COST- VOLUME – PROFIT (CVP)ANALYSIS portion of each sale that contributes to covering fixed costs and

generating profit. It's a key indicator of profitability.

4.1 The Basics of CVP Analysis
● Break-Even Point Calculation: The break-even point is the level of sales
● Introduction to CVP Analysis or production at which total revenue equals total costs, resulting in zero
● Cost-Volume-Profit (CVP) Analysis is a financial management tool used profit or loss. It can be calculated as follows: Break-Even Point (in units) =
by businesses to understand how changes in sales volume, costs, and Fixed Costs / (Sales Price per Unit - Variable Cost per Unit)
prices affect their profits and overall financial performance. It helps in Graphical Representation of CVP Analysis:
making informed decisions regarding pricing, production levels, and
product mix by analyzing the relationships between costs, volume, and ● Break-Even Chart: A break-even chart visually represents the relationship
profits. between costs, revenue, and profit. It displays the break-even point and
helps businesses understand at what level of activity they start making a
● Cost refers to the expenditure or expense incurred by a business or profit.
individual in the process of producing goods, providing services, or
running day-to-day operations. Costs can be categorized into various ● Profit-Volume (P-V) Chart: This chart illustrates how profits change with
types, such as fixed costs (which remain constant regardless of variations in sales volume. It provides a clear picture of the profit
production or sales levels) and variable costs (which change in direct potential at different levels of activity.
proportion to production or sales volume). Understanding and managing
costs is crucial for businesses to determine their profitability and make ● Limitations of CVP Analysis: While CVP Analysis is a valuable tool, it has
informed financial decisions. certain limitations:

● Volume, generally refers to the quantity of goods or services produced,

Assumes Linearity: CVP Analysis assumes that costs and revenues are
sold, or consumed within a specific time frame. It is often associated with
production volume, sales volume, or the volume of units in inventory. linear, which may not hold true in complex, nonlinear business
Analyzing volume data is important for businesses to assess their market environments.
demand, production efficiency, and overall performance. Changes in
● Simplistic Assumptions: It simplifies reality by categorizing costs as
volume can impact both costs and profits.
strictly fixed or variable, whereas some costs may exhibit mixed behavior.
● Profit is the financial gain or surplus that remains after deducting all
costs, expenses, and taxes from the total revenue generated by a ● Static Analysis: CVP Analysis is based on a static snapshot and may not
business or individual. It is a key indicator of financial success and account for dynamic changes in the market or business conditions.
sustainability. Profit can be categorized into different types, including
gross profit (revenue minus the cost of goods sold), operating profit ● Ignores External Factors: It often ignores external factors like
(gross profit minus operating expenses), and net profit (total profit after competition, market demand, and economic fluctuations.
all expenses, including taxes). Maximizing profit is often a primary goal
for businesses. 4.2 Significance of Cost-Volume-Profit Analysis

PURPOSE OF CVP Analysis ● Pricing Decisions: CVP Analysis plays a crucial role in setting the right
prices for products or services. Businesses must balance the need to
● Determining Break-Even Point: It calculates the level of sales or cover costs, achieve profit targets, and remain competitive in the market.
production at which a business neither makes a profit nor incurs a loss, CVP Analysis helps in the following ways:
known as the break-even point.
● Determining Optimal Pricing: By analyzing the relationship between
● Profit Planning: CVP Analysis assists in setting profit targets and planning costs, volume, and profits, businesses can identify the price points that
for achieving those targets. maximize profitability.
● Pricing Strategies: Businesses can evaluate the impact of different pricing ● Price Changes Impact: It allows companies to assess the impact of price
strategies on profitability. changes on their bottom line. For example, they can analyze how a price
increase or decrease affects sales volume and overall profit.
● Cost Control: It identifies fixed and variable costs, aiding in cost control
measures. ● Competitive Positioning: CVP Analysis helps in understanding how
pricing decisions influence market share and competitiveness. It's
● Product Mix Decisions: CVP Analysis helps in deciding the optimal mix of especially important when dealing with price wars or new market entries.
products to maximize overall profitability.
● Product Mix Decisions: Many businesses offer multiple products or
● Importance in Decision-Making: CVP Analysis is a critical tool for services. CVP Analysis assists in making informed decisions regarding the
decision-making in various aspects of business management: mix of products to maximize overall profitability:
● Pricing Decisions: It helps determine the appropriate selling price by ● Product Contribution: Businesses can identify which products contribute
considering cost structures and profit objectives. most to overall profits and focus resources on promoting or improving
● Production Planning: Businesses can plan production levels that align those products.
with demand, avoiding overproduction or underproduction. ● Sales Mix Optimization: By analyzing the contribution margins of
● Budgeting: CVP Analysis assists in setting realistic budgets by estimating different products, companies can decide on the optimal mix of products
expected revenues and costs. to offer, considering their cost structures and market demand.

● Investment Decisions: When considering new projects or products, CVP ● Budgeting and Planning: CVP Analysis is a valuable tool in the budgeting
Analysis assesses their potential profitability. and planning process:

● Risk Assessment: It provides insights into the sensitivity of profits to ● Revenue Planning: It helps in setting revenue targets based on expected
changes in variables, aiding in risk management. sales volume and pricing strategies.

Fixed Costs Vs. Variable Costs ● Cost Control: By distinguishing between fixed and variable costs,
businesses can create more accurate cost budgets and identify cost
● Fixed Costs: These are costs that remain constant regardless of changes reduction opportunities.
in production or sales volume. Examples include rent, salaries, and
insurance premiums. ● Profit Targets: CVP Analysis assists in setting realistic profit targets and
understanding the required level of sales to achieve them.
● Variable Costs: Variable costs change in direct proportion to changes in
production or sales volume. Common examples are raw materials, direct ● Risk Assessment and Sensitivity Analysis: Understanding the sensitivity
labor, and sales commissions. of profits to changes in variables is essential for risk assessment and
decision-making under uncertainty:
● Sales Price per Unit: This represents the amount a company charges for
each unit of its product or service. It's a crucial factor in CVP Analysis as it ● Scenario Analysis: By conducting sensitivity analysis, businesses can
affects total revenue. assess how changes in variables such as sales volume, costs, or prices
impact profits in different scenarios. This helps in risk mitigation and
● Contribution Margin: The contribution margin is the difference between contingency planning.
the sales price per unit and the variable cost per unit. It represents the
 ● Case Studies: Real-life case studies are invaluable in showcasing the Contribution Margin Ratio
practical significance of CVP Analysis. These illustrate how businesses
from various industries have used CVP Analysis to make critical decisions: Contribution Margin Ratio = (250,000 / 1,000,000) x 100

● Break-Even Scenarios: Case studies can demonstrate how companies

determined their break-even points and how it influenced their pricing
and production decisions.
● Profit Planning: Examples can show how CVP Analysis helped businesses
set profit targets and strategies for achieving them.
● Product Mix Optimization: Case studies can highlight how companies
adjusted their product mix to enhance overall profitability. Contribution Margin Ratio = 25%
● Risk Mitigation: Real-world examples can illustrate how sensitivity Variable Cost Margin Ratio
analysis and risk assessment using CVP Analysis helped businesses
navigate economic downturns or unexpected market shifts Variable Cost Margin Ratio = (750,000 / 1,000,000) x 100

The Contribution Margin Income Statement

● The contribution margin income statement is an income statement in
which all variable expenses are deducted from sales to arrive at a
contribution margin. Then, all fixed expenses are subtracted to arrive at
the net profit or net loss for the period.
● Presentation of a Contribution Margin Income Statement
The format of a contribution margin income statement is as follows
Variable Cost Margin Ratio = 75%
4.4 CVP Analysis for Break-Even Planning, and Revenue, and Cost Planning
Break-Even Planning
CVP Analysis is the foundation for break-even planning, which helps businesses
identify their critical "break-even point." This is the point where total revenue
equals total costs, resulting in neither profit nor loss.
(In CVP, the break-even planning is identifying if whether you’re making a profit
In many cases, direct labor is categorized as a fixed expense in the or not and to figure your situation like if you are in-between on losing or
contribution margin income statement format, rather than a variable expense, having a great income.)
because this cost does not always change in direct proportion to the amount of Considerations in Break-Even Planning
revenue generated. Instead, management needs to keep a certain minimum
staffing in the production area, which does not vary for lower production Loss Zone: Before reaching the break-even point, many businesses experience
volumes. the challenging "loss zone," where expenses exceed revenue, leading to
financial losses.
The contribution margin income statement and a normal income
statement, the net profit or loss will be the same, because all revenue and Strategies to Overcome the Loss Zone:
expense items are included in both formats; only their order of presentation
differs. ● Marketing Efforts

It is useful to create an income statement in the contribution margin ● Cost Reduction

format when you want to determine that proportion of expenses that truly ● Pricing Adjustments
varies directly with revenues. In many businesses, the contribution margin will
be substantially higher than the gross margin, because such a large proportion Break-Even Point: The break-even point is the point where total revenue equals
of its production costs are fixed, and few of its selling and administrative total costs. Beyond this point, every additional sale contributes to profit.
expenses are variable.
Strategies to Reach and Surpass the Break-Even Point:
● Sales Growth
● Pricing Optimization
● Operational Efficiency
Profit Zone: After surpassing the break-even point, businesses enter the coveted
"profit zone," where sales exceed costs, leading to incremental profits with each
unit sold.
Strategies for Profit Zone Optimization:
● Market Expansion
● Cost Control
● Innovation
Revenue Planning
Revenue planning is closely linked with CVP Analysis, enabling businesses to
predict how varying sales levels impact their revenue. This facilitates the
establishment of ambitious sales targets and pricing strategies to maximize
income.
● Sales Mix refers to the proportion of different products or services sold
Calculation: by a business. A business with a higher proportion of high-margin
products or services will have a higher revenue potential than a business
•Sales = Selling price per unit x No. of units sold =$2,000 x 500 =$1,000,000 with a higher proportion of low-margin products or services.
•Cost of Goods Sold = $1,000 x No. of units sold =$1,000 x 500 =$500,000 ● Market Segmentation: Tailor products or services to specific customer
•Selling and administrative costs = $500 x No. of units sold =$500 x 500 needs through effective market segmentation. This can help to increase
=$250,000 sales and revenue potential.
 ● Diversification Strategies: Explore diversification to expand your product 2. How will profit change if sales volume decreases by 70 units (10 percent)?
or service portfolio and tap into new revenue streams.
3. How will profit change if fixed costs decrease by $15,000 (30 percent) and
Market Monitoring: Continuously monitor market trends to adapt your revenue variable cost increases $15 per unit (10 percent)?
plan to changing customer preferences
Sensitivity Analysis for Snowboard Company
Cost Planning
Complementing revenue planning, CVP Analysis equips businesses with the
ability to discern how different costs, encompassing both fixed and variable
expenses, influence their financial performance.
COST PLANNING STRATEGIES
● Cost Control Mechanisms: Implement cost control mechanisms to align
expenses with revenue objectives. This can help to improve profitability.
● Cost-Benefit Analysis: Conduct regular cost-benefit analyses to assess the
impact of cost reductions or investments on profitability. This can help to
make informed decisions about resource allocation.
● Contingency Planning: Establish contingency plans for cost fluctuations
The column labeled Scenario 1 shows that increasing the price by 10 percent will
and unexpected financial challenges to maintain financial stability. This
increase profit 87.5 percent ($17,500). Thus, profit is highly sensitive to changes
can help to mitigate risks and protect profits.
in sales price. Another way to look at this is that for every one percent increase
Formula for Break-Even Point in sales price, profit will increase by 8.75 percent, or for every one percent
decrease in sales price, profit will decrease by 8.75 percent
Break-Even Point (BEP) = Fixed Costs / (Selling Price per Unit - Variable Cost
per Unit) The column labeled Scenario 2 shows that decreasing sales volume 10 percent
will decrease profit 35 percent ($7,000). Thus, profit is also highly sensitive to
● Fixed costs are costs that remain the same regardless of how many units changes in sales volume. Stated another way, every one percent decrease in
are produced or sold. Examples of fixed costs include rent, salaries, and sales volume will decrease profit by 3.5 percent; or every one percent increase
insurance. in sales volume will increase profit by 3.5 percent.
● Variable costs are costs that change depending on how many units are When comparing Scenario 1 with Scenario 2, we see that Snowboard Company’s
produced or sold. Examples of variable costs include the cost of raw profit is more sensitive to changes in sales price than to changes in sales volume,
materials and direct labor. although changes in either will significantly affect profit.
Example: The column labeled Scenario 3 shows that decreasing fixed costs by 30 percent
and increasing variable cost by 10 percent will increase profit 22.5 percent
A small business that sells handmade jewelry has fixed costs of 560,000 PHP per
($4,500).
month and variable costs of 280 PHP per unit sold. The business sells its jewelry
for 1,120 PHP per unit. Expanding the Use of Sensitivity Analysis
Break-Even Point (BEP) = Fixed Costs / (Selling Price per Unit - Variable Cost per Although the focus of sensitivity analysis is typically on how changes in variables
Unit) = 560,000 PHP / (1,120 PHP - 280 PHP) = 667 units will affect profit (as shown in Figure 6.6 "Sensitivity Analysis for Snowboard
Company"), accountants also use sensitivity analysis to determine the impact of
Using the break-even point formula, we can calculate that the business needs to
changes in variables on the break-even point and target profit. How is sensitivity
sell 667 units per month to break even.
analysis used to evaluate the impact changes in variables will have on break-
4.5 Sensitivity Analysis of CVP Results even and target profit points?

Sensitivity analysis shows how the CVP model will change with changes in any Let’s look at an example for Snowboard Company. Assume the company is able
of its variables (e.g., changes in fixed costs, variable costs, sales price, or sales to charge $275 per unit, instead of $250 per unit. How many units must
mix). The focus is typically on how changes in variables will alter profit. Snowboard Company sell to break even? The following calculation is based on
the shortcut formula presented earlier in the chapter:
Sensitivity Analysis: An Example
To illustrate sensitivity analysis, let’s go to Snowboard Company, a company that
produces one snowboard model. The assumptions for Snowboard were as
follows:
Sales price per unit $ 250
How would this same increase in sales price change the required number of
Variable cost per unit $ 150 units sold to achieve a profit of $30,000? We apply the same shortcut formula:
Fixed costs per month $ 50,000 Scenario Analysis Monte Carlo
Target profit $ 30,000 Real-Life Applications and Case Studies
Recall from earlier calculations that the break-even point is 500 units, and
Snowboard must sell 800 units to achieve a target profit of $30,000.
Management believes a goal of 800 units is overly optimistic and settles on a
best guess of 700 units in monthly sales. This is called the “base case.” The base
case is summarized as follows in contribution margin income statement format

COST ACCOUNTING CYCLE

Although management believes the base case is reasonably accurate, it is

concerned about what will happen if certain variables change. As a result, you
are asked to address the following questions from management (you are now
performing sensitivity analysis!). Each scenario is independent of the others.
Unless told otherwise, assume that the variables used in the base case remain
the same. How do you answer the following questions for management?
1. How will profit change if the sales price increases by $25 per unit (10
percent)?
 ▪ Materials that cannot be readily identified with any particular
manufactured are called INDIRECT MATERIAL.

2. DIRECT LABOR: is the total cost of wages, payroll taxes, payroll benefits,
and similar expenses for the individuals who work directly on
manufacturing a particular product.

▪ The wages and salaries of employees who are required for the
manufacturing process but do not work directly on the units being
manufactured are considered INDIRECT LABOR.

3. FACTORY OVERHEAD: is the cost incurred during the manufacturing

The Cost Accounting Cycle is a sequence of activities that describes the process, not including the costs of direct labor and direct materials.
preparation and analysis of financial data. It ensures that financial information
for use by investors, creditors, management, and other interested parties are ▪ Examples: Depreciation of equipment and factory facilities. Rent,
accurate and timely. property taxes, insurance, and utilities.
Parts of Cost of Goods Sold Statement
MANUFACTURING CASH FLOW
Manufacturing Inventory Accounts
❑ It describes how cash enters and leaves a company for the period. It
⮚ It is a tool that companies can use to help manage the finances and
includes product costing, inventory valuation, and financial report
inventory of a manufacturing company. This account can track depends on the defined, structured flow of manufacturing cost.
production costs, materials used, and inventory levels. Manufacturing
accounts can also help businesses manage their cash flow and budget for THE MANUFACTURING STATEMENT
future production.
❑ Also called the schedule of cost of goods manufactured or the schedule
⮚ Manufacturing companies have three inventory accounts: raw materials
of manufacturing activities, is a summary of all of the manufacturing
inventory, work-in-process inventory and finished goods inventory.
activities and costs.
RAW MATERIALS INVENTORY
❑ Financial statements of manufacturing companies differ from those of
✔ Raw materials inventory refers to the materials that are used to create a merchandising companies. Depending on the industry, the account titles
business's finished goods. While raw material inventory is not sold to end found on the balance sheet are the same in most corporations.
customers as-is, a company keeps raw materials in stock so that they can
turn them into work-in-process (or WIP) inventory or finished goods ❑ Examples: Cash, Accounts Receivable, Buildings, Machinery, Accounts
inventory. Payable
WORK-IN-PROCESS INVENTORY STATEMENT OF COST OF GOODS MANUFACTURED AND SOLD

✔ Work in process (WIP) inventory refers to materials that are waiting to ❖ Cost of Goods Manufactured (COGM) is the total cost of making
be assembled and sold. WIP inventory includes the cost of raw materials, products for sale. COGM does not include marketing or distribution costs
labor, and overhead costs needed to manufacture a finished product. — it only includes direct labor, materials, and factory overhead costs
associated with producing finished goods inventory.
✔ Also refers to the intermediary stage of inventory in which inventory has
started its progress from the beginning as raw materials and is currently ❖ The Cost of Goods Sold (COGS) is the actual expenses related to
undergoing development or assembly into the final product. producing those products.
FINISHED GOODS INVENTORY PREPARATION OF FINANCIAL STATEMENT

✔ Finished goods inventory is the total number of manufactured products WHAT IS FINANCIAL STATEMENT?
that are available, in stock, and ready for purchase by vendors, retailers,
✔ This is written records that convey the business activities and the
and consumers. With that said, finished products are often a relative
concept, since a seller's goods may actually become another buyer's raw financial performance of a company. Financial statements are often
materials inventory. audited by government agencies, accountants, firms, etc. to ensure
accuracy and for tax, financing, or investing purposes.
Preparation of Cost of Goods Sold Statement
✔ The three main types of financial statements are the balance sheet, the
The cost of goods sold is computed as follows:
income statement, and the cash flow statement. These three statements
together show the assets and liabilities of a business, its revenues and
costs, as well as its cash flows from operating, investing, and financing
activities.

BALANCE SHEET

❑ a statement of the assets, liabilities, and capital of a business or other

organization at a particular point in time, detailing the balance of income
and expenditure over the preceding period.
Manufacturing or production costs are classified into three basic
INCOME STATEMENTS
elements:

1. DIRECT MATERIALS: are the costs of those materials that can be directly ❑ An income statement is a financial statement that shows you the
traced to the manufacturing of the product and which can be readily company's income and expenditures. It also shows whether a company is
identified with a certain product. making profit or loss for a given period.

CASH FLOW STATEMENT

 Depreciation for the portion of the building used for factory operations
❑ is a financial statement that shows how cash entered and exited a
750,000 x 6% x 1/12 x 9/10; for the portion used by the office= 750,000 x 6% x
company during an accounting period. Cash coming in and out of a
1/12 x 10
business is referred to as cash flows, and accountants use these
statements to record, track, and report these transactions. 6. Depreciation expense for machinery and equipment is 20% per year. All
machinery and equipment is used in the factory for production purposes, so the
REMEMBER: The income statement, along with balance sheet and cash flow
depreciation expense is charged for Factory Overhead Control.
statement, helps you understand the financial health of your business. These
three statements are informative tools that traders can use to analyze a Factory Overhead Control 2,500
company‘s financial strength and provide a quick picture of a company's
Accumulated Depreciation – Machine & Equipment
financial health and underlying value.
2,500
ILLUSTRATION OF COST ACCOUNTING CYCLE:
7. The cost of heat, light, and power for the month was P 3,000.
The Noel Products Company is a small, newly organized company that
Factory Overhead Control 2,700
manufactures dining tables and chairs. The company’s products are sold to
jobbers or wholesale distributors, who in turn sell them to retailers. The basic Selling and Administrative Control 300
steps in the company’s manufacturing process are as follows:
Accounts Payable 3,000
1. Lumber is cut size for table tops, legs, seats, arms and backs.
8. Miscellaneous expenses for telephone, office supplies, travel, and rental of
2. The individual pieces of cut lumber are painted in various bright colors.
office furniture and equipment totaled P 1,500.
3. The pieces are assembled into tables and chairs.
Selling and Administrative Expense Control 1,500

Accounts Payable 1,500

After posting the journal entries to the appropriate ledger accounts, the
factory overhead Account will reflect the following debits.

TRANSACTIONS:

1. Materials (lumber, paint, screws, lubricants, and solvents) are purchased on

account at a cost of P 50,000.

Materials 50,000 9. Factory overhead is charged to production at 85%of direct labor cost.

Accounts Payable 50,000 Work in Process 17,000

2. During the month, direct materials, (lumber and paint) costing P 40,000 and Factory Overhead Applied 17,000
indirect materials (screws, lubricants for machines, and solvents for cleaning)
costing P 1,900 are issued to the factory. The three elements of manufacturing cost of direct materials, direct labor, and
factory overhead are now accumulated in Work in Process, and the debits in
Work in Process 40,000 the account are as follows:

Factory Overhead 1,900

Materials 41,900

3. Total payroll for the month amounted to P 36,000, consisting P 20,000 earned
by laborers working on the product; P 7,000 for factory supervision; P 9,000 for 10. Assuming that all goods started in process have been finished, the following
sales and administrative employees. The entry to record the payroll and the entry is recorded:
payment to employees (ignoring payroll deduction) would be:
Finished Goods 77,000

Work in Process 77,000

Payroll 36,000
Assuming that 1,000 tables were produced during the month, the unit cost is P
Accrued Payroll 36,000 77.00. The unit cost for each element of manufacturing cost is calculated as
follows:
Accrued Payroll 36,000

Cash 36,000

4. The entry to record the distribution or classification of the payroll would be

Work in Process 20,000 After considering the anticipated selling and administrative expenses, a selling
Factory overhead 7,000 can be established that should provide a reasonable profit. If management
determines that a 400 gross profit percentage is necessary to cover the
Selling and Administrative Expense Control 9,000 product’s share of selling and administrative expenses and earn a satisfactory
Payroll 36,000 profit, the selling price per unit, rounded to the nearest cent, would be
computed as follows:
5. Depreciation expense for the building is 6% per year. The office occupies one-
tenth of the total building, and the factory operation is in the other nine-tenths. Manufacturing cost P 77.00

Factory Overhead Control 3,375 Gross profit (40%) 30.80

Selling and Administrative Expense Control 375 Selling Price P 107.80

Accumulated Depreciation – Building 3,750 11. Costs of materials, utilities, and selling and administrative expenses paid
amounted to P 34,000.
 Accounts Payable 34,000

Cash 34,000

12. 800 tables are sold to jobbers at a net price of P 86,240

Accounts Receivable 86,240

Sales 86,240

Cost of Goods Sold 61,600

Finished Goods 61,600

13. Cash totaling P 55,000 is collected on accounts receivable.

Cash 55,000

Accounts Receivable 55,000

After considering the anticipated selling and administrative expenses, a selling

can be established that should provide a reasonable profit. If management
determines that a 400 gross profit percentage is necessary to cover the
product’s share of selling and administrative expenses and earn a satisfactory
profit, the selling price per unit, rounded to the nearest cent, would be
computed as follows:

Manufacturing cost P 77.00

Gross profit (40%) 30.80

Selling Price P 107.80

11. Costs of materials, utilities, and selling and administrative expenses paid
amounted to P 34,000.

Accounts Payable 34,000

Cash 34,000

12. 800 tables are sold to jobbers at a net price of P 86,240

Accounts Receivable 86,240

Sales 86,240

Cost of Goods Sold 61,600

Finished Goods 61,600

13. Cash totaling P 55,000 is collected on accounts receivable.

Cash 55,000

Accounts Receivable 55,000

The accounts in the general ledger will reflect the entries as follows:
 ▪ Psychological Value refers to the many ways that a product creates and
need satisfaction for the customer

▪ 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).

▪ Total economic value is the maximum price that a smart shopper fully
informed about the market and seeking the best value would pay.
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 for pricing decisions because it lacks the detail and quantification
needed to shape strategy.

▪ In this section, we describe:

MODULE 6: ECONOMIC VALUE ● techniques that can be used to develop quantified estimates of customer
value that, in turn, can be used to help set more profitable prices
ECONOMIC VALUE: THE GUIDING FORCE OF PRICING STRATEGY
● how to collect and analyze competitive reference prices.
▪ Economic value is a measure of benefits derived from a product or
● two approaches for quantifying monetary and psychological value
service. In free markets, it is the highest price a consumer is willing to pay
for a particular product or service. COMPETITIVE REFERENCE PRICES
Conceptually, identifying the next-best competitive alternative is simply
▪ Understanding the values that different combinations of features and
the answer to, "If I, the seller, did not exist, what would my customer do?" Yet
services could create for customers, and how the best combination might the work of identifying the next-best competitive alternative and gathering
differ for different segments for customers, is essential for creating offers accurate reference prices offers a number of challenges that often trip up
that will enable a company to grow profitably. pricing strategists.

▪ Creating a profitable marketing strategy likewise requires understanding IDENTIFYING COMPETITIVE ALTERNATIVE
not only the value created, but also what causes customers perceptions
of the value to be aligned or misaligned with reality. ▪ In some cases, marketers may have a myopic view of their markets.
One of the authors recalls the first consulting project he served on where
▪ Marketing can influence customers brand choices not only by changing the client, a manufacturer of uniforms, thought they had an 85 percent
the actual value offered relative to price, but also by changing the context market share.
from which customers perceive the value created and the fairness of the
price. ▪ However, rudimentary market research quickly revealed that
customers considered competitive offerings not just from other uniform
▪ Strategic pricing involves creating differentiated offers that represent manufacturers, but anyone who sold clothing such as department stores
“good value” to customers, freezing willingness-to-pay via value and discounters. Consequently, when viewed against this larger backdrop
communication, creating price structures that reflect the differences in of potential uniform vendors, we found that the client only had a 35
value to different users, and adapting pricing policies that lead customers percent share of the market and they were shocked to learn that they
to make purchase choices based upon value. were missing many more sales opportunities than they had originally
thought.
THE ROLE OF VALUE IN PRICING
▪ In other cases, there may not be just one competing product; instead
customers might construct a basket of products and services as a viable
alternative.

▪ ESTABLISHING THE COMPETITIVE REFERENCE PRICE

• requires gathering accurate price data

• ensuring that it is comparable to the pricing for your product.
• ensure that competitive prices are measured in terms familiar to customers
in the segment (for example, price per pound, price per hour) and are stated in
THE ROLE OF VALUE IN PRICING the same units as your product.

▪ In common usage, the term “value” refers to the total savings or ▪ Customers are a valuable information resource. One of the more
satisfaction that the customer receives from the product. Economists effective ways to get competitive price information is to take advantage
refer to these as use value or the utility gained from the product. of the customers who call your customer service support line asking
whether you are willing to match a competitive price. It is very easy for
▪ The value that is key to developing effective pricing strategy is not use the customer service representative to ask a few simple questions-what
is the competitive brand or product and its price and record that
value, but is what economists call exchange value and we call economic
information. While the data will not be entirely accurate due to
value.
gamesmanship by customers, over time enough data accumulates to
offer a perspective on competitive price positions.
▪ Economic value comes in two forms: Monetary and Psychological
Estimating Monetary Value
▪ Monetary value represents the total cost savings or income
▪ After determining the competitive reference prices, the next step in
enhancements that a customer accrues as a result of purchasing a
product. value estimation is to gain a detailed understanding of customer value
 drivers and translate that understanding into quantified estimates that with a detailed assessment of the customer's business model to
can be used to sup- port pricing decisions. understand how our product contributes to the business customer's
ability to create value for its own customers and to reduce its operating
▪ The distinct characteristics of monetary and psychological value drivers costs.
require different approaches to quantify. As we noted earlier, monetary
value drivers are tied to the customer's financial outcomes via tangible ▪ 2. COLLECT SPECIFIC DATA TO DEVELOP QUANTIFIED ESTIMATES.
cost reductions or revenue increases. Since monetary value drivers are
already quantitative, monetary value can be estimated using qualitative - Once the mechanisms for value creation are understood in terms
research techniques that allow for a rich understanding of the customer's of the customer's business model, the next step is to collect specific data.
business model or personal finances. In contrast, the intangible nature of In-depth customer interviews are the best source of information. Very
psychological value drivers such as satisfaction, security, or brand value different from survey or even focus group methods, in- depth interviews
are not inherently quantifiable. Therefore, marketers often rely on probe the underlying economics of the customer's business model and
sophisticated quantitative techniques such as conjoint analysis to your product's prospective role in it. The goal is to develop value driver
quantify the worth of the various elements of a product offering. algorithms, the formulas and calculations that estimate the differentiated
monetary worth of each unit of product performance
STEPS IN QUANTIFYING MONETARY VALUE
▪ 3. SUM THE REFERENCE VALUE AND THE DIFFERENTIATION VALUE TO
▪ 1. UNDERSTAND HOW THE PRODUCT CATEGORY AFFECTS THE DETERMINE THE TOTAL MONETARY VALUE.
CUSTOMER'S COSTS AND REVENUES.
- There are several guidelines for estimating monetary value that
- In consumer markets, this is a relatively straightforward will enable you to simplify the process and avoid common errors.
exercise because end consumers usually have fewer monetary value
drivers for a given product category. Quantifying monetary value drivers ● First, consider only the value of the difference between your product and
in business markets is more challenging because of the complexity of the next-best competitive alternative (NBCA) product. The value of any
most business operations and the need to understand fully how a benefits that are the same as those delivered by the NBCA is already
product affects a customer's profitability. This complexity is why we start determined by competition and incorporated
● into the reference value. You can charge no ▪ Step 4: Create Primary and Secondary
more for it than the price of the NBCA Segments. This that combines what you've
product, regardless of its use value to the learned so far about how customer values
customer. differ and about your costs and constraints
in serving different customers. Also, your
● Second, measure the differentiation value
primary segmentation should account for
either as costs saved to achieve a particular your company's capabilities and constraints
level of benefit or as extra benefits achieved as well as customer needs. A primary value
for an identical cost. Don't add both; that's segmentation that recognizes such a
double counting. "strategic overlap" discriminates on what is
▪ Step 1: Determine Basic Segmentation
● Finally, do not assume that the percentage likely to be the most important
Criteria. The goal of any market differentiator among customers.
increase in value is simply proportional to
segmentation is to divide a market into
the percentage increase in the effectiveness
subgroups whose members have common ▪ Step 5. Create Detailed Segment
of your product. Although your part might
criteria that differentiate their buying
last twice as long as a competitor, it does Descriptions. Value-based segmentation
behaviors. Choosing appropriate
not follow that your value is only twice as variables can look fine to the price strategies
segmentation criteria starts with a
large but segment should be described in
descriptive profile of the total market to
everyday business terms so that salespeople
VALUE-BASED MARKET SEGMENTATION identify obvious segments and differences
and marketing communications planners
among them. In consumer markets basic
know what kind of customer each segment
▪ Market segmentation is one of the most demographics of age, gender and income
represents.
provide obvious discriminators. Enterprise
important tasks in marketing. Identifying
firm a graphic such as revenue, EXHIBIT 2.11 CHARACTERISTICS OF 3 PRINTER
and describing market subgroups in a way
homogeneous groups in puts for the basic CUSTOMER SEGMENTS
that guides marketing and sales decision-
analysis can include existing segmentation
making makes the marketing and pricing
studies industry databases government
process much more efficient and effective.
statistics and other secondary sources.
▪ At many companies, however, segmentation
▪ Step 2: Identifying Discriminating Value
strategy focuses on customers attributes
Drivers. Having preliminary Segmentations
that are not useful for pricing decisions
in hand, you identify those value drivers, the
creating customer groupings that do not
purchase motivators, that every the most
adequately describe differences in purchase
among segments but which have more or
motivations among customers and
less homogeneous levels within segments.
prospects or classify them in a way that is
This allows you to zero in on what's most
meaningful for making pricing decision.
important to each customer.
▪ Value-based market segmentation is a
▪ Step 3: Determine Your Operational
marketing strategy that categorizes
Constraints and Advantages.
customers into segments based on the
perceived value they receive from a product In this step, you examine where you have
or service. This approach recognizes that operational advantages. Which value drivers can
different customers may have varying you deliver more efficiently and at lower cost than
perceptions of value, and tailors marketing others? Also, which drivers are constrained by your ▪ Step 6: Develop Segments Metrics and
efforts and product offerings to meet the resources and operations? Experience, capital Fences. This is the next logical step in pricing
specific needs and preferences of each spending plans, personal capabilities and overall strategy and management, it's important to
segment. company strategy are among the inputs to the recognize that segmentation is not truly
step. You should also examine competitive useful until you develop the metrics of value
To conduct a value-based market
strength and weaknesses on key drivers as closely delivery to market segments and device
segmentation, a six-step process should be
as you can. With this data you can cross reference fences that encourage customers to accept
applied:
and compare list of customer needs serve and price policies for their segments. Fences are
unserved, the seller's advantages and resource those policies rules programs and structures
limitations and competitors’ abilities. that customers must follow to qualify for
the price discounts or rewards. For example,
minimum volume requirements time-based
membership requirements, bundled.
PRICE AND VALUE COMMUNICATION • But for other purchases, especially a high visible and high-cost brand in the
consumer products, psychological benefits market to assess relative value.
❑ Price and value communication is the such as comfort, appearance, pleasure,
strategic process through which businesses status health or personal fulfilment play a ✔ By managing a customer’s understanding of
convey information to potential customers critical role in customer choice. the relevant competitive alternatives, a
regarding the cost or price of their products • Value quantification should be a central part seller can significantly influence the
or services and the perceived value and of the message because the data calls customer’s willingness to pay.
benefits associated with those offerings. attention to any gaps between the 2. SWITCHING COST EFFECT
customer’s perception of the value and the
❑ Understanding the value of your products actual monetary value of the product.
✔ Buyers are less sensitive to the price of a
created for customers can still result in poor
sales unless customers recognize the value • For Psychological benefits the value product as the added costs (both monetary
they are obtaining. messaging will focus on how a product will and non-monetary) of switching supplier
make the customer feel. rises.
❑ A successful pricing strategy must justify the LOW-INVOLVEMENT, PSCHOLOGICAL BENEFITS
✔ The reason for this effect is that many
prices charged in terms of the value of the
benefits provided. ❖ Low-involvement goods whose benefits are products required that the buyer make
products specific investment to use them.
mostly psychological include many
❑ Developing price and value communications consumer-packaged goods, cosmetics, or
✔ The greater the product-specific investment
is one of the most challenging tasks for apparel.
marketers because of the wide variety of that a buyer must take to switch suppliers,
product types and communication vehicles. ❖ Many of these products are sufficiently low the less price sensitive that buyer is when
choosing between alternatives.
The Role of Price and Value Communication in cost that consumers do not find it
worthwhile to conduct extensive research 3. DIFFICULT COMPARISON EFFECT
The role of value and price communications, prior to making a purchase.
therefore is to convey your value proposition in a ✔ The concept of economic value assumes
compelling manner to accomplish three goals: ❖ For products of this nature the role of value
that customers can actually compare what
communication will focus on the psychology the alternative suppliers have to offer. In
✔ Enable customers to fully understand the it'll benefits as well as creating offers that fact, it is often quite difficult to determine
benefits; make it is here to try out a product. the true attributes of a product or service
LOW-INVOLVEMENT, PSCHOLOGICAL BENEFITS prior to purchase.
✔ Improve their willingness-to-pay;
❖ Many low involvements can have benefits ✔ Buyers are less sensitive to the price of a
✔ Increase the likelihood of purchase. known or reputable supplier when they
that are predominantly economic
have difficulty comparing alternatives.
VALUE COMMUNICATION
❖ For example, GE’s energy efficient light
✔ Rather than attempting to find the best
✔ Value communication can have a great bulbs.
value in the market and risk of poor value in
effect on sales and price realization when HIGH INVOLVEMENT, PSYCHOLOGICAL BENEFITS the process, many purchasers simply settle
your product or services creates value that for what they are confident will be a
is not otherwise obvious to potential ❖ A product that falls into the high satisfactory purchase.
buyers.
involvement psychological benefit would be 4. END-BENEFIT EFFECT
the purchase of the weight loss program.
✔ The less experience a customer has in a
market or the more innovative a product’s ✔ The importance of the end result is a critical
❖ Engaging in such a program is usually the
benefits, the more likely it is that customer driver of the end-benefit effect. The greater
outcome of a careful personal decision and
will not recognize nor fully appreciate the the risk and the higher the cost of failure,
requires the evaluation of many competing
value of a product or a service.
offer such as gym membership, dietary the more salient this effect becomes.
supplements, and pre-packed meal
✔ A buyer’s perceptions of value are shaped 5. PRICE-QUALITY EFFECT
programs.
by the way information is conveyed.
HIGH INVOLVEMENT, ECOCNOMIC BENEFITS ✔ Generally, price represents nothing more
ADAPTING THE MESSAGE FOR PRODUCT
than the money a buyer must give to the
CHARACTERISTICS ❖ High involvement products that deliver
seller as part of the purchase agreement.
primarily economic benefits include services For a few products, however, the price
• The first step in developing a value message
such as management consulting & university means much more and the old adage, “you
is determining which customer perceptions
education, as well as products such as get what you pay for” has special resonance.
to influence. We start with an
airplane engines and surgical devices.
understanding of the value drivers that are
6. EXPENDITURE EFFECT
deemed most important to a customer
segment. The goal is to help the customer ❖ A key decision criterion in the purchase of
recognize the linkage between a products these products is relative economic benefit ✔ The expenditure effect states that buyers
most important differentiated features and in the form of labor efficiency future are more price sensitive when the
the salient value drivers. earnings potential fewer servings or expenditure is larger, either in dollar terms
treatment costs. or as a percentage of available budget.
The two dimensions that frame a communication
strategy are: MOST COMMON EFFECTS AND THEIR INFLUENCE
✔ The effect of the expenditure size on price
ON A BUYER’S PERCEPTION OF VALUE AND THEIR
i. The type of value delivered Economic sensitivity is confounded in consumer
CONSEQUENT SENSITIVITY TO PRICE markets by the effect of income.
or Psychological
ii. The degree of buyer’s environment. 1. COMPETITIVE REFERENCE EFFECT
✔ The relationship between a buyer’s price
• Understanding the type of value sought has ✔ True value is what is perceived by sensitivity and the percentage of income
a significant implication for the consumers who are fully informed of devoted to the product results from the
communication strategy. Measurable alternatives, understand the benefits of trade-offs buyers must make between
monetary benefits such as profit, cost differentiation, and act in rational ways. conserving their limited income and
savings, or productivity motivate many conserving the limited time they have to
purchases and translate directly into shop.
✔ One of the most common shortcuts is to
quantified value differences among
competing offers. find a competitive reference product, often 7. SHARED-COST EFFECT
 they’re looking for a solution. Information is Segmentation is much more challenging for
✔ The short quotes effect is a fundamental
not only gathered about stuff and on things pricing than for other aspects of marketing
design principle built into the federal tax
but from people via recommendations and because customers to whom you intend I to charge
code. It should also be noted that sharing
through previous experiences we may have a higher price have a strong incentive to
the cost does not always lead to greater
had with various products. undermine it. Channeling strategy by buying
demand.
intermediaries too can undermine a segmented
3. Evaluation of alternatives
8. TRANSACTION VALUE EFFECT pricing by buying the product intended for delivery
to customers entitled lower price but then actually
⮚ Customers want to be sure they’ve done
✔ Transaction value suggests that buyers are diverting it for resale to customers targeted to
thorough research prior to making a receive a higher price. Commonly referred to as
motivated by more than just the
purchase, because of this, even though they gray-market sales, they create a huge challenge for
“acquisition utility” associated with
may be sure of what they want, they’ll still companies serving international markets because
obtaining and using a product. They are also
want to compare other options to ensure distributors in countries where prices are lower
motivated by the “transaction utility”
their decision is the right one. cross ship products to ones where prices are
associated with the difference between the
price paid and what buyer considers a higher.
⮚ This is the time when questions start being
reasonable or fair offer for the product. Gray-market diversions by channel
asked. Is this really the right product for me
do? Do I need a different product? intermediaries can undermine not only different
✔ Transaction utility is framed by the pricing by region but also by application.
difference between the actual price paid 4. PURCHASE DECISION
and the reference price which is the amount In markets where sales are made directly,
that they would consider reasonable or fair. ⮚ At this point, the customer has explored without a channel intermediary, it is easier to
charge different prices to different customers.
multiple options, they understand pricing
9. FAIRNESS EFFECT Recognize the huge potential for profit
and payment options and they are deciding
improvement from aligning price with value, many
whether to move forward with the purchase
✔ The form of a price change can have companies adopt flexible pricing policies,
or not.
significant impact on perceptions of empowering sales reps and sales management to
fairness. The elimination of a discount is 5. Purchase discount prices for customers.
viewed as a fair way to raise prices in cases
⮚ The customer has now decided based on the Flexible pricing can work in markets where
where demand has risen.
customers buy a complex product or service very
knowledge gathered what to purchase and
infrequently, such as when they are purchasing
✔ Fairness is often framed by the shadow of where to purchase what they desire.
funeral services for a recently departed relative or
the future for one-time transactions
6. POST-PURCHASE EVALUATION a business hires a law firm to defend it against a
consumer tend to be more willing to accept
novel civil suit. Staying flexible in negotiating
market rate pricing. However, when they
⮚ After a purchase is made, it’s inevitable that customer-specific prices in this way can improve
anticipate future interactions with the seller
the customer must decide whether they are both revenue and profitability when selling to
the norms of fairness are applied more
satisfied with the decision that was made or uninformed buyers. The problem arises because
rigorously
not – they are in a process of evaluation buyers, especially those who are professional
THE CONSUMER’s BUYING PROCESS that could have consequences for your purchasing agents, learn over time how to
business such as repeat purchases or manipulate a sellers flexible pricing policy and will
reviews. do so aggressively to gain competitive advantage,
or to avoid being put at a disadvantage. Flexible
MODULE 8: PRICE STRUCTURE pricing in this case undermines rather than
reinforces profitability.
A price structure is a system that a company
uses to set the prices of its products or services. It OFFER CONFIGURATIONS
is a way of organizing and presenting prices to
customers in a clear and consistent manner. A When differences in the value of an offer
good price structure should be aligned with the across segments is caused by differences in the
company's overall pricing strategy and business features and services that customers need or
goals. value, a seller can segment the market by
configuring different offers consisting of different
A pricing structure prices products and bundles of features and services for different
services so that it makes sense to customers and segments. To create an effective bundled offer
gets them to buy. For instance, you might offer a structure, one must first determine which features
discount when customers buy more than one and services the firm should include in bundles,
product. rather that pricing each element à la carte and
leaving customers to customize their own offers.
THE CONSUMER’s BUYING PROCESS 8.1 TACTICS FOR PRICING DIFFERENTLY ACROSS
CUSTOMER SEGMENTS
1. Problem Recognition ✔ Optimizing the Structure of Offer Bundles
After developing products or services that
⮚ The first stage of the process is working out create value and making customers aware of it, a Creating bundles is simple when customers
marketer must determine how most profitably to targeted for higher prices value some feature, like
what exactly you or the customer needs.
capture a share of that value in both volume and the ability to make changes in an airline ticket,
The customer feels like something is missing
margin. which other customers do not. By including that
and needs to address it to get back to
feature only in the higher-priced bundle, high-
feeling normal. If you can determine when To illustrates the huge benefits of a well- value customers (e.g., business travelers with
your target demographic develops these defined segmented price structure, suppose that a schedules subject to change) choose to pay the
needs or wants. supplier faced five different segments, all willing to higher fare. Sometimes value-adds can be used, to
2. Information Search pay a different price to get the benefits they attract the lower-value customer.
sought from a product (see Exhibit 4-1).
⮚ This is the search stage of the process. Here ✔ Designing Segment-Specific Bundles
CHALLENGES THAT CAN UNDERMINE SEGMENTED
the customer knows there is an issue and PRICING
Bundling can also facilitate segmented pricing, thus insurance, any potential new price metric also A very common challenge for a company
increasing profitability, when different customer needs to pass muster with regulators and legal that sells capital goods is that the value of owning
segments have different price sensitivity for a core requirements. them can vary widely across segments based upon
product or service (for example, lodging at a ho intensely they are used.
popular vacation spot). When it is possible to find ✔ Performance-Based Metrics
Value-Based Pricing Finances Hamlet's Castle
features or services that one segment values highly
and another does not, it is easy to design segment- An ideal price metric would tie what the The seeds of value-based pricing were
specific pricing by bundling. Bundling a "free" or customer pays for a product or service directly to planted centuries ago with the nearest
low-cost service or feature specifically preferred by the economic value received and the incremental documented use of value-based pricing metrics to
this segment, however, can improve the value cost to serve. In a few cases, called performance- improve profitability. The use occurred in the 15th
proposition for that segment without having to cut based pricing, price structures can actually work century when Erik of Pomerania, King of the
the offer price explicitly. that way. Most importantly, performance-based United Kingdom of Scandinavia, summoned to
pricing has the effect of shifting the performance Copenhagen a group of merchants from the
✔ Unbundling Strategically risk from the buyer to the seller. powerful German Hanseatic League, which at the
Ex. General Electric (GE) used bundling to time dominated nearly all trade in northern
While bundling can be a profit-enhancing
reduce risk when it launched a new series of highly Europe. He informed them henceforth, he
strategy for segmentation, it often has the
efficient air- craft engines, its GE90 series. intended to levy a new toll: Every ship wishing to
opposite effect when variable cost services are
bundled simply to differentiate an offering. In many cases, however, performance- sail past Elsinore, whether on its way out of or into
based pricing is simply impractical. It requires too the Baltic, would have to dip its flag, strike its
Companies can unbundle the price structure topsails, and cast anchor so that the captain might
much information and too much trust that the
without upsetting customers who have come to go ashore to pay the customs officer in the town a
buyer will actually report the information
expect a costly service as part of the package by toll of "one English noble.“ Erik foresaw that if he
accurately. It also leaves the buyer uncertain
including it in the price but offering rebates for also established a proper town at Elsinore, sea
regarding the cost of a purchase until after it is
forgoing its use. captains, after paying their toll and then waiting for
used.
PRICE METRICS a favorable wind, would welcome an opportunity
Evolution of the Price Metric for Mobile Video to replenish stocks of water, wine, meat,
Not all differences in value across Segments Games vegetables, and whatever else they needed. Erik of
reflect differences in the features or services Pomerania's toll of one English noble per ship had
For several decades, video games were
desired. Value received is sometimes not even long been regarded by skippers and ship owners as
largely published for three mediums: Personal
related to differences in the quantity of the grossly unfair. After all, ships were of so many
computers, TV-based gaming consoles, and
product consumed necessitating a price structure different sizes, carried so many different cargoes,
portable gaming consoles. The established
shat involves earning revenues unrelated to the and according to nationality, had various interests
consumer price metric for the industry was price
quantity of the product or service provided. and affiliations. The system had also been proving
per video game title. Although the price-per-title
Price metrics are the units to which the metric served to recover development costs, it was increasingly disadvantageous from the Danish
price is applied. They define the terms of exchange far from optimal. It didn't align with how a user king's point of view.
what exactly the buyer will receive per unit of price might experience value when playing the game, PRICE FENCES
paid. There are often a range of possible options. and it didn’t really track with cost to serve. It also
did not lend itself to discounting to induce product Price fences are fixed criteria that customers
The problem with most price metrics is that they must meet to qualify for a lower price. Price fences
trial.
are adopted by default or tradition. For example, are the least complicated way to charge different
initially, software companies charged a price per The success of the Apple and Android prices to reflect different levels of value.
copy Installed on one server machine. A few smartphones beginning in the mid-2000s created a
creative vendors recognized that when more users relatively huge new market for games. The ✔ Buyer identification Fences
accessed the software, the buyer was getting more fundamental problem that the price metric didn't
value. track well with how buyers experienced value Occasionally pricing goods and services at
remained. Fortunately, two other evolutions in different levels across segments is easy because
✔ Creating Good Price Metrics technology opened opportunities for customers have obvious characteristics that sellers
improvement. Access to cheap, high-speed can use to identify them. Rarely is identification of
There are five criteria for determining the most internet ultimately became ubiquitous in most customers in different segments straightforward.
profitable price metrics for an offering developed markets. Publishers of popular, Yet, management can sometimes structure price
technically sophisticated, but previously expensive discounts that induce the most price-sensitive
game titles soon realized that it was possible to buyers to volunteer the information necessary to
compete with less sophisticated free titles by identify them. Deal proneness is another form of
transforming the price structure of games to a self-induced buyer identification- especially
“Freemium “in which it is free for the end-user to through the use of coupons and sales promotions,
download a game, and then pay for value delivered a frequent tool of consumer marketers.
within the game.
✔ Purchase Location Fences
Three broad categories of virtual products offered
within a game: When customers who perceive different values buy
1. Consumables help a player to continue playing a at different locations can be segmented by
game or to ascend to the next level in the game purchase location. This is common practice for a
without the effort of earning it. range of products.

In some cases, it is not possible to achieve all of 2. Durables are in-app purchases that help a player ✔ Time-of-Purchase Fences
these criteria with one metric. but they can be to succeed in the game but do not get consumed.
achieved with a multi-part metric. When customers in different market
3. Personalization enables the user experience to
segments purchase at different times, one can
It should also be noted that, depending on be customized
segment them for pricing by time of purchase.
the context, the criteria outlined above may need
Priority pricing is one example of segmenting by
to be modified or added to. For example, in highly ✔ Tie-ins As Metrics
time of purchase. Innovative new retail products
regulated markets such as utilities, health care, or
are offered at full price, or even at a premium.
Priority pricing also applies in business-to-business Three tasks required for effective yield company sets its prices, taking into account the
purchases. This tactic is most successful in markets management. different factors that are important to the
with a combination of occasional buyers who are company and its customers.
• The first is to use one of the pricing tactics
relatively unfamiliar with the market, and with
described above to enable segmented Here are some examples of the difference
more regular buyers who know when the sales are
pricing based upon value to the purchaser. between pricing structure and pricing strategy:
and plan their purchases accordingly. Time is also a
useful fence when demand varies significantly with • Second, because one must generally set the • A company may have a pricing strategy of
the time of purchase but the product or service is price level by segment before potential being a premium brand, but it may have
not storable. customers reveal their demand, yield different pricing structures for different
management requires a means to forecast products or services. For example, it may
✔ Purchase Quantity Fences changes in demand by segment over time. charge a higher price for its luxury products
than for its more basic products.
When customers in different segments buy • Third, yield management involves
different quantities, one can some- times segment estimating demand price elasticity by • A company may have a pricing strategy of
them for pricing with quantity discounts. There are segment to determine which prices should being competitive, but it may have different
four types of quantity discount tactics: Volume be adjusted to optimize the balance pricing structures for different customer
discounts, order discounts, step discounts, and between margin and capacity utilization. segments. For example, it may offer a
two-part prices. discount to students or seniors.
8.2 PRICE STRUCTURE VS. PRICING STRATEGY
Peak Pricing and Yield Management 8.3 STEPS IN PRICING STRUCTURE
What’s the difference?
In industries where the product or service is How to set up a pricing structure?
A pricing strategy is not the same as a
not storable, a seller's current capacity imposes a
pricing structure. Step 1: Do your homework Before you
limit on the amount of demand that can be
tackle pricing, do your homework. Research
satisfied at any point in time, while any capacity Pricing structure
and understand your target customers, the
that is not sold when available is lost forever. This
◦ Involves your whole approach to competition, and the marketplace.
is a common problem for airlines, hotels, taxi
pricing across your company but with
fleets, and amusement parks. It is also a common Step 2: Define success metrics You’ve done
a specific emphasis on how your
problem for services from government such as the the research and set a pricing strategy
pricing relates to the features of your
capacity of roads and central city streets that aligned with your company’s positioning,
product being made available and
become Congested and impassable at peak times. which defines how your business is
how it affects customer use of your
The easiest solution to this problem involves simply presented to customers. Now decide how to
product.
raising price reactively, or peak pricing, whenever measure your sales.
supply is inadequate to meet the quantity Pricing strategy
Step 3: Find a base price Establish a base
demanded.
◦ Pricing strategy is the overarching price to build your pricing structure. The
The most challenging pricing problems occur approach used to set pricing for a base price is the foundation for pricing
is when a seller attempts to manage both the peak company's products and services. It decisions, even if the amount isn’t applied
demand problem and pricing across different defines the principles that guide the to all offerings.
segments simultaneously. In the distant past, most company's pricing decisions. The
Step 4: Develop pricing models This is the
sellers would attempt to manage one and simply pricing strategy should take into
culmination of the other steps. Using your
accept management of the other as a lost account a number of factors,
success metrics and base price, model how
opportunity. As the cost of computing power and including the company's costs, its
you see your business growing.
data management declined over recent decades, target market, and the competitive
companies with the most to gain began developing landscape. Step 5: Experiment to grow market share
a process called Yield Management to optimally and profit Despite your best efforts, you
The pricing structure is a way of implementing the
manage these two pricing problems won’t know how customers will respond to
pricing strategy. It is the specific way in which the
simultaneously. your pricing until you try them.