INDIAN INSTITUTE OF TECHNOLOGY ROORKEE

PRICE SETTING PROCESS

 Three step approach

Step 1 Step 2 Step 3

Define price window Set initial price Communicate price to
market
Set initial price range Determine amount of Develop communication
based on differential differential value to be plan to ensure prices are
value and relevant captured with price perceived to be fair
costs
Key questions Key questions Key questions
• What is the • Is the price point • What is the best
appropriate price consistent with my approach to
ceiling for this overall business communicate price
product? objectives? changes to
• How should I • What are the non- customers?
incorporate value related • What are the
reference prices determinants of price considerations for
into my price sensitivity? implementing
window? • What are the price- significantly higher
• What is the role of volume tradeoffs and prices?
costs in setting my what is their impact
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Step 1- Defining Price Window

• The first step in the process is to set an initial price window defined by a price
ceiling and floor for each segment.

Price ceiling = The highest allowable price point

Price Floor = The lowest allowable price point

• The price points for the price ceiling and floor will differ depending on whether the
product is positively or negatively differentiated

• The price ceiling is determined by the economic value created for customers

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 If Price >Economic Value

Then, customers would be better off buying the competitor’s product even
though they might very much want (or need) some of the differentiated value
of the firm’s offering.
Economic value can also be the maximum price or amount of money
that someone is willing to pay for a good or service. As a result,
economic value can be higher than market value.

The same customer would have a net gain of Rs.10 if they purchased
from firm’s competitor, even though they would have to forgo some of
the differential value offered by the firm’s product.
Customer Your product Competitor’s product

Reference price 100 150 90

Positive differential 60 20 20
value

Negative (20) (60) (60)

differential value

Total economic 140 110 50

value
Price 150 100 100

Net benefit -$10 $10 -$50

a) Positively Differentiated Offering

The price floor for a positively differentiated product is determined by the

competitor’s reference price.
Positive Differentiation Value-
The monetary value that an
offering creates for the customer,
either in cost savings or
increased income that is over and
Price above what the Next Best
WindowCompetitive Alternative provides.

Positive Differentiation Value is

comprised of multiple value
drivers.

A value driver is a mathematical

formula that quantifies a
particular economic impact.

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b) Negatively Differentiated Offering

The price floor for a negatively differentiated product cannot be the competitive
reference value because that would place the floor above the price ceiling
defined by the economic value. The limiting factor for a negatively
differentiated product is the relevant
costs of the offering that are defined
as those that determine the profit
impact of prices.
The price window for negatively
differentiated products is lower than
Price
Windo those that are positively differentiated
w
, and it is important to allow those
offerings to maintain lower prices in
order to maintain stable market prices.

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 Step 2- Establishing an Initial Price Point

• Once the price window has been defined for different customer segments, the next step is to determine where,
within that window, the initial price should be set.

• The decision should not be driven by altruism but rather by judgment about what will yield long-term,
sustainable profits.

• Leaving more of the economic value “on the table” can, induce customers to migrate to a new product or
service more quickly.

3 considerations in determining where in the price window the initial price should be set-
Alignment
Customer
with Overall
Response
Business
Strategy Price-Volume
Trade-offs

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Consid. 1- Alignment with Overall Business Strategy

SKIM THE NEUTRAL MARKET

MARKET PENETRATE THE PRICING
MARKET
When Jeff Bezos founded [Link] in 1995, his goal was to grow market share
quickly in the retailing sector before any competitor could enter and duplicate the
company’s business model.

His pricing strategy was to undercut traditional retailers so much that customers
would be willing to switch their purchases to the new Internet channel. Although
[Link] creates significant differential value through quicker search, greater
selection, and customer reviews, a premium pricing strategy intended to capture that
value would not have advanced the company’s mission.

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Consid. 2 - Price-Volume Trade-offs

• The inability to establish fences between different segments will force a seller to make
trade-offs between price and volume.

• The financial impact of these trade-offs is determined primarily by a firm’s cost structure.

• If a firm’s costs = variable

Percent contribution margin will be low

As a result, small decreases in price require large increases in volume to be

profitable.

• In contrast, if costs = fixed,

Percent contribution margin will be high

As a result, small decreases in price will require much smaller increases in volume to
improve profits because each additional sale adds significant contribution to profit

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 Economic theory indicates that profit-maximizing prices

where, MR = MC

• But Identifying marginal revenues is challenging because revenues are dependent on multiple factors

• Identifying relevant costs can be challenging because much of the data available to marketers is averaged or loaded
with nonavoidable costs such as corporate overhead.

• Thus, Rather than attempting to determine marginal revenues and costs, marketers can first understand the
financial trade-offs between price and volume and then analyze the market to estimate consumer response .
• Rather than attempt to answer the impossible question of “How will sales change
following this price change,” managers need to focus on the below two questions
• How much volume could I afford to lose before a particular price increase would be unprofitable?
• How much volume would I have to gain in order for a particular price decrease to improve my
profitability?

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• A 10 percent price cut for a product with a 20 percent contribution margin would
have to result in a 100 percent increase in sales volume to be profitable.
• A 10 percent price cut for a product with a 70 percent contribution margin would
only require a 17 percent increase in sales to be profitable. We are frequently
surprised by how many managers make unfortunate pricing decisions because they
do not understand these basic financial considerations.
• Contribution margin = S.P – V.C

P = Q* (S.P-V.C) -
F.C

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Consid. 3 – Customer Response

“How will customers respond to the new prices?”

• One of the major drivers of how consumers respond to new prices is the degree to
which factors other than value influence willingness-to-pay. It is called “price”
sensitivity.

• PRICE-SENSITIVITY DRIVERS

Size of Buyers are more (or less) price sensitive

expenditure when expenditures are relatively large (or
small).
I
How significant is the expenditure for the product in monetary
terms (for B-to-B) or as a portion of income (for B-to-C)?

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 Buyers are less price sensitive when some
Shared costs
II or all the purchase price is paid by others

Does the buyer pay the full cost of the product? If not, what portion of the cost
does the buyer pay?

Buyers are less sensitive to the price of a

Switching costs product the greater the added cost (both
monetary and non-monetary) of switching
III
from their current supplier (if any)?

To what extent have buyers already made investments (both monetary and
psychological) in dealing with one supplier that they would need to incur again if
they switched suppliers?
• For how long are buyers locked in by those expenditures?
• Have customers invested heavily in product-specific training that would have to
be repeated if they chose to switch?

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 Perceived Buyers are less price sensitive when it is
risk difficult to compare suppliers and the cost
of not getting the expected benefits of a
purchase are high.

How difficult is it for buyers to compare the offers of different

IV suppliers?
• Can the attributes of a product be determined by
observation (search goods), or must the product be purchased
and consumed to learn what it offers (experience goods)?
• Is the product new or innovative to a segment of customers,
requiring some radical change in how they consume it?
• Is the product highly complex, requiring specialized skill to
evaluate its differentiating attributes?
• Are the prices of different suppliers easily comparable, or
are they stated in ways that make comparisons difficult?

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 Buyers are less price sensitive when the
product is a small part of the cost of a benefit
Importance of end-benefit with high economic or psychological
importance.
V
How economically or psychologically important is the end-benefit that buyers seek
from the product?
• How price sensitive are buyers to the cost of that end-benefit?
• What portion of the end-benefit does the price of the product account for?
Price-quality perceptions Buyers are less sensitive to a product’s price to
the extent that price is a proxy for the likely
quality of the purchase.
VI

Is a prestige image an important attribute of the product?

• Is the product enhanced in value when its price excludes some
consumers?
• Is the product of unknown quality with few reliable cues for
ascertaining quality other than price?
Example- J&J’s Cypher stent case

• Use of stent
• Exchange value model
• Marginal cost and consumer utility
• Economic value of life:$100000(assume)
• Price can range between $375-$100000
• Thus, a narrow boundary is required
• Differential value
• Standard metal stents average unit cost $1050 (failure chance=25%)
• Cypher fully loaded stent average cost $375,
• Is it rightly priced?

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Case 1
• Hospital charge=10950+1050(metal stent cost)=12000
• In case of revisit to hospital =25%*12000 =3000
• Total = 1st visit and stent implant +2nd visit
• Total=12000+3000=15000
In case of no stent: no stent till now, decision to be taken
• 12000(hospital charge)-1050(metal stent in market)=10950
Case 2: use cypher stent
• (10950+X) + (10950*0.05)
• Let us equate it to 15000 which is maximum for case 1
• (10950+X) + (10950+X)*0.05 = 15000
• X = 3340
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Without stent $12000-$1050=$10950

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Marketers must understand which of these price sensitivity drivers are relevant for
their particular products in order to influence them favorably through price and
value communications.

Research

Controlled Price Experiments

Ways to Find
which is the Purchase Intention Surveys
best way
Structured Inferences

Incremental Inferences

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I. Price Experiments

Involves testing new prices on a controlled sample of customers

before rolling the price change out to the entire market

• Price experimentation is most useful when the cost of implementing the change
is low and useful comparisons can be made between the experimental and
control groups.

• The online environment is ideally suited to price experiments because the

cost to implement new prices is minimal and it is difficult for some customer to
realize they are seeing different prices than others

This ability to customize prices at the individual customer level is

invaluable to the ability to conduct price experiments.
 II. Price Intention Surveys

• This can be used when price experimentation is impractical, like for infrequently purchased products (such as
automobiles and enterprise software) that don’t lend themselves to experimentation.

• Here, surveys of various types can be used to uncover customer product preferences at various price points.

• Differences in responses at different price points are compared, and by adjusting for historical biases in
responses, researchers can infer how customers would respond if faced with those price differences in actual
purchase situations.

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 III. Structured inference

• This approach leverages managerial market knowledge combined with appropriate analysis to arrive at a sound
price point.

• Structured inferences can range from the highly formal and statistical to the purely judgmental

• In all cases, the idea is to use results that managers have seen in the past to estimate the likelihood that they
will achieve the necessary break-even sales changes under new conditions.

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 Step 3- Communicating New Prices to the market

• The final task in setting the price level is to ensure that new prices are communicated to the market. The most
important consideration when communicating price changes to customers is that they understand the rationale
for the change and believe it to be fair.

Perceived fairness is one of the most powerful factors driving

price sensitivity.

Example-
Small Businesses Are Being Honest About Price Increases—and It’s Wor
king

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AMAZON 15-DAY PRICE GUARANTEE

• If there exists any price drop from the actual

purchase price within 15 days of the purchase
date of a particular product sold by a
participating seller, cashback shall be credited
to the Amazon pay account.

• The credit made to the Amazon pay account

is automatic without customer intervention.

• Amazon terms the experience as ‘Complete

Peace of mind’

• Applicable on a limited Product category as

intimated by Amazon

• Offered by selected participating Sellers

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