Marketing Management Notes...

pricing - return on investment method

The "return on investment" pricing method determines the price of a product based on the target return on the amount invested in a product:

The calculation is as follows:

Unit Price

Total costs (fixed and variable) + (%u0025 return x Investment)

Budgeted sales volume

This calculation can be illustrated using the following example:

Willowbrook Limited has developed a new product called the "Eternal Flame" - a methane-powered heater for use in industrial buildings.%uFFFD Willowbrook requires a return on invested capital of 25% per annum.%uFFFD The sales price for the Eternal Flame should be set using a target return on investment method.%uFFFD The following additional information has been provided:

Budgeted sales volume

25,000 units

Variable production cost per unit

%uFFFD45

Fixed production cost per unit

%uFFFD25

Other annual fixed costs (overheads etc.)

%uFFFD550,000

Investment in new machinery to produce the Eternal Flame

%uFFFD350,000

Period over which investment in new machinery to be written off

4 years

Research and development costs for the Eternal Flame

%uFFFD225,000


The total investment in the Eternal Flame is (New machinery + R&D costs)

%uFFFD575,000

The required annual profit = %uFFFD575,000 x 25%

%uFFFD143,750


Total annual costs can be calculated as follows:


Production costs per unit (%uFFFD45 + %uFFFD25) x 25,000 units

%uFFFD1,750,000

Annual depreciation on new machinery (%uFFFD350,000 / 4)

%uFFFD87,500

Other annual fixed costs

%uFFFD550,000

Total annual costs

%uFFFD2,387,500


Total required annual revenue = total annual costs + required annual profit

%uFFFD2,531,250

Unit price (total required revenue / budgeted sales volume

%uFFFD101.25

The use of a targeted return on investment to determine price has the following advantages:

- Consistent with other performance measures - e.g. Return on Investment

- A suitable method for market leaders which are able to set a price which competitors follow

- A relevant pricing method for new products - particularly those which have a substantial investment.

The method does, however, have some disadvantages:

- With new products, there is an inherent uncertainty about what the achieved sales volume will be - which in turn will be influenced by the price chosen

- Some investment may be common to several products or product groups (e.g. an extension to a factory; investment in new development facilities).%uFFFD This raises the question of how to apportion investment amongst products.

pricing strategies - other pricing strategies

Prestige pricing

Prestige pricing refers to the practice of setting a high price for an product, throughout its entire life cycle %u2013 as opposed to the short term %u2018opportunistic%u2019, high price of price %u2018skimming%u2019. This is done in order to evoke perceptions of quality and prestige with the product or service.

For products for which prestige pricing may apply, the high price is itself an important motivation for consumers. As incomes rise and consumers become less price sensitive, the concepts of %u2018quality%u2019 and %u2018prestige%u2019 can often assume greater importance as purchasing motivators. Thus advertisements and promotional strategies focus attention on these aspects of a product, and, not only can a %u2018prestige%u2019 price be sustained, it also becomes self-sustaining.

Pre-emptive pricing

Pre-emptive pricing is a strategy which involves setting low prices in order to discourage or deter potential new entrants to the suppliers market, and is especially suited to markets in which the supplier does not hold a patent, or other market privilege and entry to the market is relatively straightforward.

By deterring other entrants to the market, a supplier has time to

%u2022 Refine/develop the product
%u2022 Gain market share
%u2022 Reduce costs of production (through sales/ experience effects)
%u2022 Acquire name/brand recognition, as the %u2018original%u2019 supplier

Extinction pricing

Extinction pricing has the overall objective of eliminating competition, and involves setting very low prices in the short term in order to %u2018under-cut%u2019 competition, or alternatively repel potential new entrants.

The extinction price may, in the short term, be set at a level lower even than the suppliers own cost of production, but once competition has been extinguished, prices are raised to profitable levels.
Only firms dominant in the market, and in a strong financial position will be able survive the short-term losses associated with extinction pricing strategies, and benefit in the longer term.

The strategy of extinction pricing can be used selectively by firms who can apply it either to limited geographical markets (making up any losses by increasing prices in other geographical markets), or to certain product %u2018lines%u2019. In the latter case, the low price of a product at one end of the product range might attract new purchasers to the product line, and sales of different, more profitable items might increase.

pricing strategies - skimming

The practice of %u2018price skimming%u2019 involves charging a relatively high price for a short time where a new, innovative, or much-improved product is launched onto a market.

The objective with skimming is to %u201Cskim%u201D off customers who are willing to pay more to have the product sooner; prices are lowered later when demand from the %u201Cearly adopters%u201D falls.

The success of a price-skimming strategy is largely dependent on the inelasticity of demand for the product either by the market as a whole, or by certain market segments.

High prices can be enjoyed in the short term where demand is relatively inelastic. In the short term the supplier benefits from %u2018monopoly profits%u2019, but as profitability increases, competing suppliers are likely to be attracted to the market (depending on the barriers to entry in the market) and the price will fall as competition increases.

The main objective of employing a price-skimming strategy is, therefore, to benefit from high short-term profits (due to the newness of the product) and from effective market segmentation.

There are several advantages of price skimming

%u2022 Where a highly innovative product is launched, research and development costs are likely to be high, as are the costs of introducing the product to the market via promotion, advertising etc. In such cases, the practice of price-skimming allows for some return on the set-up costs

%u2022 By charging high prices initially, a company can build a high-quality image for its product. Charging initial high prices allows the firm the luxury of reducing them when the threat of competition arrives. By contrast, a lower initial price would be difficult to increase without risking the loss of sales volume

%u2022 Skimming can be an effective strategy in segmenting the market. A firm can divide the market into a number of segments and reduce the price at different stages in each, thus acquiring maximum profit from each segment

%u2022 Where a product is distributed via dealers, the practice of price-skimming is very popular, since high prices for the supplier are translated into high mark-ups for the dealer

%u2022 For %u2018conspicuous%u2019 or %u2018prestige goods%u2019, the practice of price skimming can be particularly successful, since the buyer tends to be more %u2018prestige%u2019 conscious than price conscious. Similarly, where the quality differences between competing brands is perceived to be large, or for offerings where such differences are not easily judged, the skimming strategy can work well. An example of the latter would be for the manufacturers of %u2018designer-label%u2019 clothing.

pricing - link between price and business objectives

The pricing objectives of businesses are generally related to satisfying one of five common strategic objectives:

Objective 1: To Maximise Profits

Although the %u2018maximisation of profits%u2019 can have negative connotations for %u2018the public%u2019, in economic theory, one function of %u2018profit%u2019 is to attract new entrants to the market and the additional suppliers keep prices at a reasonable level. By seeking to differentiate their product from those of other suppliers, new entrants also expand the choice to consumers, and may vary prices as niche markets develop

Objective 2: To Meet a Specific Target Return on Investment (or on net sales)

Assuming a standard volume operation (i.e. production and sales) target pricing is concerned with determining the necessary mark-up (on cost) per unit sold, to achieve the overall target profit goal. Target return pricing is effective as an overall performance measure of the entire product line, but for individual items within the line, certain strategic pricing considerations may require the raising or lowering of the standard price.

Objective 3: To Achieve a Target Sales Level

Many businesses measure their success in terms of overall revenues. This is often a proxy for market share. Pricing strategies with this objective in mind usually focus on setting price that maximises the volumes sold.

Objective 4: To Maintain or Enhance Market Share

As an organisational goal, the achievement of a desired share of the market is generally linked to increased profitability. An offensive market share strategy involves attaining increased market share, by lowering prices in the short term. This can lead to increased sales, which in the longer term can lead to lower costs (through benefits of scale and experience) and ultimately to higher prices due to increased volume/market share.

Objective 5: To Meet or Prevent Competition

Prices are set at a level that reflects the average industry price, with small adjustments made for unique features of the company%u2019s specific product(s). Firms that adopt this objective must work %u2018backwards%u2019 from price and tailor costs to enable the desired margin to be delivered.

pricing strategies - expansionistic pricing

Expansionistic pricing is a more exaggerated form of penetration pricing and involves setting very low prices aimed at establishing mass markets, possibly at the expense of other suppliers.

Under this strategy, the product enjoys a high price elasticity of demand so that the adoption of a low price leads to significant increases in sales volumes.

Expansionistic pricing strategies may be used by companies attempting to enter new or international markets for their products. Lower-cost version of a product may be offered at a very low price to gain recognition and acceptance by consumers. Once acceptance has been achieved more expensive versions or models of the offering can be made available at higher prices.

The extreme case of expansionistic pricing, where offerings are made available to the (overseas) market at a price that is actually less than the cost of production is known as dumping. This practice is closely scrutinised by governments since it can force domestic producers out of business and many countries have enacted anti-dumping legislation.

Markets that might benefit from expansionistic pricing strategies include those of magazine and newspaper publishers. Where low prices (annual subscription rates) attract a large number of subscribers, publishers can benefit from the higher rates that they are able to charge advertisers for their advertising %u2018space%u2019. Book and CD %u2018clubs%u2019 also use expansionistic to attract new members.

products - introduction

A product is defined as:

"Anything that is capable of satisfying customer needs"

This definition includes both physical products (e.g. cars, washing machines, DVD players) as well as services (e.g. insurance, banking, private health care).

The process by which companies distinguish their product offerings from the competition is called branding.

For most companies, brands are not developed in isolation - they are part of a product group.

A product group (or product line) is a group of brands that are closely related in terms of their functions and the benefits they provide (e.g. Dell's range of personal computers or Sony's range of televisions).

There are two main types of product brand:

(1) Manufacturer brands

(2) Own-label brands

Manufacturer brands are created by producers and use their chosen brand name. The producer has the responsibility for marketing the brand, by building distribution and gaining customer brand loyalty. Good examples include Microsoft, Panasonic and Mercedes.

Own-label brands are created and owned by distributors. Good examples include Tesco and Sainsbury's.

The main importance of branding is that, done well, it permits a business to differentiate its products, adding extra value for consumers who value the brand, and improving profitability for the company.

Businesses should manage their products carefully over time to ensure that they deliver products that continue to meet customer wants. The process of managing groups of brands and product lines is called portfolio planning.

Two models of product portfolio planning are widely known and used in business:

%u2022 The Boston Group Growth-Share Matrix, and

%u2022 GE Market Attractiveness model


Businesses need to regularly look for new products and markets for future growth. A useful way of looking at growth opportunities is the Ansoff Growth matrix which suggests that there are four main ways in which growth can be achieved through a product strategy:

(1) Market penetration - Increase sales of an existing product in an existing market

(2) Product development - Improve present products and/or develop new products for the current market

(3) Market development - Sell existing products into new markets (e.g. developing export sales)

(4) Diversification - Develop new products for new markets

We define a product as "anything that is capable of satisfying customer needs. This definition includes both physical products (e.g. cars, washing machines, DVD players) as well as services (e.g. insurance, banking, private health care).

Businesses should manage their products carefully over time to ensure that they deliver products that continue to meet customer wants. The process of managing groups of brands and product lines is called portfolio planning.

The stages through which individual products develop over time is called commonly known as the "Product Life Cycle".

Introduction Stage

At the Introduction (or development) Stage market size and growth is slight. it is possible that substantial research and development costs have been incurred in getting the product to this stage. In addition, marketing costs may be high in order to test the market, undergo launch promotion and set up distribution channels. It is highly unlikely that companies will make profits on products at the Introduction Stage. Products at this stage have to be carefully monitored to ensure that they start to grow. Otherwise, the best option may be to withdraw or end the product.

Growth Stage

The Growth Stage is characterised by rapid growth in sales and profits. Profits arise due to an increase in output (economies of scale)and possibly better prices. At this stage, it is cheaper for businesses to invest in increasing their market share as well as enjoying the overall growth of the market. Accordingly, significant promotional resources are traditionally invested in products that are firmly in the Growth Stage.

Maturity Stage

The Maturity Stage is, perhaps, the most common stage for all markets. it is in this stage that competition is most intense as companies fight to maintain their market share. Here, both marketing and finance become key activities. Marketing spend has to be monitored carefully, since any significant moves are likely to be copied by competitors. The Maturity Stage is the time when most profit is earned by the market as a whole. Any expenditure on research and development is likely to be restricted to product modification and improvement and perhaps to improve production efficiency and quality.

Decline Stage

In the Decline Stage, the market is shrinking, reducing the overall amount of profit that can be shared amongst the remaining competitors. At this stage, great care has to be taken to manage the product carefully. It may be possible to take out some production cost, to transfer production to a cheaper facility, sell the product into other, cheaper markets. Care should be taken to control the amount of stocks of the product. Ultimately, depending on whether the product remains profitable, a company may decide to end the product.

more on pricing

pricing strategies - penetration pricing

Penetration pricing involves the setting of lower, rather than higher prices in order to achieve a large, if not dominant market share.

This strategy is most often used businesses wishing to enter a new market or build on a relatively small market share.

This will only be possible where demand for the product is believed to be highly elastic, i.e. demand is price-sensitive and either new buyers will be attracted, or existing buyers will buy more of the product as a result of a low price.

A successful penetration pricing strategy may lead to large sales volumes/market shares and therefore lower costs per unit. The effects of economies of both scale and experience lead to lower production costs, which justify the use of penetration pricing strategies to gain market share. Penetration strategies are often used by businesses that need to use up spare resources (e.g. factory capacity).

A penetration pricing strategy may also promote complimentary and captive products. The main product may be priced with a low mark-up to attract sales (it may even be a loss-leader). Customers are then sold accessories (which often only fit the manufacturer%u2019s main product) which are sold at higher mark-ups.

Before implementing a penetration pricing strategy, a supplier must be certain that it has the production and distribution capabilities to meet the anticipated increase in demand.

The most obvious potential disadvantage of implementing a penetration pricing strategy is the likelihood of competing suppliers following suit by reducing their prices also, thus nullifying any advantage of the reduced price (if prices are sufficiently differentiated the impact of this disadvantage may be diminished).

A second potential disadvantage is the impact of the reduced price on the image of the offering, particularly where buyers associate price with quality.

pricing - variable or marginal cost pricing

With variable (or marginal cost) pricing, a price is set in relation to the variable costs of production (i.e. ignoring fixed costs and overheads).

The objective is to achieve a desired %u201Ccontribution%u201D towards fixed costs and profit.

Contribution per unit can be defined as: SELLING PRICE less VARIABLE COSTS

Total contribution can be calculated as follows:

Contribution per unit v Sales Volume

The resulting profit in a business is, therefore:

Total Contribution less Total Fixed Costs

The break even level of sales can be calculated using this information as follows:

Break even volume = Total Fixed Costs / Contribution per Unit

Consider a business with the following costs and volumes for a single product:

Fixed costs:


Factory production costs

%uFFFD750,000

Research and development

%uFFFD250,000

Fixed selling costs

%uFFFD550,000

Administration and other overheads

%uFFFD325,000

Total fixed costs

%uFFFD1,625,000

Variable costs


Variable cost per unit

%uFFFD8.00

Mark-Up


Mark-up %u0025 required

35%


Budgeted sale volumes (units)

500,000

Prices are set using variable costing by determining a target contribution per unit. This reflects:

%u2022 Variable costs per unit

%u2022 Total fixed costs

%u2022 The desired level of target profit (i.e. contribution less fixed costs)

The variable/marginal costing method can be illustrated using the same data used further above:

%u2022 Assume that the selling price per unit is %u00A312
%u2022 Variable costs per unit are %u00A38
%u2022 The contribution per unit is, therefore, %u00A34 (%u00A312 less %u00A38)

What is the break even volume for the business?

%u2022 Total fixed costs are %u00A31,625,000
%u2022 To achieve break-even, therefore, the business needs to sell at least 406,250 units (each of which produces a contribution of %u00A34)

Looked at another way, what would be the required sales volume to generate a profit of %u00A3250,000?

%u2022 Total contribution required = total fixed costs + required profit
%u2022 Total contribution = %u00A31,625,000 + %u00A3250,000 = %u00A31,875,000
%u2022 Contribution per unit = %u00A34
%u2022 Sales volume required therefore = 468,750 (%u00A31,875,000 / %u00A34)

The advantages of using a variable/marginal costing method for pricing include the following:

%u2022 Good for short-term decision-making;
%u2022 Avoids having to make an arbitrary allocation of fixed costs and overheads;
%u2022 Focuses the business on what is required to achieve break-even

However, there are some potential disadvantages of using this method:

%u2022 There is a risk that the price set will not recover total fixed costs in the long term. Ultimately businesses must price their products that reflects the total costs of the business;
%u2022 It may be difficult to raise prices if the contribution per unit is set too low

Thanks, good one.