Cost and Economics in Pricing

Cost and Economics in Pricing Strategy
Week 2 Slides
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Price Discrimination
Intro to Price Discrimination
Developed by Ron Wilcox, Darden School of Business and Jean-Manuel Izaret and Thomas Kohler, Boston Consulting Group,
for the University of Virginias Darden School of Business Coursera Pricing Strategy for Profit Maximization Specialization 1
Week 2 Slides
Cost-plus pricing
Price discrimination based
on cost variation
Price and margin waterfall
Other incentives that lower
costs
Three principles of product
line pricing
Case application: Heinz
Ketchup
Week 2 Slides
By the end of this module

youll be able to
Utilize cost-plus pricing to
determine prices
Recognize the opportunity
for price discrimination and
use it to optimize prices
Create price and waterfall
margin charts to analyze
your business
Cost-Plus Pricing
Week 2 Slides
#6
Economics Cost-plus pricing

(Thomas)
How does a business decide what

to charge for its products?
Week 2 Slides
Three main approaches to

setting prices
Price setting approaches
Cost- Value- Market-

plus based based
pricing pricing pricing
Marginal-cost
pricing
Cost-plus pricing
$ %
Full cost Markup Selling
per unit price
Seller is Buyer is
Price setter Price taker
Week 2 Slides
Example calculation
$100 20% $120

Full cost Selling
Markup
per unit price
(
Total Total (
variable fixed
cost cost
Quantity
When is cost-plus pricing useful?
Situations Transactions
where sellers with very
have sufficient custom
pricing power specifications
and outcomes
Industries with Starting point

regulated prices to set the price
for a new
product
Week 2 Slides
Advantages vs. disadvantages

of cost-plus pricing
Advantages
Simple to execute
Guarantees targeted margin
Intuitively understandable
Easy to defend
Advantages vs. disadvantages

of cost-plus pricing
Disadvantages
Usually leads to sub-optimal pricing
Promotes cost inefficiency
Ignores opportunity cost
Uses historical cost rather than

current or future replacement value
Week 2 Slides
Target-cost pricing
$ $
Target cost Market price Target
per unit per unit margin
$90 $110 $20
Cost-plus vs. target-cost pricing
Cost-plus
pricing $ %
Full cost Markup Selling
"How much per unit price
to charge?"
$100 $20 $120
Target cost
"How much can
$ $
it cost?" Market Target Target cost
price margin per unit
per unit
$110 $20 $90
Week 2 Slides
With target-cost pricing, buyers

set a product's price
Target-cost pricing
$ $
Market Target
Target
price cost
margin
per unit per unit
Buyer is Seller is
Price setter Price taker
Wrap-up
How would you go about setting the

price for the product in this box?
Week 2 Slides
#7
Economics Price
discrimination based on cost
variations
(Thomas)
Why does the price vary for the

exact same product by 3 ?
Airport
$3.99
Grocery store
$1.20
Week 2 Slides
Price discrimination
Price discrimination describes the

practice of selling an identical
product to different buyers at
different sales prices
Synonyms
Price differentiation
Differential pricing
Price discrimination vs.

product differentiation
Branded spring water
National brand
Spring water $1.20
Priced higher
Different products
Private label purified water Different prices

No brand
Purified water (not spring) $0.65
Priced lower
Week 2 Slides
Why do sellers discriminate

when setting prices?
Improve margins
because
they can
Incentivize buyers
to buy differently because
or more
they have
Sell to new to
customer segments
Why do buyers accept

price discrimination?
Higher prices
Price can be less important than
other factors, e.g. convenience
Lower prices
Buyers can't afford to pay more and
enjoy a 'good deal'
Week 2 Slides
What is cost-based price discrimination?
Cost of doing business often varies widely between

different customers and transactions
Higher cost:
Airport
Rent
$3.99 Labor
Logistics
... But also:
Grocery store Higher willingness to pay
$1.20 Higher cost of next best
alternative
Let's be honest...
Cost of doing business at an airport

is certainly higher, but so much to
justify a price of 3 more?
... probably not
So what else is going on?
Week 2 Slides
Cost-based price discrimination

helps sellers to optimize margins
Higher cost
Seller passes cost plus additional
markup through to buyer
Lower cost
Seller passes only part of cost
savings through to buyer
Wrap up
What you learned

Price discrimination and how it is
motivated by differences in cost
Product vs. price differentiation
How price discrimination is used to
optimize margins
How could you discriminate prices in

your business to improve margins?
Week 2 Slides
#8
Economics Price and margin

waterfall
(Thomas)
Pricing practitioners have to

worry about two core issues
Setting prices
Managing
margin leakage
Week 2 Slides
What's happening when products

make hardly any money ...
... despite a high starting price?

$/
unit 100
Starting Operating
Price Margin
Price and Margin waterfall is a great tool to

discuss margin leakage
Price waterfall Margin waterfall

$/
unit 100
75
Starting Price Net Cost Operating Margin

Price adjustments price
Week 2 Slides
Price waterfall and its components

$/
+5 105 -22
unit 100
83 -8
75
Global FX rate Local On-invoice Invoice price Off-invoice Net

list & country list price deductions (gross) deductions price
price adjustments
Exchange rate adjustments Discounts (volume, payment, etc.) Cash discounts

Country specific adjustments, Promotions Coop advertising
e.g. for GDP/capita Rebates Buyback guarantee
Margin waterfall and its components

$/
unit
75 -52
-7
16 -7
-4 5
Net Cost of Cost to Contri- Direct Indirect SG&A Operating

price goods serve bution SG&A + other cost Margin
sold Margin
Cost of materials and components Freight, Warehousing Direct sales expense General management
Factory conversion cost Warranty (salary, travel) Branding
... Goodwill... Other selling costs Other overhead
Week 2 Slides
Margin waterfall and full cost (per unit)

$/ Full cost
unit $ per unit
75 -52
-7
16 -7
-4
5

sold Margin
Margin waterfall and fixed and variable cost

$/
unit Fixed and variable
75 -52
cost in each category
-7
16 -7
-4 5

sold Margin
Variable cost Fixed cost
Week 2 Slides
Closing thoughts
Price and margin waterfall

... illustrates relationship between price
and margin
... great tool to discuss your business with
stakeholders
Cost and margin buckets can be easily

benchmarked to identify root causes of
leakage
Closing thoughts
Often difficult to get the data. Do your best;
its important to determine profitability
Select most useful dimensions when

constructing waterfall charts
(Y axis) a SKU, product category,
or business segment
(X axis) $ per unit, absolute $,
or % of Net Sales
Week 2 Slides
#9
Economics Other incentives

to lower costs
(Thomas)
How do lower costs benefit

both buyers and sellers?
Seller wants
to sell more Buyer wants to
and at pay less
better margins
Week 2 Slides
How do lower costs benefit

both buyers and sellers?
Win-win for buyer and seller!
Buyers need incentives to help

sellers achieve lower costs
Margin waterfall to illustrate sales incentives

$/
unit
75 -52
-7
16 -7
-4 5

sold Margin
Week 2 Slides
Example for sales incentives (I)

$/
Reliable, predictable volume lowers
unit
production costs
75 -52 Customers who place orders in a very linear way,
i.e. a constant volume on a regular schedule,
creates predictability for the supply chain
-7
16 -7
-4 5

sold Margin
Slight product variations

Discounts for linear orders
Example for sales incentive (II)

$/
Shipping full containers lowers
unit
freight costs
75 -52 Shipping full truckloads (FTL) have a lower
per unit cost than smaller order sizes
-7
16 -7
-4 5

sold Margin
Freight
Different warranty and
goodwill terms
Week 2 Slides
Example for sales incentives (III)

$/
Online purchases cost suppliers less
unit
than purchases made in-store
75 -52 Online sales or phone sales cost less than
direct face-to-face selling which involves
a salesperson's time
-7
16 -7
-4 5

sold Margin
Variation in Sales expenses for

different customer segments
How can you use these categories

to create sales incentives?
How could you prevent
margin leakage and
improve price realization
along the margin waterfall?
What incentives to reduce

cost might you design to
create a win-win?
Week 2 Slides
Product Line Pricing Principles
Product Line Pricing

Very few companies sell only one
product
The products can have demand
interrelationships
These products may (or may not) be
part of a product line.
Product lines are generally
constructed to try to achieve some
level of price discrimination.
Week 2 Slides
Types of Product Lines

Quality differentiated
K2 Skis
Week 2 Slides
Types of Product Lines

Quality differentiated
Quantity differentiated
Heinz Ketchup
14 oz. 20 oz. 24 oz. 32 oz. 36 oz. 46 oz. 64 oz. Twin 50 Twin 66
Week 2 Slides
Quantity Differentiated
Product Lines: 3 Principles
Larger-size products should have a lower
price on a per-unit basis than smaller-size
products.
The size of the per-unit price discount
should be greater if people consume
more of the item when they have a larger
quantity on hand.
should be lower if the economic or
psychological costs of an out-of-stock
situation are high.
Product Lines: Principle 1
Larger-size products should
have a lower price on a
per-unit basis than
smaller-size products.
Intuitive
Retailers will generally enforce
this provision.
Week 2 Slides
Pricing: Principle 2
Larger-size products should
have a lower price on a per-
unit basis than smaller-size
products.
The size of the per-unit price
discount should be greater if
people consume more of the
item when they have a larger
quantity on hand.
Week 2 Slides
Product Line Pricing: Principle

3
Larger-size products should have a lower
price on a per-unit basis than smaller-size
products.
should be greater if people consume
more of the item when they have a larger
quantity on hand.
should be lower if the economic or
psychological costs of stock-outs are
high.
Week 2 Slides
Psychological Costs
Cereal, yogurt
Pharmaceuticals, toilet
paper
Module Takeaways
Week 2 Slides

youll be able to
Utilize cost-plus pricing to
determine prices
Recognize opportunities for
price discrimination and use
it to optimize prices
Create price and waterfall
margin charts to analyze
your business

youll be able to
Decide how to price a product
line based on volume
incentives
Prevent margin leakage and
improve price realization along
the margin waterfall
Apply knowledge of price
discrimination and pricing
through a distribution channel
to analyze a real-world case

Cost and Economics in Pricing

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Cost and Economics in Pricing

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Cost and Economics in Pricing Strategy

Intro to Price Discrimination

By the end of this module

Economics Cost-plus pricing

How does a business decide what

Three main approaches to

Price setting approaches

Cost- Value- Market-

$100 20% $120

When is cost-plus pricing useful?

Industries with Starting point

Advantages vs. disadvantages

Guarantees targeted margin

Advantages vs. disadvantages

Promotes cost inefficiency

Ignores opportunity cost

Uses historical cost rather than

Cost-plus vs. target-cost pricing

With target-cost pricing, buyers

How would you go about setting the

Why does the price vary for the

Price discrimination describes the

Price discrimination vs.

Private label purified water Different prices

Why do sellers discriminate

Why do buyers accept

What is cost-based price discrimination?

Cost of doing business often varies widely between

Cost of doing business at an airport

... probably not

So what else is going on?

Cost-based price discrimination

What you learned

How could you discriminate prices in

Economics Price and margin

Pricing practitioners have to

What's happening when products

... despite a high starting price?

Price and Margin waterfall is a great tool to

Price waterfall Margin waterfall

Starting Price Net Cost Operating Margin

Price waterfall and its components

Global FX rate Local On-invoice Invoice price Off-invoice Net

Exchange rate adjustments Discounts (volume, payment, etc.) Cash discounts

Margin waterfall and its components

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

Margin waterfall and full cost (per unit)

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

Margin waterfall and fixed and variable cost

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

Variable cost Fixed cost

Price and margin waterfall

Cost and margin buckets can be easily

Select most useful dimensions when

Economics Other incentives

How do lower costs benefit

How do lower costs benefit

Win-win for buyer and seller!

Buyers need incentives to help

Margin waterfall to illustrate sales incentives

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

Example for sales incentives (I)

Net Cost of Cost to Contri- Direct Indirect SG&A Operating

Slight product variations