II.

Power Pricing

Presented by David Mok

UC Berkeley Product Management Program
The Power of “1”
What does a 1% Improvement in Pricing
do for your Company’s Bottom Line?
Improve Improve Improve
Metric P&L Statement Fixed Costs 1% Cost of Sales 1% Price 1%
Revenue $ 100,000,000 $ 100,000,000 $ 100,000,000 $ 101,000,000
- Cost of Sales $ 80,000,000 $ 80,000,000 $ 79,200,000 $ 80,000,000
Gross Profit $ 20,000,000 $ 20,000,000 $ 20,800,000 $ 21,000,000
- SG&A and R&D $ 10,000,000 $ 9,900,000 $ 10,000,000 $ 10,000,000
EBIT $ 10,000,000 $ 10,100,000 $ 10,800,000 $ 11,000,000
- Intersts and Taxes $ 2,000,000 $ 2,020,000 $ 2,160,000 $ 2,200,000
Net Income $ 8,000,000 $ 8,080,000 $ 8,640,000 $ 8,800,000
Net Income % 8.0% 8.1% 8.6% 8.7%
% Improvement Baseline 1.0% 8.0% 10.0%

© 2011 UC Berkeley 2
Rule #3 in Pricing

Know When to Be Desperate

(Know When to Hold and When to Fold)

© 2011 UC Berkeley 3
• Currently selling your product on newegg at $99.99
• Sales is saying the competition is “enabling” $89.99
at newegg and seeing it at other accounts
• Sales is saying we are losing volume and share at
ecommerce channel and requesting price take down
to $89.99
What Would You Do?

Variable Cost = $80

Volume = 100Ku

© 2011 UC Berkeley 4
The Logic of Profitable Pricing

-∆P
Old Price % Breakeven Sales
Change
=
∆P CM + ∆P
New Price

$ ∆Q

Variable Cost
Per Unit

Current Req’d
Units Units Quantity
© 2011 UC Berkeley 5
Proactive Price Change Breakeven Analysis

Current New

Price $100 $90

Variable Cost $80 $80

CM $20 $10
Volume 100 Ku 200 Ku

-∆P - (- $10)
% Breakeven Sales
Change
= = = + 100%
CM + ∆P $20 + (-$10)

© 2011 UC Berkeley 6
Reactive Price Change Breakeven Analysis

P1 P
A
P2
A

VC VC

Q Q2 Q1
Reactive Price ∆P
Change =
CM

© 2011 UC Berkeley 7
Reactive Price Change Breakeven Analysis

Current New

Price $100 $90

Variable Cost $80 $80

CM $20 $10
Volume 100 Ku 50 Ku

∆P (- $10)
% Breakeven Sales
Change
= = = - 50.0%
CM $20

© 2011 UC Berkeley 8
 Observed Price % Volume
Response Change Required

Uplift Required - Analysis showed only 2 of 6

major etailers are at $89.99
- Pricing initiated by newegg,
Price Move
Proactive

Potential Uplift only Amazon responded

- Based on breakeven and
100% observed price response,
70% decided to hold at $99.99

Saved company millions of

Price Move

Baseline Run Rate Baseline Run Rate dollars in profit

Reactive

-50%
-60%

Absorbable Downside
Potential Downside

© 2011 UC Berkeley 9
Which is More Profitable Price Move?

Product A
Price = $50 to $47.50
VC = $45
Volume = 100,000 to 150,000

Product B
Price = $100 to $90
VC = $70
Volume = 50,000 to 75,000

© 2011 UC Berkeley 10
Two Products, Equal Net Profit

Product 1 Product 2

Net Profit Net Profit

VC = 80% VC = 20%
FC = 10% FC = 70%

© 2011 UC Berkeley 11
Two Products, Diff Contribution Margin

Product 1 Product 2

P Contribution P
Margin Contribution
VC Margin

VC
VC = 80% VC = 20%

© 2011 UC Berkeley 12
Drop Price 10%: Higher Volume Demand Needed
for Lower CM Product to Breakeven
Product 1 Product 2

P1 P1
A A
P2 P2
B C
VC B C

VC

Q1 Q2 Q1 Q2

© 2011 UC Berkeley 13
Raise Price 10%: Higher Volume Loss Needed for
Lower CM Product to Breakeven
Product 1 Product 2

P2 P2
A A
P1 P1
B C
B C
VC

VC

Q2 Q1 Q2 Q1

© 2011 UC Berkeley 14
Back to Example - Which is More Profitable?

Product A GM% Before Move = 10%

Price = $50 to $47.50
VC = $45 Breakeven in Profit
Volume = 100,000 to 150,000 Volume = 200,000

Product B GM% Before Move = 30%

Price = $100 to $90
VC = $70 Breakeven in Profit
Volume = 50,000 to 75,000 Volume = 75,000

© 2011 UC Berkeley 15
What Does This Mean?

● Lowering prices on low-margin, high-volume

products requires large significant increases in
volume to breakeven in profit dollars
– Financially, companies should avoid lowering prices
unnecessarily with mature low-margin products to grab share

● Conversely, lowering prices on high-margin growth

market products requires small increases in volume
to breakeven in profit dollars
– Financially, companies should consider lowering prices with
high-margin growth products to increase volume

© 2011 UC Berkeley 16
Know When to Be Desperate
Significant Channel Little Channel
Profit Risk Profit Risk (Channel Metric)

Concede if
Quid pro quo
Do Not or Sizable
Strong
Give In change in
BATNA ∆ Profit $
Strength
Make
Concession Be Prepare
Weak
for Strategic to Concede
Reasons

< BEV > BEV (Acct Metric)

Breakeven Profit Dollars

© 2011 UC Berkeley 17
Rule #4 in Pricing

Only Incremental Costs

Matter in Pricing

© 2011 UC Berkeley 18
Wilson Enterprises
• Wilson Enterprises provides contract consultants for
logistics services in the travel industry
– Consultants charge $200 per hour and paid $120 per hour
– Volume is 100,000 hours per year
– Marketing and computer support are $5,000,000 per year
– Administration is $1,000,000 per year
• New customer, Hawaiian Adventures
− Wants to pay $160 per hour, will order 25,000 hrs per year
− Accept Idaho support center where cost per hour is only
$110
• Wilson Enterprises know they will need to add . . .
− Additional computer capacity will cost of $500,000
− Administrative overhead will increased by $125,000

Will the New Service be Profitable?

© 2011 UC Berkeley 19
Company A: Full Costing Approach

Hawaiian
Per Unit
Opportunity

Revenue $200 $160

Var. Costs ($120) ($110)

Tech &
($44) = ($5M + $500K) / (100K + 25K)
Marketing

Admin & OH ($9) = ($1M + $125K) / (100K + 25K)

Total Costs ($163)

Profit ($3)

© 2011 UC Berkeley 20
Company B: Using Incremental Costing Approach

Per Allocated Incremental

Current Total Added New Total
Unit Per Hour Per Hour

Hours 100,000 25,000 125,000

Revenue $200 $20,000,000 $4,000,000 $24,000,000 $160 $160

Var. Costs ($120) ($12,000,000) ($2,750,000) ($14,750,000) ($110) ($110)

Tech &
($5,000,000) ($500,000) ($5,500,000) ($44) ($20)
Marketing

Admin &
($1,000,000) ($125,000) ($1,125,000) ($9) ($5)
OH

Total
($18.000,000) ($21,375,000) ($163) ($135)
Costs

Profit $2,000,000 $2,625,000 ($3) $25

© 2011 UC Berkeley 21
Only Incremental and Avoidable Costs are
Relevant for Pricing

• How are costs used in pricing decisions at your

company?
– Finance teams are notorious with providing “average” costing

• If you are using average costs like Company A, some

“profitable” opportunities will look unprofitable and
be turned away
– May even think the competition is nuts to take the business

• If you are using incremental costs like Company B,

some seemingly “unprofitable” opportunities are
actually attractive and the business accepted
– You actually gain more sales
– You become more profitable

© 2011 UC Berkeley 22
While Only Incremental Costs Matter in a Pricing
Decision, Firms Must Profitably Manage the P&L

Pricing Decisions P&L Statement

Sales Sales
- Variable Costs - Cost of Sales
Total Contribution Gross Profit
- Avoidable Fixed Costs - SG&A and R&D
Net Contribution Operating Profit
- Other Fixed or Sunk Costs - Interest Expense
Pretax Profit Pretax Profit
- Income Taxes - Income Taxes
Net Profit Net Profit

© 2011 UC Berkeley 23
Rule #5 in Pricing

Apply 1 of 3 Pricing Strategies

© 2011 UC Berkeley 24
There are Only Three Pricing Strategies
Competition You SKIM: High for value offered
Capture high margins at
expense of volume

Competition You NEUTRAL: Competitive for

value offered
Leverage other marketing tools
to win
Competition You PENETRATION: Low for
value offered
Capture volume at expense of
high margins
© 2011 UC Berkeley 25
First Rule on Pricing Strategy
• Have One! Get Agreement
• Most firms fail with pricing strategy because they fail
to define one
● What would you do?
● Costco threatens to stop selling
Apple products

● Prices are not low enough to offer deep

discounts
Pricing Strategy ● Costco can undercut Apple stores by 7.5%
Leader ● iPod Touch - $399 (Apple Store)
● $369 - Costco / $364 - Amazon

The Apple story has an important

message – Take Control
© 2011 UC Berkeley 26
Second Rule on Pricing Strategy
• Know when to change it!
• Most firms fail with pricing strategy because executives lack the
confidence … and competence … to make it work

And one that almost made it . . .

. . . But failed to adjust

© 2011 UC Berkeley 27
Price Strategy Changes with Market Life Cycle
Pricing Skim Skim Skim Skim
Strategy Neutral Neutral Neutral Neutral
Penetrate

Maturity
Decline

Growth
Demand
The Danger Zone

Emerging

Time

© 2011 UC Berkeley 28
Strategic Pricing is . . .

• The effective use of pricing to drive sustainable

increases in profits
• Built on a balanced consideration of both demand-
side and supply-side dynamics
– To enhance the competitive position of the firm
– With a result of increased pricing power
– And better control over revenues and profits

© 2011 UC Berkeley 29
Rule #6 in Pricing

Segmenting Prices
Improves Revenue and Profit

© 2011 UC Berkeley 30
Why is Movie Popcorn so Expensive?

© 2011 UC Berkeley 31
Different Customers have Different Uses (Value)
for your Product – It’s why Firms Price Segment

Enjoy You can price

Value Theater tickets high and
Received Experience popcorn low

You can price

tickets low and
popcorn high
Movie
Only

Customer Segment

© 2011 UC Berkeley 32
Two Problems with Single Price Strategy

• Leave money on the table

(margin opportunities)
– Some customers are willing to pay
more
• Pass-up Profit
(volume opportunities)
– Some potential customers were
not served even though the firm
could have served them at prices
above the variable cost

© 2011 UC Berkeley 33
Rule #7 in Pricing

Use Consumer Pricing

Psychology to Your Advantage

© 2011 UC Berkeley 34
Consumers Need Reference Prices
iPod Touch iPhone iPad

$399 (64GB) $299 (32GB) $699 (64GB)

$299 (32GB) $199 (16GB) $599 (32GB)
$229 (8GB) $99 (8GB) $499 (16GB)
Source: Apple Website on 9/18/10

© 2011 UC Berkeley 35
More Loss Averse than Gain Seeking
Prospect Theory
Value
A $10 loss causes more pain +
A
than a $10 gain causes
pleasure
Losses Gains

Minimize Pain
B
Value -

Highlight Gain Reframe Pains

as Gains
© 2011 UC Berkeley 36
Declining Sensitivity

Two $5 losses cause more pain Prospect Theory

than one $10 loss Value
+
A
Two $5 gains cause more
pleasure than one $10 gain
Losses Gains

Bundle Pain
B
Value -

Unbundle Gain

© 2011 UC Berkeley 37
Rule #8 in Pricing

Seek to Understand and Shape

Competitive Pricing Behavior

© 2011 UC Berkeley 38
Determine Market Tiers and Pricing Behavior

Price Tiers

Tier 1

Price cuts by higher quality

tiers are more powerful in
Tier 2 pulling customers up from
lower tiers, than vice versa

Tier 3

© 2011 UC Berkeley 39
Dealing with “Dumb” Competitors
What you say about What Competitors
your competitor say about you

Their Their
Prices are Prices are
Crazy! Crazy!

You May be
the Problem!

© 2011 UC Berkeley 40
Tips in Shaping Competitive Pricing Behavior

• Price competition is a negative sum game – no winners

• Determine market tiers, understand how price influences

customer purchases

• Look internally first, is your internal process driving

undesirable competitive pricing behavior - if it is, fix it

• Fog of Pricing: Develop competitive information process,

identify few simple things to determine whether the pricing
is driven by competitor or something else

• Lastly, create a global discount chessboard, it gets

everyone working in the same direction with their time and
discount resources

© 2011 UC Berkeley 41
 Summary

© 2011 UC Berkeley 42
Power Pricing Summary for Profitable Growth
• Rule #1: If the value is not clear to the customer, your price
will always be too high

• Rule #2: Trade value for price

• Rule #3: Know when to be desperate

• Rule #4: Only incremental costs matter in pricing

• Rule #5: Apply 1 of 3 pricing strategies

• Rule #6: Segmenting prices improve revenue and profit

• Rule #7: Use consumer pricing psychology to your

advantage

• Rule #8: Seek to understand and shape competitive pricing

behavior

© 2011 UC Berkeley 43