Marketing Chapter 10: Pricing PDF

10 OBJECTIVES OUTLINE Pricing Understanding and Capturing Customer Value OBJECTIVE 10-1 Answer the question “What is price?” and discu...

10 OBJECTIVES OUTLINE Pricing Understanding and Capturing Customer Value OBJECTIVE 10-1 Answer the question “What is price?” and discuss the importance of pricing in today’s ­fast- changing environment. OBJECTIVE 10-2 Define price, identify the major pricing strategies, and discuss the importance of understanding customer-value perceptions, company costs, and competitor strategies when setting prices. OBJECTIVE 10-3 Identify and discuss the other important external and internal factors affecting a firm’s pricing decisions. CHAPTER In this chapter, we look at the second major To start, we’ll look at Peloton, the fitness brand that has marketing mix tool—pricing. If effective prod- turned its industry upside down. Peloton sells its in-home, PREVIEW uct development, promotion, and distribution internet-connected stationary bikes, treadmills, and other ­ sow the seeds of business success, effective pricing is the har- equipment at a substantial price premium over the competition. vest. Firms successful at creating customer value with the other Yet it has quickly attracted a large and growing cult following marketing mix activities must still capture some of this value in the of users who like what they get for the prices they pay. For prices they earn. In this chapter, we discuss the importance of the Peloton faithful, it isn’t just about Peloton’s prices. It’s about pricing, dig into three major pricing strategies, and look at internal inspiration, streaming content, and membership in a dynamic, and external considerations that affect pricing decisions. In the closely connected Peloton community of like-minded exercise next chapter, we examine some additional pricing considerations enthusiasts. and approaches. PELOTON: Premium Priced. But It’s Not about the Price P eloton in-home exercise bikes sell at a steep price of Although Peloton’s bike prices might seem steep, when $1,745, compared with the typical bikes you’d find at customers buy a Peloton, they’re getting much more for their your local sporting goods store for as little as $200 or money than just a premium home fitness bike. They’re buying $300. What’s more, buying a Peloton requires a $39 into an absorbing lifestyle and a closely connected community of like-minded exercise enthusiasts, who ride together through monthly membership fee to access the brand’s digital network classes on-demand or live-streamed from Peloton’s studios to and most appealing features. But even at those prices, Peloton an internet-connected tablet on the bike. As one writer says, has revolutionized an industry and built a large and loyal it’s “the allure of sweating buckets and feverishly cycling en 6.5 million–strong membership base. masse to the beat of Beyoncé as an all-too enthusiastic instruc- On average, the $4 billion company’s annual revenues tor shouts encouragement about ‘feeling the burn, baby!’”—all from equipment and subscription sales have doubled every from the comfort and convenience of your own home. year since its 2014 launch. Peloton’s sales got an astronomical In recent years, a fast-growing number of fitness boutiques boost from the COVID-19 pandemic as gym closings and so- have popularized “spinning”—high-intensity, indoor cycling cial distancing left millions of gym-less people scrambling to workout classes led by popular instructors in upscale exercise get their fitness fixes with Peloton’s in-home gear and work- studios. With names like SoulCycle, CycleBar, Revolve, and out app. Peloton found itself selling gear faster than it could Swerve, these studios evoke a vibe that is more “swanky pri- make it. vate club” than “sweaty fitness gym.” For example, cyclists M10_KOTL9364_19_GE_C10.indd 310 06/03/23 4:39 PM  CHAPTER 10 | Pricing: Understanding and Capturing Customer Value 311 in one of SoulCycle’s candle-lit “soul studios” pay $34 for an instructor-led 45-minute class. But more than a workout, SoulCycle promises “A powerful mind-body experience. Change your body. Find your SOUL.” Peloton founder and now executive chairman John Foley—a triathlete and then new father—enjoyed spin- ning. But as the SoulCycle spinning craze grew in popular- ity, he found it increasingly difficult to book the classes and popular instructors that he wanted. Like others, his time- challenged lifestyle often made it tough to get to an exercise studio, and sometimes he just wanted more privacy when working out. So Foley found a better way. Instead of making customers go to spinning classes, he would take the spin- ning classes to customers. Working with a team of engineers, instructors, and sales reps, Foley designed Peloton around the tech-forward, time-starved, on-demand lifestyles of to- day’s consumers. For the Peloton faithful, it isn’t just about Peloton’s premium prices. Every premium Peloton cycle comes mounted with a It’s about the values received from membership in the dynamic, large touchscreen tablet by which riders can track their perfor- closely connected Peloton community. mance, stream content from Peloton, or interact with others in Peloton Interactive the Peloton online community. Peloton streams 24 hours of live virtual rides; they interact between rides. They communicate content daily and offers more than 8,000 on-demand cycling online, offering advice and encouragement and congratulat- classes and thousands more “Beyond the Ride” classes such ing each other on reaching new milestones. They meet up at as yoga, arms, legs, stretching, and core strengthening. Riders local showrooms and travel cross-country to attend Peloton’s can select their favorite instructors, class length, class type, and annual Homecoming—a three-day gathering of classes, even music genre. They can follow and compete with other rid- meetups, cocktails, and meet-and-greets with Peloton’s ers in real time. And they can do all that from the comfort and celebrity-like instructors. When one Peloton member posted convenience of home. on the Official Peloton Page that he needed to sell his recently Peloton’s early adopters were affluent riders who weren’t purchased bike to cover his wife’s medical expenses, fellow deterred by the high price of admission. The brand quickly riders set up a GoFundMe page that raised $25,000 in just earned a cult following of well-off users. But based on customer 48 hours. data gathered through the Peloton network, the company soon Peloton now sells bikes, treadmills, other equipment, and discovered opportunities among less affluent riders. So Peloton subscriptions all over the world through its online store and began offering a financing option that bundled the bike with a 100-plus showrooms throughout the United States, Canada, monthly subscription for $97 a month for 39 months. By com- the United Kingdom, and Germany. In turn, competitors like parison, two in-studio spinning classes a week at any Peloton SoulCycle have felt the burn of Peloton’s success. Although competitor cost from $200 to $300 a month. Three spins a week other spinning studio chains have expanded into in-home op- in a New York City studio runs a hefty $500 a month. That tions similar to Peloton’s—from bikes to subscription services— makes Peloton a real bargain in the eyes of its fans. competing studio-based brands have struggled, especially as But again, for the Peloton faithful, it isn’t just about the COVID-19 ravaged the industry. price of a bike. Joining Peloton provides benefits that cus- Peloton itself faces its share of challenges. The COVID-19 tomers can’t get from either standalone bikes or in-person pandemic unleashed a great deal of uncertainty, with exercise spinning studios: owning a premium bike, workout and sched- patrons bouncing back and forth between in-home exercise and uling convenience, access to quality content, and membership in going to the gym. Demand spikes coupled with global supply a dynamic, thriving community. Because an unlimited number chain issues at times made quick order fulfillment impossible. of people can participate in a given Peloton class, the company And design flaws in the Peloton Tread treadmill caused injuries can spend generously to produce a wide selection of top-quality to some customers, resulting in expensive recalls and a blow to classes taught by the best instructors. And Peloton collects tons Peloton’s premium image. The company’s stock price is down, of user data that help shape future content offerings, making it and it has yet to turn an annual profit. But even with all the what some analysts have called the challenges, Peloton’s equipment “Netflix of fitness.” sales and memberships continue More than a fitness brand, Peloton sells its in-home stationary to grow at healthy rates. Peloton is Peloton is a “microcultural” phe- bikes and other fitness equipment at now by far the most popular sta- nomenon. Members self-select a substantial price premium over the tionary cycling brand. into groups on Facebook based All of this makes Peloton an competition. Yet it has attracted a large and on age, height, profession, loca- interesting study in pricing strat- tion, instructor preferences, and growing cult following of users who like the egy. Although at first blush, the other characteristics. And Peloton value they get for the price they pay. price might seem unreasonably groups don’t just get together for high, most customers see it as a M10_KOTL9364_19_GE_C10.indd 311 06/03/23 4:39 PM  312   PART 3 | Designing a Customer Value–Driven Strategy and Mix bargain for what they are getting. In fact, Peloton initially set bike must be poorly built if you’re charging $1,200 for it. We lower prices to attract more customers. But raising prices actu- charged $2,000 for it, and sales increased, because people said, ally increased demand. “It was interesting psychology that we ‘Oh, it must be a quality bike.’” teased out,” says Foley. “In the very, very early days, we charged Whatever the psychology, with its cultlike following and $1,200 for the Peloton bike for the first couple of months. And ­industry-largest membership base, even at its high price, Peloton what turned out happening is we heard from customers that the appears to be giving riders more than their money’s worth.1 COMPANIES TODAY FACE a fierce and fast-changing pricing environment. ­ alue-seeking. smartphone-wielding customers have put increased pricing pressure on V many companies. Thanks to tight economic times in recent years, the pricing power of the internet, and value-driven retailers such as Walmart and Amazon, today’s consumers are pursuing more frugal spending strategies. In response, it seems that almost every com- pany has been looking for ways to cut prices. Yet cutting prices is often not the best answer. Reducing prices unnecessarily can lead to lost profits and damaging price wars. It can cheapen a brand by signaling to cus- tomers that price is more important than the customer value a brand delivers. Instead, in both good economic times and bad, companies should sell value, not price. In some cases, that means selling lesser products at rock-bottom prices. But in most cases, it means per- suading customers that paying a higher price for the company’s brand is justified by the greater value they gain. What Is Price? OBJECTIVE 10-1 Answer the question “What is price?” and discuss the importance of pricing in today’s fast-changing environment. In the narrowest sense, price is the amount of money charged for a product or a service. More broadly, price is the sum of all the values that customers give up to gain the benefits Pricing: No matter what the state of having or using a product or service. Pricing remains one of the most important ele- of the economy, companies should ments that determine a firm’s market share and profitability. sell value, not price. Pricing has been described as the moment of truth in marketing. Almost everything magicoven/Shutterstock that the company does in marketing, it does for the customer. For example, innovation and new product development, advertising, distribution, packaging, and other activities are all aimed at increasing the value delivered to the customer. Pricing is the only marketing mix ­Price element that translates the value created for customers back into revenues and profits for The amount of money charged for a the company. A company can pour significant resources into creating customer value, but product or service, or the sum of the poor pricing decisions can lay waste to all those inputs. Pricing too high can reduce profits values that customers exchange for the by driving away profitable customers. Pricing too low can reduce profits by leaving too benefits of having or using the product much value on the table for customers. or service. Pricing is one of the most flexible marketing mix elements. Unlike product features and channel commitments, prices can be changed quickly in response to market developments. Given these significant implications of the pricing decision and the fact that prices are flexible, one might think that pricing decisions should be top-of-mind for managers. Unfortunately, pricing is the number-one problem facing many marketing executives, and many companies do not manage pricing well. Managers often view pricing as a big head- ache, preferring instead to focus on other marketing mix elements while treating pricing as an afterthought. In contrast, smart managers treat pricing as a key strategic tool for capturing customer value. Prices have a direct impact on a firm’s bottom line. A small percentage improvement in price can often generate a large percentage increase in profitability. And, as part of a company’s overall value proposition, price plays a key role in influencing the value per- ceived by consumers and in building customer relationships. Instead of shying away from pricing, smart marketers embrace it as an important competitive tool.2 M10_KOTL9364_19_GE_C10.indd 312 06/03/23 4:39 PM  CHAPTER 10 | Pricing: Understanding and Capturing Customer Value 313 Author Setting the right price Comment is one of the marketer’s Major Pricing Strategies most difficult tasks. A host of factors come into play. But as the opening OBJECTIVE 10-2 Define price, identify the major pricing strategies, and discuss the story about Peloton illustrates, finding importance of understanding customer-value perceptions, company costs, and and implementing the right pricing competitor strategies when setting prices. strategy is critical to success. The price the company charges will fall somewhere between one that is too low to pro- duce a profit and one that is too high to produce any demand. Figure 10.1 summa- rizes the major considerations in setting prices. Customer perceptions of the product’s value set the ceiling for its price. If customers perceive that the product’s price is greater than its value, they will not buy the product. Likewise, product costs set the floor for a product’s price. If the company prices the product below its costs, the company’s profits will suffer. In setting its price between these two extremes, the company must consider several external and internal factors, including competitors’ strategies and prices, the overall marketing strategy and mix, and the nature of the market and demand. Figure 10.1 suggests three major pricing strategies: customer value–based pricing, cost-based pricing, and competition-based pricing. We discuss each strategic pricing ap- proach in turn. Author Like everything else in Comment marketing, good pricing Customer Value–Based Pricing starts with customers and their In the end, the customer will decide whether a product’s price is right. Pricing decisions, perceptions of value. like other marketing mix decisions, must start with customer value. When customers buy a product, they exchange something of value (the price) to get something of value (the ben- efits of having or using the product). Effective customer-oriented pricing involves under- standing how much value consumers place on the benefits they receive from the product and setting a price that captures that value. Customer value–based pricing Customer value–based pricing uses buyers’ perceptions of value as the key to Setting price based on buyers’ pricing. Value-based pricing means that marketers cannot design a product and marketing perceptions of value rather than on the program and then set the price. They must consider price along with all other marketing seller’s cost. mix variables before they set a marketing program. Figure 10.2 compares value-based pricing with cost-based pricing. Although costs are an important consideration in setting prices, cost-based pricing is often product driven. The company designs what it considers to be a good product, adds up the costs of making the product, and sets a price that covers costs plus a target profit. Marketing must then convince buyers that the product’s value at that price justifies its purchase. If the price turns out to be too high, the company must settle for lower markups or lower sales, both resulting in disappointing profits. Value-based pricing reverses this process. The company first assesses customer needs and value perceptions. It then sets its target price based on customer perceptions of value. The targeted value and price drive decisions about what costs can be incurred and the resulting product design. As a result, pricing begins with analyzing consumer needs and value perceptions, and the price is set to match perceived value. Value-based pricing is generally the most logical and profitable way to price products and services. It focuses both on creating market offerings that deliver appreciable value to customers and on pricing that captures that value in return in order to drive profits. FIGURE 10.1 Competition and other Considerations in Setting Price Product external factors Consumer perceptions costs of value Competitors’ strategies and prices If customers perceive that a product’s price is greater Marketing strategy, objectives, than its value, they won’t buy it. If the company prices Price floor Price ceiling the product below its costs, profits will suffer. Between and mix No profits below Nature of the market and demand No demand above the two extremes, the “right” pricing strategy is one this price this price that delivers both value to the customer and profits to the company. $ $$ Price M10_KOTL9364_19_GE_C10.indd 313 06/03/23 4:39 PM  314   PART 3 | Designing a Customer Value–Driven Strategy and Mix Cost-based pricing Convince buyers Design a Determine Set price based of product’s good product product costs on cost value Costs play an important role in setting prices. Value-based pricing But like everything else in marketing, good pricing Design product Assess customer Set target price to Determine costs starts with the customer. to deliver desired needs and value match customer- that can be value at target perceptions perceived value incurred price FIGURE 10.2 Value-Based Pricing versus Cost-Based Pricing However, companies often find it hard to measure the value customers attach to their products. For example, calculating the cost of ingredients in a meal at a fancy restaurant is relatively easy. But assigning value to other measures of satisfaction such as taste, environ- ment, relaxation, conversation, and status is very hard. Such value is subjective; it varies for both different consumers and different situations (see Real Marketing 10.1). It’s important to remember that “good value” is not the same as “low price.” For example, a Steinway piano—any Steinway piano—costs a lot. But to those who own one, a Steinway is a great value:3 Steinway’s more popular piano models typically run any- where from $70,000 to $150,000. But ask anyone who owns a Steinway and they’ll tell you that, when it comes to Steinway, price is nothing; the Steinway experience is everything. Steinway makes very high-quality pianos—handcrafting each Steinway requires up to one full year. Steinway claims that old-world crafting combined with state-of-the-art technology gives a Steinway “the widest range of tonal colors and the most responsive touch of any instrument...by far.” But Steinway owners get much more than just a well-made piano. More importantly, they get the Steinway mystique. The Steinway name evokes images of classical concert stages and the celebri- ties and performers who’ve owned and played Steinway pia- nos across more than 160 years. Yet Steinways aren’t just for world-class pianists and the wealthy. Most Steinway buyers are amateurs who perform only in their dens. So is a Steinway piano worth the premium price com- pared to less expensive pianos? To many consumers, the an- swer is no. But to Steinway’s customers, whatever a Steinway costs, it’s a small price to pay for the value of owning one. Says Customer value–based pricing: A Steinway piano—any Steinway one Steinway user, “A pianist without a Steinway, for me, is the piano—costs a lot. But to a Steinway customer, it’s a small price to pay same as a singer without a voice.” Says another, “My friendship for the value of owning one. with the Steinway piano is one of the most important and beau- © Westend61 GmbH/Alamy Stock Photo tiful things in my life.” Who can put a price on such feelings? At some level, consumers will use perceived values to evaluate a product’s price, so the company must work to measure and communicate them. Sometimes, companies ask consumers how much they would pay for a basic product and for each benefit added to the offer. Or a company might conduct experiments to test the perceived value of different product offers. For consumer marketers, this can be difficult. Final consumers rarely break down the value of products into different value-adding components. In contrast, business-to-business marketers can often make deeper and more calcu- lated assessments of value delivered to their customers. For example, consider leading industrial robot manufacturer KUKA: KUKA makes automated and programmable robots that can undertake a remarkable range of complex manufacturing tasks usually done by humans. For example, KUKA robots intricately weld together components of the instrument panel and other body parts for Mercedes vehicles. To price such KUKA welding robots, the company must compute the total value they deliver to customers like Mercedes. M10_KOTL9364_19_GE_C10.indd 314 06/03/23 4:39 PM  CHAPTER 10 | Pricing: Understanding and Capturing Customer Value     315 Value-Based Pricing: It’s All about Real Marketing 10.1 Customer Perceptions of Value For centuries, marriage proposals have in- no greater “function,” add value through “lux- product, maintains high customer value volved engagement rings. And today, 80 per- ury,” “status,” or “exclusivity.” perceptions, and charges high prices accord- cent of engagement rings in the United States Recently, a new type of jeans buyer has ingly. But Porsche recently added a some- feature a central diamond costing thousands emerged, one who values “heritage” and “au- what different twist with its Porsche Drive of dollars. Prior to World War II, however, only thenticity” above the more commonly sought subscription program. Porsche Drive takes 10 percent of engagement rings contained jeans characteristics. These buyers seek things a step further by giving a select group diamonds, and the rings cost much less. Why brands such as Rogue Territory, the bou- of buyers a value-price bundle that goes be- the big increase? Thank the De Beers dia- tique jeans maker known for its raw denim, yond the basic product. mond company. In the early to mid-1900s, it “selvedge” jeans, handmade in the United People who drive Porsches love driv- began a pricing strategy that focused on the States. Raw denim jeans are not prewashed. ing. They happily pay a premium price for a symbolic value of engagement rings—the Instead, they start out stiff and dark. Selvedge ­ superior-performing, highly styled car. For love and commitment associated with them. denim is woven “the old-fashioned way,” on example, the MSRP for a Porsche Cayenne De Beers set that association in stone with shuttle looms that produce a unique weave SUV starts at $69,000; the Cayenne Turbo the now-famous tagline “A Diamond is Forever.” in narrow swaths. The edges are finished in starts at $129,900. The starting price for Just what is the value to customers of white thread with a single-colored yarn down a Porsche 911 Carrera sports car runs just proving one’s vows with a diamond? After the middle, preventing the cloth from fraying over $100,000 for a base model and typically all, who really needs a diamond in their ring? (hence, self-edge). Selvedge jeans wearers exceeds $125,000 with options, license, and During the Great Depression, De Beers set typically wear them cuffed to show off this registration; the 911 Turbo starts at $187,100. the standard at one month’s salary. By the unique characteristic. To most people, that For most Porsche customers, one Porsche 1980s, De Beers doubled the ante with ad- goes unnoticed. But to fans, it’s a subtle sign does the job. True Porsche enthusiasts might vertising headlines such as “2 months’ salary of a fellow denim-head who is in the know. have two or three models—a Cayenne SUV for showed the future Mrs. Smith what the fu- What’s the value of such heritage and transporting kids and cargo, a Taycan EV sedan ture will be like.” Twenty years later, the value authenticity? Rogue Territory jeans start at for commuting in comfort and style, and a 911 rose yet another tick to three months’ salary. $295, more than four times the price of a pair for spirited weekend excursions. But what if Today, although the average engagement ring of Levi’s. But that’s only part of the cost-value someone wants to drive different Porsches but price is only one and a half months’ salary, proposition. Raw selvedge cloth requires has garage space for only one car? Or some- De Beers has successfully created a value ex- a break-in ritual that would turn away most one loves driving different Porches but dreads pectation that a diamond confirms “A promise jeans buyers. Rogue Territory recommends the hassle of maintaining even one car? Finally, of the heart.” As one early De Beers ad pro- wearing them many times—maybe 30 to 60 what if someone’s budget allows for the out- claims: “This radiant gem will ever flame for times—before washing them. This extensive right purchase of a single Porsche but won’t them, holding the memory of their promise, break-in process creates unique fading pat- expand to buying multiple models? the message of their love,...to be cherished terns along wear creases. And after the first For such buyers, the Porsche Drive sub- always, by [them] and all who follow.” wash with mild detergent, selvedge jeans scription plan, the only one of its kind in Setting price based on customer value is should be drip-dried until damp and then the auto industry, offers a value bundle that simple in concept but often difficult in practice. worn again, letting them conform to the user’s gives buyers the benefits of owning several It’s hard to get a handle on value perceptions. body as they dry fully. Thus, Rogue Territory Porsches at a subscription price that’s much It requires accurately identifying and measur- jeans don’t ing the benefits that customers seek and per- just cost more, ceive and then setting a price to match. More, they take more it often involves boosting customer value per- work. But to ceptions to support higher prices. The task is loyalists, the re- all that much more challenging because ben- wards reaped efits sought, and the value attached to those in terms of au- benefits, can vary substantially across cus- thentic look and tomers and buying situations. fit are more than Consider blue jeans, a basic item in ward- worth the extra robes all over the world. What do consum- money and ef- ers value in a pair of jeans, and what are they fort invested. worth? Levi Strauss & Co. invented the riv- Luxury perfor- eted denim blue jean more than 150 years mance carmaker ago, and Levi’s is still the best-selling jeans Porsche has long brand. It offers numerous versions featuring practiced value- basic combinations of style, comfort, and based pricing. durability starting at $69.50 a pair. But con- Like De Beers sumer tastes and value perceptions in jeans and Rogue The Porsche Drive subscription program promises “Dreams on vary widely. Most consumers are content with Territory, Porsche demand—a fleet of Porsches at your fingertips.” That makes the value the basics. But others willingly pay premium has created a well worth the price for the group of Porsche enthusiasts who sign up. prices for fashion jeans that, while providing differentiated North Monaco/Shutterstock M10_KOTL9364_19_GE_C10.indd 315 06/03/23 4:39 PM  316   PART 3 | Designing a Customer Value–Driven Strategy and Mix less than buying them outright, all without the The Porsche Drive plan doesn’t come Porsches that only the wealthiest consum- headaches of car ownership. cheap. For example, a single-vehicle sub- ers with the biggest garages could ever For a fixed monthly rate, registered cus- scription plan for a Porsche 911 starts at hope to own, all with none of the hassles tomers can keep and drive almost any Porsche $2,950 a month. By comparison, a three- of ownership. “Experience the thrill on your model, including the Macan, Cayman, year lease for that same 911 runs only about own terms,” says Porsche. “An adrenaline- Boxster, Cayenne, Taycan, Panamera, and $1,600 a month, and the monthly payment pumping selection of Porsche vehicles is 911. Customers select the model they want on a five-year loan for outright purchase of a [only] a touch away in the Porsche Drive through an app. They can keep the car for 911 would be around $2,300 a month. app.” Have “a Porsche fleet at your own one month or as many months as they wish The most enticing Porsche Drive plan is fingertips.” at the monthly rate and then change it out the flagship multi-vehicle subscription. For Is Porsche Drive worth the price? To most for a different version of the same model or $3,100 a month, customers can point and consumers, even steadfast Porsche loyalists, for another model at a new monthly rate. The click on any Porsche model that suits them probably not. But it’s all about perceptions monthly subscription fee covers everything, in the moment. They can keep and drive it of value versus price. For those who buy including maintenance, insurance, cleaning, or change it as often as they want for any into the plan and its promise of “Dreams on roadside assistance, and concierge vehicle other Porsche model in the program. The demand,” Porsche Drive would be a steal at delivery. plan gives the customer access to a fleet of twice the price.4 To begin, KUKA estimates how much Mercedes spends on welding without the robots, using human labor. Then it adds three incremental sources of value that its robots provide. The first is functional value, that value related to better welding—more even welds, fewer errors, and lesser reworking. The second is economic value—increased profitability of doing the job roboti- cally through lower labor costs, faster welding, less consumption of welding materials, and other improvements. The third is psychological value, that value related to creating a safer and less stress- ful working environment where workers are not exposed to high-temperature welding arcs and noxious fumes generated during welding. Thus, KUKA can make a solid estimate of total value delivered to Mercedes in financial terms and use it as a basis justifying the prices it charges. According to an old Russian proverb, there are two fools in every market—one who asks too much and one who asks too little. If the seller charges more than the buyers’ per- ceived value, the company’s sales will suffer. If the seller charges less, its products will sell very well, but they will produce less revenue than they would if they were priced at the level of perceived value. We now examine two types of value-based pricing: good-value pricing and value-added pricing. Good-value pricing Offering just the right combination of ­Good-Value Pricing quality and good service at a fair price.Recent years have seen a shift in consumer attitudes toward price and quality. Increasingly, consumers want to know that they are getting good value for their money. In response, many companies have changed their pricing approaches to bring them in line with changing price and value perceptions. More and more, marketers have adopted the strategy of good- value pricing—offering the right combination of quality and good service at a fair price. In many cases, this has involved introducing less- expensive versions of established brand name products or new lower-price lines. For example, Kroger carries three ­low-priced product lines—Heritage Farm, Check This Out, and Psst, which offers ­ thrift-conscious customers rock- bottom prices on grocery staples such as chicken, toilet paper, and sugar. And Google’s Nest brand recently intro- duced a lower-priced smart thermostat, simply called the Nest Thermostat, priced at $129 versus $249 for the high- end Nest Learning Thermostat. Good-value prices are a relative thing—even premium brands can launch value ver- sions. Mercedes-Benz released its CLA Class, entry-level Good-value pricing: Even premium brands can launch good- models starting at $31,500. From its wing-like dash and value versions. The Mercedes CLA Class gives customers “The Art diamond-block grille to its 208-hp turbo inline-4 engine, the of Seduction. At a price reduction.” CLA Class gives customers “The Art of Seduction. At a price North Monaco/Shutterstock reduction.”5 M10_KOTL9364_19_GE_C10.indd 316 06/03/23 4:39 PM  CHAPTER 10 | Pricing: Understanding and Capturing Customer Value     317 In other cases, good-value pricing involves redesigning existing brands to offer more Value-added pricing quality for a given price or the same quality for less. Some companies even succeed by Attaching value-added features and offering less value but at very low prices. For example, the ALDI supermarket chain has services to differentiate a company’s established an impressive good-value pricing position by which it gives customers a basic offers and charging higher prices. assortment of quality items at super-low everyday prices. ALDI practices an important type of good-value pricing at the retail level called every- Cost-based pricing day low pricing (EDLP). EDLP involves charging a constant, everyday low price with few Setting prices based on the costs of or no temporary price discounts. Perhaps the king of EDLP is Walmart, which practically producing, distributing, and selling the defined the concept. Except for a few sale items every month, Walmart promises every- product plus a fair rate of return for effort day low prices on everything it sells. In contrast, high-low pricing involves charging higher and risk. prices on an everyday basis but running frequent promotions to lower prices temporar- ily on selected items. Department stores such as Kohl’s and JCPenney have historically practiced high-low pricing by having frequent sale days, early-bird savings, and bonus earnings for store credit-card holders. Value-Added Pricing Value-based pricing doesn’t mean simply charging what customers want to pay or setting low prices to meet competi- tion. Instead, many companies adopt value-added pricing strategies. Rather than cutting prices to match competitors, they add quality, services, and value-added features to dif- ferentiate their offers and thus support their higher prices. For example, luxury outerwear apparel brand Canada Goose doesn’t try to beat out the competition by offering discounts or more affordable versions of its cold- weather jackets, parkas, vests, and other gear. Instead, for more than 60 years, Canada Goose has poured resources into making high-quality, carefully crafted products that merit the premium prices it charges. Its iconic Snow Mantra parka was initially developed to meet the needs of work- ers in the Canadian Arctic. Made to keep you warm in the harshest climates, Canada Goose jackets can withstand temperatures as low as −30 ° Celsius. This kind of quality doesn’t come cheap—Canadian Goose jackets can run any- where from $500 to $1,500. Despite those premium prices, or perhaps because of them, Canada Goose has grown to become a near-$1 billion luxury brand. It now sells its popular cold-weather outerwear globally in 12 of its own stores, in high-end partner retailers such as Nordstrom and Bloomingdales, and at its expansive online site, capturing 6 percent of the world’s premium outerwear market.6 In sum, an important insight is that value-based pricing Value-added pricing: Luxury outerwear brand Canada Goose does not itself signal a low or a high price. Rather, value-based creates high-quality, carefully crafted products that keep you warm pricing involves a careful assessment of the value delivered in the harshest climates, adding value that merits its premium prices. by the product to the customer and a resulting pricing deci- Jenny Wong, Photographer sion that captures a good fraction of delivered value back in terms of profitability, even while allowing the customer to retain an appreciable chunk of the delivered value. Author Costs set the floor for Comment price, but the goal isn’t Cost-Based Pricing always to minimize costs. In fact, many firms invest in higher costs so that they Whereas customer value perceptions set the price ceiling, costs set the floor for the price can claim higher prices and margins that the company can charge. Cost-based pricing involves setting prices based on the for the enhanced value they create costs of producing, distributing, and selling the product plus a fair rate of return for the (think back about Canada Goose company’s effort and risk. apparel). The key is to manage the Some companies, such as Walmart or ALDI, work to become the low-cost producers spread between costs and prices— in their industries. Companies with lower costs can set lower prices that result in smaller how much profit the company makes margins but greater sales and profits. However, other companies—such as Apple, BMW, for the customer value it delivers. and Steinway—intentionally pay higher costs so that they can add value and claim higher M10_KOTL9364_19_GE_C10.indd 317 06/03/23 4:39 PM  318   PART 3 | Designing a Customer Value–Driven Strategy and Mix prices and margins. For example, it costs more to make a “handcrafted” Steinway piano than a Yamaha production model. But the higher costs result in higher quality, justifying the higher price. The key is to manage the spread between costs and prices—how much the company makes for the customer value it delivers. Types of Costs Fixed costs (overhead) A company’s costs take two forms: fixed and variable. Fixed costs are regularly incurred Costs that do not vary with production or costs that do not vary with production or sales level. For example, a company must pay sales level. each month’s bills for rent, heat, interest on loans, and executive salaries regardless of the company’s level of output. Many of these fixed costs are classified as overhead costs. In Variable costs contrast, variable costs vary directly with the level of production. Each smartphone or Costs that vary directly with the level of tablet produced by Samsung involves costs related to computer chips, wires, plastic, pack- production. aging, and other inputs. Although these costs tend to be the same for each unit produced, they are called variable costs because the total varies with the number of units produced. Total costs Total costs are the sum of the fixed and variable costs for any given level of production. The sum of the fixed and variable costs Management wants to charge a price that will at least cover the total production costs at a for any given level of production. given level of production. The company must watch its costs carefully. If it costs the company more than its com- petitors to produce and sell a similar product, the company will need to charge a higher price or make less profit, putting it at a competitive disadvantage. ­Costs at Different Levels of Production To price wisely, management needs to know how its costs vary with different levels of production. For example, suppose Lenovo built a plant to produce 1,000 tablet comput- ers per day. Figure 10.3A shows the typical short-run average cost curve (SRAC). It shows that the cost per tablet is high if Lenovo’s factory produces only a few per day. But as production moves up to 1,000 tablets per day, the average cost per unit decreases. This is because fixed costs are spread over more units, with each one bearing a smaller share of the fixed cost. Lenovo can try to produce more than 1,000 tablets per day, but average costs will increase because the plant becomes inefficient. Workers have to wait for machines, the machines break down more often, and workers get in each other’s way. If Lenovo believed it could sell 2,000 tablets a day, it should consider building a larger plant. The plant would use more efficient machinery and work arrangements. Also, the unit cost of producing 2,000 tablets per day would be lower than the unit cost of producing 1,000 units per day, as shown in the long-run average cost (LRAC) curve ( Figure 10.3B). In fact, a 3,000-capacity plant would be even more efficient, according to Figure 10.3B. But a 4,000-daily production plant would be less efficient because of increasing diseconomies of scale—too many workers to manage, paperwork slowing things down, and so on. Figure 10.3B shows that a 3,000-daily production plant is the best size to build if demand is strong enough to support this level of production. If sufficient demand existed, the company could even set up two plants, each with 3,000-daily production capacity. Costs as a Function of Production Experience Suppose Lenovo runs a plant that produces 3,000 tablets per day. As Lenovo gains experi- ence in producing tablets, it learns how to do it better. Workers learn shortcuts, become FIGURE 10.3 Cost per Unit at Different Levels of Production per Period 1 Cost per unit Cost per unit 2 3 SRAC SRAC 4 LRAC What’s the point of all the cost curves in this and the next few figures? Costs are an important factor in setting price, and companies must understand them well! 1,000 1,000 2,000 3,000 4,000 Quantity produced per day Quantity produced per day A. Cost behavior in a fixed-size plant B. Cost behavior over different-size plants M10_KOTL9364_19_GE_C10.indd 318 06/03/23 4:39 PM  CHAPTER 10 | Pricing: Understanding and Capturing Customer Value     319 FIGURE 10.4 more familiar with their equipment, and share knowledge. With practice, the work be- Cost per Unit as a Function of comes better organized, and Lenovo finds better equipment and production processes. Accumulated Production: The With higher volume, Lenovo becomes more efficient and gains economies of scale. As a re- Experience Curve sult, the average cost tends to decrease with accumulated production experience. This is shown in Figure 10.4.7 Thus, the average cost of producing the first 100,000 tablets is $10 $10 per tablet. When the company has produced the first 200,000 tablets, the average cost has fallen to $8.50. After its accumulated production experience doubles again to 400,000, Cost per unit $8 the average cost is $7. This drop in the average cost with accumulated production experi- $6 ence is called the experience curve (or the learning curve or economies of scale). $4 A downward-sloping experience curve is highly significant for a company. Not only $2 will the company’s unit production cost fall, but it will fall faster if the company makes and sells more during a given time period. But the market has to stand ready to buy the higher 100,000 200,000 400,000 800,000 output. And to take advantage of the experience curve, Lenovo must get a large market Accumulated production share early in the product’s life cycle. This suggests the following pricing strategy: Lenovo should invest heavily in early marketing so its sales will increase and its costs will decrease through gaining more experience. Following that, it can lower its prices in order to manage its competition better. Experience curve Some companies have built successful strategies around the experience curve. The drop in the average per-unit However, a single-minded focus on reducing costs and exploiting the experience curve production cost that comes with will not always work. Experience-curve pricing carries some major risks. The aggressive accumulated production experience. pricing might give the product a cheap image. The strategy also assumes that competitors are weak and not willing to fight it out by meeting the company’s price cuts. Finally, while the company is building volume under one technology, a competitor may find a ­lower-cost technology that lets it start at prices lower than those of the market leader, which still operates on the old experience curve. Finally, once the company lowers prices, it’s almost impossible to increase them later. ­Cost-Plus Pricing Cost-plus pricing (markup pricing) The simplest pricing method is cost-plus pricing (or markup pricing)—adding a Adding a standard markup to the cost of standard markup to the cost of the product. Construction companies, for example, may the product. submit job bids by estimating the total project cost and adding a standard markup for profit. Lawyers, accountants, and other professionals sometimes price by adding a standard markup to their costs. Some sellers tell their customers they will charge cost plus a speci- fied markup; for example, aerospace companies often price this way to the government. To illustrate markup pricing, let’s apply it to a toaster manufacturer. The manufac- turer’s variable costs are the costs of metal, electronics, and other inputs that go into each unit produced. In contrast, fixed costs—such as the rental costs for offices and factories— are spent in bulk and have to be distributed across units. Suppose the toaster manufacturer had the following costs and expected sales: Variable cost per toaster $10 Fixed costs $300, 000 Expected unit sales 50,000 Then the manufacturer’s cost per toaster is given by the following: fixed cost $300,000 unit cost = variable cost + = $10 + = $16 unit sales 50,000 Now suppose the manufacturer wants to earn a 20 percent markup on sales. The man- ufacturer’s markup price is given by the following:8 unit cost $16 markup price = = = $20 ( 1 − desired return on sales ) 1 − 0.2 The manufacturer would charge dealers $20 per toaster and make a profit of $4 per unit. The dealers, in turn, will mark up the toaster. If dealers want to earn 50 percent on the sales price, they will mark up the toaster to $40; that is, $20 + 50% (or 0.5) = $40. This number represents a markup on the sales price of 50% ($20/$40) but a markup on cost of 100 percent ($20/$20). M10_KOTL9364_19_GE_C10.indd 319 06/03/23 4:40 PM  320   PART 3 | Designing a Customer Value–Driven Strategy and Mix Markup pricing remains popular in some situations. First, sellers are more certain about costs than about demand. By tying the price to cost, sellers simplify pricing; they do not need to make frequent adjustments as demand changes. Second, when all firms in the industry use this pricing method, prices tend to be similar, so price competition is mini- mized. Third, many people feel that cost-plus pricing is fairer to both buyers and sellers. Sellers earn a fair return on their investment but do not take advantage of buyers when buyers’ demand becomes great. But does using standard markups to set prices make sense? Generally, no. The practice of cost-plus pricing is usually difficult to support from a business viewpoint. First, any pricing method that ignores demand and competitor prices is not likely to lead to the best price. Second, when a company uses cost-plus pricing, it is implicitly acknowledging it is seeking only a “sufficient” level of profits. Instead, the company should be aiming to maxi- mize profits by delivering great value to customers and using prices to extract some of that value in terms of profitability. Thus, except for some specific cases, such as government contract pricing, cost-plus pricing is not commonly used. At most, the cost-plus approach is used to set a floor below which prices must not dip. Break-Even Analysis and Target Profit Pricing Break-even pricing (target return Another cost-oriented pricing approach is break-even pricing (or a variation called pricing) target return pricing). The firm sets a price at which it will break even or make the target Setting price to break even on the costs return on the costs of making and marketing a product. of making and marketing a product, or Target return pricing uses the concept of a break-even chart, which shows the total setting price to make a target return. cost and total revenue expected at different sales volume levels. ­Figure 10.5 shows a break-even chart for the toaster manufacturer discussed here. Fixed costs are $300,000 regardless of sales volume. Variable costs are added to fixed costs to form total costs, which rise with volume. The total revenue curve starts at zero and rises with each unit sold. The slope of the total revenue curve reflects the price of $20 per unit. The total revenue and total cost curves cross at 30,000 units. This is the break-even vol- ume. In other words, at a price of $20 per unit, the company must sell at least 30,000 units to break even—for total revenue to just cover total cost. Break-even volume can be calcu- lated using the following formula: fixed cost $300,000 break-even volume = = = 30,000 price − variable cost $20 − 10 If the company wants to make a profit, it must sell more than 30,000 units at $20 each. Suppose the toaster manufacturer has invested $1,000,000 in the business and wants to set a price to earn a 20 percent return, or $200,000. In that case, it must sell at least 50,000 units at $20 each. If the company charges a higher price, it will not need to sell as many toast- ers to achieve its target return. But the market may not buy even this lower volume at the higher price. Much depends on price elasticity and competitors’ prices. The manufacturer should consider different prices and estimate break-even volumes, probable demand, and profits for each. This is done in Table 10.1. Fixed costs are assumed to be $300,000, and unit variable costs are assumed to be $10. The table shows FIGURE 10.5 At the break-even point, Break-Even Chart for 1,200 here 30,000 units, total revenue equals total cost. Determining Target Return Total revenue Cost in dollars (thousands) Price and Break-Even 1,000 Target return Volume ($200,000) 800 Total cost 600 To make a target return of $200,000, the company must 400 sell 50,000 units. But will Fixed cost customers buy that many units 200 at the $20 price? The company should consider different prices and estimate break-even volumes 0 and probable demand at each 10 20 30 40 50 price. Take a look at Table 1. Sales volume in units (thousands) M10_KOTL9364_19_GE_C10.indd 320 06/03/23 4:40 PM  CHAPTER 10 | Pricing: Understanding and Capturing Customer Value     321 Table 10.1 | Break-Even Volume and Profits at Different Prices Unit Demand Needed Expected Unit Demand Total Revenue Profit Price to Break Even at Given Price (1) × (3) Total Costs* (4) − (5) $14 75,000 71,000 $994,000 $1,010,000 −$16,000 16 50,000 67,000 1,072,000         970,000    102,000 18 37,500 60,000 1,080,000         900,000    180,000 20 30,000 42,000      840,000         720,000    120,000 22 25,000 23,000      506,000         530,000     −24,000 *Assumes fixed costs of $300,000 and constant unit variable costs of $10. that as price increases, the break-even volume drops (column 2). But as price increases, the demand for toasters also decreases (column 3). At the $14 price, because the manufacturer clears only $4 per toaster ($14 less $10 in variable costs), it must sell a very high volume to break even. Even though the low price attracts many buyers, demand still falls below the high break-even point, and the manufacturer loses money. At the other extreme, with a $22 price, the manufacturer clears $12 per toaster and must sell only 25,000 units to break even. But at this high price, consumers buy too few toasters, and profits are negative. The table shows that a price of $18 yields the highest profits. Note that none of the prices produce the manufacturer’s target return of $200,000. Competition-based pricing To achieve this return, the manufacturer will have to search for ways to lower the fixed or Setting prices based on competitors’ variable costs, thus lowering the break-even volume. Alternatively, the manufacturer can strategies, prices, costs, and market aim to increase consumers’ willingness to pay by differentiating the product and making offerings. it more appealing. Or it can work to enhance consumer perceptions of delivered value, which would again enhance consumers’ willingness to pay (see Real Marketing 10.2). Author In setting prices, the Comment company must also consider competitors’ prices. No ­Competition-Based Pricing matter what price it charges—high, Competition-based pricing involves setting prices based on competitors’ strategies, costs, low, or in between—the company must be certain to give customers prices, and market offerings. In judging the value delivered by a company’s ­product-price superior value for that price. combination, consumers will often be influenced by the prices that competitors charge for simi- lar products. In assessing competitors’ pricing strategies, a com- pany should ask several questions. First, how does the company’s market offering compare with competitors’ of- ferings in terms of delivered value? If consumers perceive that the company’s product or service provides greater value, the company can charge a higher price. If consum- ers perceive less value relative to competing products, the company must either charge a lower price or enhance cus- tomer perceptions to justify a higher price. Next, how strong are current competitors, and what are their current pricing strategies? If the company faces a host of smaller competitors charging high prices relative to the value they deliver, it might charge lower prices to drive weaker competitors from the market. If the market is dominated by larger, lower-price competitors, a com- pany may decide to bypass those competitors and tar- get unserved or underserved market niches by offering value-added products and services at higher prices. Pricing versus competitors: Caterpillar dominates the heavy Importantly, the goal is not to match or beat com- equipment industry despite charging premium prices. Customers petitors’ prices. Rather, the goal is to set prices according believe that Caterpillar gives them a lot more value for the price over to relative value. If a company creates greater value for the lifetime of its machines. customers, higher prices are justified. For example, Kristoffer Tripplaar/Alamy Stock Photo Caterpillar makes high-quality, h ­ eavy-duty construction M10_KOTL9364_19_GE_C10.indd 321