Relationship Between Effective Pricing and Effective Marketing

Week 1 Introduction

Week 1: Introduction

By the end of Week 1, you will be able to:

• Describe the relationship between effective pricing and effective marketing.
• Introduce key elements of pricing strategy.
• Expose common fallacies that undermine the ability to price profitably. (pg 2-5)

cost plus pricing: allows managers to pricing decision that undermine profits. Overpricing in weak markets and underpricing in a strong ones.  Based on on the belief that one can determine sales levels, then calculate the unit cost and profit objectives, and set a price.

Fails to take into account the effects of price on volume, and of volume on costs, leads managers directly into pricing decisions that undermines profits. Under this approach, you add together the direct material cost, direct labor cost, and overhead costs for a product, and add to it a markup percentage (to create a profit margin) in order to derive the price of the product. 

  (http://www.accountingtools.com/cost-plus-pricing)

customer-driven pricing: most companies take the pricing authority away from the financial managers and give it to the sales or product managers. The misuse of pricing to achieve short term sales objectives undermines the perceived value and depresses profits.

Marketers price at whatever buyers are willing to pay, rather than at what the product is really worth. This undermines the long-term profitability

There are 2 main problems.

1. sophisticated buyers are rarely honest about how much they are willing to pay for the product. Buyers learn that sellers prices are flexible, the buyers have a financial incentive to conceal the information from and mislead sellers. This does not allow the salespersons to establish a close relationship with customers and to understand their needs.
2. The job of sales and marketating is not tp process orders at whatever price that customers are willing to pay, but rather to raise customers willingness to pay to a level that better reflects the product’s true value. Low pricing is never a substitute for an adequate marketing and sales effort.

Share-driven pricing: some mangagers belief this is “pricing strategically”. Let Pricing dictate the competitive conditions. Managers confuse priorities and reduce the profitability of each sale to achieve the market-share goal. Price cutting is a poor decision financially. The long term price of using a competitive weapon to exceeds any short term benefits.  Price differentiation, advertising, and improved distribution do not increase sales as quickly as price cuts, their benefit is more sustainable.

• Determine the relevance of pricing decisions.

“strategic pricing” required informed trade-offs between price and volume in order to maximize profits.  These trade offs are in 2 forms.

1. Willingness to lower price to exploit a market opportunity to drive volume.  Cost-plus pricers are often reluctant to exploit these opportunities because they reduce the average contribution margin across the product line, giving the appearance that it is underperforming relative to other products.
2. Willingness to give up volume by raising prices.  Competitor and customer oriented pricers find it diffuclt to hold the line on price increases in face of lost deal or reduce volume..

• Understanding the strategic pricing pyramid. (pg 7)
• Understanding the effects of an effective pricing strategy.

Week 1 Notes

Week 1: Instructor Notes

Chapter 1

Why pricing is often ineffective

Pricing at many companies is only an afterthought to other aspects of marketing strategy.  Consequently, such companies fail to integrate their value-creating activities with their pricing decisions.  The only way to ensure profitable pricing is to reflect those products and service charges for which adequate value cannot be captured to justify the cost.  Strategic pricing requires that management take responsibility for establishing a coherent set of pricing policies and procedures, consistent with its strategic goals for the company.

The cost-plus pricing delusion

Cost-plus pricing deludes managers into believing that they can price “prudently” to cover fixed costs and achieve desired profit margins.  Because this fallacy is so ingrained in our business culture, it will come up again and again in this class.  Consequently, it is important to quickly discredit this approach right up front.

Cost-based versus Value-based Pricing

                   Cost-Based Pricing

PRODUCT->COST->PRICE->VALUE->CUSTOMERS

                    Value-Based Pricing

CUSTOMERS->VALUE->PRICE->COST->PRODUCT

Customer-driven pricing

As companies recognize the fallacy of cost-based pricing, they have begun to take pricing authority away from financial managers and given it to sales management or even to individual sales people.  The logic is that those who work directly with the customer are best able to determine customer value, and thus capture that value in the pricing.  Unfortunately, there are a number of reasons why this approach actually undermines profitability in many cases.

1. An important job of the sales force is to understand the customers need and then explain to the customer how the product can more cost-effectively satisfy those needs than can competing products.  This process requires a lot of work, however, on the part of the salesperson.  It is always quicker and easier to sell on price rather than on value.  A sales person who wishes to maximize sales achieved will therefore avoid the time-consuming task of selling value in favor of discounting to sell volume.  This problem can be partially overcome by measuring sales force performance in terms of contribution rather than sales volume achieved.
2. In repeat purchase markets, customers learn quickly when prices are not objectively determined.  When prices are negotiable based on the salesperson’s estimate of willingness to pay, “difficult customers” who are tough negotiators, who hide the true value from the salesperson by limiting contact only to purchasing agents, and who get many alternative suppliers bidding for their business, enjoy lower prices than “good customers” who are open with and loyal to the supplier.  In the face of this reward, most customers become difficult.  A customer’s motivation to get a “fair” price, equal to or better than what others are paying, replaces the motivation simply to get a good value.  Consequently, value-based pricing becomes unsustainable.  Companies that offer superior products at above average prices must keep customers’ attention focused on value and cultivate the belief that price charge is related to value delivered, not to the customer’s ability to be tough in negotiation.

To capture value, one must have a pricing strategy implemented with objective pricing policies.  Ad-hoc pricing on a customer-by-customer basis precludes the ability to manage pricing proactively.  Pricing is driven reactively by customers’ negotiating strategies.

The customer question to pricing is not:

• What price is the customer willing to pay?

The customers’ questions relevant to pricing are:

• What price can we convince customers is justified by the value of our product (or service) to them?
• How can we better segment customers to reflect the differences in value to different types of customers?

Competition-driven pricing

The policy of letting price be dictated by market share or growth goals, even customers all receive objective prices, can still undermine a company’s ability to capture the value it creates.  This policy differs from customer-driven pricing in that it is not ad-hoc negotiated pricing (prices are set by objective policies), but pricing is still driven by the desire to beat the competition.  The problem with this approach is that it allows the “tail to wag the dog”.  Why do we value growth and market share—presumably because we have priced the product profitably and each additional sale adds to that profitability?  Prices should be lowered only when they are no longer justified by the value offered in comparison to value offered by the competition.  The goal of pricing should be to find the combination of margin and market share that maximizes profitability over the long term.

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