Power Pricing: How Managing Price Transforms the Bottom Line - Hardcover

Über die Autorin bzw. den Autor

Robert J. Dolan teaches marketing management at the Harvard Business School where he is the Edward W. Carter Professor of Business Administration. Among his previous books are Strategic Marketing Management and Managing New Product Development.

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In today's hypercompetitive global marketplace, a company's pricing policy can make or break the bottom line. Yet a surprising number of firms attempt to increase profits without the aid of a carefully and creatively designed pricing strategy. Now, in this long-awaited book, the world's two leading price experts Robert J. Dolan and Hermann Simon take managers beyond conventional thinking to show how their breakthrough system of "power pricing" will improve the bottom line by an order of magnitude. They destroy popular but not necessarily financially savvy ideas on pricing, such as relying on a standard markup on cost rule. They expose as passive the "strategy" of letting the market or a competitor "set the price." But the key is in what they provide: the tools by which the pedestrian pricer can become a "power pricer" who achieves quantum leaps in financial performance by aggressively implementing sophisticated pricing strategies. The authors argue that firms must view pricing as a key and highly manageable element in the profit equation, worthy of attention equal to that accorded to sales volume and costs. Companies must have data at their finger tips which are more accurate, timely, relevant, and dissaggregated than their competitors'. Using these data to create a systematic analysis of customers and competitors, companies will be able to create and assess pricing scenarios to achieve long-term profitability. This targeted, quadrupled approach to transforming the bottom line by managing price leaves no strategy or option unturned. Power Pricing is a highly detailed yet practically focused book which will become required reading for business leaders; general managers; marketing, product, and brand managers; accountants, financial managers, and marketing students, world-wide.

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Chapter 2

Price, Costs, and Profit

Economic Underpinnings of Pricing

INTRODUCTION

This chapter shows how price affects profit and describes major price determinants. In principle and in theory the economic underpinnings of price are simple, but in practice they are more subtle, due to the multiple effects of price on profit.

It is obvious that price directly affects the unit profit margin. A higher price yields a higher margin per unit sold, and thus a higher profit for a given sales volume. However, a higher price typically implies a lower sales volume, thus producing an offsetting impact on profit. Price may also impact cost: e.g., a higher sales volume resulting from a lower price may induce a decrease in unit costs due to economies of scale or learning. Or a lower price may attract new buyers who remain loyal in the future, and thus increase future profits. These issues will be addressed in subsequent chapters. Here we focus on the more direct and current influences of price on profit.

Figure 2-1 shows the profit system in a simple hierarchical form. Scanning downward, at the first level profit drivers are sales revenue and costs. The sales revenue is, in turn, price times sales volume. Costs have variable and fixed components. Variable costs change with the sales volume but fixed costs do not. The cost of an additional unit is referred to as marginal cost.

WHAT THIS CHAPTER WILL DO

This chapter addresses the following questions:

1. How do price changes affect profit?

2. How do customers respond to price changes?

3. Which factors affect the price decision and how?

4. How can conflicting objectives like profit and volume be reconciled when making pricing decisions?

5. What is the role of variable and fixed costs in pricing?

Knowing the answers to these questions will help the manager to:

1. fully understand and correctly judge the effects of price

2. consider the right factors in making price decisions

3. base price decisions on the customers' perceived value rather than on cost

4. deal with practical conflicts in pricing

THE IMPACT OF PRICE CHANGES

To illustrate the profit impact of a specific price and possible changes in that price we consider the case of a product we call POWERSTAR, an electric power tool. The manufacturer sells the product directly to professional customer's at a price of $100. The worldwide annual sales volume is around 1 million units. The variable unit cost or marginal cost of the product is $60, so that the unit contribution -- the difference between price and variable unit cost -- is $40. Thus, each unit sold contributes $40 to the recovery of fixed costs and to profit.

The upper part of Figure 2-2 illustrates this situation, in which the company achieves a sales revenue of $100 million ($100 times 1 million units). The shaded rectangle represents the total contribution of $40 million, which results from 1 million units each of which contributes $40. The total contribution can always be represented as a rectangle since it is obtained as the product of unit contribution and sales volume.

The fixed costs such as plant and administration for POWERSTAR are estimated at $30 million; subtracting this from the total contribution of $40 million yields a profit of $10 million or 10% of the sales revenue. Alternatively, the profit can be calculated by taking the total costs of $90 million ($60 million variable costs plus $30 million fixed costs) and subtracting them from the sales revenue of $100 million. Total costs per unit are $90 and the unit profit margin (to be distinguished from the unit contribution) is $10. The return on sales of 10% is a relatively typical magnitude for industrial products of this kind.

POWERSTAR management questioned whether the current $100 price yielded the highest possible profit and suggested considering alternative prices in the range of plus or minus 20% from the current price. As a first step, management wanted to know the sales volume required to maintain the $10 million profit with alternative prices.

We first consider a 20% price cut alternative. An $80 price and unchanged variable unit costs of $60 reduce the unit contribution from $40 to $20. Thus, POWERSTAR now has to sell twice as many units as at a price of $100 to achieve the same total contribution and profit. With 2 million units sold at $80, sales revenue would increase to $160 million. We show the $80 price scenario in the middle of Figure 2-2. Since the profit contribution is unchanged, the surface of the shaded rectangle is the same as in the upper part of Figure 2-2. While the price reduction is only 20%, the reduction in unit contribution is 50%. The sales increase required to compensate for this smaller margin accordingly is 100%. Such a 100% increase in sales volume due to a 20% price change was seen as unrealistic to management. In addition capacity was insufficient to manufacture the higher volume. A capacity expansion would have induced higher fixed costs.

The 20% price-increase scenario is summarized at the bottom of Figure 2-2. Unit contribution increases to $60, thereby requiring only 667,000 units to be sold to generate $10 million profit, a 33.3% decrease in volume. If sales decline by less than 33.3%, the price increase would drive profit up. For example, if 750,000 units were sold at $120, profit would increase from $10 million to $15 million. Thus POWERSTAR management judged the price-increase scenario worthy of more investigation.

As we see, price decreases and increases have highly leveraged effects. A seemingly small price reduction can have a large negative impact on unit contribution, requiring a tremendous increase in sales volume to generate the same profit. A small-percentage price increase can have a strong positive effect on unit contribution, creating a large acceptable decrease in sales volume while still retaining the profit level.

The POWERSTAR case is somewhat typical for industrial products where variable costs often amount to 50% or more of price and are high relative to fixed costs. Such service industries as hotels, airlines, and telecommunications, in contrast, typically have relatively low variable but high fixed costs. Similar cost structures characterize industries such as software and pharmaceuticals, where R&D accounts for the bulk of costs and unit variable costs tend to be very low.

Cost structure has a strong impact on the price-profit relationship. For example consider SUPRACOM, a new entrant in the telecom market in a European country. It runs its own network in its domestic market but has to buy capacity from third parties for its international services. Its variable cost for domestic traffic is 5 cents per minute; for international traffic, SUPRACOM has to pay 40 cents per minute to its foreign suppliers.

SUPRACOM's price per minute is 40 cents for domestic and 60 cents for international traffic, yielding per-minute contributions of 35 cents for domestic and 20 cents for international service. To cope with increasing competitive pressures the company was considering price cuts of 10 cents a minute for both services. What increases in sales volume would be required in each service to leave its profit unchanged? Per the analysis above, the required sales volume increases for international and domestic service are 100% and 40% respectively.

The 10-cent price cut requires a much stronger sales increase for international service because the international-unit contribution is cut to half while the domestic-unit contribution declines only by 28.5%. In general, a much greater increase in sales volume is required to offset the negative effect of a price cut if variable costs are high.

In judging price decrease advisability, one must consider available capacity. In 1994 Lufthansa offered flights on domestic...