CHAPTER 2

PRICING STRATEGY
Presented By:

BAGTAS, ANDREA NICOLE N.

CASTRO, KYLA JOY T.
RAMOS, ELLA
OCAMPO, ALYZZA
 THE SOURCE OF PRICING ADVANTAGE
Strategic pricing harvests the fruit of a company’s investment in developing and delivering
differentiated products and services to market.

At the foundation of the pyramid, in what should be the first task of any strategic marketing
organization, is gaining a deep understanding of how products and services create value for customers
—the essential initial input to pricing strategy.

For many firms, the pricing harvest is less than bountiful because they fail to understand and leverage
their potential to create value through their products, services, and customer relationships. They erroneously
assume that merely adding features or improving performance will lead to profitable gains in price, volume,
or both. But more and better features will not lead to greater profitability unless those
features translate into higher monetary and/or psychological value for the customer.

An in-depth understanding of how your products create value for customers is the key that unlocks your
organization’s ability to improve pricing performance by enabling managers across the organization to make
more profitable business choices.
STRATEGIC PRICING PYRAMID
 THE ROLE OF VALUE IN PRICING
EXHIBIT 2-1 ECONOMIC VALUE

The term value commonly refers to the overall satisfaction that a customer receives from using a
product or service offering. Economists call this use value— the utility gained from the product.

The value at the heart of pricing strategy is not use value, but is what economists call exchange value
or economic value. Economic value accounts for the fact that the value one can capture for commodity
attributes of an offer is limited to whatever competitors charge for them.

Economic value accounts for the fact that the value one can capture for commodity attributes of an
offer is limited to whatever competitors charge for them. Only the part of economic value associated with
differentiation, which we call differentiation value, can potentially be captured in the price.
 THE ROLE OF VALUE IN PRICING
EXHIBIT 2-1 ECONOMIC VALUE

Differentiation value comes in two forms: monetary and psychological, both of which
may be instrumental in shaping a customer’s choice but require very different approaches to
estimate them.

Monetary value represents the total cost savings or income enhancements that a
customer accrues as a result of purchasing a product. Monetary value is the most important
element for most business-to-business purchases.

Psychological value refers to the many ways that a product creates innate satisfaction
for the customer.
 THE ROLE OF VALUE IN PRICING
EXHIBIT 2-1 ECONOMIC VALUE
More formally, a product’s total economic value is calculated as the price of the customer’s best alternative (the reference
value) plus the worth of whatever differentiates the offering from the alternative (the differentiation value).

One of the most critical factors driving customer

choice and willingness-to-pay is the set of alternative products
under consideration for purchase. From the marketer’s
perspective, these products represent the “next best
competitive alternatives” or NBCA. Given the centrality of
competitors’ pricing in the purchase decision, economic value
estimation begins by determining the price the competitor
charges (not necessarily the NBCA’s use value), which
becomes the reference value in our model.
 HOW TO ESTIMATE ECONOMIC VALUE

Marketers have historically invested considerable effort to develop effective value propositions to
represent their company and products. And few would argue that an effective value proposition, a concise
statement of customer benefits, is an essential input to brand building and sales conversations. But a general
statement of value is insufficient input to pricing decisions because it lacks the detail and quantification needed
to shape strategy.
 Competitive Reference Prices
Identifying the next best competitive alternative to your product
and gathering accurate reference prices is a conceptually simple.
Some products may not have a single competing product that
customers would consider a suitable alternative. Customers might
construct a basket of different products and services as a viable
alternative.

Establishing competitive reference prices is one of the biggest

challenges for marketers. You must ensure that prices are measured in
terms familiar to customers in the segment. Secondary price data of
this sort will invariably contain some bias and be less reliable than
primary data obtained directly at the point of sale.
Exhibit 2-2 Untreated Reference Price Data

Exhibits 2-2 show how secondary

price data can be treated for use in a value
estimation exercise. The data in this example
was collected by a technology manufacturer
as part of a competitive strategy assessment.
After the pricing data was adjusted for these
factors, Exhibit 2-3 revealed much more
consistent pricing behaviors that could be
used as an input to the value estimation.
Exhibit 2-3 Adjusted Reference Prices

As this example illustrates,

collecting reference prices is often more
than just a data collection exercise. It
requires some judgement and analysis to
ensure that the data is ready to be
incorporated into a value estimation
calculation.
Estimating Monetary Value
After determining the competitive reference prices, the next step in value estimation is to gain a detailed
understanding of customer value drivers. The distinct characteristics of monetary and psychological value drivers
require different approaches to quantify. Since monetary value drives are already quantitative, monetary value can
be estimated using qualitative research techniques that allow for a rich understanding of the customer's business
model or personal finances.

Quantifying monetary value drivers in business markets is more challenging because of the complexity of
most business operations. Although there are many value-drivers for a hybrid car, with the exception of fuel and
maintenance costs, most are psychological in nature and do not affect customer finances.
Exhibit 2-4 Examples of Value Driver Algorithms
for Equipment Manufacturer
Estimating monetary value is the sum
of the difference between your product and
the next best competitive alternative (NBCA).
You can charge no more for it than the price
of the NBCA product, regardless of its use
value to the customer. Measure differentiation
value either as costs saved to achieve a
particular level of benefit or extra benefits
achieved for an identical cost. Don't add both;
that's double counting.
Monetary Value Estimation: An Illustration
GenetiCorp creates products that accelerate the process of genetic testing.
One product, Dyna-Test, synthesizes a complementary DNA strand from an existing
DNA sample. For criminal investigators, getting a "fuzzy picture" in a criminal
investigation may produce a false-negative result. Hospitals and medical
professionals use DNA to diagnose diseases. Pharmaceutical companies use DNA
analysis to target genes susceptible to new drug treatments.
Exhibit 2-5 Monetary Value Estimation for Dyna-
Test Industrial Buyers
Value Driver 1—Yield Opportunity Costs:

The yield opportunity cost avoided by using DynaTest

is $1,055, somewhat less than for commercial researchers
because of the lower economic rewards from breakthroughs
Conduct
in primary research. Synthesiz
Value Drivers 2, 3, 4, and 5: e
The yield labor savings of $231, quality control
savings of $29, sample size opportunity cost avoided of $317,
and sample size labor savings are also less because of the
reduced cost of labor within university systems.
Exhibit 2-6 Monetary Value Estimation for Dyna-Test
Academic and Government Buyers
Economic value cannot indicate the
appropriate price to charge. A better
solution to the perception problem often is
to increase price while aggressively
educating the market. GenetiCorp raised
prices two- to fivefold, at the same time
launching an aggressive marketing
campaign. Profits increased significantly in
the following year as purchasers accepted
the need to pay for value.
Exhibit 2-7 Monetary Value Profile for Dyna-Test

Pharmaceutical companies have been

forced to add cost and performance evidence to
their traditional claims about a drug's clinical
effectiveness. Some now offer purchasers
elaborate tests to show that greater effectiveness
is worth a higher price. Johnson & Johnson's
invention of the medicated arterial stent initially
appeared expensive at $1,300 per stent.
 Segmentation by Distribution
Price per unit

Revenue
# of units sold
Company
Profit
Variable costs

Cost
Fixed costs
Estimating Psychological Value
❖ Psychological value drivers such as satisfaction and security, by virtue of their subjective
nature, do not lend themselves to estimation via qualitative research techniques like in depth
interviewing. Instead, pricing researchers must rely on a variety of quantitative techniques to
estimate the worth of a product’s differentiated features.

❖ The most widely used of these techniques is conjoint analysis.

❖ The basis approach is to decompose a product into groups of features and then provide
customers with a series of choices among various feature sets to understand which they
prefer.

❖ Using conjoint analysis makes it possible to estimate the value of different feature sets in
driving willingness-to-pay and ultimately, the purchase decision.
Estimating Psychological Value

❖ Similarly, conjoint is a common approach to estimating brand

value because it enables brand to be treated as any other
attribute. Treating brand as another attribute in the choice
decision allows us to understand how customers might value a
36 inch Sony TV relative to a 42 inch Samsung model.
 Psychological Value Estimation: An Illustration

❖ Sport Co. (disguised name) a leading sporting goods manufacturer, has developed a
revolutionary golf club named the “Big Drive”. The new design has led to significant
increases in distance and accuracy for both beginning and advanced players.

❖ The approach involved several steps. This segmentation work uncovered four unique
segments:

● Innovators - Frequent golfers highly focused on performance.

● Value Seekers - are thrifty, but they will pay a premium for added performance.
● Lost Players - They do not purchase significant amounts of golf equipment, but they can
be drawn back to playing if a new innovation creates enough buzz to capture their
attention.
● Budget Shoppers - They typically buy new equipment through discount stores such as
Wal-Mart and online outlets.
❖ The extensive list of attributes that were tested, three were noted most commonly
by all segments: distance, straightness, and consistency.

❖ The results of the conjoint study provided the needed inputs to developed a
segmented pricing strategy.

❖ The initial hypothesis was that a warranty was not a key driver in the purchase
decision. Interestingly, extending the warranty from one to two years did not lead
to a similar increase in willingness to pay.

❖ The data in Exhibit 2-9 shows the differences in willingness to pay between the
innovator and budget shopper segments based on the conjoint result.
❖ As expected, the optimal proces point for budget shoppers was
considerably less at $275. This difference in the value.

❖ In this instance, the quantified value estimates of the different segments

combined with a detailed understanding of segment buying patterns and
value drivers enabled the team to make a solid business case for a two tier
pricing strategy.

❖ They introduced the premium model aimed at innovators and value

buyers to be sold at a higher price in pro shops and high end sporting
goods outlets.
Exhibit 2-8 Impact of Warranty Length on
Willingness to Pay
❖ It was possible to generate reliable
estimates of psychological value for the
“Big Drive” because the key benefits of
distance and accuracy are ones with
which golfers have prior experience.

❖ The research subject in that case must

guess what the benefits are and how
satisfying they might be. Most people,
even those deeply familiar with the
technology, are not good at inferring the
benefits of innovation.
Exhibit 2-9 Impact of Warranty Length on
Willingness to Pay
❖ The importance of this feature
benefit value linkage will
become clear in later chapters
where we discuss bundling and
value communication choices.
The High Cost of Shortcuts
- When setting prices, there are no shortcuts for understanding the economic value received
by the customer.

- “x” percent more effective than the competition, then the product will be worth only “x”
percent more in price.

- The value based price premium one can charge is often much greater than the percentage
increase in an offering’s technical efficiency.

- That would be the case only if using 50 percent more of the competitive cancer drug or
painting with two brushes at the same time would produce the same increase in efficiency as
using the superior products.

- At the center of this misconception is the popular concept of customer value modeling
(CVM), which emerged from the total quality management movement when companies tried
to measure and deliver superior quality at a competitive price.
The High Cost of Shortcuts
- Avoiding the translation of relative attribute performance into hard dollar estimates, CVM is
analytically simpler than economic value estimation, particularly for pricing consumer
products with their heavily psychological values.

- CVM methods define value differently than does economic value estimation. Then CVM
calculates the average relationship between perceived quality and price, creating what is
variously called a “ fair value line” a “value equivalence line” “indifference line” or other
term for the presumed linear relationship between price and perceived quality.

- First, customers don’t pay for average differential benefits estimates; they pay forbthe worth
of the benefits they receive.

- Second, CVM fails to distinguish between the value of common benefits that are priced as
commodities and the value of the unique benefits associated with a differentiated offering.
The High Cost of Shortcuts
- The reference value is the price a customer pays for the next best alternative offering like the
price of the second paintbrush, the price of the EnSyn DNA test kit, or the price of a soda at
the refreshment stand.

- Customers can get them from more than one source. Competition among suppliers drives the
price for those benefits below their use value, making the price to use value ratio of the
reference product lower than one to one.

- The differentiation value, expressed in monetary terms, is equivalent to the price premium
the differentiated supplier could charge as a fair price.

- In other words, the relationship between price and economic value is function of two
different price to quality ratios, not the single average ratio hypothesized in a CVM model.
Exhibit 2-10 Impact of Warranty Length on
Willingness to Pay
 Exhibit 2-10 Impact of Warranty Length on
Willingness to Pay
- The overall “fair value line” (FVL) represents the CVM determined average relationship of
price to economic value delivered, in this case a ratio of 0.61. The reference value is $40, the
most that any supplier can charge for commoditized everybody offer them benefits, even
though the use value of reference product A is $80. The low reference price forces the
average price to value relationship designated by a single CVM FVL into a slope that’s less
than 1.0, implying that a dollar’s worth of price produces only 61 cents additional value.
More accurate might be a curvillinear FVL, or a linear FVL representing only differentiation
values.

- The fair economic value estimation price exceeds the fair CVM price as the differentiation
value of the product grows.
 VALUE-BASED MARKET SEGMENTATION

Market segmentation is one of the most

important tasks in marketing. Identifying and
describing market subgroups in a way that guides
marketing and sales decision-making makes the
marketing and pricing process much more efficient
and effective.
Significant differences between value-based segmentation and other
methods are especially critical for pricing.
First, most segmentation criteria correlate poorly with different
buyers’ motivations to pay higher or lower prices.
Second, even needs-based segmentations give priority only to those
differences that are important to the customer.
 To conduct a value-based
segmentation, we recommend a
six-step process.

Step 1: Determine Basic Segmentation Criteria

Step 2: Identify Discriminating Value Drivers
Step 3: Determine Your Operational Constraints and
Advantages
Step 4: Create Primary and Secondary Segments
Step 5: Create Detailed Segment Descriptions
Step 6: Develop Segment Metrics and Fences
 Step 1: Determine Basic Segmentation Criteria

The goal of any market segmentation is dividing a market into subgroups

whose members have common criteria that differentiate their buying
behaviors.
A segmentation done by industry using industrial classification criteria
would not indicate, however, whether customers use the grinders in similar
ways. A segmentation based on application criteria would account for
different ways of using the grinders, but would not indicate if the grinder is
more important to one segment business model than to another’s.
 Step 2: Identify Discriminating Value Drivers

Having preliminary segmentations in hand, you then identify value

drivers. Value drivers mean nothing else than the purchase motivators
that vary the most among segments but which have more or less
homogenous levels within segments. This allows you to zero in on
what’s most important to each customer segment. Never assume for
pricing purposes that preliminary segmentations based on obvious
criteria will coincidentally yield effective discrimination on value
criteria.
 Step 3: Determine Your Operational Constraints
and Advantages

In this step, you examine where you have operational advantages.

This step combines what you’ve learned so far about how customer
values differ and about your costs and constraints in serving different
customers.
In theory, your primary segmentation is based on the most
important criterion differentiating your customers. Your secondary
segmentation divides primary segments into distinct subgroups
according to your second most important criterion. Your tertiary
segmentation divides second segments based on the third most
important criterion, and so on.
 Step 4: Create Primary and Secondary Segments

This step combines what you’ve learned so far about how customer values differ and
about your costs and constraints in serving different customers. Unless you’re
comfortable with multivariate statistical analyses accounting for several value drivers
simultaneously, you’ll find it most convenient to segment your marketplace in
multiple stages, value driver by value driver.
Exhibit 2-8 Impact of Warranty Length on Willingness
to Pay
 Exhibit 2-11 shows a primary
segmentation based on the strategic overlap
of customer scheduling needs and printer
operational capabilities. Two primary
segments emerge: buyers needing precise
timing and those who are willing to
relinquish timing control for a break on
price.
Exhibit 2-11 Primary and Secondary Segmentation:
Catalog Printing Industry
 Step 5: Create Detailed Segment Descriptions

Value-based segmentation variables can look fine

to the price strategist, but segments should be
described in everyday business terms so that
salespeople and marketing communications planners
know what kinds of customers each segment
represents.
 Step 6: Develop Segment Metrics and Fences

This is the next logical step in pricing strategy and management. In this final step, it is important to

recognize that segmentation is not useful until you develop the metrics of value delivery to market segments and

devise fences that encourage customers to accept price policies for their segments. Metrics are the basis for tracking

the value customers receive and how they pay for it. Fences are policies, rules, programs, and structures that

customers must follow to qualify for price discounts or rewards.

Firms should choose metrics and fences that help to enforce premium prices for high value segments, and

allow feature repackaging and unbundling to appeal to low-value and low-cost-to-serve segments. The result should

be a menu of prices, products, services, and bundles that reflect different value received for different prices paid.
Exhibit 2-12 “Associate More Detailed Descriptions for
Easier Identification”
 Summary
The foundation of a profitable pricing strategy begins with a complete
understanding of the economic value the product delivers to buyers because, ultimately,
value is the primary determinant of willingness to-pay. This foundational understanding
of value contributes to a comprehensive pricing strategy in a number of ways. First, it
provides insight into how willingness-to-pay differs across segments. As the commercial
printing company example illustrates, a value-based segmentation can inform not only
pricing, but offering design as well. Second, understanding value is the only way to
develop effective communications campaigns to increase customer’s willingness-to-pay.
Although a hot beachgoer probably recognizes the value of a cold drink delivered to her
blanket, most customers are not so well informed, and it is the job of the seller to get the
value message across. Finally, value can and should be one of the key inputs to the price
setting decision because, as we demonstrated in Chapter 1, building a pricing strategy on
other metrics such as market share or costs leads to less profitable results.
THANK YOU!