Chapter 10

Pricing: Understanding and

Capturing Customer Value

Learning Objectives

1. Answer the question “What is price?” and discuss the importance of pricing in
today’s fast changing environment.
2. Identify the three major pricing strategies, and then discuss the importance of
understanding customer-value perceptions, company costs, and competitor
strategies when setting prices.
3. Identify and define the other important external and internal factors affecting a
firm’s pricing decisions.

Chapter Overview

In order for firms to be successful at creating customer value with the other marketing
mix activities, they must capture this value in the prices they earn. In this chapter, we
discuss the importance of pricing, dig into three major pricing strategies, and look at
internal and external considerations that affect pricing decisions. In the next chapter, we
examine some additional pricing considerations and approaches.

Chapter Outline

1.0 INTRODUCTION

Etisalat Egypt, a subsidiary of the UAE based telecommunications company. In a highly

competitive market, the business has succeeded in establishing itself by investing in the
latest technology from the very beginning of its entry into the market. Egypt has one of
the lowest sets of tariffs for calls in the world, this makes it difficult for providers to make
a profit and therefore have the funding to reinvest in the networks. Some newcomers to
the market have even had to offer free lines, one in Algeria was forced out of business
due to significant loses. The differing approaches of the service providers still leave
room for competition. Whilst one provider will focus on prices, another will shift their
emphasis to customer service and quality. In an ever developing market place, there is
still significant room for expansion in Egypt with a market of some 80 million potential
customers of which only around a quarter have been tempted by one or other service
provider.

Opening Vignette Questions

1. Do you believe that the price war is healthy? Why or why not?
2. Who, besides the service providers gains or loses in this situation?
3. Envision the typical Etisalat customer, and then envision the typical Mobinil
customer. What differences do you see? Similarities?
4. Whilst Etisalat sees room for additional price reductions, Vodafone believes the focus
should be on customer service and quality. Which one do you agree with? Explain.

© 2012 Pearson Education 1

Companies today face a fierce and fast-changing pricing environment. In response, it
seems that almost every company is looking for ways to cut prices. Yet, cutting prices is
often not the best answer. Instead, no matter what the state of the economy, companies
should sell value, not price.

2.0 WHAT IS A PRICE?

In the narrowest sense, price is the amount of money charged for a product or service.
More broadly, price is the sum of all the values that customers give up in order to gain the
benefits of having or using a product or service. Historically, price has been the major
factor affecting buyer choice. Price is one of the most flexible marketing mix elements.

3.0 MAJOR PRICING STRATEGIES

The price the company charges will fall somewhere between one that is too high to
produce any demand and one that is too low to produce a profit. The pricing strategies are
customer value-based pricing, cost-based pricing, and competition-based pricing.

3.1 Customer Value-Based Pricing

In the end, the customer will decide whether a product’s price is right. Effective,
customer-oriented pricing involves understanding how much value consumers place on
the benefits they receive from the product and setting a price that captures this value.

Customer value-based pricing uses buyers’ perceptions of value, not the seller’s cost, as
the key to pricing. The company first assesses customer needs and value
perceptions. It then sets it target price based on customer perceptions of value.
Companies often find it hard to measure the value customers will attach to their
products. Still, consumers will use these perceived values to evaluate a product’s
price, so the company must work to measure these values.

3.1.1 Good-Value Pricing

Recent economic events have caused a fundamental shift in consumer attitudes

toward price and quality. Companies have changed their pricing approaches to bring
them in line with changing economic conditions and consumer price perceptions.
Increasingly, marketers are adopting good­value pricing strategies—offering just the
right combination of quality and good service at a fair price. In many cases, this has
involved introducing less-expensive versions of established, brand-name products. In
other cases, good-value pricing has involved redesigning existing brands to offer more
quality for a given price or the same quality for less.

An important type of good-value pricing is everyday low pricing (EDLP), which involves
charging a constant, everyday low price with few or no temporary price discounts. In
contrast, high-low pricing involves charging higher prices on an everyday basis but
running frequent promotions to lower prices temporarily on selected items.

3.1.2 Value-Added Pricing

Rather than cutting prices to match competitors, many companies use value­added
pricing. They attach value-added features and services to differentiate their offers and
thus support higher prices.

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3.2 Cost-Based Pricing

A company that uses cost­based pricing sets prices based on the costs for producing,
distributing, and selling the product plus a fair rate of return for its effort and risk.

3.2.1 Types of Costs

A company’s costs take two forms. Fixed costs (also known as overhead) are costs that
do not vary with production or sales level. Variable costs vary directly with the level of
production. Total costs are the sum of the fixed and variable costs for any given level of
production. Management wants to charge a price that will at least cover the total
production costs at a given level of production.

3.2.2 Costs at Different Levels of Production

To price wisely, management needs to know how its costs vary with different levels of
production. Two graphs are shown on p. 320 in your textbook. Figure 10.3A shows a
typical short-run average cost curve (SRAC). Figure 10.3B shows a long-run average cost
curve (LRAC).

3.2.3 Costs as a Function of Production Experience

Average cost tends to fall with accumulated production experience (see Figure 10.4 on p.
321 in your textbook). This drop in the average cost with accumulated production
experience is called the experience curve (or the learning curve).

Some companies have built successful strategies around the experience curve. However, a
single-minded focus on reducing costs and exploiting the experience curve will not
always work. The aggressive pricing might give the product a cheap image. The strategy
also assumes that competitors are weak and not willing to fight it out by meeting the
company’s price cuts. Finally, while the company is building volume under one
technology, a competitor may find a lower-cost technology that lets it start at prices lower
than those of the market leader, who still operates on the old experience curve.

3.2.4 Cost-Plus Pricing

The simplest pricing method is cost­plus pricing (or markup pricing), which
involves adding a standard markup to the cost of the product. Does using standard
markups to set prices make sense? Generally, the answer is no. Even so, markup pricing
remains popular for many reasons. First, sellers are more certain about costs than about
demand, so tying price to cost simplifies pricing. Second, when all firms in the industry
use this pricing method, prices tend to be similar and price competition is minimized.
Finally, many people feel that cost-plus pricing is fairer to both buyers and sellers.

3.2.5 Break-Even Analysis and Target Profit Pricing

Another cost-oriented pricing approach is break­even pricing, or a variation called

target return pricing. The firm tries to determine the price at which it will break even
or make the target profit it is seeking.

Target pricing uses a break-even chart that shows the total cost and total revenue

© 2012 Pearson Education 3

expected at different sales volume levels (see Figure 10.5 on p. 322 in the textbook). The
manufacturer should consider different prices and estimate break-even volumes, probable
demand, and profits for each (see Table 10.1 on p. 322 in the textbook).

3.3 Competition-Based Pricing

Competition-based pricing involves setting prices based on competitors’ strategies, costs,

prices, and market offerings. Consumers will judge a product’s value based on the prices
that competitors charge for similar products. When assessing the pricing strategies of
competitors, the company should ask several questions. First, how does the company’s
market offering compare with competitors’ offerings in terms of customer value? Next,
how strong are current competitors, and what are their current pricing strategies?

4.0 OTHER INTERNAL AND EXTERNAL CONSIDERATIONS AFFECTING

PRICE DECISIONS

Beyond customer value perceptions, costs, and competitor strategies, the company must
consider several additional internal and external factors. Internal factors include
the company’s overall marketing strategy, objectives, and marketing mix, as well
as other organizational considerations. External factors include the nature of the
market and demand, as well as other environmental factors.

4.1 Overall Marketing Strategy, Objectives, and Mix

Price is only one element of the company’s broader marketing strategy. Thus, before
setting price, the company must decide on its overall marketing strategy for the product or
service. If the company has selected its target market and positioning carefully, then its
marketing mix strategy, including price, will be straightforward.

Price decisions must be coordinated with product design, distribution, and promotion
decisions to form a consistent and effective integrated marketing program. Many firms
support such price-positioning strategies with a technique called target costing. This
technique starts with an ideal selling price based on customer-value considerations, and
then targets costs that will ensure that the price is met. Some companies may de-
emphasize price and use other marketing mix tools to create nonprice positions. Often,
the best strategy is not to charge the lowest price but rather to differentiate the marketing
offer to make it worth the higher price. Some marketers even position their products on
high prices as part of the product’s allure.

4.2 Organizational Considerations

Management must decide who within the organization should set prices. In small
companies, prices are often set by top management rather than by the marketing or sales
departments. In large companies, pricing is typically handled by divisional or product line
managers. In industrial markets, salespeople may be allowed to negotiate with customers
within certain price ranges. In industries in which pricing is a key factor, companies often
have pricing departments to set the best prices or to help others in setting them. Others
who can influence pricing include sales managers, production managers, accountants, and
finance managers.

4.3 The Market and Demand

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Before setting prices, the marketer must understand the relationship between price and
demand for the company’s product.

4.3.1 Pricing in Different Types of Markets

The seller’s pricing freedom varies with different types of markets, each of which
presents a different pricing challenge.

Under pure competition, the market consists of many buyers and sellers trading in a
uniform commodity, such as wheat or copper. No single buyer or seller has much effect
on the going market price. In a purely competitive market, marketing research, product
development, pricing, advertising, and sales promotion play little or no role. Thus, sellers
in these markets do not spend much time on marketing strategy.

Under monopolistic competition, the market consists of many buyers and sellers who
trade over a range of prices rather than a single market price. Sellers can differentiate
their offers to buyers via price, advertising, and personal selling. Because there are many
competitors, each firm is less affected by the pricing strategies of competitors than in
oligopolistic markets.

Under oligopolistic competition, the market consists of a few sellers who are highly
sensitive to each other’s pricing and marketing strategies. There are few sellers because it
is difficult for new sellers to enter the market. Because there are few sellers, each seller is
alert and responsive to the pricing strategies and moves of competitors.

In a pure monopoly, the market consists of one seller. The seller may be a government
monopoly, a private regulated monopoly, or a private nonregulated monopoly. Pricing is
handled differently in each case.

4.3.2 Analyzing the Price-Demand Relationship

Each price the company might charge will lead to a different level of demand. The
relationship between the price charged and the resulting demand level is shown in the
demand curve (see Figure 10.6 on p. 326 in the textbook). The demand curve shows the
number of units the market will buy in a given time period at different prices that might
be charged. In the normal case, demand and price are inversely related; that is, the higher
the price, the lower the demand.

4.3.3 Price Elasticity of Demand

Price elasticity is how responsive demand will be to a change in price. If demand hardly
changes with a small change in price, we say demand is inelastic. If demand changes
greatly with a small change in price, we say the demand is elastic. The price elasticity of
demand = % change in quantity demanded/% change in price.

What determines the price elasticity of demand? Buyers are less price sensitive in the
following cases:

• The product they are buying is unique or when it is high in quality, prestige, or
exclusiveness.
• Substitute products are hard to find or when they cannot easily compare the
quality of substitutes.

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 • The total expenditure for a product is low relative to their income or when the
cost is shared by another party.

If demand is elastic rather than inelastic, sellers will consider lowering their prices. A
lower price will produce more total revenue. This practice makes sense as long as the
extra costs of producing and selling more do not exceed the extra revenue. At the same
time, most firms want to avoid pricing that turns their products into commodities.
Therefore, marketers need to work harder than ever to differentiate their offerings when a
dozen competitors are selling virtually the same product at a comparable or lower price.
More than ever, companies need to understand the price sensitivity of their customers and
the tradeoffs people are willing to make between price and product characteristics.

4.4 The Economy

Economic conditions can have a strong impact on the firm’s pricing strategies. In the
aftermath of the recent Great Recession, consumers have rethought the price-value
equation. Many consumers have tightened their belts and become more value conscious,
and they are likely to remain thrifty well beyond any economic recovery. As a result,
many marketers have emphasized value-for-the-money pricing strategies.

The most obvious response to the new economic realities is to cut prices and offer deep
discounts. However, such price cuts have undesirable consequences. Lower prices mean
lower margins. Deep discounts may cheapen a brand in consumers’ eyes. Once a
company cuts prices, it’s difficult to raise them again when the economy recovers. Rather
than cutting prices, therefore, many companies are shifting their marketing focus to more
affordable items in their product mixes.

4.5 Other External Factors

Beyond the market and the economy, the company must consider several other factors in
its external environment when setting prices. The company must consider what impact its
prices will have on other parties in its environment. For example, how will resellers react
to various prices? The government is another important external influence on pricing
decisions. Finally, the company’s short-term sales, market share, and profit goals may
need to be tempered by broader social concerns.

Student Exercises

1. Key Term: Price

Price is the amount of money charged for a product or service, or the sum of the values
that consumers exchange for the benefits of having or using the product or service. Visit
the University of Toronto online at (www.utoronto.ca). What benefits does the University
of Toronto offer to its students in exchange for their tuition fees?

2. Key Term: Price

Price is the amount of money charged for a product or service, or the sum of the values
that consumers exchange for the benefits of having or using the product or service. Go to
Dell’s home page (www.dell.com) and build your ultimate desktop computer. Determine
the price you would pay for the benefits associated with the features you have selected.

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3. Key Term: Customer Value-Based Pricing

It is important to remember that “good value” is not the same as “low price.” For
example, a Steinway piano costs a lot. To those who own one, however, a Steinway is a
great value. Visit Steinway & Sons online at (www.steinway.com). How does the website
support the assertion that Steinway is the “maker of the finest pianos in the world”?

4. Key Term: Good-Value Pricing

Many companies these days are adopting good-value pricing strategies—offering just the
right combination of quality and good service at a fair price. Visit McDonald’s online
(www.mcdonalds.com) and/or go to one of its fast-food restaurants. Locate some items
on the menu that you believe exemplify good-value pricing.

5. Key Term: Value-Added Pricing

Rather than cutting prices to meet the competition, companies can adopt a value-added
pricing strategy. This involves attaching value-added features and services to differentiate
their offers and thus support higher prices. Check out Apple’s website at
(www.apple.com). What value-added features and services do you see that could
encourage consumers to pay a premium for Apple’s products, rather than choosing
products from lower-cost competitors?

6. Key Term: Fixed Costs

Fixed costs are costs that do not vary with production or sales volume. At Tomasini Fine
Linens and Accessories (www.tomasinifinelinens.com), customers can create their own
designs for their bedding, within its product line; or, they can select collections from the
company’s catalog and give their specifications (i.e., size, lengths, etc.) to the design
staff. What are some of Tomasini’s fixed costs?

7. Key Term: Variable Costs

Variable costs vary directly with production volume. Although these costs tend to be the
same for each unit produced, they are “variable” costs because the total varies with the
number of units produced. Consider Subway Restaurants (www.subway.com). What are
some of the variable costs involved in making a typical Subway sandwich?

8. Key Term: Cost-Based Pricing

When a company uses cost-based pricing, it sets prices based on the costs for producing,
distributing, and selling a product, plus a fair rate of return for its effort and risk. For well
over a century and a half, the Martin Guitar Company (www.martinguitar.com) has been
producing acoustic instruments that are acknowledged to be the finest in the world.
Would a company such as this utilize cost-based pricing? Why or why not?

9. Key Term: Oligopolistic Competition

Under oligopolistic competition, the market consists of a few large sellers who are very
aware of each other’s pricing and marketing strategies. There are few sellers in the market
because it is difficult for new sellers to enter the market successfully. Browse the Internet
to discover a market that is characterized by oligopolistic competition.

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10. Key Term: The Economy

In today’s economy, says a P&G marketer, “value is the magic word.” Check out P&G’s
brands online at (www.pg.com). Did you find any evidence that P&G is focused on
helping consumers see the value in its products?

Marketing ADventure Exercises

1. Ad Interpretation Challenge: Value-Based Pricing

Ad: Umbrellas—Stag

When faced with competition from lower-cost imports from China, Ebrahim Currim &
Sons, makers of Stag Umbrellas in Mumbai, India, responded at first by cutting prices.
When it started losing money for the first time since 1940, the company shifted gears to
pursue a value-added strategy, bringing to market umbrellas with funky designs and cool
colors, as well as umbrellas with safety features for those who walk unlit roads at night.
Check out the website for Stag Umbrellas at (www.stagumbrellas.com). What do you see
there that could explain why Stag’s customers willingly pay 100 percent premium for the
new products?

2. Ad Interpretation Challenge: Value-Based Pricing

Ad: Southern Sun—Real Marketing 10.1

By building added value based on brand image, Southern Sun has been able to focus on
quality and style. Read Marketing 10.1 on pp. 318-319 in your textbook. What does
Southern Sun do to offer its customers a full-value service?

3. Ad Interpretation Challenge: Cost-Based Pricing

Ad: Student Choice

Cost-based pricing involves setting prices on the costs for producing, distributing, and
selling a product, plus a fair return for effort and risk. Some companies intentionally pay
higher costs so they can claim higher prices and margins for their products. Browse the
Internet to locate the website for a company that captures higher prices based on the
quality of its products. Identify some elements on the website that convey the exceptional
quality of that company’s products.

4. Ad Interpretation Challenge: Variable Costs

Ad: Restaurants—Panera Breads

Variable costs vary directly with the level of production. What are some of the variable
costs associated with Panera Bread’s (www.panerabread.com) goal of serving wholesome
food and fresh-baked bread, in a warm and inviting environment?

5. Ad Interpretation Challenge: Target Costing

Ad: Alcoholic Beverages—Grand Marnier

Some companies position their products on price and then tailor other marketing mix
decisions to the prices they want to charge. Grand Marnier (www.grand-marnier.com)
offers a $225 bottle of Cuvée du Cent Cinquantenaire that is marketed with the tagline,

© 2012 Pearson Education 8

“Hard to find, impossible to pronounce, and prohibitively expensive.” What elements on
its website are meant to convince customers that they are getting the best value in terms
of benefits received for the prices paid for Grand Marnier liqueur?

6. Ad Interpretation Challenge: Monopolistic Competition

Ad: Food and Beverage—Heinz

When a market consists of many buyers and sellers who trade over a range of prices
rather than a single market price, monopolistic competition exists. A range of prices
exists because sellers can differentiate their offers to buyers. Visit the website of the H.J.
Heinz Company at (www.heinz.com). How does this website use strong branding and
advertising to develop differentiated offers for different customer segments?

7. Ad Interpretation Challenge: Inelastic Demand

Ad: Pharmaceuticals—Cymbalta

What determines the price elasticity of demand? Buyers are less price sensitive if the
product they are buying is unique or when it is high in quality, prestige, or exclusiveness.
They are also less price sensitive if substitute products are hard to find or they cannot
easily compare the quality of substitutes; and the total expenditure for a product is low
relative to their income or when the cost is shared by another party. Consider the drug
Cymbalta (www.cymbalta.com) that can offer improvement across a broad range of
symptoms of depression. Based on the criteria for price sensitivity listed in this question,
is demand for Cymbalta elastic or inelastic?

8. Ad Interpretation Challenge: Elastic Demand

Ad: Student Choice

If demand for a product changes greatly with a small change in price, the demand for that
product is elastic. In such a case, sellers will consider lowering their prices. Consider the
recent spike in prices of gasoline. In your opinion, is demand for gasoline elastic or
inelastic? What is the basis for your opinion?

© 2012 Pearson Education 9