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The role of costs in Value Based Pricing

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johan plettinckx

on 12 March 2013

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Transcript of The role of costs in Value Based Pricing

Is Value Based Pricing always the best
pricing strategy? What are relevant costs for pricing decisions? How to perform a break-even sales analysis? The role of costs in Value Based Pricing Pricing Strategies to create profit in Business markets Cost
based pricing Competition based pricing Customer value
based pricing 44% 37% 17% also known as:
price leadership / price followers
predatory pricing
penetration pricing
price skimming
sealed bid pricing bpost examples:
b2b bpack
International mail & parcels
public bids strengths:
simple - no pricing knowledge required
satisfies market share goal
provides 'feel good' sense of beating the market limitations:
no focus on costs / customer value
can lead to price wars
requires access to accurate competitive pricing info also known as:
cost plus method
target ROI pricing
target CM pricing
break-even pricing bpost examples:
Daily Mail
VAS factory
Distripost strengths:
relatively simple - limited pricing knowledge required
comfort about reasonable and fair margins
relies on readily available data limitations:
ignores info on customers and competitors
internally driven and static in nature
dependency on costing info
circular argument in case of full costing approach also known as:
EVE (economic value estimation)
perceived value
willingness to pay
bpost examples:
solutions strengths:
promotes benefits and performance features
improves profitability
value sharing limitations:
requires critical resources and capabilities
requires organizational transformation
insight needed in customers perception of value competition based pricing competition based pricing cost based pricing cost based pricing customer value based pricing customer value based pricing Apple ipod / iphone / ipad

high price for early adopters (low price sensitive)
product differentiation to attract price sensitive segment
perceived value still high but competitive pressure rises
frequent releases, extra features
smaller market share but profitable margin Pricing over the product life cycle competition cost customer value The ideal pricing strategy is based on customer value without ignoring costs & competition 140.000€ 70.000€ 70.000€ 40.000€ 20.000€ 20.000€ # 10.000
A - brand
20€ # 10.000
white label
12€ 30.000€ 20.000€ 40.000€ 30.000€ total cost
A - brand total cost
white label 140.000€ 160.000€ Revenue = 320.000€
A - brand 200.000€
white label 120.000€ total costs
300.000€ white label
margin analysis fixed & indirect variable & indirect fixed & direct variable & direct fixed <--> variable direct <--> indirect elasticity = 1.1 What are relevant costs for pricing decisions? avoidable costs What are relevant costs for pricing decisions? incremental costs change in volume impacts
labor time labor costs (overtime !)
raw materials
capacity fixed assets (machines) can be incremental as opposed to sunk costs (eg R&D)
the resale price of a machine
replacement cost of inventory
cost of a product manager for a stopped product line competing product (Distripost vs BD)
substitute (Admin vs digital)
existing internal processes (solutions)

Don't assume but study customer economics Reference Value
= the price of the next best competitive alternative revenue drivers (DM moment)
cost drivers (C&S saves time)
psychological value drivers (bpost brand)

Don't assume + Focus on what matters the most for your customers. Differentiation Value
= the extra benefit on top of the reference value Value estimation
reference value + differentiation value = total economic value
Value communication
document customer value (see above)
demonstrate customer value, e.g. via "value word equations"
Value capturing
share value with your customer How to make a customer value proposition? illustrate the differences with the next best alternative in words and simple mathematical operators

extra contribution generated =
{# folders * customer visits * average sales * gross margin}
- {same formula} Value Word Equations THEM WE extra contribution generated =
{# folders * customer visits * customers buying * average sales * gross margin}
- {same formula} extra contribution generated =
{10.000 * 10% * 50% * 100€ * 20%}
- {10.000 * 7% * 50% * 100€ * 20%} = 3.000€

WE generate 3.000€ extra contribution compared to reference value of next best alternative relevant costs for pricing decisions next chapter legal constraints Pricing based on economic value estimation 10.000 D2D folders (unaddressed) to promote a store opening
10% comes to store
50% buys for an average value of 100€ --> rev = 50.000€
gross margin of 20% --> total gross margin = 10.000€

economic value = 1€ per folder
share value --> price set at 0,80€ per folder Deal closed ??? Pricing based on economic value estimation Pricing based on economic value estimation reference value THEM = 10.000 folders * 0,30€ = 3.000€
differentiated value WE = 150 extra buyers * 20€ = 3.000€
total economic value WE = 6.000€
maximum sales price = 0,60€ What to do? Stop with white label? Circular argument in case of full costing approach ROI = return on investment
CM = contribution margin = costs that change when prices change price increase lower volume
price decrease higher volume = future costs of a sale What we all know When prices volumes When prices volumes exception = inelastic demand
(gasoline, water, life saving drug) What we often don't know How much would the sales volume have to increase to profit from a price reduction? How much could the sales volume decline before a price increase becomes unprofitable? To know if a price change is profitable, we need to know the CM (contribution margin) q ≥ - p CM + p (break-even sales analysis) Size matters ! q ≥ - p CM + p Low CM (20%)
price cut (-10%)
required volume increase (+100%) High CM (80%)
price cut (-10%)
required volume increase (+14%) Non symmetrical q ≥ - p CM + p price cut (-10%)
low CM (20%)
required volume increase (+100%) price increase (+10%)
low CM (20%)
allowable volume decrease (-33%) Why are incremental & avoidable costs important for pricing decisions? Once the incremental & avoidable costs are covered, the remaining share of the price adds to profit.
It is called the contribution margin (CM).

CM = price - (incremental & avoidable) cost Are non incremental & sunk costs never important for pricing decisions? All costs have to be covered to earn profits.

Every cost is incremental & avoidable at some time.

Fixed costs are only important for pricing when considering to start / to stop a product line. The European Commission and Belgian regulatory authorities impose that bpost sets its prices such that they are compliant with the rules and regulations concerning:
abuse of dominant position
state aid
postal regulatory framework The type of costing test depends on
the regulatory qualification (commercial service, universal service, public service)
the market position of the product in question (dominance or not on the relevant product and geographic market). legal constraints The cost-price tests are the following:
LRAIC test (under abuse of dominance rules)
Chronopost test (under State aid rules)
Private investor test (under State aid rules)
Cost-orientation test (under postal regulatory framework) 140.000€ 40.000€ 30.000€ 40.000€ 20.000€ Elasticity and Profit sensitivity to Price Pricing Lunch 11/06/2013
Dany De Souter Questions?
Thank you.
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