Chapter 13: Understanding Pricing

Name:

There are several different approaches that can be used to determine the price that should be charged for a product: (a) price derivation based on theoretical economic analysis, (b) cost-plus, and (c) the marketing approach. The price derivation method requires more information than simple exercises allow, so it has not been included in this set of questions.

Cost-Plus

Cost-plus pricing uses some base cost figure per unit or case to which is added a markup to cover unassigned costs and to provide a profit. Arriving at a price based on the cost-plus method involves two steps:

a) Base cost figure per unit x Desired markup percentage = Proposed Markup
b) Base cost figure per unit + proposed markup = Proposed Selling Price

For example, if the base cost is $20.00 per case, and the desired markup percentage is 25%, the proposed markup is $5.00. The proposed selling price is then $20.00 + $5.00 = $25.00.

Let us continue with the Ariadne skin cream project introduced in the Chapter 11 Marketing Math Questions.

You have decided to continue working with the Ariadne B version of your new product, the formula that provides a single, important U-V protection advantage versus competition. That decision was based on charging a price of $28.00 per case to retailers. However, you now you need to fine-tune your price decision and want to check out your full range of options starting with the cost-plus pricing approach. Calculate the following prices per case using the above cost-plus formula information.

If you assume a base cost figure per case of $18.00, Ariadne’s selling price per case with a 50% markup is __________.

If you assume a base cost figure per case of $18.00, Ariadne’s selling price per case with a 60% markup is __________.

If you assume a base cost figure per case of $18.00, Ariadne’s selling price per case with a 66% markup is __________.

The above calculations result in the price you would charge per case to the retailers you will deal with directly, not the unit retail price that they will charge consumers for the product on the shelf. To calculate the retail prices that consumers will pay at the store for your product, you must apply the cost-plus approach to your case selling price. First, divide the case price by the number of units in the case. Second, multiple this unit price by the markup that retailers typically charge in your product category. Third, add the markup and the case price per unit to get the estimated retail price.

If Ariadne is going to be packed 12 units per case and the retailers who will sell your product typically add a 50% markup to the price they pay for brands in this product category, the above case prices will result in the following retail prices:

Retail price resulting from a case price with a 50% markup: _________

Retail price resulting from a case price with a 60% markup: _________

Retail price resulting from a case price with a 66% markup: _________

Short Answer

The Marketing Approach

The marketing approach to pricing is based on taking into account not only costs, but the potential responses of various consumer segments and the likely reactions of individual competitors to the expected retail prices that will be charged for a product.

With Ariadne, suppose you conducted market research on the retail prices that will likely result from the case price options you set above in order to establish the potential responses of your target market to your product’s pricing. Suppose as well that you assessed the likely reactions of your two main competitors to each of these retail prices. Your findings were as follows:

Retail price resulting from a case price with a 50% markup:

· poor consumer response: price is lower than key competitor pricing in the category ($3.49 – $3.69) so product quality is suspect.
· immediate negative competitive response: price is low enough that it will be perceived as a threat; competitors will act to undermine the Ariadne launch through, for example, flooding the market with coupons.

Retail price resulting from a case price with a 60% markup:

· positive consumer response: the product has a clear performance advantage but is comparably priced to key competitors ($3.49 – $3.69).
· no competitive response expected with regard to price since the product is comparably priced to competition and thus does not represent a threat; competition will respond to the Ariadne launch using non-price means such as advertising.

Retail price resulting from a case price with a 66% markup

· positive initial consumer response: the product has a clear performance advantage which is supported by having a slightly higher price than the key competitors ($3.49 – $3.69).
· no immediate competitive response: competition will wait to see whether consumers respond positively to the premium price; if they do, competition may respond by increasing their own prices; in the meantime, competition will respond to the Ariadne launch using non-price means.

As a result of the above analysis, you decide that you can and should price your product so that it retails at the highest of the above three options.

Adjusting the Profit and Loss Statement

Revise your profit and loss estimate for Ariadne B assuming that you price it at the highest of the three options you investigated:

	Ariadne B Original Estimate	Ariadne B Revised Estimate
Estimated Total Annual Sales Volume (cases)	120,000	120,000
Estimated Price per case ($)	28.00	Your case estimate
Total Fixed Costs ($)	750,000	750,000
Average Variable Cost per case excl. product costs ($)	7.00	7.00
Average Variable Cost per case – product costs ($)	5.50	5.50
Total Average Variable Cost per case ($)	12.50	12.50

Record your revised profit and loss estimate for Ariadne B in the following chart:

	Ariadne B Original Estimate	Ariadne B Revised Estimate
Sales Revenue ($)	3,360,000
Total Fixed Costs ($)	750,000
Total Variable Costs ($)	1,500,000
Net Profit ($)	1,110,000
Profit Margin (%)	33.0

How much did fine-tuning Ariadne’s price improve its sales revenue line? How much did it improve its net profit?