Business Horizons (2006) 49, 415 — 424

www.elsevier.com/locate/bushor

Making effective pricing decisions

Kostis Indounas

Department of Marketing and Communications, Athens University of Economics and Business, 76 Patission
Street, 104 34 Athens, Greece

KEYWORDS Abstract Pricing is one of the most complex decisions facing any company. Along
Pricing; with a lack of academic interest (especially among marketing academics) in the field
Contribution margin; of pricing, this complexity has contributed to the dominance of simplified, cost-
Avoidable fixed costs; based formulas when levying prices. This article offers an alternative approach
Variable costs; based on the concept of contribution margin and the need to take into consideration
Value only those costs that are related directly to a specific pricing decision, an approach
that is especially useful when a company decides to change its prices. Moreover, an
empirical study regarding the practical use of this approach is also presented.
D 2006 Kelley School of Business, Indiana University. All rights reserved.

1. The paradox of pricing
One of the most difficult decisions facing any
company is how to price the products or services
it renders. Nevertheless, pricing cannot be exam-
ined in isolation from the other elements of a
company’s marketing strategy. The marketing dis-
cipline is based on the marketing mix concept,
which consists of the 4 Ps: price, product, place,
and promotion. The goal of the marketing mix is to
satisfy customers through offering the right product
with the right promotion and place (i.e., distribu-
tion channels) at the right price in order to satisfy
customers’ needs better than competitors, and
thus achieve the firm’s corporate objectives.
This is the definition of marketing as put forward
by the American Marketing Association in 1985.
E-mail address: Indounas@aueb.gr
0007-6813/$ - see front matter D 2006 Kelley School of Business, Indiana University. All rights reserved.
doi:10.1016/j.bushor.2006.02.003
Based on the wording, one can easily understand
that price cannot be separated from the other
elements of the marketing mix; for instance, a high
price conveys a prestigious image, leaving a
company no other option than to offer a high
quality product in the market. Moreover, in order to
convey this prominent image, the product needs to
be rendered in the market through an exclusive
distribution strategy, by which it might be found
through limited points of sale. Within the same
context, there is a need for a promotion campaign
(e.g., advertising, sales promotion, direct market-
ing) that will target those customers who are price
insensitive, and thus are willing to pay a higher
price for a higher quality, exclusive product. A
different marketing strategy would be formulated
in the case of a low price targeted at customers
characterized by high price elasticity. Many similar
examples could be cited, illustrating how pricing
fits within the overall marketing strategy.
416
Of course, this interaction extends both ways in
that the product itself, its promotion, and its
distribution also affect its final price and even the
success of the pricing strategy. Product determines
the value of the product, reflecting the extent to
which a price can skim, penetrate, and remain
neutral in a market. Promotion influences price
through its effect on price sensitivity, while the
choice of a distribution channel indicates the
image that a company conveys, complementing in
this way the product’s price. Kotler, Armstrong,
Saunders, and Wong (2002) point out that pricing is
an integral part of a wider and more general
marketing strategy; thus, a company needs to
formulate a cohesive and integrated marketing
strategy, part of which is a well-developed pricing
strategy.
Given the relationship between pricing and the
other components of the marketing strategy, it
should be noted that pricing is the only element
within this strategy that is associated directly with
revenues and profits, while the others are associ-
ated with costs and expenses. For example, an
advertising campaign or a decision to modify an
existing product entails expenses. Moreover, pric-
ing decisions are characterized by flexibility, in
that the decision to decrease or increase the price
of a product can be implemented relatively quickly
and its results can be realized in a much shorter
period than other managerial decisions (e.g., new
production introduction).
Despite all this, a decade ago, Nagle and Holden
(1995) portrayed pricing as the most neglected
element of the marketing mix. Since that time,
things have not changed dramatically. In the words
of Hinterhuber (2004, p. 765), bNot only managers,
but also academics, have shown little interest in
the subject of pricing.Q A possible explanation may
be that price is considered as part (and often the
least important part) of a complex strategic
decision involving all aspects of the marketing
mix. As such, there is a tendency within the
marketing discipline to suggest that a sustainable
competitive advantage can be achieved by placing
emphasis not on price, but on non-price elements
(e.g., efforts to differentiate a product or service
or to add value to it, to offer increased service
quality, to invest in branding, to promote corporate
image and fame, etc.).
Another explanation could be rooted in the fact
that pricing decisions are, by nature, complex,
leading many managers to feel uncomfortable
when discussing pricing strategies, rely on simpli-
fied (mainly cost-based) formulas, and not perceive
pricing from a strategic perspective. This complex-
ity is realized in many different ways. Firstly,
K. Indounas
contrary to other marketing or even broader
corporate decisions, determining prices is, effec-
tively, associated with the use of mathematical
formulas, which many managers find difficult to
understand and apply. Recent studies have tended
to empirically validate the argument that managers
responsible for setting prices are often arithmo-
phobic, and find difficulty in comprehending the
numerical implications of pricing decisions (Avloni-
tis & Indounas, 2005).
Secondly, there seems to be confusion among
both academics and practitioners regarding funda-
mental aspects of the pricing process, such as
pricing objectives and pricing methods. What, for
example, is the difference between pricing meth-
ods, policies, and strategies? Some managers and
practitioners treat them as the same concept,
while others have endeavoured (even from a
conceptual point of view) to clarify the differences
between them.
Thirdly, pricing decisions can hardly be made
without effective cooperation among different
departments within the company. Levying prices
that are in line with market conditions and that also
satisfy the a priori set marketing and corporate
objectives necessitates a close collaboration among
people with different managerial experience and
backgrounds.
Based on these arguments, there seems to be a
need to better understand how pricing decisions
are made and provide practical recommendations
toward the direction of improving these decisions.
This article aims to contribute to this direction; to
this end, an alternative approach for setting prices
is presented, along with the views of a sample of
managers that were interviewed regarding this
approach.
2. The cost-based pricing illusion
A number of empirical studies have indicated that
cost-based methods (especially cost-plus and
mark-up) have dominated the pricing practices of
companies, regardless of sector of operation (Avlo-
nitis & Indounas, 2005; Carson, Gilmore, Cummins,
O’Donnell, & Grant, 1998; Meidan & Chin, 1995;
Shipley & Jobber, 2001). Under these methods, cost
is the starting point of every pricing decision,
followed by a consideration of the market’s aver-
age competitive price and an informal evaluation of
customers’ reactions.
Construction companies, aerospace companies,
lawyers, and accountants have traditionally used
the cost-plus method in order to levy prices. To
better illustrate this method, the following real
Making effective pricing decisions
case of a Greek transportation company (which
was interviewed as part of a study regarding the
extent to which the contribution margin analysis
pricing method is used) is provided. This company
specializes in transporting goods to countryside
locations and presents the following costs:
Total drivers’ salaries o125.000
Total drivers’ hours 45.126
Cost per hour (for each driver) o2.77
Other variable costs of lorries o100.000
used (e.g., fuel)
Lorries’ total miles 250.000
Variable cost per mile o0.40
Other fixed costs o30.000
Fixed cost per mile o0.12
Desired profit 15%
For a 200 mile trip that necessitates 12 hours of
driving, the final price under the cost-plus method
is calculated as follows:
200 miles 4 o0.40 = o80
12 hours 4 o2.77 = o33.24
Fixed costs (allocated on the basis of miles)
200 miles 4 o0.12 = o24
Total cost for this trip (or unit cost differ-
ently) = o137.24
10% desired profit = o13.72
Final price = o150.96
As illustrated by this example, in order to
calculate a final price, total fixed costs need to
be allocated on the basis of some criteria (in this
case, miles). Such an allocation, however, may be
misleading in that it assumes total fixed costs are
allocated proportionally to all the products or
services a company offers. Unfortunately, this is
seldom the case. The problem is intensified even
more due to the fact that companies following this
approach tend to allocate fixed costs on the basis
of the forecasted total volume or sales they
expect to achieve within a fiscal year. This is the
trend, even among leading companies within
different industries. Is it, however, possible to
make a precise estimation of expected sales?
Additionally, the total fixed costs that need to
be allocated across total units produced or total
sales expected actually depend on these units or
sales, which, in turn, depend on a product’s final
price. Thus, there seems to be a vicious circle
when applying the cost-plus method. Cost is the
starting point in the process of determining a
product’s price, while, in reality, it is affected by
the final outcome of this process, which is price.
As such, it seems that the effort to determine a
product’s unit cost (which is a prerequisite for
417
applying the cost-plus method) is misleading, since
this cannot be done before first determining the
price itself. In other industries (especially service-
based ones), this calculation is almost impossible;
for example, consider an airline or insurance
company. What is the unit cost of an individual trip
or the unit cost of life insurance? Certainly, it is not
easy to say.
Another disadvantage associated with the cost-
plus pricing method is that it disregards market
conditions. Although many managers take into
consideration market conditions when, after having
calculated the unit cost, they determine the
maximum price that can be set, this method does
not provide a solid and systematic way for doing so;
in practice, consideration takes place in an intui-
tive and informal manner. Finally, under this
approach, the required sales level that is needed
in order to make any price change profitable for the
business is not examined.
Why, then, has the cost-plus method dominated
the pricing practices of even leading companies?
The ease of its practical implementation could be
one reason, the fairness that customers associate
with the method, another. Under cost-plus, though,
managers may be easily enticed to underprice or
overprice their products, since it is not a market-
oriented method. Even worse, it does not rely at all
on the value that customers attach to a product.
A deviation of the cost-plus pricing method is the
mark-up pricing approach. For years, this approach
has dominated the pricing practices of retailers and
distributors, and it recently has begun to be adopted
in sectors where agents play a fundamental role
(e.g., travel agencies). Under the mark-up pricing
approach, the company adds a percentage to the
cost of purchasing (not producing, as in the case of
cost-plus) a product or service. This percentage is
typically based on past practices and industry
norms, while in some (especially oligopolistic)
sectors, it is the result of agreements among existing
competitors. The mark-up pricing approach suffers
from some of the same drawbacks associated with
cost-plus pricing; in particular, it is unable to provide
answers to questions like: How are customer inputs
taken into consideration? Does this percentage
reflect the value that customers attach to the
product, or is it just a way to cover its costs?
A third cost-based pricing method is that of
target profit, the rationale of which is that for a
specific level of expected sales or production units,
a specific capital is required. Thus, a target profit
needs to be achieved that will provide a satisfactory
return on this capital. A leading Greek information
technology firm has used this approach for many
years, as reported by the company’s marketing
418
director. In 2005, the company’s capital equals
o500.000 and its target profit is 15%, suggesting
that the total turnover should equal o575.000. If
the forecasted production units that will be sold
total 80.000, then the final price will be o575.000:
80.000 = o7,19. Under the target profit approach,
the need to forecast a priori the sales or production
units is obvious; thus, this method is bound to have
the same disadvantages as the other two previously
discussed cost-based pricing methods.
Cost-based pricing addresses effectively the issue
of what prices are needed to cover costs and lead to
profitability. This ability might seem legitimate and
even justify the overemphasis attached to cost-
based formulas; nonetheless, it leaves untouched
the issues of what value the customer assigns the
product and how that value can be communicated
through price. Similarly, while it addresses what
profits are needed in order to meet volume, market
share, or other objectives, it does not touch what
level of sales can be achieved profitably.
Managers should realize that sales levels depend
on price and let price, itself, determine cost rather
than the other way around. Thus, instead of
product-driven cost-based pricing, managers
should endeavour to apply value-based pricing
formulas, which take into account the value
customers attach to a product. Rather than reflect
the cost of a product, price should reflect its value.
Taking this into account, value-based pricing might
help managers design their pricing strategy in a
more sophisticated and systematic way. The con-
tribution margin analysis approach is a value-based
approach that solves many of the drawbacks
characterizing cost-based pricing. The fundamen-
tals of the contribution margin analysis approach
(e.g., the need to take into account only the direct
costs that are affected by specific pricing deci-
sions) can be traced back to analyses by authors
such as Morris and Morris (1990), Simon (1992), and
Smith and Nagle (1994). Nagle and Holden (1995),
however, were the first authors to systematically
review the method in question and endeavour to
apply all the mathematical formulas associated
with its practical implementation.
3. The contribution margin analysis
approach
The contribution margin analysis approach is a
value-based pricing method that endeavours to
incorporate not only cost, but also competitors’
and customers’ inputs when levying prices into a
single mathematical formula. As such, it avoids the
traditional distinction between cost-based, compe-
K. Indounas
tition-based, and demand-based pricing methods,
placing its emphasis on all these factors simulta-
neously. More specifically, instead of pricing on the
basis of a product’s cost, the cost contributes in
estimating the amount of sales that need to be
achieved as a result of a price change. Instead of
marketers’ perception that price should be based on
what customers are willing to pay, price is a function
of the value that customers attach to the product. As
opposed to a traditional approach, whereby prices
are set by only one department or the CEO, a wider
cross-functional cooperation is encouraged. In such
a scenario, the financial department may provide
necessary cost-related data, while the sales or
marketing department might provide market-relat-
ed data, especially as it relates to customers’
potential responses to different price levels. The
introduction of a pricing committee made up of
representatives of different functions (e.g., mar-
keting, sales, finance, production) could further
improve the effort. This committee would have the
responsibility of proposing a final price, after taking
into consideration all company- and market-related
conditions and making the mathematical calcula-
tions associated with the approach in question.
Finally, top management would have the responsi-
bility of approving this price.
In a sense, this approach endeavours to com-
promise cost-driven and market-driven pricing.
Traditionally, marketers have believed that costs
should play no role in pricing, given the need to
take into account customers’ needs and adapt
costs accordingly. On the other hand, financial
managers are sometimes overly concerned with
controlling costs; thus, they base their pricing
strategies solely on these costs. Within this con-
text, many businesses face the need to compro-
mise these two different views and practices. The
proposed approach can partially break this dead-
lock and introduce some kind of balance in pricing
decision-making.
The importance of the contribution margin
analysis method is increased even more if we take
into account that, with the exception of new
products, all other pricing decisions are associated
with existing products; more specifically, with
whether an existing product’s price needs to be
maintained, increased, or decreased. It is based on
the break-even formulas businesses use in order to
evaluate the financial implications of potential
investments or products they offer. Here, however,
the incremental profitability of a price change, in
particular, is examined. More specifically, any
change of price should be evaluated on the basis
of the quantity of sales that is required in order to
make this price change profitable for the business.
Making effective pricing decisions
A reduction of price is expected to increase sales
but reduce profit; thus, it is necessary to estimate
that amount of sales that will, at least, offset the
lost profits. Accordingly, a price increase is
expected to increase profits but reduce sales,
leading again to the need to estimate that amount
of sales that can be bsacrificedQ in order to make
this price increase profitable. As Nagle and Holden
(1995, p. 37) stated, managers need to ask:
! How much would sales volume have to increase
to make a price reduction profitable?
! How much could the sales volume decline
before a price increase becomes unprofitable?
Both questions indicate a need to take into
account the conditions surrounding a company’s
market in order to make the most precise estima-
tions. As such, both competitive potential reactions
and customers’ attitudes to different price levels
are bound to be taken into consideration. Of
interest are how customers will respond if prices
are increased or decreased, how competitors will
react, who will follow the initiative, and whether
it’s possible to achieve or sacrifice the proposed
sales level given the conditions facing the market.
Properly addressing these issues requires intra-
company collaboration.
Managers need to understand the value that
customers attach to their products. Although many
definitions have been provided, there seems to be a
consensus among academics (even those belonging
to different disciplines) that value represents a
kind of cost—benefit analysis or trade-off for the
consumer. This is what Zeithaml, Bitner, and
Gremler (2006, p. 526) refer to as bWhat I give vs.
what I take.Q Nagle and Holden (1995, pp. 76—77)
propose a four-step approach for evaluating the
value customers attach to a product:
(1) Identify the cost of the competitive product
that the customers perceive as the best alter-
native. This is the product’s reference value;
(2) Identify all factors that differentiate your
product from the competitive product;
(3) Determine the value to the customer of these
differentiating factors, called the differentia-
tion value; and
(4) Sum the reference value and the differentiation
value to determine the product’s overall value
(the value that someone would pay in order to
obtain the product).
Apart from evaluating their product’s value,
managers have a lot to gain by estimating custom-
ers’ sensitivity to different price levels. Formal
market research conducted by the company’s
419
marketing department or through an external
market research agency could help in this effort.
Such market research often reveals unanticipated
and surprising results, challenging managers’ views
regarding their customers’ behaviours and beliefs.
Once having identified the value customers attach
to a product and their price sensitivity to different
price levels, managers will be better able to
anticipate customers’ potential responses to price
increases and decreases.
With reference to competitors’ potential
responses, managers should collect and evaluate
information regarding competitors’ past reactions.
In every industry, there are competitors that would
react immediately, especially to price decreases, in
order to avoid the possibility of losing market
share. Other firms, however, might think more
strategically and endeavour to identify the reasons
behind a price cut initiative. They could avoid
retaliating, as lowering their prices could cause a
downward pressure for the whole industry, leading
to unanticipated price wars. Formulating scenarios
regarding how competitors are expected to react to
different price levels is another way to evaluate
their potential reactions. This analysis can be
conducted either for the whole market or for each
individual market segment in which a company
operates.
Along with examining competitors’ potential
reactions, investigating their current prices is
another fruitful action. There are many different
ways of identifying competitors’ prices, including
through sales force reports, industry trade reports,
industry experts’ opinions, loyal customers who
reveal information, and employees who previously
worked for competitors.
Incorporating customer and competitive inputs
into pricing decision-making can also be aided by
managerial experience and intuition. For example,
many managers have a grasp on competitors’
prices, especially in highly competitive markets.
Similarly, in business-to-business contexts, where
other criteria such as fame, customer service, or
after-sales service are more important than price in
choosing among alternative suppliers, customers
might be characterized by price inelasticity, and
thus react marginally to price changes. The effort
to evaluate all these inputs more systematically
and strategically could improve the effectiveness
of pricing decisions. To this end, the contribution
margin analysis approach is based on mathematical
formulas that are simple and easy to apply. These
formulas can help companies determine the
amount of sales that need to be achieved or can
be sacrificed every time a decision to alter an
existing price is made.
420
To better understand these formulas, consider
the case of a leading Greek shipping company. The
firm offers many different trips in the Greek
islands, with the majority of its turnover being
derived from a specific trip to a popular destina-
tion. Currently, the company’s unit variable costs
are estimated at o8 per passenger, and its normal
unit sales per month run o20.520 during low
season (November—March) and o70.690 during
high season (April—October). Due to Greek shipping
industry regulation, the trip is priced at o24.60 in
both seasons; the fare covers economy seating only.
This results in total revenues of o2.243.766
[o24.60 4(70.690 + 20.520)]. On the suggestion of
the sales manager, who believes a price reduction
would enable penetration of price-sensitive target
segments and increase sales dramatically, the
company is examining the possibility of reducing
the fare by 10% (i.e., o2.46). The finance manag-
er, however, has some reservations regarding this
idea, as he feels such a price decrease would lower
the company’s profits significantly. In dealing with
similar situations in the past, the company has used
the contribution margin analysis approach to ana-
lyze whether proposed changes would be benefi-
cial. In order to investigate the profit implications
of the 10% fare reduction price initiative, the
marketing, sales, tickets-booking, finance, and
general managers held a meeting to figure the
amount of sales that would offset possible losses in
profits and make the price decrease profitable; in
other words, the contribution after the price cut
must exceed the contribution before the price cut.
In order to calculate the required amount of sales,
the company used the following mathematical
formula (expressed as a percentage):
Percentage change of sales
 Price Change
¼ fixed costs). For instance, if a company decides to
Contribution Margin þ Price Change
where Contribution Margin = Initial Price  Variable
Costs.
In the case of the 10% fare reduction price
initiative, the percentage of sales would equal
( o2.46) / [o16.60 + ( o2.46)] = 0.174, or 17.4%.
According to this calculation, the company would
have to increase its typical monthly sales by at
least 17.4% in order to make the price decrease
profitable. Based on past competitive behaviour,
the company’s three main competitors are
expected to follow such a price decrease, so as
not to lose sales. In conclusion, the pricing
committee decided that it was almost impossible
to achieve the required sales level and abandoned
K. Indounas
the idea. Also contributing to the decision was the
real possibility that a low price could, in the long-
run, lead to further price decreases, reducing total
profits in the market. This notion was intensified by
the fact that, as revealed by a study conducted on
behalf of the company, some categories of custom-
ers (especially the residents of the islands) are
rather price sensitive; as such, a price cut could
prompt them to negotiate even lower prices in the
future.
The previous example illustrates how the con-
tribution margin analysis approach can help a
company in its everyday pricing decisions, partic-
ularly with those related to price changes. The
proposed formula could also be used to investigate
the profit implications of a price increase. In this
case, a company would estimate the amount of
sales that could be sacrificed, given that a higher
price would increase net profits. Moreover, the
proffered mathematical formula could be adjusted
to take into account changes in either a product’s
variable or fixed costs. For example, a new booking
software system the Greek shipping company has
established is expected to reduce the variable cost
by o0.02. Additionally, its fixed costs are expected
to increase by o5.000, due to an advertising
campaign devoted to promoting the specific trip.
Why, though, is the contribution margin impor-
tant? Contrary to the average profit, which is
calculated after taking into consideration all the
costs (both fixed and variable) of the business, the
contribution margin is related to that percentage of
sales that contributes to fixed costs and profit
every time an additional unit of the product is sold.
It is based on the variable cost and that amount of
fixed costs associated directly with a pricing
decision (avoidable fixed costs), disregarding those
fixed costs that would occur anyway and have any
relationship with a specific pricing decision (sunk
increase its product’s price and this necessitates
some potential improvements in product quality,
the fixed costs related to these improvements
(e.g., a new production machine) need to be
included in calculating the product’s total costs;
however, other fixed costs that are unrelated to the
specific improvements (e.g., an increase in the
marketing director’s salary) should not be taken
into consideration when setting the price of the
product in question.
In order to understand more thoroughly the
significance of the contribution margin and the
overemphasis managers usually attach to average
cost or profits, consider the true case of an airline
that conducts, among other routes, a flight every
Sunday to an isolated Greek island. According to
Making effective pricing decisions 421

Table 1 Current situation that the airline faces gers. Five of these passengers, however, would
1 2 choose the Sunday flight in any case; and
All 40 seats Only 25 seats (3) A new flight every Thursday evening, priced at
sold (in o) sold (in o) o90, which is expected to attract 22 passen-
Price 90 90 gers. Seven of these passengers, however,
Sold tickets 40 25 would choose the Sunday flight in any case.
Total sales 3.600 2.250
Total cost 1.800 1.500 Table 2 presents the analysis of the three
Average cost per 45 60 proposed solutions. It is characteristic that the
passenger first option leaves the highest profit margin,
Profit margin 1.800 750
although it just covers the average cost. The reason
for this is that the direct costs related to this option
data provided by the sales director of the company, are lower than those of the other two options, since
the firm faces the following expenses: the flight cost already exists and isn’t directly
related to the specific pricing decision. Nonethe-
less, the emphasis that’s placed on average cost as
Administrative expenses o1.000.000
a factor in pricing decisions would lead many
Cost of the specific flight o1.000
managers to choose the second or third option over
(e.g., personnel wages, fuel)
the first.
Variable costs per passenger o20
The contribution margin is also significant in that
(e.g., meal, magazines)
it may guide a company in deciding which product
Currently, the company faces the problem of a prices to lower and which to increase. Specifically,
very small profit margin. The normal price for the products with a low contribution margin can bear
specific flight is o90 and the capacity of the an increase in price, given that they can sacrifice
aircraft used is 40 seats. If the aircraft is full, total more sales than can products with a high contribu-
sales will equal o3.600 and total cost will equal tion margin in order to make the specific pricing
o1.800. Normally, however, the company only sells decision profitable. Accordingly, products with a
25 seats per flight, resulting in total sales of high contribution margin can afford a decrease in
o2.250 and a total cost of o1.500. This creates price, as they need to achieve less sales than
a profit margin of o750 and an average cost per products with a low contribution margin.
passenger of o60 (see Table 1). The previous case analysis makes clear the need
In order to increase profitability, company to change existing mentalities regarding pricing
managers are currently examining the following decisions. Standard accounting practices should be
three options: re-examined, leaving room for more realistic
approaches for calculating a product’s direct cost.
(1) A reduced price of o60 for students traveling to In order to achieve that, the abstract allocation of
this island, who otherwise would not choose to fixed costs across a firm’s range of products should
travel by plane. This solution is expected to be avoided. Companies could endeavour to find
attract 15 students, but the proposed price just that proportion of fixed costs related directly to a
covers the average cost; specific pricing decision. Alternative accounting
(2) A new flight every Tuesday evening, priced of techniques, such as activity-based costing, could
o85, which is expected to attract 25 passen- certainly contribute to this direction.

Table 2 Analysis of the three different pricing solutions in the case of an airline
1 2 3
Reduction of the A new flight every A new flight every
price for students (in o) Tuesday evening (in o) Thursday evening (in o)
Price 60 85 90
4 Sold tickets 15 25 22
= Sales 900 2.125 1.980
 Opportunity cost (lost sales) 0 450 630
Total sales 900 1.675 1.350
Cost of flight 0 1.000 1.000
Variable costs 300 500 440
Direct costs 300 1.500 1.440
Profit margin 600 175 90 (Loss)
422 K. Indounas

4. Managers’ views the method we’ve followed for years; it hasn’t ever
disappointed us, or them.Q
In order to examine the extent to which the
Despite the number of surveyed businesses that
contribution margin analysis approach is used
do not employ the contribution margin analysis
(along with potential reasons for not employing
approach when setting prices, an information
it), a study of 129 transportation and 48 informa-
technology company specializing in software sol-
tion technology companies operating in Greece
utions for opticians does. Until three or four years
was conducted over a period from February until
ago, this market had been dominated by a small
September 2005. Part of a wider research effort
number of companies, including the aforemen-
concerning the pricing practices of industrial
tioned firm. The environment cultivated long-term
service companies, the study found that:
relationships between buyers and suppliers, in
which price was not considered to be the most
! Only 13.9% of the transportation companies
(i.e., 18 companies in total) and 10.2% of the
important purchase criterion. After the entrance of
larger companies to the market, however, things
information technology companies (i.e., 5 com-
changed dramatically. The bigger firms’ low costs
panies in total) were found to have adopted the
permitted them to offer almost similar services at
approach in question.
lower prices, which led to a situation whereby price
! The main reasons that were reported for not
using this approach by the rest of the
changes became a rather regular phenomenon
among market competitors. Within this context,
companies (144 in total) refer to the difficulty
existing smaller companies were bound to re-think
associated with its practical implementation,
their pricing strategies.
the use of less complicated approaches, the
The information technology company specializ-
fact that pricing is more or less a top
ing in software solutions for opticians was one of
management decision, and the fact that
the first to adopt the contribution margin analysis
when prices are altered, this is mainly based
approach. Historically, the company had undertak-
on managers’ experience and intuition (see
en price changes in an informal and intuitive
Table 3).
manner, based on managers’ experience regarding
how competitors and customers would react. With
These results suggest minimal use of the contri-
the introduction of a pricing committee (consisting
bution margin analysis approach by the companies
of the marketing, sales, and finance managers),
in our sample. In addition to the reasons cited
however, the firm began to examine these poten-
above, this finding might be attributable to the fact
tial reactions in a more systematic way. Records
that the two industries studied consist mainly of
consisting of previous competitor actions and prices
small- and medium-sized firms that don’t rely on
have been established, and are monitored regularly
systematic procedures to set their prices. The
by the marketing and sales departments. Addition-
views of a managing director of a transportation
ally, the company has started investing in under-
company are characteristic:
standing customer behaviour via formal market
bI feel that the proposed approach is rather research (usually through in-depth interviews on
complicated for us. It requires time, and I don’t the basis of qualitative research). Conducted
know if we have the right people for making all approximately twice per year, this research asks
these calculations. I can perhaps understand its customers about the value they feel they get from
potential benefits, but discussing prices with cus- the company’s services, the price they believe
tomers (even through some kind of negotiation) is reflects this value, the price under which they

Table 3 Reasons for not adopting the contribution margin analysis approach
Important (%) Very important (%)
1. Difficulty associated with its practical implementation 51.2 30.4
2. Use of less complicated approaches 41.7 25.3
3. Pricing is a top management decision 29.5 24.1
4. Prices are changed on the basis of intuition and experience 28.3 16.7
Research note: During February—September of 2005, a mail survey of a proportionate stratified sample of 420 transportation and
180 information technology companies operating in Greece was conducted (600 companies in total). Responses were received from
177 companies in total (129 transportation and 48 information technology companies), representing a response rate of 29.5%. In this
scale, respondents who reported that they do not use the contribution margin analysis approach (144 in total) were asked to
indicate through a 1—5 point scale (1 = Not important at all, 5 = Very important) the reasons for not using it.
Making effective pricing decisions
would switch to competing offers, and their
potential reactions to proposed price changes. As
in the case of competitors, customer profiles have
been established, especially for key customers that
contribute significantly to the company’s total
turnover.
Furthermore, the company has endeavoured to
modify its existing cost accounting techniques by
placing the emphasis on finding the true cost of its
services and, subsequently, its pricing decisions.
For example, all employees have been encouraged
to fill out a form outlining their everyday activities
and describing how much time they spend on each
activity. Thus, when a specific pricing decision is
made, it is easy to figure out the proportion of costs
(variable and avoidable fixed) directly affecting the
decision. To this end, the company has also
developed a different costing system than the
traditional financial reporting, as follows:
Sales
 Variable Costs
= Total contribution
 Avoidable fixed costs
= Net contribution
 Other fixed or sunk costs
= Pretax profit
The benefits of adopting this method have been
compelling: the company has managed to almost
triple its profits during the last three years.
Although using the proposed method might not
be the only reason for this improvement, the
company’s marketing manager has suggested it is
one of the most important. The company has
started to monitor more closely the profit impli-
cations of all pricing strategies and tactics, along
with the relationship between sales level and
profitability of single pricing decisions, abandoning
a previous over-emphasis on market share and
sales. It is a perfect example of a company
operating in a niche market, characterized by high
profitability.
By investigating more closely the impact of
different sales levels on pricing decisions’ profit-
ability, companies in our sample that do not
currently employ the approach in question could
be aided in making more realistic and systematic
pricing decisions, and treat pricing from a more
strategic perspective than they currently do. Thus,
the prices that they will levy will be in accordance
with both their internal considerations (especially
the ones related to controlling their costs) and the
conditions surrounding the market in which they
operate. Authors such as Nagle and Holden (1995)
have suggested that such an amalgam of pricing
423
thought and practice is bound to make pricing a
powerful marketing tool and lead to profitability in
the long-run.
5. Key recommendations
Companies face difficult decisions when altering
the prices of their products. This is especially
true in competitive industries characterized by
frequent price changes, as the ones examined in
this study. In such industries, making effective
pricing decisions requires continuous monitoring
of prices and managerial expertise in deciding the
timing of a price change. This article has
theoretically and empirically examined a pricing
method that can aid managers in making such
decisions; namely, the contribution margin analy-
sis approach.
Under this approach, the effort is to determine,
through the use of a straightforward mathematical
formula, the level of sales that must be achieved in
order to make any price change profitable. The
first step in applying this method is to identify
those costs that are relevant to a specific pricing
decision (i.e., variable costs and avoidable fixed
costs), disregarding all other irrelevant costs. The
second step is to understand how to use these
costs. The calculation of the contribution margin
figures the amount of sales that contributes to the
rest of fixed costs (sunk costs) and profits. The
third step is to examine whether market conditions
(e.g., potential competitive reaction, attitudes
toward different price levels) favour the calcula-
tions derived from the aforementioned formulas.
Certainly, understanding the effect of sales on a
product’s profitability and applying the proposed
method is not always an easy task, as it requires a
re-examination of current pricing practices and a
re-focus on different accounting techniques. This
may partially explain its limited use, as identified
in this study; nonetheless, managers responsible
for setting prices have much to gain by endeav-
ouring to understand the method’s merits. The
first benefit is that the contribution margin
analysis approach lacks the arbitrariness associat-
ed with cost-based pricing, which, in most cases,
leads to overpricing or underpricing phenomena.
Thus, instead of allocating fixed costs across
different units, an effort is made to identify the
real costs that may be attributed to a specific
pricing decision. Similarly, instead of relying solely
on managerial expertise and intuition to predict
competitors’ and customers’ potential responses
to price changes, the method emphasizes adopting
and applying specific tools for the purpose of
424
finding a concrete answer. The second benefit of
the method is that it incorporates into the final
price levied a reflection of the value customers
attach to a product or service. To this end, prices
are closer to customers’ individual needs and
characteristics, and can thus become a powerful
marketing tool. The third benefit of this approach
is cross-functional cooperation, which is contrary
to the functional isolation derived from cost-based
pricing. Such cooperation results in greater crea-
tivity when setting prices, along with imposition of
prices that are in line with both corporate goals
and strategies and the objectives and strategies of
the company’s individual departments. The fourth
benefit is related to the closer examination of the
relationship between sales and profitability, espe-
cially the investigation of the sales level that is
needed to make any price change profitable.
Within this context, neither a practitioner nor an
academician would suffer from examining the
contribution margin analysis approach more closely.
A comprehensive review of the literature on pricing
reveals that the contribution margin analysis ap-
proach has been treated solely through a normative
perspective and, even worse, by just a small
minority of scholars. Dominant theories still classify
pricing methods under three prevailing categories:
cost-based, demand-based, and competition-
based. As such, there seems a need to develop a
more solid and integrated approach capable of
incorporating all these factors simultaneously.
The contribution margin analysis approach
endeavours to provide a solution. Given the lack
of an empirically-based theory behind it, future
research could investigate more thoroughly some
contextual variables that may impact its adop-
tion. Some questions that might be addressed
include:
! How does market structure affect its use?
! Does the type of service (e.g., consumer vs.
industrial) have any impact?
K. Indounas
! Does the type of relationship with customers or
a strategic perspective regarding pricing lead to
different patterns regarding its adoption?
! Do high cost service providers have a different
behaviour than low cost providers?
! Does top management’s attitude have an
impact?
Further research could explore these issues in
more detail, and thus enrich the existing theory on
this topic.
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