin waterfall

Starting Price Net Cost Operating Margin

Global FX rate Local On-invoice Invoice price Off-invoice Net

• Exchange rate adjustments • Discounts (volume, payment, etc.) • Cash discounts

Margin waterfall and its components

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

Margin waterfall and fixed and variable cost

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

Variable cost Fixed cost

Price and margin waterfall

Cost and margin buckets can be easily

Select most useful dimensions when

Product Line Pricing

Economics – Other incentives

How do lower costs benefit

Win-win for buyer and seller!

Buyers need incentives to help

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

Example for sales incentives (I)

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

• Slight product variations

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

Example for sales incentives (III)

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

• Variation in Sales expenses for

• What incentives to reduce

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