Price, Costs, and Profit:Economic Underpinnings of Pricing

The Drive of Profit

Comparison of Profit Drivers

Comparison of Profit Drivers

What is a Price?

Narrowly: price is the amount of money charged for a product or service.

Broadly: price is the sum of all the values that the consumers exchange for the benefit of having or using the product or service.

Pricing Mechanism

Throughout most of history, prices were set by negotiation between buyers and sellers.

At the end of 19th century, the development of large-scale retailing → fixed price policies, i.e. setting one price for all buyers.

At the end of 20th century, the Internet → dynamic pricing, i.e. charging different prices depending on individual customers and situations.

Case: Priceline

Its customer base has grown to almost 17 million users, and as many as 9 million people visit the Priceline site monthly (64% are repeat customers).

Working mechanism Attractive to the “time sensitivity” product

such as travel-related products (e.g. plane tickets, hotel rooms, rental cars, cruises, and vacation packages).

Dynamic Pricing on the Web

Sellers can charge lower prices, reap higher margins, e.g.

Dell’s “made-to-order”. monitor customer behavior and tailor offers to

individuals, e.g. Amazon. charge prices on the fly according to changes in

demand or costs, e.g. online catalog retailers.

Dynamic Pricing on the Web

Buyers can get instant price comparisons from thousands of

vendors, e.g. Compare.Net, PriceScan.com, and 比價王.

find and negotiate lower prices. Both sellers and buyers can negotiate prices

in online auctions and exchanges. E.g. 阿里巴巴.

Case: A Symphony Orchestra

Demand Cost

Price $10 Fixed overhead costs

$1,500

Usual attendance

900 patrons Rehearsal costs $4,500

Entire number of seats

1100 Performance costs

$2,000

Profit $100 Variable costs (e.g., programs,

tickets)

$1 per patron

* The orchestra usually performs two Saturday evenings each month during the season with a new program for each performance.

Three Proposals

1. Student rush: Pstudent = 4, Qstudent = 200.

2. Sunday matinee: Psunday = 6, Qsunday = 700, Qsaturday = 650 (= 800 – 150).

3. New series: Pnew = 10, Qnew = 800 (= 700 +100).

Analysis of Three Proposals for the Symphony Orchestra

Determining Relevant Costs

In principle, identifying the relevant costs for pricing decisions is actually fairly straightforward. They are the costs that are incremental (not average) and avoidable (not sunk).

In practice, identifying costs that meet these criteria can be difficult.

Incremental Costs

Incremental costs are the costs associated with changes in pricing and sales.

Variable costs, such as the costs of raw materials in a manufacturing process, are always incremental for pricing.

Some fixed costs, however, are incremental for pricing decisions, and they must be appropriately identified.

Avoidable Costs

Avoidable costs are those that either have not yet been incurred or can be reversed.

The hardest principle for many business decision makers to accept is that only avoidable costs are relevant for pricing.

The opposite of avoidable costs is sunk costs – those costs that a company is irreversibly committed to bear.

Avoidable Costs

The cost of assets that a firm owns may or may not be sunk. Ex. Airplanes.

The easiest way to identify the avoidable cost is to recognize that the cost of making a sale is always the current cost resulting from the sale, not costs that occurred in the past. Ex. Oil company – LIFO (last-in, first-out) or NIFO

(next-in, first-out).

Case: A Small Publisher of Esoteric Books

The firm printed 2,000 copies of each book on the first run and normally sold less than half in the first year.

$20 per copy, which included a $4 contribution to overhead and profit.

A pricing consultant: run a half-price sale on all their slow-moving titles!

The publisher’s business manager pointed out …

Case: A Small Publisher of Esoteric Books

The cost of capital at the time was 18%. Interest cost to year n = $10*(1.18^n – 1).

Accounting Convention vs. Managerial Costing System

Cost-Plus Pricing

Add a standard markup to the product’s cost. Ex. (1) In a restaurant, food is marked up 3 times

direct, beer 4 times, and liquor 6 times; (2) COSTCO – 14% rule.

The most common pricing procedure because it carries an aura of financial prudence. Noble and Gruca (1999) reported that the most

common pricing policy used by managers is cost-based (about 56% of respondents).

Cost-Plus Pricing

Reasons: (1) sellers are more certain about costs than about demand; (2) it is simple and easy to apply; (3) it seemingly copes with market uncertainty; (4) price competition can be minimized; (5) fairer to both buyers and sellers.

Make sense?

Westside Manufacturing

Price: $10 Sales: 4000 units Variable unit cost: $5.5 Fixed costs: $15,000 Westside is considering a 5% price cut…

Finding the Break-Even Sales Change

Break-Even Analysis

Break-Even Analysis

Break-Even Analysis

Before price change: , , , . After price change: , , , . %BE(units) = % break-even sales change in

units = ? %BE($) = % break-even sales change in

dollars = ? Special cases: (1) ; (2) .

$CM and %CM

= the dollar contribution margin per unit = price - variable cost

The size of %CM has important strategic implications %CM is a measure of the leverage between a firm’s sales

volume and its profit. %CM is an indicator of the firm’s ability to compete against

competitors. % CM is a measure of the extent to which you can use

segmentation pricing to serve and penetrate multiple market segments.

Increases and Decreases in Sales to Return Same Profit

Increases and Decreases in Sales to Return Same Profit

Effect of Contribution Margin on Break-Even Sales Changes

Break-Even Sales Curve Calculations (with Incremental Fixed Costs)

Transfer Pricing

Q = min{A, B} Alpha Parts Inc. → A; Beta Parts Inc. → B Independent Manufacturing, Inc. (IDM) Integrated Manufacturing, Inc. (ITM) If 5% price cut → 10% sales increase, what

will IDM and ITM do?

Transfer Pricing (Before Price Cut)

IDM Alpha Beta ITM

Current unit sales (million)

10 10 10 10

Price 1 0.2 0.3 1

Variable cost/unit 0.6 0.05 0.15 0.3

Fixed Cost/unit 0.2 0.05 0.1 0.35

Contribution margin 0.4 0.15 0.15 0.7

% 40% 75% 50% 70%

Annual pretax profit (million)

2 1 0.5 3.5

Transfer Pricing (After Price Cut)

IDM Alpha Beta ITM

Current unit sales (million)

11 11 11 11

Price 0.95 0.2 0.3 0.95

Variable cost/unit 0.6 0.05 0.15 0.3

Fixed Cost/unit 0.18 0.046 0.091 0.317

Contribution margin 0.35 0.15 0.15 0.65

% 36.8% 75% 50% 68.4%

Annual pretax profit (million)

1.85 1.15 0.65 3.65

IDM如何因應 ITM降價的威脅 ?

購併供應商，即垂直整合 (vertical integration)。內化供應商的固定成本後，在以後的採購中，僅補償供應商的變動成本及保證供應商一定的利潤。 一次性繳付供應商的固定成本，甚至可以藉由參股或控股等方式獲取這些資產的部分產權。這種作法在汽車製造業 (ex. General Motor)的供應鏈管理中較為常用。

最初以高價購買供應商的產品，使其能補償供應商的固定成本。

Price Response Curve

Break-Even Sales Curve Relationship between Price Elasticity of Demand and Profitability

Break-Even Sales Curve Relationship between Price Elasticity of Demand and Profitability

The Optimal Price

由利潤曲線獲得結論必有一個可以創造最大利潤的價格。偏離最適價格愈遠，利潤曲線的下滑斜坡也會愈陡。

定價過高或定價過低一樣糟。

Profit Growth, Volume Growth, or Both?

定價目標矩陣

Profit Growth, Volume Growth, or Both?

Examples of quadrant I: Europe Disney, Intel. Examples of quadrant II: First Chicago Bank,

selective relationship management. Examples of quadrant III: 鬍鬚張 Examples of quadrant IV: Lufthansa

Tokyo Disney vs. Europe Disney

東京迪士尼成功的原因歐洲迪士尼為文化融合所做的努力

法文及英文為正式語言，但是，荷蘭文、西班牙文、德文及義大利文的多國語言導覽也隨處可見。

依據法國作家 Jules Verne科幻小說來興建「發現樂園」。

總裁的老婆是法國人。歐洲迪士尼的疏忽

德國漢莎航空公司 (Lufthansa)

Lufthansa於 1994年推出國內航線一律 99馬克的促銷活動。儘管優惠條件的限制嚴苛，卻仍供不應求，未來五個月內的機位全部銷售一空。由於機位有限，新定價顯然過低，未能替Lufthansa創造利潤。

這種情況在動輒降價 50%(或以上 )的航空業者身上，屢見不鮮。為了抵銷單位貢獻減少所必須增加的銷售量，往往會超過產能極限。

Selective Relationship Management

Weed out losing customers and target winning ones for pampering.

Examples: Citibank, First Chicago Bank, and Fidelity Investment.

Risk: future profits are hard to predict.

An Example of Selective Relationship Management

西南航空 (Southwest Airlines)流傳一個故事，有一名對公司抱怨不休的顧客，每回搭機後，一定寫信到公司總部抗議，她在每封信結語中都發誓再也不搭西南航空的飛機了，但抗議信還是不斷寄來。最後，有個顧客溝通人員火大了，把整疊信拿去給創辦人 Herb Kelleher。Kelleher 看過後，拿出一張印有公司名稱的信紙，寫道：「瓊斯太太：我們會想念妳的！」

節錄自哈佛商業評論 全球繁體中文版 (p. 42, December 2007)

Customer Relationship Groups

Projected loyalty

High

Low

Long-term customers

Short-term customers

Good fit between company’s offerings and customer’s needs; high

profit potential

Limited fit between company’s offerings and customer’s needs; low

profit potential

Little fit between company’s offerings and customer’s

needs; lowest profit potential

Good fit between company’s offerings and

customer’s needs; highest profit potential

Strangers

Butterflies True Friends

BarnaclesProfitability