Pricing Strategy
ROLES AND IMPORTANCE OF PRICING
Our tendency is to think of price purely in financial terms. After all, price figures into so many of the
financial calculations associated with business operations, both on the revenue side (i.e., the price we
charge) and the cost side (i.e., the price we pay). There’s certainly nothing wrong with considering price
in financial terms, however, thinking of price in purely financial terms is a narrow perspective. Price is
much more than that. Think about the different roles of price in consumer markets, for example.
Price acts as a signal to buyers. It’s a communication tool that consumers use to make inferences about
the characteristics of the products and its suitability to their needs. The natural assumption, particularly
for consumers unfamiliar with a product category, is that price signals higher quality or greater prestige.
While these are not always safe assumptions, they often are, so especially to novices in a category, price
is a powerful means of communication to customers.
Price is a competitive weapon. While products are certainly priced in an absolute sense, they are also
priced relative to one another as well, and customers use this information to make comparisons.
Therefore and obviously, price plays a major part in the competition between brands. This is true in
both the long term positioning of brands and in short term efforts to increase sales or encourage trial,
especially when attempting to draw customers of a competitive brand to yours.
Finally, price is a tool of financial performance. In addition to its effects on the decision processes of
buyers and on the actions of competitors, price has very large financial implications. While marketers
often shy away from this aspect of pricing in order to focus on its customer and competitor implications,
marketers cannot ignore how price affects finances. All marketing activities should produce
measureable financial returns, and price is pivotal in those efforts.
PRICE CHANGES IN THE CURRENT STRATEGIC SITUATION
In order to develop pricing strategies, marketers must understand how consumers respond to price and
in particular, changes and differences in price. If price remained constant, the pricing strategy would be
easy. After setting an initial price, the strategic dimension of price would be over. But prices change,
and depending on the product, they change frequently. For example, at the consumer level, gasoline
prices change daily in response to commodity price changes. While food prices do not change quite as
frequently, they also respond quickly to changes at the producer level, so grocers are constantly
changing prices on products, often putting them on sale for set periods of time.
Pricing Strategies 2
Sale prices or other promotional effects on price are the most common reasons for price changes.
Marketers offer special promotional prices for two main reasons. One is to account for the actions of
competitors. When a company drops prices, competitors frequently must follow suit. Second, products
may be put on sale to help move excessive inventory. If marketers underestimated demand for a
product and produced too much, sale prices may help clear the backlog of inventory. These temporary
price reductions account for the majority of day-to-day price fluctuations we see at the retail level,
however, they also occur in channels. Producers such as Procter and Gamble offer temporary discounts
to major retailers or receive temporary discounts from their own suppliers. Indeed, some of the retail
discounts we see at the stores we shop originate with discounts the retailer received further up the
distribution channel.
Price Elasticity of Demand
The fact that prices change in the normal course of events is not terribly interesting. What is interesting
is why and the effects of the changes. In particular, marketers are interested in how changes in price
will affect a changes in quantity sold. That’s because that amount of change actually determines overall
revenue. Marketers want to find a price that, for a given level of demand, can maximize revenue. To
figure this out, marketers must understand a concept called price elasticity of demand, or just price
elasticity for short. Price elasticity simply reflects how much quantity sold will change for a given change
in price. Elasticity is calculated with the simple formula:
𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 =
%Δ𝑄
(𝑄2 − 𝑄1 )⁄𝑄1
=
%ΔP
(𝑃2 − 𝑃1 )⁄𝑃1
Elasticity ranges simply from low to high. The differences between the two is explained below. Before
jumping into those explanations, it would be helpful to suggest that you think about elasticity of
demand in terms of brands. In other words, when a price change occurs, think of the price change as
occurring at the brand level. For example, consider competing brands of Ketchup such as Heinz, Hunts,
Del Monte, etc. The question that analysis of elasticity attempts to answer is what the effect on sales a
change in price of one brand will have.
Relatively Elastic Demand. The formula expresses elasticity as the proportion of change in quantity to
change in price of some brand. When Elasticity is greater than one, meaning that the numerator is
larger than the denominator, the percent change in quantity is greater than the percent change in price,
indicating that demand is relatively elastic. Said another way, a small change in price yields a
proportionately larger change in quantity sold. The phenomenon of relatively elastic demand is shown
in Exhibit 1 on the next page. Graphically, the diagram shows that when priced at P1, the brand sells Q1
units. When price drops modestly from P1 to P2, unit sales jump from Q1 to Q2. As a proportion, the
difference between Q2 and Q1 is far greater than the difference between P2 and P1.
The strategic question facing marketers when such circumstances occur is where do all these extra sales
come from? While a little analysis with tools such as the substitution index we learned about earlier,
marketers can arrive at a fairly detailed answer. However, with a little logic, we can narrow down the
possibilities here. Let’s continue the ketchup example. Suppose Del Monte ketchup drops its price and
notices a big jump in sales afterwards. One source of the extra quantity sold may be people who
Pricing Strategies 3
P
P1
P2
D
Q1
Q2
Q
Exhibit 1. Price Change Under Relatively Elastic Demand
normally buy Del Monte, see that it’s on sale, and decide to pick up a couple of extra bottles. These
shoppers are called stockpilers and under many circumstances are not particularly helpful to the brand
because once the price goes back up to its original level, even these loyal customers will not be buying
soon because they stickpiled a few bottles of ketchup. A second source of additional sales is from
people who normally buy other ketchup brands, but decide to buy the Del Monte while it’s on sale.
These people, called brand switchers (obviously), see their regular brands and Del Monte as easily
substitutable. Unlike stockpilers, brand switchers represent new sales for Del Monte, who hopes that
they will like the ketchup so much that they continue to buy it. The same is true for category switchers,
who are shoppers who may buy other types of condiments or sauces, but switch over to Del Monte
ketchup because of the price drop. For example, a shopper who was looking for a can of sloppy joe
sauce may opt to make their own with ketchup. Finally, first time shoppers may decide to try a bottle of
sale-priced ketchup. While this seems a little unlikely with a staple product such as ketchup, it is
certainly not beyond the realm of possibilities. For example, a person new to the United States whose
native foods do not include ketchup may decide to try it because it is at a reduced price.
Brands whose prices are relatively elastic generally share several commonalities that can affect
marketing strategy. One, elasticity assumes consumers are price aware. That is, they notice the price
changes of competitive brands. Second, elasticity indicates that consumers are price sensitive. That is,
for the product category and brands in question, they respond behaviorally to changes in price. Third,
consumers are not brand loyal. They are willing to use price as a reason to switch from an otherwise
preferred brand. Fourth, elasticity suggests that competitive brands or close categories are seen as
substitutable. If all brands of ketchup are the seen as essentially the same or just as good, then
substituting one for another is no big deal. Fifth, when prices are relatively elastic, price is often the
only effective competitive tool. Brands that are perceived as equally suitable may have little available to
distinguish themselves from competitors, leaving only price as a tool of competition.
Relatively Inelastic Demand. When the elasticity equation on the previous page yields a value of less
than one, it suggests that large changes in price produce proportionately smaller changes in quantity
sold. In other words, the numerator is less than the denominator. Relatively inelastic demand is
illustrated in Exhibit 2 on the following page.
Pricing Strategies 4
P
P1
P2
D
Q1
Q2
Q
Exhibit 2. Price Change Under Relatively Inelastic Demand
Exhibit 2 shows an opposite set of circumstances to Exhibit 1. In Exhibit 2, the drop in price from P1 to P2
is substantial, yet the increase in sales from Q1 to Q2 is small by comparison. This situation implies
several things to marketers as well. One is that the slight increase in quantity sold is probably from
stockpilers but not from customers who usually buy something else. That’s because relatively inelastic
demand suggests high levels of brand loyalty. The customers buying more of your product are brand
loyal to your product. However, your price decrease is not enough to draw loyal customers of other
brands to your brand. Products are not seen as substitutable and consumers are not as price sensitive.
Under these circumstances, price is often a poor competitive weapon because products are well
differentiated from each other in ways that make the perceived costs of switching high.
Residual Price Elasticity
Now that you have some refresher on the basic concepts of elasticity, let’s make the concept somewhat
more realistic. The explanation of price elasticity above leaves out an important facet of competitive
markets: the competitive part. That is, the price elasticity discussion above assumes that competitors to
a firm that lowers its price will not respond with lower prices of their own. This is often a very
unrealistic assumption. Competition often responds within minutes to changes in pricing by a
competitor. For example, when airlines have fare wars or when gas stations at an intersection change
prices, competitive response can be nearly instantaneous.
Does this mean that when a competitor responds to a price change with one of its own, that its price
change completely negates the effects of the first one? No it does not. For one thing, the elasticity of
one brand may not be the same as the elasticity of a competitive brand. In other words, Del Monte
ketchup may get more from a price drop than Hunts does. If Hunts drops its prices in response to a drop
by Del Monte, it could be that Hunts’ price drop only partially offsets the gains by Del Monte. Second,
Pricing Strategies 5
competitors may not respond with a price drop that equals the original. So if Del Monte drops its
ketchup price by twenty percent, Hunts may respond with a ten percent drop.
The concept of residual elasticity is intended to account for the effects of competitor responses to price
changes. That is, residual elasticity is the proportional effect on quantity sold of a price change after
accounting for competitors’ responses. To understand residual elasticity, we need to define a few
terms. First is own elasticity, which is simply the price elasticity of the first company to change prices.
Own elasticity is what we discussed in the previous section. Second is competitor reaction elasticity.
This is the proportional effect on competitor prices produced by a change in our prices. For example, if
Del Monte drops its prices twenty percent and Hunts responds with a ten percent price drop, then the
competitor reaction elasticity is 0.50. If Del Monte drops its ketchup price by twenty percent and Hunts
responds with a forty percent price drop, then the competitor reaction elasticity is 2.0. Third is cross
elasticity, which is the effect of a competitor’s price change on our quantity sold. Cross elasticity for two
brands is calculated as:
𝐶𝑟𝑜𝑠𝑠 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦𝑂,𝐶 =
%Δ𝑄𝑂
(𝑄𝑂2 − 𝑄𝑂1 )⁄𝑄𝑂1
=
%Δ𝑃𝐶
(𝑃𝐶2 − 𝑃𝐶1 )⁄𝑃𝐶1
where QO = Quantity sales of our brand and PC = Price of competitor brand.
Note that this is essentially the same elasticity equation as shown on page two except that this equation
calculates the percent change in our sales that results from a competitor’s drop in price. If a competitor
brand drops its price and we do not drop ours, we can expect our quantity sold to decrease. If we
respond with our own price cut then we will gain back some or all of that loss. That’s in part what
residual elasticity tries to account for. Our price changes and our competitor’s price changes have
opposing effects on our quantity sold. Exhibit 3 on the following page illustrates how residual elasticity
works and gives the very simple calculation. Data for these calculations are relatively easy to obtain in
many consumer markets because of scanner data.
Our Price
Change
Competitor Reaction Elasticity
(B)
Competitor
Price Change
(C)
Cross Elasticity
Own Elasticity
(A)
Our Quantity
Change
Residual Elasticity = A + (B × C)
Exhibit 3. Diagram of Residual Price Elasticity (Adapted from Farris et al. 2007)
Pricing Strategies 6
Profit, Promotion, and Time Dimensions of Price Changes
Many if not most price reductions are temporary and occur as part of a promotion, whether directed
toward consumers or one between channel members. As a general rule, because of inflation, base
prices trend upward, albeit slowly sometimes, so significant reductions in prices are rarely permanent.
Therefore, it’s important to factor in the profitability of temporary price reductions in a way that
accounts for the behavior of customers before, during, and after the price promotion. In this section,
we examine how price reductions affect profitability from two perspectives. One is the retail
perspective. That is, a retailer reduces the price on a branded product carried in the retailer’s stores.
The other is from a channel perspective. That is, a retailer receives a discount on a branded product it
carries from the product’s producer. We’ll begin at the retail level.
Price Promotions Offered by Retailers to Consumers. Retailers put products “on sale” all the time.
Reductions are offered in-store, online, through coupons, in bundles, and any other creative means of
getting consumer attention and ultimately response. The question for retailers is, will the price
reduction be profitable? The simple answer to the question rests largely with whether the loss in per
unit revenue from the price reduction is sufficiently made up by an increase in volume (hence, the
importance of elasticity). Said another way, will total revenues with the price reduction exceed the
revenue of not offering the promotion at all?
Exhibit 4 shows the effect on brand sales of a promotion that lasts one time period, during all of period
t2. The profitability of the promotion depends on whether the sales bump produces sufficient revenues
Brand
Sales
increased sales from
promotion (“sales
bump”)
b
t1
t2
regular anticipated
sales
t3
t4
t5
Time (t)
Exhibit 4. Profitability of Price Reduction Offered to Consumers (Source: Tellis 1998)
Unb
Pricing Strategies 7
to overcome the costs that produced the sales bump in the first place. The sales under time periods t1
and t3 through t5 represent the normal anticipated sales of the brand with no promotion. The sales at t2
represents the bump caused by the promotion. The area above the regular sales line (b) represents the
additional sales from the promotion.
To figure whether the promotion would be a profitable investment, we must consider a few variables.
First, we should account for the margin produced by the product at its regular unpromoted price. We
will label this variable m. Next, we must include the reduction of product margin caused by the
promotion. In the case of a simple price reduction, we reduce m by the amount of the price reduction.
In the case of premiums or other nonprice promotions, we reduce m by the per-unit cost of offering the
promotion. Both cases result in a reduction that we will label as d. Referring to the diagram in Exhibit 4,
the promotion will be profitable if:
𝑏(𝑚 − 𝑑) > 𝑡1 𝑑
The left hand side of the inequality represents the additional profits gained by the promotional offer.
The increase in sales over normal levels during the promotional period (b) occur at a lower level of
margin than regular sales; that is the regular margin less the discount or cost of the promotion (m-d).
The product of these variables represents the additional profit earned by holding the promotion.
The right hand side of the inequality represents the opportunity cost of holding the promotion. Had the
promotional offer not been made, the firm would have achieved its normal level of sales (t2). During the
promotional period, these customers who would have purchased at the regular price can take
advantage of the promotion. Multiplying this figure by the discount (d) provides the lost profit of
offering the promotion to people who would have bought without the offer. As the inequality
demonstrates, unless the increase in profits from having the promotion exceed the lost opportunity of
not incurring the costs of the promotion the promotional offer should not be made.
Price Promotions Offered by Producers to Retailers.
The preceding discussion assumes that the retailer offers a discount on a product that it bought at the
regular price from the producer. In today’s channel environments, that scenario has a good chance of
being wrong. Retailers have the power in most distribution channels and frequently use that power to
extract price concessions from producers. As such, they often will only put products on sale to
consumers when they receive discounts from producers on those products. For example, suppose you
went into your local Kroger grocery store and saw that Tide detergent was reduced in price by a dollar.
Chances are that Kroger reduced the retail price by a dollar because they received a price reduction
from the producer, Procter and Gamble. Therefore, Kroger’s profits are reasonably well protected. But
what about P&G? Before offering Kroger the discount, they probably did analysis to see whether the
price reduction would be profitable to them.
Any temporary price reduction relies on estimating whether the additional profits garnered by the
promotion exceed the opportunity costs of selling at discount to those who would have purchased at
the regular price. In the case of price reductions offered between channel members (i.e., P&G offering
Kroger a temporary price reduction on Tide), we can examine the sources of additional profits more
closely because tracking these sources presents less of a problem in a channel environment than it does
Pricing Strategies 8
Brand
Sales
increased
sales during
promotion
b1
b2
“baseline” sales
b3
t1
t2
t3
t4
t5
t6
Time (t)
time of price reduction
Exhibit 5. Evaluating the Profitability of a Temporary Price Reduction (Source: Tellis 1998)
in a retail environment. This is because there are fewer retailers and other trade customers than there
are consumers. Moreover, producers carefully track the promotional deals offered to and purchases
made by retailers. Therefore, the analysis that follows is written in the context of a producer such as
P&G offering a temporary price reduction to a retailer such as Kroger on a branded consumer product
such as Tide detergent.
Take a look at Exhibit 5. The graph shows how sales of a product, shown with the blue line, tracks over
the time before, during, and after a temporary price reduction. The graph is somewhat similar to Exhibit
4, however, some important differences need to be explained. First, the sales line does not stay level in
the period prior to the trade deal; instead it dips slightly in anticipation of it. This is because the
manufacturer’s salesforce likely makes many retailers aware of the pending promotion and advises
them to delay their purchases until the promotion begins. Second, the sales curve during the
promotional period assumes something of a v-shape at the top. This shape results from retailers
purchasing on deal twice (i.e., at the reduced price) during the promotional period. Many make an
initial purchase, determine how much to pass through, divert, or stockpile, and then purchase additional
amounts toward the end of the promotional period if necessary. Third, the sales line dips below its
average baseline level following the promotion, showing the effects of stockpiling and forward buying.
Finally note that in this example, the promotional offer lasts for two periods. While trade promotion
offers vary in duration, they typically last somewhat longer than many consumer-oriented sales
promotions.
Pricing Strategies 9
For the sake of clarity, brief definitions of the terms stockpiling, diverting, and passthrough would be
helpful. As you probably guessed, stockpiling occurs when retailers buy as much of a product as possible
while its price is reduced. They then store the product so that they have additional inventory to sell
even after the producer returns the price to regular levels. Diverting occurs when retailers send product
bought at reduced prices to stores where the reduced prices are not available. For example, suppose
P&G offers the discount on Tide detergent to a retailer’s stores in the Northeast and Midwest, but not
on the West Coast. If the discount is significant enough, it may be worthwhile for the retailer to buy as
much product as possible at the discount and then send a portion of the inventory to stores where the
deal is not available. Producers hate the practice of diverting, but there is little they can do to stop it. If
the discount is deep enough to cover shipping, retailers will continue diverting. Finally, pass through
refers to the percent of a producer’s discount to a retailer that actually winds up being “passed through”
to consumers. The main reason producers discount their products is to provide incentives for retailers
to lower the price to consumers. However, retailers may choose to not pass through any of the discount
they received, or they may pass through only a portion of it.
The increased sales during the promotional period itself may be decomposed or broken down into three
sources. The area under the sales curve labeled b1 represents incremental increases by the retailer in
anticipation of increased retail sales to consumers. As noted earlier, we refer to this as forward buying.
Of course, the increase from forward buying presumes some degree of pass through by the retailer. The
area labeled b2 represents increased purchases due to retailer brand switching. That is, the retailer’s
increased purchases of the promoted brand may come at the expense of other brands in the product
category. The area labeled b3 comes from stockpiling and diverting. That is, retailers buy extra
quantities of the promoted brand on deal, and then store the product to sell later at regular price, or
buy extra quantities and ship then to stores in areas where the promotion is unavailable.
To evaluate profitability, we must account for some additional variables. The time periods labeled t1
through t6 in Exhibit 4 show the sales activity prior to and following the promotional period. Sales
during t1 and t6 are assumed to occur at some “baseline” level of sales when the product is sold at its
regular price. We use m to refer to the normal profit margin enjoyed by the producer and d to
represent the amount of discount given by the producer to the retailer. Finally, we introduce f as the
fixed costs associated with offering the promotion. These costs do not change with the amount of the
promoted brand sold to retailers and can include costs of administration or preparation of promotional
materials offered to retailers.
With these variables in place, and referring to the diagram in Exhibit 5, a trade promotional will be
profitable if:
(𝑏1 + 𝑏2 )(𝑚 − 𝑑) > (𝑡1 − 𝑡2 )𝑚 + (𝑡3 + 𝑡4 + 𝑏3 )𝑑 + 𝑓
The value to the left of the greater-than sign represents the increase in profits resulting from the trade
promotion. In this example, only b1 and b2 add to the producer’s profits; b3 does not. When retailers
stockpile or divert, they buy discounted merchandise they would have purchased at regular price during
one or more future periods. This is represented in Exhibit 1 as b3, which accounts for sales decline in t5
following the promotional period. The increased profit from b1 and b2 is calculated by multiplying them
by the difference between regular margin m and the amount of the trade discount d.
Pricing Strategies 10
To the right of the greater-than sign are the fixed and opportunity costs of offering the promotion. The
first part of the expression, (t1 – t2)m, accounts for the dip in sales just prior to the promotional period.
The assumption is that the dip is in part made up by purchases under b1. But because the sales would
have occurred at baseline had the promotion not been offered, the small decline represents an
opportunity cost. Similarly, the sales that would have occurred at regular prices during the promotion
had it not been offered as well as the future sales lost due to stockpiling are captured in the part of the
expression, (t3 + t4 + b3)d. Finally, fixed costs are given by f.
So as always, offering a sales promotion deal adds more to profits than not offering it if the incremental
increases in profit from offering the deal exceed the opportunity costs associated with offering it.
SETTING BASE PRICES
While we have discussed the effects of price changes to this point, we have yet to cover setting base
prices for products. Obviously when prices change, they must change from something to something else.
Generally, these are done relative to a base price, which is the “standard” undiscounted price against
which other price calculations are performed. At the University of Dayton, the full base price for tuition
and housing is something over forty thousand dollars per year. You and your family learned of your
charges by receiving financial aid discounts and scholarships against that base price. In private education,
the base price is especially important because varying discounts and financial aid packages apply to
virtually every student enrolled. The same principle applies to automobile sales. The base price serves as
the point of comparison for calculating the “sticker price,” which is the base price plus additional options,
and then the negotiated price, which is what a buyer pays after haggling with the salesperson.
Exhibit 6 shows a price setting process suggested by Peter and Donnelly (2009) that generally describes
the decisions needed to set base prices. In fact, the process would probably work well for evaluating
price changes assuming time and data were readily available to perform the analyses called for in the
process. Many promotional price changes occur quickly and in response to competition, so an intuitive
understanding of their likely effects would be very useful to managers. Base price setting is a more
deliberative process, particularly for new products, when managers have time to consider the various
inputs and effects of their decisions. Let’s look at each step in the process. Some of the material
pertinent to each step has already been covered in this topic or in previous topics.
Setting Pricing Objectives
As with all major activities in marketing, objectives are a must and pricing is no exception. As mentioned
in the opening comments to these notes, pricing serves a variety of purposes, and as such, should relate
to many of these purposes. First and foremost, pricing objectives must relate to so-called ultimate
objectives, which usually pertain to the financial and marketplace performance of the product. For
example, it’s not difficult to see how pricing relates to profitability, sales, and market share. However,
pricing to achieve profit, sales, and share levels may be more complicated. That said, even though the
relationships may be complicated, they cannot be ignored. Prices must be set with these ultimate
objectives in mind.
Pricing Strategies 11
Set Pricing Objectives
Evaluate Product Price
Relationships
Estimate Costs and Other
Price Limitations
Forecast Profit Potential
Set Base Price Structure
Adjust Prices Where
Necessary
Exhibit 6. Steps to the Price Setting Process (Source: Peter and Donnelly 2009)
According to Peter and Donnelly (2009), most pricing objectives pertain to financial performance. These
authors identify the four most frequently used pricing objectives, three of which are financial in nature:
pricing to achieve a target investment return, stabilization of price and margin, and pricing to achieve a
target market share. The fourth commonly used pricing objective cited by Peter and Donnelley (2009) is
pricing to meet or prevent competition, which should be a consideration in objective setting for any
function of marketing. However, this particular type of pricing objective relates closely to brand
positioning and the relationship of one brand’s price to others in its category, the details of which are
discussed next.
Evaluate Product-Price Relationships
Because price is often used as an indicator of product quality, especially when customers lack
confidence or experience purchasing in certain product categories, price plays a very large role in how
customers perceive one brand relative to competitive brands. Therefore, price is a critical and usually
Pricing Strategies 12
unavoidable variable in positioning brands. The key to using price as a positioning variable is that
consumers must find price’s relationship to a particular brand to be credible. They must believe that
their mental calculations of value (see web notes on nature strategy) are consistent with the price of
brands under consideration.
Logically, prices can be set relative to competition in three ways. One, prices can be set lower than
relevant competition. Under this commonly employed strategy, brands must position themselves as
better values than overpriced alternatives, which may be more than customers need. Recall the Sparkle
paper towel commercial that asks if people really need a paper towel that can pick up a bowling ball.
This line refers to premium paper towel commercials that tout their strength.
A second approach is to price at or near major competition. The idea here is to position the brand as
solidly “middle class,” high enough quality to provide better value than high priced options, but high
enough that customers do not worry about being ripped off or being too cheap. For example, for many
years, UD set its prices such that we were at the median of a group of peer Catholic universities.
Finally, brands can make the “you get what you pay for” argument and position themselves as the high
priced but secure value alternative. Many Apple products take this approach, for example. Some mass
market brands have been known to take it a step further and actually point out their high prices. In the
1970s, a brand of television called Curtis Mathes proudly proclaimed in its advertising that it was “the
most expensive television in America and darned well worth it.” The strategy worked well for about ten
years, but eventually televisions imported from Asia, which were of very high quality and much lower
priced than American brands, sent Curtis Mathes, along with all U.S. television companies, into
bankruptcy or out of business. Another example is L’Oreal hair color, which also claimed to be the
“most expensive hair color in the world,” and then added, “But you’re worth it.”
Estimate Costs and Other Price Limitations
Obviously, profit is the goal of any business endeavor, meaning that products must also account for the
costs associated with making and selling them. In all likelihood, you have already learned about
breakeven analysis, which is a simple analytical technique that helps estimate the sales and price
necessary to just cover expenses. While the tool has been criticized for oversimplifying complex pricing
and costing situations, breakeven analysis can provide reasonable price and quantity estimates if the
input costs used to make the estimates are fairly accurate.
The relationships underlying breakeven analysis are shown in Exhibit 6 on the following page. The
diagram shows the simple idea that when the total cost curve intersects the total revenue curve, then
profits will be zero, but so will losses. That is, the firm will just break even. The cost and revenue curves
are shown as straight lines, which some argue reflects a weakness in breakeven analysis. The analysis
assumes that average costs increase monotonically with output, which is generally not the case because,
among other things, economies of scale produce per unit savings at higher levels of output. On the
revenue side, price elasticity of demand is typically not linear. However, these criticisms miss an
important point about breakeven analysis. The analysis is not meant to set a precise price. The analysis
is intended to give a rough idea of what level prices cannot fall below. The actual setting of prices is far
more complex. In fact, with sufficiently accurate data, the breakeven analysis could be conducted to
reflect nonlinear price and revenue. In general, however, given the usual purpose of breakeven analysis,
the effort is really not necessary.
Pricing Strategies 13
$
Total
Revenues
Breakeven
Revenue
Total
Costs
Breakeven
Point
Fixed
Costs
Units
0
Breakeven Quantity
Exhibit 6. Illustration of the Breakeven Quantity at a Given Price
The calculation of the breakeven point is really pretty straightforward. The formula, expressed as
breakeven quantity is given below. (We’ll express it in terms of price later.)
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 =
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 𝐶𝑜𝑛𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
You should already understand what fixed costs are. Fixed cost contribution represents the amount of a
product’s selling price that’s available to pay for fixed costs. In other words, it’s price once average
variable costs (or variable costs per unit) is removed:
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝑃𝑟𝑖𝑐𝑒 − 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠
We can now substitute the formula for fixed cost contribution into the denominator of the original
breakeven formula, which yields:
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 =
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝑃𝑟𝑖𝑐𝑒 − 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠
The average variable cost formula gives the variable costs attributable to each unit produced. It’s
calculated as follows on the next page:
Pricing Strategies 14
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 =
𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠
𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑
The formula for average variable costs can now be substituted into the breakeven formula. With this
final substitution, the breakeven equation looks like:
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 =
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝑃𝑟𝑖𝑐𝑒 − (𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠⁄𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑 )
With this equation, marketers can input different estimates for costs and price and then determine how
many units must be sold to break even. By changing price, and therefore breakeven quantity, marketers
can develop a sense of how price interacts with costs. With estimates about demand and price
elasticity, marketers can also calculate a profit maximizing price. Of course, the estimate is just that: an
estimate. But at least it is empirically based. The actual price must be set with many other marketplace
variables in mind. Also, long term strategies must be taken into consideration. Breakeven analysis is
more in tune with short term planning.
Forecast Sales and Profit Potential
Forecasting sales is a notoriously tricky and sometimes inaccurate exercise that is nonetheless critical to
many businesses. As we will learn later in the semester, sales forecasts help managers in all functional
areas of the business plan for the allocation of company resources. However, as important as it is,
predicting the future is fraught with uncertainty.
This step and the previous step are closely related. However, when forecasting sales, we need two
things that breakeven analysis does not provide. One is an estimate of what future sales will actually be
at a given price, not just the number to breakeven. Making such forecasts frequently involve regression
modeling past sales data with other pertinent data and using the predicted values of the estimated
regression model to predict future sales under varying conditions.
The other is some sense of how desired profits affect the estimate. Here, the basic breakeven approach
can be used, but with an allowance for either a necessary rate of return or some minimum fixed dollar
profit amount. These approaches are illustrated in Exhibits 7A and 7B on the following page. Exhibit 7A
shows how a fixed amount of profit could be added to fixed expenses, which effectively raises the total
cost curve and making the level of sales necessary to cover expenses and achieve the desired dollar level
of profit. Fixed dollar amounts of profits are not often used as profit targets, but if the amount
represents some minimum needed amount, for example, to meet an upcoming dividend payment, I can
be used to analyze a minimally acceptable circumstance. Figure 7B shows how a rate of return can be
incorporated into a standard breakeven analysis. Note that as the desired rate rises, it increases the
slope of the TC+Rate curve, thereby increasing the breakeven number of units. These approaches are
similar in their basics to breakeven analysis, but with the added dimension of profitability.
Pricing Strategies 15
$
$
TR
Acceptable
Minimum
Sales
TR
Acceptable
Minimum
Sales
TC + Fixed Profit
TC +
Return
TC
Desired Return
FC
Desired Fixed Profit
(a) Breakeven Plus Profit
Expressed as Fixed Dollar
Units
FC
(b) Breakeven Plus Profit
Expressed as Rate of Return
Units
Exhibit 7. Breakeven Analysis with Profitability Added
Set Base Price Structure
The term, base price structure, refers to the variations that can be used in establishing a pricing policy.
The nature of these variations have much to do with the type of product and the competitive
environments in which firms compete. The price structure is generally formulated against a base price
for a standard model of product. Variations in price are typically made relative to the base price. While
some of the preceding discussion pertained to estimating the base price based on factors such as costs
and even the reactions of some major customers, the price structure is intended to provide a system for
the variations in price around the base price.
Pricing structures include such policies as optional product pricing, where a standard model at the base
price can be purchased and then options and upgrades can be added to it. Automobile manufacturers
commonly use optional product pricing, where options in engines, transmissions, interiors, trim, audio,
and other gadgets can be added to the standard model. Computers bought online also use optional
product pricing. After selecting a standard model, buyers can upgrade monitor size, memory, and other
options.
The opposite pricing approach is called product bundling, where a standard model may exist at a base
price, but only in theory; they are not for sale. What’s offered for sale are product configurations that
include various combinations of options over the standard model, with no flexibility in choice. Buyers
can choose any of the configurations, but cannot modify or change anything. Think of a restaurant that
offers various meals but will not allow substitutions.
Structured discounts are another way of varying price but in permanent and predictable ways.
Structured discounts are not temporary promotional price reductions. Structured discounts include such
things as quantity discounts, which lower per unit product prices when large orders are placed.
Seasonal discounts may be offered during specific times of year. Seasonal discounts are generally
offered for purchases made during months of slower sales. Cash discounts may be offered to customers
who pay immediately or within a few days of placing the order. The typical cash discount is offered as a
two percent discount if the invoice is paid in full within ten days. This is where the phrase “two-ten, net
Pricing Strategies 16
thirty” comes from. Customers receive a two percent discount if they pay their invoice in ten days, or
the full amount if paid within thirty days. The common thread linking these discounts is that they are
not temporary promotional offers. They are permanent discounts built into the pricing structure of the
firm.
Make Necessary Price Adjustments
Adjustments to price are typically temporary, situational, and offered as promotional discounts. Base
prices may change, but in general marketers prefer for base prices to change infrequently. With a
relatively stable base price, marketers have a constant point of reference around which to offer
discounts and make other price and promotional concessions. The ability to put things “on sale” both at
the retail level and in the channel is an important competitive tool that not only gives customers a
financial incentive to speed up their purchase decisions, but also communicates things psychologically to
customers that affect impressions of the brands involved. Obviously, many luxury brands must use price
concessions judiciously for fear of diminishing the perceived status of the brand, but for the bulk of
everyday mid-priced and economy brands, promotional pricing around a stable base price is a standard
but important marketing tool.
Base prices do change from time to time, but generally, they rise rather than fall. Base prices most often
change when producers or retailers face rising costs. For example, in the past few years, energy costs
have affected the prices of many goods, many of which reflect significant transportation costs. In other
cases, competitive conditions may permit a price rise. For example, when low cost or discount airlines
pull out of some smaller markets, the remaining major airlines raise base prices on those routes simply
because they can. Finally, general economic conditions, such as high inflation, may force base price rises
in order to keep pace with currency devaluation. Overall, however, the majority of price changes, which
were discussed earlier in these notes, occur because marketers offer promotions of one kind or another.
Pricing Strategies 17
REFERENCES
The diagram and a portion of the discussion on residual elasticity was adapted from
Farris, Paul W., Neil Bendle, Philip E. Pfeifer, and David J. Reibstein (2006), Marketing Metrics: 50+
Metrics Every Executive Should Master. Upper Saddle River, NJ: Wharton School of Publishing.
The section on retail and channel price promotions and profitability draws from
Tellis, Gerard J. (1998), Advertising and Sales Promotion Strategy, Reading, MA: Addison-Wesley.
The diagram on setting base prices was adapted from
Peter, J. Paul and James H. Donnelly, Jr. (2009), Marketing Management: Knowledge and Skills, 10 ed.
New York: McGraw-Hill-Irwin.