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THE STRATEGY AND TACTICS OF PRICING QWerty On KAT For more Fifth Edition The Strategy and Tactics of Pricing A GUIDE TO GROWING MORE PROFITABLY Thomas T. Nagle Monitor Group John E. Hogan Monitor Group Joseph Zale Monitor Group Editorial Director: Sally Yagan Editor in Chief: Eric Svendsen Acquisitions Editor: James Heine AVP/Executive Editor: Melissa Sabella Director of Marketing: Patrice Lumumba Jones Marketing Manager: Anne Fahlgren Marketing Assistant: Melinda Jensen Project Manager: Renata Butera Operations Specialist: Renata Butera Creative Art Director: Jayne Conte Cover Designer: Margaret Kenselaar Full-Service Project Management: Nitin Agarwal Composition: Aptara®, Inc. Printer/Binder: Courier, Westford Cover Printer: Courier, Westford Text Font: Palatino Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate pages within text. Copyright © 2011, 2006, 2002, 1995, 1987 Pearson Education, Inc., publishing as Prentice Hall, One Lake Street, Upper Saddle River, New Jersey 07458. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Permissions Department, One Lake Street, Upper Saddle River, New Jersey 07458. Many of the designations by manufacturers and seller to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication Data Nagle, Thomas T. The strategy and tactics of pricing / Thomas T. Nagle, John E. Hogan, Joseph Zale.—5th ed. p. cm. ISBN-13: 978-0-13-610681-4 ISBN-10: 0-13-610681-1 1. Pricing. 2. Marketing—Decision making. I. Hogan, John E., Ph.D. II. Zale, Joseph. III. Title. HF5416.5.N34 2010 658.8’16—dc22 2009047553 10 9 8 7 6 5 4 3 2 1 ISBN 13: 978-0-13-610681-4 ISBN 10: 0-13-610681-1 BRIEF CONTENTS Chapter 1 Strategic Pricing Coordinating the Drivers of Profitability Chapter 2 Value Creation The Source of Pricing Advantage Chapter 3 Price Structure Tactics for Pricing Differently Across Segments Chapter 4 Price and Value Communication Strategies to Influence Willingness-to-Pay Chapter 5 Pricing Policy Managing Expectations to Improve Price Realization Chapter 6 Price Level Setting the Right Price for Sustainable Profit Chapter 7 Pricing Over the Product Life Cycle Adapting Strategy in an Evolving Market Chapter 8 Pricing Strategy Implementation Embedding Strategic Pricing in the Organization Chapter 9 Costs How Should They Affect Pricing Decisions? Chapter 10 Financial Analysis Pricing for Profit Chapter 11 Competition Managing Conflict Thoughtfully Chapter 12 Measurement of Price Sensitivity Research Techniques to Supplement Judgment Chapter 13 Ethics and the Law Understanding the Constraints on Pricing CONTENTS Preface Chapter 1 Strategic Pricing Coordinating the Drivers of Profitability Cost-Plus Pricing Customer-Driven Pricing Share-Driven Pricing What Is Strategic Pricing? Value Creation Price Structure Price and Value Communication Pricing Policy Price Level Implementing the Pricing Strategy Summary • Notes Chapter 2 Value Creation The Source of Pricing Advantage The Role of Value in Pricing How to Estimate Economic Value Competitive Reference Prices Estimating Monetary Value Monetary Value Estimation: An Illustration Estimating Psychological Value Psychological Value Estimation: An Illustration The High Cost of Shortcuts Value-Based Market Segmentation Step 1: Determine Basic Segmentation Criteria Step 2: Identify Discriminating Value Drivers Step 3: Determine Your Operational Constraints and Advantages Step 4: Create Primary and Secondary Segments Step 5: Create Detailed Segment Descriptions Step 6: Develop Segment Metrics and Fences Summary • Notes Chapter 3 Price Structure Tactics for Pricing Differently Across Segments Price-Offer Configuration Optimizing an Offer Bundle Designing Segment Specific Bundles Unbundling Strategically Price Metrics Creating Good Price Metrics Performance-Based Metrics Tie-Ins as Metrics Price Fences Buyer Identification Fences Purchase Location Fences Time of Purchase Fences Purchase Quantity Fences Summary • Notes Chapter 4 Price and Value Communication Strategies to Influence Willingness-to-Pay Value Communication Adapting the Message for Product Characteristics Adapting the Message to Purchase Context The Buying Process Multiple Participants in the Buying Process Price Communication Proportional Price Evaluations Reference Prices Perceived Fairness Gain–Loss Framing Summary• Notes Chapter 5 Pricing Policy Managing Expectations to Improve Price Realization Policy Development Policies for Responding to Price Objections The Problem with Ad Hoc Negotiation The Benefits of Policies for Price Negotiation Policies for Different Buyer Types Policies for Dealing with Power Buyers Policies for Managing Price Increases Policies for Leading an Industry-Wide Increase Policies for Transitioning from Low One-Off Pricing Policies for Dealing with an Economic Downturn Policies for Promotional Pricing Summary • Notes Chapter 6 Price Level Setting the Right Price for Sustainable Profit The Price-Setting Process Defining the Price Window Establishing an Initial Price Point Pricing Objectives Defining the Price-Volume Trade-off Estimating Consumer Response Communicate New Prices to the Market Summary • Notes Chapter 7 Pricing Over the Product Life Cycle Adapting Strategy in an Evolving Market New Products and the Product Life Cycle Pricing the Innovation for Market Introduction Communicating Value with Trial Promotions Communicating Value with Direct Sales Marketing Innovations Through Distribution Channels Pricing New Products for Growth Pricing within a Differentiated Product Strategy Pricing within a Cost Leadership Strategy Price Reductions in Growth Pricing the Established Product in Maturity Pricing a Product in Market Decline Alternative Strategies in Decline Summary • Notes Chapter 8 Pricing Strategy Implementation Embedding Strategic Pricing in the Organization Organization Organizational Structure Decision Rights Pricing Processes Motivation Customer Analytics Process Management Analytics Performance Measures and Incentives Managing the Change Process Senior Management Leadership Demonstration Projects Summary • Notes Chapter 9 Costs How Should They Affect Pricing Decisions? The Role of Costs in Pricing Determining Relevant Costs Why Incremental Costs? Why Avoidable Costs? Avoiding Misleading Accounting Estimating Relevant Costs Activity-Based Costing Percent Contribution Margin and Pricing Strategy Managing Costs in Transfer Pricing Summary • Notes Chapter 10 Financial Analysis Pricing for Profit Break-even Sales Analysis: The Basic Case Break-even Sales Incorporating a Change in Variable Costs Break-even Sales with Incremental Fixed Costs Break-even Sales Analysis for Reactive Pricing Calculating Potential Financial Implications Break-even Sales Curves Watching Your Baseline Covering Nonincremental Fixed and Sunk Costs Summary • Notes Appendix 10A Derivation of the Break-even Formula Appendix 10B Break-even Analysis of Price Changes Chapter 11 Competition Managing Conflict Thoughtfully Understanding the Pricing Game Competitive Advantage: The Only Sustainable Source of Profitability Reacting to Competition: Think Before You Act How Should You React? Managing Competitive Information Collect and Evaluate Information Selectively Communicate Information When Should You Compete on Price? Summary • Notes Chapter 12 Measurement of Price Sensitivity Research Techniques to Supplement Judgment Types of Measurement Procedures Uncontrolled Studies of Actual Purchases Experimentally Controlled Studies of Actual Purchases Uncontrolled Studies of Preferences and Intentions Experimentally Controlled Studies of Preferences and Intentions Using Measurement Techniques Appropriately Using Judgment for Better Measurement Using Internet-Based Techniques Outside Sources of Data Selecting the Appropriate Measurement Technique Summary • Notes Chapter 13 Ethics and the Law Understanding the Constraints on Pricing Ethical Constraints on Pricing The Legal Framework for Pricing The Effect of Sarbanes-Oxley on Pricing Practices Price-Fixing or Price Encouragement Horizontal Price-Fixing Resale Price-Fixing or Encouragement Vertical Price-Fixing Direct Dealing Programs Resale Price Encouragement Price and Promotional Discrimination Price Discrimination Defenses to Price Discrimination Promotional Discrimination Competitive Injury, Defenses, and Indirect Purchasers Using Nonprice Variables to Support Pricing Goals Vertical Nonprice Restrictions Nonprice Incentives Other Pricing Issues Predatory Pricing Price Signaling Summary • Notes Index PREFACE One purpose of this book is to change the common misperception that pricing is simply about calculating the “right” price for a product or transaction. In the years since the first edition was published in 1987, we have learned that pricing, if it is to be effective, cannot be so reactive and simplistic. Profitable pricing requires looking beneath the demand curve to understand and manage the monetary and psychological value that is a primary determinant of the purchase decision. Mastering the value proposition enables a firm (1) to segment prices to reflect differences in value and cost, (2) to communicate the value of offers to customers unfamiliar with the market, and (3) to create pricing policies for managing pricing issues fairly and consistently. In short, this book shows managers how to move from tactically “optimizing” prices in markets where they seemingly exercise little control to managing their markets strategically. When that happens, pricing becomes an integral part of a profitable growth strategy, rather than a blunt instrument to drive sales and market share. The principles of strategic pricing, which were foreign to most business practitioners more than two decades ago, are now more widely accepted in principle. But most companies still struggle with the application. The changes in this fifth edition of our book reflect our attempts to address this need: • A completely new chapter on “Pricing Strategy Implementation” identifies the challenges involved in embedding strategic pricing principles within an organization and describes how managers can lead a structured change process to build a commercial organization more consistently focused on value creation. • The revised chapter on “Pricing Policy” provides a theoretically grounded framework to describe specific policies for managing price changes for a variety of situations, including raw material cost increases, demand recessions, and new product launches. • The chapter on “Value Creation” for the first time addresses explicitly how to deal with value differently when it is driven by subjective psychological drivers (such as doing the right thing for the environment) rather than by tangible monetary drivers (for example, saving money on fuel). • The chapter on “Value and Price Communication” has been substantially revised to describe how to communicate value in a wide variety of product and customer contexts. It demonstrates how to target communications to affect specific behaviors throughout the customer’s buying process. • The chapter on “Price Setting” has been expanded to provide a robust process for setting prices that can be widely applied both to consumer and business markets. • Throughout the book, we have updated examples with more topical illustrations of current pricing challenges (such as iPhone pricing, new models for pricing music, and services pricing). To complement this edition, we also introduce software from LeveragePoint Innovations Inc. for creating and communicating economic value estimations systematically. The trial software can be accessed at http://demo.leveragepoint.com/strategyandtacticsofpricing. While versions of the software that enable sharing require corporate contracts for access, versions for individual student and practitioner use are available without charge for three months. This software puts theory into practice and allows the reader to explore real-world scenarios. ACKNOWLEDGMENTS Over the years, this book has benefited from the influence and efforts of individuals too numerous to mention here. Nevertheless, we would be remiss in not acknowledging a few whose contributions have been either very large or new to this edition. Professor Gerald Smith’s contributions to three prior editions of this book and the instructor’s manuals are still reflected in the current ones. Michael Goldberg of Monitor Group was a diligent researcher, copy editor, and administrator without whose incessant prodding this edition would still be “in process.” Georg Muller and Tony Seisfeld of Monitor Group and Paul Boni of Grail Research drew from their experience in pricing research to update our chapter on “Measurement of Price Sensitivity.” Eugene Zelek of Freeborn and Peters once again shared his knowledge of pricing and the law to keep that chapter current. We would also like to thank our colleagues at Monitor Group who, since the previous edition, have taught us the concept of the buying process and the importance of aligning interventions at the most appropriate point in it. Our administrative assistant, Vivi Camin, diligently sought reprint permissions and recreated versions of diagrams and tables. Last, but certainly not least, we want to thank our colleagues at Monitor Group for their indulgence while we closeted ourselves to complete this edition, and to thank our families, which we neglected and to whom we now hope to make amends. THE STRATEGY AND TACTICS OF PRICING
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