PRICE

STRATEGY
WEEKS 8-9
BREAK-EVEN ANALYSIS

EXCHANGE VALUE MODELS

 BREAK-EVEN ANALYSIS
• A breakeven analysis determines the sales volume a business
needs to start making a profit, based on fixed costs, variable
costs and selling price
• Often used in conjunction with a sales forecast when developing a
pricing strategy, either as part of a marketing plan or business plan

• A subset of cost-volume-profit (CVP) analysis which is used

by firms to understand the link between them

• The breakeven analysis also helps in establishing the

break-even point which is defined as:
• The level of sales where the company will not incur a loss, yet not
make a profit

•Breakeven analysis entails
calculating the margin of safety
for an entity based on the
revenues collected and
associated costs
•In short, the breakeven analysis
shows:
•How many sales it takes to pay
for the cost of doing business
•Price levels relating to various
levels of demand
Side note:
Margin of safety may be viewed using
two different perspectives:
1. From an investment perspective:
principle of investing in which an
investor only purchases securities
when their market price is
significantly lower than their
intrinsic value
2. From an accounting perspective: it
refers to the difference between
actual sales and breakeven sales
 Reasons for calculating for the
breakeven:
1. Increasing selling price
2. Reducing fixed costs
3. Reducing variable costs
4. Increasing sales
 Breakeven Chart
SUNSHINE FLASHLIGHTS
Volume of Total Revenue Total Cost Profit
Production
500 PHP75,000 PHP235,000 (PHP160,000)
1000 150,000 270,000 (120,000)
1500 225,000 305,000 (80,000)
2000 300,000 340,000 (40,000)
2500 375,000 375,000 0 Breakeven point
3000 450,000 410,000 40,000
3500 525,000 445,000 80,000
 SUNSHINE FLASHLIGHTS
Volume of Total Revenue Total Cost Profit
Production
500 PHP75,000 PHP235,000 (PHP160,000)

500 X 150 500 X 70 75,000-235,000

TR=75,000 VC=35,000 FC=200,000 P=-160,000

35,000 + 200000
TC=235,000
1000 150,000 270,000 (120,000)
1500 225,000 305,000 (80,000)
2000 300,000 340,000 (40,000)
2500 375,000 375,000 0
3000 450,000 410,000 40,000
3500 525,000 445,000 80,000

You should remember these:
• The break-even point is that
volume of output where the
firm will have neither profit nor
loss
• If the level of output goes
below the breakeven point, the
firm incurs losses
• Any output increases beyond
the breakeven level will mean
profit
Major Takeaways:
But then…
• Cost side: when a firm reaches
full utilization of its capacity,
additional output will require
increase in productive facilities
or increase in fixed costs
• Revenue side: increases in the
supply of the product may push
prices downwards, which will
mean decreases in revenue with
the same volume of production
 Exe
HARRY’S POTS ‘N PANS rcis
Volume of Total Revenue Total Cost Profit
e
Production
1000
1050
Given: 1100
Fixed Cost: PHP221,000 1150
Variable Cost: PHP80.00
Selling Price PHP250.00 1200
1250
1300
1350
1450
1500
 EXCHANGE VALUE MODELS
Acknowledging that the right price lies within some range
necessitates identifying the boundaries of a good price
• Knowing the boundaries of a good price narrows
pricing discussions to a reasonable range of potential
price points
• Zone of Potential Agreements

Exchange value models quantify the price boundaries

• Using exchange value models to manage pricing
decisions requires focusing on the value created and
the firm’s ability to capture its fair share of that value
 TWO SETS OF BOUNDARIES FROM EXCHANGE VALUE MODELS

1. The extreme boundaries

define the range of
acceptable prices outside of
which no rational buyer or
seller would ever transact

2. The narrower boundaries

which lie within these extremes
define the range of prices that are
most likely to encourage customer
transactions and leave the firm in
the most favorable position
 THE CASE OF THE CYPHER DRUG
ELUTING STENT BY CORDIS, A J&J CO.
• Stents are used to reopen clogged arteries leading to
the heart after plaque has narrowed the passage and
restricted blood flow
• The addition of a pharmaceutical formulary coating
the standard metallic stent was demonstrated to
improve the patient’s body’s ability to accept the
stent within the artery
• The addition of a patented formulary that was
approved by the U.S. Food and Drug Administration
(FDA), Cypher was a revolutionary new product when
launched
• Cordis executives could not simply copy a
competitor’s practices in pricing it. Rather, pricing
would be a particularly daunting challenge for these
executives.
• For revolutionary products, such as Cypher, exchange
value models are a commonly used best-practice
approach to identifying launch prices.
• Once an exchange value model has been used to set
prices, it can then be repurposed as a sales tool to
support the communication of value.
• As such, exchange value models are an important
quantitative tool for setting prices and influencing price
acceptance.
 Extreme Boundaries
Marginal Full consumer
cost utility

PRICE
 Marginal Costs Define the Extreme Lower Boundary

Marginal costs constitute the seller’s bottom line

• Any price below marginal costs leaves the seller worse off than
it would have been without the transaction. Any price above it
leaves the seller better off. At times, sellers may choose to
price very near marginal costs for tactical price purposes, but
in general, sellers will seek to profit from their transactions.
Failure to profit from transactions removes any motivation to
participate in the trade; hence executives cannot be expected
to price at this level.
• Estimates vary widely on the marginal cost to produce Cypher
• some reports indicate that standard metal stents had an average unit cost
near $150 at the time of launching Cypher. Some estimates indicate that
Cypher had a fully loaded average unit cost of $375 at the time of its
launch.

• Regardless of how low the true marginal costs are, Cordis should
not price Cypher anywhere near this level. It would not be a fair
exchange to expect Cordis to price the drug eluting stent near
marginal cost.

• Developing Cypher required a tremendous amount of research and

development—a risky investment made with the expectation of
high rewards.
 • Not only should Cordis desire prices to cover the investment
costs of developing Cypher, but it should also seek to gain
profits:
1. to reward investors
2. to invest in further research and development leading to
the creation of new products that will be valued by
consumers in the future
3. To counter the business risk posed by other research and
development efforts that may also develop new solutions
for coronary heart disease long before the patent on
Cypher has expired
• Rather than using marginal costs as a guide to making pricing
decisions, therefore, the executives of Cypher are better off
using them as a bright line below which prices should not fall
• Marginal costs are simply a lower boundary on prices and
provide little guidance to what the price should be. It basically
states that the price of Product X should not be below this level.
• Internal cost accounting considerations of marginal costs fail to
account for the value that the product delivers to customers.
• The price of Product X should be connected to the value that the
product delivers so that the sellers have better insight into their
pricing potential.
 • Failing to understand value from the customer’s perspective
may result to:
1. executives setting really high prices for Product X to recover
sunk costs or opportunistically profit from uninformed
customers which can make the firm irrelevant to the market
as customers refuse to purchase
2. sellers will base the price of Product X on marginal costs and
price a new product too low, denying the firm its
well-deserved reward for the hard work that it takes to
develop a new product and deliver its value to customers.
 CONSUMER UTILITY DEFINES THE EXTREME UPPER
BOUNDARY
• If marginal costs are the seller’s bottom line, customer utility is
the buyer’s bottom line.
• Customer utility is based on the value a customer gains from
having/using the product.
Utility > Price
• So long as the consumer surplus is positive, customers will
value the product.
Consumer Surplus=Overall customer utility –transaction price
 • Customers gain utility from a product directly from the benefits that the
product delivers

• These benefits have been categorized into four fundamental types

1. Form
2. Place
3. Time
4. Ownership
 FORM

• Form utility derives directly from the

intrinsic properties of the product itself,
such as:
1. the value that customers place on
extending their lives with a stent
2. the enjoyment that customers
experience when drinking a beverage
3. The ease of breathing that sick people
get by using an oxygen concentrator
 PLACE
• Place utility derives from the ability to
acquire the product in a desired location,
such as:
1. having the stent available at a nearby
hospital
2. drinking the beverage at a local cafe,
3. buying the oxygen concentrator at a
nearby medical supplies store
 TIME
• Time utility derives from the ability to access
the product at a convenient moment, such as:
1. receiving the stent when coronary heart
disease has been detected
2. drinking the beverage when thirsty,
3. having the oxygen concentrator on hand
when it is needed
 OWNERSHIP
• Ownership utility is gained from possessing the
rights to the value of the product even if the
possession is never actually taken, such as:
1. the value of insurance coverage that would pay
for the implant of the stent when and if needed
2. the value of holding a beverage which can either
be drunk or resold,
3. The value of the availability of and accessibility to
an oxygen concentrator
• While customers derive utility from an improved stent from all four
fundamental types, in pricing Cypher, Cordis should focus on the form utility.
• The most significant value created in producing Cypher is that which is most
closely related to the value that customers gain in extending their lives.

LIFE
• As with many decisions in pricing, we cannot perfectly
quantify everything and rather work with the best estimates
and commonly accepted practices that we have.

• As such, let us estimate the value that people place on their lives as
the present value of future earnings. In addition, while the wages
and duration of future productivity vary between individuals, let us
estimate that the present value of the lifetime earnings of a coronary
heart disease patient is Php10,000,000 on average.

• One may argue that that is a ridiculously low value for a

person’s life. However, if the customer utility of a stent is near
Php10,000,000 should Cordis launch Cypher near this level?
 • Quickly we realize that such Php10,000,000 would be absurd
If Cordis did price Cypher anywhere near this level, any of the following can
happen:
1. most customers would find it unattainable.
2. customer sentiment would likely sour on Cordis, leading to retaliation, claims
of unfair pricing practices, and protests that Cordis was charging too much or
that Cordis was only serving the rich elite
3. governments might force Cordis to forgo its patents and allow other firms to
produce similar copycat products.
• Clearly, pricing near the customer’s utility is not a very informed or advisable
approach.
• Neither marginal cost nor customer utility reveals the right
price by itself, but combined, they reveal the hard boundaries
of potential price for launching Cypher.

• The range of prices between these boundaries is quite wide.

Estimating marginal costs at $375 and customer utility at
Php10,000,000 leaves a range of potential prices that is far too
wide for any meaningful decision making.

• Executives need a tighter set of boundaries than those

provided by marginal costs and customer utility for pricing
decisions. For more evolutionary products, they are likely to
demand pricing guidance that narrows the range.
 NARROWER BOUNDARIES
• Executives making pricing decisions need a narrower and
more relevant set of boundaries than those identified by
considering marginal costs and customer utility.
• Strategically, prices should reflect the value to customers of
accomplishing their goals in comparison to alternative
means.
• Higher prices reflect the ability of a product to fulfill a need better
than the alternatives.
• Lower prices reflect the ability of a product to fulfill a subset of the
needs as well as the alternatives.
• The nature of strategic pricing calls for pricing in proportion
to the value delivered in light of the comparable
alternatives.
The narrower price boundaries are defined by
the:

1. comparable alternatives
2. differential value
 Comparable Alternatives
• Comparable alternatives are solutions that customers may have to accomplish
the same or a similar set of goals.
• They may be directly competitive offers or indirect substitute solutions to the challenges
facing customers. Competing alternatives can usually be identified within the
marketplace and will have an existing transaction price. As such, they can inform the
pricing decision.
• In formulating pricing guidance, it is best to use the most
closely comparable offer on the market.

• Customers are more likely to evaluate their willingness to pay in

relationship with a closely comparable solution than they are
with some distant alternative.

• As such, executives should use the closest competing or

substitute solution when identifying potential price points.

• Inferior alternatives are any
competing alternatives that
deliver similar benefits to the
one under consideration with
less overall consumer utility.
Inferior alternatives define the
narrow lower bound for pricing
decisions.
Inferior Alternatives
• In general, executives should
price products higher than their
next nearest inferior alternative
because their new product will
deliver more value.
• In some cases, executives may
price below this boundary if they
expect to tap into a new market,
but in general, pricing below an
inferior alternative implies the
firm is forgoing some profit
potential.
 Inferior Alternatives
• Cordis produced a standard metal stent priced at roughly $1,050 prior to its
launch of Cypher. Using this data point to guide a pricing decision and the fact
that the Cypher drug eluting stent is superior to a standard metal stent implies
that Cypher should be priced at or above this level.
• To determine how much higher to price Cypher than the standard metal stent,
we need to determine the value of its superiority.
 Differential Value
• Differential value is the change in customer utility that a product delivers in
comparison to the alternative.
• If the new product is superior to its comparable alternatives, the differential value is
positive.
• If the new product is inferior to its comparable alternatives, the differential value is
negative.
• The economic exchange value of a product is the price the price that
customers would pay for its nearest comparable offer plus the value of the
increased (or decreased) benefits of the improved (or degraded) new product.
• For a given product, rational customers should be willing to pay any
price up to that determined by the exchange value. A new product
priced at the exchange value would, on average, leave customers
indifferent between the new product and the nearest comparable
alternative. Some customers may value the new product more and
thus be willing to pay more, while others will value it less.

• Executives may price higher than the exchange value but usually find
it more beneficial to price slightly lower. Any price below the
exchange value will, on average, leave customers better off with the
new product than they would be with its comparable alternatives,
and definitely better off than they would be without the product at
all, and therefore would be a good price.
Thank you.