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MKT 301 – PRICING STRATEGY

MODULE

LESSON 3
Price Structure
Learning Outcomes
Understand tactics for pricing differently across segments, through price
offer configuration, price metrics and price fences.
Introduction
After developing products or services that create value, a marketer must
then determine how most profitably to capture that value in both volume and
margin. The challenge in doing so is that customers value products differently
because of different abilities to pay, different preferences, and different intended
uses. Moreover, the timing of customers' needs, the speed of their payments, and
the level of service and support they require can drive significant differences in
the cost to serve them. When a company tries to serve all customers with one
price, or a standard markup in the case of distributors and retailers, it is forced to
make large tradeoffs between volume and margin — enabling some customers to
acquire the product for much less than they would be willing to pay for it, while
others are excluded even though the lower price that they would pay is sufficient
to cover variable costs and make a positive contribution to profit.
Lecture Notes / Lesson Content
Except for pure commodities, such as ethanol or pork bellies, a single
price per unit is rarely the best way to generate revenues. Realizing a company's
profit potential created by the differentiation in its features or services requires
creating a structure of prices that aligns with the differences in economic value
and cost to serve across customer segments. The goal of that structure is to
mitigate the tradeoff between winning high prices for low volume and high
volume for low prices. The goal is to capture more revenue from sales where
value or cost to serve is higher, while accepting lower revenue where necessary
to drive still profitable volume.
To illustrate the huge benefits of a well-defined segmented price structure,
suppose that a supplier faced five different segments, all willing to pay a different
price to get the benefits they sought from a product . Segment 1 with sales
potential of 50,000 units is willing to pay $20 for the firm's product. Segment 2
with sales potential of 150,000 units is willing to pay $15, and so on. What price
should the firm set? The right answer in principle is whatever price maximizes
profit contribution. If you calculate the profit contribution at each of the five
prices assuming a variable cost of $5 per unit, the single price that produces the
maximum contribution ($2,750) is $10.

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EXHIBIT 3-1 The Incremental Contribution from Price

Segmentation Tactics for Pricing Differently Across Segments

However, a single-price strategy clearly leaves excess money on the table

for many buyers who are willing to pay more: those willing to pay $20 and $15.
These high-end buyers perceive significantly greater value from purchasing this
product, relative to other buyers. At the price of $10, they are enjoying a lot of
what economists call “consumer surplus.” The firm would be better off if it could
capture some of this surplus by charging higher prices to these buyers. The
second problem is that the supplier leaves nearly half of the market unsatisfied,
even though it could serve those customers at prices above the $5 per unit
variable cost.
For industries with high fixed costs, serving those additional customers is
often very profitable and, when they constitute large amounts of volume, can be
essential for a company's survival. Railroads could not maintain, let alone expand,
their costly infrastructures without a segmented price structure. Railroad tariffs
are designed to reflect the differences in the value of the goods hauled. Coal and
unprocessed grains are carried at a much lower cost per carload than are
manufactured goods, resulting in a much lower contribution margin per carload.
Still, the large volumes of coal and grain transported enables that low-priced
business to make a substantial contribution to a railroad's high fixed cost
structure. If railroads were required to charge all shippers the tariff for
manufactured goods, they would lose shippers whose commodities would no
longer be competitive on a delivered cost basis and so would lose that profit
contribution. On the other hand, if railroads had to charge all shippers the tariff
currently charged for a carload of unprocessed grain, their systems would reach
capacity before they generated enough contribution to cover their fixed costs and
become profitable. Freight railroads survive and prosper by leveraging their
capacity to serve multiple market segments at value-based prices for each
segment.
Even companies that serve only the premium end of a market often find
that it is risky to limit themselves to that segment when they could be leveraging
some common costs to serve other segments as well. In his book, The Innovator's
Dilemma, Clayton Christensen cites numerous examples of companies that failed
to meet demand from the lower-performance, lower-margin segment of a market
that they dominated. Invariably, someone eventually addressed that need and used
it as a base to partially support the fixed costs investments necessary to enter
higher margin segments. For years, Xerox owned the high end of the copier
market. It lost that dominant position only after companies that had entered at the
bottom of the market developed service networks of sufficient size to support the
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higher-priced equipment bought by customer segments, such as copy, centers that

require quick service to minimize downtime.
How many segments with different price points should a supplier serve?
To return to our illustration, shows that if the firm were to set two price points
serving two general price segments — high-end buyers willing to pay $15 or
more, and mid-level buyers willing to pay $8 or more — it could increase profit
contribution by 40 percent. But if the supplier could charge separate prices to each
of the five market segments, it could increase profit contribution by 80 percent
relative to the single price strategy. In principle, more segmentation is always
better. In practice, however, the extent of price segmentation is limited by the
ability of the seller to enforce it at an acceptable cost.
Segments for pricing are easier to define conceptually than to maintain in
practice because customers whom you intend to charge a higher price have an
incentive to undermine the structure. They will not freely identify themselves as
members of a relatively price-insensitive segment simply to help the seller charge
them more, but will try to disguise themselves as customers who qualify for a
lower price. Distributors, too, can undermine a segmented pricing strategy by
buying the product for delivery to a customer entitled to a lower price but then
actually sell to segments that will pay more and pocketing the difference for
themselves. This is a huge problem for companies in the European Union because
distributors in countries where prices are lower will ship products to one where
prices are higher, which often happens simply due to changes in currency values.
European law prohibits attempts by national governments to restrict such “parallel
trade” even between two European Union countries that have different currencies.
Thus, the manufacturer without a segmentation strategy can lose sales in the low
value country due to shortages, while losing margin to competition with “parallel
traders” into the high-value countries.
So how can sellers charge different prices to different customers and for
different applications? The answer is by creating a segmented price structure that
varies not just the price, but also adjusts the offer or the criteria to qualify for it. A
segmented price structure is one that causes revenues to vary with differences in
the two key elements that drive potential profitability: the economic value that
customers receive and the incremental cost to serve them. There are three
mechanisms that one can use to maintain such a segmented structure: price-offer
configuration, price metrics, and price fences. Each is appropriate for
addressing different reasons for the existence of value-based segments.
Price-offer Configuration,
When differences in the value of an offer across segments is caused by
differences in the value associated with features, services, or both, a seller can
segment the market by configuring different offers for different segments. Using
offer design to implement segmented pricing requires minimal enforcement of the
segments because customers self-select the offers that determine their prices. The
segmented pricing of airline seats described in is based partially on offer design,
with passengers freely choosing whether they want the price that includes the
ability to cancel or change flights freely, or want to forgo that feature in return for
a much more discounted price. To determine whether it would be profitable to add
another offer combination to the menu of choices, you would need to create a
spreadsheet analogous to the one in

. With that spreadsheet, you could analyze whether the additional offer
combination costs more to administer than the incremental profits it would
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contribute. The right number of price points depends in each case on the sizes of
the customer segments, the value and cost-to-serve differences between them, and
the cost inefficiency from a proliferation of offers.
EXHIBIT 3-2 The Financial Benefits of Price Segmentation

To create an effective price structure, one must first determine which

features and services the firm should price à la carte, leaving customers to
customize their own offers and which features and services to bundle into
packages. There are multiple arguments against pricing all individual features and
services separately. A single price for a bundle of features and services
reduces transactions costs for both customers and sellers. The costs to make
and deliver most products and services increase with the number of
variations allowed, although technology is reducing the cost of mass
customization. Lastly, research has shown that people are less sensitive to the
cost of value-added features and services when bundled as a single expenditure.

Price Metrics
Not all differences in value across segments reflect differences in the
features or services desired. Value received is sometimes not even related to
differences in the quantity of the product consumed, necessitating a price metric
unrelated to quantity of product or service provide. For example, in the field of
health care, both government and private payers are resisting paying for health
care on a “fee for service” basis since delivery of more days in the hospital or
more tests is often indicative of poor treatment choices, not better patient
outcomes. Both payers and health care providers, like Kaiser Permanente and
Mayo Clinic, that have a proven ability to deliver care more cost effectively than
their peers, have benefited from adopting more value-based price metrics: either a
“capitation” price that covers all services required by a patient during a year or a
price per illness or procedure that covers all services required to treat a condition
to a satisfactory outcome. By adopting such metrics, health care providers that can
do that more cost-effectively can avoid the difficult problem of having to
convince payers to pay more per service to reflect the value of better treatment. It
is much easier to make the case that they can get patients “back on their feet” for
no more than the cost per patient of less effective providers.
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The example just described involved changing from a feature-based to a

benefit-based price metric. Price metrics are the units to which the price is
applied. They define the terms of exchange — what exactly will the buyer
receive per unit of price paid. There are often a range of possible options. For
example, a health club could charge per hour of use, per visit, per an “annual
membership” for unlimited access, or per some measure of benefit (inches lost at
the waist or gained at the chest). The club might also vary those prices by time of
day (low for a midday membership, higher for peak-time membership) or by
season of the year to reflect differences in the opportunity cost of capacity.
Finally, it might have a multi-part metric: an annual membership with an
additional hourly charge for use of the tennis courts. These reflect the common
categories of price metrics: per unit, per use, per time spent consuming, per
person who consumes, per amount of benefit received.
The problem with most price metrics is that they are adopted by default or
tradition. For example, initially software companies charged a price per copy
installed on one “server” machine. In most cases, that led to a poor alignment with
value. A few creative vendors recognized that when more users accessed the
software, the buyer was getting more value. Consequently, they changed the price
metric from a price “per server” to a price “per seat,” resulting in customers
paying more when they had more users accessing the software. When this “per
seat” metric proved much more profitable for the computer-aided design and
financial analysis companies that adopted it, other software companies copied it.
For many of their applications, however, the number of users still aligned poorly
with value, leaving many customers underpriced while pricing others out of the
market. The most thoughtful among them created still better price metrics.
Leaders in manufacturing software replaced “price per seat” with “price per
production unit.” Storage management software suppliers replaced “price per
server” with a “price per gigabit of data moved.” Each time a company discovers
a better metric than its competitors, it gains margin from existing customers,
incremental revenue from customers formerly priced out of its markets, or both.
Price Fences.
Sometimes value differs between customer segments even when all the
features and measurable benefits are the same. Value can differ between customer
segments and uses simply because they involve different “formulas” for
converting features and benefits into economic values. The difference may be tied
to differences in income, in alternatives available, or in psychological benefits
that are difficult to measure objectively. Unless there is a good “proxy” metric
that just happens to correlate with the resulting differences in value, the seller
needs to find a price fence: a means to charge different customers different price
levels for the same products and services using the same metrics.
Price fences are fixed criteria that customers must meet to qualify for
a lower price. At theaters, museums, and similar venues, price fences are usually
based on age (with discounts for children under 12 years of age and for seniors)
but are sometimes also based on educational status (full-time students get
discounts), or possession of a coupon from a local paper (benefiting “locals” who
know more alternatives). All three types of customers have the same needs and
cost to serve them, but perceive a different value from the purchase. Price fences
are the least complicated way to charge different prices to reflect different levels
of value. Unfortunately, while simple to administer, the obvious price fences
sometimes create resentment and are often too easy for customers to get over
whenever there is an economic incentive to do so. Thus, finding a fence that will
work in your market usually requires some creativity.
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Colegio ng Lungsod ng Batangas
Contact No. (043) 402-1450

Summary
The three mechanisms that one can use to maintain a segmented structure are
price-offer configuration, price metrics, and price fences. Each is appropriate for
 addressing different reasons for the existence of value-based segments.
References

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%20c ost%20of%20mass%20customization.
Nagle, Hogan & Zale, The Strategy and Tactics of Pricing; A Guide to Growing
more Profitably, 5th Edition, Prentice Hall, 2011(e – book)

Prepared by:

Mrs. Anabelle B. Perez, LPT, MBA

09568429103
annable_perez@[Link]
Republika ng Pilipinas
Lungsod ng Batangas
Colegio ng Lungsod ng Batangas
Contact No. (043) 402-1450

MODULE MKT 301

Lesson 3 ANSWER SHEET
Republika ng Pilipinas
Lungsod ng Batangas
Colegio ng Lungsod ng Batangas
Contact No. (043) 402-1450

MODULE MKT 301

Lesson 3 ANSWER SHEET