'Price Analytics' by Scandinavian Institute of Business Analtycs SCANBA
Illustrated script to an online course by Scandinavian Institute of Business Analytics SCANBA. SCANBA produced high quality, easy to understand, professional level course that is right for you, as a person interested in business education.
Published on: Mar 4, 2016
Transcripts - 'Price Analytics' by Scandinavian Institute of Business Analtycs SCANBA
online course script (without examples)
Scandinavian Institute of Business Analytics SCANBA
In this course, we will follow Lars and his company Lars
Coffee Mugs. Lars manufactures three lines of thermal
coffee mugs: high efficiency thermal coffee mugs, easy
grip coffee mugs, and compact eco mugs.
On behalf of Lars, we will study different pricing
techniques, pricing assessment methods, concept of
profitable pricing, and learn price discrimination.
In this section, we will walk through a series of pricing
techniques that Lars can potentially use:
Creaming Pricing, Demand-Based Pricing, Everyday Low
Pricing, Going Rate Pricing, Markup / Cost Plus Pricing,
Penetration Pricing, Prestige Pricing, Target-Return ,
Pricing, Tiered Pricing, Value-in-Use Pricing, Variant
In creaming pricing, we set prices high during the introduction of a
new product or service by targeting the top one to five percent of the
market. The “cream" of the market represents individuals who value
the product or service highly and show low sensitivity to price
Advantages: The high prices used in creaming pricing results in higher
initial revenue during the launch of the new product or service.
Companies use the revenue to offset the significant cost required to
develop new products and services.
Disadvantages: Creaming pricing only works if consumers cannot
purchase the same product or service from another company for less.
If competitors sell similar products and services, consumers will
purchase the lower-price versions instead, and the creaming pricing
technique will fail.
Demand-Based Pricing In demand-based pricing, we set prices to maximize profit, based on
consumer demand for the product or service. Economics tells us that
for most goods, demand increases as we decrease price, and vice versa
Applications. Demand-based pricing works well for situations where
companies have the freedom to adjust prices to market demand.
Demand-based pricing works especially well when companies can
change prices quickly based on market demand.
Advantages. Demand-based pricing represents an effective method to
maximize long-term profit. Use of demand-based pricing resulting in
vast bodies of knowledge about the subject. Furthermore, the
technique is rooted in sound economic theory, lending confidence in
Disadvantages. We must know the demand curve for the product or
service to apply demand- based pricing. To construct the demand
curve, we find out the quantity sold at different price points. Obtaining
the data for the demand curve could prove time-consuming and
Everyday Low Pricing Everyday-low-pricing sets prices consistently low to attract price-sensitive
customers and increase sales quantities. The technique avoids deep discounts
and sales promotions.
To execute an everyday-low-pricing approach, companies must achieve a
competitive advantage in low cost operations. Everyday-low-pricing works well
for consumer packaged goods with well-known brands
Advantages. Everyday low pricing tends to smooth out the demand for
products. Without everyday low pricing, companies face peaks of demand
during sales promotions. The peaks of demand strain the supply chain to keep
up, forcing manufacturing factories to work overtime. Once the promotion
ends, demand wanes. The manufacturing inefficiencies from the rapidly
varying demand can cause costs to increase.
Disadvantages. Everyday low pricing avoids deep discounts and sales
promotions to keep manufacturing costs down, contributing to lower prices.
However, many companies rely on sales promotions to boost revenues in
certain situations, such as slow sales cycles. The companies might also find
themselves responding to consumer expectations for sales promotions at
certain times, such as the end of year holiday season.
Going Rate Pricing
In going rate pricing, companies align their prices with those of competitors
and adopt a so-called market price. Companies thus charge identical, or nearly
so, prices for similar goods. For example, adjacent gas stations of different
brands often post very similar prices, often within a few pennies of each other.
Going rate pricing is also common in concentrated industries, where a few
companies dominate the market. Smaller companies believe that they must
align their prices with the leaders to survive
Advantages. Proponents of going rate pricing state that the technique “reflects
the collective wisdom of the industry" where each company applies uniform
pricing throughout the industry. Smaller companies benefit from the approach
by avoiding potential price wars that could occur if they set significantly
different prices than those of the larger firms.
Disadvantages. Problems arise in the theory behind the approach as well as
the execution. The theory of the "collective wisdom of the industry" is flawed,
because the industry could be wrong. Going rate pricing also threatens to
violate antitrust laws. For example in most countries, the antitrust low forbids
two gas station owners from meeting to set a price that both will charge.
Markup / Cost Plus Pricing
In markup / cost plus pricing, we simply add an arbitrary percentage, such as
twenty percent, to the unit cost to arrive at the final price. The technique is
popular for near-commodity products like frozen pizza because higher profit
margins could attract additional competitors, and services like building
contractors and attorneys, who add a percentage to their costs to arrive at
their billing fees.
Advantages. The markup/ cost plus pricing technique is fast and easy to
Disadvantages. The technique fails to incorporate customer demand in the
price. Perhaps customers are willing to pay much more for the product or
service than the company is charging using markup/ cost plus. Therefore, the
technique is not likely to result in the highest profit. In addition, the actual
markup percentage is arbitrary, and might not reflect the cost of capital or
In penetration pricing, companies set prices very low, lower than many of its
competitors, to attract new customers and expand market share.
Advantages. Penetration pricing can increase sales volume and market share
quickly. Once customers purchase from the company offering the lowest price,
they can be reluctant to switch to a competitor's version, even if prices begin
Disadvantages. Penetration pricing will not yield maximum profitability in the
short term, due to the low prices involved. The technique might also result in a
price war, where competitors undercut the company's low price with an even
Prestige pricing sets prices high to signal high quality or status. Prestige pricing
is also known as image pricing, perceived value pricing, or premium pricing.
Advantages. Prestige pricing's high prices can result in high revenue for the
Disadvantages. Prestige pricing demands strong brand equity and highly
differentiated products and services. Unknown or poorly regarded brands
rarely can command the high pricing premiums.
Target-return pricing calculates price to achieve a company-defined return on
investment. The technique is similar to the markup/ cost plus technique, but
substitutes the target return in place of an arbitrary percentage. Companies
selling industrial products to businesses often set prices according to the
target-return technique, like safety equipment, industrial supplies, and so on.
Advantages. Target-return pricing is quick and easy to calculate, and has been
used for many years.
Disadvantages. Similar to markup/ cost plus techniques, target-return pricing
rarely results in the highest possible profit, because it fails to incorporate
market demand. Companies with unique products or services will likely
generate higher profits by applying demand-based methods. In addition,
target-return pricing calculations are dependent on the assumptions we make
for our sales forecast.
Tiered pricing, also known as good-better-best pricing or price lining, sets
different price points for different levels of features or quality for the same
type of product or service. Customers can self-select the level most suited to
them from the three levels offered.
Advantages. Tiered pricing makes it easier for customers to select the
particular product or service that suits their needs. Many will gravitate toward
certain tiers. Tiered pricing also makes it easier for retailers to explain the
inherent value of the different tier options. By making the options clear,
customers face lower uncertainty in what they can expect.
Disadvantages. Tiered pricing for complex products and services can require
skilled retail salespeople to explain the value of the different levels.
Value-in-use pricing, also called value-based pricing, sets prices based on the
product or service’s value to the customer. We price the products or services to
make customers indifferent as to whether to use their existing products or
services, or switch to a new offering. For example, a ceramic coating
manufacturer sells its product as an alternative to house paint, guaranteeing
that its product will last twenty five years, compared to only three to five years
for traditional house paint.
Advantages. Value-in-use pricing captures the value customers place on
products and services. The technique separates the notion of price and cost.
The separation allows companies to gain profitability from products and
services that provide real value to customers.
Disadvantages. In order to execute value-in-use pricing, companies must
understand the benefits that customers realize from the product or service and
explain it to the customer in monetary terms.
The variant pricing technique sets different prices for different versions, or
variants, of products and services. Variant pricing works because different
market segments have different priorities and evaluation criteria.
For example, automobile makers sell different cars variants to different market
segments using variant pricing.
Advantages. Variant pricing allows us to capture the value different market
segments place on their particular needs. For example, some customers will
pay ten times the amount to ship a package from one location to another, just
to get it there earlier. The special variants often face little competition,
allowing great freedom in pricing.
Disadvantages. Variant pricing requires companies to understand their market
and the segments within it. Companies must conduct market research to
determine the segments interested in their products and services, and the
amounts the segments are willing to spend for the different variants.
Companies must also stock additional products and services to accommodate
the needs of those segments.
Here we summarize the pricing techniques:
Creaming Pricing : Set prices high during new product or service introduction Demand-Based Pricing : Set prices to
maximize profit, based on consumer demand
Everyday Low Pricing : Set prices consistently low to attract price-sensitive customers
Going Rate Pricing : Set prices to align with those of competitors
Markup/ Cost Plus Pricing : Set prices by adding percentage to unit cost
Penetration Pricing : Set prices low to attract new customers and expand share
Prestige Pricing : Set prices high to signal high quality or status
Target-Return Pricing : Set prices to achieve company- defined return on investment
Tiered Pricing : Set prices at different price points for different levels of features
Value-in-Use Pricing : Set prices based on product or service's value to the customer
Variant Pricing : Set different prices for different variants, for different segments
In the previous section, Lars considered various pricing techniques based on
the market and his product. Before moving forward with the technique, we
must assess how the technique will affect financial goals of the Lars Coffee
In this section, we review three popular models to assess the impact of pricing
on organizational goals.
First, we cover break-even analysis, which estimates the quantity of units we
must sell before we turn a profit.
Second, we address net present value capital budgeting, which assesses if new
proposed projects will meet organizational goals for return on investment
based on the projects’ expected revenue stream.
Third, we review internal rate of return capital budgeting, which determines
the rate of return expected on new projects.
Organizations use break-even analysis to predict the quantity we must sell
before a new product or service becomes profitable. The break-even point is
defined as the point at which revenue from a proposed new product or service
equals its costs.
We use break-even to calculate if the proposed price will meet organizational
revenue goals in certain time-periods. If the price is too low, the break-even
time will be too long, and organizations will not move forward with the project.
Advantages. The break-even model is simple to compute and is widely used.
The model can quickly indicate if a proposed price will meet, for example, a
one-year break-even objective.
Disadvantages. The break-even model makes some strong assumptions and
ignores several important factors. It assumes that sales prices are constant at
all levels of output. It also assumes that all products produced are immediately
sold. In addition, the model can only apply to a single product or single mix of
products. Projects involving radically new processes or technologies often take
longer than the common one-year threshold. Therefore, dogmatic use of the
break-even model can yield an excessive short-term focus.
Break-even Analysis Process
The chart shows the break-even analysis technique.
Fixed cost for a project is defined as all costs assigned to a project that stay constant as production volume increases.
Typical examples include insurance, property taxes, and depreciation. We make the assumption here that the production
increases stay within reasonable limits and do not require significant additional resources such as new machinery or new
Variable cost is defined as costs that vary according to volume, such as parts and materials per unit, as well as direct labor
expended per unit
Unit cost is the cost to produce each unit. The unit cost is defined as the fixed cost divided by the unit sales, or quantity of
units forecast to be sold, added to the variable cost
At the stage named “Select price to assess” we can test several prices before we find one that meets the organization’s
Finally, we calculate the break-even volume using the following formula.
In some cases, we will need to cycle through the process multiple times, each time testing new prices, until we find a price
that provides us with in an acceptable break-even.
Net Present Value Capital Budgeting Model
In this section, we address net present value capital budgeting, or NPV, which assesses if
proposed projects will meet organizational goals for return on investment, or ROl, based
on the projects’ expected revenue stream. Because the expected revenue stream is
dependent on price, the net present value capital budgeting model can be viewed as a
tool to validate price selection. Because of its versatility, net present value capital
budgeting analysis can be used to virtually any new product or service.
Different projects will have different cash flows. Cash flows are the revenues that projects
make over time, with a certain amount being made in the first year, another amount in
the second year, and so forth. We calculate revenue by multiplying price by quantity, so
price is an important component of cash flow. Capital budgeting analysis techniques
determine if the cash flows associated with a project warrant investment in it.
Advantages. The net present value capital budgeting technique is straightforward to
execute and the technique is very popular.
Disadvantages. The simplistic approaches of capital budgeting techniques ignore possible
threats and make significant assumptions. For example, the approaches do not take into
account future competitive environments. The approaches are also highly dependent on
the accuracy of cash flow calculations.
Net Present Value Capital Budgeting Model (continued)
The net present value technique assesses whether a project is
worthy of investment by calculating the sum of its cash flows
discounted to reflect the time value of money. The time value
of money is the value of money acknowledging the effects of
compounding interest over a period of time. The interest rate
here is designated as the discount rate. The discount rate is
typically the rate of return the organization could make with an
investment of equivalent risk.
Net present values greater than zero indicate that the
investment generates a greater rate of return than the discount
rate, and should therefore be pursued. NPVs less than zero
should be avoided, because the rate of return is less than the
NPV Analysis Process
The chart shows an overview of the process.
At first, we identify the required initial investment
Then we select the price we wish to test. As with the break-even technique, we might
test several prices before we find one that meets our goals.
Next, based on historical company sales, or of sales of similar units from other
companies, we forecast the number of units we expect to sell each year throughout the
After that, we multiply the price by the units we expect to sell each year to arrive at the
expected cash flow for each year. For example, if the unit price is ten euro, and we expect
to sell hundred units, then the annual cash flow would be ten euro times one hundred
units, or one thousand euro.
Finally, we calculate the net present value using the formula.
Internal Rate of Return Capital Budgeting Model
The internal rate of return model is similar to the NPV method. The internal rate of return model, or IRR, also uses a sum of
discounted cash flows to decide whether to invest in a project. In fact, the internal rate of return model uses the same
equation as that for NPV. However, instead of determining if NPV is greater than zero, we set NPV to zero and solve for the
Like with the NPV capital budgeting method, companies can apply the internal rate of return model to test the financial
feasibility of new product and services, or enhancements to existing ones, based on our price we wish to test.
In the model the resulting interest rate is called the internal rate of return. The internal rate of return is compared to the
company’s cost of capital, sometimes called the hurdle rate. The hurdle rate is defined by the company, and is often equal
to the interest rate of the companies’ loans.
If the internal rate of return is greater than the hurdle rate, the project is financially justified. If not, then the company
should not move forward with the project
Advantages. The principal advantage of the internal rate of return method over the net present value approach is the
calculation of the actual rate of return in the IRR method. The NPV approach only returns a go/no-go decision.
Disadvantages. In addition to the disadvantages of the NPV model, the internal rate of return approach is a bit more
difficult to calculate. Although, spreadsheet tools can make the process easier.
IRR Analysis Process
The chart shows an overview of the process.
We start by estimating the initial investment required to launch
the project, just as we did with the net present value capital
Next, we select a price we wish to test.
Then, we examine the sales history for previous similar
products, as well as that of relevant competitive products in the
marketplace, to forecast the quantity of units we expect to sell
After that, we multiply the price we wish to assess by the
quantity of units we expect to sell to obtain the expected cash
flow for each year.
Finally, to calculate the internal rate of return, we apply the net
present value equation. We set NPV to zero and solve for the
internal rate of return.
We can incorporate consumer demand into our pricing
approach to increase product and service profitability.
Economics tells us that consumers generally purchase less of a
product or service when we charge more for it. Exceptions
exist. Some products, such as luxury electronics, jewelry, and
perfumes, can show the opposite behavior.
The price elasticity of a product or service is the rate at which the percentage of the change in quantity demanded varies
with respect to the percentage change in price.
Because consumers generally purchase fewer goods and services as prices increase, elasticity is often a negative number.
Nevertheless, we customarily express elasticity as a positive amount for convenience (i.e., we express it as the absolute
value of the negative amount). Elastic demand situations are situations where the elasticity is greater than 1. In elastic
demand, the quantity demanded depends a great deal on the price in the short term.
For example, consumers tend to purchase more non-perishable consumer packaged goods, such as frozen vegetables at
lower prices than they do at higher prices. They feel they can "stock up" at the lower prices in the short term. In the long
term, they do not continue to buy because there is a limit to the amount of frozen vegetables they want to own, even at
very low prices.
If elasticity is less than 1 then the demand is called inelastic. In inelastic demand, the quantity demanded depends little
on the price in the short term.
For example, consumers tend to purchase about the same quantity of gasoline regardless of price in the short term.
Consumers feel they have little choice because they need the gasoline to commute to work or perform other required
tasks. We use caution by saying "in the short term” to recognize long-term changes in behavior. For example, consumers
can purchase fuel-efficient cars or start commuting to work on gas-sipping motorcycles in the long term.
Gather the Demand Data
We can gather the demand data using three different approaches.
Surveys. We can conduct market surveys, asking customers how
many units they would purchase at certain prices. We will need to
specify the buying motivation to ensure we gather relevant data.
Analysis. We can statistically analyze past sales data to determine
how demand changed as we changed prices. For example, a
company can examine how the quantity demanded changes during
sales promotions launched in the past
Experiments. We can conduct market experiments. In the
experiments, we nudge prices up and down and observe the
results. For example, we can track how sales vary in relation to
discounts and price hikes.
We define the optimal price as the price yielding maximum profit. Once we know a product or service's
demand curve, we can find its optimal price. We discuss optimal pricing by examining the impact the demand
curve has on the optimal price.
For each point on the demand curve, we can calculate the resulting revenue and cost. Once we know revenue
and cost, we can calculate profits ! Profit is equal revenue subtracted cost.
We sometimes face situations where different types of
people place different values on our products and services.
We can apply price discrimination to capture the extra
value some segments find in our offerings.
Unlike the variant pricing technique, which charges
different prices for different variants tailored to each
segment, price discrimination charges different prices for
Here are examples of price discriminations.
Channel Pricing. Companies can vary prices by distribution
channel. For example, we can charge two euro for a bag of
chips at a supermarket, and charge four euro for the same
bag at convenience store next door. In channel pricing, we
target the value some customers place on convenience.
Demographic Pricing. Organizations can vary prices by
demographic attributes of individuals. For example, ski
resorts offer lower prices to senior citizens to encourage
that demographic group to enjoy their facilities.
Geographic Pricing. Companies can vary prices by location
or geography. For example, baseball stadiums charge
increased prices for seats near home plate. Automobile
manufacturers offer the same vehicles at different net
prices, based on the state where customers purchase the
vehicle, due to different state tax rates.
Occupational Pricing. Organizations can vary prices
according to customer occupations. For example, clothing
retailers offer employee discounts as a benefit to
Quantity Pricing and Two-Part Pricing. Companies can vary
prices according to the quantity customers purchase. For
example, fast food restaurant McDonalds applies quantity
pricing encouraging customers to "supersize” their orders,
for a lower price per amount of food. Cellular phone
providers employ two-part pricing, charging a fixed rate per
month for basic service, and then a per-minute rate for
Temporal Pricing. Companies offer different prices
depending the time the product or service is offered. For
example, some museums offer free admission once per
month, such as the first Tuesday. Companies manufacturing
seasonal items, such as snow-blowers, reduce prices during
the off-season to stimulate sales.
Price discrimination advantages. Price discrimination
matches the prices of products and services with the
perceived value of customers, which is the intent of
efficient pricing methods. In economic terms, we would
describe this situation as "extracting the full buyer surplus."
Price discrimination benefits customers, in that they receive
the value they sought. Price discrimination benefits
companies in that it increases profits.
Price discrimination Disadvantages:
There are number of it!
Reservation Prices. Organizations can find difficulty in
discovering buyers’ reservation prices. The reservation
price is the maximum price customers will pay. Without
knowing how different people value the product or service,
we cannot assign the appropriate price.
Arbitrage. When companies sell the same product at
different prices, some enterprising individuals will seek to
profit by buying the product at the lowest price and re-
selling it at a higher price, known as arbitrage.
Legalities. In most countries, antitrust laws prohibit
charging different prices to different customers with the
Intent to harm competitors. For example, a company
cannot charge different prices to two or more purchasers
within a reasonably close time period where the practice
could harm competitors.
Ethical. Legalities aside, some individuals consider the
practice of price discrimination unfair, because it treats
different people differently. Customers may complain about
paying the full rate when certain classes of individuals enjoy
a lower rate.
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