Pricing Intricacies

Introduction
Could you name some recent failures?

Why did the product fail?

Product features not meeting current market need

Too high price for the value delivered

What is value worth?

The determination of the value of an item must not be based on the price, but
rather on the utility it yields…. There is no doubt that a gain of one thousand
rupees is more significant to the pauper than to a rich man though both gain the
same amount
Cost driven pricing

Might not capture all the value in the market, but it simply requires that the product
capture a target return over its full cost

What this means is that we take the obvious direct variable costs, and we then take
all the other costs and we allocate them as overhead “burdens”

Thus, every product has its direct costs, plus its share of the overhead burden
 Cost plus pricing intricacies

Now if you add a margin or profit on top of that total cost then you can’t help but
make a profit. It may not be the optimum profit, or the best comprehensive
solution, but you certainly won’t lose money. It is a prudent way to proceed.
Moreover, it requires that each product pull its own weight. Each product is
equally accountable and comparable, and its performance is measured on profit.
 Problem with cost plus

Well, an obvious problem: In order for the Accountants to do all the allocations
of costs, they have to know one thing. What the sales volume will be.
You can’t figure out what the sales are until you know what the price is. So you
have a circular dilemma. Which comes first, the price or the sales?
The fallacy of cost-plus pricing

To illustrate, a company plans to introduce a new product and needs to set its
introductory price

At projected sales of 1 million units, finance calculated that the price required to
achieve financial objectives was $9.00
Example of Cost-based Pricing

Projected Costs and Revenues at

Expected Sales = 1,000,000 units

Total Per Unit

Direct Variable Costs $3,000,000 $3.00
Direct Fixed Costs $3,000,000 $3.00
Administrative Overhead $1,500,000 $1.50
Full Cost $7,500,000 $7.50
Revenue $9,000,000 $9.00

Profit $1,500,000 $1.50

How would you solve this problem?

After product launch, however, the actual sales are running at only 750,000,
which causes fixed costs to be spread over fewer units, unit costs to rise, and
profitability to disappear.
The obvious answer is to raise the price to at least $10.50 (to achieve the same
profit per sale), or to $11.00 (to earn the same total profit)
Example of Cost-based Pricing

Actual Costs and Revenue at

Actual Sales = 750,000 units

TotalPer Unit
Direct Variable Costs $2,250,000 $3.00
Direct Fixed Costs $3,000,000 $4.00
Administrative Overhead $1,500,000 $2.00
Full Cost $6,750,000 $9.00
Revenue $6,750,000 $9.00

Profit $0 $0

How would you solve this problem?

Example of Cost-based Pricing
Projected Costs and Revenues with
Price Increased to $10.50 Per Unit

5% Decline 33% Decline

Current in Unit Sales in Unit Sales
Price $9.00 $10.50 $10.50
Unit Sales 750,000 712,500 500,000
Variable Costs $3.00 $3.00 $3.00
Fixed Costs $4.00 $4.21 $6.00
Admin. Overhead $2.00 $2.11 $3.00
Unit Cost $9.00 $9.32 $12.00
Unit Profit $0 +$1.18 -$1.50
Total Profit $0 $843,750 -$750,000
Example of Cost-based Pricing

Financial Implications of a 10% Price Cut

5% Increase 33% Increase

Current in Unit Sales in Unit Sales
Price $9.00 $8.10 $8.10
Unit Sales 750,000 787,500 1,000,000
Variable Costs $3.00 $3.00 $3.00
Fixed Costs $4.00 $3.81 $3.00
Admin. Overhead $2.00 $1.90 $1.50
Unit Cost $9.00 $8.71 $7.50
Unit Profit $0 -$0.61 +$0.60
Total Profit $0 -$480,375 $600,000
 Price & Ease of competitive entry
• Concept of “Specialty degeneration”
• Determines the speed of degeneration of a
specialty
• In the washing machine, Maytag was the
originator
• With little basic patent protection, Maytag’s
position was quickly eroded by small
manufacturers who just assembled and sold!
 Price & Ease of competitive entry
• The ball-point pen was a $12 novelty
• It became a 49-cent “price football,” because
entry barriers of patents and techniques were
ineffective
• Frozen orange juice, a specialty of Minute
Maid, sped through its competitive cycle, with
competing brands crowding into the market
 Reference Points
• You are lying on the beach on a hot day.
• For the last hour you have been thinking about how
much you would enjoy a nice cold bottle of your
favorite beer
• A companion gets up to make a phone call, and offers
to bring back a beer from the only nearby place where
beer is sold, a fancy resort hotel
• He asks how much you are willing to pay for the beer.
• What price do you tell him?
 Reference Points
• You are lying on the beach on a hot day
• For the last hour you have been thinking about how
much you would enjoy a nice cold bottle of your
favorite beer
• A companion gets up to make a phone call, and
offers to bring back a beer from the only nearby
place where beer is sold, a small, run-down grocery
store
• He asks how much you are willing to pay for the
beer
• What price do you tell him?
Guru Mantra Tool: Gap Analysis
Theoretical
Theoretical Maximum
Maximum Market
Market

Theoretical
Theoretical Realistic
Realistic Market
Market
Total Population

Theoretical
Theoretical Potential
Potential Market
Market

Real
Real Potential
Potential Market
Market
Those with teeth

Actual
Actual Market
Market
Market
Market
Habits and religion

Income levels

Share
Share
Served market

Actual share
Market make up for a toothpaste
 Price Waterfall

800

620 45

600 1 67

507 15
25
Price ($) 10 50

400
60

Major 155
Opportunity
200

0
Transaction Ordersize Upcharges Bid Invoice Credits Discount / Misc. Rebates Cost of Pocket
Price Discount Discounts Price Terms Charges / Goods Price
and Waived Allowances
Upcharges
 Impact of Price Discounts

Price decrease %
X 100
Volume Increase (%) =
Gross Margin % – Price Decrease %

By what % volume should increase, if we intend

giving 9% discount and the gross margin is 30%?
 Impact of Price Discounts

Price decrease %
X 100
Volume Increase (%) =
Gross Margin % – Price Decrease %

Thus, for a 9% discount, from a 30% gross margin,

the sales must jump by 42.86% to retain current
level of profitability
 Bidding
• Our cost = 100
• Total bids 50
Competitor 80 90 100 110 120 130 140 150
bid
Frequency 2 3 8 14 10 7 4 2
Relative 0.04 0.06 0.16 0.28 0.20 0.14 0.08 0.04
Frequency

So if you bid say 75, you are losing 25 and so on…

Decision Making

choice…
maximizing utility
framing effects
 Scenario
• Take 20 and you can get up to 50 if you
gamble
• Take 50, return 30 and to win it, gamble

• Kahneman’s belief
 Prospect Theory
• How framing changes your decisions
• Something does not happen too often is not
likely to happen?
 Framing Effects
- People’s tendency to be influenced by the manner in which
choices are presented or framed.
Choice A. Winning $40 with probability .40 people pick this
Choice B. Winning $30 with probability .50

if both probabilities are doubled:

A. Winning $40 with probability .80
B. Winning $30 with probability 1.00 people pick this
Certainty Effect: People tend to prefer sure gains (risk averse for
gains)
 Cash or Credit??
$1.30/gal
5 cent discount
for cash...
Discount seems gains
negligible, people
use credit card.

$1.25/gal
5 cent charge losses
for credit...
Surcharge is
outrageous…
people pay cash.
 A Hypothetical Value Function
Value

gains
}
}
losses

- “The pain of a loss is greater than the pleasure of a gain.”

- “ small losses hurt (proportionally more) than big losses”
Framing effects are everywhere…

What’s better?

A basketball player who makes 75% of his

free-throws, or one who misses 25% or his
free-throws?
 Justification: living with your decisions

• People make choices that they can justify to themselves (thus

reducing regret)
• Even if those choices are sometimes irrational
• One last example:
– you passed the exam -> you buy ticket to Hawaii (to celebrate)
– You failed the exam -> you buy ticket to Hawaii (to cheer yourself
up)
– You don’t know whether you passed or you failed
• Logically, you should buy the ticket, but
• People are reluctant in this situation (no justification?)
 Summary
• Utility theory fails to describe how people
make decisions:
– Frame effects
– Influence of justifications (minimize regret)
 Gamble 1
• Gamble A: There is a 100% chance that you
win $240
• Gamble B: There is a 50% chance that you win
$400 and 50% chance that you win $100

• Which one do you choose?

 Gamble 2
• Gamble A: Win $1000 with 100% chance
• Gamble B: Win $2500 with 50% chance and
win $0 with 50% chance

• Remember you MUST play!

• Which one do you choose

 Gamble 3
• Gamble A: Lose $1000 with 100% chance
• Gamble B: Lose $0 with 50% chance or lose
$2500 with 50% chance

• Remember you MUST play!

• What do you choose?